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Thursday, June 1, 2006

Institutions and Development: The Case of China

James Dorn ([email protected]) is a China specialist and vice president for academic affairs at the Cato Institute. He is coeditor of China’s Future: Constructive Partner or Emerging Threat? (Cato Institute, 2000).

An earlier version of this article appeared in Vital Speeches of the Day (November 15, 2005).

From a liberal perspective the goal of economic development is not simply to maximize output but, rather, to increase freedom of choice. As Peter (Lord) Bauer wrote in Economic Analysis and Policy in Underdeveloped Countries, “I regard the extension of the range of choice, that is, an increase in the range of effective alternatives open to people, as the principal objective and criterion of economic development.” Those countries that have liberalized trade—such as China and South Korea—have expanded individual choices and outperformed those that have clung to protectionism—such as Cuba and North Korea.

When considering how individuals and nations move from poverty to prosperity, one needs to emphasize that natural constraints (scarcity of resources) can be overcome if artificial constraints (such as trade restrictions) don’t impede development. This idea is consistent with Hong Kong Chief Executive Donald Tsang’s call for adherence to the principle of “small government, big market.”

There is a saying in China: “If no artificial constraints, then there is nothing you cannot do.” Nonintervention (wu wei) results in spontaneous order (zi fa) if government is limited to the protection of persons and property. In the fourth century B.C., long before Adam Smith, the great Chinese philosopher Lao Tzu held that when the ruler takes “no action,” “the people of themselves . . . become prosperous.”

Wu wei does not imply “the complete absence of all activity, but only of such as is forced, artificial, and unspontaneous,” according to Derk Bodde, the translator of Fung Yu-lan’s classic A History of Chinese Philosophy.

The Taoists saw a good government as one consistent with nonintervention so people could improve their welfare. Thus in the Chuang-tzu, we read: “Where knowledge and plans are not utilized, one must fall back upon the natural. This is perfect peace, the acme of good government.”

In the Han Fei Tzu (Han Fei was a legalist who died in 233 B.C.), one sees a clear understanding of the importance of free trade for creating harmony and prosperity:

When a man sells his services as a farm hand, the master will give him good food at the expense of his own family, and pay him money and cloth. This is not because he loves the farm hand, but he says, “In this way, his ploughing of the ground will go deeper and his sowing of seeds will be more active.” The farm hand, on the other hand, exerts all his strength and works busily at tilling and weeding. He exerts all his skill cultivating the fields. This is not because he loves his master, but he says: “In this way I shall have good soup, and money and cloth will come easily.” Thus he expends his strength as if between them there were a bond of love such as that of father and son. Yet their hearts are centered on utility, and they both harbor the idea of serving themselves. Therefore in the conduct of human affairs, if one has a mind to do benefit, it will be easy to remain harmonious, even with a native of Yüeh [a barbarian state]. But if one has a mind to do harm, even father and son will become separated and feel enmity toward one another.

This passage was written more than 2,000 years before The Wealth of Nations!

In 1987 China’s paramount leader and reformer Deng Xiaoping recognized the principle of spontaneous order when he said: “Our greatest success—and it is one we had by no means anticipated—has been the emergence of a large number of enterprises run by villages and townships. They were like a new force that just came into being spontaneously.”

Kate Xiao Zhou, in her 1996 book How the Farmers Changed China, describes the demise of China’s collective farms and the creation of the household-responsibility system (baochan daohu), with its township and village enterprises (TVEs), as “a spontaneous, unorganized, leaderless, nonideological, apolitical movement.”

China began to unilaterally liberalize foreign trade well before joining the World Trade Organization in December 2001. The first four special economic zones (SEZs) were created in 1980, and since then the coastal provinces (such as Guangdong, Zhejiang, and Fujian) have become highly “marketized.” The nonstate sector, including private firms, now overshadows the state sector.

Nicholas Lardy, a China specialist at the Institute for International Economics, has pointed out that in 1978 only 12 large state-owned enterprises (SOEs) were authorized to conduct foreign trade. However, by 2001 there were 35,000 domestic firms engaged in international trade, including private enterprises, and more than 150,000 foreign-funded enterprises. Today any registered firm can engage in foreign trade. Moreover, China reduced the average tariff rate from 55.6 percent in 1982 to 15.3 percent at the beginning of 2001. The average tariff on manufactured goods is now less than 9 percent. As a result of this dramatic liberalization, China is now one of the world’s most open economies.

