Modern Market Economy and the Rule of Law
Perspectives, Vol. 1, No. 5
essay is about the relationship between the market economy
and the rule of law. My assertion is that the fundamental
rule of game in a modern market economy is the rule of law.
Three Types of Economic System: Planned Economy, Traditional
Market Economy and Modern Market Economy
about everyone in China is in favor of market economy now.
But we are far from being able to claim that we have constructed
a mature market system in China. Nor can we assert that our
economists or leaders already have a good understanding on
how a market economy works. On the contrary, our understanding
of the modern market economy has long been tainted by the
history of a planned economy as well as a petty-peasant economy.
In today's world, there are good market economies as well
as bad ones, and there are more cases of the latter than of
the former. Historically, an overwhelming majority of countries
had bad market economies for very long periods of time. Indeed,
in the history of mankind, the transition toward the modern
market economy is only a recent phenomenon.
then, is the institutional foundation of a modern market economy
as opposed to a planned economy? One difference between a
market economy and a planned economy lies in the mechanism
of resource allocation: a market economy relies on market
prices to allocate resources, whereas a planned economy uses
administrative commands of planned quantities. At a deeper
level, the core of a market economy is a free enterprise system,
while the essence of a planned economy is state ownership
are, however, more than one kind of market economy. For purpose
of this article, I will identify two types of market economy:
the traditional market economy and the modern market economy.
Market economy is nothing novel: it came into existence long
before the planned economy. A traditional market economy is
not just characterized by small-scale market activities. From
the perspective of the new institutional economics, a traditional
market economy has two important characteristics. First, contracts
between economic agents are enforced mainly through reputation
mechanisms rather than by a neutral third party such as the
state. Secondly, the state is not constrained institutionally
vis-ид-vis business enterprises and individuals. In other
words, there is no distance between the government and the
historians such as Douglass North and Nathan Rosenberg attributed
the rise of the West to a fundamental transformation of the
relationship between the state and the business enterprises
to an "arm's length type;" that is, the government
started to distance itself from private individuals and business
enterprises. Since the Glorious Revolution in 1688, the English
royal power has gradually retreated from commercial activities.
Henceforth, the relationship between the state and the economy
has fundamentally changed. The rule that emerged to stipulate
the relationship between the state and the economic agents
was the rule of law. This change in the state-market relationship
is the origin of the modern market economy based on the rule
Fourteenth Congress of the Chinese Communist Party (CCP) stipulated
the concept of "socialist market economy," and the
Fifteenth Congress of CCP further endorsed the principle that
"non-public ownership of enterprises is an important
part of the economy" and "the country is governed
according to law." To date our economists still have
not fully integrated these three principles into their thinking
of the economic reform. We should be aware that the very essence
of the modern market economy is an independent and autonomous
enterprise economy based on free transactions and operated
under the rule of law. In contrast, both planned economies
and traditional market economies do not build themselves under
the rule of law. One of the most important distinctions that
separate a bad market economy from a good one is that, in
a bad market economy, there exists an unhealthy relationship
between the state and the economic agents (including business
enterprises) due to the absence of the rule of law.
The Two Economic Functions of the Rule of Law
often associate the word "democracy" with the word
"rule of law". I do not intend to dwell upon the
issue of democracy here. Neither do I want to focus on the
intrinsic moral values of the rule of law. What I want to
focus here is on how the rule of law works in a market economy.
In other words, I want to look into how the rule of law facilitates
economic efficiency and development.
economic systems are governed by certain rules of game, and
the governing rule for a modern market economy is the rule
of law. The rule of law has two economic functions. First,
the rule of law regulates and limits discretionary interventions
of the state in economic activities. Secondly, the rule of
law regulates the economic behavior of individuals and enterprises
to create an orderly, stable environment with fair competition,
clearly defined and well protected property rights, and effectively
enforced contracts. In essence, these two economic functions
of the rule of law are about regulating the relationship between
the state and the market through legal institutions so that
economic development is both possible and sustainable.
first economic function of the rule of law is to constrain
government arbitrariness. This is where the fundamental differences
between the "rule by law" and the "rule of
law" come into play. The rule by law is by no means a
novel idea to us Chinese. An emperor could govern his citizens
by means of legal codes. In contrast, an important part of
the rule of law is about how common people can constrain the
government's power by legal institutions. Only the rule of
law can safeguard a free economy. If the government's behavior
is not constrained, then no economic freedom can be guaranteed,
and in turn there will be no modern market economy.
