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The Institutional Evolution of China

Government vs Market

Fan Zhang

China’s experience over the past decades is not just a story of economic growth, it is also one of institutional change. The current political-economic system is a bureaucratic market system, in which the government and the market both coexist and conflict with each other. This book gives a detailed description of the institutional evolution in China, using large amounts of documents and cases. The book provides a theory explaining the origin of China’s reform, the political and economic forces driving the reform, and the reasoning behind the stagnation and turn-over of reform.
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Chapter 1: Analytical framework

Fan Zhang

China began its transition to a market economy nearly thirty years ago under an authoritarian and hierarchical political system … the dramatic change in transition strategy … gives insight into the achievements, limitations, and future prospects of reform under authoritarian auspices.

Barry Naughton (2008, p. 91)

In this book, I will illuminate features of institutional changes in China since the late 1970s, focusing on the relationship between the government and the market during the economic reform. Douglass North defines institutions as ‘humanly devised constraints that structure political, economic and social interactions’ (North 1991, p. 97). Constraints, as North describes them, are devised as formal rules (constitutions, laws, property rights) and informal restraints (sanctions, taboos, customs, traditions, codes of conduct), which usually contribute to the perpetuation of order and safety within a market or society. Institutions work as structures or mechanisms of social order (e.g. the rules and organisations), the background upon which economic and political activities perform. The book highlights the institutional bases of the economic growth in China in the process of economic reform in the past four decades.

China has experienced dramatic changes in economic performance in the past 40 years, but not enough attention has been paid to the background of this progress: the institutional changes. China’s success over the past several decades is a story of not only economic growth but also institutional changes. These changes in economic performance and the difference between the planned economy of the past and the market economy today are rooted in the evolutions of China’s political and economic institutions. Furthermore, to perform an international comparison, the differences between the economies in Western industrial countries and in China are also based on the differences between their institutions.

In the planned period from 1949 to 1977, the Chinese government played a near-omnipotent role in China, owning most of the resources, infrastructure, and enterprises.1 It made the decisions of what to produce, for whom to produce, and how to produce. Only a small market existed in the area of consumer goods, and government rationing interfered with this. The tight control created incentive problems for workers, and per capita income was at a very low level. The poverty and the political conflict hurt every citizen and helped to form a consensus, among the leadership and the ordinary people, that this controlled-economy system should be abandoned, and the reform began in 1978. The economic reform from 1978 to the 2010s introduced market principles and opened up the Chinese economy to the world.2 In the process of reform, the government deliberately and gradually relaxed its control over the economy, letting the market play a more important role. The government gave the peasants rights to use the land, and lifted price controls on most consumer goods and some producer goods, letting the price mechanism work freely in these sectors. There was a silent privatisation in 1990s, in which the government sold most of the small and medium-sized state-owned enterprises (SOEs) to the public. More and more development zones were established, opening to the outside world. These institutional changes resulted in unprecedented growth. Many institutional innovations were created in the process of reform. While the government changed its role to some extent during the reform, the basic political system did not change much.

As a result of this unfinished reform, the current political-economic system in China is a dual system a bureaucratic-market system in which the government and the market coexist and conflict with each other. The government is in a dominant position, whereas the market has occupied a corner of Chinese society and become part of the existing hierarchical system.3 The government makes major macroeconomic decisions and intervenes in the market to a certain extent, whereas enterprises maximise their profits under government regulation. As a result of reforms to the economic system, for example the relaxing of government control of pricing and the selling of small state-owned firms to the public, private firms have grown significantly and now play an indispensable role in the economy. On the political side, however, after nearly 40 years of economic reform, to some extent the political system is moving back towards its historical and tradition form. Many of the changes in the reform process can be explained by this dual political-economic system. As noted by Barry Naughton, ‘new economic powers have grown up alongside authoritarian hierarchy’ (Naughton 2008, p.130). All solutions to socioeconomic problems need to address the roles of both the government and the markets, and the system is still in a process of change and far from equilibrium.

The most incredible event of the economic reform in the past 40 years has been the creation of private enterprises and the market from the institutional rubble of the Cultural Revolution. China’s institutional reform created a miracle of economic performance, in which both the government and the market played an extremely important role. The increased productivity comes from two sources: (i) creativity from the bottom of the society made possible by relaxation of government regulations; and (ii) strong leadership by the government, especially local government, in economic development as a product of the competition between local governments.

