第15页 | How China Became Capitalist-Ronald Coase

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From Capitalism to Capitalisms

In the concluding speech at the close of the 2008 Chicago Conference on China’s Market Transformation on July 18th, 2008, Ronald Coase pronounced that “the struggle of China is the struggle for the world.”¹ On December 10th, 2008, Time magazine published a commentary on China’s three decades of market transformation and the heroic role played by Deng Xiaoping in this remarkable human drama. The article ended by stating “That is the great story of our time. It is our story, everyone’s story – not just China’s.”²

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When this narrative opened its first chapter after Mao died in 1976, the post-Mao Chinese government made a determined shift in strategy in the aftermath of the Cultural Revolution, giving up class conflict and embracing socialist modernization as an alternative approach to realizing the “superiority of socialism.” The ideological radicalism that had persisted since the mid-1950s was at last recognized as flawed and harmful, and this opened up room for common sense and pragmatism in policymaking. This shift in leadership and policy loosened the grip of socialist ideology and precipitated the ensuing Chinese economic reform. During Mao’s era, waves of political campaigns to impose the dictates of socialism had failed to take China to the promised land of shared prosperity. Dismay and discontent were widespread and deeply felt, especially amongst Party veterans who had lost positions during Mao’s era, intellectuals who had been attacked as “rightists,” and the majority of the 800 million Chinese peasants who had been struggling to make ends meet ever since agricultural collectivization. They desperately wanted change.

Rejecting class struggle and embracing socialist modernization, China finally broke the spell of a negative sum game of political infighting and started a positive sum game of economic development. Their bitter disappointment with Mao’s grandiose but disastrous socialist experiment had clearly taught the Chinese to be skeptical of any grand blueprint for reform. At the same time, having long been isolated from the outside world, the Chinese were hardly aware of any alternatives to socialism. This left their leaders with no choice but to work with whatever they could find, through improvisation and tinkering. Still rallied under the ideological banner of socialism, they tried out different ways of achieving its practical ends. However, by the end of the twentieth century, instead of celebrating itself as a “great, modern, socialist power” resting on public ownership and state planning, as intended in the 1978 Communiqué,³ China found itself with a vibrant economy awash with private entrepreneurship and market forces. This is the most unexpected aspect of the Chinese economic transformation. China became capitalist while it was trying to modernize socialism. The story of China is the quintessence of what Adam Ferguson called “the products of human action but not human design.”⁴ A Chinese proverb puts it more poetically: “flowers planted on purpose do not blossom; the willows no one cared for have grown into big trees offering ample shade.”

China’s economic reform, as conceived at the beginning and thought of throughout its progress, was never intended to dismantle socialism and move to capitalism. Rather, its aim was “socialist modernization”; a second revolution, another “Long March,” to carry out the economic development that Mao had failed to do, making China “a modernsocialist country before the end of the [twentieth] century,” as the 1978 Communiqué put it.⁵ Since communism claims to be the destined burier of capitalism, the Communist Party is widely believed to be incompatible with market reform. But we should not make the mistake of equating a political organization (the Communist Party) with its political ideology (communism). Every individual has multiple identities (a male, a professor, a husband, an economist, and an admirer of Adam Smith, for example). Likewise, political organizations also have multiple and fluid identities. Any Marxist individual or organization must be more than a Marxist.⁶ While communism and capitalism as rival ideologies stand in direct opposition to each other, a communist party may allow for and experiment with anything, including capitalism, when its survival is at stake.

The failure to separate the Communist Party from communism has predisposed many to take a misleading approach to economic transition. It gave rise to a belief that market reforms were impossible in a socialist country unless the whole communist system, including both its ideology and political organization, had been wiped out first. A clear and clean break from the communist past was deemed an absolute precondition for a fresh new move toward a market economy. As a result, a piecemeal approach to reform by tinkering with the preexisting economic system was ruled out from the very beginning, giving birth to what has become known as the big bang approach to reform.⁷ At the same time, many economists who served as advisors to policymakers trusted that their mastery of modern economics would enable a market economy to be constructed anew only if the traces of socialism were thoroughly erased. But the belief that a market economy could be rationally designed committed what Hayek called the “fatal conceit” of constructive rationalism.⁸ Many decades earlier, Hayek warned in his Nobel lecture that “To act on the belief that we possess the knowledge and the power which enable us to shape the process of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.”⁹

China was fortunate to escape from this fatal conceit only by accident. At the time when economic reform was started, China did not (and could not possibly) contemplate eradicating communism and starting afresh, and so, instead of beginning reform with a brand new blueprint, it started by adjusting the preexisting system.

But China’s continuing commitment to socialism did not prevent it from recognizing the defects of socialism. Indeed, a public debate erupted after Mao’s death on the nature and prospect of Chinese socialism, on what had gone wrong under Mao, and where China should be heading next. Hu Yaobang, who replaced Hua as Chairman of the Chinese Communist Party in 1981 and became General Secretary in 1982, raised a question to himself and the Party in the course of a 1984 interview with the Italian Communist daily L’Unità. “Since the October Revolution [of 1917], more than 60 years have passed. How is it that many socialist countries have not been able to overtake capitalist ones in terms of development? What was it [in socialism] that did not work?”¹⁰

Nor did their commitment to socialism prevent the Chinese leaders from re-evaluating, and even appreciating, capitalism once they were exposed to it during their trips abroad. Wang Zhen, Vice Premier in charge of industrial development at the time, visited Britain from November 6th to 17th, 1978. Wang was astonished to learn of the high level of economic and social development enjoyed by the British working class.¹¹ Before the visit, Wang’s knowledge of British capitalism was still largely derived from Marx’s writings. Wang had expected to see slums in London and poverty, destitution, and exploitation. To his surprise, Wang found that his wage was only one-sixth of that of a garbage collector in London. At the end of his trip, he reached a better and more accurate understanding of British capitalism and of China’s commitment to communism.

I think Britain has done a good job. Products are abundant; the three inequalities [that between urban and rural areas, between industry and agriculture, and between mental and manual labor, the elimination of which, according to Marx, was a critical task for socialism] are almost done away with; social justice and welfare have received a lot of emphasis. Britain would simply be our model of a communist society if it were ruled by a communist party.¹²

Wang’s formula of communism, which equaled Britain plus communist rule, revealed a down-to-earth, non-ideological attitude to capitalism and socialism as well as an enduring attachment to the Party. If it were not for this pragmatic mentality, China’s remaining commitment to socialism would have made the ensuing market reform impossible.

The most extraordinary feature of Chinese economic reform is perhaps that the Chinese Communist Party has survived, and indeed thrived, over the three decades of market transformation. It clearly attests to the organizational flexibility and adaptability of the Party in the aftermath of a failed socialist experiment – not its own invincibility or the superiority of socialism itself.¹³ But what is even more extraordinary is that a reform intended to save socialism has inadvertently turned China into a market economy. The Trojan horse in this astonishing tale is the Chinese teaching “seeking truth from facts,” which Deng Xiaoping mistakenly called “the essence of Marxism.” When China became a gigantic economic laboratory, the forces of competition were able to work their magic. In an experimental process of discovery, resources were directed to their most profitable utilization, institutional arrangements and organizational structures emerged to facilitate collective learning. Tinkering with Mao’s legacy on the ground, China, step by step, not without side steps or retrogressive movements, found itself transformed into a market economy after thirty years of reforms which had been intended to save socialism. After the fall of the Berlin Wall socialism was abandoned in the former Soviet bloc; it was defeated on its own ground in China. Villages of starving peasants restored private farming and township and village enterprises outperformed state enterprises. In Chinese cities the introduction of self-employment and private entrepreneurship brought more vitality to the urban economy than did state-led enterprise reforms. The story of Chinese economic reform is one of obdurate private entrepreneurship, of bold but piecemeal social experiments, and of humility and perseverance in the human struggle for a better life.

To represent the story of Chinese reform accurately it is imperative to recognize the co-existence of two reforms in China’s market transformation. First, the Chinese post-Mao government clearly attempted a state-led reform agenda. The disastrous economic record of Mao’s socialism overwhelmed a once triumphant Party with disappointment, frustration, and humiliation. That sense of failure was deepened after the Chinese leaders learned of the rapid economic development achieved by their Asian neighbors and countries elsewhere. But they were also inspired and encouraged by the technological innovation and economic prosperity that they observed during their trips abroad. If only China could open itself up and learn from the developed economies, they reasoned, China could catch up. The Chinese leaders knew that there was no roadmap for the journey ahead. They probably were not even cognizant of where the journey would take them. Nonetheless, nothing deterred them from being determined reformers, eager to get the stagnant economy moving.

The state-led reform began at the end of 1976 when Hua Guofeng revived the “Four Modernizations,” an inspirational economic program that was originally proposed by Premier Zhou Enlai in 1964 but was quickly shelved with Mao’s launch of the “socialist education” movement and two years later, the Cultural Revolution. Under Hua, China quickly ended the self-destruction of class struggle, and embarked on socialist modernization. A year later, an ambitious economic program of opening up – which would be later called the “Leap Outward” by its critics – was launched to use foreign capital to finance two dozen or so development projects, most of which were in heavy industry and related infrastructure. But the “Leap Outward” did not last long and was ended in early 1979 partly because of its inherent defects and partly because of the shift in power after the Third Plenum of the Eleventh Central Committee in December 1978 when Deng Xiaoping and Chen Yun returned to the political center.

As Chen resumed leadership in managing the Chinese economy, the Central Committee of the Party launched in April 1979 what was then called the “Eight Character Guiding Principle” – “adjustment, reform, rectification, and improvement” [in Chinese each of the terms has two characters], which ushered in the second round of the state-led reform by the post-Mao Chinese government.¹⁴ This new economic policy called off the “Leap Outward.” Even though “reform” was included, the new policy was essentially an economic retrenchment program, with its priority squarely placed on “adjustment.” What was it in the Chinese economy that cried for adjustment? The answer is easy to find: the “Leap Outward,” which, in the eyes of Chen Yun, had further exacerbated China’s macroeconomic problems, particularly the structural misalignment between heavy and light industry, and between industry and agriculture.

The first priority under the new economic policy was agriculture. From the government’s perspective, the most serious defect of the “Leap Outward” was the continuous stress on heavy industry at the expense of agriculture, which, as admitted in the 1978 Communiqué, was in deep trouble. Food scarcity and starvation had long been a chronic and widespread problem during the Mao era. The 1978 Communiqué made several references to the bleak situation in Chinese agriculture and pledged to raise the purchasing prices for agricultural products and boost investment in rural areas. This express and urgent emphasis on agriculture would later lead the Chinese government to claim that economic reform started in agriculture. It is important to note that reform in other areas, such as the enterprise reform, proceeded at the same time. Moreover, the measures taken at the time in agriculture, raising purchasing prices for agricultural products, reducing quotas and increasing grain import to allow more food consumption for peasants, encouraging sideline productions, including the development of the commune and brigade enterprises, certainly helped to bring about a steady and significant increase in agricultural output and a reduction in inequality between rural and urban China in the next few years. But they were not the forces that set in motion what we know today as China’s agricultural reform, that is, private farming under the household responsibility system, which was a grassroots innovation by starving peasants and local cadres. Private farming was conditionally accepted in 1980 after it had been widely spread underground in many provinces, and did not become a national policy until 1982.

As far as industry was concerned, the first goal of the adjustment policy was to slow down the development of heavy industry and speed up investment in light industry, to cut capital investment in production and increase spending on housing and other non-production related areas, including labor compensation. The economic rationale was to tilt the economy toward consumer spending and reduce its dependence on capital investment, particularly in heavy industry. The adjustment policy was quickly translated into a rapid improvement in living conditions in both rural and urban China.¹⁵

In addition, as part of the economic policy, the Chinese government also implemented a reform initiative formulated in 1978, “delegating rights and sharing profits,” to decentralize the economy, giving more autonomy (“rights”) and incentives (“profits”) to local actors, including both local governments and enterprises in cities as well as production teams in rural areas. This government initiative was carried out mainly in three areas, state-owned enterprises, international trade, and public finance, in addition to agriculture.¹⁶ As far as international trade was concerned, the policy effectively ended the monopoly of the Ministry of Foreign Trade, allowing trading companies to be set up by local governments and state-owned enterprises. In public finance, the policy essentially made local governments more or less autonomous in charge of local finance, independent from the Ministry of Finance.

The most critical target of this reform initiative was clearly the state-owned enterprises. Unlike the “Leap Outward,” where the emphasis was placed on constructing brand new plants, the new policy aimed to improve existing state-owned enterprises. Though the enterprise reform was first tried in Sichuan under the leadership of provincial Party Secretary Zhao Ziyang, before the convening of the Third Plenum of the Eleventh Central Committee of the Party in December 1978, it became a national policy only in 1979. Its goal was to make state enterprises more autonomous, largely by shifting much of managerial decision-making from the government to enterprises, without privatization. This effort, then called “enhancing the enterprise’s vitality,” marked the second concerted measure after the “Leap Outward” undertaken by the Chinese government to reinvigorate the stagnant industrial sectors. Because of China’s continuing commitment to socialism, the enterprise reform was severely constrained more by ideology than by economic considerations. As a result, while this reform helped to inject vitality into state enterprises and improve the incentives of managers and workers alike, it failed to free the state-owned enterprises from the state, but further confounded the convoluted relations between the two.

The overall effectiveness of the “Eight Character Guiding Principle” was rather limited, even though all measures were clearly a move in the right direction. For example, the measures taken by the Chinese government in agriculture were quite successful as far as they went; their positive effects on the living conditions of peasants were immediate and significant. But they fell far short of freeing peasants from the heavy hand of the state. Such severe limitations of the government-led agricultural reform, however, would not become clear until the upsurge of private farming, which had been explicitly ruled out by government policy. Similarly, the enterprise reform generated a quick and noticeable improvement on worker’s incentives. But its shortcomings were evident, even though the most serious limitations came to light only when state-owned enterprises began to compete with non-state firms.

