Jon Elster goes to China

With an American friend I recently spent two weeks travelling in China at the invitation of the Chinese Academy of Social Sciences. Besides lecturing, our main purpose was to understand the economic reforms in Chinese industry. The three cities we visited, Changzhou, Shanghai and Wenzhou, offer three different models of reform. The first two are experimenting with more independence for state and collective enterprises, whereas in Wenzhou private entrepreneurs and capitalism are emerging as the vehicle of change. For the purpose of grasping what is happening in China, the visit was like scratching the surface of the visible tip of an iceberg. We were not able to see much, and our understanding of what we saw was no doubt limited, distorted and superficial. Yet the scale of (intentional) reform and (unintended) change is such that even untrained observers like ourselves could perceive them in rough outline, especially since the Chinese scholars we met helped us sort out many initial confusions.

A dominant impression is that the Chinese do not know what they are doing. First, the leaders do not know where they want to go. One economist we met said that in his opinion the end-state of the reform process was capitalism with high progressive taxation. Others said that the goal was some combination of a market economy and socialism, but none were able to specify the exact mix of ingredients. Only this year, the party leaders have changed their minds twice concerning the basic goals of the reforms. At the beginning, they asserted that the new contract system for state enterprises was merely a transitional stage on the road to a market economy. Then they said that the contract system was the ‘goal model’. Then they changed their minds again and reasserted the transitional view.

Even if the leaders knew where they wanted to go, they would not know how to get there. Economic theory has nothing to say about the transition from communism to capitalism, nor is there any precedent from which they can learn. The official metaphor for the reforms is ‘feeling the stones with one’s feet in crossing the river’. The leaders, as they say themselves, think of the reform process as a gigantic experiment, constantly subject to retreat and revision. Given the lack of firmly-grounded theory, this attitude is probably inevitable. Yet it also threatens to undermine the reform process itself, by inducing a very short time horizon in the economic agents.

Finally, nobody knows what will be the outcome of the reforms that are actually being undertaken. Once again, economic theory has nothing to say about the short and medium-term effects of changes in ownership structure or price-setting mechanisms; and once again, there are no precedents from which to learn. The economics of planning and the economics of market economies are well understood: mixed systems are not. Equilibrium properties of economic systems are well understood: out-of-equilibrium effects are not. In consequence, it is quite possible that the elements of market economy now being introduced will make things worse rather than better.

Post-1949 developments in China can be divided into three periods: golden age, turbulence and reform. The golden age, which ended around 1956, can be compared to the period of national reconstruction in many European countries after World War Two. There was a spirit of national unity, uncorroded by either self-interest or group interest. In particular, the corruption which has since become a serious problem in China was largely absent. Poverty, prostitution and drugs were eliminated. At China’s low level of economic development, the Soviet-style central planning yielded rapid improvements without too much waste and inefficiency.

The period of turbulence included the Hundred Flowers period and the subsequent crackdown on intellectuals, the Great Leap Forward and the subsequent famine, and above all, the ‘ten terrible years’ of the Cultural Revolution. This period left two lasting legacies. First, it created a deeply-held and widely-shared scepticism about policy announcements. The zig-zag policies followed during those years, and the repeated crackdowns on those who had taken the previous policy literally, made people wary of speaking their minds and of using the opportunities that were offered to them. This way of thinking in the future perfect tense rather than in the present has been reinforced by the fact that Chinese law does not exclude retroactive legislation.

The second legacy of the Cultural Revolution is the low work morale. According to Andrew Walder, in Communist Neo-Traditionalism, this period saw ‘the emergence of indulgent patterns of authority’ in the workplace. ‘Out of a mixture of indifference, fear, and considerable demoralisation of their own, and knowing that they could not attack the source of the problems by raising wages or restoring prohibited bonuses,’ he says, managers ‘did little to enforce work discipline’. These attitudes still survive. Although it is doubtful whether workers believe in the collectivist ideology, they use it as a weapon against managerial efforts to extract more labour from them.

The third period is the reform movement from 1978 to the present. The reforms began in agriculture, where the re-introduction of private farming was immediately and strikingly successful. Industrial reform presented an immensely more complicated problem. One of the difficulties stems from the agricultural success story, which created unrealistic expectations about the pace of progress in industry. More important were the intrinsic economic and political problems, which created stop-go patterns and thus contributed to the general climate of uncertainty.