The institutional change in China is a long-term process from a planned economy to a market economy or, politically, a change from a totalitarian to an authoritarian system. A market economy has large numbers of economic agents making their decisions independently, reacting to the signals of the price mechanism. Therefore, decentralisation of authority and incentive creation4 are the central issues of transition. Since the beginning of the reform, the government has reduced its control on society, and it has increased the incentives of the lower level of government and the society to work. The public domain is still controlled by the government, whereas the private sphere has been freed to some degree. Strong economic performance has become the primary measure of political legitimacy in China. In the transition process, where the existing system lacks a number of institutional features, the government has played an important role and served as an alternative to the formal legal system in providing security and stability to non-state-owned firms.

The central issue of the institutional changes in China over the past 40 years has been, and continues to be, the relationship between the government and the market. This book develops a framework of a political-economy theory of government and market in a bureaucratic-market economy like China. The government is rational and has multiple targets, including maintaining social stability and improving the living standards of its citizens, under certain restrictions. Economic performance and social stability become two major restrictions on political power, whereas firms maximise their profits under the supervision of the government. The government is the designer, controller, and supervisor of society, and the firms and citizens choose to follow the rules or disobey them in different ways. As for the relationship with the different levels of government, the central government sets the rules, while the local government changes its behaviour given the rules set by the central government. A principal–deputy relationship is involved. Supervision and incentive become two major issues in this dual political-economic system, a major trade-off policy makers must face.

Path dependence matters a lot in the process of China’s institutional evolution. The reform experienced a circuitous path, from the creation and development of the market to stagnation and redirection of the reform. Historical connections can be seen before and after reform. China’s economic reform came from the depths of the Cultural Revolution, which hurt every group in society, including government officials, shaking Chinese society to its foundations. This built the consensus on the need for change in the whole society and resulted in the government-led reform, which was supported by all walks of society. The reform was initiated from the bottom of the society, while the government later accepted the reform and relaxed the relevant regulations. As the reform went on, government took over leadership and initiated follow-up reforms from the top. Since the majority of government officials were seriously damaged by the Cultural Revolution, they became leaders of the reform, which determined its government-led nature. The reform has been an economic one without a balanced political counterpart following the events of Tiananmen Square in 1989. The bureaucracy–market combination is a result of the planned economy and gradual reform. The nature of the bureaucratic-market system fostered corruption among government officials and business executives, many of whom acquired their initial wealth by using their connections with political power. This kind of systematic corruption damaged social equity and justice, and resulted in stagnation of the reform. The market itself proved to be a double-edged sword, hurting some individuals and institutions in the society during the reform process and finally helping to alter its path. The consensus on economic reform has been gradually lost in the process of change when the newly created market hurts the interests of some social groups. A new consensus on the need to stamp out corruption now exists in today’s Chinese society. Because the extreme case of the Cultural Revolution is not easy to duplicate, China’s economic reform was a black swan event, which cannot be repeated on a similar scale in the near future. Reform is a process involving progress, adjustments, and readjustments. To make adjustments, the government has occasionally changed policy back towards the old system, because of the lack of means of checks and balances.

From the dynamics perspective, the institutional changes have alternately followed bureaucratic logic and market evolution logic and created conflicts. The current situation in China can be considered as an unstable equilibrium in the short run. The long-run equilibrium depends on the balance of government power and market vitality. The future path of China’s institutional evolution depends on the trade-off between political stability and economic development by the elites and general society. Compared with the risks of market flaws, the main risk in China is the government’s unrestricted power to further squeeze out the private market. Even after 40 years of marketisation reform, the government is still much stronger than the private firms in the market and dominates most aspects of social life. To balance government control and market vitality, further reforms need to be made and government power should be restricted. Economic reform without a balanced political counterpart and the government-led nature of the reform eased economic reform in its early years but left the bureaucratic system largely untouched, and this became a source of stagnation.

This book is unique in several respects. First, I use many documents and cases to give a detailed description of the institutional changes in the past 40 years in China, focused on the government–market relationship, covering changes in formal and informal rules, in political and economic organisations, and in attitudes of government officials, business people, and ordinary citizens. Second, I provide a historical perspective to explain the origin and reasons for China’s economic reform, the political and economic forces driving economic reform, and the causes that led to the stagnation of the reform. Third, I present a framework of a theoretical model of political economy, based on existing literature, to explain the targets and incentives of government and business firms in a dual politicaleconomy society. Finally, I offer an index of marketisation in China since 1978, which shows that, overall, market expansion has continued but with diminishing marginal gains, and government control has been enhanced.

