第13页 | How China Became Capitalist-Ronald Coase

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A Bird in the Cage: Market Reform under Socialism

China’s economic reform in the early 1980s was a tale of two economies: a stagnant state sector contrasting with a fast rising non-state economy. During the marginal revolutions, the vibrant non-state sector was born at the periphery of the socialist economy. It took very little time for ambitious entrepreneurs to find and pursue economic opportunities underexplored or unexploited. With the socialist economy’s decades-long bias toward heavy industry, Chinese consumers had long been undersupplied with even the most basic consumer goods and services. All this was about to change. In the early 1980s, entrepreneurs began to address these unsatisfied demands, and doing so proved to be highly profitable. Self-employed barbers, for example, came to earn higher incomes than surgeons in state hospitals. Street vendors who sold noodles and snack foods earned more than nuclear scientists. Traders, small shop and private restaurant owners, many of them the former “youths waiting to be employed,” were among the highest income groups in China during the 1980s. Not surprisingly, the number of self-employed household businesses and single proprietorships increased from 140,000 in 1978 to 310,000 in 1979, 806,000 in 1980, and reached 2.6 million in 1981.¹ City residents started to enjoy many goods and services that had not been available from state-owned establishments.

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Agriculture, the economy’s most troublesome sector at the time of Mao’s death, witnessed remarkable growth between 1979 and1984, with output growing by 6.7 percent per annum. As a result, agricultural output jumped from 305 million tons in 1978 to 407 million tons in 1984.² Moreover, with the conditional sanction of private farming in 1980, Chinese peasants were gradually freed from the yoke of collective farming and, for the first time since the Land Reform, started to exercise some degree of economic freedom. June 18th, 1980 saw the first People’s Commune disbanded in Sichuan province. At the end of 1982, the household responsibility system was implemented in more than 80 percent of the rural population, including at Dazhai, the national model commune during Mao’s era. A year later, the rate had reached 95 percent and agriculture was effectively decollectivized.³

In the meantime, township and village enterprises became the fastest growing sector in the whole Chinese economy throughout the 1980s. The percentage of the total rural labor force employed by such enterprises increased from 9 percent in 1978 to above 14 percent in 1984. By the mid-1980s, output made up over half of the total rural economy, and one-quarter of China’s industrial output.⁴

In contrast, the reforms intended to revitalize state enterprises – a priority of the Chinese government since 1978 – turned out to be a disappointment. Under the enterprise reform initiatives, state enterprises were given more autonomy in business decision-making, as well as the right to retain a certain amount of profit for discretionary use. This improved incentives for both managers and workers. But individual enterprises had to negotiate with their supervising authority exactly what rights they would have, as well as the proportion of profit handed to the state. In this bargaining process, political power and other non-economic considerations often overshadowed economic logic. This resulted in more profitable firms turning over a higher percentage of their profits to the state, while insolvent firms received state subsidies. Consequently, profitable firms did not necessarily grow and loss-making firms did not go bankrupt. In addition, the state-owned enterprises were still subject to multiple sources of interventions from the state. As the Chinese proverb puts it, they were under the joint supervision of many “mothers-in-law.” Moreover, since these reforms were carried out within the decentralized administrative structure inherited from Mao, local governments created various trade barriers to protect firms in their jurisdiction in exchange for their influence on the operation of the firms. This grossly undermined the enterprise reforms. At the national level, local protectionism pushed the whole country towards a fiefdom economy.

So why were the enterprise reforms such a failure? To answer this requires a close look at China’s preexisting industrial structure.⁵ Due in part to Mao’s repeated efforts of decentralization, the Chinese economy had rarely been run on the Soviet model. In that system, production, distribution, pricing, and investment were all strictly managed by directives from a single central planning office (or Gosplan). In China, state-owned enterprises were supervised by governments at a number of levels, from the central government (various ministries under the State Council) down to the provincial, the prefecture, and the municipal government (in cities) and the county government (in rural areas). As well as the state-owned enterprises, there existed urban collective enterprises and rural enterprises owned by the governments below the municipal and county level. Moreover, state-owned enterprises operated under two separate chains of command, the vertical chain, or “tiaotiao,” and the horizontal chain, or “kuangkuang.” For all industries, the vertical chain of hierarchy ran from the central government Ministry down to the local bureaus of the provincial, municipal, and county authorities. The horizontal chain in the hierarchy ran from the State Council to the provincial, municipal, and county government.

Along the vertical line of command, a state-owned steel mill, for example, fell under the jurisdiction of the Ministry of Metallurgical Industry if it was supervised by the central government and was thus classified as a central state enterprise, or the provincial (municipal, country) bureau of metallurgical industry if it was supervised by the provincial (municipal, county) government, and was thus classified as a provincial (municipal, county) state enterprise. Along the horizontal chain, a state enterprise was supervised by the central (provincial, municipal, or county) government if it was a central (provincial, municipal, or county) state enterprise. A direct chain of command ran from the central, down to the provincial, municipal, and county government. As a result, state-owned enterprises faced a grid structure of supervision.

Other factors further complicated the governance structure of state-owned enterprises. First, all the local bureaus of an industry reported to both their local governments and the higher level bureaus and, ultimately, the Ministry under the State Council. Under the Stalinist model of central planning, the horizontal line of hierarchy did not exist. In China, however, Mao’s repeated attempts at decentralization gave more power to local authorities and more credence to the horizontal line of command. Second, a number of state enterprise operations were often supervised by different authorities. These included personnel (promotion, transfer, and hiring), wage control, finance, production planning, and investment planning. Personnel and wage control usually fell under the horizontal line of command, while production and investment planning were mainly supervised by the vertical line of command, though they were also influenced by the horizontal line. This partitioning of supervision and interlinking of supervising authorities made the management of state-owned enterprises overwhelmingly complex. Third, just like the Chinese Party and government officials whose salaries and privileges were (and still are) highly differentiated in accord with their ranks, the state enterprises and their managers also had different administrative rankings. Enterprises supervised by higher level authorities had higher rankings, and often enjoyed higher priorities in their access to various resources controlled by the government, such as finance and raw materials. They also shouldered higher responsibilities in fulfilling the production plan. Last, and most troublesome, the division of supervision changed from one enterprise and industry to another, and also varied over time in correspondence with the cycle of political decentralization and centralization. Thus, not only did the state-owned enterprises face a web of regulation, but that regulation was effectively different for each individual operation.

At the operational level, many practices added further variations to the constraints facing each of the state-owned enterprises. For example, governments often selectively subsidized some enterprises for a variety of temporary and contingent reasons, which consequently discriminated against others. Even when state enterprises were working outside the production targets of the state plan, which was not uncommon, they still faced the same issues. The economic plan devised by the central government did not cover all production undertaken by the state-owned enterprises. Consequently, there had always been economic transactions outside the plan which were referred to as “cooperation relations.” For these transactions to take place, the involved parties had to negotiate prices, creating a problem that did not exist when meeting the targets of a production plan. Since the production plan was specified in quantities, for both inputs and outputs, prices were simply an instrument of accountancy. Due to this lack of market price information, the spot prices governing transactions outside the production plan varied greatly.

At any point in time, different enterprises faced different prices for the same raw materials or intermediate inputs, though this did not include labor – wages were fixed nationwide and, consequently, seldom reflected productivity. This is the exact opposite of what one would find in a market economy, where wages are individually negotiated, but all firms face a similar market price for other inputs. When the enterprise reforms allowed each operation to bargain individually with the government about its rights and responsibilities, it merely added to the chaos of constraints faced by each state-owned enterprise.

In a free market economy, the firm is constantly influenced by the wider market in which it operates. The product market reveals information critical to a firm’s survival, such as what not to produce – when the sale price for a product will not cover the cost of its production; the factor market informs the cost of substitution between factors of production. While there is some room for price-seeking, firms cannot greatly alter the market price for their inputs. To increase its chance of survival, a firm can innovate and supply new and better products to consumers, or it can improve efficiency and produce the same goods at a lower cost than its competitors. Thus, market competition allows profitable firms to grow and causes unprofitable ones to wither, forcing them to produce something different.

At the same time, firms in a market economy adjust the wages paid to their employees in accord with their productivity; employees will lose their jobs if performance is unsatisfactory. This gives firms a powerful incentive with which to motivate their employees, whose productivity, unlike that of other factors of production, is open to the influence of the rate of compensation. This internal pressure encourages workers to make their best efforts, and whether those are good enough is judged only by consumers. The performance of the firm is decided by the ultimate test of market survival.

Prior to the enterprise reforms implemented in 1981, Chinese state industry did not really have any genuine price mechanism, or true market discipline. The price level for consumer and capital goods was largely set by the state, with little room to reflect variations in their quality. This meant that enterprises had little incentive to improve the quality of their products, let alone introduce new ones. As each state enterprise faced an idiosyncratic set of constraints imposed by a web of supervising authorities, even if a state enterprise was motivated to improve its condition it would work first on changing the constraints to its advantage rather than improving its production or innovating better products. Moreover, since workers’ pay was not linked to productivity, workforce morale was understandably low. Worse still, firms could not take the decision to lay off or hire workers. In the name of socialism – secure employment and egalitarianism being foremost among these – state-owned enterprises were deprived of basic managerial methods of incentivizing workers and producing better products.

Enterprise reform gave state enterprises more autonomy in business decision-making and the right to retain profit; but they were still inclined to change external constraints rather than improve internal strength. Indeed, firms were welcome to negotiate with their supervising authorities on almost all aspects of the production process. This might include the quantity of a product the enterprise was required to produce, the quantity of raw materials it could consume, the credit it could obtain from the state, and the percentage of profit it was able to retain. It was equivalent to a firm being allowed to set its own prices for inputs and choose its rate of taxation. As the firm was able to negotiate the rules of the game, there was little pressure to improve its internal strength. In essence, this was why the enterprise reform failed. It did not subject the enterprises to market discipline, which would reward only firms whose products were favored by consumers. There was still little pressure for enterprises to innovate and improve their profitability.

