China: House Divided

There have been claims that China’s enormous economic growth and widely shared prosperity are the result of turning to capitalism. I think this is not true; China is not capitalist.

Of course, that depends on having a definition of capitalism that is clear, and that does not simply apply to all nations. It also requires a definition that is not so naively aspirational that no nation could satisfy the conditions to qualify as truly capitalist, because of the tendency toward cronyism in democracies.

I have come to think of it in terms of concentric circles, each smaller than, and fully contained in, the larger category. For me, the categories are exchange relations, market societies, and capitalism. All capitalist countries are market societies, and use exchange relations. But many market societies are not capitalist.

Exchange relations

Exchange is a means of improving the welfare of both (all) parties to an exchange, if the exchange is voluntary. I have written a number of papers (this, and this) on the nature of “truly voluntary,” or euvoluntary, exchanges. Exchange that is not voluntary, but coerced by human agency, is theft. Such exchanges can look voluntary, if routinized over time, as in the case of Mancur Olson’s “stationary bandit.”

Voluntary exchange must leave the exchangers better off, because they are not obliged to exchange and yet choose to do so. The bases of voluntary exchange are three:

  1. Different preferences, same endowments
  2. Different endowments, same preferences
  3. Division of labor and specialization that creates what looks like different endowments, on steroids

More simply, if I like bananas and you like oranges, and we both have bananas and oranges, then I’ll give up some of my oranges in exchange for your bananas, and we are both better off, even with the same total amount of stuff. If I have many bananas, and you have many oranges, and we both like fruit salad, again we exchange and we are both better off.

The really interesting example is the one that Adam Smith and David Ricardo described, resulting from division of labor and comparative advantage. If we were all clones, but specialized, we would soon have more stuff than if each of us supplied all of our own individual needs. And if that specialization were further guided by differences in endowments, climate, natural resources, and local skills, the increase in the total amount of products available is redoubled and redoubled again.

Exchange is likely to have been common in the earliest days of human clans and tribes of hunter-gatherers. Groups of 150 roaming the terrain could likely find most of what they needed. But some people learned how to make clothing, and others learned how to make spear points and attach those sharpened stones to sticks to make spears. Division of labor, even at this level, rewarded tribes that fostered internal specialization, so that the group could increase its total output.

But, as Adam Smith noted, division of labor is limited by the extent of the market. So the pressure to extend exchange beyond internal specialization in a tribe created rewards to figuring out how to multiply transactions over greater distances and larger numbers of people who can specialize.

Market relations

Exchange, in the sense of barter, is cumbersome, and transaction costs can hinder all but the simplest exchanges. Barter requires a “double coincidence of wants,” where I want what you have but we can only exchange if I happen to have something that you want in exchange, and we can find each other.

Markets are a subset of exchange relations where institutions have emerged, or perhaps been created, to reduce the transaction costs of impersonal and geographically extensive exchange. Some widely accepted currency, an accounting system, a shared system of weights and measures, and a system for adjudicating disputes over contract breaches using rules that are consistent and predictable, all transform simple exchange into something else entirely. Markets enable the degree of division of labor to reach much greater elaboration, and create much faster growth in the wealth of market participants. Adam Smith’s observation that division of labor is limited by the extent of the market is a recognition that increasing returns are not only the source of wealth, but a requirement that commercial society evolves institutions to handle the increased volume of trade, and the commodification of many aspects of human activity.


The constraint on the expansion of markets is partly the difficulty of extending shared commercial norms over physical and cultural distances. But markets and their consequent division of labor can also be held back by a lack of liquid capital. Physical capital is the buildings, machines, tools, and technology that increase the productivity of labor and foster the creation of products and services. Liquid capital is the product of saving, or foregone consumption, that allows entrepreneurs to use abstract value in the form of money to give physical form to their conceptions of production. The genius of capitalism in the US can be seen in Silicon Valley or Wall Street, where “venture capitalists” accept shares of ownership in a potential venture after they provide the liquidity that the entrepreneurial founders need to give their ideas physical shape and structure. This conversion of the capital structure from liquid form, which could be invested anywhere, into physical form, which is now at risk because it cannot be easily turned back into cash, is both the source of profit and the source of risk in a capitalist system.

Capitalism, however, also creates concentrations of economic power because of the ability of successful investors and entrepreneurs to gather large amounts of wealth. Ownership in a capitalist system is both the mechanism for raising liquid capital—by selling shares that are claims against the value of future profits—and a means of controlling substantial resources independent from state direction and control. The private ownership of tools and materials that characterize a market system are on a much smaller scale than the ownership of land and a controlling interest in the shares of joint stock corporations. Nations that do not have the corporate form of private ownership are likely to run up against capital constraints, as it is difficult to generate liquidity on a scale, and in a time frame, that allows the successful exploitation of profit opportunities.

So, is China Capitalist?

Which brings me back to the question posed at the outset: Is China capitalist?  The answer is NO; China is a commercial market system, but it is not capitalist. China’s great increase in total wealth, and the widely distributed nature of that increase in prosperity resulting in an unprecedented decline in poverty, were the product of the adoption of market reforms starting in 1978. There were some early hopes that China might continue to evolve in the direction of capitalism, but the government has (correctly) seen that actual capitalism would create what are, in effect, countervailing centers of power in great concentrations of wealth in the hands of owners of corporations.

Markets are systems that produce wealth and sharply reduce poverty. Capitalism is a system for raising liquid capital and creating countervailing power centers that constrain totalitarian aspirations of government. As long as the Chinese state is primarily centralized and authoritarian, capitalism will be blocked. But that means that Chinese economic growth will be strangled, as capital becomes more and more constrained.

To paraphrase Abraham Lincoln, the Chinese commercial state cannot stand divided against itself. China will not cease to exist, but it will cease to be divided. It will become all authoritarian, or it will become capitalist. 

The post China: House Divided was first published by the American Institute for Economic Research (AIER), and is republished here with permission. Please support their efforts.

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