May/June 1996

China’s Fatal Conceit

China's born-again planners, led by President Jiang Zemin, are addicted to the idea that social and economic order are impossible without the firm hand of the state. The Ninth Five-Year Plan (1996-2000) reconfirms the Chinese Communist Party's (CCP's) faith in socialism and distrust of capitalism. The plan embraces the illusion that it is possible to revitalize state-owned enterprises by a change in management rather than ownership.

To think that China's ruling elite can control an economy of 1.2 billion people is a fatal conceit. The failure of central planning and of communism throughout the world is testimony to the ill-fated desire to engage in social engineering. Indeed, recent studies have shown that those countries that have fostered economic freedom have experienced greater wealth creation than have those that have failed to protect economic liberties. And as people have acquired greater economic freedom, they have demanded other significant rights, including the right to participate in political life. That demand is exactly what worries China's hard-liners.

Institutional innovation in China since 1978 has produced the fastest economic growth in the world and enlarged opportunities for many people, but it has not eliminated the main obstacle to China's future prosperity — the CCP. The party's monopoly of power has been eroded by the market-based reforms of China's paramount leader Deng Xiaoping, but with the Deng era ending, China is at a crossroads. The nation must decide whether to deepen reform and risk pressures for political change or slow reform and risk alienating China's newly emerging middle class and fomenting social unrest. The dilemma is complicated by the advent of democracy in Taiwan and the return of Hong Kong in 1997.

China at a Crossroads

In less than two decades China has become one of the top 10 trading nations in the world. Over the past decade nearly $90 billion in direct foreign investment has flowed into China's emerging markets. If the Chinese economy continues to grow at an average annual rate of 9 percent, it could soon become the world's largest.

The challenge for China is to develop the hard institutional infrastructure of a market economy. The centerpiece of that infrastructure is a rule of law that protects property rights and limits the power of government. Therein lies the difficulty, for the CCP is unlikely to give up its power and let freedom reign. Nevertheless, there are internal and external forces at work that may push China in the direction of greater liberalization and democratization. Internally, China's reformers have created an economic space that allows individuals the freedom to improve their living standards outside the state sector. Externally, China's "open-door" policy has allowed foreign competition and know-how to help the nonstate sector grow. In the process, new business practices have evolved along with legal norms associated with a market-liberal order.

The Ninth Five-Year Plan may slow China's march toward the market, but it won't stop it. The forces for change are too strong. And the further the market advances, the more costly it will become for the CCP to try to reverse it. Yet it is clear from China's saber rattling on the eve of Taiwan's ascension to democratic rule that China's authoritarian rulers are willing to incur considerable economic losses to protect their positions of power and privilege. That willingness is further evidenced by China's vow to crush any democratic movement in Hong Kong after 1997.

The dilemma facing Western leaders is whether to contain China and risk military confrontation or to peacefully engage China with the knowledge that the best way to foster human rights is by opening markets and cultivating exchanges — not by using the blunt instrument of economic sanctions or the rhetoric of China bashing.

In evaluating their options, Western leaders should heed the lesson of Taiwan — a police state that turned into a free-market democracy because economic liberalization led to political liberalization. Taiwan's leaders were willing to experiment with institutional change and had the courage to let the people speak — in the market and in the polity.

China, too, has created a new economic space but has resisted political change. Even so, there is reason to believe China may follow Taiwan's "quiet revolution." According to Lee Teng-hui, Taiwan's first democratically elected president, "Vigorous economic development leads to independent thinking. People hope to be able to fully satisfy their free will and see their rights fully protected. And then demand ensues for political reform." Thus, he predicts, "The model of our quiet revolution will eventually take hold on the Chinese mainland."

Deng's Experiment

The key to China's progress has been its willingness to allow institutional change on a trial-and-error basis and to promote success. Like Taiwan, China has reduced the relative size of the state sector by cultivating the nonstate sector, not by privatizing large state enterprises. State-owned firms now account for only 25 percent of China's total output (including agriculture and services), and their share of industrial output has fallen from 80 percent in 1978 to 40 percent today.

On the heels of the failure of central planning, Deng had no grand vision for institutional change, but he was willing to experiment. His guiding principle was, "Once we are sure that something should be done, we should dare to experiment and break a new path."

