Wednesday, November 26, 2014

China’s Evolving Web

HONG KONG – In a recent article, the economist Axel Leijonhufvud defines the market system as a web of contracts. Because contracts are linked with each other, one default can trigger an avalanche of broken promises, “[making] it possible to destroy virtually the entire web of formal and informal contracts which the market system requires for its functioning.” The state’s role is to protect, enforce, and regulate these contracts and related property rights, as well as to intervene to prevent systemic failure.

This web of contracts – often taken for granted in mainstream economics, to the extent that it becomes almost invisible – embodies the formal and informal rules embedded in the market system that shape and constrain individual and social behavior. They form the fabric of all human institutions.

Advanced economic systems have very complex webs of contracts, such as financial derivatives. For Europe, Leijonhufvud argues, this implies a three-pronged approach that focuses on “levels of leverage,” “maturity mismatches,” and “the topology of the web,” – that is, “its connectivity and the presence of critical nodes that are ‘too big to fail.’” This is because “[t]he web of contracts has developed serious inconsistencies.” To insist that all contracts be fulfilled would “cause a collapse of very large portions of the web,” with “serious economic and incalculable social and political consequences.”

By contrast, emerging markets like China have less sophisticated systems and evolve more complex contractual/institutional links over time, particularly through globalized transactions. Under China’s planned economy, most contracts were between individuals and the state, whereas more sophisticated market contracts have emerged or re-emerged only over the last 30 years. Indeed, the widespread use of market contracts with publicly-owned companies was a recent and important adaptation in the move toward a “socialist market economy.”

The web of contracts, however, can also be understood as complex adaptive market systems, which encompass the state and family relations as well. To understand China’s socialist market economy, it is essential to examine systematically these different forms of contracts and their institutional structures.

Family and kinship contracts, which govern marriage, adoption, cohabitation, inheritance, etc., form the basic unit of human society. These contracts are the most ancient and remain the foundation of social relationships in China today.

Corporate contracts place the profit-oriented legal person at the center of the transaction and bind all of its stakeholders. Chinese corporate contracts have grown exponentially over the last 30 years, but they have special characteristics that reflect the primary role of Chinese state-owned enterprises.

Market contracts between producers and consumers – and/or among producers in supply chains – link individuals, families, firms, governments, and public organizations through local or global markets. Over the last few decades, China has begun to practice modern contract law and joined the World Trade Organization, committing itself to international rules governing trade and investment.

Non-governmental and non-profit civil contracts bind people together for communal, religious, social, and political activities. These contracts are still relatively new and evolving in China.

Social contracts created by constitutional and administrative laws define the powers and responsibilities of the state and its constituent bodies vis-à-vis individuals and the private sector. They include the authority to impose taxes and restraints on individuals and private entities through criminal, administrative, and civil law, as well as the state’s obligation to provide public goods and services. China has strengthened its unitary state with important institutional innovations that have delivered growth and middle-income prosperity, but it still retains the basic five-level administrative structure – central government on top, with provincial, city, town, and village bodies below – that first emerged two millennia ago.

Deciphering the structure of the web of contracts holds the key to understanding how an economy behaves, including its dynamic non-linear adaptation to internal and external forces. Following the physicist Fritjof Capra, one should regard living organisms, social systems, and ecosystems as an interconnected and interdependent, complex adaptive system. This means that we should view the economy and society not as rigid hierarchies or mechanical markets, but as networks or webs of life, in which contracts, formal and informal, fulfilled or violated, are the essence of human activity. Examining webs of contracts should be similar to a biologist’s examination of cell structure and DNA.

China has created four functioning global-scale modern supply chains in manufacturing, infrastructure, finance, and government services, thanks to its evolving, expanding, and complex web of contracts. But how was China able to build a modern industrial base within a relatively short period of time from its traditional, patrimonial family contracts and archaic constitutional structures?