Without a price system that would subject all firms to the same market disciplines, enterprise reform could not possibly work. Even though the reform certainly improved incentives within firms, it could not make them as efficient as Nissan, the Japanese firm that impressed Deng Xiaoping most during his first visit to Japan. One of the best-known Chinese economists and a veteran economic official, Xue Muqiao, was among the first to recognize the limitations of the enterprise reform.⁶ In a document prepared for the State Council in early 1980, “Preliminary Comments on the Economic System Reform,” Xue envisioned that economic reform would gradually replace central planning with market mechanisms. He believed that all government intervention would eventually be lifted from the operation of state-owned enterprises, allowing them to become fully independent profit-seeking entities.⁷ Xue’s report was highly praised by General Secretary Hu Yaobang after it was presented at a meeting in September 1980.⁸ Its perspective on reform was echoed in Premier Zhao Ziyang’s report to the People’s Congress in 1981: “These reforms [enterprise and agricultural reform] are still partial and exploratory in nature and our work has suffered from certain incongruities and from lack of coordination. The task before us is to sum up our experience in these reforms and, after careful investigation and study and repeated scientific confirmation, to draw up as soon as possible an overall plan for reforming the economy and carry it out step by step.” The price reform that Xue envisioned – replacing government planning with the price system as a primary mechanism of resource allocation, thus imposing market discipline on all the enterprises – would become the core of Zhao’s “overall plan.”

The proposal was endorsed by General Secretary Hu Yaobang and Zhao Ziyang, Premier of the State Council. However, price reform ran contrary to the accepted wisdom of socialism, which held the market antithetical to central planning and collective ownership. Throughout the 1980s Deng Xiaoping, Chen Yun, and a handful of other Party veterans remained the eminence grise of the Chinese Communist Party and, for this group, the old habit of thinking died hard.⁹ Though age prevented them from holding official positions in the Party and government, they dictated government policy. In the debate on the relation between the market and central planning in socialism and the very nature of socialism itself, the strongest and most articulate voice was that of Chen Yun, the most economically experienced and widely respected senior Chinese leader.¹⁰

Chen was the architect of China’s first Five Year Plan and an adamant defender of central planning. Born and raised in bustling Shanghai, Chen was also appreciative of the value of private business. His criticism of Mao’s war on private enterprise in the early to mid-1950s cost him his position as the czar of the Chinese economy. Chen’s economic policy, summarized as “three primaries, three supplements,” was first proposed at the Eighth National Congress of the Chinese Communist Party in 1956.¹¹ Chen maintained that, regarding industry and commerce, the state and collective sector should be primary, supplemented by the private sector; regarding production planning, central planning should be primary, supplemented by market adjustment; regarding the whole socialist economy, the state-controlled market should be primary, supplemented by the free market. Between them, Chen’s clear vision of a mixed economy and Mao’s famous lecture “On the Ten Major Relationships” ensured China’s decisive ideological departure from Stalinism. However, Chen’s explicit references to the private sector and market mechanism were not to Mao’s liking; while Chen’s view was well received at the National Congress, his views were ignored by Mao himself and had little impact on economic policy.

Chen was called back to run the economy after the disastrous Great Leap Forward, but fell out of favor again soon after. He returned to office only after the Third Plenum of the Eleventh Central Committee. His vision of socialism as “the planned economy as primary, market adjustments as auxiliary” was to serve as the guiding light of the Chinese economic reform until the mid-1980s. Chen’s rationale for incorporating the market and the private sector into socialism was pragmatic: the central plan could not be designed in so complete a manner as to cover every detail of the economy. The inevitable gaps in the central plan could be filled by the private sector and the market. However, Chen believed that the macroeconomic balance of the socialist economy (investment versus saving, total government revenue versus fiscal spending, as well as the balance between the industrial, agricultural, and service sectors, and the proper speed of growth) could only be maintained through central planning. While pleased to see the return of the non-state sector and market mechanism, Chen was worried by their rapid growth and potential to undermine the economic foundations of socialism. He was not ready to accept a socialism devoid of central planning or collective ownership.

In Chen’s vision, if the socialist economy was a bird, then the central planning capacity of the socialist state was represented by a cage. This bird-cage metaphor captured the core of Chen’s economic thinking, and it prevailed among the Chinese government at the initial stage of economic reform. The cage in the metaphor was meant by Chen as a constraint, an interpretation widely accepted by both its opponents and critics.¹² Without the cage, the bird would flee and the economy would disintegrate; this happened during the Great Leap Forward when total decentralization allowed the economy to run out of control. Most important, the cage should continually adjust itself to the size of the bird. As the bird grows, the cage must be enlarged to allow it more space and freedom. Chen’s view of the economy helped to facilitate Chinese economic reform at the early stage by easing the revival of the market and the private sector. But this representation of the state and economy was too restrictive to accommodate a genuine market economy.

This tension in the overall vision had little significance at the time, since no one in the government thought China was moving toward a market economy anyway. The goal of the reforms had always been to strengthen socialism. However, as Chen had repeatedly advocated the use of the market mechanism and private sector as a supplement to central planning and collective ownership, his view of a mixed socialist economy helped to legitimize the presence of the market and private sector in Chinese economic thinking. Not surprisingly, Deng was content to see Chen’s view prevail. He was not prepared to give up on socialism altogether, but he was eager to push forward economic reform and see the economy grow, whether it was driven by the private or state sector.

As a result, Chen’s adage, “the planned economy as primary, market adjustments as auxiliary,” became the government’s official position in 1982. It essentially ruled out the proposal of price reform that Xue had proposed, even though the proposal had been warmly endorsed by Hu and Zhao. In his speech to the Twelfth Communist Party Congress in September 1982, Hu felt obliged to stress the primacy of the state sector and central planning in the economy. “In the past few years, we have initiated a number of reforms in the economic system . . . This orientation is correct, and its gains are apparent,” as Hu reported. “However . . . cases of weakening and hampering the state’s unified planning have been on the increase. . . . Hereafter, while continuing to give play to the role of market regulation, we must on no account neglect or relax unified leadership through state planning.”¹³ The proposal to implement wholesale price reform was shelved.

While the Chinese government had no difficulty in rejecting price reform, another genie was proving more difficult to return to its bottle: this was the rapidly expanding private sector in the Chinese economy. In the early 1980s the Chinese government was preoccupied with two dilemmas, how to keep the private sector and prevent it from squeezing out the state sector, and how to maintain the market but without sabotaging central planning. Once the market and private sectors were seen as threatening the economic foundation of socialism, the Chinese government acted resolutely. On January 11th, 1982, the Central Committee issued a notice, calling for immediate action to halt various economic crimes and preserve the socialist economic order. On 8th March the Standing Committee of the People’s Congress passed the Resolution to Strike Hard against Serious Economic Crimes, and even revised certain clauses in Chinese Criminal Law to make it congruent with the Resolution. A national campaign against economic crimes was launched immediately afterward; this was intended to curb the growth of the private sector, with a particular eye on coastal areas witnessing a strong resurgence of private business. As the Resolution stated, “from now on, the struggle against the corruption from decayed bourgeois thought shall be strengthened. Emphasis is placed on preserving the purity of communism in the process of reform.”¹⁴

III

Throughout the 1980s, the Chinese government faced an ideological dilemma. While the Chinese leaders still believed in the ultimate superiority of socialism, they were embarrassingly aware that China lagged far behind the West. This put them in a politically vulnerable position. This sense of vulnerability, coupled with their continuous commitment to socialism, led the Chinese government to develop a paranoid fear of “peaceful evolution” – their suspicions that hostile forces outside China were constantly attempting to undermine and ultimately overthrow the Communist regime with “ideological weeds” and “cultural poisons.” Ensuring that China would resist the temptations of capitalism became another preoccupation of the Chinese government. In 1983 a full-scale campaign was launched against so-called “spiritual pollution.”¹⁵ A handful of outspoken Party members was expelled from the Party for their advocacy of individual freedom. Though Deng in 1979 had marked political reform as a prerequisite for the success of economic reform, in 1983 this was still out of the question. Even discussions on market economics and liberalism were coming under attack.

In spite of this inhospitable political environment and blatant policy discrimination, China’s fledgling private sector managed to survive and grow throughout the 1980s. But what enabled China’s non-state sector to survive the ideological hostility of the government?

To answer that question, we have to recognize that the strengths of the rising Chinese private economy were much broader and deeper than is commonly recognized. In agriculture, for example, the implementation of the household responsibility system was instrumental to the success of agricultural reform. But other factors made a telling contribution, including a 22 percent rise in the purchase price of grain in 1979 and the increased use of fertilizers. The two pioneering villages described in the previous chapter certainly demonstrated the pure force of improved incentives. As a result, the public image of Chinese agricultural reform rests on increasing the incentives of Chinese peasants through decollectivization. However, this does not do justice to a very complex reality. When the household responsibility system was first implemented, it was no more than a performance contract between peasants and the state, which turned rural households into motivated residual claimants after the fulfillment of state quotas. Initially, it was still for the government to decide what crops to plant. But the government quickly lost its ability to enforce its directives. Gradually, the peasants came to have more and more control. The most important and long-lasting effect of decollectivization was regained economic freedom. Peasants were soon able to decide what to plant on their land, how much time to spend on farming, and what other jobs to take. The massive reallocation of time and labor from farming to non-farming activities led to greater efficiency in farming and also brought horticulture, aquaculture, commerce, handicraft, and industry back to rural China. Peasants were no longer chained to the land, and became free to make their own choices. As a result, the sources of income and employment were greatly diversified and the rural economy grew far beyond agriculture and traditional crafts.

Some critics of decollectivization had stressed what they regarded as a serious weakness of the rural reform: many local public works projects undertaken during Mao’s era (particularly irrigation projects) were left to decay. Initially, this cast a long shadow on the prospect of private farming. As time went on, however, the loss of public investment in agriculture was made up by increased private investment. This saw the introduction of improved farming tools, increased use of well water (which did not require an extensive irrigation canal system), and better seeds, fertilizers, and pest controls. While private investment was not a perfect substitute for public works, private farming turned out to be out far more resilient than its critics had thought. Moreover, what was commonly regarded as local public goods, such as roads, gradually came to be provided by private interests or through the joint efforts of the private and public forces.