Deng began to break a new path in 1978, when he launched his agricultural reform. Communal ownership of land was abolished and a system of contractual relations was introduced through the "household responsibility system." Rural families were allowed to hold long-term leases and acquired the right to use the land at their disposal. They could sell their crops in the open market, provided they first satisfied the state quota. Under the new incentive structure, farmers increased production and began to invest their profits in town and village enterprises (TVEs), which are beyond the reach of state ministries.

Although TVEs are legally owned by local governments, individual households are allowed to share profits, hold (nontransferable) shares, and receive dividends. Wages are tied to profits, and the managers of TVEs face hard budget constraints, unlike the politically motivated managers of state-owned enterprises (SOEs). As a result, TVEs have mushroomed while SOEs continue to whither on the vine of state subsidies.

In addition to creating new ownership arrangements, Deng's reforms decontrolled prices, opened China to the outside world through trade liberalization and the establishment of Special Economic Zones, devolved power from the central government to local governments, and instituted a system of fiscal contracts that limited Beijing's share of tax revenue and provided local officials with an incentive to promote markets — a system Yingyi Qian and Barry Weingast have called "market-preserving federalism." Those institutional changes resulted in a parallel economic structure to compete with the SOEs, reduced the central government's share of tax revenue from 60 percent in 1978 to 40 percent in 1993, and helped weaken the central government's grip on everyday life.

Those reforms, however, have failed to create a genuine market system founded on the principles of private ownership and freedom of contract. The goal of China's born-again planners is not market liberalism but market socialism. The resultant lack of clear rules at the enterprise level and attempts to plan the market are, in the absence of a constitution that protects property and contracts, reflections of what F. A. Hayek aptly called the "fatal conceit" of socialism.

Revitalizing Civil Society

The quiet revolution that has been taking place in China's economy since 1978 is combining with the information revolution to strengthen the fabric of civil society and weaken the CCP. As China has expanded the freedom to earn a living outside the state sector, individuals have gained greater control over their lives. In its 1994 report on human rights, the U.S. Department of State noted the connection between economic rights and human rights: "A decade of rapid economic growth, spurred by market incentives and foreign investment, has reduced party and government control over the economy and permitted ever larger numbers of Chinese to have more control of their lives and livelihood."

People are learning how markets work by participating in the growing nonstate sector and by engaging in foreign trade. As the market has replaced Marx, newly acquired ideas and wealth have given rise to a spirit of independence and to a rebirth of civil society, especially in China's southern coastal provinces. Commenting on China's cultural transformation, Jianying Zha writes in her book China Pop,

The economic reforms have created new opportunities, new dreams, and to some extent, a new atmosphere and new mindsets. The old control system has weakened in many areas, especially in the spheres of economy and lifestyle. There is a growing sense of increased space for personal freedom [so long as people stay out of politics].

Anyone who has visited China and seen the vibrancy of the market, the dynamism of the people, and the rapid growth of urban areas will concur with Zha's cautious optimism.

New towns and cities are evolving naturally as people flee the countryside for improved living conditions and the chance to strike it rich in the nonstate sector. Villages that were once small fishing centers along the southern coast are now booming with the flow of trade and people. The new urban centers, such as Shishi in the province of Fujian, are characterized by the market, not the plan. Their model of development, writes Kathy Chen of the Wall Street Journal, is "small government, big society [xiao zhenfu, da shehui] — which advocates less involvement by cash-strapped governments and more by society."

Ambitious young people want to become capitalists, not communists. A recent survey found that young people ranked being an entrepreneur first among 16 job choices and employment with the national government eighth. Freer labor markets have led to a growing demand among college students for business courses, and universities are responding. The CCP has lost much of its credibility and is no longer the major route to success.

The freedom to trade is an important human right in China. As trade expands, there will be a growing middle class with a large stake in China's future. Moreover, China's high savings rate gives all those who sacrifice current consumption and invest their earnings in the nonstate sector a strong incentive to further depoliticize economic life. The formation of economic and civil society will lead to a natural call for greater participation in political life. Yet as long as the CCP stands in the way of the spontaneous market order, controls the flow of information, and prevents free association, the future of China's civil society will be in jeopardy.

Institutional Change and Democratization

If democratization is to proceed in China, the government must continue to allow experimentation and new forms of ownership. Yuan Mu recently articulated the key role of ownership reform in the Beijing press: "We should discover the best model for ownership by the whole people [notice the bias against privatization], so that they will genuinely become the main body of market competition and operate with vigor and vitality in accordance with the rules of the market economy."

