On Gao Yao Temple / Sheng Hong

Customs used to be as laws in far ancient,
Judge Gao Yao civilized people assisted with punishment;
Punishing was in order to no punishing,
It seemed not real that the jail of his drawing.
上古礼为法,士师刑辅教;
有刑期无刑,画牢似非牢。

Note: English is not my mother language. As a practice, this poem is translated from my poem in Chinese: 题皋陶祠。 I hope the experts who master both English and Chinese to offer me some suggestions.

Why is Random Selection More Effective than “Rational Selection”? / Sheng Hong

When people talk about the origin of life or intelligent creatures, they are always amazed at the extremely low probability of its realization, so some people take this to prove that if there is no intentional design with super wisdom, how can this happen? The implication of this hypothesis is that super intelligence can carry out rational design, and its success rate is much higher than the random choice of nature. In fact, this is a specious concept. The actual situation may be just the opposite.

We must first assume that this super wisdom is not a mysterious existence of super rationality, but only has higher rationality. At the beginning, we do not know the structure and parameters of creating life or intelligent creatures. We can design and create only after exploring the knowledge that can constitute life or wisdom. We already know that the probability of success of this life form is very small, for example, only one in 100 trillion. How can this super wisdom find such a small probability of knowledge? One way is to try at random until finding the right knowledge. Another way is to conceive the structure of a life form first, and then design a screening program according to this idea. Among the 100 trillion possibilities, 9999 / 10000 are screened away first, so there are 10 billion left, and then they are randomly selected here. Which of these two methods is more efficient?

At first glance, the latter method seems to be more effective. If true knowledge is hidden in the 10 billion possibilities screened by the program, even if the selected 10 billion possibilities are selected randomly or sequentially, it is 10000 times the efficiency of completely random selection of 100 trillion possibilities. However, if true knowledge is not hidden among these 10 billion possibilities, and people believe that the screening program is right, they will ever lose the opportunity to find true knowledge. If people design another screening program to choose the possibility outside of the last screening, in principle, it is no different from comprehensive random selection. The method of randomly selecting 100 trillion possibilities may be 10000 times slower than the previous method, but it will never lose the opportunity to find real knowledge. Thus, random selection is more effective than “rational” selection.

The question is, how the screening procedure of the above hypothesis came from. Designing this screening program also requires knowledge. To make this screening program effective, the best way is to know what the potential knowledge is, but this is a paradox, because this is the object to be found. Therefore, people think it is deliberate screening, but in the view of nature it is only a random choice. The key is that if people think that the screening program they design is better than random selection, it may lead to a worse result, that is, they miss the real knowledge. We call comprehensive random selection “neutral selection”, so all artificially designed screening procedures are “non neutral”. This means that one screening program may be biased away from real knowledge, while the other may be biased close to real knowledge. Which direction a screening program is biased in is just a random probability. So on average, deliberate screening is no more efficient than random selection.

So, since it is so difficult to find real knowledge, isn’t the scientific exploration since modern times deliberately looking for it? Haven’t people made great achievements? Isn’t it more effective than random selection? Since the probability of finding true knowledge is so small, hasn’t human society developed a brilliant civilization for thousands of years? First of all, it should be clear that successful science has only made some achievements in the field of simple systems. One is that the number of possibility rules of simple systems is small, and the other is that these knowledge can be observed directly. It seems that people choose deliberately. In fact, scientists find true knowledge after many failures, twists and turns. This process, in nature’s view, is actually random. Human civilization is indeed a complex system, but this complex system is developed from very simple rules, and the number of rule possibilities is not much. We now recognize that human civilization is not the design of a wise man, but originated from spontaneous order. This is a random choice.

For example, when Wolfram, the author of A New Kind of Science, experimented with the rules of one-dimensional ternary two-state Cellular Automata, he found a total of 256 possible rules. He was able to experiment one by one and found three interesting complex structures, and the rest rules were of little significance. When the rules are very simple, the number of possibilities of rules is relatively small. People can find them through experiments one by one. Although they feel that they are looking for them according to rational design, in fact, they later found that true knowledge is an accident, a random probability. Just as Michael Faraday found that electromagnetic induction was an accident. Usually, scientists put forward various hypotheses, then confirm or falsify them. If false, continue to improve the hypothesis or give way to another hypothesis. For example, the heliocentric theory negates the geocentric theory, and the oxidation theory negates the phlogiston theory. Or some complementarity is formed between several hypotheses, such as the wave theory of light and the particle theory of light, and finally the wave particle duality theory is formed. These practices, in a pure sense, are random choices.

Stephen Wolfram: A New Kind of Science | Online—Table of Contents

The rules formed in civilized society seem complex, but almost all of them are formed in the minimalist initial rules. For example, for a specific situation at each moment, people have only two choices as to what to do next. Yes or no, as time goes on, they form observable and orderly rules. This situation is similar to the one-dimensional ternary two-state model of cellular automata, and the number of possibility rules is relatively small. For example, in the securities market, everyone just decides according to the current situation whether to buy or sell or not to change the status quo (if they have held and continue to hold, if they have been short, continue to be short). If everyone goes on like this step by step, a complex price and quantity structure and time fluctuation series of the securities market will be formed. What human beings can do now is to know through experience which rules are effective, which are invalid and which are negative. Market rules are the rules discovered and mastered through the early trial and error process of mankind. This process is random. Hayek said the market was “discovered by chance”.

The basic rules of some complex systems are not as simple as the one-dimensional ternary two-state cellular automata model. For example, plants in nature should be said to be three-dimensional. Every step of plant growth must decide how to change in three directions: length, width and height. Once cellular automata is a little more complex, such as changing into one-dimensional ternary three states, there are 7625597484987 possible rules (Wolfram, 2002, page 60). When entering the two-dimensional level, the number of rule possibilities will further increase. There are 4294967296 kinds of rules for two-dimensional nine element two states only (Wolfram, page 213). If “in systems containing more than just a few cells, the total number of possible patterns is absolutely astronomical, and so enumerating them becomes completely impractical.” (Wolfram, page 217) It can be imagined that if it is a three-dimensional system, the number of possible rules is even more uncountable.

In this case, the method of sequential experiment by experiment is obviously not feasible. According to the above statement, it is not feasible to “rationally” design a screening procedure. Wolfram once designed a program to automatically search a huge number of possible rules of mobile cellular automata, added various parameters of how he expected mobile cellular automata to behave, and quickly searched 1 million possible rules, followed by 10 million. But he “got nothing”. So he removed these parameters. After a short time, he found two interesting patterns. He concluded, “The main challenge was always to avoid assumptions, and set up experiments that were simple and direct enough that they did not miss important new phenomena.” (Pages 112-113) This confirms our previous conclusion that random selection is better than “rational” selection.

Even in the aspect of minimalist behavior rules, as long as people can’t observe directly, people can’t find true knowledge through rational design in a large number of possible rules faster than random selection. For example, in human society, which is much simpler than animals and plants, no rule or system has been man-made so far. On the contrary, even when some organisms or self-organizations are formed according to these rules, such as market, village community or social order, people cannot know how the original basic rules were found because they did not see their origin. Hayek once said that the formation of spontaneous orders such as customs is ancient. People do not know when and how they were formed. The information contained in them is not fully understood and grasped by us. This is enough for Hayek to emphasize that most of the rules of human society are formed spontaneously, not artificially designed.