Today, there are five main types of industrial enterprise.

1. State enterprises are directly under the control of an industrial bureau, but need not be directly under the central government. In Shanghai, for example, state enterprises have contracts with the city government, which in turn has a contract with the central government. The core of the contract specifies the amount of profit to be handed over to the Government, usually calculated as a percentage of realised total profits in the previous year or years. In addition, the contract might specify the total wage fund; the part of the output that is to be exported; the expected rate of productivity increase; the development of new products; the proportion of retained profits to be allocated to investment, bonuses and welfare benefits (usually 40-30-30). Today, the contract rarely specifies physical quotas to be realised. These enterprises sell most of their production at prices which are set by the state, although they are increasingly allowed to sell part of their products at (more or less) free-market prices. Workers have low wages, but full job security (see below) and extensive welfare benefits.

2. Collective enterprises proper are owned by a corporate entity, which can be a neighbourhood (e.g. a street committee), a commune or brigade, a local government or a state enterprise. Their products are sold at market prices. Workers and managers have higher incomes than in the state industries, but less security and fewer benefits.

3. Shareholding enterprises are classified as ‘collective enterprises’ in the official statistics, but are in reality privately-owned. They pay only 55 per cent tax on profits, whereas private enterprises pay 85 per cent, which creates a strong incentive to use this mode of organisation. These enterprises apparently have limited liability, although we were unable to find out if any had actually gone bankrupt. Workers and managers have high incomes, but no job security and few if any benefits. In Shanghai, the rate of return on shares in these enterprises was limited to 15 per cent. In Wenzhou, where they are much more widespread, we visited a private bank in which the investors got a return of 32 per cent on their shares.

4. Private enterprises are owned by one person and have at least eight employees. The largest private enterprise we heard about (again in Wenzhou) employed more than seven hundred workers. Some of the entrepreneurs become extremely wealthy. Some, we were told, own houses that cost a hundred times as much as the yearly wage of the (highly-paid) workers they employ. In Wenzhou, private enterprises pay no taxes during the first three years of operation.

5. Household enterprises are privately-owned firms employing seven workers or less. (Marx apparently says somewhere that a firm does not become capitalist until it employs more than seven workers.) These enterprises pay a fixed tax or licence fee, not a percentage tax on profits. In the official statistics they are classed with private enterprises.

In 1986, in the country as a whole, state enterprises employed about 70 per cent of the industrial workforce, collectives of both types about 25 per cent and private enterprises of both types about 5 per cent. In Wenzhou the value of output produced in these types of enterprise was, respectively, 17 per cent, 49 per cent and 34 per cent. Although one cannot infer employment proportions directly from output proportions, these figures suggest that Wenzhou is far more advanced in the direction of private ownership than the rest of the country, especially when we take into account the fact that many, perhaps most of the collective enterprises in this region are in fact individually-owned (category 3 above).

There is a clear correlation between the type of enterprise and the nature of the product. State enterprise is linked with heavy industry, collective enterprises (2 and 3) with light industry, and private enterprises (4 and 5) with craft work and trade. Many individually-owned enterprises (3, 4 and 5) make machine parts and semi-finished products for state and collective enterprises on a sub-contractual basis.

The movement towards a market economy has begun, but remains very limited and incomplete.

Land market. There is no privately-owned land, and hence no market in land. With the new long-term contract system in agriculture there is, however, some sub-leasing of land. Many industrial workers are former peasants who sub-let their land to a neighbour. It isn’t clear whether a market in leases is emerging.

Product markets. There are a number of inter-related obstacles to the emergence of product markets. First, state enterprises are not free to set prices on their products. Some prices are artificially low, others are artificially high. State enterprises can usually sell part of their production at prices which may fluctuate by 20 per cent above or below the state-set price. Or they may be able to sell at completely free prices. Part of the inputs then must also be bought at ‘negotiated’ or market prices.

Secondly, there are strong internal barriers to trade. It is widely recognised today that the decentralisation from central to local government, combined with the increased power of individual enterprises, has created strong local monopolies – alliances between enterprises and local authorities – which prevent an efficient allocation of resources. The distorted price structure makes it possible even for inefficient firms to make very high profits (and generate tax income for the local government), provided they are protected from competition.

