China’s Evolving Web

A market economy can be understood as a web of public and private contracts that are linked with each other, with one default potentially triggering an avalanche of broken promises. To understand China’s socialist market economy, it is essential to examine these different forms of contracts and their institutional structures.

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.”

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