In comparison, plants and animals on earth were originated much earlier and grew in three-dimensional space. It is impossible for human beings to see their origin, and because the possibility of their formation rules is astronomical, it is impossible to find the true rules of their formation. Therefore, human beings are doomed to be impossible to create life. They can plant seeds and let them germinate, blossom and bear fruit. They can change plant characters by grafting. They can implant chromosomes in one cell into another cell. They can also imitate the formed life to synthesize a life, but they can’t create a new life type. It is said that Craig Venter’s team synthesized organisms in 2010, but bioethicist Arthur Kaplan commented that “Venter did not really create life.” because the formation of any life type is as if win a trillion awards, the probability is very low. If human beings look for it in order, it will take billion years, which is almost impossible in human society; to “rationally” design a screening program to speed up this process, as mentioned earlier, the result will be worse than random selection.

However, such time-consuming and permanent work can be done by Nature. It has plenty of time. The best way is to choose at random. We can imagine that in the huge experimental field of the universe, random choices are taking place in trillions of different places all the time. Because they are random, it is equivalent to trillions of experiments at the same time. Because the rules are simple, the experiment is not difficult. We can imagine that the vast majority and nearly all of the experiments failed. But after a long time, one random selection succeeded. From the perspective of time, successful behavior will show an orderly structure, just like the 30th, 90th and 110th rules of one-dimensional ternary two-state cellular automata, showing the pattern formed by one-dimensional space over time, which is a complex structure. The characteristics of this structure are: first, it can be repeated, but it is not simple repetition; second, it will form some coordination among multiple individuals. Due to the “use and disuse” evolutionary mechanisms, the structure of behavior in the time dimension will be transformed into the structure in the space dimension.

Behavior is the different forms of energy, and matter is the spatial structure of energy. This is very similar to the explanation of string theory. At the most basic level of matter, there are only some energy forms expressed as strings, or “energy strings”. Elementary particles are the spatial structure of strings. This spatial structure is mainly manifested in the repetition and coordination of energy behavior. “Repetition” is expressed as movement along a circular orbit or fluctuation at a certain frequency; “Synergy” is the connection and structure between strings. According to the same meta rule, countless elementary particles randomly choose the true rule to form quarks, electrons, protons and so on; atoms and molecules are formed according to the same meta rules. This is the emergence of the material universe, the solar system and the earth. The appearance of all these substances is related to the behavior of the basic individuals who form them, that is, the selected behavior. In the same way, a more complex spatial structure has emerged, which is the original organism.

This means that it is life and it can copy itself. Although the replication process is not very fast, it is a moment compared with the process of randomly selecting true rules. These primitive lives still follow the simplest meta rules and make random selection of behavior rules, that is, make behavior choices of yes or no, black or white, 0 or 1, and also conduct trillions of experiments simultaneously on the huge experimental field of the earth. However, this round of random selection is not a simple repetition of the initial selection, but is quite different. First, individuals are different. The original is still an inanimate individual, and the space of choice is relatively narrow; now it is life that makes choices, and the capacity of behavior is different. The space of choice becomes larger, and the complexity of behavior rules increases. At the same time, the possibility of behavior rules also increases sharply. There are many such levels from the simplest individual to the most complex life. For each level of complexity, the loop described above is repeated.

In the random selection at each level, most of the behavior rules are proved to be invalid or failed. Occasionally, one or two behavior rules are effective, so they are affirmed and continued. The organisms that adopt this behavior rule will develop. The organisms that do not adopt this behavior rule either stay in the original state or go to extinction. Once again, the time structure of the new selected behavior rules is transformed into the spatial structure of the organism, and the organism becomes more complex, and this organism change is conducive to the implementation of the selected behavior rules. Like Darwin’s theory of evolution, cattle ruminate, so they grow two stomachs; people have to think, so the brain has a large capacity. This rule has been like this from the beginning. Organisms that have evolved more complex will randomly explore the rules of behavior to adapt to new organisms in all directions, which has carried out a new cycle. The new behavior rules are determined, which leads to new changes in the body.

Of course, the behavior rules affirmed by nature are not necessarily one, but many. For example, even among the 256 possible rules of the one-dimensional ternary two-state cellular automata model, there are still three showing complex structures. So you can see all kinds of microorganisms, plants and animals, even people. These are the successful schemes of organisms with complex structures affirmed by nature in random exploration. In each change bifurcation, there will be a variety of choices. For example, although modern plants are ever-changing, most of their branches and leaves diverge at an angle of 137.5 º, indicating that after the plant ancestors chose this appropriate angle, a large number of different species appeared. Another possible situation is that a behavior rule with time structure and its system structure have been selected, and there is no opponent for a long time, but it does not mean that it is optimal, because a better rule and structure have not yet been selected. For example, the angle of antelope horn bending does not need to be the best, as long as it is better than its competitors, it can dominate. Moreover, there is no so-called pure optimization, only the optimization in a specific environment. This is what Darwin’s theory of evolution has revealed.

Some people argue that if it is a random choice, “it will take nearly 100 billion years to produce even a very simple pronuclear life.” This is absolutely impossible for the earth with a history of only 4.6 billion years. However, this view takes the probability of the emergence of known organic structures as the object of discussion. In fact, this does not refute Darwin’s theory of evolution. Evolution theory precisely means that all kinds of biological species in today’s universe have evolved from the simplest structure. That is, the evolution process is from simplicity to complexity. This is much easier than creating a complex system at once. According to Wolfram’s “new science”, nature begins with the simplest rules of behavior. That is, any individual randomly selects behavior rules. This rule allows the individual to make the next choice according to the current state. There are only two choices, yes or no, black or white, 0 or 1. Although the number of possible rules is also huge, it is much less than the number of possible combinations of alternatives to a prokaryotic life structure, and the probability of being selected is much higher. For example, there is only 10 to the 14th power.

This hierarchical evolution path greatly reduces the number of possible forms of behavior rules if there is no stratification, which itself saves the cost and time of random search and selection. This path was discovered by another author, Brian Arthur. In his book Complexity Economics, Arthur pointed out that the evolution of complexity has three forms. The first is called “growth of coevolutionary diversity”, that is, due to the formation and emergence of new individuals or “species”, it creates “niche”, which makes other individuals or “species” easier to generate, and they will produce new “niche”; there are interactive cycles as such (2018, P. 227). In other words, when the simplest individual is generated, it will bring convenience to the more complex individual generation in the future. Each level of complexity will have a similar effect in the future. Therefore, the most complex structure or “species” is not a super rational sacred design, nor can it be formed randomly out of thin air, but is formed step by step from simplicity to complexity, and it is the result of random selection in each level.

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In this way, the random selection of behavior rules generates life and intelligent creatures on earth. We have proved earlier that this method is more efficient than the “rational” choice method, that is, the method of rationalist constructivism. It is also much simpler than the random selection of the organism structure to prove creationism, so that the work of forming life and even human beings can be completed within the age of the earth. From the perspective of occurrence, the random selection of organism structure is fundamentally against common sense. If you can’t do simple machines, but directly do complex machines, it will be much more difficult than the step-by-step way. Comparing with the organism, behavior is easier to change. Therefore, evolution must start with behavior change, and then the organism adapts to behavior, not behavior to adapt to the organism. More clearly, the random choice of behavior rules is between “rational” choice and random choice of organism structure. Its success probability is so small that rational choice cannot be better than it, but often not as good as it; it is so  simple that it can form life and intelligent creatures in the  time-length of earth.

So, if rational choice is not as good as random choice, what is the use of rationality? The first and most important thing is to know that “rational choice is not as good as random choice”. This is not nonsense. This is the most important knowledge in human cultural tradition. Through his search for behavior rules, Wolfram found that randomness is the most important property to ensure the emergence of orderly structure. He said, “For essentially all purposes the only reasonable model for important new features of organisms is that they come from programs selected purely at random.” (Wolfram, Pp. 399). Randomness here is expressed as “freedom”, “nature” and “spontaneous order” in the existing human culture. We found that this is the most valuable part of human culture. Look closely again, they all contain the meaning of randomness. For example, “freedom” means not excluding any possibility, that is, it can develop in any direction, that is, there should be no restrictions, including those that seem “rational”. And “nature”, which directly excludes man’s deliberate action, is to make nature work, which is the role of random change. “Spontaneous order” is the order that excludes human rational design.