Throughout the volume, Chinese names are given in the Chinese official style that is used in mainland China today: the family name without a comma followed by the given name (i.e. Deng Xiaoping). Commas are used only in the Reference list for the first author, following the family name (i.e. Deng, Xiaoping). For the names after the first author in the Reference list, the given name is followed by the family name. The author’s name on the cover follows the Western style, the given name (Fan) without a comma followed by the family name (Zhang). All information used in this book is from open sources. Values of RMB are converted to US dollars using official annual average exchange rates. In the period before 1994, the official rates were overvalued compared to market rates, which may distort comparisons between different years (National Bureau of Statistics 2009a and 2015).

I belong to the generation born at the beginning of the planned economy, who were children when the Great Leap Forward resulted in the Great Famine in the late 1950s, who could not finish their middle school when the Cultural Revolution began, who entered colleges when they were in their mid-twenties, and who experienced the whole process of economic reform. I believe that it is our responsibility to rethink the changes in China over the past 40 years and explore reasons behind these changes.

1.1  LITERATURE REVIEW

A tremendous amount of literature exists in the fields related to this book, of which I can only review the most closely related ones due to limited space. These literatures are divided into two groups: (i) the relationship between the government and the market; and (ii) institutional changes in general and those specific to China.

The Relationship between the Government and the Market

Many studies focus on the relationship between the government and the market. Karl Polanyi’s The Great Transformation (1957 [1944]) analyses the power and limits of the free market, the role of government in economic governance, and the boundaries of the two. One of the functions of the government is to provide a safety net to reduce the damage of the free market on ordinary people. Stiglitz (2016) discusses the advances in understanding of the role of the state in the developmental process over the past 30 years, and the contribution to those advances played by changes in economics, changes in the world, and key experiences, in particular the successes in East Asia and the failures for the countries pursuing Washington Consensus policies. Przeworski (2003) offers a highly readable account of the main ideas around the relationship between the government and the market. The author emphasises that the operation of the economic system depends on the relationship between the state and the private agents, and that the institutional design of this relationship is critical for the development of a society. Other researches on this topic include Datta-Chaudhuri (1990), Bai and Wang (2013), Zhang Jun (2014), Zheng Lixin (2013), Cheng (2013), and Du (2006).

The literature on regulation is closely related to that on the relationship between the government and the market. Stigler (1971) focused on how regulation benefits producers more than consumers, which is a phenomenon termed ‘regulatory capture’. Peltzman (1976) improved on Stigler’s model and rebalanced Stigler’s explanation by showing that the political actors ultimately responsible for regulatory agencies have significant interests that may conflict with those of producers. Legislators seek an equilibrium solution between the interests and campaign contributions of producers and the votes and contributions of citizens on whom they depend for their re-election.

Some literatures are related to the experience in East Asia. Stiglitz (1996 and 2003) offers a list of the ingredients that contributed to the success in East Asia and argues that it is the combination of these ingredients, many of which involve government interventions acting together, that accounts for this success. Robert Wade (1990) provides an analytical account of East Asia’s economic miracle in the second half of the 20th century in his book Governing the Market. He rejects the claims of both those who see it as the result of the free market and those who see it as the result of government intervention. He argues that what needs attention is the way allocation decisions were divided between markets and the public administration. Aoki et al. (1996) discuss two competing views which have shaped inquiries into the source of the rapid growth of Asian economies: the market-friendly view, according to which government intervenes little in the market, and the developmental state view, in which it governs the market. The authors suggest a third view: the market-enhancing view. Instead of viewing government and the market as mutually exclusive substitutes, it examines the capacity of government policy to facilitate or complement private-sector coordination. Page (1994) has also conducted research on the topic.

Many researchers have studied the transition in East European countries. Shleifer and Vishny (1994) present a model of bargaining between politicians and managers that explains many stylised facts about the behaviour of state firms, their commercialisation, and privatisation. The model was used to understand why commercialisation and privatisation might work, and what forces contribute to the effective restructuring of public enterprises.

A large number of studies focus on the relationship between the government and the market in the economic reform in China. Wu and Ma’s Restarting the Reform Agenda (2013) raises the question of where China is going, and points out that the only way out is to restart the economic and political reform. The current system, which consists of both the new market economy and the old controlled economy, could either move forward to a more improved market economy through reform or move back to the planned economy by increasing the government’s control. To push forward the reform, China needs to adhere to the direction of marketisation and promote the institutionalisation of socialist democracy.

