Does China Have the Institutions for Economic Success?

December 30, 2015 Updated: January 4, 2016

What factors are important for an economy to succeed? Interest rates? Taxes? Property rights?

The recently deceased Nobel laureate Douglass North said institutions determine an economy’s success. He defined them as follows: “Humanly devised constraints that structure political, economic, and social interactions.”

Nowhere else is this concept as true as in modern China. So Andrew Sheng, an adjunct professor at Tsinghua University in Beijing, and Xiao Geng, a professor at the University of Hong Kong, took a look at North’s work and applied it to China’s institutions today. 

They find that China is moving toward the institutional framework North recommends. Let’s see if their arguments measure up to reality. 

North said that institutions should foster competition within and between sovereign entities. Sheng and Geng say this is by and large the case in China and it’s getting better.

When the big guy needs to, he’ll pay the judge off to put you out of business.
— Woody Brock, president, Strategic Economic Decisions Inc.

“Its major cities (including Shanghai, Guangdong, Tianjin, and Xiamen) are still competing vigorously with one another, and a new breed of technologically innovative companies (such as Huawei, Tencent, and Alibaba) are battling to open up new markets in goods, services, talent, capital, and knowledge,” they write.

They also note that “the ruling Chinese Communist Party (CCP) has dedicated itself to creating a more efficient, services-driven economy, subject to the market and the rule of law.”

We can easily accept that Chinese cities and private companies are competing with each other, but has the CCP really created an economy subject to the market and the rule of law?

(World Economic Forum)
(World Economic Forum)

Woody Brock, president of Strategic Economic Decisions, doesn’t think so: “When the big guy needs to, he’ll pay the judge off to put you out of business,” he says.

This is even true for the above named tech giant Alibaba. With shareholder ties to the family of former Chinese regime leader Jiang Zemin, it recently got into trouble with current Chinese leader Xi Jinping precisely because of these political connections. 

What about the shocking mismanagement of the stock market crash over the summer? The authors say, “Despite serious market turmoil, the CCP upheld its commitment to allow the market to play a ‘decisive role in resource allocation.'”

If the CCP and the authors mean engineering a stock market bubble and then arresting and bullying journalists and investors alike to stop the market from declining, they must have misunderstood what North meant by rule of law and the functioning of the market.

In fact, “allowing the market” means the following for the CCP: They will allow it as as long as it suits their prime directive, which is to stay in power.

In fact, the economy’s slowdown has scared policy makers so much, they are resorting to their old (not so market) methods to keep social unrest under the lid. So they devalued their currency to spur exports and told local governments and state-owned enterprises to start investing in infrastructure again.

“This represents a return to the old investment- and export-led growth model from which Beijing was trying to escape. When confronted with a slowdown earlier this year that far exceeded their expectations, Communist Party officials changed course, no doubt fearing that high unemployment in older industries would lead to social unrest that could pose a threat to the Party’s grip on power,” writes John Plender of the Financial Times.

So what would Douglass North say about China?

“North observed that institutional change is extremely difficult, as it requires overcoming not only vested interests, but also outdated belief systems and mental models,” according to Sheng and Geng. Contrary to their optimistic interpretation of North’s theories, the CCP is not quite there yet.