Those rules will evolve as individuals grope for ways to lower the costs of exchange and expand markets. In China Pop, Zha quotes Liu Ge, a lawyer trained in both China and the United States, as saying,

Gradually, there will be more laws and rules; the market will be more mature, more compatible with international standards, the competition more fair and open. Then, China will have been structurally transformed! Political change will come after that.

According to Zha, "A lot of the educated urban Chinese . . . echo this way of thinking." There is reason to believe, therefore, that institutional change in China will bring about what Princeton University professor Pei Minxin has called "creeping democratization."

Pei points to the upward mobility of ordinary people, occasioned by the deepening of market reform, and to the positive impact of China's "open-door" policy on political norms. In his view, public opinion and knowledge of Western liberal traditions, such as the rule of law, "have set implicit limits on the state's use of power" and have promoted the democratization of the legal system. People are starting to use the court system to contest government actions that affect their lives, liberty, and property. There has been a sharp rise in the number of civil lawsuits against the state, and individuals are beginning to win — perhaps as many as 20 percent of — their cases, according to official sources.

The opening of the legal system is important because it paves the way for the transition from "rule by law" to "rule of law." Marcus Brauchli of the Wall Street Journal writes,

The state's steel-clad monopoly on the legal process, which makes the courts just another arm of government, is corroding. China's economic liberalization . . . has spawned a parallel legal reform that raises the prospect of rule of, not merely by, law.

Nevertheless, Brauchli recognizes that "legal ambiguity" remains "a ruthless weapon" for harassing the population. Until that facet of China's institutional structure changes, no one's rights will be secure.

China's Future

The challenge for China is to get out of the way of the market and let it grow naturally along with civil society. Doing so, however, requires an understanding of the institutional infrastructure that makes the market system tick and an appreciation of the spontaneous order that emerges when private property and freedom of contract are protected by a rule of law. Democracy is neither necessary nor sufficient for a market system — as the experience of Hong Kong has illustrated. What is necessary is a stable legal framework that protects life, liberty, and property. If China is to prosper in the global economy, the nation will have to adopt common-law practices and abide by international commercial codes and customs. Old habits are hard to break, but the forces for change are strong, and there is reason to believe that China will "creep along in the right direction."

China has been willing to experiment, but it has not yet provided the climate of freedom necessary for growing market-liberal institutions. In fact, there is an effort to give the central government greater power by ending the system of fiscal federalism. Putting more money into the pockets of Beijing bureaucrats by recentralizing the tax system, however, is not the answer to China's problems. Nor will improving the management of SOEs do anything to solve the problems of loss-ridden enterprises that have no real owners.

Real stability will come to China only when its leaders abandon their fatal conceit and realize that it is impossible to plan the market or society. Although the leadership is willing to tolerate gradual reform to keep the economy strong, there is no indication that they will tolerate political reform. The crackdown on dissidents, especially the arrest of Henry Wu and Wei Jingsheng, is a clear signal to Hong Kong and the rest of the world that democratic rule is unacceptable. The West should not confuse economic liberalization with a desire for democratization.

Foreign pressure is unlikely to foster positive political change in China. Indeed, such pressure is likely to be counterproductive. Beijing's frosty attitude toward the United States and our confrontational approach to China will do little to promote stability in East Asia or to advance human rights in China. Economic sanctions and partial removal of most-favored-nation trade status for China would surely damage China, but they might damage the wrong people. Sanctions or higher tariffs could inflict harm on those who are fleeing the state sector for greater opportunities and freedom in the market sector, and protectionist measures clearly would harm U.S. consumers and Americans who do business in China.

To depoliticize economic life, China needs constitutional change and new thinking. As Chinese scholar Jixuan Hu writes, "By setting up a minimum group of constraints and letting human creativity work freely, we can create a better society without having to design it in detail. That is not a new idea, it is the idea of law, the idea of a constitution." Ultimately it is up to the Chinese people to shape their own institutions and to secure their fundamental rights, including the right to self-government.

The United States, as the world's leading constitutional democracy, should spread its ethos of liberty by keeping its markets open and extolling the principles that made it great. It should not play the dangerous game of pitting human rights activists against free traders. China should be admitted to the World Trade Organization as soon as possible and be given most-favored-nation status unconditionally.

It may take another generation for China's quiet revolution to succeed, but with patience and foresight China may yet join Taiwan in a mutually beneficial alliance based on free markets and free people.

James A. Dorn is vice president for academic affairs at the Cato Institute. He has lectured at Fudan University in Shanghai and is coeditor of Economic Reform in China: Problems and Prospects.