Thirdly, there is no mechanism of bank-ruptcy for state enterprises and thus nothing to ensure effective competition. Given the distorted price structure, one cannot assume that bad performance means bad management. Instead, each case has to be examined on its merits, to determine whether the failure was due to external, objective conditions or to internal, subjective problems. In practice, excuses are always found. Conversely, firms that do well are often penalised for their performance, by means of an adjustment tax or by a raising of the quota. It hardly needs to be said that in capitalism firms are often penalised for failures due to sheer bad luck, but any scheme to help out firms which get into trouble through no fault of their own would create massive problems of moral hazard, a point that seems insufficiently appreciated in China.

Lastly, the positive incentives for profit-maximisation are very weak. Even if the manager was the residual claimant – which he isn’t – he would have little incentive to exceed the quota set for him. True, he would then be able to retain any excess profits, but he would also have to face the prospect of having his quota raised for the next contract period. In other words, even when efficiency is rewarded in the short term, it is penalised in the medium term. Finally, the short contract period – usually three years, as against 15 years in agriculture – does not create the right incentives for long-term investments.

Labour market. In the still dominant state sector, workers are tied to their firms in much the same way as a serf was tied to his land. On the one hand, he cannot be fired. Until very recently, he could also hand the job over to his children. On the other hand, he cannot leave for another job or go into business for himself without the firm’s explicit permission, which is rarely given. In the other sectors, the freedom of the management to fire workers is greater, and there are no obstacles to workers quitting. There is no social security or unemployment benefit system, however. Unless the worker has a piece of land to which he can return, being fired would be a disaster.

Capital market. State enterprises get loans at artificially low rates of interest. As a result, they invest more than is efficient. Another consequence is that the rate of interest on loans from private banks – and the profits made by their shareholders – are artificially high.

The internal and external relations of the state enterprises are only to a small extent governed by the market mechanism. What, then, are the princples that explain the working of state enterprises? Three possible answers are clientelism, bargaining and ‘joint resistance’ to superior powers.

Walder argues that relations within the state enterprise are a form of clientelist dependence, operating through two main mechanisms. On the one hand, model or activist workers are rewarded according to the biaoxian, i.e. their ideological attitude and loyalty to the firm. On the other hand, the discontent of the rank-and-file is defused by guanxi or ‘connections’, a mechanism which ranges from the use of pre-existing affective relations, through the deliberate creation of ‘instrumental friendships’, to outright bribery. Workers with good guanxi can use it to obtain housing, consumer durables and other scarce goods. As a result, there is something for everyone, or almost everyone.

I am sure this description is correct in many respects, but it seems to miss the other side of the coin of dependence: managers are no less dependent on workers than workers on managers. Formally, managers can fire workers. In practice, everything and everyone conspires against this practice. The manager’s political superiors are afraid of the social consequences of unemployment in a society without social security. The trade unions, which may have something close to veto power on this issue, will oppose him. The workers themselves will resist. The People’s Daily recently reported that seven factory managers were beaten by workers outraged by wage adjustments or the dismissal of fellow labourers.

Another explanation comes from the lack of managerial incentives – there are no carrots and no sticks. Managers do not earn more than skilled workers, nor do they have much reason to fear bankruptcy. Managers and workers jointly resist any attempt from above to extract more effort from them. John Hicks’s dictum that ‘the greatest of all monopoly profits is a quiet life’ may be particularly apt here.

Relations between the state enterprise and its immediate political superiors exhibit similar complexity. There is clientelism, in that the enterprise is heavily dependent on cultivating good relations (guanxi) with its administrative superior (the industrial bureau), the tax office and the local bank. There is bargaining, in that the terms of the contract between the enterprise and the bureau are set by bilateral negotiation rather than by unilateral decision. And there is joint resistance to the central government, in that the enterprise and the local organs have a common interest in protecting inefficient enterprises. Banks will extend loans indefinitely rather than see ‘their’ firm go bankrupt.

The issues of inequality, exploitation and distributive justice were very much at the forefront of our talks. Chinese planners and social scientists do not seem to have a clear solution to the problem of justifying inequalities. There was agreement that some inequality had to be tolerated, even encouraged, but little consensus on the principles one could use to set upper limits to acceptable inequalities.