Besides the official track of reform directed by the Chinese government, there existed a separate track of reform. This was a combination of several spontaneous, grassroots movements, some expressly prohibited by the Chinese government (private farming before 1982, self-employment in cities before 1980), some discriminated against by government policy (self-employment in cities after 1980 and township and village enterprises), and some guarded warily by Beijing (Special Economic Zones). This made headway quietly all over China when starving peasants secretly tried private farming in defiance of government policy, when under-employed peasants turned to non-farming jobs where they could earn a higher income, when unemployed city residents were forced into self-employment and private entrepreneurship, and when thousands of illegal immigrants took the dangerous, to many fatal, path to cross the border to Hong Kong in hope of a better life. This second reform consisted of what we call “marginal revolutions.”

It was this second, bottom-up reform that set in motion in the early 1980s the Chinese market transformation, bringing back to the Chinese economy a vibrant private sector and resilient market forces, while the state sector was largely kept intact. What the four “marginal revolutions” had in common was that all of them erupted outside the purview of the state. The protagonists in the four revolutions were all marginal actors under socialism. Unlike the state-owned enterprises, which were the pride of socialism and thus enjoyed the tight protection and control of the state, these marginal actors were more or less left alone, particularly when their presence was not perceived as threatening or undermining socialism. Despite many practical obstacles and blatant policy discrimination, peasants in rural China and unemployed city residents quickly translated the economic freedom they had gained into private entrepreneurship. The rising non-state sectors became the most powerful source of economic growth throughout the 1980s and beyond. On the other hand, state-led reform measures, including both the “Leap Outward” and the government initiative of “enhancing the enterprises’ vitality,” fell far short in turning state-owned enterprises into free, competitive enterprises.

Even the success of the Special Economic Zones, which were intentionally created by the Chinese government to experiment with capitalism, revealed the marginal and grassroots nature of the second reform. In the first place, the idea of setting up experimental zones came from the local government in Guangdong, which had been hard pressed to cope with illegal immigration along the border with Hong Kong. Inviting businessmen from Hong Kong to set up factories in Guangdong and hire local labor emerged as a viable solution. Second, the reason for carving out an industrial park or a special economic zone was to create a confined environment to try out a highly uncertain and politically risky experiment outside the socialist economy. Socialism could thus be well preserved while capitalism was allowed a chance in the periphery.

Throughout the 1980s, these marginal forces grew rapidly while the protected state enterprises were struggling to survive. As a result, the Chinese economic reform, unlike reforms in Russia and Eastern Europe, did not suffer a severe recession at the start. The overall economy had always kept growing since reform started, despite the increasing rate and scale of insolvency suffered in the state sector. When the protected and privileged state sector continued its decline, the non-state sectors were rising robustly.

III

The presence of two reforms – one state-led, one grassroots – in China’s economic transformation is beyond any doubt. The failure to recognize the dual-track structure of reform has become a source of confusion in understanding the “great story of our time.” As the grassroots reform was often overshadowed by, and not explicitly distinguished from, the first, the Chinese government, which clearly orchestrated the first, was also credited as the planner and instigator of the second. This misattributes a grassroots movement to the state and gives rise to a state-centered misinterpretation of Chinese market transformation. It has led some Chinese scholars to believe that the initial stages of Chinese economic reform were carried out by the Chinese government in “a top-down” fashion, and to ignore grassroots reform, which had a totally different character.¹⁷ In his widely used and generally informative and authoritative textbook on Chinese economic reform, Professor Wu Jinglian pointed out the presence of two different reforms, one pertaining to the state sector, and the other to the non-state sectors, but writes as if both reforms were planned by the Chinese government. “When the reform of expanding enterprise autonomy in the state sector fell into plight, the Chinese leaders headed by Deng Xiaoping shifted the focus of reform from the urban state sector to the rural nonstate sectors.” As the book continues, “Instead of taking major reform measures in the state sector, China focused its reform effort on nonstate sectors, aiming at establishing market-oriented enterprises so as to let them drive the growth of the economy. The new strategy was called the strategy of ‘outside the system’ preceding ‘inside the system’, or the strategy of incremental reform.”¹⁸

Our account of marginal revolutions shows that China’s market transformation in the 1980s was primarily carried out by the non-state sectors while the state-led reform failed to revitalize the state sector. But this outcome of “incremental reform” did not result from a deliberate strategy on the part of the Chinese government. It is true that the government had gradually loosened their control over farmers and also allowed unemployed city residents to seek self-employment. But it is unlikely that the authorities at the time could have hoped that non-state sectors would become a major driver of economic growth, when socialism was still believed to depend primarily on state ownership. Rather, as the state-led enterprise reform ran out of steam, the Chinese leaders were relieved to see the strong and unexpected growth of the non-state sectors. It was the emerging private firms that supplied goods and services that the state enterprises did not provide, created jobs for peasants who were no longer chained to the land, and for unemployed city residents whom the state enterprises could not absorb.

The Chinese leaders themselves were candid in admitting the presence of a second track of reform outside their control, calling private farming and township and village enterprises two “great innovations of Chinese peasants.”¹⁹ But the official account of Chinese economic reform conceals the different sources of the two reforms and portrays the Chinese government as a prescient designer, carefully and patiently overseeing the whole process of market transformation. In a meeting with Chancellor Helmut Kohl of West Germany on October 10th, 1984, Deng Xiaoping articulated this gradualist, state-centered interpretation of Chinese reform for the first time.

First we solved the problem of rural policies, instituting the contracted responsibility system for farming with remuneration linked to output, encouraging diversified production and the use of scientific advances in farming, and granting peasants the power to manage their own affairs. All these policies were so effective that, three years after their implementation, notable changes had taken place in the countryside. In 1978 we held the Third Plenary Session of the Eleventh Central Committee, and in a few days we shall convene the Third Plenary Session of the Twelfth Central Committee, which will have its own special features. The first Third Plenary Session focused on rural reform, whereas this Third Plenary Session will focus on urban reform, including the reform of industry, commerce and other sectors. We can say this will be a comprehensive reform. The basic content of both rural and urban reform is to invigorate the domestic economy and open China wider to the outside world. Although urban reform will be more complex than rural reform, since we have succeeded in the one, we are confident that we can succeed in the other.²⁰

Deng’s statement was a masterpiece of concealment, weaving the two reforms, one pushed by Beijing and the other resulting from grassroots movements, into a single grand narrative, in which the Chinese government was presented as the mastermind. Even though the 1978 Communiqué stated that “the whole Party should concentrate its main energy and efforts on advancing agriculture as fast as possible,”²¹ it did not lift the ban on private farming. There is nothing in the 1978 Communiqué that comes close to what Deng referred to in his talk as “instituting the contracted responsibility system” or “granting peasants the power to manage their own affairs.” Instead, the Communiqué stressed that “the right of ownership by the people’s communes, production brigades and production teams and their power of decision must be protected effectively by the laws of the state,” and “the people’s communes must resolutely implement the system of three levels of ownership with the production team as the basic accounting unit, and this should remain unchanged.”²² These statements, in fact, wholeheartedly rejected private farming. Blending the second reform in agriculture spearheaded by starving peasants with the first, Deng misled his guest into believing that private farming and the ensuing changes in the Chinese countryside were brought about intentionally by the Chinese government.

In this state-centered narrative, 1978’s Third Plenum of the Eleventh Central Committee launched the agricultural reform, and the Third Plenum of the Twelfth Central Committee in 1984 was responsible for starting industrial reform. Neither assertion, however, stands up to scrutiny. The first post-Mao government began economic reform and opening up in state-owned enterprises. The “Leap Outward” was aimed at heavy industry. After the “Leap Outward” was called off, the focus was shifted to “revitalize state-owned enterprises.” Industrial reform was well underway by 1984.

In the official account of the Chinese economic reform, 1984 is taken as the beginning of “comprehensive urban reform,”²³ relegating all measures of industrial and urban reform made prior to 1984 to the status of “trials” or “preparations.”²⁴ This state-centered view ignores the rise of township and village enterprises as well as the return of self-employment and private entrepreneurship in Chinese cities. Since both were non-state actors, they were simply not considered in the state-centered account of China’s industrial or urban reform. But township and village enterprises and private entrepreneurs in Chinese cities were pioneers in pushing for industrial and urban reforms in the Chinese economy, creating a vibrant private sector outside the control of the state.

The presence of two distinct reforms in China’s market transformation was most pronounced during the late 1970s to mid-1980s. After the Fourteenth Congress of the Chinese Communist Party held in October 1992, when the socialist market economy was officially embraced as the main goal of China’s economic reform, the private sector and market forces introduced to the Chinese economy, primarily by marginal revolutions, gained more political recognition. What had been marginal economic actors gradually became the backbone of the emerging socialist market economy. Ideological animosity toward the second track of reform began to dwindle soon after this. Nonetheless, the dual structure of reform remained a feature of China’s market transformation in the 1990s and beyond, with one track of reform dictated by Beijing, and the other driven by local initiatives. The continuous presence of the locally initiated track of reform and its irreplaceable pioneering role in pushing forward China’s market transformation were manifested in the development of stock markets in Shenzhen and Shanghai in the early 1990s, the privatization of state-owned enterprises, and the proliferation of industrial parks since the mid-1990s.

The recognition of two distinct reforms not only helps to give an accurate picture of Chinese economic reform, or at least, to avoid some factual errors that are common in the literature, but also allows us to better understand the nature of China’s market transformation. In particular, it allows us to explore two of its most puzzling aspects: its extraordinary speed and the fact that the move to capitalism was carried out under the auspices of the Chinese Communist Party.

In Steven Cheung’s original analysis of institutional change, the cost of institutional change arises from two sources, the information cost of discovering alternative institutional arrangements and the cost of negotiating or forcing the change itself, particularly the cost of compelling acquiescence from members of the society whose interests are expected to be hurt by the change.²⁵It was this simple but powerful analytical framework, aided by his insightful but unsystematic observation of the trend of change in China after the death of Mao, that allowed Cheung to predict that China was definitely moving toward capitalism. Its analytical clarity and logical rigor notwithstanding, this framework had a weakness. It treats society as a homogenous entity and institutional change as a single event, sweeping the whole society in one strike, in which a superior institution replaces an inferior one. Twenty years later, this still is by and large how institutional change is treated in much of the social science literature.²⁶ There is no process, no time in institutional change.²⁷

This static view of institutional change, like the comparative static analysis in economics, is more concerned with the result or endpoint of institutional change than with the process. Institutional change in China, a country of continental dimensions and remarkable regional variations, rarely occurs as a singular event. Instead, it takes place gradually and unevenly. This compels us to treat institutional change as a process in time and space. Whether early changes encourage similar changes to follow elsewhere depends on how actors elsewhere regard the outcome of these early changes and how they assess the new constraints and opportunities they face. Thus, whether early experiments in institutional change gain momentum and ultimately prevail, or whether they encounter antipathy and are rejected, is difficult to predict. In this process of development, the state stands out as a prominent source of uncertainty, due to its regulatory role and coercive capacity to alter the costs, incentives and choices other actors face.

Benjamin Franklin observed that a great empire, like a big cake, is most easily diminished at the edges. How this logic was played out in China’s marginal revolutions was heavily influenced by the dual structure of reform. The recognition of two reforms enables us to trace the interplay between them over time and the interactions of competing ideas. This allows us to examine, in a unique manner, the dynamics of change in Chinese leaders’ political beliefs, specifically those related to socialism, and its relations to the market and the private sector. As we have seen, this was mainly an adaptive response to the fast changing economic reality, with the failure of state-led reform leading to a readjustment in attitudes to private-sector reform. This in turn allowed much greater scope for economic reform in both the private and state sectors.

Four marginal forces – private farming, township and village enterprises, individual entrepreneurship, and the Special Economic Zones – pioneered in transforming the Chinese economy during the 1980s. Economic experiments initiated at the grassroots level were tolerated precisely because they were conducted at the periphery of the socialist economy and so were perceived as posing little direct political challenge to the regime. Regarded as inferior and insignificant, these marginal forces of reform enjoyed some political freedom as long as their presence was no longer perceived as a threat to socialism. Once peasants and unemployed city dwellers were allowed the freedom to pursue private entrepreneurship, it did not take long for their endeavors to outshine the state sector and convince the pragmatic Chinese leaders to recognize these experiments as beneficial rather than inimical to socialism. When such unorthodox practices became officially recognized, they inevitably weakened the grip of socialist ideology and stretched the boundaries of political thought.

In contrast, reforms of the state sector, including the economic program launched under Hua as well as the enterprise reform started since 1978, were largely ineffective. Any reform targeting the economic core of socialism was inevitably directed and closely supervised by the state. In both cases, the Chinese leaders could not afford to take their hands off the economic sector which they deemed vital for both the wellbeing of the whole socialist economy and for political stability. The heavy-handed approach they took implies that the state-led efforts were severely constrained by socialist ideology; more often than not this resulted in disappointing outcomes. This was the price China paid for its remaining commitment to socialism.

Fortunately, with regard to private-sector reform, the government was more willing to take a hands-off approach. They were more likely to tolerate measures that appeared incompatible with socialism, partly because Chinese leaders then believed socialism could be preserved as long as they kept control of the state enterprises. Less constrained by political ideology and state bureaucracy, and strictly disciplined by competition, the marginal economic forces originating at the periphery of the socialist state were able to overtake the state sector.

As time went by, the marginal revolutions that sprang up at the periphery of the socialist economy not only won popular support and outlasted political resistance, but also served as a catalyst for changes in political ideology. They gradually moved socialism away from its traditional image as the antithesis of the market economy, and generated political tolerance for further economic reforms. As a result, the state-led reform became more open to market forces and its protagonists less hostile to the private sector. Since the Chinese government controlled many economic resources as well as the policy agenda, reform initiatives that Chinese government put into place remained critically important, even when they did not work out as intended.

