Globalization And Rise of China's Economy Part Seven, Social Trust And Social Cohesion.

"Virtually every commercial transaction has within itself an element of trust"
                                                                                 ---K J Arrow

Living in the modern society like ours, we take for granted how our lives are utterly dependent on others. We trust that we won't be robbed while we walk past strangers. We don't stock six months of food and water, trusting that the water will always come out of the tap. We put our money in the bank, trusting that it will be there for us tomorrow. Trust is the foundation for social cooperation and fundamental to the working of modern societies, but it has not always been that way.

When we were hunter gatherers, we only trusted our small tribe. Strangers were viewed with suspicion. If you see a stranger in your hunting ground, your instinct is to kill him, because he competes with you for your food source. Nicholas Wade, in his book  Before the Dawn, documented research findings that indicated hunter gatherer societies were significantly more violent compared to agricultural societies. Our skulls were thicker before farming and we went through Gracialization while forming our agrarian society. Indeed, the history of humanity has been a story of increasing cooperation involving ever larger number of us in one place. Ever increasing trust is required by each member of the society as we congregate in increasing numbers and specialize, making the society more productive and making us more dependent on others. Along the way, living with large group of humans in close proximity changes us. It changes our culture. It changes our personality make up, which has a strong basis in genetics. To go from a small tribe to a large empire, we got a jump start through agriculture, where a group composed of many unrelated families must live in close proximity and cooperate to have successful farming. The rest was accomplished mostly through conquest. The victors, which started out as a single group, had high social cohesion and trust. The losers were either vanquished completely, or assimilated into the group. This involved passing the genetics and the cultures of the victor group to the loser group and could take centuries as tribes turned into nation states.

It stands to reason that societies that had gone through long periods of urbanization will have members that are more suitable for dense living environment that requires high degree of cooperation. Societies with multi-ethnic groups where each group has similar powers fare worse than societies with a single dominant group. Societies that were still basically tribal until the British arbitrarily drew a line in the map and declared them as countries will have a harder time with social trust. This was made worse as the British drew their national borders to ensure internal strife. They ensure strife by ensuring that each nation contain several different religious or ethnic groups. It would be difficult for a country like, say, Afghanistan or Iraq, to pick themselves up and transform into a high trust society in the foreseeable future.

This foretells a dim future for many countries in the world with regard to their ability to modernize. Many will fail at this first step to modernity and it could take centuries, if ever, before they grow to become high trust societies.

The United States was a high trust society at the beginning, at least among the colonists. However, things had degraded over time. In the absence of an external threat like the Soviet Union, our internal fissures like race and gay rights, which first surfaced in the sixties, have grown more intractable and more strident. We balkanize into thousands of special interest groups that will sacrifice the interests of the nation for their own interest. In my neighborhood, one of the most desired place for a teacher to be working, the teachers have collectively bargained for ever more benefits and pay. Their salaries are already one of the highest in the state and maybe the country. The resulting compromise by the school board and the teachers resulted in a lot of days where the kids don't get to go to school. It was so called development days for the teachers, who only works nine months out of a year and have the entire summer to do their development. We are still a fairly coherent society, at least for a majority of us, but the trajectory is not headed in the right direction.

The Chinese has a pretty high societal trust among its citizens. Indeed, I think the biggest achievement of the Chinese civilization was to forge one of the largest group of people who identified themselves as Chinese, with similar language, genetics and culture. The Chinese have had a long history of urban civilization compared to most of the world. However, in the absence of external challenges, Chinese societal trust and cohesion had degraded. In 1900, an alliance of eight European nations invaded China. The Chinese lost. What is poignant is that if you look at many images of the period, you see the many Chinese working alongside the foreign invaders for pay. In many cases, with our European masters picking who should die, the Chinese were actually the executioners of our own people.

Seen in this light, the external forces so rudely awakened China from her slumber had helped us to re-define ourselves as Chinese again, this time in the context of other competitors stronger then ourselves. This process of re-discovering our societal cohesion takes many generations and sees many painful lows. For example, many from Hong Kong still don't see themselves as Chinese, but part of Britain.

Going forward, still facing competition and pressure from the outside, but economically ascendant, We can expect the Chinese social cohesion to strengthen. The high social trust and growing social cohesion of the Chinese is one of the bedrocks from which Chinese economic modernization is built.

