How China Became Capitalist

Today, I will talk about how China became capitalist. This is still an ongoing process; recent developments in China give us more confidence in the arguments. China's transformation has been ongoing for decades now and is a multi-level and multi-aspect process. The nation has moved from a centralized to a market economy. I would like to emphasize one aspect for discussion: the role played by the government in China's market transformation. On that dimension, there are many controversies, and it is not very well understood.

It is very common in the United States that when people talk about the Chinese market transformation, the assumption is that China became capitalist because of Deng Xiaoping or because of the Chinese Communist Party (CCP). The idea is that Beijing somehow led China from socialism to capitalism. This basic assumption is seen in both popular media and academic writings.

There are many reasons behind that idea, and there is a certain truth in it. China and Vietnam are the only transition countries in which the communist party is still in power. In Russia, for example, the communist party disappeared. The party in China has not only survived but also has become bigger and stronger along with the market reform. In the Chinese economy today, many sectors are still controlled by the state--banking, energy, transportation, etc. The state monopoly is still quite significant. Those facts can lead people to easily believe that the CCP is responsible for what occurred in China.

Also, when we compare China with Japan or the United States, it is easy to see that state intervention is much stronger in China than in other leading economies. Cross-country comparison has led many people to believe that the state is the major factor behind China's economic transition. But that is misleading.

We propose that we need to take a historical perspective, looking at exactly what the CCP has done in China's transition to the market. We take two points in time: before and after reform. Before the reform, every aspect of the Chinese economy, from production to consumption, was controlled by the state. After three or four decades of reform, today it is a market-driven economy. The private sector contributes more to the economy than the state sector. That process took place because the state has gradually withdrawn itself from the economy. If we look at the role played by the state historically in market reform and so on, we get a very different view. The state has undeniably and greatly withdrawn itself. We argue that this is the precondition for market reform in China.

Next, we look at a brief history of Chinese reform from the beginning to early 2010, to see exactly what the Chinese government has done. The Chinese reform actually started with a government-led reform. At that time, Chairman Mao Zedong died in 1976, and his appointed successor was Hua Guofeng who started a reform package in 1977. Hua was appointed by Mao and was very loyal politically to Mao, but he was an economic modernizer, realizing the Chinese economy was in dire need of change. His reform was a program of the state, by the state, and for the state, as the policy was to strengthen the state enterprises basically by building up new manufacturing facilities, particularly in biochemical, energy, ports, and steel. However, it didn't last long, about one year or so. The program faced mounting difficulties. In the political domain at the end of 1978, China had a CCP meeting and Deng Xiaoping and Chen Yun came back to power, and Hua was no longer in charge. Hua's economic program was quickly ended, and a new program started up in its place. This time, the policy focus was to reform state-owned enterprises. That was the main concern of the Chinese government at the beginning of the reform.

But it was not those sorts of policies imposed by the Chinese government that transformed China. What happened instead were so-called marginal revolutions. This kind of reform is started by peasants, workers, and/or local officials, not by the leaders in Beijing. The first reform that really changed the landscape of the Chinese economy was rural reform, the rise of private farming. Private farming at that time was illegal. But it is what transformed Chinese agriculture, started by Chinese peasants, not the government. There was a reform led by Beijing in agriculture, but that concerned subsidies to farmers. We know today that, instead, it was private farming that transformed Chinese agriculture.

The township and village enterprises, the most powerful engine of growth in the Chinese economy in the first two decades of reform, were inventions of Chinese peasants as well. In the beginning, state enterprises did not take them seriously because they used outdated technology, employed poorly educated workers, and supplied low-quality products. However, in a few years, these private enterprises went on to quickly outperform state-owned enterprises.

In Chinese cities, the private sectors emerged right after the death of Mao because Chinese state enterprises at that time were unable to solve the problem of unemployment. The growth of the city residents--as youths came back to the cities after Mao died and were unable to find jobs in the state sector--forced the government to allow self-employment. This was the start of the private sector in Chinese cities.

The last marginal revolution is the special economic zones. The special economic zone was first proposed in Guangdong province to speed up economic development. Beijing approved it as an experiment because it did not know how to develop the economy either. The success of Shenzhen was a surprise to everyone--to the Chinese government and outside world as well. It brought modern technology and foreign capital to China. But for a long time, Beijing viewed special economic zones as a dangerous experiment. Chinese people outside the special economic zones were not allowed to enter unless they obtained special permits. At the very beginning, Shanghai also wanted to be considered as a special economic zone, but its proposal was denied by Beijing; Shanghai was too important a city to try such a risky experiment. By 1984, however, the success of special economic zones convinced the Chinese leaders to open up 14 more cities to foreign investment. Later, all provincial capital cities were allowed to compete for foreign investment.