Justin Yifu Lin and Zhang Weiying had famous debates on the relationship of the government and the market as early as in 1995, which aroused a lot of attention from economists and political scientists in China. They recently had another debate on the industrial policy of the government. Lin insisted that an industrial policy is necessary for developing countries and the government needs to support enterprises, while Zhang argued that all industrial policies fail due to the lack of information and the biased incentives of governments (Lin and Zhang 2017). Zhang Weiying’s Market vs. Government: The Key Game of China’s Reform (2014) points out that effectively restraining the government’s destruction of the market is the central issue of every market economy. Tian Guoqiang and Chen Xudong (2015) argue that the slowdown of the Chinese economy in recent years is due to institutional problems, including the halfway marketisation and the unclear boundary between the government and the market. The focus point of marketisation should include allowing private companies to become the main part of the economy, freedom of the financial market, and marketisation of the land. Zhang Jun (2014) reviews the process of economic reform and discusses in detail the relationship between the government and the market. Zhang Qianfan (2012) discusses, from a legal perspective, the division of power between the central government and the local governments in China. This book argues that without legalisation on the central–local relationship, the centralisation and decentralisation of government power cannot solve China’s problems of central–local government relations. The book discusses the meaning of Constitutionalism in dealing with the relationship between central government and local governments in China, and offers suggestions on how this relationship could be dealt with.

Some researchers have tried to find the advantages of a bureaucratic-market economy. Daniel A. Bell’s The China Model: Political Meritocracy and the Limits of Democracy (2016) defines the Chinese system of political meritocracy, which has a long history and is widely used today in China. Bell argues that the system is a good alternative to the democratic system in Western countries. The system is able to select leaders who have long-term vision and overall consciousness, through examination and evaluation. Ian Bremmer describes state capitalism as a challenge to the free market economies of the developed world. In this system, governments use various kinds of state-owned companies to manage the exploitation of resources. They use selected privately owned companies to dominate certain economic sectors and sovereign wealth funds to invest their extra cash in ways that maximise the state’s profits. The ultimate motive of the state is not economic (maximising growth) but political (maximising the state’s power and the leadership’s chances of survival). This is a form of capitalism but one in which the state acts as the dominant economic player and uses markets primarily for political gain (Bremmer 2010).

Du and Xu (2005) find that the contemporary economic system of China represents a state capitalist system as opposed to a market socialist system. One reason for this categorisation is the existence of financial markets in the Chinese economic system, which are absent in the market socialist literature and in the classic models of market socialism; another is that state profits are retained by enterprises rather than being equitably distributed among the population. Vladimir Popov (2007) asked why many transition economies succeeded by pursuing policies that are so different from radical economic liberalisation. His answer is that optimal policies are context dependent. They are specific for each stage of development and what worked in Slovenia cannot be expected to work in Mongolia. Growth will be different depending on the history and on the path chosen going forward. The reduction of government expenditure as a share of gross domestic product (GDP) did not significantly undermine the institutional capacity of the state in China, but in Russia it turned out to be ruinous. He suggests that the art of the policy maker is to create markets without causing the government’s failure.

Theoretical and empirical analyses on the central–local relationship have been done based on China’s experience. Qian and Xu (1993) and Qian et al. (1999) create a theory of China’s fiscal federalism from the perspective of organisation theory, arguing that China developed an M-form government structure to improve the incentives and efficiency of the local officials. Zhou (2008) builds a championship theory of local government competition and a theory of administrative subcontracting and promotion competition to model the relationships between central and local governments and among local governments. Zheng Yongnian’s De Facto Federalism in China (2013) points out that the relationship between central and local governments in China is actually de facto federalism, which provides an institutional foundation for the power of local government. The central government uses selective re-centralisation to adjust the central–local relationship, from which a new institutional framework is emerging. Zhang and Gong (2005) empirically test the relationship between fiscal decentralisation and economic development in China between 1986 and 2002 and find that the improvement of coordination between government agencies after the tax-sharing reform was one important factor promoting fiscal decentralisation. Other literatures in this field include Berkowitz and Li (2000) and Li and Hu (2010).

Many empirical studies have been carried out in related fields. Csanadi’s paper ‘A Comparative Model of Party-States’ draws up an empirically based comparative analytical model and details the elements, the principles of connection of these elements, and the principle of operation of the whole party-state construct. The model reveals the structural reasons for power distribution and different patterns of communications in this party-state structure. It also defines the specific principles of operation based on the characteristics of the structure, the specific motivations, and behaviour deriving from those (Csanadi 2004). Li and Zhou (2005) discuss the relationship between political turnover and economic performance, focusing on the incentive role of personnel control in China. Other researches about politically connected firms include Claessens et al. (2008), Faccio (2006), and Fisman (2001).