For example, in Chen Yun’s view of socialism, which was developed in the 1950s in the wake of Mao’s radical push for socialist transition and total elimination of the market, “the planned economy as primary, market adjustments as auxiliary,” served as a fundamental guiding principle in the early days of Chinese economic reform.²⁸ As the rapid expansion of the market and private sector helped to improve the living conditions of the Chinese people, the Chinese government became more willing to accept what was then called the “commodity economy.” This Marxian term allowed the Chinese government to avoid the use of a politically sensitive name – the “market economy” – but was still able to blur the lines between socialist doctrine and the increasing dominance of the market. By October 1987, when the Thirteenth Congress of the Party was held, the Chinese economy had doubled in size since 1978. The Party was proud to announce its commitment to economic development; to recommit itself to socialism and Party rule as well as to economic reform and opening up. This policy was conveniently summarized at the time as “one center, two basic points.”²⁹ The development of the private sector was encouraged and welcomed for its contribution to China’s further economic growth. Even stock markets, a conspicuous symbol of capitalism, were allowed to open in Shanghai in 1990 and in Shenzhen one year later.

Throughout the reform, the state-led track engineered by Beijing was heavily influenced by political ideology. The policy initiatives emerging from private-sector reform were far less ideologically constrained. Successful initiatives that originated in the private sector were often accepted by Beijing and adapted to fit state-sector reform initiatives. Not by design, the dual structure of reform provided an effective and flexible institutional framework for Beijing to navigate China’s move to a market economy. It first created a political buffer for Beijing, reducing the political risk of reform. When loyalty to socialism remained strong at the early stage of reform and when private entrepreneurship and market forces were still perceived as politically dangerous, Beijing could tolerate the second track of reform’s experiments with capitalism without compromising its commitment to socialism. Indeed, the second track of reform was allowed to roam when Beijing was not yet emancipated from the doctrine of socialism. Moreover, economic reforms inevitably involved political risks. Political leaders could lose their positions if the economic reforms they championed went awry. The presence of the second track of reform gave Beijing more room to maneuver in reform policy without tying itself to any reform initiative undertaken by local governments. This structure helped to make the political system still controlled by one single party much more elastic, adaptable, and receptive to economic changes than it would otherwise have been.

The dual structure of reform and the decentralized political system behind it also played a critical role in facilitating collective learning throughout the market transformation. China’s market reform encountered two obstacles, one ideological, the other practical. Until 1984 when Beijing first accepted the “commodity economy,” the ideological hostility toward the market and private sector presented a major hurdle. In addition, the practical challenges of reforming socialism were intimidating, as attested to by the two abortive attempts at price reform in the 1980s. As ideological opposition to market reform faded and the market economy gradually gained a foothold, China’s reform was hampered by a lack of understanding of the working of the market economy as a live, evolving system, with many interdependent subsystems, and by the uncertainties inherent in such a radical move. The two-track reform allowed Beijing to tap into the enthusiasm and local knowledge provincial and sub-provincial governments had gained through their own development initiatives. The local initiatives that had proved successful were carefully studied by Beijing before being adopted into national policy. This is aptly demonstrated by the case of privatization in Zhucheng and in the restructuring of state enterprises in Shanghai and Changsha. Sometimes, Beijing took a more active role, experimenting with policy initiatives first at local levels before imposing them nationwide. Examples of this include the expansion of the Special Economic Zones to include many coastal cities in 1984 and later, industrial parks all over China, as well as the 1994 tax reform.

Few would question the assumption Steven Cheung made that the move from socialism to capitalism is efficiency-improving. In China, the knowledge that such potential gains existed gave rise to a desire for change. But a desire is one thing; the actual process of change is another. For China, it involved taking actions when the information possessed by the leaders was far from complete, and the potential consequences were far from clear. The dual structure of reform helped to moderate the political risk of reform and cut down the cost of implementation which significantly eased China’s move to a market economy. While Cheung’s early prediction that China would go capitalist turned out to be correct, it was the two tracks of reform that actually moved China to capitalism.

The unintentional presence of two parallel tracks of reform worked surprisingly well in easing the rapid return of a market economy to China while Beijing was still committed to socialism. Along the way, Beijing adopted three key reform measures in the early 1980s: extensive use of the managerial contract responsibility system, the adoption of dual-track pricing, and the use of contracts in sharing tax revenues between central and local government. To varying degrees, these were successful in moving the economy forward. However, these measures were responsible for fragmenting the national economy and creating a chaotic pricing environment for state and non-state firms in the economy. A consequence of this was to hinder market competition and undermine the emerging market economy.

In the early 1980s, the managerial contract responsibility system was introduced to formalize the autonomy gained by state enterprises vis-à-vis their supervising governmental agents. But the use of contracts in enterprise reform opened a Pandora’s box. Each state enterprise created its own idiosyncratic constraints through individual bargaining with its government agent, including prices and quantities for inputs as well as their tax burden. In collaboration with the government regulatory agents, each state enterprise wrote its own rules.

At the same time, the Chinese government expanded dual-track pricing – as a substitute for price reform. Dual-track pricing emerged as early as in the late 1970s when the Chinese government allowed state oil companies to sell their product in the market for a higher price after fulfilling the state quotas. As a result, state enterprises were exposed to and disciplined by market signals without privatization. At the same time, dual-track pricing allowed non-state firms to access materials controlled by the state, and opened the door for them to compete head on with state enterprises. They often paid a much higher price for their inputs, but had much greater freedom in running their businesses, including labor relations; they also faced a stricter market discipline. As a result, by the early 1990s, township and village enterprises were contributing 40 percent of China’s industrial growth and 40 percent of China’s exports.³⁰ But the widescale adoption of dual-track pricing led to chaos in the Chinese economy. The gap between the government price and the market price, which could be many times higher, was a gray area where the spot price would have fallen. Because of the wide variations in the prices paid by different firms for their inputs, it became impossible to compare their productivity and economic efficiency even when they competed in the product market. In addition, dual-track pricing also engendered lucrative arbitrage activities, which not only became a source of resource misallocation, but also created social resentment and popular opposition to economic reform.

In addition to price distortions at the enterprise level, the enterprises also faced distortions at the macro level; both these factors worked together to create a chaotic pricing environment, particularly by undermining market discipline for state enterprises. Throughout the 1980s, the Chinese central government used a contract system to collect taxes from the provinces. This was introduced in 1980 to impose fiscal discipline and to give incentives to local governments. Under the contract-based tax regime, the tax burden of each province was negotiated individually with Beijing. As a result, each region had a different tax burden, further compounding the chaotic pricing environment created by the managerial contract responsibility system and dual-track pricing.

The most fundamental difference between capitalism and socialism is the operation of a market pricing mechanism in the former and its replacement by state planning in the latter. Textbook economics treats the market – the adjustment of demand and supply through price changes – as an efficient mechanism of resource allocation. But the market is also essentially a mechanism of collective learning. It provides all economic actors with scope for trial-and-error-based learning, allowing them to explore existing opportunities and create new ones.

To make this process of collective learning effective, one condition must be met. All economic actors must be free to act and be held responsible for their actions. Probably for this reason, the market economy used to be more commonly called “the free enterprise economy,” as opposed to a command economy. This implies that, in a market economy, all actors are equally disciplined by a common set of constraints – buying from a competitive factor market and selling in a competitive product market – so that competent or fortunate learners are rewarded with access to more resources and are thus able to expand and serve more consumers, and poor or unlucky learners are punished, forcing them to withdraw from their current pursuit and start something new.

In the Chinese market transformation, two factors effectively bring this process to a complete halt even after private firms are allowed to operate. First, when the national economy is so fragmented that each local economy is essentially sheltered from the outside world, competition will lose its disciplinary force on firms; in turn, the firms lose a feedback mechanism critical to their operations. In such an extreme situation, there is little direct competition among firms in different locations. Inefficient firms face no pressure to improve or close, giving rise to static inefficiency in resource misallocation. Moreover, good business practices – the ones that allow economic actors to serve their consumers better and improve their market performance – cannot be quickly recognized and imitated widely, leading to dynamic inefficiency in collective learning. The more integrated and bigger the national economy is, the more firms and human talents will be brought into the game of collective learning, and the faster will they learn. As a result, it improves firms’ static efficiency and dynamic efficiency. When a common national market exists, all firms, no matter where they are located in the economy, are part of the collective process of experimental learning.

Second, the process of market competition and experimental learning can be severely undermined if firms in the economy are not equally constrained by common market discipline even when they compete with each other. In a market economy, firms are disciplined because competition winnows poorly performing firms from good ones. The experiments firms engage in, such as what products to bring to consumers and at what price, involve many uncertainties – resulting from the lack of information about consumer preferences, other firms’ plans and the price of inputs, as well as relevant government regulations. Market discipline works when firms can survive only by providing products consumers are willing to buy and, with receipts from consumers, firms can secure the services of more factors of production. The system breaks down when firms can survive on other grounds, such as political favors.

The most damaging effect of chaotic pricing was not attributable to the presence of multiple prices for industrial inputs per se. Despite the law of one price, different firms often purchased the same materials at different spot prices due to various information problems and other differential costs of using the market mechanism. Nor was repetitive and duplicative investment across regions the main problem; rather, the lack of a common national market severely weakened market discipline, a critical feedback mechanism that is indispensable if market competition is to function. This created a problem beyond the soft budget constraint, a chronic defect of state enterprises under socialism when the government was willing to subsidize them on political grounds.³¹ In addition to the budget, many other constraints that state enterprises faced were not only soft but worse, idiosyncratic and open to ad hoc negotiation. There was hardly any disciplinary mechanism in place to discriminate between firms with diverging performance records. As a result, the real economic performance of state enterprises became almost unknowable to outsiders. Moreover, it created a distorted incentive structure for state enterprises – managers could gain more by striking an advantageous contract with the government agent than by improving enterprise productivity or winning the patronage of consumers. Consequently, massive inefficiency in resource allocation was inevitable. Just as destructive was the massive redistribution effect when arbitrage opportunities created by the chaotic pricing system were exploited by government officials and managers of state enterprises.

After Deng’s southern tour in 1992, China took a series of steps to consolidate the market economy. The 1992 price reform and 1994 tax reform greatly removed price distortions and facilitated the rise of a common national market. Dual-track pricing was gradually phased out by the mid-1990s. As a result, the market became a meaningful and significant disciplinary mechanism in the economy. Firms were compelled to improve their products to attract consumers, rather than cultivate guanxi or relationships with its supervising government. A clear indicator of increasing market competition in the Chinese economy is the rapidly growing ratio of the total amount of losses to the total amount of profits made by state enterprises. It was on average 5 percent in the period1981– 1985 and 28.2 percent in the period 1986–1990, and jumped to 74.6 percent in 1990–1995, reaching almost 200 percent in 1996.³²

Another related development was the privatization of state enterprises. After more than a decade of enterprise reform, the Chinese government finally came to the conclusion that delegating rights and sharing profits had failed to make state enterprises independent and autonomous. As more and more state enterprises fell into insolvency and became a financial burden for local governments, economic logic started to prevail over ideology. Local governments started to drop their ideological commitment to public ownership; the way to privatization was clear. At the same time, the recovery of the private sector after 1992 and its further consolidation started to attract employees from the public sector. The development of the urban housing market, pension reform, and health insurance began to free state sector employees from their employers. All this helped to ease the process of privatization and make it politically acceptable.

With the privatization of state enterprises, most local governments at the county level let go of all their state enterprises. The number of state enterprises owned and managed by the central, provincial and municipal governments was also significantly reduced. Since only a few monopoly industries were in the hands of state enterprises, local governments could no longer rely upon state enterprises as the backbone of the local economy or the main source of tax revenue. Instead, government officials had to provide local public goods and cultivate a business-friendly environment to attract investment, setting up a new stage for regional competition.

Regional competition was rejuvenated in the 1990s after the rise of a common national market and the privatization of state enterprises. In the previous decade, local protectionism and various barriers to internal trade effectively fragmented the national economy. The Chinese economy was decentralized; but competition among regions was restrained. As more and more state enterprises became a financial burden to local governments in the 1990s, local governments began to take a non-ideological approach to the private sector, which quickly became recognized as the foundation of the local economy. From the perspective of local public finance, after the 1994 tax reform, value added taxes and land rent became the main sources of revenue for local governments. Both were positively linked to the growth of the local economy. At the same time, the development of a common national market implied that regional competition was now subject to strict market discipline. As a result, regional competition in the 1990s and beyond arose as the most powerful driving force behind China’s economic transformation.

Much attention has been paid to the strong connection between China’s decentralized political structure and intense regional competition in the economy.³³ Since local government officials are ultimately appointed by Beijing based on the performance of the local economy, Chinese local governments run their jurisdiction – the province, city, county, town, and village – much like a business corporation.³⁴ The active role played by the Chinese government is similar to that of the leadership of a corporate entity. In addition, the Chinese government still controls many important economic resources, particularly bank loans as well as access to sectors under state monopoly. It is no surprise that the Chinese government has been duly emphasized as a critical force in the transformation of the Chinese economy.

The continuous preponderance of the state in the rising Chinese market economy is a result of the unique nature of China’s economic reform. As detailed in earlier chapters, this reform did not follow a blueprint but was carried forward by a combination of grassroots initiatives and state-led policy experiments. The rise of the Chinese market economy did not follow the path suggested by some property rights economists. However, it is not the case that the Chinese experience of market transformation challenges secure and well-defined property rights as a legal foundation in the working of a market economy. The success of township and village enterprises did not negate the critical importance of private property rights because many of them were indeed private. Even those township and village enterprises owned by local governments had a better defined structure of property rights relative to state-owned enterprises. But what really mattered was that township and village enterprises were subject to market discipline while state-owned enterprises were not. The focus on the ownership structure of township and village enterprises was rather misplaced.

