The Free Market System and Hong Kong

by Gregory C. Chow

一 個 國 家 的 民 主 發 展 是 會 影 響 其 自 由 市 場 經 濟 的 發 展 。 香 港 及 中 國 各 有 不 同 的 政 治 體 系 ， 中 國 如 要 進 一 步 發 展 自 由 市 場 經 濟 體 系 ， 便 應 吸 取 其 他 國 家 在 發 展 過 程 中 的 經 驗 。

Conditions for a Free Market System

There is no better place and time to discuss the free market system than in Hong Kong as we are celebrating the first anniversary of the return of its sovereignty to China. Hong Kong has a nearly perfect market economy. Since 1992 when China officially adopted a socialist market economy, Hong Kong and Mainland China have learned from each other how a market economy works through trade, investment, cultural exchanges and personal travel.

The free market system is one of the most ingenuous of human creations. It was not invented by a single or a few persons, not by a government, but has evolved as an economic institution to satisfy the needs of society in different parts of the world. Why does the free market system function so well? It provides freedom and opportunities for individuals and families to better themselves by hard work and ingenuity. Through competition the market selects the best to produce for individual profits and at the same time for the needs of the society. Thus there is harmony between self interest of the individual and the common good. This generalization is valid only under three conditions. First the rules of the game in market competition have to be clear, effectively enforced and fair. Second, the domain of the market economy has to be spelt out. Third, a suitable political institution is needed to specify the economic activities performed by the market and those performed by the government. The first deals with the definition and enforcement of competition. The second touches on the economic role of the government, and the third on the way the government exercises this role.

To insure that competition works for the common good, it has to be defined and enforced effectively. This requires a well-functioning legal system. A set of laws governing economic conduct has to be enacted and the citizens should be law abiding. There should also be a judicial system to enforce the laws.

Legal institutions are different because the method of enforcement and the degree of enforcement may be different. In some East Asian countries business agreements are partly enforced by a set of informal human relationships known as guan-xi. Guan-xi serves as supplement to the formal legal system. Even in the United States where the number of lawyers per capita is much higher than in the rest of the world, not all disputes are settled through the legal system because it is sometimes too costly to do so. To have informal human relations to settle disagreements can be an advantage over having the legal system alone.

How the Government Decides

What the government decides in practice depends not so much on economic arguments as on the way the government makes its decisions. How the government decides in turn depends on the form of the government.

Hong Kong is governed under the principle of  'one country two systems'. As far as the two economic systems are concerned there is much similarity between Hong Kong and Mainland China. Both are market economic systems. The Hong Kong economic system is more mature as free markets and the associated legal institutions have been in existence for over a century. The two political systems are more different. Mainland China's is a one-party system. It is in the process of development toward a democratic government as the leaders of China have repeatedly proclaimed and partially achieved. Witness the expansion of local elections and delegation of more power to the People's Congress. Hong Kong's is built upon a former colonial system and is also in the process of transformation to a democratic government. It is a local and not a national government. Because the people in Hong Kong are better educated and the rule of law has been practised longer than in China one can expect the development of democracy to advance faster in Hong Kong. The two democracies may turn out to be different in the near future. In both Hong Kong and China this development will take time. The 53 percent voter participation in the May 1998 election for members of Hong Kong's legislature was encouraging, but social harmony under an undemocratic colonial rule will be sacrificed. Progress toward a democratic government in Hong Kong will provide an important example for the development of democracy in Mainland China. Chinese leaders will not copy the Hong Kong model, but as always they will learn from the valuable experience in other parts of the world.

Before 1997 government economic decision making in both Hong Kong and China were made by a government which was not democratically elected. Both economies functioned extremely well for two decades, and Hong Kong's for even longer. It is reasonable to surmise that under a democratic government neither economy could have done better. The question is, as democracy is being gradually introduced, would the government do worse in performing its economic functions? I raise this important question not because I believe that democracy is bad for a free market economy. After all many free market economies have been developed under or alongside with democratic institutions. I raise this question so that we will be aware of some possible developments that are unfavorable to the free market economic system under a democratic government.

One ideal of a democracy is to give political rights to its citizens. To exercise these rights public elections are held to select government officials who will make economic and other decisions. The election procedure is not without its shortcomings. Votes of poor or disinterested citizens can be and have been purchased. Even in the United States there are problems of improper campaign financing when money can unduly influence the outcome of elections. Once legislators are elected, decision by majority rule can be in conflict with minority rights. A simple example is a highly progressive income tax passed by the legislature which is inconsistent with the property rights of high-income citizens. Hong Kong's flat tax levied only on wage above a certain level and not on capital gains is an important feature of its free market system. This flat tax has probably contributed to the vitality of its economy through more savings and more investments. It is doubtful whether such a tax system would have been enacted if the Hong Kong legislature had been democratically elected and given the authority on income taxation. I hope that future legislation on income tax in China takes the negative effects of income tax into consideration, and that other forms of taxation such as a consumption tax or a flat tax similar to Hong Kong's will be seriously examined. The democratic political process has the tendency to redistribute income through taxation perhaps without sufficient regard for the incentive effects. When income is earned goods and services are produced. Why tax people for producing? Relative to an income tax, a tax on consumption encourages saving and makes possible a higher rate of capital accumulation.

Under a free market system economic gains can be obtained mainly by competition in the market place. In a democracy, to the extent that the government has economic power to allocate resources, political forces determine economic benefits to different members of the society. In the United States we have lobbyists to represent different economic interest groups. Tobacco farmers want and get government subsidies. The defense industry fights for more spending on defense. Laws are passed to satisfy these interest groups. In Hong Kong, now that both the chief executive and the legislators are elected they are bound to be influenced by political pressure to make economic decisions not necessarily for the common good but for the benefit of special interest groups. Let us hope that they can resist such pressure.

Whatever the ideal lines to be drawn between government and private economic activities might be, and I have suggested that there might not need to be such lines, a democratically elected government has a tendency to increase the sphere of government influence. This can be the result of political pressure from interest groups or of the desire of government officials to increase their power or simply to show their superior performance. A minister of education may wish to demonstrate his performance by setting up some new programs or even a new university, and the benefits of these initiatives often cannot be measured during his tenure. Given such temptations the Chinese government deserves much credit in the current downsizing of the State Council by reducing the number of ministries from 40 to 29. We will all observe with interest future changes in the size of the Hong Kong government, especially those parts that deal with economic affairs, and find out whether the changes, if they occur, are justified.

Balancing Individual and Societal Interests

An intrinsic problem in human society is to find the delicate balance between individual self interest and the good of society. In schools in Hong Kong and Mainland China students are taught to give up self interest for the common good. Individualism is sometimes identified with selfishness and treated as a bad thing. When we study economics we learn that under a free market system we can all pursue our self interests and at the same time benefit the society. However the harmony of individual self interest and the welfare of society cannot be expected to operate automatically.

Prof. Gregory C. Chow is Professor at the Department of Economics, Princeton University, U.S.A. The above is an extract of his speech at the Hong Kong Economic Forum organized jointly by Hong Kong Policy Research Institute and Hong Kong Trade Development Council, 29-30 June, 1998, Hong Kong.