Here, we should distinguish between two kinds of randomness. Randomness is that, first, the probability of any choice is equal; second, the possibility of any individual changing in any direction is equal. However, the differences between individuals are different. For example, in the case of maximum entropy, the temperature at different points is the same, that is, the difference is very small, so the random selection here will not have any results, because each individual is almost the same. In another case, such as the big bang, the universe continues to expand, and the differences between individuals, including temperature and spatial location, are different or even expand. At this time, random selection is meaningful, because different choices have different results. Therefore, these two randomness can be called Big Bang randomness and Big Collapse randomness, or expansion randomness and contraction randomness respectively. In this paper, “randomness” refers to the former randomness. In this case, random selection is better than rational selection.

What else can reason do? First, the behavior rules of simple system are discussed. This is what science has done since modern times. Physical or chemical laws are the “rules of behavior” of simple systems. Because of the small number of possible rules, many scientists’ trial and error and Einstein’s genius conjecture are still useful. Second, imitate the simple system itself. Man-made simple systems can directly imitate natural simple systems, such as ancient houses; It can also be built according to the “rules of behavior” of simple systems, such as modern architecture. Third, explore the behavior rules of organisms, such as the origin of customs and DNA; simple imitation of the structure of an organism itself, such as a bionic machine. The so-called “simple imitation” is a much more rough imitation, which can only realize one or two simple functions of the imitated object, and must not be equivalent to the imitated object. If we cross this border, it will lead to problems and even disasters. For example, a simple imitation of the existing social order and structure and the establishment of a planned economy is a much worse imitation.

After organisms and social systems have been generated, random selection will be limited by the selection results. That is, it will exclude the negation of the selected organism or social system. That’s what Hayek meant when he said that freedom and order are two sides of the same coin. Order is the selected behavior rule. Following order is not the result of denying freedom, but the result of freedom. The human brain is the organic structure of the selected behavior rules, and its thinking is the affirmation of the brain structure. Therefore, the brain’s exploration of all behavior rules and system structures and following the results of exploration seem to be a negation of randomness, but in fact it is an affirmation of the results of randomness. Of course, any formed behavior rules or system structures also face variation and new choices. Therefore, nature does not rule out the changes of existing rules or structures. Therefore, when affirming the selected rules and structures, the brain will also hold a more tolerant attitude, that is, follow the rules but do not rule out a certain degree of deviation.

Then, is there still a God when we have proven that random selection can generate humans? In fact, God is another way of saying that man is limited. As mentioned earlier, the random selection of behavior rules is much simpler than the random selection of organism structure, so the earth has enough time to develop people; however, the random selection of behavior rules is more effective than rational selection. The possible number of behavior rules greatly exceeds the ability of human beings to choose one by one, so it is beyond human rationality. So it still highlights the limitations of human beings. And who arranged the real rules of behavior hidden in hundreds of millions of possibilities? What rules does this arrangement follow? This is still a bigger mystery. Those random choices in nature, those social orders formed spontaneously when human beings are ignorant, human beings only know these things, but do not know how they are formed; it can only be named “spontaneous order”. The visible spontaneous order may not be the best. The natural law hidden behind may never be known by mankind. Therefore, after proving that random selection is more effective than rational selection, people should still be in awe of the omniscient existence.

(Stephen Wolfram, A New Kind of Science, Wolfram Media Inc., 2002.

Brian Arthur, Complex Economics, Zhejiang People’s publishing house, 2018.)

At Five-woods Study on January 30, 2019

The Chinese version of this essay was published firstly in the fourth issue of 《读书》(Readings)in 2019

On the Song of Beating Soil when Yao Visited to Kang Village / Sheng Hong

To Kang village Yao visited,
For farmers he was too good to be recognized;
They still sang the song of beating soil,
the emperor's force we don't feel.
唐尧访康庄,太上民不知;
犹唱击壤歌,帝力我不识。

《击壤歌》:日出而作。日入而息。凿井而饮。耕田而食。帝力于我何有哉。

Song of Beating Soil: Work while sunrise. Sleep while sunset. Dig a well for drink. Farm for eat. Is there Emperor’s force to me?

Note: English is not my mother language. As a practice, this poem is translated from my poem in Chinese: 尧访康庄之《击坑壤歌》。 I hope the experts who master both English and Chinese to offer me some suggestions.

Visit of Musuem of Jin / Sheng Hong

In Xiao mountain Strong Qin feard,
Around palace wall the branched families of King's Family dead;
Poorly Jin State was busy for 600 years,
Wasn't what it did for the three families who made the Jin divided?
崤山强秦惧,萧墙公族亡;
可怜六百载,岂为三家忙?

Note: English is not my mother language. As a practice, this poem is translated from my poem in Chinese: 观晋博。 I hope the experts who master both English and Chinese to offer me some suggestions.

A Theory of Partial Property Rights and the Illusion of State-Owned Enterprises / Sheng Hong

Abstract: State -Owned Enterprises (SOEs)do not pay profits and rents, they pay much less interest than other types of enterprises, and they have monopolistic power, but they are not subject to restrictions on labor (including management) income, which seems very attractive. Because this very substantial benefit is not transferred to certain individuals, there is competition for this benefit. However, the competition for senior manager positions attracts individuals whose probability of being convicted of a crime is 94 times higher than that of executives of private enterprises; thus, it seems that the position of senior manager in an SOE with very substantial benefits is actually risky, and the expected benefits are much smaller than the intuitive benefits and are not worth fighting for. Once the illusion of SOEs is punctured, SOE leaders with higher education and long-term vision may become the driving force of SOE reform.

1、 Question raised

In the 40 years of China’s reform and opening-up, SOEs have played an important role. In the early stage of the reform, in which SOEs dominated, the reform of SOEs was related to social stability and the rate of economic growth. However, from the late-1980s to the 1990s, under competition from township enterprises, private enterprises and foreign-funded enterprises, SOEs faced a dilemma. Given that SOEs still bore the heavy responsibility of employment and economic development and lacked exit mechanisms, an important task at that time was that “SOEs extricate themselves from difficulties”. Finally, at the end of the 1990s and the beginning of the 21st century, a way out of the difficulties was discovered, which was to use nonmarket forces.

Of course, nonmarket forces are mainly government forces. In China, executives of SOEs and officials of administrative departments belong to the category of government officials, and their status are interchangeable. Thus, they are members of the same interest group. Today’s top executive of a central enterprise may become the vice governor of some province tomorrow. Likewise, administrative officials in charge of SOEs can become senior managers of SOEs one day. However, in China, the formulation of important economic policies and the granting of monopoly power are usually decided by the relevant administrative officials without the approval of the legislature. In the absence of constraints, administrative officials will make policy decisions that are beneficial to themselves but not to society. Although it is not convenient for them to use their power to directly act in their own interests, they can create a kind of “collective welfare” with their power, and each official is a member of the collective. “Making effort for collective welfare” is a virtue in the circle of officials and executives. A person is a hero if he or she strives for more benefits for the group. Therefore, administrative officials use their power to seek welfare for SOEs and thus indirectly pursue their own welfare, which is a behavior that is somewhat concealed.