It was peculiar, though, that China did not first delineate property rights, specify other relevant institutional rules and then allow market forces to allocate rights to the highest bidder. Instead, what rights economic actors were allowed to have, such as the discretionary rights peasants had over farmland or residual rights held by managers of state-owned enterprises, and what institutional constraints they faced in exercising their rights were delineated when the state released the rights of control to private economic actors. The delineation and transfer of rights took place in one step. During the first two decades of reform, as China remained committed to socialism and against outright privatization of state assets, what rights private actors obtained from the state were subject to individual negotiation. A major advantage of combining rights delineation, and rights transaction or reallocation into one step was to speed up the introduction of market forces into the economy. If all had to wait until rights were delineated by the state before initiating any business dealing, it would have subjected the state to a test of wisdom – getting the rights right before their economic values were revealed in competition between entrepreneurs – and private entrepreneurs to a test of patience – waiting for the state to delineate all the rights. The first test would require the state to make a correct first-time decision on rights delineation with little information on the market value of the rights. This challenge was so demanding by itself that it could readily delay, if not derail, China’s economic reform.

This approach to reform conflicts with the conventional portrayal of the state in economics. As commonly assumed in economics, a primary economic function of the state is to delineate property rights and then withdraw itself from the economy to make room for free bargaining among private actors. Unless conflicting claims to rights arise and call for resolution, the state stays at arm’s length from the economy.³⁵ In the Chinese case, since rights delineation and transaction were combined in one step, decisions on what rights were significant and thus worth delineating was part of the negotiation between economic actors and the state. Most of the rights delegated by the state were not initially transferrable. For example, the household responsibility contract did not allow peasants to transfer land use rights, nor were managers of state-owned enterprises able to transfer their rights. As a result, the state was called back to the bargaining table every time rights changed hands. Moreover, as economic conditions changed over time, certain rights which were excluded in the original bargaining became economically significant. Even the rights that were included in the original contract may have changed so much in significance that a revision was warranted. The state was thus frequently called in to revise and redefine the structure of rights. In addition, as the original contracts were up for renewal – some contracts would last as long as seventy-five years, as in the case of many land contracts; many more lasted five to ten years, as in the case of performance contracts between managers of state enterprises and the supervising agents, as well as between firms and industrial parks – the state was called forth to re-open the contractual negotiation, which inevitably involved re-specification of rights. Not surprisingly, the Chinese state remained an important actor in the economy.³⁶

But it is misleading to suggest that Chinese economic reform represents the triumph of state interference over market forces. It is true that Chinese local governments are heavily involved in the operation of the local economy. In most cases, local governments compete with each other in mobilizing factors of production to figure out the best economic development model for local conditions. This service is essentially what Alfred Marshall called organization, the fourth independent agent of production. When local governments open up a new industrial park and solicit potential investors, what they do is to clear the ground and set the stage, and to facilitate the inception and growth of private firms. The local government may get involved in the conception of the plots and selection of actors, but the show is run by business firms. And the fate of an industrial park – whether firms located there can survive and grow – is not dictated by the government but determined by market competition.

The most crucial contribution made by the local governments in regional competition is to capitalize on China’s physical size and internal diversity. Their actions translate the advantage China has in space to superior speed of industrialization. When each of the local Chinese governments, including 32 provincial level governments, 282 city governments, 2862 county governments, 19,522 town and 14,677 village governments, tests out its way of developing the local economy, numerous different experiments are conducted simultaneously, each in competition with the other. The time of collective learning based on trial and error is cut significantly. The diffusion of successful practices is made fast and easy. Regions compete not only in factor markets – capital and labor have become increasingly mobile since the mid-1990s – and product markets, but also in the provision of local public goods, the structuring of business–government relations, and the local organization of production. Repetitive and duplicative investment is inevitable, and indeed, an essential part of the process. This has resulted in an erosion of economies of scale to capital due to its under-utilization, but has greatly accelerated and diffused industrialization, turning China into a formidable workshop of the world in less than thirty years. The loss in what Alfred Marshall called “internal economies” is more than compensated for by what he called “external economies.” This is the key to understanding the extraordinary speed of market transformation in China during the 1990s and beyond.

Today, the Chinese Communist Party remains the only political party in China. In the past three decades or so, many observers and commentators have hoped that China would eventually drift towards a western model of capitalism. In this process, the Chinese Communist Party would either become less relevant, with the progress of market reform, or even obsolete, along with communism, or embrace democratization, following in the steps of Taiwan and South Korea. Today, there is little sign that the Chinese Communist Party is ready to reform the system of one-party rule. With more than 80 million members (at the end of 2011), from every profession, including a rising percentage of private entrepreneurs and college graduates, the Party appears as strong as it has ever been. With the endurance of the Chinese Communist Party, the Chinese model of capitalism is increasingly seen by some as an alien, belligerent force, with the potential to confront, if not overthrow, western capitalism.

The persistence of the Communist Party in China, which certainly is one of the most striking features of the Chinese economic reform, has led many to focus on the seemingly unfailing role of the Chinese party-state during the whole process of reform. Unlike other transition economies, in the former Soviet bloc for example, where the former ruling communist parties have collapsed one after another to make room for market-oriented reforms, China stands out as an unique instance where the Communist Party and market economy seem to be able to thrive together. This perplexing partnership between economic liberalization and the continuity of communist rule is widely perceived as a key to understanding the extraordinary record of China’s market transformation. In a simplified and widely circulated version of events, the enviable performance of the Chinese market reform is mainly attributed to an all-powerful Chinese party-state. The Chinese economic model is commonly referred to as “authoritarian capitalism,”³⁷ or “state-guided capitalism,”³⁸ highlighting the role played by the Chinese government and the Party. Even the pervasive and corrupt intervention of the state and special interest groups in the Chinese economy, what critics call “crony capitalism”³⁹ or “quan-gui” capitalism⁴⁰ in Chinese, are seen to vindicate a state-centered view of the Chinese economic reform.

Readers who have followed our account of how China became capitalist have good reasons to dismiss such a statist interpretation of China’s economic reform as self-serving propaganda of the Chinese Communist Party. Even the Chinese leaders, particularly during the 1980s, have described the reform as “crossing the river by groping for stones.” Time and again, the Chinese government was taken by surprise – when the starving peasants proved the superiority of private farming and township and village enterprises; when the formerly unemployed city residents earned higher incomes than state employees with “an iron bowl”; when Shenzen was quickly transformed from a fishing village to an urban center in South China and a hub of capitalism. The Chinese leaders were also disappointed and embarrassed when their repeated efforts to revive state-owned enterprises failed to save them and they were forced to allow millions of workers to become unemployed. China’s transformation into a rising economic power certainly did not come about through the deliberate and patient designs of an omniscient government.

The continuity of the Chinese Communist Party and its monopoly of political power have concealed two important changes. First, the role of the Chinese state in the economy has become progressively less significant, no matter what measurement is used. Before the economic reforms, the Chinese people had little economic freedom and the state controlled every aspect of the economy, from production, to retail, and even consumption. Today, private entrepreneurship is the primary driving force of the Chinese economy. The size of the state sector in the economy has fallen significantly relative to the non-state sector. Many international comparative studies have characterized the Chinese economy as state-led capitalism, due to the still considerable size of the state sector. But the undeniable fact is that the Chinese state has steadily withdrawn itself from the economy over the past few decades of reform. If the state is seen as contributing to the rise of the Chinese economy, it must be the gradual withdrawal of government from the economy, rather than the strength or omnipresence of the political leadership, that explains the success of Chinese market transformation.

Second, the Chinese Communist Party today no longer identifies itself as a revolutionary vanguard. The “mandate of heaven” has replaced communism; the party-state rests its legitimacy on effective governance and the improvement of living standards for the people.⁴¹ At the 2002 APEC (Asia-Pacific Economic Cooperation) meeting held in Los Cabos, Mexico, the then President Jiang Zemin made the following statement:

Despite the host of problems facing the international community and more that will still crop up unexpectedly in the future, the tide of history in favor of peace and development cannot be reversed, nor will the people of all lands change their yearning for a better life. Wherever they live, people want lasting peace and stability in the world, a world that enjoys universal prosperity and sustainable development. If world peace and common development are to be secured, it is necessary for statesmen of all countries to display the vision and courage needed to move history forward in response to the will of the people.

The key to our success lies in our ability to respect diversity in light of the varied interests and concerns of the members, seeking common grounds while shelving differences. Our world is a diverse and colorful place. Even more so is the Asia-Pacific region. Respecting the historical and cultural diversity in the members and their different paths or models of development is the important foundation for us to achieve common development and prosperity. The mingling and mutual influencing of different cultures throughout history have provided the engine for the development of human civilization. We should follow the law of history, conduct intercultural exchanges more vigorously and draw upon each other’s strength more consciously so as to ensure common progress of all human societies.⁴²

Hu Jintao, the current President of China, at the Opening Ceremony of the Boao Forum for Asia Annual Conference held on April 12th, 2008 in Hainan, was equally emphatic on economic development.

If a country or a nation is to develop itself in this increasingly competitive world, it must advance with the times, carry out reform and opening up, boost development, put people first and promote harmony. This is the conclusion we have drawn in the great cause of reform and opening up.

There is no ready or unchanging path and model of development that suits all countries in the world. We must explore and improve our development path and model in keeping with China’s national conditions. In so doing, we must adapt to new trends both at home and abroad and meet the people’s growing expectation for a better life. We must make Chinese society more vibrant. And we must truly keep up with the trend of the times and share the same destiny with the people.⁴³

Few, if any, of the new Party members are attracted to, or even familiar with, communism. When Professor Richard Madsen of the University of California at San Diego spent the year 2007–2008 visiting Fudan University he found a top student in his class who was joining the Party but had barely heard of the Communist Manifesto.⁴⁴ When a communist party has put aside class struggle between the proletariat and capitalists as well as rivalry between socialism and capitalism, and has committed itself to seeking truth from facts, it is no longer a communist party as we understand the term in the West. In this sense it is misleading to continue to treat China as a communist regime.

To what degree China was a communist regime even before the start of economic reform is an open question. At the very least, Mao’s China was much more than communism. The history of Marxism in China is fleetingly short, even if we take the founding of the Chinese Communist Party in 1921 as the start, as long as we bear in mind the long and continuous history of Chinese civilization and the continuing predominance of Confucianism. Since Marxism was sanctioned as the official ideology under Mao, it has had a more significant influence on China’s economy and society than its short lifespan might suggest. But, if we look at Chinese political thought as an accumulation of ideas over thousands of years, Marxism is no more than surface decoration.

Moreover, Marxism was rarely, if ever, seriously studied or understood by Mao and his comrades.⁴⁵ Those who had studied Marxism more systematically either died at the hands of the Nationalist government before 1949 or lost out to Mao in the Party’s repetitive power struggles. Since Mao’s rise to power, the Chinese Communist Party has always been more Chinese than communist. Mao’s vision of communism, for example, was based more on his immersion in the Chinese classics than in his reading of Marx or Lenin, which was quite limited.⁴⁶ Despite his repeated efforts to uproot China from its traditions, Chinese socialism remained profoundly influenced by China’s long social and political history. China under socialism remained Chinese.

For example, even though socialism was believed to rest on public ownership and central planning, those two pillars were not regarded equally in China. While the sacred status of public ownership meant that private property rights were under constant attack in Mao’s China, central planning was enforced for only a few years during the first Five Year Plan. This patent disjunction between public ownership and central planning in Chinese socialism has deep historical roots. The idea of an ideal society founded on public ownership has a long intellectual history in China; this can be traced back to the time of Confucius. Traditional Chinese legal-political thinking has an entrenched bias against the “private.” This contrast between the public and private was forcefully reformulated in the late nineteenth and early twentieth century by Kang Youwei, who popularized the Confucian terms, the society of Datong, as a utopia, in contrast to Xiaokang. In Kang’s vision, public ownership stood as the foundation for the ideal Datong society. This view had a lasting impact on Mao and other Chinese communists.⁴⁷ However, decentralization had, historically, also been a prominent feature of Chinese politics. The commanding emperor, an embodiment of Chinese political authoritarianism, could not micromanage a landmass as big and diverse as China.

Since communism was born in the western intellectual tradition, it was not surprising that the West chose to view Mao’s China through the lens of communism. That Mao was eager to rebuild China in accordance with the teachings of communism and was aggressive in ridding China of its cultural heritage also facilitated such a reading. Moreover, since the Soviet Union was the first socialist country, the West found it convenient to think of China as being similar to the Soviet Union. This was understandable, as while Mao’s China was closed to the outside world, the Soviet Union was more accessible. But even during the high tide of socialism, China was strikingly different from the Soviet Union, in ideology as well as organization. China under Mao was certainly not another Soviet Union.

Whether we call China communist or capitalist, we have to recognize the legacy of Chinese history in order to develop a better understanding of China’s rapid economic transformation and its future prospects. China is no stranger to capitalism, and certainly not to free commerce and private entrepreneurship.⁴⁸ It is widely known among students of Chinese history that the operation of long-distance trade, the common use of paper money, and flourishing market activities were ubiquitous in China’s past. This is particularly true of the late Tang and Song dynasties as well as during Ming and Qing times. When Marco Polo traveled to China during the thirteenth century, he was deeply impressed by the burgeoning commerce and sophisticated industry in China. He was particularly intrigued by the use of paper money, which did not emerge in the West until the seventeeth century.⁴⁹ However, such early buds of commerce did not give rise to a full-scale modern industrial revolution; a world-leading civilization began to stagnate exactly when the West began its rise. Nonetheless, China’s historical precedents of capitalism bear direct and significant relevance to the current revival of a market economy in China.