Globalization And Rise of China's Economy Part Six, A Strong Financial System

"Here we don't pray for the weak, we prey on the weak"
                                                   ---Teresa Mummert

The Tech Industry has a cluster of some of the world's strongest companies. Yet if you trace the Tech Industry since its inception, you will find that every decade, the leading companies are almost completely changed from the previous decade. Many once major player in the industry like JDSU, 3Com, Yahoo have ceased to exist altogether, while others like IBM(the tech part), HP, Sun Micro Systems etc. have been reduced to a shadow of their former selves. In their place are upstarts that just a few years ago was unheard of by the vast majority of the world.

The constant culling of the weak and the boosting of the strong is what made the Tech Industry so strong. For a nation, that is also true. The countries that allow this process to go to its logical conclusion stands to be stronger and prosper in the long run even though there is more pain in the short term. The financial system plays a decisive role in this.

In this regard, the United States stands heads and shoulders above most countries. Fortress Europe has resulted in a Europe that has few tech companies. Indeed, few new companies of any kind. In Japan, over-investment, which can be blamed by the financial system along with the Japanese government, results in bubbles. When the bubbles burst, the financial system, again controlled by the government, propped up the companies that should have gone bankrupt. Zombie companies that should have died long ago are still around, decades later. This resulted in the Lost Decade, a multi-decades long slump that could have been at least mitigated. The Japanese went from being 17% of the world economy in their peak to 4% of the world's economy today. In contrast, during the 2007 burst of the housing bubble, not only do we allow smaller companies like Countrywide to fail, very large financial institutions like Lehman Brothers and Bear Stern were all bankrupt or taken over. While some intervention was made for the remainder of the financial companies, the United States have allowed the market a much freer hand to deal with the fate of the companies. This is one of the reasons why the United States is so strong financially today. The companies in the U.S., on average, are subjected to a much greater degree of market pressure compared to other major industrial countries.

The Koreans did not fare better in this regard compared to the Japanese. The Chaebols contains captive banks which finance their masters. Competitive lending did not apply to them. Instead of relying on the market mechanism, the government just told some Chaebols that did not do well in certain industries to get out and give the market share to another that had better success. While this is not as good as the invisible hand of the market at picking winners and losers, it does produce some pretty impressive results. Samsung for electronics, Hyundai for cars, they all seems to hold their own against their international competitors. Still, the financial system is held captive not only by the government, but also by the Chaebols. The lack of a more rational financial system that does a better job of picking winners and losers could at least partly explain why the Koreans are stuck at a lower GDP per capita compared even to the Europeans and the Japanese.

How about the Chinese? The private sector, the so call small and medium size companies that are privately held, are very efficient. Since the banks favor the state sector, the private companies must pay a premium for the capital. Those that survived with this added cost are very competitive. The large state own enterprise is a mixed bag. Most state own enterprises still have to compete to survive. On the other hand, State enterprises sometimes are tasked with other missions besides making a profit. For social stability, or acquiring technology abroad, or ensuring that the country has enough oil, State Enterprises are often asked to undertake work that are money losing deals. While in the West, private money could at least be counted on to protect its own interest, in China, those who operated using money that belongs to the country may also become entrenched vested interests that will defy even the central government to protect their own special interests. Since they also have power, they often will direct the state to invest in something that turn out not to be the best use of capital, as long as they benefit. In the future, this will lead to significantly slower growth even in the most optimistic case. Michael Pettis, the most credible economist on this front, predicted that the best case scenario is 2-3% for the next decade. I believe the reason Xi Jinping spend so much effort to consolidate his own power did so in order to deal with these special interest groups outside of the central government.

On the positive side, There are a few strengths that partially mitigated problems with capital allocation. First, China is sufficiently large that competition still exists for these enterprises. Even in Telcos, there are multiple companies representing various part of the country where as a smaller nation may have a monopoly. Second, up to now, there is still a lot of low hanging fruits for investment. Third, China has enough smart folks such that the people making the policies are very capable. Finally, if it looks like the ship is about to capsize, the collective communist party members will over rule some of the worst special interest groups to ensure the survival of the party and the nation.