At the same time, since land was still owned by the state and state procurement of grain remained in place (it was not ended until 1985), agricultural reform posted little threat to either public ownership or central planning. It was therefore rarely affected by the policy debate on central planning and the campaign against economic crimes. Township and village enterprises were equally immune; under the protection of local authorities, these enterprises were officially collective rather than private concerns, even if the truth was somewhat different. Indeed, the early 1980s witnessed a proliferation of township and village enterprises all over China. At one point, the Economic Planning Committee of the State Council planned to absorb all township and village enterprises into the state production plan. The plan met strong resistance from Jiangsu and other provinces where the local governments were heavily involved in the development of township and village enterprises, and the proposal was quickly dropped.

Private business in cities was most vulnerable to accusations of “economic crime.” The story of Nian Guangjiu in Wuhu of Anhui province provides an excellent example.¹⁶ Nian, an illiterate man with no fixed job, was twice imprisoned for street peddling before economic reform began. After Mao’s death and his release from prison, Nian supported himself by selling baked watermelon seeds on the street. Tasty and inexpensive, these were (and still are) a favorite snack all over China. A few years later, Nian developed his own recipe for baking watermelon seeds, with a unique flavour and delicious taste. His watermelon seeds became so popular that people often had to queue to buy them. To expand production, Nian started employing workers beyond his family. From a Marxist perspective, this was blatant exploitation. Even though in February 1979, the State Administration for Industry and Commerce allowed city residents without jobs to be self-employed for repair work, services and handicrafts, hiring workers was prohibited. Nian’s wife was worried that he would be taken to prison again and asked him to give up his business. Nian’s case was reported to Deng Xiaoping but, instead of denouncing Nian, Deng said, “Let’s wait and see.” In 1980, Nian trademarked “the Fool’s Watermelon Seeds.” By the end of the year, Nian had become one of the first millionaires in China. “The Fool’s Watermelon Seeds” would quickly become one of the few household brand names in the food industry in China. However, Nian’s business remained a political liability; Deng had to speak out again in 1984 and 1992 to defend Nian and save him from imprisonment.

Nian was probably China’s luckiest private businessman. The businessmen of Wenzhou in Zhejiang province, the birthplace of the Chinese private economy, did not have the same good fortune.¹⁷ There, and elsewhere, the campaign against economic crimes turned into a thinly disguised assault on private business. In the summer of 1982, eight private businessmen, all in different businesses, were charged with “profiteering” and arrested – though one was able to escape and remained at large for eight months. These “economic criminals” did nothing more than profit from private undertakings. By the end of 1982, more than 16,000 cases of economic crimes had been filed nationwide, and more than 30,000 people were arrested.¹⁸ In this hostile environment many private businesses were forced to register themselves as collective or state enterprises. The owners of these businesses often paid a certain “administration fee” to a real collective or state enterprise or a supervising authority, in exchange for a nominal affiliation. This practice came to be known as putting on a “red hat”; private businesses gained the political protection needed to survive in an inhospitable political environment.

Fortunately, it did not take long for the Chinese government to realize that the most damaged part of the economy was actually the state-owned enterprises. This damage had been caused, in the main, by the lack of a proper pricing system, but state-owned enterprise was the very sector that the Chinese government had sought to protect by delaying price reform. With expanded autonomy, state-owned enterprises became more motivated. Productivity was improved and output went up. Without price reform, however, the whole pricing system was in chaos. The price signal that enterprises acted on did not reflect the true cost to the economy or genuine business opportunities. Under a convoluted price structure, enterprises with good products might not necessarily make any money, and those making large profits were often not supplying products desired by consumers. For example, because the price of coal was kept artificially low, no enterprise in the coal-mining industry was able to make any profit, despite increasing demand for coal. Moreover, state enterprises with guaranteed access to subsidized coal had no incentive to economize on their use of coal even though the real cost had gone up significantly. By holding off price reform, the Chinese government aimed to retain price control as a tool to bolster state enterprises. But without market price signals, there was no market discipline. State enterprises were thus deprived of the most effective mechanism of surviving competition.

Private enterprises and township and village enterprises, on the other hand, were in a different situation. Excluded from the state economic plan, they could buy what they needed and sell what they produced at prices more or less determined by the market. As the factor and product markets were just emerging, information cost remained high for the private firms, and sometimes prohibitively so. This period saw people in charge of purchase and sale in private firms traveling all over China, exploring new sources of inputs and new markets in which to sell their products. These salesmen also earned higher incomes. While their high wage largely reflected their contribution, it also indicated the high cost of exchange for private firms. The high transaction cost resulted in huge inefficiencies in the private economy, diverting resources away from production and innovation. But private enterprises were free of state-imposed constraints on their business decision-making and operated with hard budget constraints and genuine market discipline. Private enterprises did not always perform better than the state-owned enterprises, but those that survived the process of market selection were all but certain to do so.

Thus, the growth of China’s non-state sector had as much to do with its own strength and dynamism as with the weakness of state-owned enterprises. The “non-state” sector was rarely viewed as a “private” sector in confrontation with socialist ideology. Seen as supplementary to the state sector, the non-state sector was allowed to exist outside the strict control of the state. Still, the Chinese government could have crushed it altogether if it had chosen to do so, as its campaign in the early 1980s against “economic crimes” had demonstrated, and as Mao had done previously. So why did the Chinese socialist government allow the non-state sector to grow?

In its early stages, China’s economic reform had a rare advantage in that the political establishment was largely free of vested interests.¹⁹ Despite the longstanding tensions between central and local government, and the emerging conflict between the private and state sector, the political elite was united in its mission to turn China into a rich and powerful socialist country. Chen Yun’s strong preference for the state sector and central planning, for example, mainly rested on his belief in the superiority of socialism over capitalism, a view that was shared, to varying degrees, among most Chinese leaders at that time.

Throughout the 1980s and early 1990s, Chinese politics was largely dominated by the veteran duo Deng Xiaoping and Chen Yun. While Deng has always been seen as the architect of economic reform, Chen is usually viewed by observers outside China as Deng’s cautious, conservative foil. On the surface, Chen and Deng could not be further apart. Deng built his career as a Party leader, with strong roots in the military, while Chen was rarely directly involved in the army or party affairs, being mainly the overseer of financial and economic affairs. Unlike Deng, Chen was deeply skeptical of fast growth, which he believed would create more economic problems than it could resolve. The failure of Mao’s Great Leap Forward and Hua’s “Leap Outward” only reinforced his conviction. Chen had a much stronger belief in the value of central planning and collective ownership. But unlike Mao and most other Chinese leaders, who had little knowledge of the modern economy, Chen followed an apprenticeship in Shanghai during his youth. He knew private business too well to believe in pure socialism and the total elimination of private ownership and market forces. The disagreement between Deng and Chen was so wide that in the 1980s the Politburo Standing Committee seldom convened for meetings.²⁰ Instead, Deng would simply call in Hu Yaobang, Zhao Ziyang, and others to his home and Deng would visit Chen only once a year. Nonetheless, the characterization of Deng as a reformer and Chen as a conservative has reinforced a simplified black-and-white view of the Chinese leaders that is a long way from the truth.

The divide between Deng and Chen was not driven by any conflict of interest or clash in ideology, even though Chen undoubtedly showed a deeper commitment to socialism. While it is generally known that this divide slowed down the speed of the Chinese reform, it is less well understood that the pair’s disagreements helped to maintain a relatively tolerant political atmosphere – a stark contrast to that of Mao’s era. The co-presence of Deng and Chen and their wide disagreements inadvertently turned post-Mao Chinese politics away from a “one-man show.” Despite their differences and disagreements, Chen and Deng had in common a real commitment to pragmatism, a point which is seldom recognized among observers of Chinese politics. Chen’s aphorism “do not rely on higher authorities, do not rely on books, but rely on facts,” was an important part of the post-Mao pragmatism spearheaded by Deng.

This new feature of Chinese politics had a powerful influence on the course of economic reform. Most Chinese leaders were willing to change their views once they had been proven inconsistent with facts. Their questioning and rejection of once-unquestioned ideology created a milieu conducive to change and open to new ideas. This was not because Deng Xiaoping, Chen Yun, and other post-Mao Chinese leaders were wiser than their predecessors; the tragedy of the Great Leap Forward and calamity of the Cultural Revolution had simply dented their faith in any doctrine. If socialism could go so terribly wrong, then an omnipotent ideology must be nothing more than a fatal conceit. It was this shared conviction that brought together Chen Yun and Deng Xiaoping in their pragmatic, experimental approach to reform. Despite the commanding presence of Deng, Chen, and other veterans, in post-Mao China no political leader could simply impose his will on the Party, as Mao so frequently had done. This contributed greatly to the survival and development of a more open-minded attitude. General Secretary Hu Yaobang’s liberal policies in the early 1980s clearly attested further to a profound change in attitude within the Party.²¹

The extraordinary willingness of the Chinese leaders to alter deeply ingrained views is best illustrated by the political debate on central planning and the market. In this debate, resistance to the market as a coordinating mechanism was both ideological and intellectual. Ideologically, the market was condemned as the ultimate cause of various disorders in the market economy, including unemployment, inflation, economic fluctuation, and recession. Moreover, since Marxism had hitherto been accepted unquestionably in China, and treated as the ultimate truth, there was a substantial intellectual barrier which prevented the Chinese people from appreciating the virtues of the market. Mao, for example, once proposed a return to a barter economy, which he thought would be effective in eliminating economic inequality once and for all. As a consequence, even the failure of many of Mao’s radical policies was attributed to his deviation from socialism and the doctrine of central planning. For Chen Yun and many others in the Party and the government who had disagreed with Mao, Mao’s failures actually validated the socialist way.

