It's a pleasure to be here in Shanghai to discuss market reforms for China for a new millennium. I should say at the outset that unlike many at this conference, I am not a student of China, much less of the Chinese economy. Nevertheless, the issues that concern this session on "Building China's Institutional Infrastructure" are universal in that all societies, whatever their histories or stages of development, face certain classic problems that are inherent in the human condition as such. We know, of course, that people are conditioned by their cultures; but once we look beyond that truism we see certain general features in human affairs that help to explain, in the context of differing institutional arrangements, why some societies prosper and others do not.

It is those differing institutional arrangements that I want to focus on this morning, using as my organizing principle a title that was assigned to me by our conference director, Jim Dorn, "Simple Rules for a Complex World." As many of you doubtless know, that is the title of a recent book by Professor Richard Epstein of the University of Chicago School of Law, which I edited at an early stage. One of the more salient conclusions to come from the book is the intimate connection between law and economics. We have understood that connection for some time, of course, but Professor Epstein has reduced it to its essential elements, which I would like to outline for you this morning, especially for the benefit of those who may be unfamiliar with the book.

Whatever the extent of China's move toward a market economy--and to be candid, I find the institutional evidence less than reassuring--there can be no question that if the Chinese people are to realize the aspirations that all people have they will need a modern legal system to underpin and structure their pursuit of happiness. In human affairs, individual self-serving behavior is a given that no socialist system has ever been able to stamp out. As we have understood at least since Adam Smith, markets channel that behavior in socially useful ways. But they do so only in the context of an underlying legal system that authorizes the use of force to serve that end. If the Chinese people are to unleash the creative power of individual self-interest, therefore, they will need to attend not simply to economic but, more basically, to legal arrangements as well.

Here, it strikes me, there are two problems that need to be distinguished. The first is the transition problem--the move from a planned to a free economy. Assuming that the lessons of the 20th century have been learned--that planning does not work, or works only at a substantially reduced level of efficiency--it is less than clear how to "unplan" a society. This is not a problem unique to China, of course. The 20th century's lust for government has left all nations, including America, with a set of deteriorating institutions, yet with whole classes of people dependent upon those institutions. In general, one wants to move as quickly as possible from unsatisfactory to more satisfactory arrangements; but if the new order is to be thought legitimate, much less to be brought about, those with a legitimate vested interest in the old order cannot be entirely ignored. Thus, the transition must be handled carefully if it is to succeed; but at the same time, the problem of making the transition must be distinguished clearly from the basic problem, which is to determine the shape of the new order toward which the transition is moving.

Turning, then, to this second problem, what prompted Epstein to fasten upon his title of "Simple Rules for a Complex World" was the belief, common in the West, that as human affairs become more complex, legal arrangements must also grow more complex. Nothing could be further from the truth, he argued. In fact, it is precisely when human affairs are complex, as with the advent of technology, that simple legal rules must be kept in view. And indeed, that is a lesson that the folly of central planning itself teaches. Simple societies, after all, can be managed from the top down. As affairs grow more complex, however, we come to appreciate that the knowledge required to coordinate complex economies is found, of necessity, at lower, not at higher levels of society. To maximize economic efficiency, therefore, decision-making authority must devolve to lower levels--much as we have seen it doing for some time here in China.

But the devolution of power is only part of the solution to the problem of insuring efficiency under conditions of growing complexity. In addition, one wants accountability. More precisely, one wants decision-making authority in the hands of those who will enjoy the benefits or suffer the consequences of their decisions. At the end of the day, in short, one wants a legal system that recognizes the fundamental place and role of individual and institutional accountability in human affairs--including government accountability. That, precisely, is what the simple rules aim to do, to bring individuals and their decisions together so that individuals are held legally accountable for their decisions. Such a system provides incentives for productive behavior--the individual directly profits from his behavior--and disincentives for unproductive behavior--the individual directly suffers from his behavior.

How can a legal system accomplish this? There are six simple rules, Epstein says, relating to individual autonomy, private property, contracts, torts, and private and public necessity. Although I will treat each of those rules only in outline here, taken together, and in their various applications, they maximize the ability of individuals and institutions to order their own affairs, to enjoy the benefits of doing that well, and to suffer the consequences of doing it poorly. No one is subject to having his affairs ordered by others, whether by a majority or by some political elite. By the same token, everyone is responsible for his own decisions and behavior.

It is said, of course, that this individualistic approach is wholly Western. Yet we know as well that individualism knows no real geographic or cultural boundaries, that individuals are motivated by self-interest whatever their cultural conditioning. But we know too that it is important to begin, methodologically, with the individual, not only from a consideration of methodological simplicity but because in the end it is individuals who choose, who act, and who enjoy or suffer the consequences of their actions. And it is individuals who respond to any incentives the legal or economic system might offer.

