Challenges of China's economic system for economic theory, by Gregory C. Chow 1997 American Economic Review
Compared with the western world, China seems to be another world. In his paper (AER, 1997, 124 citations), the most eminent Chinese American economist Gregory Chow summarized four types of differences: private versus public ownership of assets, Western legal system versus Eastern semiformal legal system, individualism versus the collective good, and multiparty versus one-party political systems.
Does state ownership or collective ownership (owned by township or villages) predicts worse performance? Not necessarily. The successful experience in China challenges the dogma that only private enterprises can be efficient. As questioned by Milton Friedman, the statement that “most assets in China are publicly owned” is misleading. Though the asset such as land is publicly owned, the enterprise using the land is privately owned. The manager of the enterprise and the land is connected through “leases”, or known as “responsibility system”. Similarly, the government can lease a state enterprise to a manager. The positive relation between profits of the enterprise and the economic benefits of the management and workers provides enough incentives. Providing incentives for the management of publicly owned assets is a key to China’s success.
It is said that China is ruled by people and not by law. The legal system, which might be called “semi-legal system", is truly different from the Western legal system. Under Chinese law, a contract is enforced partly by an informal social relationship known as guanxi. Guanxi plays an important role in insuring that a contract is honored. Chow mentioned that a State Department official having had dealings with the Chinese once remarked to him that “After signing a contract, the Chinese often regard the provisions in the contract as a starting point for further negotiations”. But this does not necessarily imply that the Chinese system is bad. Law has been practiced in China for more than four thousands of years. At least the system is not so bad that it hindered the rapid economic growth that has taken place since 1978.
Developing guanxi is like having knowledge of which friend would be helpful when needed. We could think it as one way of human capital accumulation, just like getting a college degree or promoting a brand name. Having a reputation is similar to what conveyed by a college degree, and having a good credit rating. Social pressure acts like the legal enforcement for informal relationship.
Economically speaking, given an objective function, there is some optimum degree for enforcing contracts to balance the costs and benefits. The relative ratio of formal to informal enforcement could also be optimized. The high cost of enforcement under the American legal system suggests that perhaps there is some advantage in enforcement partly by an informal network. Not all contingencies can be anticipated and written down explicitly. When disputes arise in the future, informal relations might settle the issue in a better way than legal enforcement. In his paper, Chow discussed the cases of intellectual property rights, abortion, birth control, suicide and death penalty.
Individualism is an ideal in a Western market economy, as expounded by Hayek (1949). This ideal is not generally accepted in Asian countries, where the common good is often considered to be more important than individual rights. The society is more than a collection of individuals. Hence the welfare of the society is more than the sum of the welfares of its individual members. Three questions are important in welfare economics. First, how is a welfare function defined for an individual citizen or family, for a collection of citizens, and for a political organization? Second, how are these different welfare functions formed? Third, how do these different welfare functions affect the economic outcome? Government provision of a public good, such as education, should take account of the common good, not simply of the private needs of individual citizens. When collectivism is emphasized, the education levels of other citizens and perhaps some aggregates of these levels also enter the welfare function of each citizen. The welfare function of the government may depend not only on the individual welfare functions, but on some measure of collective education.
What is the relationship between a multiparty political system and a market economy? The answer is not simple. A one-party political system is consistent with a market economy, as evident from mainland China, Taiwan (until 1996), South Korea, Singapore and Japan (1958-1994). Democracy in the sense of a government of the people, for the people and by the people, is not in contradiction with one party political system per se.
The four differences are linked to each other. Informal networks could solve the ex post allocation of power and explain township or village enterprises’ advantage. Public ownership has the intrinsic incentive problem stem from the separation of ownership and management. Local government’s power to enforce contracts and the reputation of public institutions provide credit for fund raising. Welfare functions under collectivism might seem unnatural. But in a society emphasizing the common good, government leadership is strong, like one party political system, and in turn formalized welfare functions with common good as a component.
Does state ownership or collective ownership (owned by township or villages) predicts worse performance? Not necessarily. The successful experience in China challenges the dogma that only private enterprises can be efficient. As questioned by Milton Friedman, the statement that “most assets in China are publicly owned” is misleading. Though the asset such as land is publicly owned, the enterprise using the land is privately owned. The manager of the enterprise and the land is connected through “leases”, or known as “responsibility system”. Similarly, the government can lease a state enterprise to a manager. The positive relation between profits of the enterprise and the economic benefits of the management and workers provides enough incentives. Providing incentives for the management of publicly owned assets is a key to China’s success.
It is said that China is ruled by people and not by law. The legal system, which might be called “semi-legal system", is truly different from the Western legal system. Under Chinese law, a contract is enforced partly by an informal social relationship known as guanxi. Guanxi plays an important role in insuring that a contract is honored. Chow mentioned that a State Department official having had dealings with the Chinese once remarked to him that “After signing a contract, the Chinese often regard the provisions in the contract as a starting point for further negotiations”. But this does not necessarily imply that the Chinese system is bad. Law has been practiced in China for more than four thousands of years. At least the system is not so bad that it hindered the rapid economic growth that has taken place since 1978.
Developing guanxi is like having knowledge of which friend would be helpful when needed. We could think it as one way of human capital accumulation, just like getting a college degree or promoting a brand name. Having a reputation is similar to what conveyed by a college degree, and having a good credit rating. Social pressure acts like the legal enforcement for informal relationship.
Economically speaking, given an objective function, there is some optimum degree for enforcing contracts to balance the costs and benefits. The relative ratio of formal to informal enforcement could also be optimized. The high cost of enforcement under the American legal system suggests that perhaps there is some advantage in enforcement partly by an informal network. Not all contingencies can be anticipated and written down explicitly. When disputes arise in the future, informal relations might settle the issue in a better way than legal enforcement. In his paper, Chow discussed the cases of intellectual property rights, abortion, birth control, suicide and death penalty.
Individualism is an ideal in a Western market economy, as expounded by Hayek (1949). This ideal is not generally accepted in Asian countries, where the common good is often considered to be more important than individual rights. The society is more than a collection of individuals. Hence the welfare of the society is more than the sum of the welfares of its individual members. Three questions are important in welfare economics. First, how is a welfare function defined for an individual citizen or family, for a collection of citizens, and for a political organization? Second, how are these different welfare functions formed? Third, how do these different welfare functions affect the economic outcome? Government provision of a public good, such as education, should take account of the common good, not simply of the private needs of individual citizens. When collectivism is emphasized, the education levels of other citizens and perhaps some aggregates of these levels also enter the welfare function of each citizen. The welfare function of the government may depend not only on the individual welfare functions, but on some measure of collective education.
What is the relationship between a multiparty political system and a market economy? The answer is not simple. A one-party political system is consistent with a market economy, as evident from mainland China, Taiwan (until 1996), South Korea, Singapore and Japan (1958-1994). Democracy in the sense of a government of the people, for the people and by the people, is not in contradiction with one party political system per se.
The four differences are linked to each other. Informal networks could solve the ex post allocation of power and explain township or village enterprises’ advantage. Public ownership has the intrinsic incentive problem stem from the separation of ownership and management. Local government’s power to enforce contracts and the reputation of public institutions provide credit for fund raising. Welfare functions under collectivism might seem unnatural. But in a society emphasizing the common good, government leadership is strong, like one party political system, and in turn formalized welfare functions with common good as a component.
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