By Andrew Sheng and Xiao Geng

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.

Andrew Sheng, President of the Fung Global Institute, is a former chairman of the Hong Kong Securities and Futures Commission and is currently an adjunct professor at Tsinghua University, Beijing. Xiao Geng is Director of Research at the Fung Global Institute.

Copyright: Project Syndicate, 2012.
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