But the disappointing performance of the state-owned enterprises relative to the private sector led the Chinese leaders to soften their position. Central planning was gradually relaxed to allow both a “compulsory economic plan” and a “recommendatory economic plan”—the former continued the traditional state plan that state-owned enterprises had to follow strictly, while the latter was presented as recommendations and was not binding. As time went by, the recommendatory economic plan grew in importance. This gave the state-owned enterprises more room to exercise their economic freedom. Without any change in ownership structure, the state-owned enterprises gradually became more responsive to market forces. The part of the Chinese economy that was not subject to central planning continued to expand. It is worth pointing out that Chinese economists who had promoted a “recommendatory economic plan,” including Liu Guoguang and Xue Muqiao, had a difficult time in 1982–83 during the campaign against “spiritual pollution.”²² Nonetheless, the freedoms of the recommendatory plan were not totally eliminated in the economy or in policy. In fact, in April 1984, a national conference was held to discuss and promote the recommendatory economic plan.²³

The change of economic policy was most striking in the government’s attitude toward township and village enterprises. Despite their strong contribution to economic growth, township and village enterprises were viewed by the Chinese government as an inferior rival to state-owned enterprises, and essentially disruptive to the state plan. However, in March 1984, the State Council issued what was known as the Number 4 Document.²⁴ This document outlined the government’s support for township and village enterprises and, in particular, for the private enterprises set up by rural households. Township and village enterprises were endorsed as “an important force of the national economy and an important supplement to state-owned enterprises.” Acknowledged as a key element in modernizing Chinese agriculture and industrializing rural China, township and village enterprises were now allowed to enter all industries except tobacco. They were also given tax breaks, access to bank credit, and other financial incentives. Indeed, compared with state-owned enterprises, township and village enterprises now had a lower tax burden. As one veteran scholar put it, “1984 marked a dramatic step in liberalizing the rural economy and improving the policy environment for rural enterprises, which opened the door to accelerated growth.”²⁵

While the Chinese government in the 1980s was certainly more pragmatic and open to the idea of reform, this did not guarantee that the new policies they adopted were necessarily better than previous ones. As the Chinese leaders then proclaimed, “reform should tolerate mistakes, but we cannot stand an absence of reform.” Deng Xiaoping himself probably emphasized more than anyone else the importance of learning from mistakes in the process of reform. However, many challenges remained. Not least of these was minimizing mistakes in learning and experimenting so as to maintain the political consensus behind reform, as well as relaxing political constraints without threatening the political legitimacy of the Party.

Any account of the Chinese economic reform would be incomplete and misleading if the policy of opening up is not properly emphasized as a critical and integral component. China’s opening up, particularly to the West, was a policy pursued by the Chinese government throughout the 1980s and beyond. Each step of China’s economic reform brought it closer to the global market economy.

Five years after Deng’s historic visit to the United States, Premier Zhao Ziyang visited the country in early January 1984. This was reciprocated by President Reagan’s visit to China in April 1984, the first since Nixon’s visit in 1972. The easing of Sino-US relations helped to open up American universities to Chinese students and American markets to Chinese goods. It also made China an attractive destination for western investment; all of this would have a long-lasting impact on the Chinese economy and society. Beyond these obvious changes, improved Sino-US relations also exerted another, subtler, but equally profound influence on the character of Chinese economic reform. The United States of America came to replace the Soviet Union as a role model for China, particularly in the minds of Chinese students. From the mid-1980s onwards, college students in China’s elite universities came to view graduate training in the United States as the ultimate career opportunity. Even the sons and daughters of senior Chinese leaders began to travel to the United States to study; in the 1940s and 1950s their parents had been sent to Moscow.

No place in China was a more effective conduit to capitalism than the Special Economic Zone in Shenzhen. In January 1984, Deng Xiaoping visited Shenzhen for the first time since the founding of the Special Economic Zones. Encouraged by its rapid development, Deng praised Shenzhen as a successful model of China’s “open-door” policy. Deng’s visit and his affirmation sent a clear message to the West that China was committed to economic reform and opening up. As reported in the Japan Economic Journal, after Deng’s tour, “major Japanese trading firms [were] rushing to open offices in Shenzhen.”²⁶ Later in the year, fourteen more coastal cities were opened up, a move noticed by the Business Week as “China’s bold new program to lure foreign investment.”²⁷

But the experiment at Shenzhen did not always run smoothly. No Chinese leader was more supportive and enthusiastic about Shenzhen than Deng Xiaoping. Yet, in June 1985, Deng admitted that “The Shenzhen Special Economic Zone is an experiment. We need more time to see whether it has gone well. We wish it success; if it fails, it will provide some lessons.”²⁸ There was no shortage of disagreement among Chinese leaders on the future of China; they also kept revising their views as the reform went on. At the beginning, the leaders were united in wanting to make China “a powerful, modern, socialist country” (1978). It did not take long for them to revise their mission to put in place “socialism with Chinese characteristics” (1982) and “a commerce economy with plan” (1984), before finally embracing “a socialist market economy with Chinese characteristics” (1992). In this process, Shenzhen was caught in a constant struggle to reconcile itself with the continually shifting Party line.

As a pioneering experiment, Shenzhen never wanted for critics. Always a few steps ahead of the policies being pursued, it often found itself at odds with the prevailing ideology. This was inevitable since Shenzhen and other Special Economic Zones were created to co-opt capitalist practices to save socialism. But this strategy necessitated the adoption of a quasi-capitalist system in Shenzhen. It thus faced overwhelming ideological and practical challenges. Ideologically, China was not at all ready for a market economy, and Shenzhen was often viewed as a conduit for “spiritual pollution,” suffering a wave of condemnation in 1982 and1983. Many years later, in 1992, Deng revealed his solution to such opprobrium. “It was my idea to discourage contention, so as to have more time for action. Once disputes begin, they complicate matters and waste a lot of time. As a result, nothing is accomplished. Don’t argue; try bold experiments and blaze new trails.”²⁹

Chen Yun and Li Xiannian never visited Shenzhen, despite Li’s direct role in setting up the Shekou Industrial Park. This is commonly read as indicating their disproval of the opening-up policy, and there is no doubt that Chen at the beginning was firmly opposed to the setup of the Special Economic Zones and his skepticism and reservation remained for a long time.³⁰ When Li died in 1992, Chen wrote an obituary, which was published in the People’s Daily on July 21st.³¹ In the article, Chen mentioned the fact that he and Li had never been to Shenzhen. He continued:

but we have always been interested in the development of the Special Economic Zones and thought that we have to continuously accumulate lessons to make them work well. In the past few years, Shenzhen had basically changed from an importing to exporting zone, with many new high rise buildings. The development was indeed fast. Today the scale of our economy is much bigger and more complicated than ever before. Many practices that worked before had become obsolete under the current economic reform. This requires us to constantly learn new things, to explore and resolve new problems.

To many outside observers, the setting up of Shenzhen and other Special Economic Zones was interpreted as a triumph for Deng, the reformist, over Chen, the conservative. Many other episodes of the reform were also interpreted in the same fashion. However, the simple and important fact is that both Deng and Chen shared an experimental approach to reform and were both open-minded enough to learn new lessons in spite of their disagreements.³²

The introduction of foreign capital and knowledge to China was by no means confined to Shenzhen and other Special Economic Zones. The Pearl River Delta in South Guangdong province emerged in the 1980s as the most powerful driver of China’s economic growth, largely due to its ability to attract foreign investment from the overseas Chinese. Guangdong was close to Hong Kong and shared the same dialect and local culture. It quickly established itself as the first choice for investment from Hong Kong; it also gained technology, managerial know-how, and access to the international market. Many of the early joint ventures or foreign-owned companies set up in Guangdong were attracted by China’s low production costs. These companies concentrated mainly in the manufacturing of clothing, shoes, and toys. They were later criticized for bringing little advanced technology to China. But in the early stage of reform, these joint ventures played a pioneering role in exposing the Chinese to the culture of private enterprise. In addition, various aspects of Hong Kong culture, including movies, music and literature, were transmitted through Guangdong to the rest of China. In the mid-1980s, Cantonese became a popular language widely learned in Shanghai and elsewhere in China. Capitalism turned out to be less threatening and corrupting than had been projected by the state-controlled media.

China’s opening-up policy was not confined to attracting foreign capital and acquiring advanced technology. Expertise in management was also eagerly sought after by the Chinese government. Through the German Senior Expert Service, an organization of retired professionals in West Germany, a group of retired German engineers were invited to visit Wuhan in 1984.³³ Wuhan, the capital of Hubei province and the largest city in the middle Yangzi River, was among the top manufacturing centers in China before the economic reform. It had a high concentration of large state-owned enterprises. One of the German engineers, Willner Gehrig, stayed on and became the first foreign manager of a Chinese state-owned enterprise, the Wuhan Machine Tool Plant. During his two-year tenure, Gehrig brought in many reforms to improve workers’ incentive and the firm’s productivity, with a special focus on quality control. The quality of the firm’s main product, diesel engines, improved substantially, and for a short time the company became the top brand in the industry in China. But Gehrig’s reform measures were far ahead of their time and most did not survive after his departure in 1986: Wuhan Machine Tool Plant eventually went bankrupt. But after his success, many foreign experts were hired by China’s state-owned enterprises. The impact of these foreign managers and consultants in furthering managerial knowledge in China was greatly appreciated. In 2005, two years after his death, a bronze statue of Gehrig was erected in the center of Wuhan, in remembrance of his lasting influence.