Even though this account of how China became capitalist in the past three decades does not allow us to do justice to China’s long and involved history, it is worth stressing that Chinese civilization has always been remarkably open. Before Qin unified China in 221 BC, a wide variety of schools of thought emerged and engaged with each other, giving birth to the Chinese axiom “let a hundred schools of thought contend.” From the Han to the Tang dynasties, the Silk Road served as the highway of commerce linking China to the rest of the world, allowing China to absorb many ideas from India, central Asia, and beyond. The perceived continuity of Chinese civilization leads many people to forget that Chinese culture went through a long and significant transformation after its encounter with Buddhism in the third century. It took several centuries for Confucianism to absorb Buddhism, giving rise to Neo-Confucianism in the Song dynasty.⁵⁰ As of today, China has barely started its interaction with the West on equal terms. China holds the promise of developing a different form of capitalism, one that builds upon its own rich and diverse cultural traditions while engaging openly with the West as well as the rest of the world. Any society or civilization thrives on cross-fertilization and hybridization in an open, tolerant, and politically stable environment, and dies when subjected to close-mindedness and political chaos. As we free ourselves from a locality-centered point of view and look at human history from a global perspective, China did not rule the world in the past, nor does the West dominate the world today. Only an open and tolerant civilization could and will prevail, and all other familiar identifiers, including its geographic origin or ethnic face, are accidental and contingent.

Under the visible and powerful hand of the Chinese Communist Party, the emerging Chinese market economy is often treated as a distinct species, not simply different from, but even inimical to, a liberal market order. It is true that the Chinese market economy is different from the British, the American, or any other preexisting model of capitalism. This is partly due to historical influences, along with many other distinctive features that China has, such as its sheer size in both population and geography and the role of the Chinese Communist Party. It is also partly due to the fact that China is one of the latest members of the global market economy and is able to learn from different models of capitalism. There was an enormous gap between China and the developed world in technology and production possibility frontier. Once the Chinese people were freed from the shackle of ideology, they were able to catch up quickly. At the same time, the huge potential of the Chinese market made China a favorite destination of foreign direct investment from all over the world. From the 1990s for example, Shanghai became a showcase of global capitalism.

But the charge that the Chinese economy poses a threat to the global market order is based more on fear and misapprehension than on reason. On the contrary, the post-Mao economic reform marked the beginning of the fall of communism. China’s re-embracement of market forces since the death of Mao dealt a deadly blow to the socialist experiment that began in the Soviet Union at the beginning of the twentieth century. China’s market-oriented reforms, including the setup of the Special Economic Zones and the inflow of foreign direct investment, quickly pulled millions out of poverty and raised the living standards for a quarter of humanity. These remarkable outcomes have convinced other countries, including India and Vietnam, of the benevolence of the market and the folly of state planning.

Moreover, the Chinese market transformation has opened up new horizons for global capitalism. As a rising economic power, China is now contributing to the development of many countries in Central and Southeast Asia, Latin America, and Africa, whose economies have been increasingly integrated with the Chinese market. China’s great economic transformation has already become a pillar of the emerging global market economy. More important, the operation of a vibrant and distinctive market economy in China makes a compelling case that capitalism can take root and flourish in an ostensibly nonwestern society. Capitalism with Chinese characteristics arises as an example for other developing countries whose cultures and histories are also different from those in the West to embrace the market. By breaking the West’s monopoly on capitalism, China helps to globalize capitalism and fortifies the global market order by broadening the cultural milieu of and adding cultural diversity to capitalism. A global liberal economic order will be far more resilient and sustainable if capitalism grows beyond the West and blooms in varying cultural backgrounds and political systems.

VII

In January 2010 Foreign Policy published a bold forecast by Professor Robert Fogel, who predicted that the Chinese economy in 2040 will make up 40 percent of global GDP, while the United States will be a distant second (14 percent).⁵¹ Fogel’s prediction was challenged by a rebuttal that appeared in the same issue, which criticized Fogel for “entirely overestimating the Chinese government’s omniscience.”⁵² It is important to reiterate a point that has been consistently stressed throughout this book that the remarkable growth record that China has achieved recently cannot be attributed to “the Chinese government’s omniscience.” Were that the case, our confidence in the future of China’s market economy would be much weaker. This account of how China became capitalist cites on a number of occasions the crucial part played by Deng Xiaoping and other Chinese leaders. But Deng, unlike Mao, was never what Adam Smith called “a man of system.”⁵³ While Mao prided himself on forming a utopian blueprint and imposing it on the Chinese people, Deng was too down to earth to hold dear any theory in defiance of facts. What Deng did was to hold politics and ideology at bay and keep the Chinese government coolheaded. Few people would doubt that the course and outcome of the Chinese economic reform would be quite different had it not been for Deng’s unfailing pragmatism and shrewd political skills. But the root cause of the miraculous rise of the Chinese economy is the Chinese people, full of optimism, energy, creativity, and determination.

We share the optimism that Professor Fogel held about China’s future. But the framework of analysis presented here does not provide a model of economic growth that is able to predict the quantitative trajectory of the Chinese economy. Many have criticized Fogel for his overestimation. But even if we cut his prediction by half it would not change the broader picture.

The most critical advantage China has is its vast population of 1.3 billion enterprising, hard-working, and persevering people. Despite the birth control policy implemented since the late 1970s, China still is the most populous country in the world. After decades of rapid urbanization, half the country’s population today continues to live in rural areas. There is a core among the rural population that is eager to move to cities for a better job and better life, and there remains room for continuous urbanization and industrialization, which will be critical to the continuous growth of the Chinese economy in years to come. But China has a population which is ageing at an alarming rate. When many countries in the developed world subsidize childbirth, the Chinese government should feel fortunate that many Chinese still desire a big family. When each individual is educated and inventive, not someone waiting in the line to be employed as was the case under socialism, government-imposed birth control seems a wrong-headed policy. The one-child policy was meant to be a temporary emergency policy; if it persists too long its detrimental impact on the Chinese economy and society will be lasting and severe.⁵⁴

Even a highly educated and capable labor force will not realize its potential unless it is eager and free to discover economic opportunities anywhere in the country, free to set up business organizations to pursue the opportunities, and free to compete against any other actors. Since the beginning of reform, China has made great progress in facilitating labor mobility and encouraging private entrepreneurship. The migration of millions of rural workers to cities and the privatization of state enterprises, which allowed the transfer of human capital to the private sector, have been two major channels of labor movement. The gradual development of a national labor market has not only greatly improved labor productivity but also brought real economic benefits to peasants. But considerable barriers still exist today in the labor market, particularly the household registration (or hukou in Chinese) system and various institutional hurdles faced by migrant workers. Their gradual removal will provide a strong source of gain in labor productivity in years to come.

Private entrepreneurship has clearly enjoyed a great leap forward in China. Prior to reform, private entrepreneurship was illegal; today, it has been recognized as a primary driver of the economy. Nonetheless, private entrepreneurs still face many prejudices and adversities. The most menacing force they have to deal with is state monopoly. While most state enterprises have been restructured or privatized since the mid-1990s, the remaining ones have retreated into a few monopolized sectors, including banking, energy, and communication. Such state enterprises in monopolized industries have become a powerful interest group in the Chinese economy. The inflationary monetary policy implemented since 2008 has further pumped up the state sector. Most of the bank credits created by the 4-trillion yuan (about 586 billion USD) stimulus package were channeled into state-owned enterprises and local governments. The state sector has grown on cheap credit at the expense of the private sector. In 2009, an unprecedented total of thirty-four Chinese firms (not including three from Hong Kong) were listed in the Fortune Global 500. Only one, however, was a private enterprise.⁵⁵ In 2010, forty-two Chinese firms (not including four based in Hong Kong) made it to the Fortune Global 500, two of them being private.⁵⁶

What is disturbing is not state ownership per se, but the prima facie assumption that state enterprises better serve public interests than private firms. This has been used to justify state monopoly and restrict entry for private firms to many industries which the government deem “strategically important.” In reality, state monopoly enables many state enterprises to work as tax collectors and take in enormous profits, allowing the government revenue to grow almost twice as fast as the growth of GDP in the new millennium.⁵⁷ The easy profits enjoyed by state enterprises shelter them from market discipline and hide their weaknesses. With access to monopoly profits, state enterprises are freed from the constant pressure of innovating to satisfy consumers, and are thus inadvertently deprived of the learning mechanism that is indispensable if any firm is to survive market competition. In addition, the artificially high profit margins are readily translated into a widening gap in wages between monopolized and competitive sectors. For example, while the sectors monopolized by the state employ 8 percent of China’s non-farming workforce, the state workforce takes away 55 percent of wages.⁵⁸ Moreover, the monopoly profits enjoyed by state enterprises give them advantages even in sectors open to private firms. State enterprises also use their political connections and monopoly profits to force or buy out private firms, undermining market competition. In addition, the presence of state enterprises also undermines the development of China’s capital market. For example, banks prefer to lend money to state enterprises because of their protected profit margins, not to mention the political preferences that state banks have shown for state-owned enterprises. Private firms, particularly start-ups, are often denied access to bank credit, partly because they face high uncertainties and are more likely to fail. As a result, state banks, with a ready and safe group of clients, can afford not to do business with private firms, denying themselves the opportunities to learn how to effectively screen and monitor the debtors. This makes them even more reluctant to extend credit to private firms.

The entrenched socialist view, which is still commonly invoked by the Chinese government, that public ownership always serves public interests and guarantees shared prosperity is clearly no more than wishful thinking. On this issue, the ancient Chinese statesmen and philosophers actually knew better. It is relevant to quote at length a Chinese classic, the Book of Lord Shang (Lord Shang twice helped the emperor of Qin to reform his state, which ultimately unified China in 221 BC).

Law is the authoritative principle of the people and is the basis of government; it is what shapes the people. Trying to govern while eliminating the law is like a desire not to be hungry while eliminating food, or a desire not to be cold while eliminating clothes, or a desire to go east while one moves west. It is clear enough that there is no hope of realizing it.

That a hundred men will chase after a single hare that runs away, is not for the sake of the hare, for when they are sold everywhere on the market, even a thief does not dare to take one away, because their legal title is definite. Thus if the legal title is not definite, then even men like Yao, Shun, Yu, or Tang would all rush to chase after it. Now if laws and mandates are not clear, nor their titles definite, the men of empires have opportunities for contention; in their contentions people will differ and there will be no definiteness. The ruler may make laws from above, the inferior people will quarrel and contend, the law will not be definite and the inferiors will prevail. This may be called a condition where rights and duties are indefinite. When rights and duties are indefinite, even men like Yao and Shun will become crooked and commit acts of wickedness, how much more then the mass of the people! This is the way in which wickedness and wrong-doing will be greatly stimulated, the ruler of men will be despoiled of his authority and power, will ruin his country and bring disaster upon the land and its people.⁵⁹

A similar stress on the delineation of rights can be found in the work of a still earlier Chinese philosopher, the Book of Master Shen: “[When] a rabbit crosses a street; one hundred people will run after it. Even though those who chase after the rabbit are greedy, no one blames them because to whom the rabbit belongs is unsettled. The meat market is full of rabbits. People walk by but barely look at them. This is not because people do not want the rabbits. But after the rights are settled, even greedy people do not quarrel any more.”⁶⁰

The strong presence of state enterprises would be less troubling if the state subjects itself to the rule of law, as recommended by Lord Shang. But few socialist economies, with a heavy presence of state ownership, have ever been ruled by a government under the rule of law. When a government stays above the law, but possesses enormous assets, it inevitably leaves many rights unspecified and open in the public domain. This corrupts politics, invites plunder and engenders injustice, planting the seeds of social unrest and political disorder. When state enterprises operate above the rule of law and make themselves immune to market competition they not only threaten the operation of private firms, but also, as Master Shen and Lord Shang have made clear, put the economic and political foundation of the whole society at risk.

VIII

A market economy does not operate in an institutional vacuum. When the price system is investigated in isolation from the broad institutional setting under which it works, all non-market institutions, including the state, the law, social norms, and moral codes, are deemed external to and separated from the working of the market. Nothing can be further from the truth. Economists have increasingly been trained to forget that most economic phenomena are what sociologists call “social facts,” distinct from natural or physical facts on the one hand, and psychological data on the other.⁶¹ Contract, money, and property rights are social constructions. A distinctive feature of social versus natural or psychological phenomena is, as Hayek reminded us many decades ago, that “[they] are what people think they are.”⁶² What is known as a social fact in one society at one time – the belief that business partners are treated honestly, for example, or that business contracts are usually honored – may not be so in another place or at a different time.

In this regard, our confidence in the long-term prospects for the Chinese market economy is further strengthened by another development in China, less visible than China’s growth record and the rise of market institutions but of no less significance to the future of market economy in China. In 2004, a new Chinese edition of the Wealth of Nations was published.⁶³ The first was translated by Yan Fu (1854–1921), and published in 1902; the second came out in 1930 (with a revised edition in 1972). In the preface to this new Chinese edition, the translators explained why a new translation was necessary. “China has now returned to the market economy. A market economy calls for a corresponding economic theory. And Smith’s Wealth of Nations is the theoretical foundation of the market economy.”⁶⁴ Since China’s re-embracement of the market economy, it has become an imperative for the ordinary Chinese to have access to the Wealth of Nations, but the language used in the first two translations is too outdated and scholarly for current readers.

It is of great interest to note that the recent translators of the Wealth of Nations bemoan the under-appreciation of the Theory of Moral Sentiments by contemporary economists.⁶⁵ This has resulted in an unbalanced understanding of Smith, and worse, a much impoverished economics. In China, Smith is read and respected as the author of both the Wealth of Nations and the Theory of Moral Sentiments.

In an interview with Lionel Barber, editor of the Financial Times on February 2nd, 2009, Wen Jiabao, China’s Premier, stated that “The society that we desire is one of equity and justice, is one in which people can achieve all round development in a free and equal environment. That is also why I like Adam Smith’s Theory of Moral Sentiments very much.”⁶⁶ When asked about the future of China’s political and economic reform, Wen had the following to say.