Going forward, in the longer term, the Chinese will have a stronger economy if they have a financial system that performs the job of selecting the right winners and killing the losers as quickly as possible. While it does not have to mimic the U.S. financial system in every way, it should at least do this job as efficiently as the financial system in the United States. China will continue to prosper if they can successfully reform to get there. Since there is currently serious misallocation of capital by the state sector, in the intermediate term, they need to at least correct these misallocations.

Globalization And Rise of China's Economy Part Five, the Rule of Law

The freedom enjoyed in Western society under the rule of law and constitutional government explains both the quality of its civilization and its wealth.
                                                                                            ---Paul Johnson


Imagine that your cousin with whom you have grown up all your life has come up with a great idea about making some better tennis shoes. To start a company, he will need some money. Since you knew him all your life, you would be able to invest in his company with your hard earned money. Had he been a stranger trying to convince you of his company in a busy street corner in New York City, you would almost certainly turn him down. Without the rule of law, a good idea gets turned into a good product only if the inventor is sufficiently connected to raise the funds to turn the idea into a company.

The genius of the Western society is that the rule of law enable every investor, big or small, to invest in the best companies. While a sound financial system directs investment to the best investment opportunities, it is the rule of law that is the foundation which empower even the smallest and least able members of the investor class to channel their hard earn money to the best use. Without the rule of law to enforce good behavior and punish bad behavior, investors would be very afraid of being swindled and would not invest in something that they don't personally know. This severely limits the scope of their investments. The rule of law also minimize bad investments by those with power and also control how large amount of money is being invested. Had this been their own money, they would surely invest for the best return. In the case where this is not their own money, they would invest this in order to maximize their own benefits, even if the investment itself yields negative returns.

The rule of law is more than just some words written down about what is allowed and what is not allowed. It is also a state of mind. On paper, Greece and Sweden both probably have similar rules. In practice, there is a world of difference on how these two countries are run. Similarly, India was endowed with the same rules that the British use for their country, but by any measure, Britain is light years ahead of India in having better rule of law. To go from a third world to first world, every citizen must go through the growth to gain a mindset similar to their Western counterpart, both in obeying the laws and in the low tolerance of others breaking the law.

Were there abuses of the system? sure, Do the crooked still take advantage of the hapless? absolutely, but by and large, the rule of law works amazingly well in the United States. There is low impedance for investors to invest in the best companies. When corporations commit malfeasance, the people responsible are generally held accountable. We all know the fabled stories of Enron and Countrywide. In some cases, some of the perpetrators were spared, like most of the financial system after 2007 financial melt down, but this was done for the good of the country.

In this regard, the Chinese still lag very far behind the United States. The powerful runs rough shot over the population. This is especially egregious at the village level, where heads of villages often stage land grabs which drove the fellow villagers from their land and their livelihood. Corruption by those with power by definition means those without access to power is placed at a disadvantage. Most of the Chinese view the stock market as a casino, not a place to put most of their hard earn cash. As a result, those with money puts most of their money into real estate, causing bubbles to form. Michael Pettis, an economist intimately familiar with the Chinese economy, has warned for many years that the marginal return on investment has gone down and is turning negative. This is partly because in many cases, the state owns the companies, while the people who run them are able to run them for their own personal gain at the expense of the companies.For example, while the Chinese oil companies and defense industries are very competitive, the banks and the financial sector in general are still mired in corruption and low efficiency.

To be fair, there are also benefits that resulted from the government fiat rule, at least during the current stage of China's development. Think of the commercial jet industry, So far, there is Boeing and Airbus dividing the world market. For a third company to get into this business, playing by the rules, it would mean a Chinese aircraft industry would never get off the ground. To compete against two well funded and entrenched companies supported by their respective states means decades of money losing without end in sight. No sane person would invest in something like that. In fact, the government is able to to take this hit. The Chinese military needed to build fighter jets and military transports anyways, so decades long perseverance (and money losing) have paid off. This technology has spilled over to the civilian side and the C919 was born. In fact, many industries in China were born and thrive because the government assisted. In many cases, joint ventures set up by the government enable the local partners to gain the expertise from their foreign counterpart and be able to compete world wide. While Trump would call this unfair practice, the reality is somewhat different. Companies go to China to do business. The treatment they get depends on what they bring to the table. Witness how Amazon's search for a new headquarter sparked the mad rush of all the cities that comes out of the wood works to offer them special treatments. They would not have done that for Joe's diner. What a business brings to the table in China include the possibility of sharing their technology. Technology is perishable item. Sharing them gets these company a better deal.