Their efforts were “successful.” In December 1993, the State Council issued the “Decision on the implementation of the tax-sharing financial management system”, which proposed that “as a transitional measure,” most of the old state-wholly owned enterprises registered before 1993 did not need to hand over their after-tax profits in the near future according to specific conditions. It was not until December 2007 that the Ministry of Finance and the State-owned Assets Supervision and Administration Commission (SASAC) jointly issued the Interim Measures for the Collection and Management of State-owned Capital Gains of Central Enterprises, which stipulate that the SOEs of the central government should turn over their profits pursuant to a three-tier system, with a maximum of 10% and a minimum of zero. In fact, the profits turned over by SOEs are returned to the SOEs in their entirety in the form of investments or subsidies. For example, from 2008 to 2019, SOEs handed over profits of 2248.9 billion yuan, while the investments in or other subsidies to SOEs totaled approximately 1842.1 billion yuan. The difference is 406.8 billion yuan, which is equivalent to 2% of the total net profit of 20584 billion yuan in the same period; this result is not different from what the result would have been if no profit had been handed over. This means that, as a whole, SOEs do not pay in their profits.

Almost all the SOEs established in the period of planned economy use land allocated by the planned authority without charge. Since the reform and opening-up, the land institutions of SOEs have not been marketized, that is, they are still owned and used by the SOEs and can even be rented to obtain rental income. Only when SOEs enter into joint ventures with other enterprises do state-owned lands need to be priced as part of the SOEs’ assets. When SOEs are listed, state-owned lands are priced and become the assets of the listed companies. However, state-owned land is often regarded as a kind of land use right and is evaluated as zero due to the uncertainty of its duration. Another exception is that listed companies can rent land from their state-owned parent companies and pay rent, which is generally much lower than the market rent rate. On the whole, the land rent paid by state-owned listed companies stays within the SOEs. According to our estimation, in 2013, the allocated land occupied by state-owned industrial enterprises totaled approximately 26091 square kilometers, and the corresponding unpaid land rent was 547.9 billion yuan (Unirule Institute of Economics, 2015). Therefore, it can also be said that SOEs do not pay land rent.

As the banking industry is monopolized by SOEs and SOE groups have strong political power, the loans of state-owned banks are mainly to SOEs. According to the relevant statistics, in 2018, the loan balance of SOEs accounted for 85.08% of the total state-owned bank loan balance (Wind Information, quoted from Lujiazui Financial Port, 2018). Since the interest rate of state-owned banks has been the regulated interest rate for a long time, the interest rate difference between deposits and loans is relatively fixed, to the benefit of state-owned banks; the interest rate difference is 1-1.5 percentage points higher than that in market economy countries, that is, 50-100% higher. On the other hand, to take care of the interests of SOEs as borrowers, the deposit interest rate is lowered, which causes huge losses for depositors. Due to the large scale of SOEs, they are in an advantageous position in financial transactions with other enterprises. They often postpone payments to suppliers or ask buyers to pay in advance, so there is a large amount of commercial financing. According to Liu Xiaoxuan and Zhou Xiaoyan (2011), from 2000 to 2007, SOEs were only required to pay 1.6% of the financing rate, while the market interest rate was approximately 4.68%, or 2.92 times greater than the SOE financing interest rate. In other words, SOEs only paid financing costs at 34% of the average market interest rate.

In the banking, oil, telecommunications, railway, power and salt industries, SOEs have monopolistic powers. Most of these monopolistic powers are not granted by the legislature but established by an administrative document of the executive organ. In many cases, the implementation of monopolies depends on the control of price and the entry of government departments. Therefore, monopoly and government regulations are mutually coordinated. In the field of oil products, for example, the National Development Commission sets prices. According to our estimation, in 2013, the pretax price of China’s oil products was 16.7% higher than the average price of oil products in major countries; thus, monopoly enterprises gained monopoly profits of 301.5 billion yuan. Another example is banking. Based on the 50% difference between the normal interest rate and the monopoly regulated interest rate, the monopoly income in 2013 was approximately 483.5 billion yuan. When the losses that we can estimate from the monopolies of the banking, oil, telecommunications, railway and salt industries in 2013 are added up, they total approximately 2273.4 billion yuan (Unirule Institute of Economics, 2015b), or 4.8% of the total operating income of SOEs in that year, which was higher than the SOEs’total profits of 19000 billion yuan in that year. It can be said that SOEs can obtain monopolistic power to increase their income by an amount equivalent to at least 4.8% of their operating income, or 21.8% of the added value of the manufacturing industry calculated by 22% of the added value ratio of the manufacturing industry.

Of course, SOEs still have the advantage of low-cost access to natural resource exploitation rights, they often receive government subsidies even if they make book profits, and they pay enterprise income tax at a rate of approximately 10%, which is significantly lower than the statutory rate of 25%. To simplify the discussion, we will ignore these policies that favor SOEs.

Conversely, the “Opinions on deepening the reform of personnel, labor and distribution systems within SOEs,” issued by the State Economic and Trade Commission in 2001, provides that “under the state’s macrocontrol, the wage level of enterprise staff and workers shall be determined by the enterprise on the basis of the local social average wage and enterprise economic benefits.” The basic meaning of this provision is that the income of the labor force, especially the managerial employees, of SOEs is actually unlimited. Since 2015, the central government has imposed restrictions on the salaries of senior managers of central enterprises, and the upper limit is not more than 8 times the average income; however, this relative proportion restriction can be avoided by raising the salary of management through an increase in the average income and can also be bypassed in the form of nonwage benefits or even noncurrency benefits. Managers can also enjoy benefits through on-the-job consumption and consume rent by reducing their efforts. In short, there is still no real restriction on the income of labor forces.

Thus, we have provided a rough description of SOEs. In summary, an enterprise may not pay land rent or its net profit, may only pay 34% of the market interest rate, and may obtain monopoly income equivalent to 21.8% of the added value, while the income of the enterprise’s labor force is not limited. The problem is, if there is such an enterprise, how will people behave? This is a question of institutional economics. The purpose of this paper is to analyze such an enterprise using the method of institutional economics, verify whether the result is correct, and roughly estimate the kind of behavior this enterprise will lead to and its impact on China’s reform and opening-up and political and social trends.

2. Theory of partial property rights

Imagine an enterprise in a pure market where the prices of its various factors are determined by the market and paid to the factor owners. Now suppose that there is a government that regulates the price of one of the factors; for example, the government sets the rent rate of land as two-thirds of the original rate. This is exactly what Professor Steven Cheung discussed in his book, The Theory of Share Tenancy, that is, the rent reduction of the “three seven five” in Taiwan, through which the land rent rate was reduced from 56.8% to 37.5% (2000, P. 88).

One question is who will obtain the reduced rent. Steven Cheung discussed two situations. The first situation is that a landowner’s land is vacant, and anyone can compete to rent the land to obtain the additional benefits brought about by the rent reduction. In other words, the reduced rent does not belong exclusively to a particular person. In this scenario, to obtain an additional 1/3 of the land rent above the original labor income, more tenants compete to rent the land, and the landowner is willing to increase the number of tenants because of the lack of 1/3 of the land rent. This changes the original optimal allocation of land and labor formed under the market by increasing the amount of labor under the condition of an unchanged amount of land. In this case, the total output will increase, but the marginal productivity of the labor will decrease. On the whole, it will cause a loss of resource allocation. This efficiency loss is equivalent to reduced rent. In other words, the benefits that rent reduction seems to bring to tenant farmers are all dissipated in the competition for rent because rent is not an exclusive interest.

In the second situation, the reduced rent is clearly and exclusively transferred to a specific individual. For example, a landlord clearly transfers this part of the rent to Peter. Regarding this scenario, Steven Cheung stated that if “the portion of rent were assigned exclusively to an individual tenant (tenants), say, through the issuance of stocks against the market value of the given land, joint ownership of the land would be established. With the entire return to the ownership right assigned to private parties, each joint owner would thereby be granted authority to make decisions concerning his share of the resource. “(2000, P. 116) The result is just like a transfer of property rights, which does not weaken the property-rights institution. “Therefore, the use of resources after rent reduction is exactly the same as that before rent reduction.” In other words, the efficiency of the allocation of resources will not be reduced after the transfer of land to specific individuals.