China’s approach to development has been primarily “bottom-up,” or experimental. Typically, local leaders would permit reform on a trial basis and not penalize entrepreneurs who were experimenting on their own. When successful, politicians would take credit and let the experiment spread. At some point Beijing would sanction the reforms.

Piecemeal reform has led to numerous ownership forms, including cooperative shareholding, foreign-funded enterprises, private firms, and TVEs. Economists Gary Jefferson and Thomas Rawski call this process “induced privatization.” Under it the state sector has shrunk from a dominant position in 1978 to less than one-third of industrial output value today.

Property Far from Secure

By letting the nonstate sector grow, China has avoided the difficult political decision of outright privatization of large SOEs. Private firms were not legal until 1988, and in 2004 the PRC constitution was amended to give greater protection to the growing private sector. Private property rights, however, are still far from secure, and corruption is rampant. So while economic liberalization has progressed, and China has become the world’s third-largest trading nation, the Chinese Communist Party (CCP) retains its monopoly on power.

Nevertheless, China’s opening to the outside world has increased personal freedom and prosperity, and has led to a demand for safeguarding private property rights. Jianying Zha, in her fascinating book China Pop, writes, “The economic reforms have created new opportunities, new dreams, and to some extent, a new atmosphere and new mindsets. . . . There is a growing sense of increased space for personal freedom.”

Kathy Chen of the Wall Street Journal notes that the development model adopted by the newly emerging urban centers, such as Shishi in Fujian, is “small government, big society” (xiao zhen fu, da she hui).

When the National People’s Congress amended the constitution to make “legally acquired private property inviolable,” that was a clear signal the market was here to stay—and a far cry from Mao Zedong’s admonition to “strike hard against the slightest sign of private ownership.”  

There is no doubt that globalization and the information revolution have increased personal freedom in China. More than 100 million Chinese have access to the Internet. 

And I am sure that computer whiz-kids will stay one step ahead of government censors. Moreover, if Shanghai is to become a world-class financial center, there will have to be a freer flow of information and open capital markets.

President Hu Jintao has recently indicated his adherence to a policy of “peaceful development,” which is precisely the policy that China has been following since 1978. The United States would be wise to continue a policy of engagement and avoid destructive protectionism. Foreign-funded enterprises and private firms account for more than 60 percent of China’s foreign-trade sector. U.S. protectionism would harm the very sector that is working to decrease poverty, increase exposure to the West, and pressure the CCP to accept change.  

Institutional reform (especially trade liberalization) has substantially reduced poverty in China—real per capita income has increased nearly fivefold since 1978, with significantly larger increases in the highly marketized coastal areas. But there has been little increase in political freedom. Further economic liberalization—especially privatization of large SOEs and capital freedom—is constrained by political issues. Whether reformers in the CCP will gain the upper hand remains to be seen.

An array of government interventions continues to restrict economic and personal freedom, and, hence, China’s future development. Artificial constraints include capital and exchange controls, state-owned banks and enterprises, interest-rate controls, and especially the lack of a transparent legal structure that protects persons and property.

“Free Private Markets”

In 1988, at the Cato Institute’s historic conference in Shanghai, Milton Friedman called for China to abandon its socialist market economy and make the transition to a full-fledged system of “free private markets.” Progress has been made since that time, as markets not planners determine most prices. There is private housing and private enterprise, but China is still plagued by widespread state ownership and control, especially in the financial sector. Without capital freedom, investment alternatives will be limited and investment decisions will continue to be politicized.

Privatization is the only way to rid the system of corruption. But as long as the CCP gains from the present socialist market system, change will proceed slowly, if at all. Economic reform eventually will require political reform. The question is whether the gradual increase in economic freedom will be sufficient to bring about political change that supports, rather than retards, further liberalization.

We should not forget that trade expands choice and, therefore, should be promoted as a fundamental human right. U.S. protectionism would be self-defeating and strengthen Chinese nationalism and anti-American sentiments. Engagement is the only rational policy to promote peace and prosperity.

  • James A. Dorn is vice president for monetary studies, editor of the Cato Journal, senior fellow, and director of Cato’s annual monetary conference.