A large amount of research focuses on the role of the Chinese government and the relationship between government and firms in the rapid growth of the Chinese economy. Li and Zhou (2005) find that the likelihood of promotion of provincial leaders increases with their local economic performance, while the likelihood of termination of provincial leaders decreases with their economic performance; that is, if a provincial leader cannot achieve good economic performance, he or she has a higher probability of being fired. The authors interpret these empirical findings as evidence that China uses personnel control to induce desirable economic outcomes. Cai et al. (2011) present the results of an investigation of corruption involving entertainment and travel costs of Chinese firms. Huang et al. (2015) examine the reasons for the Chinese government’s decision to decentralise SOEs, finding empirical evidence that a greater distance between the government and the enterprise should lead to a higher likelihood of decentralisation, since the government located closer to an enterprise has more information on that enterprise. Other researches on this topic include Li (1998) and Megginson and Netter (2001).

Other studies discussed the strategy of the political and economic reform in China. Xiao Gongqin’s Beyond Left and Right Radicalism (2012) argues that, to promote the economic and political transition, China needs to fight against challenges from both left and right radicalism and follow a middle-of-the-road strategy. Yang Xiaokai (2004) discusses the ‘curse to the latecomer’, arguing that developing countries can imitate technology already developed by developed countries without undergoing large-scale institutional reform, which will generate problems in the later stages of development in these countries. Yao Zhongqiu (2013) provides a detailed description and analysis of the development of the Chinese political system. Many institutional designs of the government in Chinese history are useful for understanding the design of the political-economic system today in China. For example, the joint governance system of the emperor and scholar-officials during the Han Dynasty and the checks and balances system between the emperor and the officials in the Song Dynasty are good references for the design of the political system today.

Institutional Changes in China

A large number of prior studies have examined institutional changes generally.

Douglass North’s Structure and Change in Economic History (1981) creates a theory to explain economic development. He emphasises the role of property rights and the role of law in long-term economic growth. Property rights have been the precondition for market transaction, and the efficiency of the property structure has determined the development or backward movement of the economy in history. North et al.’s Violence and Social Orders (2009) integrates the problem of violence into a larger social and historical framework, showing how economic and political behaviour are closely linked. The authors provide a framework for understanding two types of social orders, natural states and modern societies, which deal with violence in different ways. North (1991, p. 97) points out that institutions ‘evolve incrementally, connecting the past with the present and the future … Institutions provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation, or decline.’

Francis Fukuyama’s The Origins of Political Order (2011) provides a sweeping account of how today’s political institutions developed in world history, with a lengthy discussion on the growth of the first modern state in China. The author points out that China created the first modern state in the Weberian sense in history, but this state was not restrained by rule of law or by institutions of accountability to limit the power of the sovereign. A modern political system should consist of three components: a strong state, a rule of law, and accountability. Without these key components, economic development cannot be sustainable (Fukuyama 2011). Alston et al. (1996) provide a group of empirical analyses of institutional changes in various countries.

Acemoglu and Robinson’s Why Nations Fail: The Origins of Power, Prosperity and Poverty (2012) gives an answer to the question of why nations fail. The political and economic institutions of a country determine the economic performance of that country. It is not the geography, culture, weather, or the choice of wrong policies that make countries rich or poor but the institutions. Institutions, defined as the rules that govern and shape economic and political life, are of two types: inclusive and extractive. Institutions are ‘inclusive’ when many people have a say in political decision-making. Inclusive institutions promote economic prosperity because they provide an incentive structure that allows talents and creative ideas to be rewarded. In contrast, ‘extractive’ institutions are ones that permit the elite to rule over and exploit others, extracting wealth from those who are not in the elite. Nations with a history of extractive institutions have not prospered, because entrepreneurs and citizens have less incentive to invest and innovate. Seymour Martin Lipset’s book Political Man: The Social Bases of Politics (1960) asserts that there is a direct relationship between economic development and democracy, and this was subjected to extensive quantitative and qualitative empirical examination. The evidence shows a strong causal relationship between economic development and democracy.