On the other hand, the Chinese government has designed a series of economic programs, and it is still doing so today. The intent behind the Beijing reforms was to revive socialism. The Chinese government was clear throughout the whole process of the reform on this. In contrast, peasants, workers, and local officials who launched marginal revolutions were not motivated by any ideology. They simply wanted to have a better life, and at least to be free of starvation. At the beginning, most of these marginal revolutions were regarded as illegal. However, they ultimately transformed China.

In the book How China Became Capitalist, we emphasized the presence of two reforms, one led by Beijing and the other being marginal revolutions. We also argued that it was marginal revolutions that transformed China from socialism to a market economy. At the same time, we gave due credit to the Chinese government. In the past four decades of reform, the CCP was very flexible and adopted itself to changes in the economy. China has not yet embraced capitalism as a term even though in practice it is a market-driven economy. It still regards itself as a socialist country. But socialism itself is understood in a quite different way than how it was understood at the beginning of the reform. Before reform, socialism was associated with state ownership and central planning, in contrast to a market economy identified with private ownership and markets. Gradually, the CCP changed its interpretation of socialism. By 1985, the Chinese government gave up on central planning as an essential feature. Socialism then started to welcome markets. And by the late 1990s, China started to privatize the state enterprises, so it became possible to have socialism without state ownership. At the same time, the lingering impact of ideology is still discernible in China today. For example, reform of state-owned enterprises is still regarded as a political problem, because certain people within the Chinese government still take collective ownership as indispensable for socialism.

The current Chinese leadership under Xi Jinping and Li Keqian continues to show strong adaptability. In November 2013, at the Third Plenum of the 18th Party Congress the Chinese government committed itself to further market reform, promising to make the market a "decisive" force in the economy. This was because the Chinese leaders realized that the state was still too much involved in the economy. However, how to make the market play a "decisive role" is not an easy job. The market requires a lot of supporting institutions to make it work, including the rule of law, an open and competitive banking system, monetary stability, a free market for ideas, and so on. Unless these and many other institutions are in good standing, the market will not be able to function well.

Many around the world see the Chinese government as the main force behind the rise of the Chinese economy. I think this has to do with underdevelopment of economics for understanding the proper role of the government in a market economy.

In a market economy, why do we need a government at all? Economists in general say that in a market economy, a state is needed only when the market fails. This is the market failure theory of the state, which is the mainstream theory in economics. It is a normative theory in that it tells the state what it should do. There is another school of thought called the public choice school. This school does not ask what the state should do but looks at what the state has actually done in the economy. This school's empirical conclusion was that state regulation does not work. The first theory opens the door wide to government intervention in the market economy, calling for government provision of various goods and services, from education to roads and from electricity to postal service; the second theory, however, challenges the efficacy of the state. Neither provides an informative theory of the state.

Some basic elements of such a theory do exist. Let's go back to the basic ideas of John Locke, who made the state responsible for the protection of property rights. In hunting-gathering societies, with little private property, there is no need for the state. When the economy grows to a certain level, there emerge many property rights in the system, and that is when a state is needed. The reason we have misunderstood the economic role of the state is that we do not have a good theory informing us of what the state should do and can do in the economy. Locke's basic ideas were picked up and elaborated by Smith and others. What exactly should the state do to protect private property? Clearly, what the state should do varies depending on what kind of economy it finds itself in. But the principle should be clear: the criterion to judge state action is to see whether it protects or undermines private property. Following this principle, it is clear that the state should protect economic freedom, peace and order, free trade and open competitive market, and encourage innovation. All contribute to the protection of private property.

Let me take this opportunity to say a few words about liberty or freedom, which is commonly misunderstood, particularly in China. The Chinese translation of freedom, which I think is borrowed from Japan, literally means free of constraint, free to follow one's heart. This, however, is a gross misunderstanding of freedom as understood in classical liberalism. To quote Lord Acton, "Liberty is not the power of doing what we like, but the right to do what we ought." Freedom thus understood goes hand in hand with the rule of law, personal responsibilities, and limited government.

During the past four decades of reform, there has occurred a big change in the role of the state in the economy. The Chinese state has moved from an omnipresent government to a limited one. It has also changed from a dictator of the economy to a facilitator. The international dimension of this change is also noteworthy: China has transformed itself from an exporter of radical ideology during Mao's time to a promoter of free trade. All of these changes are praiseworthy. In the years to come, China should move faster along these lines.