The distinction made by Steven Cheung is actually based on the theory of property rights. In his opinion, if a rent reduction regulated by the government is not transferred to specific individuals, then the interests represented by that part of the rent have no property owner. In this situation, people’s behavior is similar to the competition for ownerless resources, and the rent value of the resources ultimately will be dissipated. If the rent reduction is clearly transferred to specific individuals, then the interests represented by that part of the rent are subject to a clear, exclusive property right, and people will act as they would in a situation with clear property rights. That is, the issue of rent reduction is a property rights issue. However, in this situation, if the income from the property rights is restricted and there is no exclusive right to the restricted income, there will be no rights to a certain proportion of the original property rights. In other words, this is a “partial property rights issue”. According to Steven Cheung, “[a]ttenuating the right to derive income from resource use on a percentage basis will produce the same effects as attenuating the exclusive right to use the resource. “(2000, P. 115)

In another article, “The Structure of a Contract and the Theory of a Non-Exclusive Resource”, Professor Steven Cheung argued that if a bounded resource does not have exclusive property rights, people will freely enter into the market to compete for the rent value until the rent value dissipates to zero (Steven Cheung, 1970). See the figure below.

Figure 1 Process of rent dissipation

Note: Suppose there is a bounded fishing ground where Q/L and ( Q/ L) are the average and marginal income curves, respectively, and W is the market wage rate. When the fishing ground is exclusively owned by one person, the optimal amount of labor input by the fisherperson (α) is L1, which is determined by the point where his or her marginal income curve ( Q/ L) α) is equal to the wage rate (W); the maximum rent obtained is ABCD. However, if the fishery does not have exclusive property rights, anyone can enter freely. When the second fisherperson (β) enters freely, he or she will reduce the rent value of the first fisherperson, and the latter will reduce his or her input. The joint input of the two people is L2, and the rent value of the two people is AEFG, which equals half of the rent for each person. The total rent value and average rent value are significantly lower than those values when there is one person. When the third person, the fourth person, etc. enter, the total rent value and average rent value will gradually decrease until they are completely dissipated (Steven Cheung, 1970).

Obviously, rent reduction can be generalized. “Rent reduction” can be broadly understood as a restriction on the income of resources. Resources can include capital, land, money, natural resources and even labor. The restriction can range from 1% to 100%. Based on this definition, we can analyze all similar phenomena. That is, when a government controls the price of resources formed by a market, a similar phenomenon will appear. For example, in the regulation of the income of capital, the reduced part of the income is equivalent to the restriction of the property rights of the original owner. As the limited part increases gradually from 1% to 100%, the original owner’s property rights gradually decrease proportionally until the property rights are completely lost.

However, whether the reduced part of the rate of return on resources is transferred unexclusively to uncertain competitors or to certain individuals exclusively affects the result of the restriction. These are two extremes. The outcome in the former situation is equivalent to the resources being without property rights; people will rush in for free use, and the resource rent will soon be dissipated. The outcome in the latter situation is equivalent to the resources being subject clear property rights; people will use the resources as if the resources are subject to normal property rights and thus will not cause rent dissipation. Between these extremes, there is a broad, continuous spectrum. People will try to establish a certain degree of exclusiveness to occupy and retain the rent created by the government regulation, thus producing a variety of complex behaviors and consequences. In the extreme situation in which many competitors compete for ownerless resources, the result is that the difference between the regulated price and the market price is completely dissipated; in the extreme situation of the exclusive transfer of the price reduction to specific individuals, there is no efficiency loss. In the situations between the two extremes, part of the rent will dissipate, and some will be retained through various ways or means.

Steven Cheung cited such an example. The British Hong Kong government once regulated the rent of residential buildings to 1/10 of its original value. Steven Cheung predicted that the depressed 9/10 rent value would dissipate but later found that the rent value was still 3/4 of its original value. After investigation, it was found that the owners sublet or built wooden houses on rooftop to retain part of the rent (2000, F25 ~ 28). I call these two ways “neighboring contracts”. That is, besides the object range of the government’s price control, part of the rent was retained by forming a contract. For example, subletting means that a house owner rents the house to a secondary house owner according to the price regulated by the government, and the secondary house owner divides the house into several smaller units for rent, which are not subject to government price control. There is competition between secondary house owners, so they will transfer part of the rent left over to the original house owner in other ways. For example, the original house owner can charge higher fees for furniture in the rental rooms. A wooden rooftop house is a kind of wooden house built on a roof; these houses are not regulated, so they can compensate for the rent loss of the house owner.

In an article entitled “A General Theory of Rent-seeking”, I divided the methods of retaining rent into two general categories. One category is called the “contract mode”; that is, under the premise of price control, two parties agree to retain the rent. Of course, since the price regulations do not allow this kind of situation, it is not protected by law. In addition to the abovementioned subleases and wooden rooftop houses, there are also things such as selling food coupons during the planned economy period, sending red envelopes to doctors, patients in remote areas going to large cities with extensive medical resources, administering college entrance examinations to immigrants, cooperating with monopolistic enterprises, and providing retail or services for monopolistic enterprises. The other category is called the “government mode”, which uses government power to gain certain exclusive power in the competition for rent value; this rent value may be dissipated due to regulation, such that some rent value is retained. For example, officials put their children in famous schools by paying “management fees” or bribing officials and thus obtain part of the rent value by entering the areas controlled by the government (Sheng Hong, 2016).

In fact, there is a wide range between the two extremes, with or without property rights over the regulated part, allowing people to use various means to retain the rent values to be dissipated, which leads to tortuous and complex individual situations. In turn, these complex stories can be logically linked together to provide a powerful explanation. Of course, this includes SOEs.

3. Analysis of SOEs under the theory of partial property rights

According to the logic in the previous section, we will summarize SOEs again. At present, China’s SOEs are described as follows:

1. For the capital factor, the regulated price is zero; that is, the price is reduced by 100%;

2. For land resources, the regulated price is zero; that is, the price is reduced by 100%;

3. For monetary resources, the regulated price is 34%; that is, the price is reduced by 66%;

4. Through monopolization, SOEs increase the price of their products by 4.8%, which is equivalent to 21.8% of the added value;

5. There is no limit on the price of labor (including management).

Professor Steven Cheung’s theory of price control and theory of partial property rights can be applied to this type of enterprise. In other words, what is the result if the prices of capital, land and money are regulated but the price of labor is not regulated?

We first assume that controlling the price of the nonlabor factors is equivalent to increasing the income of the labor factor. Without any barriers to entry, and with free competition of labor, what will happen? According to Steven Cheung’s theory, the extra benefits will be dissipated by the competition.

According to our estimation of the industrial added value of SOEs from 2001 to 2013 (Unirule Institute of Economics, 2015), we convert the income of various factors and the monopoly income into the share of industrial added value, but the income share of the labor factor is the surplus after deducting the income share of all of the other factors. Assuming that the share of income distribution is determined by marginal productivity, then the share of labor may be negative, as shown in the figure below.

Figure 2 The share of labor income after deducting the share of income of various factors and the monopoly income in the added value

Considering the current situation of SOEs, in which the industrial added value remains unchanged, if the shares of business profit (i.e., capital return) and land rent are reduced to zero, the interest is reduced to 34% (that is, 5.2 percentage points), and the monopoly income is reduced to zero, then the share of labor income will increase by 61.2 percentage points to 53.9%. See the figure below. The 61.2 percentage-point-profit is the rent generated by the system of SOEs, so it can be called “SOE rent”.