How did China managed to do so well all these decades with rule of law so under developed? Well, for one, back when Deng started, China had little investment and very outdated practices in running their businesses. They went on an investment spree. During this investment spree, the interest of the ruling class largely coincides with that of the country. More investment means more opportunities to enrich themselves. The dearth of investment prior to this means that the return on investment was largely positive. Since the ruling elite also control most of the money at that time, enabling efficient private investment was not a big factor in the Chinese national development.

The Chinese state run businesses, in theory, would not run as efficiently as the private enterprises. In practice, there are factors mitigating this. Imagine a company like Exon, with large and diverse share holders. A group of managers and a CEO is hired to run the company. The people who run the company owns a very insignificant share of the company, yet were incentivized to do a good job. This is not very different from Sino Petroleum and Chemical corp, the Chinese counterpart to Exon. The caveat is that the government must run the company in the best interest of its share holders, the people of China, similar to the board of Exon. In any case, the share of companies that are state own enterprises is shrinking. When China started reform in the early eighties, there were no private sector. In 2015, the share of wealth comprising the state own companies are now down to 30% or so. They comprise 3% of the total number of companies in China. So, by now, most of the state own enterprises are large companies that are not that different then the typical multi-national corporations in the United States with diverse stock holders.

China is exiting the phase where easy and obvious investments awaits those who have money to throw at them. While there are still many worthwhile investments awaiting to be done, such as the Hongqi River Project, the likelihood of resource miss-allocation is growing significantly. Part of the reason is China has a lot more money now to invest and opportunities are no longer ubiquitous as before. At the same time, the Chinese stock market is still not well developed. To increase the efficiency of the economy, China needs to have a developed stock market so money could be channeled to the best uses. Going forward, the rule of law will become increasingly important to the economic well being of China. The ability to reform to ensure better government by rules rather than by fiat and to have better accountability will mean the difference between stagnation and continue growth.

Globalization And Rise of China's Economy Part Four, An Independent Foreign Policy

There are only a handful of countries in the world that have independent foreign policies. United States being the foremost global hegemon obviously qualifies. Russia, China, India and Iran has independent foreign policies due to their relative size in their geographical area. A number of African countries were left alone due to the fact that they do  not have anything worth the effort from the other powers. The remainder of countries all live in the shadow of one or more powers.

Obviously, countries like Germany and Japan were able to reach developed nation status without having an independent foreign policy. However, I would argue that countries like Russia, India and China will not become first world countries until they have their own independent foreign policy. The reason has to do with their size.

While NATO and EU was willing to take in smaller countries like Poland, when the Soviet Union imploded, and Yeltsin wanted to join NATO, Russia was not allowed to join. The reason is simple. Russia could only join EU and NATO if it is in the interest of the bigger NATO powers. With the size of Russia and the proximity to Europe, Russia will be the biggest power in EU and NATO after United States, not only will this threaten the U.S. hegemony, it will displace the other heavyweights like Great Britain, Germany and France. Even Poland, after they joined EU, the European market was still closed to the Polish companies. The Japanese, after they become successful with their auto and electronics in the eighties, were forced to push up their currency as well as other "voluntary" restraints to allow the American auto makers to survive, even if the U.S. companies were unable to compete economically, we would use our non-economic power to bend the rules our way. Japan and South Korea as well as Taiwan benefited tremendously as junior partners in a cold war against the Soviet Union. While they were beating the U.S. in many industries, they were allowed to continue their operation because the U.S. needed them to fight the cold war. With the cold war over and U.S. industries in disarray, Trump is abandoning the rule of law and WTO etc in a naked attempt to reshuffle the deck. If China did not have its own independent foreign policy, no doubt the U.S. would use every means at its disposal to prevent the industrialization of China once it reach a state that is alarming to the United States.

An independent foreign policy allowed the Chinese to continue to develop their economy without fear of undue foreign meddling.