China's economic reform is an ongoing process with an unfinished agenda. The first item on the agenda is the rule of law. To keep the government's power limited, we need the rule of law. The Chinese government, at least on paper, has embraced the rule of law. Xi Jinping of late has repeatedly emphasized that the Party has to abide by the rule of law. But to translate words into practice, there is still a long way to go. Next is market order. The presence of state enterprises undermines market order. Then, the weakest link in the Chinese economy is the financial system. The major banks are state-owned and unwilling to give up their monopoly. Last but not the least is the market for ideas. After almost four decades of reform, China has developed a competitive market for all kinds of consumer goods. The market for goods and services is really open for foreign and domestic producers. But regarding the market for ideas, the place where people exchange their ideas, that system is still very much controlled by the state. From the creation to consumption of ideas, Chinese universities, schools and textbooks, to media, television, and newspapers, all are controlled by the state. If China wants to become a fully-developed market economy, it has to open the market of ideas.

Who were actually the drivers of the Chinese economy? As an economist working on the Chinese economy for several years, I fully agree with Dr. Wang that grassroots people led the reform. The party just followed and enjoyed the fruits of the market development. This is a very important mechanism. The party itself fully understands the situation.

The point is how to think about the functions of the state. Private farming people violated the law of the government--a very important incident. But actually looking more precisely at the history of what followed later, peasants may have been brave, yet they were still very hesitant to invest more or just engaged in very short-sighted behavior, not very long-term investment, and once the government acknowledged private farming, they started fruitful and long-term investment.

Just after Mao passed away, the CCP needed rule of law in order to protect itself, otherwise the grassroots people would try to challenge its power or ordinary operation of the state, so it needed some law. The current CCP is heavily dependent on the rule of law, but at the same time, it cannot abide by the rule of law because that would mean putting some limitations on the power of its monopolies. That is the existing problem with the situation.

What should the role of the state be? There are many contrasting views among entrepreneurs and CEOs in China on this question.

Q1. How do you get to the stage of rule of law when the Communist Party substantially has a good reason to not abide by rule of law? Second, do you have any ideas on how to develop the market for ideas in China? Third, what should other countries bring up in talks and negotiations with China?

WANG Ning
On the prospect of the rule of law in China, this is a big debate ongoing in Chinese academia. If the CCP stays in power, is there any room for genuine political reform? Is it possible to establish the rule of law with the Communist Party staying as the only political power? Some Chinese scholars are very pessimistic when they find out that the CCP is not going to give up its monopoly of power. I think they have good reasons to be frustrated. At the beginning of the People's Republic, Mao promised to share political power with other parties. Before China's transition to socialism, many high positions in the Chinese government were actually held by non-communists.

Nonetheless, it is my strong belief that even under that constraint, there is still much room for political reform in China. In the first place, the Chinese government has realized that it has to embrace the rule of law, if just for the survival of the Party. Mao's disregard of law led China to one disaster after another. As a result, the post-Mao Chinese leaders embraced rule by law. But rule by law has its serious limitation. In the recent past, without the rule of law, government corruption has become so endemic and pervasive that the survival of the Party is at stake. The challenge is find out a way to introduce the rule of law without threatening the Party's leadership. This is a challenge not just for the Chinese political leaders, but also for Chinese academia, particularly legal scholars, political economists, as well as the general public.

Second, if we look at the development of the rule of law in the West, we have no reason to be pessimistic about its prospect in China. When the British first started to have political freedom, the country was still ruled by a monarchy. If the rule of law could gradually emerge under monarchy and place a meaningful check on government power, I don't see why the rule of law cannot develop under CCP.

Third, the Chinese government has realized its weakness and vulnerability in governance. Just look at the amount of resources the Chinese government devotes to maintaining peace and harmony, which in the recent past has been even higher than military spending. Clearly, the political system needs a big shake-up. The Party rests its legitimacy on serving the Chinese people. There's huge room for political reform and to make the party more responsive to the people and more capable of serving them.

Democracy is a big concept with layers of history. Today, it is identified with multi-party competition. As such, democracy is at odds with traditional Chinese political philosophy. Party politics has never been accepted or practiced in China; the very term of "party" has a strong negative connotation in traditional Chinese political thinking. Only bad guys form a party to advance personal interests at the expense of collective good. In contrast, the market of ideas--of allowing many ideas to compete--has a long and cherished tradition in China. Even Mao Zedong believed in the market of ideas. In practice, he crushed it, but he could not deny the ideal. Clearly, this is a strong indication of the strength of the market for ideas as a political ideal. China should build on this tradition in its future political reform.