Figure 3 The share of labor income after reducing the shares of capital, land and monopoly income to zero and the share of monetary income to 34%

We construct a production function of SOEs according to the Cobb-Douglas production function:

Y=K0.7*L0.3

We take the total assets of SOEs in 2018 as the base of the fixed amount of capital investment (k) in the above production function. Labor input (L) is a variable.

If SOEs openly recruit according to market rules, people will flood in; “SOE rent” is similar to ownerless property, dissipating in competition, as shown in the figure below.

Figure 4 Schematic diagram of the labor force freely entering state-owned enterprises

Note: The horizontal axis represents the number of workers, and the unit is one million people; the vertical axis represents marginal income or marginal cost, and the unit is 1 trillion yuan. In the absence of these restrictions on the price of nonlabor factors, that is, no “SOE rent”, the number of workers is approximately A; when there is “SOE rent”, if people can freely enter the SOE, the number can be as high as B. In that case, the marginal productivity of labor is reduced by C multiplied by B-A, which is approximately C (B-A). These values have been completely dissipated.

However, SOEs have less open recruitment, so the above assumption does not appear. Therefore, do SOEs have exclusive access to the benefits from the regulation of the prices of capital, land and other factors, as Professor Steven Cheung said? If so, the efficiency of resource allocation will not be reduced.

We find that SOEs are not enterprises into which the labor force can freely enter, nor are they composed of individuals who hold clear exclusive rights; they are in a certain intermediate state. Theoretically, SOEs are enterprises owned by a state, so no one has exclusive property rights. Employees, especially managers, of SOEs are labor factors employed by property owners. None of them will stay permanently in the SOEs. In particular, managers are more mobile. Similarly, SOEs are not allowed to be entered at will, and managers also have a certain term of office, during which they can actually determine the distribution share of income. Therefore, an SOE’s existing employees and managers can obtain part of the “SOE rent”.

Thus, the actual SOEs in the study demonstrate an intermediate state. First, there is a certain degree of redundancy, but it does not affect the amount of the labor force that should be free to enter, such as in the case of B mentioned above. Accordingly, the rent brought about by the price control of the nonlabor factors does not completely dissipate in the competition but is partially retained. This part is approximately equal to the amount by which the average income of employees in SOEs is higher than that in other enterprises. For example, according to our estimation, in 2013, the average income level of employees in SOEs was 330% higher than that of employees in non-SOEs (Unirule Institute of Economics, 2015). In an ideal labor market, the average income of employees in SOEs should be equal to that of employees in other enterprises.

In summary, China’s SOEs are enterprises that can be 100% free of capital costs, be 100% free of land rent, pay only 34% of monetary costs, and obtain a monopoly price 4.8% higher than the market competition price. Such an enterprise has a large “SOE rent” and attracts a large number of people to enter. However, in the existing system, it is impossible to enter completely freely. Therefore, these SOEs are in the intermediate state identified by Professor Steven Cheung. The controlled parts of the factor prices are not subject to ownership, but the competition for them is restricted. As a result, part of the rent created by the regulations is dissipated, and the rest remains and is occupied by the current SOE management and employees, making their average income level significantly higher than that of the average income in other enterprises.

4. Seeking and limiting of “SOE rent”

Since this kind of enterprise has so many advantages, it is natural for people to flock to it. However, newcomers cause the “SOE rent” originally enjoyed by the existing employees or management to be divided, so the existing personnel do not want people to flood into the SOEs without limit. Therefore, SOE employment and personnel systems are formed in the fight between these two forces. On the one hand, the issue of redundant staff in SOEs is serious; the number of technical and managerial-level staff in SOEs obviously exceeds a reasonable number of employees in those positions. On the other hand, the existing management and staff in SOEs resist the employment of a large number of external people.

For the issue of redundant staff, we compared Sinopec with Shell Company, two companies with similar sales volumes. The former has 9.6 times more employees than the latter (Unirule Institute of Economics, 2013). If Shell’s staff size is appropriate, Sinopec’s redundancy is approximately 90%.

In contrast, SOEs consciously control their numbers of employees. For example, the total assets of nonfinancial SOEs was 116.2 trillion yuan in 2014 (Li Yang, 2015) and 210.4 trillion yuan in 2018 (State Council, 2019), which equals an increase of 81%, while the number of employees in nonfinancial SOEs decreased from 45.81 million in 2014 to 38.22 million in 2018, which equals a decrease of 19.8%. In other words, the number of employees per unit of assets decreased from 390 per billion yuan of assets to 180 per billion yuan of assets. This is remarkable.

Therefore, are there redundancies in SOEs or not? Specifically, in light of the very substantial benefits of exempting capital costs and land rent and paying only 34% of loan interest, the management of SOEs can adopt more complicated personnel systems. They should not only retain the very large rents but also let their relatives and friends enter the enterprises to share the benefits and ensure that the SOEs’ work is completed. The observations of some enterprises, such as PetroChina, show that there are three kinds of employment systems, namely, contract employment, market-oriented employment and labor dispatch. So-called contract employment refers to the employment of the original employees and important technical and management personnel of an enterprise, that is, the formal employees of the enterprise; contract employment is actually a special contract deviating from market pricing. So-called market-oriented employment refers to the recruitment of unemployed children and college graduates through talent centers. So-called labor dispatch workers are personnel exported to the oilfields through third-party labor service companies and are mainly recruited from the public. The wages of the latter two kinds of personnel are mainly determined by the market pricing of the labor force. In terms of personnel salary and income, contract employment ranks the highest, and the income in the market-oriented and labor dispatch systems is approximately 1/4 to 1/2 of the income in the contract employment system (Unirule Institute of Economics, 2013).

Although there are people who are employed based on power or relationships, due to the limitation of the number of regular employees, there is no excessive redundancy in the total number of employees. However, these people can actually use those who are employed in the market to perform practical work while enjoying the advantage of SOE rent. Their income includes not only wages and capital but also nonmonetary material income, such as low-cost housing and on-the-job consumption. We take market-oriented employment and labor dispatch as one kind of employment. We assume that the employees’ income is half that of regular employees, or only slightly higher than the market price of the labor force.

Figure 5 The number and income of regular employees and market-recruited employees under the two employment systems of SOEs

Note: In the figure, the marginal labor cost of SOEs refers to the marginal labor cost of people who have the status of formal employees of SOEs. It refers to the income level of SOEs; the marginal cost of labor in the market is the labor price in the market. The equilibrium number of formal employees in SOEs is at point A, where the marginal output of labor intersects the marginal cost of formal employees of SOEs. However, due to the existence of “SOE rent”, people can obtain more income at point A, so there will be a large number of people pouring in, which will make the equilibrium point move in the direction of B. However, the addition of employees will be resisted by the existing employees and will not exceed point B. The equilibrium point should be at point C, between A and B. While full-time employees enjoy the benefits of “SOE rent”, SOEs can also employ workers according to the labor market price. These people, called labor dispatch workers, will decide whether they enter the labor market according to the market price of labor and will not stop entering until equilibrium point D. They do not enjoy the benefit of “SOE rent.”

Therefore, to maintain the maximum interests of its regular employees, an enterprise should control the number of regular employees at point A in the figure above and enjoy the benefit of “SOE rent”, which is equivalent to the dark gray rectangle in Figure 5. However, such substantial interests will attract outsiders to enter. To enter, these outsiders must have the power to make the SOEs obey or have some relations; some people even pay to buy the right to enter an enterprise as regular employees. Therefore, employees in SOEs cannot be controlled within point A but will expand to point B. As the number of people increases, the per capita “SOE rent” will decrease, so within point B, there are two opposing forces. Suppose the final number of regular employees is at point C, between A and B. In this situation, due to the decline in marginal productivity, some “SOE rents” have been eaten up, and the remaining marginal “SOE rents” are reduced. The total amount is shown as the light gray rectangle.