For any of that to occur, however, the legal system must ensure a substantial measure of individual autonomy, and so we come to the first rule, which can be usefully cast in propertarian terms as a rule of self-possession relating not simply to the person but to the labor of any individual as well. Rooted by classical theorists like John Locke in a kind of natural necessity, self-possession is given a practical, economic rationale by Epstein, who offers a series of arguments to show how inefficient and even impossible various alternative rules would be whereby individuals did not command themselves or their labor but instead were subject to the command of others, such as a ministry of labor.

Closely related to the first rule is a second, concerning not self-possession but possession of the things in the world beyond oneself--possession of land and chattels, in particular. Here, the classic rule of first possession comes into play whereby individuals, starting from the original position of self-possession, acquire unowned things by simply taking possession of them. Although this rule may be given a deductive justification by arguing that no one else has a better claim to the unowned object than the person who first takes possession of it, here too Epstein relies on practical, economic arguments for the rule of first possession, especially on an analysis of the intractable problems that would arise under some centralized regime charged with distributing the possession and use of the things of the world.

The rules of individual autonomy and first possession establish the foundation for subsequent rules about voluntary and forced exchanges. Voluntary exchanges are the subject of rule three. Forced exchanges are the subjects of rules four, five, and six.

With liberty and property established, rule three deals with contracts--with the liberty to associate with others on terms that are mutually agreed upon and, presumably, mutually beneficial. Because they are mutually beneficial, contractual transactions move labor and property from lower to higher valued uses, thereby maximizing social wealth. And because they can be repeated with infinite variety, covering everything from spot transitions to complex corporate arrangements, contracts constitute the legal foundation of the vast and varied world of economic affairs that is the focus of this conference.

Thus, with those three simple rules in place--freedom, property, and contract--the complex world we call "civil society" can arise, all without any government planning or assistance. And we know from experience that absent government interference, individuals and organizations, motivated by self-interest alone, will create such a society and will seek constantly to better their own condition, all without government coercing that result.

But along the way people may injure each other. Thus, the law that facilitates the creation and conduct of civil society by protecting liberty, property, and contract needs to be supplemented by a fourth rule dealing with torts, or trespasses upon the liberty, property, or contracts of others. However varied this law may be because of its varied applications, at its core it tells us simply to leave our neighbors alone, to allow them the same freedom and integrity that we enjoy. Thus, the law of torts facilitates productivity by prohibiting or discouraging forced exchanges.

But there may come a time when a forced exchange is necessary due to some imminent peril to life or property. We come thus to the fifth rule, pertaining to private necessity, which temporarily and briefly suspends the ordinary rules of autonomy, property, and contract by allowing individuals to take what belongs to others under narrowly defined conditions of imminent peril, provided they offer just compensation to the owner for the loss, plus a little extra to compensate for the owner's loss of control. This is not a general welfare principle writ small. Rather, it is a narrowly defined effort to accommodate the vicissitudes of life while at the same time, through the principle of just compensation plus, discouraging aggression by the victim of the peril and extortion by an owner otherwise able to assist the person in peril.

This principle of private necessity has its public variation, which brings us to the sixth and final rule, the classic power of eminent domain. This power authorizes government to take private property for public use on payment of just compensation to the owner. Although broader that the rule of private necessity and its imminent-peril limitations, the eminent domain principle proceeds, ideally, only through some prior constitutional authorization, which to some extent mitigates complaints from forced association. Moreover, the just compensation requirement, when applied realistically, ensures that any transaction conducted under the rule is Parieto optimal or economically efficient. Here again, as with the rule of private necessity, the aim is to enable public projects to go forward without coercion, on one hand, or extortion by owners, on the other.

Those six simple rules, then, pertaining to liberty, property, contracts, torts, and private and public necessity, constitute the substantive legal foundation of a free society and a free market in particular. Drawn from the long tradition of the common law, they are the moral and legal framework through which individuals, families, and firms can plan and live their lives, free from the interference of others, including the state. Government has a role to play in all of this, of course, even if it too is bound by those rules. Its role, carried out largely by an independent judiciary, is to enforce the rules by protecting individuals and institutions from force or fraud and by enforcing contracts. Beyond that, a government that is legitimate may do only those things the people have authorized it to do through a properly ratified constitution, through which alone government derives whatever political legitimacy it may enjoy.

Thus, in the end, the rule of law is not only about efficiency but about legitimacy as well. Free markets, and the rule of law that underpins them, are both efficient and right--and even inspiring. One can only hope that the Chinese people, in their long march toward liberation, will unburden themselves of the law of planning and discover the law that truly liberates.