---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.
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.
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