In addition, on the basis of such substantial assets, new labor will bring positive marginal productivity to an SOE and increase the SOE’s total output. Therefore, enterprises will recruit employees at a slightly higher income level than the labor market price. However, these market-oriented employees cannot enjoy the income level of regular employees; that is, they cannot participate in the sharing of “SOE rent” and can only obtain a wage level approximately equal to their marginal productivity. In this case, the number of employees in SOEs can theoretically be increased to point D. Since SOEs generally control quantity even if they recruit in the market, the actual number of SOE employees may be lower than the above estimate. We already know that the number of employees in nonfinancial SOEs is approximately 38.22 million. However, we now know that dispatched workers are not included in the statistics of employees of SOEs. It is said that there are approximately 60 million dispatched workers. These dispatched workers are part of the employees of SOEs who cannot enjoy SOE rent. The two numbers add up to approximately 100 million people. Including these workers is equivalent to extending the number of personnel in SOEs to point D.

5、 The game of management

Among regular employees, there is also a group of people who are the largest beneficiaries of “SOE rent”. They are the managerial employees. They are at the top of the employee hierarchy in SOEs and determine their own income. Even when the central government limits the annual salary level of SOE executives, they can still obtain the benefits of “SOE rent” through nonmonetary income such as housing and on-the-job consumption.

Figure 6 Schematic diagram of SOE management obtaining “SOE rent”

The gray bar at the bottom of the above figure represents the SOE rent obtained by regular employees other than management; the gray box at the top left is the SOE rent obtained by management. Suppose there are 200000 people in management positions in SOEs, and they enjoy SOE rent of 500 billion yuan. This is a very substantial benefit, attracting thousands of people to come in and fight for it. A simple logic is that if you want to enter the management team of an SOE, you have to reduce the number of existing management personnel. There are two ways to achieve this: one way is to change the post in a normal manner, and the other way is to withdraw the existing management staff in an abnormal manner. At present, China’s SOEs have a normal system of turnover of senior managers, whose tenure is generally three years. This length seems to reflect the urgent mood of the people outside the SOEs who want to enter, and it is applied to the political process to form this shorter term. Of course, some executives can hold three consecutive terms in their SOEs. In any case, however, the three-year term gives outsiders a chance to enter. This leads to the frequent replacement of senior managers in SOEs, especially in central enterprises. For example, in 2018, at least 97 heads of central enterprises were transferred. However, there were only 96 central enterprises; thus, the average transfer rate was 100%.

Even so, the term seems too long. Another way to eliminate incumbents, the data suggest, is to impeach them on the basis of corruption or serious mistakes. There are two reasons why this elimination tactic may be successful. First, the executives of SOEs realize that the three-year term is too short, so they may take illegal actions to obtain benefits in addition to their legal income. According to an analysis by the China Entrepreneur Crime Prevention Research Center of Beijing Normal University, corruption crimes of SOEs, including bribery, corruption, misappropriation of public funds, private division of state-owned assets and duty encroachment, account for 81.3% of all kinds of crimes, while the proportion of such crimes committed by private enterprises is 30.7% (Hexun Mingjia, 2018); this difference obviously reflects the property rights characteristics of SOEs. That is, SOE executives will take all kinds of legal or illegal actions to obtain benefits for themselves in the case of the temporary exclusion of outsiders from the rich benefits of “SOE rent”. Because their terms are not long, they often look at the present, underestimate the negative consequences and engage in crime.

Second, their positions are coveted by powerful administrative officials, who use political means to influence the judiciary and frame SOE managers. They do this because SOEs are economic entities with “SOE rent”, and they are eager to squeeze in. There is a possibility that some people will take advantage of their public power to frame the current enterprise leaders in order to seize positions in SOEs with rich interests.

In any case, the result is that executives of SOEs are more likely to be convicted. Moreover, according to the above logic, the richer an enterprise is, the higher the probability of its senior executives being convicted; the higher the position of the executive, the more likely the executive is to fall. For example, because of monopolistic and other preferential policies, the oil industry has a high crime rate. For example, from 2014 to 2015, 12 senior executives of “three barrel oil” companies, including PetroChina, Sinopec and CNOOC, were convicted of crimes (Legal Evening News, 2015). Sinopec has had three consecutive general managers, Chen Tonghai, Wang Tianpu and Su Shulin, who have successively fallen out (Cheng Zhen, Lu Mengjun, Guo Chen, 2015). According to statistics on this issue, from the date of the 18th National Congress of the Communist Party of China to November 2015, a total of 171 senior executives of SOEs were convicted, including the following: 15 chief accountants and office directors, accounting for approximately 9% of the total number; 52 deputies and other team members, accounting for approximately 30%; and 104 presidents, general managers or party secretaries, accounting for 61% (Zhao Zhenyu, 2015). Obviously, the higher the position held by the employee, the higher the probability of being convicted.

Figure 7 Frequency of SOE executive convictions (from the date of the 18th CPC National Congress to November 2015)

According to the statistics of the China Judicial Document Network, from December 1, 2013, to November 30, 2018, 2337 entrepreneurs committed crimes, including 1569 private entrepreneurs and 768 SOE executives (Hexun Mingjia, 2018). In 2017, the number of SOEs was only 1946, while the number of non-SOEs was as high as 371054. Assuming that each enterprise had 10 executives, the probability of being convicted for SOE executives was 0.039, while that for private entrepreneurs was 0.0004. The crime rate of SOE executives was 94 times that of private entrepreneurs. Although the scale of SOEs is relatively large and the number of branches of an enterprise may be several times greater than that of private enterprises, the senior managers of SOEs are not only individuals but also have the characteristics of a “recessive family”. A person’s corruption or collapse often manifests as a “family case”, which involves a group of people. As mentioned above, the higher a person’s position is, the higher the person’s probability of being convicted. As shown in the table above, assuming that an SOE has 10 executives, the top 2 of which are leaders (the president, general manager or secretary of the Party committee), the probability of the top leaders being convicted is 623% greater than that of the other executives and 307% greater than that of the average-level employees.

In this situation, on the one hand, SOE executives should act cautiously; on the other hand, they should take measures to prevent being replaced or framed. There are generally two courses of action. One course is to strive for more political resources because the appointment and removal of SOE executives are not within the SOEs but within the political process. The senior managers of central enterprises are generally appointed and removed by the Organization Department of the CPC Central Committee, and the senior managers of local enterprises are appointed and removed by the organization department of local Party committees. The organization departments’ rules for appointment and removal are not the rules of the enterprise or the market but the political rules. Therefore, it is impossible for an executive of an SOE to believe that his efforts to do well in the enterprise and obtain more profits are the means to keep his position. SOE executives even engage in bribery for political resources or asylum. For example, in the case of Liu Zhijun, Ding Shumiao spent 44 million yuan to be the “rescuing person” for Liu Zhijun and 5 million yuan to serve Liu Zhijun as secretary of the provincial Party committee, and he arranged for a certain person to continue bribing relevant departments (Beijing Morning Post, 2013).