We were told that China has a strong ideology of equality, derived from several sources. First, the traditional ideology in China was an egalitarian one. The cause of traditional peasant uprisings may have been poverty, but their demand was always for equality rather than for abolition of poverty. Secondly, Marxist ideology is used as a weapon by workers to resist wage inequalities. A manager who tried to give himself the bonus to which he is legally entitled – three times that of the average worker – would be met with the Marxist-sounding claim that value is created by labour rather than by management. Finally, sheer envy seems to play a role in the egalitarian ideology. To avoid harassment by their fellow employees, model workers spend their bonus on a good meal for everybody. The manager keeps his bonus down not only because he fears the workers, but also because he wants to avoid the envy of the other executive officers. Industrial workers are grumbling because peasant incomes are rising faster than theirs, although they remain relatively lower.

China today has defined itself as in ‘the primary stage of socialism’. In the absence of a coherent notion of what constitutes justifiable inequalities, this is largely an empty phrase. By contrast, the earlier notion of a ‘lower stage of communism’ contained the idea that workers should be rewarded according to contribution. Unearned income was banished; those who work better, harder or longer should earn more; but the time was not yet ripe for differential needs to be the main guide to distribution. Today’s China deviates from this ideal in a number of ways.

To start with, there is undeniably a good deal of exploitation, in the form of income derived from private ownership in the means of production. We heard several justifications of exploitation. One was that capitalists deserve their high earnings because they work so hard. Another was that exploitation is morally acceptable since everyone can become an exploiter, presumably by saving and working hard. We were repeatedly told that what matters is equality of opportunity, not equality of outcome. Third was that exploitation is morally acceptable since it benefits everyone. Finally, exploitation is morally acceptable since it is a necessary stage in the development of socialism. On the other hand, there was agreement that savage exploitation was unacceptable. In theory, there was no limit to how rich entrepreneurs would be allowed to get, but there were definite limits to how poor workers could be allowed to be. A major problem, therefore, was how to allow the side-effects of efficient competition in the absence of a social security system.

Within the state enterprises, allocation of wages, bonuses, housing, cheap consumer goods and welfare benefits follows a number of different principles. In theory, productivity – to each according to contribution – is supposed to be a major determinant. In practice, equality and seniority are much more important. Need is a major determinant in the allocation of housing, along with rank and seniority. In addition, the elusive elements of biaoxian and guanxi probably remain very important. In collective enterprises, reward according to productivity seems to be more widely practised. Presumably the explanation is that many collective enterprises are engaged in forms of industry based on piece-work, which provides a non-controversial measure of productivity.

A caricaturally brief summing-up might, therefore, be as follows. The private sector of the economy has returned to capitalism, with income derived from private ownership of capital and labour-power. The collective sector is in what was traditionally called the lower stage of socialism, with incomes based on productivity. The state sector behaves as if the higher stage had been reached, with incomes based on equality, corrected by need when necessary.

The process of reform that is taking place in China (and, in a much more cautious version, in the Soviet Union) is massive, poorly-understood and unprecedented. There may be no alternative to the experimental attitude adopted by the planners. Yet there are three major, inter-related obstacles to progressing by trial and error. First, in order to assess the viability of the new institutional arrangements one can not simply look at what happens in the first two-year or five-year period. The equilibrium features of the new situation may take much longer to emerge. As Schumpeter said, comparison between two economic systems may require decades or even centuries. The costs of transition will be heavy, and the process painful. The enemies of reform will – and do – insist that these costs are equilibrium features rather than transitional ones. Secondly, the economic agents no less than the planners operate with a very short time horizon which prevents them from undertaking long-term projects. This is likely to make the experiments less successful than they would have been if the agents had been able to plan into the distant future. Costly investments which take a long time to bear fruit will not be embarked on. Thirdly, the concept of law is very poorly developed in China. I believe that the second problem – the myopic behaviour of all parties – is caused in part by the first and in part by the third problem.

The regime is under very strong pressure to get quick results, partly because the agrarian reforms in 1978 were so immediately and strikingly successful that workers now expect the industrial reforms to be equally successful, and partly because conservative groups will use any short-term costs and losses as a pretext to reverse the process of reform. As a result, the reformers are choosing the path of least resistance. There is a real danger that they will never feel that the time is ripe to eliminate the irrational price system which is at present the major obstacle to progress. Gradual and piecemeal introduction of rational prices is likely to make things worse rather than better in the short run. Many inefficient firms will go out of business if they have to buy their inputs at market prices. Wholesale introduction of rational prices would be so disruptive as to be virtually unthinkable. Delegating power to the enterprises may be positively harmful in the absence of rational prices and the right kind of managerial incentives.