is it so important to limit the government's discretionary
influence on economic activities? First of all, the government
naturally has greater power than individuals because the government
possesses an array of coercive means, an example of which
is the police force, that common people do not have. Secondly,
without constraint, it is very hard for the government to
refrain from discretionary interventions that are often arbitrary
and harmful to economic activities. An example of such arbitrary
discretionary intervention is the numerous unauthorized fees
charged by local governments in China. Thirdly, as economic
agents rationally anticipate such government behavior, they
become reluctant to invest, chase short-term and small-scale
projects, and bribe government officials. This is one major
reason why some economies stagnate. It is actually a "lose-lose"
situation for both the government and the economic agents,
because through arbitrary interventions the government hurts
itself with reduced tax revenues due to lower incentives and
distorted investment. Economists regard this kind of problem
as a lack of "credible commitment" from the government.
can we establish credible commitment from the government?
Credible commitment can be established by constraining government
behavior through the rule of law, which will ultimately bring
a "win-win" situation. The logic here is a reverse
of the "trap of economic stagnation" discussed above.
First, the government, constrained by law, cannot arbitrarily
interfere with economic activities. For example, under the
rule of law, the government cannot arbitrarily restrict economic
activities, cannot impose arbitrary charges, and cannot change
economic policies frequently and arbitrarily. Secondly, anticipating
a stable and friendly economic environment, individuals as
well as business enterprises will rationally make long term
investments. Thirdly, with the economic vitality resulting
from motivated economic agents, the government can actually
harvest more tax revenues. This logic resembles the mechanism
of increasing total taxes by cutting marginal tax-rates, but
here the issue is not about tax rates; instead, it concerns
a credible commitment from the government not to prey on individual
the above analysis we see a paradox of power. As the power
of the government enlarges, the government can act more easily
upon its own will, which renders its promises less credible.
If economic agents do not believe in the government's policies,
they will not have incentives to work or invest. Conversely,
the rule of law constrains the government's behavior, which
makes the government's promises more credible, which in turn
benefits the government itself. As an example, the English
Glorious Revolution in the 17th century transferred the tax
power from the Crown to the parliament. In the war between
Britain and France, which came after the Glorious Revolution,
Britain was able to finance a substantial amount of military
expenses by issuing government bonds because the government
had established credibility in repaying debts. In contrast,
France, which still had a arbitrary Crown, was unable to do
second economic function of the rule of law is for the state
to enforce laws and contracts in an impartial way. This can
be achieved only after the government distances itself from
microeconomic decisions. Defining property rights, preserving
fair competition, fighting monopoly and enforcing contracts
are all essential to economic development because they are
necessary for establishing credible commitments among economic
agents. Without the enforcement of contracts, economic agents
cannot become motivated because they will always worry about
opportunistic behavior of the other parties to the transaction.
But how can we establish an orderly market environment? The
enforcement of contracts and preservation of competition should
rest on the rule of law instead of the government's discretion.
For example, the government should not be in a position to
define arbitrarily what unfair competition is, or what business
activities need to be regulated.
is by no means an easy task for the government to act as a
impartial arbitrator. For example, errors could occur during
the enforcement of law, either unintentionally or intentionally
such as when induced by vested interests. Therefore, under
the rule of law, it is essential that individuals and business
enterprises are empowered to challenge the government on laws,
regulations and judgements and to sue the government if necessary.
The Administrative Procedure Law and Administrative Redress
Law that we have enacted is a promising start, but we still
have a long way to go.
substantial barrier to the effective enforcement of law is
the judicial corruption. Obviously, a corrupt judiciary, which
gives rise to insecure property rights and ineffective contract
enforcement, forces business enterprises to resort to the
traditional way of making back-door deals instead of using
legal methods when there is a dispute. This is one of the
factors that suffocate economic activities. A better way to
tackle the problem of judicial corruption is to create better
institutions rather than relying on political campaigns.
summary, the second economic function of the rule of law is
fundamentally about how the government acts as an impartial
"third-party" in economic transactions.
Two Current Examples
examples will help illustrate the relevance of the above analysis.
in the name of "normalizing the market," a variety
of government interventions emerged in China in recent years
to "strengthen rules and management" by requiring
numerous permits and certificates for business activities.
Except for a few requirements that were necessary, most of
these measures were against the spirit of the rule of law.
The economic goal of the rule of law is to minimize rent-seeking
and encourage competition. In the West, one reason for some
regulatory failures is that the government agencies may have
been "captured" by certain industries. But at least
their government's original intention was to protect consumers,
except that it did not withstand certain economic temptations.
