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

Institutional innovation in China since 1978 has produced the fastest economic growth in the world and enlarged opportunitiesfor many people, but it has not eliminated the main obstacle to China’s future prosperity — the CCP. The party’s monopoly ofpower has been eroded by the market‐​based reforms of China’s paramount leader Deng Xiaoping, but with the Deng eraending, China is at a crossroads. The nation must decide whether to deepen reform and risk pressures for political change orslow reform and risk alienating China’s newly emerging middle class and fomenting social unrest. The dilemma is complicatedby 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 $90billion in direct foreign investment has flowed into China’s emerging markets. If the Chinese economy continues to grow at anaverage 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 thatinfrastructure is a rule of law that protects property rights and limits the power of government. Therein lies the difficulty, for theCCP is unlikely to give up its power and let freedom reign. Nevertheless, there are internal and external forces at work thatmay push China in the direction of greater liberalization and democratization. Internally, China’s reformers have created aneconomic 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 toostrong. And the further the market advances, the more costly it will become for the CCP to try to reverse it. Yet it is clear fromChina’s saber rattling on the eve of Taiwan’s ascension to democratic rule that China’s authoritarian rulers are willing to incurconsiderable economic losses to protect their positions of power and privilege. That willingness is further evidenced by China’svow 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 Chinawith the knowledge that the best way to foster human rights is by opening markets and cultivating exchanges — not by using theblunt 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‐​marketdemocracy because economic liberalization led to political liberalization. Taiwan’s leaders were willing to experiment withinstitutional 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 mayfollow Taiwan’s “quiet revolution.” According to Lee Teng‐​hui, Taiwan’s first democratically elected president, “Vigorouseconomic development leads to independent thinking. People hope to be able to fully satisfy their free will and see their rightsfully protected. And then demand ensues for political reform.” Thus, he predicts, “The model of our quiet revolution willeventually 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 promotesuccess. Like Taiwan, China has reduced the relative size of the state sector by cultivating the nonstate sector, not byprivatizing large state enterprises. State‐​owned firms now account for only 25 percent of China’s total output (includingagriculture 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 toexperiment. His guiding principle was, “Once we are sure that something should be done, we should dare to experiment andbreak a new path.”

Deng began to break a new path in 1978, when he launched his agricultural reform. Communal ownership of land wasabolished and a system of contractual relations was introduced through the “household responsibility system.” Rural familieswere allowed to hold long‐​term leases and acquired the right to use the land at their disposal. They could sell their crops in theopen market, provided they first satisfied the state quota. Under the new incentive structure, farmers increased production andbegan 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 budgetconstraints, unlike the politically motivated managers of state‐​owned enterprises (SOEs). As a result, TVEs have mushroomedwhile 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 worldthrough trade liberalization and the establishment of Special Economic Zones, devolved power from the central government tolocal governments, and instituted a system of fiscal contracts that limited Beijing’s share of tax revenue and provided localofficials with an incentive to promote markets — a system Yingyi Qian and Barry Weingast have called “market‐​preservingfederalism.” Those institutional changes resulted in a parallel economic structure to compete with the SOEs, reduced thecentral government’s share of tax revenue from 60 percent in 1978 to 40 percent in 1993, and helped weaken the centralgovernment’s grip on everyday life.

Those reforms, however, have failed to create a genuine market system founded on the principles of private ownership andfreedom of contract. The goal of China’s born‐​again planners is not market liberalism but market socialism. The resultant lackof clear rules at the enterprise level and attempts to plan the market are, in the absence of a constitution that protects propertyand 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 tostrengthen the fabric of civil society and weaken the CCP. As China has expanded the freedom to earn a living outside thestate sector, individuals have gained greater control over their lives. In its 1994 report on human rights, the U.S. Department ofState noted the connection between economic rights and human rights: “A decade of rapid economic growth, spurred bymarket incentives and foreign investment, has reduced party and government control over the economy and permitted everlarger 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 themarket has replaced Marx, newly acquired ideas and wealth have given rise to a spirit of independence and to a rebirth of civilsociety, especially in China’s southern coastal provinces. Commenting on China’s cultural transformation, Jianying Zha writes inher book China Pop,

Anyone who has visited China and seen the vibrancy of the market, the dynamism of the people, and the rapid growth ofurban 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 tostrike it rich in the nonstate sector. Villages that were once small fishing centers along the southern coast are now booming withthe 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 beingan entrepreneur first among 16 job choices and employment with the national government eighth. Freer labor markets have ledto a growing demand among college students for business courses, and universities are responding. The CCP has lost much ofits 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 largestake in China’s future. Moreover, China’s high savings rate gives all those who sacrifice current consumption and invest theirearnings in the nonstate sector a strong incentive to further depoliticize economic life. The formation of economic and civilsociety will lead to a natural call for greater participation in political life. Yet as long as the CCP stands in the way of thespontaneous market order, controls the flow of information, and prevents free association, the future of China’s civil societywill be in jeopardy.

Institutional Change and Democratization

If democratization is to proceed in China, the government must continue to allow experimentation and new forms ofownership. Yuan Mu recently articulated the key role of ownership reform in the Beijing press: “We should discover the bestmodel for ownership by the whole people [notice the bias against privatization], so that they will genuinely become the mainbody 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, Zhaquotes Liu Ge, a lawyer trained in both China and the United States, as saying,

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 “creepingdemocratization.”

Pei points to the upward mobility of ordinary people, occasioned by the deepening of market reform, and to the positiveimpact of China’s “open‐​door” policy on political norms. In his view, public opinion and knowledge of Western liberaltraditions, such as the rule of law, “have set implicit limits on the state’s use of power” and have promoted the democratizationof the legal system. People are starting to use the court system to contest government actions that affect their lives, liberty, andproperty. There has been a sharp rise in the number of civil lawsuits against the state, and individuals are beginning towin — 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,

Nevertheless, Brauchli recognizes that “legal ambiguity” remains “a ruthless weapon” for harassing the population. Until thatfacet 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 ofthe 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 isnecessary is a stable legal framework that protects life, liberty, and property. If China is to prosper in the global economy, thenation will have to adopt common‐​law practices and abide by international commercial codes and customs. Old habits arehard to break, but the forces for change are strong, and there is reason to believe that China will “creep along in the rightdirection.”

China has been willing to experiment, but it has not yet provided the climate of freedom necessary for growing market‐​liberalinstitutions. 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 toChina’s problems. Nor will improving the management of SOEs do anything to solve the problems of loss‐​ridden enterprisesthat 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 themarket or society. Although the leadership is willing to tolerate gradual reform to keep the economy strong, there is noindication that they will tolerate political reform. The crackdown on dissidents, especially the arrest of Henry Wu and WeiJingsheng, is a clear signal to Hong Kong and the rest of the world that democratic rule is unacceptable. The West should notconfuse 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 inEast Asia or to advance human rights in China. Economic sanctions and partial removal of most‐​favored‐​nation trade status forChina would surely damage China, but they might damage the wrong people. Sanctions or higher tariffs could inflict harm onthose who are fleeing the state sector for greater opportunities and freedom in the market sector, and protectionist measuresclearly 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, “Bysetting up a minimum group of constraints and letting human creativity work freely, we can create a better society withouthaving 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 theChinese 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 marketsopen and extolling the principles that made it great. It should not play the dangerous game of pitting human rights activistsagainst free traders. China should be admitted to the World Trade Organization as soon as possible and be givenmost‐​favored‐​nation status unconditionally.

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