The passing of the Decision on Economic System Reform at the Third Plenum of the Twelfth Central Committee in October 1984 was another landmark in Chinese economic reform. It moved China beyond Chen Yun’s interpretation of socialism, which until then had served as the guiding principle for reform. The 1984 Decision stated that, in order to reform the economic system

we first have to break down the conventional wisdom that treated the planned economy and commercial economy [a Marxian term for the market economy] as antithetical and realize that the socialist planned economy has to consciously comply with and make use of the value theory [a Marxian term for general economic theory], and is a public ownership based commercial economy with state planning. The development of a commercial economy is a necessary stage in social and economic development, a prerequisite for the realization of China’s economic modernization.³⁴

The Decision was praised by Deng as a “new political economy of Marxism” and it also won the endorsement of Chen Yun, who reportedly said after the meeting that the Chinese economy had grown so much that many practices of the 1950s were no longer feasible.³⁵

This acceptance of both the need for and desirability of the market economy was a milestone in China’s economic reform. A few years of reform had convinced the Chinese leaders that central planning, the secret weapon of socialism, could not be counted on as a panacea. Much more than an “auxiliary” to state planning, the market was recognized as an indispensable tool for regulating the economy. However, the market economy was ideologically acceptable only on the premise that it was still compatible with socialism. While central planning was no longer the sacred pillar of socialism, collective ownership was still seen as the basic economic foundation of socialism. It was still believed that only collective ownership could secure shared prosperity and prevent economic inequality. Thus, a political bias against the private sector endured beyond 1984, even though it was not as strong as before.

An immediate impact of this new interpretation of socialism was that it opened the door for price reform.³⁶ In the early 1980s, price reform failed to win political support because central planning was still seen as indispensible to socialism. With the changing interpretation of socialism, more policy choices became possible. The most critical difference between a market and a socialist economy is the acceptance of a market-based pricing system to coordinate the division of labor; this exists in the former and is absent in the latter. But there was no quick fix to move a socialist economy to a market economy and get all prices right immediately. Under socialism, most prices are set by government decrees. In a market economy, prices emerge from competition.³⁷ Policy changes may create or expand to give room for market forces to operate, but they cannot substitute for the working of the market.

In the Chinese discussion on price reform, two distinct approaches developed. The government could adjust prices through administrative fine-tuning – referred to as “tiao” – so that prices would gradually move toward what was deemed a proper level. Alternatively, the government could free pricing from its control and leave it to the market, an approach referred to as “fang.”³⁸ After the Third Plenum of 1984, the second approach became accepted and implemented, but the first one would persist for many years to come. The co-existence of the two approaches would gradually institutionalize the dual-track pricing mechanism, one of the most recognized innovations in Chinese economic reforms.

On January 1st, 1985, the mandatory procurement program in agriculture was abolished. This system had been designed by Chen Yun to secure the food supply and was first installed in the early–mid-1950s.³⁹ When it was launched, it was meant to be an emergency measure because Chen recognized that its potential damage to peasants could be devastating. But it stayed in place for over thirty years and became the linchpin of Mao’s agricultural policy. It thus created many serious problems. Specifically, this policy robbed peasants of their basic economic freedom. When later combined with cooperativization (the brutal imposition of agricultural cooperatives and later, communes), it enslaved all Chinese peasants and sent millions of them down the road to starvation. After the abolishing of this program, the government would purchase only a set quota of grain at a stipulated price, and any quantities exceeding the quota were purchased at prices determined by the market. Although this was not the intention, a dual-track pricing system was created across the agricultural economy. The fulfillment of state quotas at artificially low prices was simply a disguised tax on peasants. Nonetheless, peasants were no longer totally confined to the state quota system and, though still under the shadow of the state, they began to interact with China’s nascent market forces. Still, urban consumers would not have to pay market price for their grain until 1992, with the government continuing to subsidize their consumption until that date. As far as rural households were concerned, the implementation of the household responsibility system in 1982 and the removal of mandatory procurement in 1985 marked the end of the era of central planning and the opening up of a new era for market and economic freedom.

Price reform in industry began on a similar course to that of agriculture, but the results were drastically different. By the end of 1984, the competitive forces vested on industry by private enterprises had ensured that the price of many consumer products was freed from state control. But the fear of inflation and other social and political concerns made the Chinese government hesitant to relinquish control over the price of raw materials. Many state-owned enterprises would have to close if they lost their access to subsidized energy and other inputs. In February 1985, the State Price Administration and Material Administration declared that state-owned enterprises could maintain two lines of material supplies, state allocation and free purchase from the market.⁴⁰ Accordingly, the prices of the goods (mainly intermediate inputs) produced in the state quota system were fixed by the state and the prices of goods produced outside the plan were left to the vagaries of the market.

Unlike agriculture, where the state bought grain from peasants at either a negotiated or market price and sold it to city residents at a fixed price, industry involved a long chain of activities and numerous enterprises before initial inputs reached consumers as finished products. Even socialism could not do away with specialization and the division of labor. This made state management and price control in industry a great deal more complex than in agriculture, and much harder to implement effectively. Since materials supplied by the state (or rather claims to such materials distributed by various authorities) could be easily sold at their (considerably higher) market price, those with personal connections to the government office or managers of state-owned enterprises had great opportunities for profiteering. As a result, China saw the rise of many “paper companies” – companies with no more than a documented presence, but whose political connections allowed them to make easy and risk-free profits selling state controlled materials on the black market. Even though such activities did help to expand the market for raw materials, they created a chaotic price environment for the whole economy. Moreover, such blatant corruption was widely resented and gave rise to a pronounced anti-reform sentiment in Chinese society.

The dual-track system was not without its merits.⁴¹ In the non-state sector, it created more opportunities for interaction with state enterprises through the market mechanism as well as providing reliable access to raw materials strictly controlled by the state. With the dual-track system in place, private enterprises no longer depended on black market purchases for their inputs; those transactions were expensive and full of uncertainties. At a market price, the private enterprises could now openly buy inputs from state enterprises. This was an important reason for the continuous growth of the non-state sector throughout the 1980s, which, undoubtedly, speeded up the decline of state enterprises.

In state enterprises, the dual-track system created an unintended consequence. With the implementation of the system, enterprise reform became something greater than “delegating rights and sharing profits.” Modeled after the household responsibility system in agriculture, a contract responsibility system had been tried among a few state enterprises as early as 1981, and this was implemented nationwide in 1984. Enterprise managers would sign a performance contract with their supervising authority, while employees signed a contract with the manager. Thus, a multi-tier contract system emerged in the state enterprises, in which rewards were tied to performance. Under the new contract responsibility system, employees of the state enterprises were given more freedom. Those who thought they possessed marketable skills and were more enterprising could now choose to produce goods and services for the market; otherwise, they could stay within the state plan and produce whatever was specified in the state plan. Thus, a proportion of state employees opted out of central planning and directed their production to the market while remaining in the state sector. Before diving into the ocean of the market, which was then called “xiahai,” they could first dip their toes in the water. This opportunity of staying with the state enterprise but producing for the market greatly moderated their apprehension of market forces and smoothed the learning curve of embracing the market. Without privatization or any change in the ownership structure of state enterprises, some state employees were able to participate in the market; this helped to encourage risk-taking and facilitate entrepreneurship among state employees while socialism was largely kept intact.

Although full price reform would have presented a severe challenge to state-owned enterprises, the dual-track pricing system offered a more convenient and less risky approach. However, this system in industry was a formalization and an extension of practices that had emerged in many industries during the previous stage of enterprise reform, and it resulted in similar problems. It did not take long for the Chinese government to recognize the urgency of the need for full price reform.

VII

The Chinese government also took a number of measures to develop a common market across the whole economy. In a market economy, the price mechanism coordinates the flow of resources within the economy, firstly by signaling the return of competing uses of resources to all economic actors, and then by allowing resources to move to their most profitable employment. The market is able to operate in this way because all firms are constrained by a common market discipline and competition in the product market can then lead to efficient utilization of the factors of production. This system breaks down, however, when the firms’ survival is not determined by their performance in the product market as judged by consumers. In China’s decentralized economy, the active intervention of local authorities and a chaotic price system thwarted the operation of market forces. One of the most severe consequences was the fragmentation of the national economy, impeding the free movement of inputs and products. When the price system was suppressed, economic resources could not seek the highest returns. Enterprises could not sell products freely in the market; consumers were denied their freedom to choose. The market system was essentially paralyzed. To allow production to continue, the visible hand of the state became a necessity.

On March 23rd, 1986, the State Council issued the Decision on Several Question in Further Pushing for Horizontal Economic Integration,” encouraging enterprises across different regions and under different authorities to merge.⁴² Horizontal economic integration then came to be regarded as a crucial component in economic reform to overcome trade barriers created by the fragmented economy. From March 31st to May 19th, the People’s Daily ran four editorials calling for, and giving specific guidance on, horizontal economic integration.⁴³ In the absence of a market system, these mergers among enterprises went some way towards promoting the efficient utilization of resources.

In support of horizontal economic integration, the Chinese government also launched reforms in labor management.⁴⁴ The “iron bowl” of socialism – lifetime employment with a single employer – began to change. Contract labor was introduced and was quickly adopted by enterprises. Many regional labor markets emerged and developed quickly. While the State Council would retain control of the total wage level for a given enterprise, in December 1986 it allowed state-owned enterprises full freedom in deciding the wages and bonuses for their employees. By introducing more flexibility to the labor market, these reform initiatives facilitated mergers among state enterprises.

At the time, the integration of enterprises had an added benefit – it helped to expand the autonomy of enterprises beyond that afforded by the contract responsibility system. A common consequence of horizontal economic integration was the creation of “share enterprises” – merged companies. In the majority of cases in China – and unlike corporate mergers in a market economy – the dominant enterprise did not purchase its junior partners outright. Instead, each negotiated for a specific amount of shares in the newly merged “mother company.” Though the transfer of stock was not permitted initially, in many other ways these resembled a modern joint-stock company. Later, the joint-stock company model was widely embraced as an alternative to the contract responsibility system as a means of furthering industrial reform. In April 1984, a state owned shopping center in Beijing was allowed to sell stocks to the public to raise capital.⁴⁵ In November, Shanghai Feilo Acoustics Corporation also sold stocks to both the public and its employees; it became the first company in China to issue stocks to the public.⁴⁶ By the end of 1986, China had more than 6000 joint-stock companies.⁴⁷ With its ability to raise capital from the public and to operate in multiple sites, the joint-stock company effectively weakened the control of the local government. This represented a significant increase in the autonomy of Chinese enterprises.

