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The Night-Watchman State’s Last Shift

Jun 05 , 2013

Too often, debate about the relationship between the state and the market casts them as opposing forces locked in a zero-sum struggle. But this simplistic approach quickly turns constructive discussion into a casualty of the ideological battle between advocates of state and market capitalism.

A more useful framework would view the state and the market as two sides of the same coin, bound together by the property-rights infrastructure (PRI). The state interacts with the market – the realm of private, voluntary exchange of property rights – in three main ways.

First, the state transacts with the private sector through taxation and expenditure. Second, it establishes and maintains the PRI, which includes all of the institutions needed to delineate, exchange, fine-tune, and protect (through enforcement of law and contracts) property rights. Among these institutions are the judiciary and arbitration panels, which function not only to adjudicate property-rights disputes, but also to address administrative abuses and disputes between the private and public sectors. Finally, the state competes with the private sector via state-owned enterprises and utilities.

Given that an effective PRI safeguards market order and stability, the market needs a strong state to manage it. This means that whether a government is “big” or “small” is less important than how well it manages the PRI – that is, whether the state is able to ensure high-quality market order.

Current policy debates have largely neglected this aspect of the state’s role, because Western thinkers take their countries’ PRI for granted, especially their regulatory and judicial systems, which have benefited from hundreds of years of development. But these countries’ experience is entirely different from that of developing economies, which are under intense pressure to build a sound PRI quickly.

For a large economy like China – which has overlapping bureaucracies in different state agencies, and many layers of government extending from the central administration to local units – creating a transparent, fair, and effective PRI is particularly complex. As a state-led economy moves toward a market-based system, policymakers are faced with a difficult choice: pursue policies associated with immediate and rapid GDP growth, or seek the longer-term, less visible benefits of PRI development.

When China began this transition, its central and local governments focused on building physical infrastructure, such as roads and electricity grids, which delivered tangible gains. But it was the state’s less visible investment in the country’s institutional infrastructure that had the biggest impact on China’s GDP growth. Over the last three decades, the government has created a transitory but effective PRI to remove barriers to market entry, define new property rights, and mimic international rules, thereby facilitating external trade and enabling foreign multinationals to operate effectively in China.

China’s government-services supply chain plays an important role in orchestrating and supporting the market economy’s development. But it is not enough. With private and foreign-owned entities now accounting for more than two-thirds of China’s output, and with China becoming a leading actor in global markets, the need to upgrade its PRI is becoming increasingly urgent.

In order to create value consistently within domestic and international markets, China must ensure that competition is fair, transparent, and subject to the rule of law. China’s leaders know that private small and medium-size enterprises with fair market access would be a far more reliable source of innovation and jobs than are large state-owned monopolies.

Given this, China’s continued economic success depends on reducing state ownership of productive capital, facilitating market innovation and growth, and investing in human capital, such as through education, health care, and social welfare. Concretely, this means introducing land reform and privatization, regulating food and drugs, protecting human capital and intellectual property, safeguarding the value of household savings, ensuring market access, and executing fair and transparent taxation.

Such reforms would not weaken the state; they would simply alter the distribution of power in order to create a more stable system. For example, the primary objective of privatization would not be to reduce the size of the state sector, but to eliminate state-owned enterprises’ unfair and hidden privileges, such as subsidized credit and monopolistic market positions. This would help to eliminate corruption, by making bureaucratic functions more transparent and preventing officials from rewarding themselves at the public’s expense.

Strengthening the rule of law and creating a level playing field essentially involve building a stable, effective PRI, composed of institutions that can motivate public officials to deliver services as effectively as possible. Such a PRI would ensure that the state fulfills its responsibility to safeguard justice, enforce the law firmly and transparently, and enable the strongest competitors to reap their just rewards.

The good news is that many of China’s local governments, which are responsible for overseeing the country’s courts, are beginning to compete with each other to deliver better PRI. They recognize that stable, equitable markets are better than physical infrastructure at creating jobs and driving long-term growth. The bad news is that those who benefit from the current system are resisting progress.

In order to navigate the complex market-state relationship and achieve a beneficial outcome, Chinese policymakers must have a clear idea of where the state’s limited capacity and political capital are needed most. And that presupposes a discourse on the state-market relationship that is very different from the one to which Westerners are accustomed.

Andrew Sheng, President of the Fung Global Institute, is a former chairman of the Hong Kong Securities and Futures Commission, and is currently an adjunct professor at Tsinghua University in Beijing. Xiao Geng is Director of Research at the Fung Global Institute.

© Project Syndicate 1995–2013

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