Through experimentation, adaptation, and evolution – a process that has been described as “crossing the river by feeling the stones” – China has been able to evolve a higher-order, or fifth, supply chain in political decision-making. This “top-level governance architecture,” as it is known in China, has been essential for coordinating and orchestrating the different supply chains and the overall web of contracts to achieve the delicate balance among individual, family, corporate, social, and national objectives.

This top-level governance architecture is analogous to a computer’s operating system, which orchestrates the other software and hardware components to form a holistic unity. Such a structure exists in many economies, but, in the Chinese context, where the state plays a central role in the economy, it is critical to the system’s effectiveness. How it is shaped will depend on how China’s history, culture, institutional context, and evolving web of contracts affect the country’s social fabric.

Read more from our "China in Transition" Focal Point.

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    1. CommentedNathan Coppedge

      The obvious correlation that may be cited in the article is the correspondence between information networks and social or business networks. But it seems, apart from a metaphor, these similarities are not bridged. There is a big difference between entities in an informational sense and entities in a cultural, social, or ambitious sense. Perhaps China's development is underwritten by a virtue such as public service or intelligence, but this is not made explicit in the article.

      How can business infrastructure resemble information functioning is a question that obviously businesses must face consistently. Yet, how much innovation is actually achieved in the information field, at a symbolic level? Should it be necessary to say that information-infrastructure development is un-symbolic? This would be like saying that economies are forged at the whim of some brute natural force, which I sense is not exactly what is being argued, defended, or put forth. What does it mean to have an economy that is shaped by symbolic forces? Perhaps this question would seem ridiculous to most businessmen and financiers or government officials, because they feel that they are above the subjectivity of the common opinion, and the common perspective, or the 'weak forces' which form the basis of simple (social) contracts and so on.

      Surely there is no 'magical force' which dictates that a business or institution must operate symbolically. Yet under a concept of kinetic information, and fair representation---aspects which subtly relate to economics, perhaps currently under no distinct umbrella of support---the nature of the modular citizen seems to be represented here, as an element of infrastructure and even information architecture. How does the individual gain symbolic representation in the economy? From my point of view, it seems that such a description or embodiment might be derived in some way from what you describe, or some local-scale variation, maybe an economic application, or some reflection of economics in the structure of informational computing. I will leave it at loose ends---perhaps economics relates to the structure of the citizen, and government and economics of some description should be biased to favor personal development. Some would assume this is already implemented---but it seems to me that somehow, in some way, citizens are not being treated as information.

      --Nathan Coppedge, philosophical writer

    2. CommentedProcyon Mukherjee

      A very stimulating article on creation of a web of contracts that also directs us towards how an institutional framework could be created around Innovation and I am infuenced by two papers as follows:

      The first is the Research paper: "China's innovation policies: Evolution, institutional structure, and trajectory", which gives a vivid detail of how China emerged into a leading player on innovation in the area of Science and Technology and the second the book, ‘Dragon at the Door’, is one other example how it has gone beyond the institutional framework to adopt innovative practices which even the Western nations could emulate.

      It is worthwhile to go through the 287 policies issued by the China’s central government agencies between 1980 to 2005 and 79 policies introduced thereafter which include financial, tax and fiscal measures to incentivize innovation. One of the fundamental observation has been the widening of focus from universities and technological institutions to all sectors of the economy that enhanced the creation and commercialization of new products and processes and services in economic activities. The top down trial and error through which the framework had moved laid down the foundation of the National Innovation System that had one single aim of moving from competitiveness to all round social welfare. It is truly a great learning for all how a State led centrally orchestrated policy making institutional framework could be created that went through a series of evolutions that encompassed all the constituents of a well crafted innovation framework that includes Science and Technology investment, tax stimulus, financial support, government procurement, talent, IPR creation and protection, education and S&T popularization, building of bases and platforms for S&T and innovation coordination.

      When we are talking of web, as in this article it is worthwhile to note how a market based system (the fundamental requirement for innovation to thrive in an economy) could evolve from within the centrally controlled system of governance where the only suffrage is limited to universal direct election at the village level.

      Procyon Mukherjee