China’s Incomplete Contracts

HONG KONG – This year’s Nobel Prize in Economic Sciences went to Harvard’s Oliver Hart and MIT’s Bengt Holmström for their pioneering work on the economics of property rights and contracts. At a time when China is attempting the difficult transition from a system of incomplete contracts to a strong property-rights regime, the real-world importance of these contributions could not be clearer.

No contract can specify every eventuality. So contracts must, instead, spell out the allocation of “control” rights – who can make decisions in which circumstances. For a centrally planned economy attempting to allocate more authority to the market, such contracts are invaluable – at least at first.

This has not been lost on Chinese reformers. From the mid-1980s to the early 1990s, they introduced both the “rural household responsibility system” and the “enterprise contract responsibility system” for state-owned enterprises (SOEs). Those systems essentially delegated more decision-making rights, as well as certain profits, to farmers and workers, so that they had a stronger incentive to work more efficiently within state-owned communes and firms.

A similar approach was adopted in China’s 1994 fiscal reform to handle tax-sharing between the central and local governments, with control rights relating to land and local economic development delegated to local officials, particularly at the municipal and county levels. This helped to advance development, though it also created space for local officials to take advantage of fringe benefits – a practice that later morphed into outright corruption.