VIII

At this point, the Chinese government made a serious policy blunder, with far-reaching implications. To examine this, we have to start with reforms in the banking sector.⁴⁸ Before 1978, China had one bank – the People’s Bank of China, which was owned and controlled by the central government and overseen by the Ministry of Finance. Its main function was to finance the physical production plans of state-owned enterprises. With little savings in private hands and credit allocated to the state-owned enterprises through central planning, the Chinese economy did not have much need for banking. According to the World Bank’s estimate, of China’s total savings in 1978, household savings accounted for a mere 3.4 percent, with government savings amounting to 43.4 percent and the remaining 53.2 percent in the hands of enterprises.⁴⁹ This situation changed dramatically after the start of reform. By the 1990s, household savings had gone up remarkably, accounting for between one-quarter to one-half of the country’s total savings.⁵⁰ The first step of banking reform was to install a two-tiered banking structure. The People’s Bank of China became the Central Bank of China, while four state-owned banks took over the emerging conventional banking business, such as taking deposits and making loans. The Agricultural Bank of China, dealing with banking business in agriculture and rural areas, was set up in February 1979; the Bank of China, dealing with foreign trade and investment, was founded in March. The People’s Construction Bank of China, dealing with fixed capital investment, was spun off from the Minister of Finance in August 1979. The Industrial and Commercial Bank of China was set up in 1983 to deal with all commercial transactions not serviced by the other three institutions.

The new structure ended the monopoly of the People’s Bank of China. The Central Bank became separated from the four specialized banks, each of which was expected to operate like a commercial bank. They competed with each other in taking deposits from enterprises and individuals, but had a protected market for loans, since each bank had a different set of customers designated by the state. The four specialized banks had little pressure to perform the basic functions of screening and monitoring; where to invest and how much continued to be decided by the government. Under the decentralized administrative system, the total amount of investment specified by the central government was seen by local governments as a common pool. This led to aggressive competition for investment quotas and bank credit. In the face of demands from local authorities, the central government often made concessions and allocated additional loans beyond the specifications of the investment plan. In addition, the local governments could, and often did, put direct pressure on the local branches of the state banks. Consequently, “investment hunger” was a constant problem in China, as in many other socialist economies.⁵¹

What made China’s case distinctive was that it was the local governments, rather than state-owned enterprises, that worked hardest to win investment. Thus, in China, “investment hunger” deepened as local governments became empowered by administrative decentralization. In addition, “investment hunger” was driven by another prominent feature of the Chinese economy. Since the mid-1950s, China had sacrificed agriculture to subsidize industrialization; a common way of doing this was by depressing the price for agricultural products and other raw materials while raising the prices of manufactured goods. Once reforms began, the price gap between agricultural and industrial products began to close, but the biased price system still made industrial production much more lucrative than it would otherwise have been. As a result, industrial investment was coveted by both local governments and enterprises, particularly the non-state firms.

After the third Plenum of the Twelfth Central Committee in 1984, another round of bank reform was begun. The goal was to give more autonomy to the four specialized banks in loan-making and, by doing so, to make the banking industry more autonomous and competitive. The first step was for the Central Bank to stipulate the amount of loans each bank could make each year and then let the banks decide for themselves how to make the loans.⁵² During the last quarter of 1984, the Central Bank leaked that total loans the banks would be permitted to make in 1985 would be based on the actual loans they made in 1984. Not surprisingly, all banks rushed to give out loans.

To make things worse, the Ministry of Labor was at the same time considering a wage reform policy. It proposed that the wages in 1984 would serve as a benchmark for wage increases in the following years. As a result, state-owned enterprises rushed to banks to borrow money to raise wages at a time when banks would take any opportunity to lend money. Consequently, the bank loans in December of 1984 increased almost 50 percent over those of December 1983. The bonus paid to employees of state-owned enterprises increased more than 100 percent and total wages increased by 38 percent. The money supply in the last quarter of 1984 increased by more than 160 percent. For the whole year, it increased almost 50 percent over the previous year, 45 percent higher than the figure stipulated in the economic plan.⁵³ Investment and consumption were both set to rise; conditions were ripe for inflation.

With this ready supply of bank credit, growth in investment accelerated over the following few years. The industrial sector expanded rapidly, particularly the township and village enterprises. In Wuxi county of Jiangsu, home to the largest concentration of township and village enterprises in China, output grew by 100 percent in each of the first two months of 1985.⁵⁴ In the meantime, inflationary pressures were building. In 1985, inflation rose to 9.3 percent, up from

2.8 percent in the previous year. It remained high in 1986 and 1987 (6.5 percent and 7.3 percent respectively), before rising to double digits in 1988. At the time, the Chinese government chose to believe that modest inflation was a necessary byproduct of economic growth; no decisive action was taken.⁵⁵

Under the contract responsibility system, managers of the state enterprises were eager to invest in projects that were able to deliver short-term gains, leaving the long-term consequences to their successors and, ultimately, to the state. In the mid-1980s, employees of the state enterprises enjoyed steady rises in incomes, while the state had to pump increasing amounts of money into the enterprises to keep them running. In 1987, subsidies to state enterprises made up one-third of government expenditure.

At the same time, the growing pains of the enterprise reform with its dual-track pricing mechanism led the Chinese government to embrace price reform. However, the timing of this could not have been more unfortunate. In 1988, when the Chinese government announced its intention to go ahead with price reform, inflation increased rapidly. The price index jumped from 9.5 percent in January to 16.5 percent in June, 19.3 percent in July and 38.6 percent in August. This was a level unprecedented in the history of the People’s Republic. February 1988 saw panic buying in many Chinese cities. It was reported that a consumer in Wuhan bought 200 kilograms of salt, and another in Nanjing bought 500 boxes of matchsticks.⁵⁶ Under such conditions, price reform came to be seen as too politically risky, and the attempt faltered. The collapse of the price reform had a wide-ranging impact. Economic reform was held back everywhere else, with reversals in certain areas. An austerity program was introduced in September and the Chinese economy entered a four-year period of “adjustment and reorganization.”⁵⁷

While economic reform was halted in the mid-late 1980s, Chinese politics suffered its own misfortune.⁵⁸ Hu Yaobang, arguably the most open-minded leader the Chinese Communist Party ever had, was forced to step down in January 1987. Hu had played a critical role in the late 1970s and early 1980s in reintroducing pragmatism and common sense to Chinese politics and stressing tolerance and liberal thinking, critical for reuniting the Chinese people behind the Party. But Hu’s liberal political views were many steps ahead of his fellow Party members and this put him in conflict with Party veterans, including Deng. While the Party was obsessed with the threat of “peaceful evolution” and “capitalist liberalization” throughout the 1980s, Hu stressed “feudal despotism” as the most insidious element in the Party. He believed that the Party could face up to any external challenge as long as it was able to strengthen itself from within by encouraging free airing of different views. Hu was far more willing to share political power and tolerate dissenters than allowed by the Party line. During the “Anti-Spiritual Pollution” campaign in 1983–1984, Hu was attacked for being too accommodating to intellectuals who were alleged to promote “spiritual pollution” in China, as well as being ineffective in preserving the leadership of the Party.⁵⁹ At a time when the majority of the Party leaders were preoccupied with consolidating one-party rule, Hu’s persistent efforts to encourage and protect dissenting voices and to create an open and tolerant environment for political discussion was perceived as a sign of political weakness.

The explicit reason for Hu’s removal was his unwillingness to use harsh measures to contain the student protests in 1985 and 1986. Throughout the mid-1980s, college students had staged occasional street protests, demanding individual freedom and political participation. Non-political concerns, such as the quality of food at school canteens, were equally important in fueling dissent on campus and motivating students to protest on the streets. In 1986, massive student demonstrations erupted in Beijing, Shanghai, and other big cities which contained concentrations of college campuses. Hu was harshly criticized by Party veterans for being too lenient in his response to students and too soft in defending the Party’s monopoly of political power. At the same time, the worsening personal relations between Hu and Deng triggered Deng’s withdrawal of support. Never a favorite of the Party veterans, Hu had no choice but to step down.⁶⁰ But he was widely perceived by the public (particularly college students and intellectuals) as a defender of freedom of expression and an innocent victim of party politics. A year later, his sudden death on April 15th, 1989, triggered an outpouring of sympathy and sorrow from people in all walks of life. Without any real avenue to express their views, college students in Beijing took to the streets, beginning the 1989 Students Movement.

Like any political event, the 1989 Students Movement had many causes and its development was shaped by multiple factors.⁶¹ The particular way it began and its tragic ending were not anticipated, but its origin and development were clearly influenced by recognizable economic forces.

Any economic reform involves change in the rules of the game, with inevitable distributive consequences. China’s enterprise reform was no exception. Losers, in both a relative and an absolute sense, were understandably eager to voice their discontent when the opportunity arose. The Chinese economic reform has been applauded as a “reform without losers.”⁶² This cannot be true, however, if gains are measured in relative terms. Even if everyone was made better off during the reform, the relative position in the income ladder would change for many members of society. In this relative sense, it was inevitable that some would feel like losers. In addition, for those with political privileges the enterprise reform in the 1980s created many opportunities to make easy money. Government officials who controlled access to state-supplied materials and managers of state enterprises were widely believed to have enriched themselves through arbitrage opportunities created by the dual-track pricing system. The abuse of public power gave rise to widespread resentment against reform; this explained why the 1989 Students Movement was so enthusiastically supported by the general public. Thus, reform without losers in the absolute sense could still give rise to widespread frustration and disillusion. Moreover, mistakes in economic policy, particularly the mishandling of monetary policy since 1985, which ultimately led to double-digit inflation in 1988, created an army of discontents ready to take to the streets.