In 1776, Adam Smith wrote the Wealth of the Nations. And in the same historical period, he wrote the Theory of Moral Sentiments. Adam Smith made excellent arguments in his Theory of Moral Sentiments. He said in the book to the effect that if fruits of a society’s economic development cannot be shared by all, it is morally unsound and risky, as it is bound to jeopardize social stability. If the wealth of a society is concentrated in the hands of a small number of people, then this is against the popular will, and the society is bound to be unstable.⁶⁷

In an earlier interview with Newsweek’s Fareed Zakaria on September 23rd, 2008, Wen made a similar comment: “I very much value morality, and I do believe that entrepreneurs, economists and statesmen alike should pay much more attention to morality and ethics. In my mind, the highest standard to measure the ethics and morality is justice.”⁶⁸ On February 28th, 2009, when Wen shared with Chinese readers via the internet his understanding of Smith, he stressed that Smith actually emphasized two “invisible hands” in the working of a commercial society, one being the market, the other morality.⁶⁹

Wen was absolutely right in recognizing the crucial importance of the laws of justice and rules of morality that Smith placed in the working of society. Justice, according to Smith, is

the main pillar that upholds the whole edifice. If it is removed, the great, the immense fabric of human society, that fabric which to raise and support seems in this world, if I may say so, to have been the peculiar and darling care of Nature, must in a moment crumble into atoms. In order to enforce the observation of justice, therefore, Nature has implanted in the human breast that consciousness of ill-desert, those terrors of merited punishment which attend upon its violation, as the great safe-guards of the association of mankind, to protect the weak, to curb the violent, and to chastise the guilty. Men, though naturally sympathetic, feel so little for another, with whom they have no particular connexion, in comparison of what they feel for themselves; the misery of one, who is merely their fellow-creature, is of so little importance to them in comparison even of a small conveniency of their own; they have it so much in their power to hurt him, and may have so many temptations to do so, that if this principle did not stand up within them in his defence, and overawe them into a respect for his innocence, they would, like wild beasts, be at all times ready to fly upon him; and a man would enter an assembly of men as he enters a den of lions.⁷⁰

Comparing justice and morality, Smith believed that “the rules of justice are the only rules of morality which are precise and accurate; that those of all the other virtues are loose, vague, and indeterminate; that the first may be compared to the rules of grammar; the others to those which critics lay down for the attainment of what is sublime and elegant in composition, and which present us rather with a general idea of the perfection we ought to aim at, than afford us any certain and infallible directions for acquiring it.”⁷¹ Nonetheless, as Smith also pointed out, the hard and definite laws of justice cannot work unless supported by loose but pervasive principles of morality.

Wen’s reading of Smith on inequality is clearly influenced by China’s rising economic inequality, which has of late become a serious social problem.⁷² In The Theory of Moral Sentiments, the term “justice” appears ninety-three times and “injustice” fifty-two times. In comparison, “equality” appears four times and “inequality” twice. When Smith talked about equality, he was more concerned with equality of treatment by the sovereign power to all subjects, the violation of which is an act of flagrant injustice. Smith did not intent this to refer to the equal distribution of all of produce from labor. Indeed, as Smith recognized, economic inequality as so currently understood is inevitable.

Wherever there is great property there is great inequality. For one very rich man there must be at least five hundred poor, and the affluence of the few supposes the indigence of the many. The affluence of the rich excites the indignation of the poor, who are often both driven by want, and prompted by envy, to invade his possessions. It is only under the shelter of the civil magistrate that the owner of that valuable property, which is acquired by the labour of many years, or perhaps of many successive generations, can sleep a single night in security. He is at all times surrounded by unknown enemies, whom, though he never provoked, he can never appease, and from whose injustice he can be protected only by the powerful arm of the civil magistrate continually held up to chastise it. The acquisition of valuable and extensive property, therefore, necessarily requires the establishment of civil government.⁷³

Because economic inequality is inevitable, the laws of justice become critical to sustain social order. Smith was fully aware that “No society can surely be flourishing and happy, of which the far greater part of the members are poor and miserable.”⁷⁴ If not for other reasons, flagrantly polarized distribution of wealth could flare up resentment against the rich, which could run so deeply and widely that even the most powerful and ruthless state cannot control it through coercion alone, leaving the rich always unsecure and even in fear. If just for the sake of the rich, the acquisition of wealth must conform to the laws of justice. When it is believed that justice is observed and opportunities are open to all, even the least fortunate class of society by and large respect existing social institutions – whatever their faults – and accept their social positions. They would work hard to provide better conditions for their children, instead of challenging or overthrowing the prevailing social system through revolution.

Thirty years ago it would have been inconceivable for a leader of a socialist country to read, let alone praise, Adam Smith, the intellectual forefather of modern capitalism. It is striking that Smith has emerged as a guiding figure in China thirty-two years after the death of Mao. It is even more extraordinary that a Premier of China admires Smith as the author of the Wealth of Nations and the Theory of Moral Sentiments. How many western political leaders have read the Theory of Moral Sentiments? On many different occasions Wen has recommended The Theory of Moral Sentiments to Chinese businessmen, writers, college students, and the general public. On the popular Chinese online bookstore, dangdang.com, there are more than a dozen Chinese editions of The Theory of Moral Sentiments, from different translators and publishers. On the cover page of several, it is printed in big red characters, “A Classic by a Master, Highly Recommended Five Times by Premier Wen.” After thirty years of market transformation, China has not only endorsed capitalism as an economic system which facilitates the creation of wealth, but also its moral character and ethical foundation, without which capitalism itself cannot be sustained.

In one respect, however, we should not be surprised that Smith is appreciated in China as a moral philosopher and the founder of modern economics. Confucianism stresses the importance of personal ethics as the foundation for social harmony. Confucius stressed that law could not be the only or primary source of social order.⁷⁵ Instead, he took benevolence as the ultimate virtue and the foundation of social harmony. Clearly, morality itself is not sufficient to make a modern society well governed; Smith makes this point himself. It is equally clear, however, that no society could possibly be well governed without a strong moral code, a point rarely considered in modern economics. A market economy would be severely crippled if all businessmen behave opportunistically, cheating partners whenever they think they can or reneging on contracts for short-term gains.

A traditional Chinese moral precept, “do not give up a good deed because it is trivial; do not commit a misconduct because it is trivial,” ostensibly contradicts the basic tenet of modern economics. The economic principle of maximization would command one to commit misconduct as long as the personal gain overwhelms the cost. This is clearly expressed in the economic approach to crime. Doing a good deed, on the other hand, would be mocked for its violation of self-interest. This Chinese teaching focuses on an aspect of human nature that is largely ignored in modern economics; that our character is formed gradually and almost imperceptibly by what we do. Since the economy is essentially about people making a living, the national character of an economy inevitably reflects the character of its people. Frank Knight made a valuable point in stressing that a society should be judged more by “the wants it generates, the type of character it forms in its people, than by its efficiency in satisfying wants as they exist at the time.”⁷⁶ Modern economics takes as a given the wants that the choice of resource allocation intends to satisfy and disregards the long-term cumulative impact that choice inevitably has on shaping the wants – it takes a snapshot view of a continuous process. But the economy both satisfies wants and simultaneously sows the seeds of new wants, which in turn drives the next round of economic production and consumption. Any action that promises short-term gains but has a corrupting effect on the moral character of the people dims the long-term future of the market economy.

How China became capitalist is an extraordinary tale. Steven Cheung, who thirty years ago correctly predicted that China would turn capitalist, did not expect that the Chinese market transformation would happen so rapidly.⁷⁷ The Chinese leaders as well as economists both within and outside China were caught by surprise when the marginal revolutions brought market forces back to China so speedily. The economic forces that tilted China towards capitalism in the late 1970s have grown stronger over the past three decades of reform. Despite rising economic inequality, economic gains are widely shared in China. Economic freedom and private entrepreneurship, even though still constrained by remaining state monopolies, are flourishing across the country. China will carry on experimenting with the market economy in the foreseeable future. Drawing upon its rich and long traditions in commerce and private entrepreneurship, capitalism with Chinese characteristics will continue to strike out on its own way.

But what exactly is capitalism with Chinese characteristics? In other words, what kind of capitalism has China ended up with after its extraordinary market transformation? Most commentators have focused on the visible hand of the Chinese government and the remaining monopoly power of the Chinese Communist Party as the defining features. While these are undeniably important, they do not hold the key to understanding capitalism in China.

According to the World Bank, the GDP of the United States, amid a devastating recession, stands at 14.58 trillion USD (2010 data).⁷⁸ In comparison, the Chinese GDP is 5.88 trillion USD. Since China has a population four times as large as that of the United States (1.34 billion versus 312 million), China still lags far behind the United States in terms of GDP per capita (4260 USD versus 47,140 USD) and labor productivity.⁷⁹ Even if China becomes the world’s largest economy in the middle of the twenty-first century, as many have so predicted, it will still be ranked as a mediocre performer in terms of productivity unless it significantly improves its innovation capacity. This will set an unprecedented example in modern human history: the largest economy in the world will not be the most productive one.

The same structural flaw in the Chinese economy manifests itself in another manner, more visible to outside observers. Today, “Made in China” can be readily found in Wal-Mart as well as high-end American retail and department stores. From shoes, clothing, to furniture and electronic products, China’s manufacturing sector now produces almost all types of consumer goods. The rapid increase in quantity of Chinese exports has notably benefited global consumers with the advantage of a wide range of consumer products at the “China price.” Nonetheless, most American consumers would be hard pressed to name any Chinese brands, even though their houses are full of products made in China.

This weakness of the Chinese economy becomes readily perceptible if we take a historical perspective. When Britain was the leading economy in the nineteenth century and when the United States became the economic superpower in the twentieth century, they not only invented a wide range of new products but also created new industries. It was their lead in innovation and productivity that defined their economic power. When the Great Exhibition was held in 1851 at the Crystal Palace in London, the English exhibits “held the lead in almost every field where strength, durability, utility and quality were concerned, whether in iron and steel, machinery or textiles.”⁸⁰ The twentieth century saw the rise of American giants Rockefeller, Carnegie, Ford, GM, GE, Boeing, IBM, Coco-Cola, P&G and, more recently, HP, Apple, Intel, Motorola, and Microsoft. And the list goes on and on. When Japan became the second largest economy in the late 1960s, it became home to Sony, Fuji, Toyota, Honda, Nissan, Mazda, Canon, Toshiba, Panasonic, JVC, and Sharp. South Korea, whose economy is one-sixth of China’s (and has only 48 million people), can boast of Samsung, LG, Hyundai, Kia, and Daewoo.

By contrast, even the best-known Chinese firms, such as Lenovo, Huawei, Tsingtao, Haier, and Geely, are not household names in the West. The top ten Chinese firms listed by Fortune are Sinopec, China National Petroleum, State Grid Corporation, Industrial and Commercial Bank of China, China Mobil Limited, China Life Insurance, Bank of China, China Construction Bank, China Southern Power Grid, and China Telecom. These are all state-owned and concentrated in energy and services (banking, communication, and insurance); they are not open to global competition. While Chinese manufacturing firms are globally competitive, most of them can only compete on price in the global market due to the advantage gained by low production costs; they are still struggling to provide new and better products. Short on innovation and lacking their own distinctive products, many Chinese firms depend on ordered manufacturing – taking orders from overseas markets and selling them under foreign brand names. This situation – best described as “production without products” – does not bode well for an economy aiming to top the world. As late as 2009, the United States still manufactured more goods (1.7 trillion USD in manufacturing value added) than China (1.3 trillion USD).⁸¹ After a decades-long decline in employment (fewer than 12 million workers at the second quarter of 2010), the US manufacturing sector still enjoys a significant lead over China, where manufacturing employs over 100 million Chinese workers. Moreover, given the large presence of foreign firms and joint ventures in China, the growth of domestic capacity in manufacturing in China is far less impressive than the name, the “workshop of the world,” might suggest.

The economic reforms that have freed most Chinese firms, forcing them to face market competition, have not had the same liberating effect on Chinese universities. Most Chinese universities and the educational system in general still remain under state control. It is here that the most serious deficiency of China’s market reform reveals itself. This deficiency stands at the root of the troubling symptoms we have indentified above, as well as other shortcomings in the Chinese economy.

Ironically, the post-Mao educational reform started in 1977 with the resumption of the college entrance examination, predating the 1978 Third Plenum. At the time Deng Xiaoping proposed that the Party should serve as the “logistics department” for Chinese scientists and scholars, enabling them to pursue scientific research independently and freely. Deng and other Chinese leaders predicted that, unless China became a nation of scientific discovery and technological innovation, it could not possibly accomplish “socialist modernization.”⁸² Unfortunately, Deng’s pledge did not stop the government from dictating how Chinese universities and research institutions operated. Most Chinese universities are run as an administrative bureaucracy under pervasive ideological control rather than as institutions of learning. As a result, while the Chinese market transformation has spawned a booming market for goods and services and allowed China to become a leading global player in manufacturing, it has not yet created an active market for ideas. Indeed, the whole process of creating, spreading, and consuming ideas, from the education system to the media, has remained under tight ideological control and state surveillance.

The most significant change in Chinese universities in the past few decades of rapid market reform has been the commercialization and expansion of higher education. Under socialism, higher education was fully funded by the state and available only to a tiny percentage of the population, if it was provided at all (during much of the Cultural Revolution, Chinese universities were shut down entirely). At the end of the 1980s, Chinese universities started to enroll fee-paying students who otherwise would not have been able to attend college because of their poor performance at the national college entrance examination. As a result, the state ceased to be the only funder of higher education. The pace of commercialization and expansion of the higher education sector picked up greatly in the 1990s, giving rise to what is widely referred to as “China’s great leap in higher education.” In 1995, only 5 percent of age group 18–22 had access to higher education; by 2007, that had increased to 23 percent.⁸³ China is now the world largest producer of Ph.D.s. Yet Qian Xuesen, a most respected Chinese scientist, asked a sobering question before his death in 2009: “Why have Chinese universities not produced a single world-class original thinker or innovative scientist since 1949?”⁸⁴

The education system makes it all too clear that growth in quantity will not compensate for a lack of progress in quality. No wonder the question raised by Qian, widely referred to in China as the “Qian puzzle,” has attracted extensive media coverage. The fatal organizational flaw of Chinese universities is their lack of autonomy. The majority of Chinese universities remain primarily funded by the state and under the strict control of the Ministry of Education. The Ministry appoints Party secretaries and presidents of major Chinese universities. Within a university, the Party secretary enjoys a higher administrative ranking than the president, and often has more say in running the university. All the degree programs that the universities offer must first be approved by the Ministry. Through its direct control of finance, personnel, and degree programs, the Ministry of Education exercises a pervasive influence over Chinese universities, a level of control the Chinese government only exercised over state-owned enterprises in the pre-reform era. During the period of reform when the Chinese state-owned enterprises were gaining autonomy from government agents and opening up to competition, China’s universities moved in the opposite direction. The most noticeable competition faced by the universities comes from abroad. Tens of thousands of China’s brightest students leave China every year for universities in Japan, Australia, Canada, the United States, and Europe. Their decision attests to their disappointment with the offerings of their own universities.