Many studies focus on the institutional changes in China. By using property rights theory, Steven N.S. Chuang produced many works on economic institutions (e.g. Chuang 1968). Xu (2011) points out that China’s institution is a regionally decentralised authoritarian system. The central government has control over personnel, whereas subnational governments run the bulk of the economy. China’s reform trajectories have been shaped by regional decentralisation. Spectacular performances on the one hand and grave problems on the other are all determined by this governance structure. Kang (2002) describes the structural changes in China since the Cultural Revolution and points out that the totalitarian state in China has changed to an authoritarian state. The paper identifies the economic reform as a counteraction movement to the Cultural Revolution. A coalition between the political and economic elite was formed in the 1990s, which stabilised the social structure in China. A market economy does not necessarily require political freedom and can coexist with an authoritarian government. He concluded that democracy may not be a good solution for China in the short term and an administrative political system is the direction of the political reform in China.

China’s Great Economic Transformation, edited by Loren Brandt and Thomas Rawski, is a collection of studies on China’s economic development and reform from the late 1970s to the first decade of the 21st century. The authors of the book combine deep Chinese experience with broad disciplinary knowledge to explain China’s mixture of high-speed growth and deeply flawed institutions (Brandt and Rawski 2008). Barry Naughton’s The Chinese Economy: Transitions and Growth (2007) provides a comprehensive overview of the modern Chinese economy since 1949 based on his extensive research. Xiao and Sui (2011) provide a history of the Chinese economy, covering different periods before and after the economic reform. Wu Xiaobo (2014a, 2014b) provide a complete history of Chinese enterprises from the late 1970s to the early 21st century, covering the stories of a large number of enterprises. Zhou (2004) summarises the experience of China’s economic reform and explains it by using the theory of institutional changes. Li et al. (2009) give a detailed review on the changes in China’s financial system since 1949, covering banking, the securities market, and many other fields. Li Youhuan (2010) gives a detailed review of the underground financial institutions in China during the period of reform. Sun (2015) discusses the deep structure of the Chinese culture and explores the behavioural foundation of Chinese institutions. The first edition of this book was published in 1983 in the United States, and the book was first published in mainland China in 2015.

Shambaugh (2016) points out that, having enjoyed unprecedented levels of growth, China is at a critical juncture in the development of its economy, society, polity, national security, and international relations. Andrew Browne (2016) reviews the process of the Cultural Revolution and finds that Mao’s legacy has formed a part of current government policy.

Many works focus specifically on property rights and institutions in China, including Che and Qian (1998), Long (2010), and Cull and Xu (2005). Li (1996) proposes a theory of ambiguous property rights, which argues that ambiguous property rights arise due to an imperfect market environment and shows that China’s highly successful non-state sector is an example of ambiguous property rights. A large number of empirical studies have been conducted on the institutions during the transition of China’s economy. Nee (1992) studies the hybrid forms in the current market transitions in state socialism through an examination of the emergence of marketised firms and cadre-entrepreneurs in China. Wen (2006) performed an economic geographical analysis on the reasons why China was trapped as an agrarian society for such a long time. A group of researchers from China Unirule Research Institute performed a large number of researches on institutional changes in China (e.g. Sheng 2017). Other related researches include Yang (2006), Zhang et al. (2008), and Li and Han (2009).

Fan et al. (2017) create an index for marketisation for China and its 31 provinces, using information on 23 variables reflecting the relationship between the government and the market, the development of non-SOEs, the development of product markets and factor markets, and the growth of market intermediary organisations.

These studies are very helpful for my studies of China’s institutional changes in this book. These researches cover the broad field of China’s development and reform from different perspectives. My book adds value to these contributions by focusing specifically on institutional changes in the economic reform, such as the reforms of enterprises and governments, the creation of the market and regulations governing the market, and the logics behind these changes.

1.2  A THEORY OF THE RELATIONSHIP BETWEEN THE GOVERNMENT AND THE MARKET

The existing literature studies China’s economic development and reform from different perspectives, some of which have provided the theoretical and empirical basis for this book. However, most of the existing researches on China’s economic development do not focus on institutional changes, while most of the researches on institutional changes do not specifically focus on China. To explain the institutional changes in China in the past 40 years, especially the bureaucratic-market nature of the Chinese economy, one needs to develop a theoretical framework of analysis. This section provides such a framework for a theory of the government-led market system.