Paradoxically, it was the sympathy and active support of the wider population that raised alarm bells in the Chinese government. Student protests in previous years were mostly confined to college students, with little participation from others. In 1989, the Beijing municipal government was stunned by the widespread participation of city residents in the students’ street protests. The frightened municipal leaders reported to Deng Xiaoping, characterizing the peaceful, non-confrontational student demonstrations as an “anti-revolutionary turmoil.” To most Chinese people, this term evoked dark memories of the Cultural Revolution. On April 26th, the People’s Daily issued a front-page editorial, “Hold the Flag Clear to Oppose Any Turmoil,” charging a few unnamed individuals – the so-called “black hands” – behind the students with fomenting “a planned conspiracy” aiming to “plunge the whole country into chaos and sabotage the political situation of stability and unity.” The harsh tone and outrageous charges did not scare the students into backing down, as the Chinese government had intended. On the contrary, disappointed and agitated, students became more angry and responded by conducting larger-scale demonstrations and winning more support from the non-student population.

Outside Beijing, student protests broke out in over 130 Chinese cities. Many students flocked to Beijing to show their solidarity and support, or just to tour the capital. The central government did not ask provincial governments or the Ministry of Railways to prevent their college students from traveling to Beijing. On the contrary, students were allowed to travel for free on the railway to Beijing. As Beijing was flooded with students from all over China, the situation became more disorderly. As time went by, the radical elements within the student movement prevailed. A few hundred students went on hunger strike on May 13th and gradually the protestors and the government were cornered into confrontation; neither side was willing or able to compromise. The Chinese government imposed martial law on May 20th, but could not enforce it in the face of strong resistance from students and Beijing residents. The 50,000 troops ordered to enforce martial law were stopped by Beijing residents and students on their routes to Tiananmen Square; after two days, the troops withdrew. This episode not only further antagonized the protestors, it also misled them into believing that they could beat the government if they stayed united and determined. Long accustomed to military revolutions and class struggles but with little experience in civil dialogue, the Party was unprepared to take a conciliatory stance. In addition, students who had occupied the Square since mid-May were too disorganized to be able to strike a bargain with the government. On the night of June 3rd, with the approval of Deng, armed soldiers, supported by trucks and tanks, stormed into the Square from all directions, leaving hundreds of civilians dead on the way.

The Tiananmen incident had significant repercussions for Chinese economic reform, at least in the short term. Foreign investment tumbled and international trade dropped significantly in the following years. Many reform measures were stopped and there were policy reversals in several areas. Private business witnessed its worst period since the reform began. Nonetheless, the incident did not turn into another lengthy political persecution. Nor did China close its door to the West. After a decade of reform Chinese politics had significantly changed compared to Mao’s time. The political fallout of the 1989 Students Movement was quickly contained. In the long run, the Tiananmen incident did not derail economic reform. In as much as it made the Chinese people more disillusioned with politics, it may have helped to re-channel human talents into private entrepreneurship. But China had to wait for Deng’s 1992 “southern tour” to rekindle the fire of market reform. The use of guns and tanks against unarmed students and other civilians clearly revealed the weakness and vulnerability of China’s fragile political power, especially its total absence of institutional mechanisms to resolve public discontent and its lack of political skills to inform and engage the public peacefully and effectively.

Throughout the 1980s, the most stubborn resistance to market reform came neither from state sector employees worried about competition, nor from Party and government officials fearing the loss of their privileges. Instead, it originated from China’s remaining commitment to socialism. Chinese politics, still largely defined by socialism, demonstrated the remarkable staying power of ideology, even as the Chinese leaders tried hard to break away from it. This is best illustrated by Chen Yun and his defense of the planned economy on the one hand and his sanctioning of the market and private entrepreneurship on the other. In this regard, the 1984 Decision on Economic System Reform marked a breakthrough in Chinese market reform because it transgressed the boundaries defined by the 1978 Communiqué. From that point on, a market economy replaced socialist modernization as the goal of China’s economic reform.

Deng viewed China’s economic reforms an adventure and experiment. During this trial-and-error-based learning process, the Chinese people, and particularly their leaders, had to break away from preexisting ideas and habits of thought and acquire many new ones. This was especially true of their knowledge of the market economy and the division of labor between the state and market, and between public and private ownership. In this collective learning process, self-interest is clearly the driving force behind peoples’ motivation to learn. Indeed, a critical component of the Chinese economic reform was to release the power of interests, which had been condemned and brutally oppressed under Mao’s radical idealism. Economic reform began with a realization that poverty was not a virtue of socialism. As Deng famously remarked, “to get rich is glorious.” At the time, his endorsement of the pursuit of interests was no less than a revolution in ideas. But economic textbooks have probably oversold the insights of Adam Smith to promote, to the exclusion of all else, the role of interests in motivating human behavior. This simplified approach would have worked better were ideas fixed forever. In the real world, ideas do change and these changes have far-reaching consequences, if only because they help to redefine who we are, reset the direction of our actions, and redraw boundary lines between what is allowed and what is not. Taking an experimental approach to reform, the Chinese government believed in the preponderance of ideas over interests, and persistently stressed the importance of “the emancipation of the mind” throughout the reform period. To paraphrase Hume, interests are the slave of ideas.⁶³

In general, institutional change is as much driven by interests as it is shaped by ideas. It often gets stymied due to the mishandling of conflicts of interest and clashes of ideas. The conflict of interests and its resolution through property rights and market competition has long been, and continues to be, a staple of economic analysis.⁶⁴ Clashes of ideas, however, have not received their due attention. When ideas and ideologies are recognized in institutional analysis, they are often treated as part and parcel of informal institutions, which includes norms, customs, and values that support the working of formal institutions. Less formal, and with little coercive power, informal institutions are often deemed less forceful or direct than formal institutions in their effect on human behavior. This, however, may have more to do with the way institutions have been conceptualized than with actual reality.

Broadly speaking, institutions serve two related but distinct social functions. First and foremost, institutions are man-made devices, without which human society would not be able to survive. Many institutions result from human actions but not human design; some are intentionally created, with unintended consequences that may overshadow their intended goal. A critical way institutions operate is to constitute various social organizations out of individuals, such as families, firms, political parties, and nation-states. Once created, how these corporate actors work and interact with each other to bring about the intended goals is further regulated and coordinated by other institutions. Unsurprisingly, the complicated functions institutions perform in the operation of the economy and society have of late attracted a lot of attention from a wide range of academic disciplines.⁶⁵

Second, as institutions are deeply involved in creating and operating organizations, and the demarcation and reinforcement of social boundaries, they gradually assume an additional role. In this second function, institutions are less a tool to serve our interests than a symbol of our identity, signaling to others who we are and what we value. When we identify ourselves with an institution, instead of seeing it as a pragmatic instrument to structure our social life and advance our interests, we take it as a badge of status. A profound cognitive change takes place at the individual and societal level when an institution that we adopted for its expected pragmatic function assumes a status role, coming to define our individual and collective identity.

When Mao launched the socialist transformation in the mid-1950s, socialism was embraced as the best way to make China strong and prosperous. The Soviet Union’s rapid rise from a backward agrarian economy to an industrial powerhouse convinced the Chinese leaders of the superiority of socialism; the Soviet’s defeat of the German army during the Second World War lent further support to the invincibility of socialism. As a result, socialism was endorsed by the Chinese government as the blueprint from which to rebuild China. Moreover, central planning and collective ownership were believed to offer the chance to stamp out economic inequality, the perceived root of all social evils. Over time, however, the relation between socialism and China went through a process of subtle metamorphosis. Socialism was gradually transformed from a political tool to an absorbing goal, the achievement of which justified the sacrifice of the Chinese people. Under the aegis of protecting and expanding socialism the Chinese people ultimately became a mere pawn. This process of double alienation remains an irony and a puzzle: how could socialism, initially adopted as a “golden highway” to peace and prosperity be used to glorify the chaos and poverty suffered by the Chinese people? How could the Chinese people, including their defiant and grandiose leader, who prided themselves on being the masters of history, turn out to be slaves to an alien ideology?

Tragically, it took the disasters of the Great Leap Forward and the Cultural Revolution for the Chinese to rethink their identification with socialism. If the Chinese leaders had learned some lesson from their past horrendous mistakes, this was certainly the most costly human lesson ever. In any case, an important consequence of the 1978 debate on the criteria for testing truth was to challenge the sacred status of Marxism and question the rationale for China’s identifying itself with socialism. When China embraced “socialist modernization” at the end of 1978, socialism was still believed to be a superior system. Nonetheless, socialism had been restored to what political ideologies should always be: a working tool rather than a non-negotiable goal. China could now subject socialism to empirical testing and judge it according to its performance. While it is hard to change one’s identity, it is much easier to replace an ineffective tool.

For the Chinese, the emancipation of their collective mentality from the grip of socialism turned out to have far-reaching implications. So long as socialism had been part of their collective political identity, any doubt regarding that ideology was suicidal, any critique of socialism an act of treason. In this climate, it was simply impossible to conduct any meaningful intellectual debate. Many of Mao’s political enemies, from Deng Zihui in the debate on agricultural collectivization in the early 1950s, to Peng Dehuai during the Great Leap Forward, as well as Liu Shaoqi and Deng Xiaoping during the Cultural Revolution, were victimized simply for voicing dissenting views. The lack of an institutional mechanism to resolve disputes in policy and disagreements in ideas not only cost these personalities their political careers (and even his life in the case of Liu), but also extended the life of Mao’s misconceived and disastrous policies.⁶⁶

In the aftermath of the Cultural Revolution, Chinese leaders became more patient and careful in their handling of political infighting and lenient in their treatment of parties on the losing side of debates. This was demonstrated in the trial of the Gang of Four and later in the depositions of Hua Guofeng (1981), Hu Yaobang (1987) and Zhao Ziyang (1989). The defeated party in a power struggle was not publicly denounced or humiliated, as had been the case in the past. Few on the losing side were ever executed, as had been common before the Communists took power and during Mao’s era. Throughout the 1980s, Chinese politics was conducted in a much more reasonable fashion.

This was largely due to two institutional developments. The first was the increasing participation of scholars in political life.⁶⁷ In stark contrast to Mao’s time, when scholars were criticized as the “stinking ninth class,” once reform began scholars were gradually recognized for their expertise. They then began to reprise their traditional role as advisors and counselors to the government. In addition to the knowledge with which they could inform policy debate, scholars were non-partisan and functioned directly in depoliticizing these deliberations.