Under rigid governmental control, Chinese universities have become more skilled in currying favor with the Ministry of Education than in offering innovative research and educational programs; this situation is not so different from state-owned enterprises before reform. In addition, hard pressed for financial resources, Chinese universities compete in their enrollment figures and focus on other avenues of money-making. Consequently, higher education in China may have been commercialized and have expanded, but the education reform has not brought about a free market in ideas. On the contrary, as the state pours money into its designated projects in the hope of creating world-class universities, the Ministry of Education has come to wield even more power over Chinese universities. This means that they are more responsive to administrative directives than to the emerging challenges in higher education.

In 1995 and 1998, the Chinese government launched Project 221 and Project 985, with the aim of building up a few world-class universities and critical academic disciplines.⁸⁵ The Ministry of Education introduced the piece rate compensation system to Chinese universities, an incentive scheme that had served well in manufacturing firms. University professors are evaluated and rewarded according to their publications. The total compensation of a professor typically consists of a basic salary, which is tied to his or her academic rank, and a performance-based reward, which is mainly dependent on publications. In most cases, the basic salary is set so low that all professors have to publish to earn a decent living. Not surprisingly, this scheme, which is now widely applied, has turned Chinese professors into publication machines. On the positive side, China has become a significant producer of academic articles worldwide. But this growth has come with a steep price tag, which is best demonstrated by the “Qian puzzle.”

In almost all human endeavor, the gap in achievement between the average and the very best is often enormous. In all science, the subject has historically been carried forward by a few giants. Human ingenuity works best and science has a higher chance to advance when self-selected and motivated scholars are given the freedom and support to pursue their own research. A performance-based reward system can force scholars to publish, but nothing works more effectively to suffocate creativity and originality than this overt link to material interests.

Given the pervasive administrative meddling of the state, it is not difficult to understand the mediocre performance of Chinese universities. As Milton Friedman remarked, the surest way to destroy an industry is to protect it with state monopoly. The state monopoly in China has severely curtailed the production of ideas. Administrative interference is so severe that even in areas such as physical and biological sciences and technology, where the impact of political ideology is limited, a free market for ideas hardly exists. As a result, the Chinese traditional proverb “to let one hundred flowers bloom and let one hundred schools of thought contend” remains a pipedream.

As far as Chinese universities are concerned, the government essentially controls both inputs (finance and personnel) and outputs (degree programs), leaving them very little autonomy. Recently, the delayed opening of the South University of Science and Technology provided a frustrating but illustrative example of this situation.⁸⁶ This new university is a local initiative, fully supported by the Shenzhen municipal government. Even though it is not a private university, the South University of Science and Technology will operate independently from the Ministry of Education as well as the local government. It is modeled on the Hong Kong University of Science and Technology and aims to be a first-rate research institution in South China, providing a much needed hub of scientific research and technological innovation for the fast-growing regional economy. The new university planned to open in the fall of 2010. But after more than three years of preparation, the Ministry of Education refused to approve and accredit its degree programs, thus making it hard for the university to attract students.

In addition to education, Chinese law and politics have also suffered severely from the lack of an active market for ideas. Although Chinese economic performance has surpassed the wildest expectations, progress in political reform has been disappointing. Many problems explicitly acknowledged in the 1978 Communiqué are still present and many of its objectives remain unfulfilled. “The bureaucratic attitude of paying no attention at all to urgent problems in the people’s livelihood” is still pervasive. China is in no way near the point where “the constitutional rights of citizens must be resolutely protected and no one has the right to infringe upon them.”⁸⁷ After more than three decades, the Chinese legal system is still far away from where it can “guarantee the equality of all people before the people’s laws and deny anyone the privilege of being above the law.”⁸⁸

The government’s monopoly on ideas has given rise to the dire situation that Deng had deplored at the beginning of reform, that is, “opposing the leaders’ views is deemed as against the law.”⁸⁹ Without a forum to express their concerns or articulate their views, dissidents are forced into conflict with the government. People of critical thinking and independent thought, the most valuable human assets in any society, often find themselves labeled political dissidents. In turn, political dissidents often find themselves deemed to be “anti-Party,” or “anti-socialism,” a charge that can end their career, if not their life.

From the economy to education, from law to politics, the absence of an active market for ideas has left its imprint throughout Chinese society. On the surface, the Chinese economy has achieved remarkable growth since the inception of reform, even without a free market for ideas. Enriched and empowered by a free market for goods and services, the political leadership, which bases its legitimacy on continuous economic growth, might think that the market for goods and services is all that is needed.⁹⁰

But nothing could be further from the truth. The lack of a market for ideas is directly responsible for the lack of innovation in science and technology, the Achilles’ heel in China’s growing manufacturing sector. The dearth of innovation and remaining state monopolies gravely reduces the range of investment opportunities that Chinese entrepreneurs find profitable. Taking manufacturing orders from others rather than inventing their own product becomes the dominant strategy for Chinese entrepreneurs. Without a free and open market for ideas, China cannot sustain its economic growth or advance itself into a global center of technological innovation or scientific discovery. At the beginning of reform, China quickly began to close the enormous gap in science, technology, and know-how between itself and the West almost as soon as the ideological blockades had been removed. But to sustain a similar growth rate in the future, China has to become more innovative, providing new products to global consumers with less and cleaner energy. While it has been transformed in a short period of three decades from a poor agrarian socialist economy into a leading dynamic manufacturing powerhouse of the global economy, China still has a long way to go to become a powerhouse in the production of ideas.

Moreover, the lack of a market for ideas also undermines China’s effort to build a harmonious society and renovate itself culturally. Harmony, as well expressed in its Chinese meaning, requires the presence of different voices. Harmony arises only as a result of interactions of different voices through a market for ideas. The fate of any government must turn on its capacity to create and defend material abundance. But it also depends on its capacity to cultivate and sustain a universe of ideas. This universe of ideas resembles what Karl Popper called the “World 3,”⁹¹ including products of human mind resulting from our attempt to understand who we are and how the natural and social world works. These two tasks, often called the development of “material and spiritual civilization” in China, are intrinsically intertwined. The world of material abundance will be boring and brittle if it is not enlivened by a rich universe of ideas; the universe of ideas will be illusory and short-lived if not rested firmly on a world of abundance. In our contemporary world, as the economy becomes more and more knowledge-intensive, the long-term health of the market for goods depends on a vibrant market for ideas through which knowledge is discovered, shared, and accumulated. The pace at which new enterprises are established, new products are invented, and new industries are created is critically dependent on an active market for ideas. Moreover, the market for ideas drives the market for goods and services in a fundamental way. As the market for goods operates under the assumption of consumer sovereignty, it is the market for ideas that directly shapes consumer wants, crucially determines what kind of consumers (as well as entrepreneurs, politicians, and lawyers) we find in the economy, their characters and values, and thus ultimately decides what the market for goods is and how effectively it works.

With a competitive market for goods and services, China has long been a favored destination for foreign capital, attracting investment from many of the global Fortune 500 companies. Without an active market for ideas, however, China’s own human talents are fleeing the country. The mounting surplus China has accumulated in financial capital is only matched by a tremendous deficit in human capital. This glaring imbalance reveals a profound flaw in the market economy with Chinese characteristics as it exists today.

State intervention is not the only force in China preventing the rise of the market for ideas. As a historical fact, modern Chinese politics, under both the Kuomintang and the Communist Party, has rarely been receptive to the market for ideas. At the turn of the twentieth century, when China was struggling for its survival, facing western powers from without and infighting among warlords from within, the modern political parties that first emerged in China were overwhelmingly preoccupied with national survival.⁹² Both the Kuomintang and the Chinese Communist Party were born as secret revolutionary organizations, and they quickly turned into quasi-military affairs. Heavily influenced by the Russian Revolution, both quickly resorted to terror and violence, and valued discipline and control. The Communist International was directly involved in the setup of the Chinese Communist Party and the reorganization of the Kuomintang during the 1920s. This legacy has had a lasting and formative impact on the development of modern political parties in China. Moreover, the hostilities between them led each to inflict terror and violence on the other, reinforcing their authoritarian inclination to use force and coercion. Under such circumstances, Mao’s statement that “the power of government comes out of the barrel of a gun” encapsulated the reality of Chinese politics. A market for ideas was preserved only beyond the reach of both parties in places like the Shanghai International Settlement and in Hong Kong.

Probably influenced by the Japanese translation of the word “party,” both the Kuomintang and the Chinese Communist Party referred to themselves as dang in Chinese. This is a term with strong negative connotations in Chinese political thought. Party politics had been persistently regarded as a secretive, insidious force, promoting narrow group interests detrimental to good governance and public interests. This is suggested by the Chinese axiom “jie tang ying shi,” which literally means “form parties to pursue private interests.” This is in direct contrast to the spirit of traditional Chinese political thinking, “tian xia wei gong,” or “the world is for the public.”⁹³ The experience of party politics throughout the twentieth century in China has not negated the validity of this axiom, but this historical legacy does not bode well for multiparty competition as a way to bring about a free market for ideas in China.

In China, the government’s monopolization of the production and transmission of ideas is largely driven by fear of sedition. The first Qin Emperor buried alive hundreds of Confucian scholars and burned books to suppress ideas that he deemed a source of danger to his rule. But, as a Tang poem put it, “Even before the ashes in the burning pit became cold, riots had begun in Shandong; it turned out that Liu and Xiang [two riot leaders] did not read books.” Mao knew this poem by heart,⁹⁴ but its historical warning still failed to stop him from instituting his Anti-Rightist Movement in 1957. The Anti-Rightist Movement led to the persecution of millions, but perhaps the most damaging consequence of this oppression of the market in ideas was to undermine the regime’s capability to govern.

A salient weakness of government bureaucracy, or any big organization for that matter, is that decision-makers at the top are often at the mercy of information controlled by those below.⁹⁵ As a result, hierarchical organizations, including government bureaucracy, often find themselves trapped in a double asymmetry of power and information. Decision-makers at the top are given enormous discretionary power but fed with narrowly selected and often biased information; gatekeepers at the lower levels of the power pyramid are better informed, but with little power to act. An active market for ideas, independent of political power, provides an indispensable institutional safeguard to ensure that decision-makers are reasonably well informed. As Wang Fu, a Confucian philosopher in the Han dynasty, put it, “[the Emperor] is enlightened because he listens to different views; he becomes benighted when he heeds only one side.” After the Anti-Rightist Movement was launched in 1957, a government bureaucracy that once was disciplined, responsive, and efficient quickly became demoralized and degenerated into a blind, self-destructive political machine, bringing about in peacetime the worst man-made famine in history.

That some “rightists” were seditious does not justify the closing down of the market for ideas. An ideal society is not one entirely free from the risk of sedition. Given the cost of controlling sedition, a society is better off not eliminating it. After a certain point, the cost of further reducing the risk of sedition simply outweighs any possible additional gains. Moreover, since a well-intended but misinformed political machine can inflict a catastrophe on its own people, as shown in the Great Leap Forward, a market for ideas, as imperfect and vulnerable as it is, offers an effective remedy to the double asymmetry problem that government bureaucracy can fall victim to.

While a market for ideas can be readily suppressed and fatally undermined by political censorship, an oppressive state is not the only predator. A less alarming, but equally dangerous, enemy of an open market for ideas comes from a different source. In China, Marxism has been, and still is, taught to students from primary school as a “scientific” theory and the final truth on human history and social evolution. Even when Marxism has been challenged and largely discredited in the past thirty years of reform, the dogmatic teaching of Marxism has cultivated a certain habit of thought, which has survived Marxism itself: the mentality to take truth as final, complete, permanent, and authoritative. But all empirical knowledge is exactly the opposite; it is provisional, incomplete, and conjectural. For an open market in ideas to operate, participants have to recognize that an unimpeachable truth does not exist. Truth emerges only in an endless struggle against ignorance and bigotry, and it rarely wins by a single, decisive, once-and-for-all battle. No authority qualifies as the final judge of truth. It is exactly due to human fallibility and irreducible ignorance in the process of seeking knowledge that an open market for ideas is the best possible tool to get as close to truth as possible. Otherwise, the market for ideas would be unnecessary and wasteful, or worse, subversive and treacherous. A critically minded public, willing to challenge authority, but tolerant and open-minded, offers circumstances conducive to a free market for ideas.⁹⁶

XII

Steven Cheung’s prediction that China would become capitalist was essentially based on the analysis that economic gains of adapting the market (for goods and services) would be so substantial as to overwhelm any resistance after China had opened itself up to the outside world. Today, a stronger argument can be made regarding the prospect of the market for ideas in China.

The market for ideas has a root as deep as, and probably more respectable than, the market for goods in China. Confucius is celebrated today in China first and foremost as an educator. It was Confucius who started the first private school in China more than 2000 years ago, ending education as a privilege of the powerful. Ever since then, education – the creation and transmission of knowledge – was largely left in private hands, even after the rise of the civil service examination. Despite much opposition and adversity, an active market for ideas was a persistent feature of Chinese history, generating intriguing technological innovations as well as splendid art and literature that we still enjoy today. In traditional China only a small percentage of the population could afford to devote themselves to study. Today, with the spread of higher education and modern communications, China in the twenty-first century may well witness a blossoming market for ideas.