Conditions for Government Intervention Set by Economic Theory

One economic theory to explain government regulation is called ‘normative analysis as a positive theory’, or ‘the public interest theory’ by Joskow and Noll (1981) and Viscusi et al. (2005). In the rest of this book, I will call this theory the ‘economic theory of government intervention’ for short. The theory is based on microeconomic theory of the requirements of competition. According to the economic theory of government intervention, a government is allowed to intervene in economic activity when unrestrained competition does not function well. According to economic theory, the market fails to reach efficiency when several conditions exist, including (i) asymmetric information, (ii) externalities, (iii) natural monopoly, (iv) absences of markets, and (v) poorly defined property rights. Under these situations, the market cannot operate efficiently. When these market failures occur, there is a potential rationale for government intervention. This book refers these conditions as ‘conditions for government intervention set by economic theory’. These areas should be the basic areas of government intervention. In China, the degree of government intervention has been much bigger than that in a standard market economy. Some of the interventions have been detrimental; others have benefited economic development. These positive interventions include China’s development mode in the 1990s and 2000s, in which the local governments worked as organisers of the local economy by designing industrial structures and attracting investments, while the central government used a performance evaluation system to control the local officials. These positive interventions were based on the institutional foundation in China during that period in which the government played a much larger role, and the market and society were less developed than that of a fully developed market economy. These interventions are necessary and should be considered as reasonable intervention. However, other government interventions might have negative effects on economic development; for example, overregulation makes it difficult for private firms to enter certain sectors. Such interventions should be eliminated. Economic theory sets a boundary for government intervention but does not explain why the government sometimes goes beyond this boundary. This book develops a theory of political economy to explain these phenomena along the following lines.

A Political-Economic Model of Government Decision-Making in a Bureaucratic-Market Economy

A bureaucratic-market political-economic system prevails in contemporary Chinese society and has two major institutional components: the government and the market. The two components form a dual political-economic system, a bureaucratic-market system. In this system, government is the dominant force, but it cannot completely control society without the support of the market. The private sector has grown, but it is still subject to a number of political and economic constraints. The government makes policies to permit the existence and guide the development of the private sector. The changes of the institutions in this society can be summarised by the relative degree of government control or, equivalently, the relative freedom of firms in the market. As a result of the changes in China over the past 40 years, the market has grown to a relatively large size and become an important force in the society, but it is still far from dominant.

The target of the authoritarian government can be described by a benefit function (or utility function) with two basic components – stability of the society and economic growth – assuming complete information. Stability of the society means safety of the rule of the regime. Economic performance has been an important source of legitimacy of the rule of the government and the primary measure of political legitimacy since the end of the Cultural Revolution in the late 1970s. The government’s reputation rises and falls with GDP, yet stability of the society has been the main target and the foundation of the existence of the government. The two components are correlated with each other. Economic performance has been a critical condition for social stability, whereas social stability provides an environment for the growth of the market. The government’s benefit function is a weighted sum of social stability and economic development.

There are two basic policy options – economic policy and social stability policy – from which the government may choose. Economic policy promotes economic growth and marketisation, whereas social stability policy maintains the stability of society and the existence of the government itself. The government has to choose the correct combination of the two policies. Although favourable to economic growth, the economic policy may create political instability and inequality in the society, which may damage government control of the society. Meanwhile, social stability policy focuses on the control of society but could be unfavourable to economic development. The government makes choices regarding these two contradictory policies. The weight of the two policies changes over time and is determined by political and economic environments. For example, in the economic turmoil of the late 1970s, the leaders greatly increased the weight of economic performance in their benefit function, which resulted in economic reform and rapid economic growth.

The game being played between firms and the government is basically a Stackelberg’s game5 in which government first maximises its net benefit knowing the firm’s strategy then the firm maximises its profit given the government’s policy.6 The government’s preference problem is to maximise its gross benefit subtracted by costs, which includes costs of government control. A firm’s profit is its total revenue subtracted by costs, which includes transaction costs. Private firms use strategies to maximise their profits legally or offer bribes to capture government officials to gain their benefits illegally. This practice is consistent with the reality in China, where a much stronger intervention by the government has been experienced than that in most market economies. The private sector has to follow government interventions and take the risk of being hurt by them. The government might have its own enterprises, which would also follow the government’s instructions to maximise the net benefit of the government.

The government’s behaviour in the system is under two major constraints: social instability and economic decline. The leadership has to work hard to avoid these situations. The critical policy decisions are made by the national leadership when acting in the context of an authoritarian political system, as reactions to the political-economic environment (Naughton 2008, p.91). The checks and balances mechanism between three branches of the Chinese government is weak. The officials are selected through an examination system and competition for promotion. The lower-level officials are supervised by higher-level government, and the local officials are mainly supervised by central government. At the highest level of leadership, the shift to the next generation of leadership is determined by the old generation of leadership or by members of the current leadership. The process needs to be more transparent.