Scholars sometimes got directly involved as members of state or quasi-state think-tanks that had emerged during the early 1980s. These included the Chinese Academy of Social Sciences (particularly its Institute of Economics), the Chinese Rural Development Research Group (established in September 1980), the Economic System Reform Office (established in 1980), the Economic Research Center (established in 1980) and the Committee on Economic System Reform (established in March 1982) under the State Council, as well as the Rural Policy Research Office (established in 1982) under the Secretariat of the Central Committee of the Party. Regardless of their status, they all worked closely with the Chinese government, informing government and conducting policy debates and formulating economic policy. The direct participation of scholars in policymaking helped to take the political heat out of policy debates and avoid direct confrontation between different Party factions. Though, in some cases, they held government positions and were trusted Party members, they were seldom contenders in power struggles. In addition, these scholars could be removed or simply ignored, with little negative impact on political stability. Debate among scholars and competition among ideas served as a proxy fight, avoiding direct clashes between rival factions at the center of political power.

In the early 1980s scholars played a significant role in framing and taming the policy debate in rural reform, enterprise reform, and price reform. A case in point was the policy debate on the “recommendatory economic plan”; this was an administrative invention to introduce market forces without abandoning central planning. While Chen Yun was firmly against it, Zhao Ziyang wanted to use it to increase policy flexibility without challenging economic planning head on. A group of economists from the Chinese Academy of Social Sciences advocated and defended the “recommendatory economic plan.” When Chen confirmed his unyielding opposition, leading scholars were reprimanded for their views, sending a clear signal to Zhao. This saved a potentially damaging confrontation between Chen and Zhao.⁶⁸

The second and more institutionalized development was the rebuilding of the Chinese legal system.⁶⁹ During the Cultural Revolution, law was essentially discarded, leaving even Liu Shaoqi, Chairman of China, unable to defend his basic rights. Since most of the Chinese leaders of Deng’s era, and particularly Deng himself, had suffered personally during the Cultural Revolution, it was not surprising that they were most anxious to rebuild the Chinese legal system. Before it began work on anything else, the post-Mao Chinese government turned its energies towards the law. On March 5th,1978, the third constitution of the People’s Republic was adopted at the first meeting of the Fifth National People’s Congress, restoring courts and procuratorates.

Deng Xiaoping became an advocate of what he called “legal democracy.” When meeting a delegation from Japan on June 28th,1979, Deng told the guests:

We must strengthen both democracy and the legal system because they have been ineffective. In order to strengthen our democracy, we have to improve our legal system. Nothing can be accomplished without an extensive democracy and a sound legal system. We have suffered a great deal from disorder and turmoil. . . .

We really have had no laws and no legal system to follow for many years now. At this session of the National People’s Congress, we formulated seven laws. Some of these laws contained articles which revised the Constitution. . . . This was a necessary precondition for creating a political situation of stability, unity and liveliness. If we do not establish such a political situation, the four modernizations cannot be realized. Following this session, we shall formulate a series of laws. We lack many necessary civil laws. We also need to enact many laws governing economic development, such as those pertaining to factories. The laws that we have made are too few. We need about one hundred laws which we do not presently have. Therefore, we have much work to do and this is just the beginning. We must promote our democracy and our legal system. They are like a person’s two hands; if either one is weak, the person will not be able to accomplish anything.⁷⁰

Later, addressing government leaders on December 13th,1979, Deng stressed the same message, admitting that “[Our] legal system needs strengthening. . . . Legal democracy needs systematizing so that the system and the laws do not change when either the leadership or its view or focus change. [In the past], people often equated the leaders’ words with laws; opposing the leaders’ views was deemed as against the laws. . . . When words from the leaders changed, laws surreptitiously changed as well.”⁷¹ In the next few years, a massive quantity of laws were put into place, covering criminal, civil, economic and administrative areas. This included a new constitution in 1982, which would go through four revisions – in 1988, 1993, 1999, and 2004 – and is still in use today. Between 1978 and 2008, China passed 229 national laws. Only eight pre-1978 laws are still in use.⁷²

In economic areas, the progress of legal development was even more impressive. On July 1st, 1979, China passed the Law on Sino-Foreign Equity Joint Ventures, which was widely welcomed as a “landmark piece of legislation,”⁷³ signaling both China’s determination to embrace foreign investment and its commitment to the use of law to make its policies credible internationally. The Economic Contract Law was passed on December 13th, 1981, followed by Trademark Law on August 23rd, 1982, Foreign Economic Contract Law on March 21st, 1985, Law on Wholly Foreign-Owned Enterprises and General Principles of Civil Law on April 12th, 1986, Enterprise Bankruptcy Law on December 12th, 1986, Law on Sino-Foreign Cooperation Joint Ventures and Law on Industrial Enterprises Owned by the Whole People on April 13th, 1988, and Provisional Regulations on Private Enterprises on June 25th, 1988. At the same time, other legal institutions, such as lawyers and the courts, developed in an equally impressive manner. For example, there were virtually no lawyers in 1979, but 10,000 full-time practicing lawyers in 1984, and 100,000 in 2004.⁷⁴

What is of direct relevance to our discussions here is that China’s legal development in the post-Mao era, described by William Alfred of Harvard Law School as “an event of epic historic proportions,”⁷⁵ helped to depoliticize Chinese politics and constrain the power of central government through the rule by law. Even today, the rule of law is still wanting in China, and administrative intervention in the economy and society at large is still pervasive. Nonetheless, rule by law, which China has aggressively pursued since 1978, has provided legal protection for local Chinese government officials pursuing economic development and other goals. A significant example of this is the passing of the Regulations for the Special Economic Zones in Guangdong Province by the National People’s Congress on August 26th, 1980.⁷⁶ It was then unprecedented that the National Congress should pass a law drafted by a provincial legislature. The Special Economic Zone was such a bold endeavor that provincial government officials could not feel comfortable unless it was sanctioned by laws passed by the central government. This law gave the Special Economic Zones a permanent legal protection independent of local authorities and made them more credible to outside investors. However, it also provided legal protection to local authorities; with what is aptly referred to in Chinese as “the Imperial Sword,” local authorities were assured of their safety in undertaking the venture.

During Mao’s time, government officials were often demoted or even imprisoned when their words or deeds were deemed anti-Party, or “anti-revolutionary.” Largely determined by the capricious Mao himself, the criteria for these misdemeanors were subjective and unreliable. Despite Mao’s attempts at decentralization, this meant that local government officials rarely acted on their own initiative, but merely catered to Mao’s changing whims. The development of China’s legal system in the post-Mao era was intended to make sure that this could never happen again and, in this regard, it was largely successful.

It is also important to stress that since law enforcement was essentially in the hands of local authorities, legal development amounted to a devolution of power from the central government to local authorities. This, as we will see in the following chapter, paved the way for regional competition.

At the same time, law and order as then understood by the Chinese leaders differed fundamentally from the rule of law as commonly used in western legal and political discourse. The primary goal of legal democracy in China was to maintain political stability and continuity of policy in a one-party political system. In the aftermath of the Cultural Revolution, the Chinese government embraced the rule by law to protect the political structure from two different threats, which were believed to have pushed the Chinese political system to the verge of collapse in the past. These were reckless decisions made by political leaders and massive direct participation in politics by the masses. Neither of these had been previously subject to any legal constraint. Without proper institutional mechanisms to channel and tame popular passions, what Mao advocated as “big democracy” utterly failed its intended goal of freeing Chinese politics of bureaucratization. What Mao failed to realize was that neither democracy nor order was achievable without law. As Mao himself often acted above the law, the two sources of political chaos intertwined and paralyzed the Chinese political system during the Cultural Revolution. This was the worst nightmare for Deng and other post-Mao Chinese leaders.

As China’s decentralized political structure could readily multiply the risk of whimsical decisions by local political leaders, the rule by law was urgently needed. Yet, as stated above, the rule by law was essentially an attempt to structure and regulate the hierarchy of power relations within the maze of Chinese politics. It meant that Beijing had to abide by legal procedures in its decision-making, and local authorities were free to act within legal boundaries. This was a significant improvement over the political system headed by Mao. But it contrasts with the rule of law, which primarily aims at horizontal relations among individual and corporate actors of equal political and legal status.

Moreover, since the legislative law-making power in China is concentrated in the central government, rule by law is more effective in constraining and disciplining the behavior of the central government. Its effectiveness is impressive in maintaining political stability. From 1949 to 1976, Beijing stuggled almost constantly to save itself from political chaos; in the post-Mao era, power changed hands several times with no serious threat to political order, except during the Tiananmen incident. The pursuit of the rule by law also helps to strengthen the position of local authorities vis-à-vis Beijing. Since Beijing is not willing to give up its monopoly of political power or subject itself to the rule of law, the central government is forced to exercise its power vis-à-vis local authorities outside the legal domain, relying on non-legal administrative measures and personnel control. This has largely been accomplished through the apparatus of the Chinese Communist Party, particularly the powerful Organization Department.⁷⁷ Consequently, economic reform did not make the Party less relevant or less important. On the contrary, the Party became an integral part of a convoluted institutional framework underpinning China’s economic reform. Yet, how to integrate the Party into the legal system remains an open question. As long as the Party stayed above the law, the law did not exist for those who could claim to act in the name of the Party. This inevitably undermined both the law and the leadership of the Party.

The Chinese economic reform entered the 1980s with a strong commitment to socialism and a strengthened leadership at the head of the Chinese Communist Party. As time went by and as the experience of reform accumulated, the grip of socialism on Chinese leaders’ mentality started to weaken. This was especially true of the economic domain, where the superior performance of the private sector vis-à-vis the state sector was too obvious to be ignored. Even though the Chinese were blessed with an open and pragmatic way of thinking, old habits of thinking were difficult to do away with and practice was sometimes too ambiguous to yield bases for decisions. Risks had to be taken and mistakes were impossible to avoid. Nonetheless, what Deng Xiaoping called “the great experiment” persisted.

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