But we Chinese have gone further. For one example, certain
government transportation bureau, instead of representing
consumer interest and encouraging competition, openly establishes
price monopoly. For another example, many municipal governments
restrict the influx of peasants by creating numerous permits.
Our rice and oil coupons already resting in history museums,
it is now the time to collect permits and certificates. Even
more alarming are some government agencies that are obtaining
monopoly profits in the name of national security.
these certificates and permits, I wrote in my article "A
Tale of Silicon Valley," published in the January 2000
issue of the "Journal of Comparative Economic and Social
Systems," that Bill Gates and Steve Jobs might not be
able to receive our "engineer certificate" because
they never finished college. The early Apple computer probably
also could not be certified by our academic experts as a "high
tech" product because it was really a toy. But Gates,
Jobs and the Apple computer are the legends of our time and
the symbols of creativity and economic success. Imagine what
the world would look like if Gates and Jobs could not develop
their ideas because they could not obtain certain "certificates!"
business enterprises and individuals in China are suffocated
by large-scale rent-making activities of government agencies
under the name of "strengthening the management of the
market." If these activities continue, they will create
the kind of "institutionalized corruption" found
in Latin America and India, which would produce a bad market
economy. We should not on the one hand try to combat corruption,
but on the other hand create new opportunities for rent-making
and open more doors for corruption. It is worth noting that
many countries including India are loosening government control
in favor of market freedom while we Chinese are moving in
the opposite direction. The irony is that one of India's motivations
for reform is "China's success in reforms in the past
rule of law is probably more important than "privatization."
Russia's example is very illuminating. The relationship between
the Russian government and their business sector did not change
much after the privatization as the government continues to
harass business enterprises and suffocate business initiatives.
Therefore, I disagree with the proposition that "sell
all, then everything will be OK." The key, instead, is
whether the government can keep a distance from businesses
regulations are needed, such as regulations of the securities
market. And some permits are also called for. But a fundamental
characteristic of a modern market economy based on the rule
of law is a real separation between the government and the
business sector. As such, it is wrong to implement and strengthen
"macroeconomic management" at each level of government
and in each government agency. In fact, the more extensive
are government regulations, the more likely there will be
second example concerns the problem of income inequality.
This is not only an issue of fairness; it is also an issue
of economic efficiency. Inequality may result in social unrest
and instability. There are two very different approaches to
address the problem of income inequality. One approach is
to strengthen government intervention by taking more away
from the rich and giving more to the poor through a radically
progressive income redistribution program. This approach can
be very dangerous and may bring us back to the era of "eating
from one big bowl." There is an alternative approach,
which recognizes the fact that people are most resentful to
inequalities that are the results of corruption and power
abuse. Few people in the United States complain about the
new multi-millionaires in Silicon Valley. But if someone is
enriched through power abuse and corruption, even if it is
only a hundred thousand dollars, people would be very upset.
At the root of corruption and power abuse is unconstrained
government power, and the solution is not to increase government
intervention, but rather to decrease intervention so as to
reduce rent-making and rent-seeking opportunities. Therefore,
the rule of law is an important measure for combating corruption
and alleviating income inequality.
Constructing a Market Economy on the Basis of the Rule of
continue our successful reforms of the last twenty years,
China now needs to embrace some new ideas. Our goal for the
next ten to twenty years should be to construct a modern market
economy on the basis of the rule of law. External conditions
such as joining the World Trade Organization and the globalization
of economy and trade have made achieving this objective even
more pressing. We are also facing enormous pressures internally,
examples of which include the lack of economic vitality, increasing
unemployment rates, corruption, and income inequality. To
address these problems, we cannot move backward; we must rely
on the establishment of the rule of law.
economists and policy-makers need to do a great deal of technical
and operational works for future reforms. But first, we need
to clear up misconceptions in our mindset. To correct these
misconceptions, we not only need to abandon the mindset of
central planning that has been with us for several decades,
we also need to throw away the feudalistic mindset that has
existed for thousands of years. The traditional Chinese culture
does not have the concept of a "limited government"
on the basis of the rule of law. But we have seen the successful
examples of other Chinese communities such as Hong Kong and
Singapore, which achieved phenomenal economic growth based
on the rule of law. We should have confidence in ourselves.
author is Professor of Economics at the University of Maryland.
This article is based on a speech given at a conference on
China's economic reform in Beijing on February 26, 2000. It
is translated from Chinese by Minfang YAN and Duan WU.)