What should the outside world say to China? We live in a connected global economy. The economy is a positive sum game, a cooperative game in which everyone benefits. In a globalizing economy, growth in one country benefits every other country. If there is one consensus in economics, it must be this: Trade is mutually beneficial. But somehow in political debates, economic competition between countries is often portrayed as a zero sum game, in which one country gains at the expensive of its competitors. Such politics distort our understanding of how the market economy works, and does not serve the interests of the people.

Unlike the governments in Japan or the United States, the Chinese government suffers from a serious weakness, which it is fully aware of. It has to do with government legitimacy. In countries like Japan and the United States, even when the economy is not doing well, the government does not worry about its legitimacy, because it is elected by the people. It may worry about the next election. In China, since the government is not elected, when the economy is in trouble, the government feels obliged to take actions, even when it does not know exactly what to do. It rushes to do something to show it cares about the welfare of the people. This is how it maintains legitimacy, or so it thinks. It is important for the party to feel comfortable, not pressed to take action. If it is not comfortable with its own ruling, it is forced to rush, and that may lead to a terrible outcome. Outside pressure sometimes makes the Chinese government more anxious and lead to outcomes against our wishes.

There is no doubt that the people want to have a more free and open society. But it remains an open question as to how fast China can go along that line, particularly given the size and diversity of the nation. We have to be patient.

Q2. Your argument that the Chinese state did not lead the economic reform, that it withdrew from economic activities, is convincing. Two stories I heard from Chinese friends came to mind while listening to your speech. First is Deng Xiaoping's tour of the south in 1992. My friend argued that he unleashed investment. The second is that China is divided into two parts: in the south, money is most important and is their source of power, while in the north, their source of power is the military and bureaucracy. You also might have left one unfinished huge agenda item out: democracy. Chinese state power may not lead economic growth, but it orchestrated it very skillfully. I still feel the political power of the CCP has been unchanged. Maybe this market of ideas is on the borderline between politics and economics.

WANG Ning
The CCP is still the ruling party, and this aspect of the Chinese political system remains the same. But the CCP today is no longer that from Mao's time. Under Mao, the CCP believed in communism. Today, it believes in and practices the market economy.

Q3. In China, is it possible to control the so-called environmental problem? Regulation does exist, but there is no real control.

WANG Ning
The laws exist on paper, but the problem is the lack of enforcement. In China, local governments do not make laws, but enforcement is in their hands. Until quite recently, local officials mainly cared about gross domestic product (GDP) growth; they cared less, if at all, about the environment. Anyone who has visited China, particularly in the past two years, must know how bad pollution has been in China. Tourists from Japan or the United States can immediately see air pollution in China once their flight gets to Beijing. Water and soil pollution are equally bad, if not worse. Now, the central government has realized that it needs to give the local officials the right incentives. Both the United States and Japan suffered from environmental problems in the 1960s. We have good reasons to believe that China will follow their steps and reverse the past trend of environmental degradation. Environmental protection is certainly a goal high on the agenda of the Chinese government.

Q4. Could you give us some idea of the share of the private sector in China compared with the public sector? And could you give a basic definition of a state-owned enterprise?

WANG Ning
It depends on which indicators you use. Using GDP, the private sector makes up 60%-70%, but using employment, the private sector comprises about 80% or even higher. The problem with Chinese statistics is that there is no real clear delineation between the private sector and the state sector. The main problem with state enterprises is not their state ownership, but their monopoly status. Many enterprises owned by the central government do not face any private competition. Without competition, there is no way to judge their real strength or how customers value their services.

For example, banking is virtually monopolized by state-owned banks. As a result, in China, capital is badly misallocated. China has the highest saving rate in the world, but private Chinese firms pay three to five times as high as their counterparts do in the United States for the cost of capital. If the Chinese banking system improves a bit in credit allocation, that would unleash huge potential for growth. In general, China still does not have high-quality institutions, particularly compared with the United States and Japan. As an economy, China remains poorly governed. Any change in the right direction could push further economic growth. If we look at GDP per capita in East Asia, China is now about $7,000, Japan is about $38,000, and South Korea is about $27,000. There is a huge gap between China and its neighbors. It does not take a genius to tell that there is still huge room for growth in China in the years to come.