The Chinese do not have the principle of legality, defined as follows: 1. An individual action is permitted unless there exists a law that expressly and unambiguously forbids it. 2. State interference is forbidden unless there exists a law that expressly and unambiguously authorises it. Instead, they have a positive conception of the law: 1. An individual action is permitted if there exists a law that expressly authorises it. 2. The state has the right to interfere in all unauthorised activities. If an activity is not authorised by the law, individuals may or may not be allowed to engage in it – they can never know. For example, there was a period when there was a law authorising mural posters. Later, when that law was withdrawn, this was interpreted as forbidding posters, even though no law expressly forbidding them was passed. The Chinese planners have allowed individuals to become millionaires through private enterprise. Because of the imbalances in the economy, there have been many opportunities to get rich fast. The entrepreneurs, however, have not been confident that the state would allow them to continue. As a consequence, successful entrepreneurs have tended to consume their profits, notably by building magnificent houses, instead of re-investing them in the enterprise.

In this kind of system, political signals are more important than laws in indicating to individuals what they can and cannot do. This induces a very short time horizon: peasants no less than managers feel they have to exploit the opportunities before the planners change their mind. Janos Kornai says that there are limits to economic reform in any socialist economy as long as ‘the bureaucracy is unwilling to observe a voluntary restraint from its interference’. This, however, may be the wrong way of putting it. The question is whether the bureaucracy is able and willing to make itself unable to interfere. There is a need for new constitutional measures, including measures which take the interpretation of the constitution out of the hands of those whom it is supposed to keep in line.

But there is a deeper question: can the planners implement constitutional reform without a normative commitment to individual rights? If they introduce a constitutional system and abdicate from some of their powers simply in order to get the economy going, the economic agents will always fear that the rights will be abolished as soon as the economy gets into trouble. Even if the planners abdicated from the power to interpret the constitution, they would for a long time be able to act outside the law. In the short and medium term, the Chinese Communist Party will not be able to make itself effectively unable to reverse the reform. It has many sorts of power, but not the power to make itself powerless. (Ulysses was lucky in that he had the requisite technology for self-binding at hand.) As a result, the economic agents will adopt a short time horizon, and the system will get into trouble. It is only if and when rights are adopted on non-instrumental grounds that they will acquire the desired instrumental efficacy, because only then will the government be able credibly to say that rights-violations will not be tolerated.

The Chinese are trying to carry out an inherently paradoxical task: a planned transition to an unplanned economy. In doing so, they run the risk that the means (planning) will interfere with the end (the abolition of planning). Two analogies can help to clarify the problem and suggest a way out of it. The first analogy is provided by Alexander Zinoviev’s analysis of the attempted de-Stalinisation of the Soviet Union under Khrushchev. What characterises the Stalinist system, in Zinoviev’s view, is the confusion of internal and external negation: whatever is not obligatory, is forbidden. In his attempt to get rid of Stalin, Khrushchev used the Stalinist method. Whereas mention of Stalin used before to be obligatory it was now forbidden. A more constructive analogy comes from the Buddhist notion of character planning, or willing the absence of will. To succeed in this endeavour, one must take care to phase the will out gradually, making sure that one never requires more will for the next step than what is left after the preceding step. Similarly, the planning agencies must progressively dismantle themselves, reduce their staff and their powers, as the economic reforms progress. Otherwise, the very knowledge of their presence will distort the process.

Another problem concerns the willingness to suffer the costs of transition. If the reforms are perceived as being sustained by a conception of justice, and as expanding individual freedom and individual rights, people may be willing to endure the experiments. If, however, they are perceived as merely instrumental devices thought up by the technocrats, of whom China’s leadership is now increasingly made up, the willingness to put up with temporary suffering may be substantially smaller. If the reforms can neither provide an unambiguous improvement in freedom and justice nor offer material benefits in the short run, popular support may be insufficient to enable reformers to resist pressure from the old guard. Hence, if I am right, a normative commitment to basic freedoms is doubly important for the success of the reforms. It will reduce the costs of transition, by creating a climate of certainty and confidence in which people can plan for the future. It will also enhance their willingness to put up with whatever costs there might be. And to repeat, the instrumental benefits of freedom are essentially by-products, and will be forthcoming only if freedom is valued for non-instrumental reasons. Perhaps the Chinese reformers, too, should think about glasnost.