The primary creators of ideas in traditional Chinese society, the literati class or shi, had a unique social, political, and cultural status that cannot be found in many other historical civilizations. This literati class essentially ruled China during much of its history, from the Qin unification of China in 221 BC to the fall of the Qing dynasty in 1911. In addition to staffing the state bureaucracy as mandarins, shi also served as the moral compass of Confucian society.⁹⁷ For the great man (da zhang fu), the embodiment of shi, in the memorable words of Mencius, “wealth and fame never mean much to him, poverty and obscurity never sway him, and imposing forces never awe him.” Today’s China is no longer a shi-centered society. Under the current political system, the intellectuals, the modern successors to shi, are not as dominant in politics or as active and influential in civil affairs as the literati class once was. But the ideal of shi and its moral calling still strike a strong chord with many educated Chinese. Trained in humanities, social sciences, and modern science and technology, Chinese intellectuals today have a much better and more sophisticated understanding of how nature and human society work than their predecessors. With an active market for ideas, there is no reason why China cannot witness another cultural renaissance that rivals past glories achieved in the Tang and Song dynasties.

Without a free market for ideas, the Chinese political system is often a cause of pessimism. But pessimists tend to forget that the same facts also support cautious optimism. China has achieved an astonishing growth record over the past three decades in spite of many serious political problems. Hence, the rise of a market for ideas and changes in the Chinese political system for the better would help to release further creativity and entrepreneurship among the Chinese people and cut down the institutional cost of running the market system, thus providing a strong source of economic growth. The potential marginal benefits from adopting an active market for ideas are even higher than the expected gains that led Cheung in the early 1980s to predict China’s move to capitalism.

Moreover, the market for ideas points to a gradual but direct, and more viable, avenue for political reform in China. The absence of political democracy and the market for ideas in China should not lead us to conflate the two. Adam Smith, for example, did not have the right to vote, a political entitlement we take for granted today in any democracy. But Smith enjoyed freedom of speech and expression, enabling his work to enrich the market for ideas forever. It is possible to have a flourishing market in ideas without a government being elected within a multi-party democracy even though the affinity between the market for ideas and democracy is undeniable. It is true that the market for ideas flourishes in most democratic countries but is harshly suppressed in most non-democracies. At the same time, however, the tyranny of the majority is inimical to the working of the market for ideas. In a multi-party environment, when political leaders vie to win a majority vote, which is regarded as the ultimate source of political legitimacy, few in the political system can afford to indulge in genuine and meaningful political debates. Even in a democracy, when the political system depends on votes for its survival, whether it facilitates a free market for ideas can become secondary.⁹⁸

While democratization (or its lack thereof) has attracted much attention in today’s political debate, an open market for ideas is a key institution fundamental to the working of the political system, be it a democracy or not. There are democracies where there is little genuine intellectual debate and, at the same time, throughout history, there have been societies that have been melting pots for new ideas that have not been democracies. A significant advantage of the free market for ideas is its compatibility with diverse cultural and political systems. A market for ideas clearly flourished in China during the Warring States period when many schools of thought, including Confucianism, Taoism, and Legalism, emerged; it also flourished during the Tang dynasty when Chang’an, the capital city, attracted scholars from Korea, Japan, Vietnam, India, and Persia. A market for ideas flouished in the city-states of ancient Greece; it also prospered at Baghdad between the ninth and thirteenth centuries when the city was the center of learning for the Abbasid Empire, where many of the tales in One Thousand and One Nights were set. Without imposing a single uniform political system, the market for ideas, instead, fosters tolerance, cultivates diversity, facilitates experiment and innovation, and enhances social resilience. A market for ideas is not always synonymous with democracy.⁹⁹

As remarkable as the Chinese market transformation is, capitalism with Chinese characteristics is impoverished by the lack of a free market for ideas; this deficiency has become the most restrictive bottleneck in China’s economic and social development. Ever since the start of economic reform, the Chinese government has been persistently calling for the “emancipation of the mind,” but nothing is more effective than an active market for ideas in freeing people’s minds.¹⁰⁰ Indeed, without this, any “emancipation of the mind” is doomed. The creative minds of the Chinese people and their inventive power have been underexploited. This is unfortunate since capitalism with Chinese characteristics could definitely be more innovative and more driven by quality rather than quantity. As the largest producer of Ph.D.s in the world, China could have contributed much more to the growth of human knowledge. In today’s world, new products and industries, novel ideas and practices, flexible and innovative organizations and institutions urgently need to tackle global challenges, from poverty and disease to war, from energy conservation and water shortage to environmental protection. We simply cannot afford to set aside the human potential of one-fifth of humanity.

XII

The post-Mao Chinese economic reform in the past few decades has profoundly transformed the Chinese economy and society. At Mao’s death in 1976, China was one of the poorest countries in the world, with a GDP per capita below 200 USD. By 2010, China was the world’s second largest economy, with a GDP per capita at more than 4000 USD. During the same time span, China’s share of the global economy rose from below 2 percent to about 9 percent. Private entrepreneurship was strictly forbidden during Mao’s era; it now thrives throughout the country and stands firmly as the backbone of the Chinese economy. With the world’s largest population of internet and cell phone users and the largest car market in the world, Chinese society is open, energetic, mobile, and well informed, full of dynamism and aspiration. Even Chinese universities have recently shown signs of improvement, realizing academic freedom as a precondition for excellence. There is still tremendous room for growth in the Chinese economy.

No one would have believed it if the tale of Chinese market transformation had been told beforehand. Probably the only economist who had predicted its coming, Steven Cheung repeatedly underestimated its speed. Those few who believed in Cheung’s analysis and prediction thought it would take a hundred years, not twenty or thirty.

It is also extraordinary for another reason. The reform efforts undertaken by the post-Mao leadership were meant to be a “socialist revolution,” turning China from a backward country to “a great, modern, socialist power.” China did not abandon socialism when it began its reform. Throughout reform the Chinese government remained committed to socialism. Only under the crushing pressure of famine and unemployment was private entrepreneurship allowed some breathing room in rural and urban China. But once the floodgate of private entrepreneurship was opened, a series of marginal revolutions, rather than state-led reform initiatives, quickly brought market forces back to the Chinese economy. While socialism was simply banished from Moscow, Warsaw, and Prague, it was defeated on its own terms in Sichuan, Anhui, Zhejiang, and Guangdong.

This is also a tale with distinctive Chinese characteristics. The political debates that have emerged and shaped the course of reform, particularly those on the nature of socialism, did not take place elsewhere. The policy choices regarding centralization and decentralization were rooted in and informed by the political history of imperial China. The philosophical discussions on the criteria of testing truth with facts could only have the significance and resonance that they had through the influence of traditional Chinese culture. In the coming decades, capitalist China will inevitably remain Chinese, as socialist China has unfailingly been, despite the terrible violence inflicted upon Chinese traditions in the course of the twentieth century.

As it stands now, the emerging market economy in China may appear too coarse to many observers in the West, where capitalism has evolved over centuries. Capitalism with Chinese characteristics is very much like traffic in Chinese cities, chaotic and intimidating for many western tourists. Yet Chinese roads deliver more goods and transport more passengers than those in any other country. In a similarly intriguing fashion, the Chinese market economy works in its own way. Because of its unique cultural traditions and political institutions, the Chinese market economy will retain some, and develop more, peculiar Chinese features. It is neither possible nor desirable for the Chinese style of capitalism to rid itself of its individual character. This is by no means a blanket endorsement of capitalism as currently practiced in China, the defects and shortcomings of which are too obvious to hide. But at the same time we should resist our human instinct to embrace what is like us and banish what appears unfamiliar. An open society thrives on diversity and tolerance. Self-imposed uniformity and rigidity have brought a once powerful and seemingly unstoppable train of socialism to a halt. If there is one lesson to be learnt from the failure of socialism, it is that diversity is a cause for celebration not for caution or suspicion.

Historically, China has always been a land of commerce and private entrepreneurship. Confucius, when asked how to govern the state, recommended “(first) to populate the state, (then) to enrich the people, and (last) to educate the people.” Lao Tzu, who founded Taoism, stated that “So long as I [the ruler] do not attend to anything, the people will of themselves get prosperous.” “The Dao of governing a state,” as told by Sima Qian, the grand historian of China, “starts with enriching the people.” That Deng Xiaoping’s slogan, “getting rich is glorious,” served as a battlecry of reform throughout the 1980s reveals how far China had disconnected itself from its traditional teachings in commerce and statecraft. In its attempt to build a market economy with Chinese characteristics at the end of the twentieth century, China, after one century and half of self-doubt and self-denial, has come full circle to embrace its own cultural roots by way of capitalism. On January 11th, 2011, a 9.5 meter high bronze statue of Confucius was quietly erected in Tiananmen Square.¹⁰¹

China’s long history and its modern manifestations have critically and formatively shaped capitalism in China. As the market economy with Chinese characteristics continues to develop, in ways that we cannot imagine today, layers of Chinese history stand as a firm foundation.

In this regard, a lesson from Mao’s era is of great relevance. Immediately after the founding of the People’s Republic of China, Mao arranged a meeting with Liang Shuming, whom a sinologist would later call the “last Confucian,”¹⁰² to seek his advice on how to build a new China.¹⁰³ Liang was a well-known expert on Chinese philosophy (particularly Confucianism and Buddhism), a scholar of great integrity, pragmatic and active in social affairs. Born in the same year (1893), Liang and Mao had known each other since the late 1910s when Liang was a professor and Mao an assistant librarian at Peking University. Liang was convinced that “building a new China” and “knowing the old China” must go hand in hand. Without a thorough understanding of the old China, both its strengths and weaknesses, the new China would be disoriented and crippled. Mao, however, thought otherwise. In Mao’s view, and that of most Chinese leaders at the time, socialism provided a reliable roadmap to prosperity and any legacy of the past was nothing but a hindrance to China’s march toward socialism. China knows better now, but only after thirty years of a failed socialist experiment and another thirty years of market transformation. As China is fast moving forward in the twenty-first century, developing a market economy of its own kind and further aligning itself with the global division of labor, it is also going back to its cultural traditions. Bringing the past into the future while openly engaging with the outside world, China stands a favorable chance for another renaissance. An open, tolerant, confident, and innovative China will surprise the world even more in the years to come.

This account of how China became capitalist is not the final word on China’s market transformation. There is still much to be learnt about this extraordinary tale. What we have attempted is mainly a historical narrative of the chain of actions that brought it about. But there is no way to present a coherent narrative of how China became capitalist without certain theoretical perspectives. Facts have to be selected and their significance assessed. Neither can be accomplished without proper guidance from theory. “Progress in understanding the working of the economic system,” in our view, “will come from an interplay between theory and empirical work. The theory suggests what empirical work might be fruitful, the subsequent empirical work suggests what modification in the theory or rethinking is needed, which in turn leads to new empirical work. If rightly done, scientific research is a never-ending process, but one that leads to greater understanding at each stage.”¹⁰⁴ It will take us decades, if not centuries, to fully explain why China became capitalist the way it did, resolving all intriguing puzzles. But we must first establish a solid understanding of how China became capitalist and ascertain exactly what we have to explain before we can possibly venture any causal explanation.

As we come to the end of this book, it is evident that the tale we have told is not the end, but the very beginning of Chinese capitalism. The Chinese market economy will continue to develop with its own characteristics, integrating its rich traditions and the diversity of the modern world. After all, capitalism is not an end state, but an open-ended evolutionary process of collective learning and self-transformation.

What had happened in China since the death of Mao is certainly breathtaking. China today would hardly be recognized by Mao if he walked out of his mausoleum. He would be astounded to find out that private entrepreneurship and free markets could actually realize his broken dream, one shared by the Chinese people for more than a century, of remaking China a rich and powerful nation. With the rise of an open market for ideas, the growth of the Chinese economy will be even stronger and more sustainable. Professor Robert Fogel’s estimate that the Chinese economy in 2040 would be as large as two-fifths of the world total may be too high,¹⁰⁵ but it may well be too low. Production per capita in China (4393 USD, 2010 data) is still very low compared with that of the United States (47,184 USD), Britain (36,100 USD), France (39,460 USD), Germany (40,509 USD), or even with that of its Asian neighbors, such as Japan (43,137 USD), South Korea (20,757 USD), and Hong Kong (31,758 USD). There remains ample room for rapid growth in China’s economic productivity.

Lack of access to high-quality human talent has been a restrictive constraint on the development of Chinese firms. Today, Beijing and Shanghai have become new lands of opportunity for American graduates, not mentioning the growing number of returned Chinese students who have been educated in the West. Chinese firms have also opened up R&D offices from California to New York, from Illinois to Arizona. With increasing access to the global pool of human talents, the Chinese economy stands a great chance to climb up the technological ladder and become more innovative and productive.

Economic productivity in any society is fundamentally determined by the makeup and quality of its human talent and the performance of its human capital market, which determines how effectively human talent is cultivated and exercised. No one would deny the critical importance of commodity exchanges, stock markets, banks, courts, and governments in the working of a modern economy. But all these institutions are regulated and operated by people. No institution is foolproof, nor set in stone. How institutions function and how they adapt to changing circumstances inevitably reflect the character of its regulators and operators.

No factor exerts more influence on the quality and performance of the human capital market than the market for ideas. The “Qian puzzle” makes it clear that a vibrant market for ideas is both a precondition for scholarly excellence and an indispensable moral and epistemic foundation for an open society and free economy, without which the great diversity of human talent would wither. During the past decades of reform and opening up, the introduction of the market for goods has brought prosperity back to China and fortuitously led the country back to its own cultural roots. The development of a market for ideas will make the growth of the Chinese economy more knowledge-driven and innovative. More important, it will enable China to revive its rich traditions through transformative integration with the diversity of the modern world. China will then stand not only as a manufacturing center of the world, but also as a lively source of creativity and innovation.

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