A political-economic equilibrium of the system can be reached under some reasonable assumptions, when the government chooses its social and economic policies given the firm’s behaviour and assuming no change in other conditions, while the representing firm maximises its profits by choosing its effort level given the government’s policy. Equilibrium will be derived by maximising government’s net benefits, which equals  the weighted sum of social stability and the firm’s profits in the society. The authoritarian government’s benefit maximisation may deviate from the  maximisation of social welfare if government’s weights on social stability and economic development deviate from that of the society. The government’s optimal policy mix is reached when the ratio between marginal benefits and marginal costs of the social stability policy equals that of the economic policy, given the weight of the two policies. These weights between social stability and economic growth are determined by the existing political and economic conditions and change over time when national and global political and economic conditions change. Under some extreme assumptions, no equilibrium exists.

In a large country with a multilevel government such as China, the relationship between the central and local government is crucial to the political system. The problem is actually one of distribution and redistribution of power in the bureaucratic hierarchy. It is basically a principal–agent relationship. The central government uses (i) a performance appraisal and accountability system and (ii) an incentive mechanism such as a fiscal revenue-sharing system to control the local government. During the reform process in China, the central government mainly used the incentive mechanism to mobilise the enthusiasm of the local government during the early stages of the reform, and then it changed to the performance appraisal and accountability system as the main tool to control the local government. Under the performance appraisal system, the local officials have competed against each other like in a championship.

The relatively classical approach above does not conflict with the institutional approach if one makes some revisions of the concept of costs. Transaction costs can be used to explain the evolution of the relationship between the government and the market. Transaction costs include the costs of arranging a contract and costs of monitoring and enforcing it. Here, I include the government’s costs of operation as a special type of transaction cost, which North (1990) identified as the transaction costs of politics. Transaction costs determine the boundary between a planned economy and the market. Economic reform has reduced transaction costs for each transaction and encouraged the use of the market as a major approach to solve economic problems. Decision-making in the process of reform can be viewed as a series of choices between the logic of the government and the logic of the market.

The relationship between the government and the market in a bureaucratic-market economy could be viewed as a dynamic game, from the perspective of the time, in which the government and the firms have strategies to play with each other. The government’s priority between control and economic development is represented by the weights of social stability and economic development in its benefit function. In a repeated game, these weights could be endogenously created in the model and negatively depend on the economic situation in the previous period. That means if the economic situation was improved, the weight of economic performance would be reduced. This can explain why government changes its priority (by reducing the importance of economic development in its list of priorities) when the economic situation improves, as has happened in recent years in China.

The above theory provides a framework for us to understand a bureaucratic-market economy such as the one in China over the past 40 or so years. The economics theory of government intervention argues that market failure provides a rationale for, and presents conditions for, government intervention, including (i) asymmetric information, (ii) externalities, (iii) natural monopoly, (iv) absences of markets, and (v) poorly defined property rights. A framework of a theory of authoritarian government’s decision-making in a bureaucratic-market economy has been developed in this section to explain the behaviour of the Chinese government in the process of economic reform. The government changed its priorities on stability of society and economic development when the economic and institutional environment changed. When the economic situation was not good, the Chinese government placed marketisation high on its priority list, as in the late 1970s. When the economic situation improved, it focused more on stability of the society, as in the early 21st century.

This analytical framework is not inconsistent with the institutional theory which emphasises the roles of path dependence, transaction costs, and property rights in the development process. I incorporate transaction cost into the government decision-making model, and path dependence is one of the main clues of analysis of the transition of the Chinese economic and political system. Using the theory of path dependence, I will show how violence during the Cultural Revolution formed the consensus on reform, how the development of the market created the need to set up a social network, and how the bureaucratic system in the planned economy determined the nature of government-led reform. I will use path dependence and the model of government decision-making in a bureaucratic-market economy as two major hidden clues to explain the institutional changes in China in the past 40 years.

NOTES

1.  Traditionally, Chinese society is composed of nucleus cells (Sun 2015). Different levels of government, units, and families have a similar structure, with a leader at the centre and a group of followers surrounding.
2.  Hereafter, if there is no particular indication, ‘reform’ refers to the economic reform from 1978 to the 2010s.
3.  The system can be further divided into market capitalism at the bottom of the society and crony capitalism at the top, according to Zheng (2016).
4.  In the planned economy in China, workers and managers did not have enough incentive to finish their jobs, because their compensation was not related to their work. The economic reform needed to create incentives by connecting workers’ contributions with their payments.
5.  Stackelberg’s game is a leader–follower game in which the leader moves first and the follower moves second following the rules set by the leader.
6.  The government knows the firm’s strategy completely, or with certain probability.