However, in addition to political efforts, the only way to hold a position is to make no or little profit for an enterprise. Only in this way will the enterprise look less attractive to outsiders. A common saying is “to be big and to fail”. It means that if you want an enterprise to look unprofitable and unattractive, you should borrow a large amount of money, raise the enterprise’s asset-liability ratio, and increase the enterprise’s financial risk. High debt will increase financial costs and squeeze out profits, and the projects being invested have risks, all of which will deter those who want to enter the enterprise, thus allowing the existing executives to keep their positions. The high asset-liability ratio of SOEs is confirmed by the data. According to the Ministry of Finance, by December 2018, after two years of “deleveraging”, the asset-liability ratio of SOEs was 64.7%, of which 67.7% was due to central enterprises. According to Gelonghui, at the end of February 2019, the asset-liability ratio of private enterprises was 58.2%. This ratio is significantly higher than the 51.5% asset-liability ratio of private enterprises at the end of 2016 (2019).

Due to excessive borrowing and underestimating the risk of investment, the assets of SOEs grow rapidly. For example, from 2014 to 2019, the average annual growth rate of state-owned assets was 15%, far faster than the growth rate of GDP in the same period and faster than the growth rate of the total assets of private enterprises. According to data from the Dacheng Enterprise Research Institute, from 2015 to 2018, SOE investment increased by 7.8% annually, while that of private enterprises only increased by 2.7% annually (2019). Moreover, the excessive investment of SOEs shows that the return on net assets of SOEs is lower than that of private enterprises even in nominal terms, and the expected return on investment for new projects is more likely to be lower for SOEs. These outcomes are reflected not only in domestic investment projects but also in foreign investment projects. Domestically, SOEs with monopoly power can obtain monopoly income, but in foreign countries, they do not have monopoly power. With the low efficiency of SOEs, their expected income will be lower. However, the foreign investment of SOEs exceeds that of private enterprises. In 2006, SOEs accounted for 81% of the total foreign investment, and they accounted for 51.3% in 2017. In the same period, their domestic investment accounted for less than 40%. In addition to the other reasons for corruption, SOEs are not concerned about high risks of investments.

The high asset-liability ratio of SOEs and the rapid growth of total assets generally prove the existence of the “to be big and to fail” strategy. However, judging from the fact that the crime rate of executives in SOEs is much higher than that of private entrepreneurs, it is not clear whether this strategy works.

6. The fate of state-owned enterprises

Through the above analysis, we find that “beautiful” SOEs are actually an illusion. On the one hand, SOEs do not pay profits, do not pay land rent, only pay 34% of interest, and have a monopoly interest equivalent to 21.8% of the added value, which increases the “SOE rent” accounting for 61.2% of the added value. On the other hand, the senior executives of SOEs have a three-year term limit, and their probability of being convicted of a crime is 94 times greater than that of private entrepreneurs. The two sides may be offset as  being negative.

Assuming that there are 20000 top executives in SOEs, each of them can share approximately 4 million yuan of “SOE rent” every year, and they share approximately 80 billion yuan in interest. Their opportunity cost, i.e., the income they will obtain as executives in private enterprises, was approximately 500000 yuan/year in 2018. The legal income of SOE executives is slightly higher than this amount. Assuming that the average tenure of these executives is five years, they will gain 20 million more yuan than a normal manager. However, once they are convicted, they will not only lose these benefits but also go to prison. Based on the existing sentences of SOE executives, the average sentence is one year for every 500000 yuan obtained illegally; the sentence for obtaining 20 million yuan illegally is 40 years. If we assume that the value of one year of imprisonment is -4 million yuan, then 40 years of imprisonment is valued at -160 million yuan. Regarding the head employees of SOEs, 12% have a probability of losing 160 million yuan of their income, and 88% have a probability of losing 20 million yuan; their expected return is -1.6 million yuan, which is a negative value. Obviously, it is not worth giving up a position in a private enterprise for such an “expected income”. In fact, this calculation is very conservative. Four million yuan a year is far from sufficient to compensate for the prison scenario. If a rational person makes such a calculation, he or she will not rush into an SOE.

However, this is not consistent with what we see. Most people still fly as moths to a fire, one after another into SOEs, and then to prison. Why? It is because people do not calculate rationally. Adam Smith once said that people’s self-love is usually manifested in “overweening conceit which the greater part of men have of their own abilities” and “absurd presumption in their own good fortune” (quoted from Coase, 1994, P. 111). Cognitive psychology tells us that people often make the psychological mistake of “ignoring the basic ratio”. That is, people only see the apparent frequency of occurrence, without considering the basic ratio of these phenomena. For example, a phenomenon that people see is that the frequency of accidents involving red cars is twice that of blue cars; then, without knowing that the number of red cars is twice that of blue cars, they conclude that red cars are more likely than blue cars to be in accidents. In the abovementioned investigative report on entrepreneurs’ crimes, 67.1% of those convicted were private entrepreneurs, while 32.9% were SOE executives. It seems that the latter are less likely to be convicted. However, if we know that the number of private enterprises is 191 times greater than that of SOEs, this view is totally wrong. In relevant psychological experiments, 45% of Harvard students made the mistake of “ignoring the basic ratio” (Eysenck and Keane, 2009, P. 578). If SOE executives assume that SOEs and private enterprises each account for half of the total number of enterprises, they will think that their probability of being convicted is only one-third of that of private entrepreneurs.

Adam Smith also said, “Avarice overrates the difference between poverty and riches; ambition, that between private and public station; vainglory, that between obscurity and extensive reputation. “(Quoted from Coase, 1994, p. 112) This sentence is suitable to describe the scramble for senior management positions in SOEs. These positions can not only bring more economic benefits but also allow service as a public servant belonging to the same group as senior government officials. With money and power, you can gain fame. For example, in recent years, some SOE executives have applied for academician positions in the Academy of Science or Engineering. However, the value of top management positions in SOEs may be greatly overestimated. If SOE executives gain power and reputation in addition to the 4 million yuan a year in rent and regard the value of their positions as 10 million yuan a year, even if there is a 12% probability of being convicted, the expected return will be 24.8 million yuan. In this way, people’s behavior is not likely to depend on rational calculation but is driven by their own psychological weakness, which leads to them making an incorrect estimate.

Furthermore, people’s calculations are limited by their vision of time. Short-sighted people often cannot see long-term results. There is always a first act of illegal gain, followed by the disclosure and punishment of the illegal behavior. Benefits and costs do not occur at the same time. Benefits come first, costs later. Short-sighted people are more likely to calculate only the benefits of taking advantage of SOEs and ignore the cost of being punished later. In my article “Vision and Calculation”, I pointed out that life is made up of a series of games. Big games include small games. When people enter into a game, they are temporarily limited by the boundaries and rules defined by the game. They generally do not consider the world outside the game. However, in fact, various factors in the outside world will affect the real cost-benefit ratio of the game’s results. For example, a person cheated in order to obtain high scores on an exam, but in the person’s actual work, the person was defeated. In other words, he won the small game and lost the big game (Sheng Hong, 2013). This is where many criminals, though “rational”, miscalculate. This is also where many people in the SOE-top-manager and administrative-official interest groups miscalculate. However, it is precisely because of this mistake of the majority that the illusion of SOEs is maintained.

More importantly, people often cannot see the institutional reason for this illusion. Due to the existence of a strong interest group of senior executives in SOEs and administrative officials, these individuals can often carry out their activities “in house” in the absence of institutional structure constraints on the actual “legislation” of the administrative departments; that is, within the administrative departments, they can directly formulate and issue preferential policies or grant monopoly powers in favor of SOEs. However, when they do so, they cannot transfer the benefits of the preferential policies and monopolies to one or more individuals among them. They can only assign the benefits to the SOEs under the label of “bigger and stronger” SOEs and act as the interest group members who are qualified to enter the SOEs as senior executives. This kind of practice creates the problem faced by all SOEs. That is, it constructs a situation described by Steven Cheung. The benefits of nonlabor factors that are controlled to lower prices are not transferred to certain individuals but to a group in which the members can compete with each other for these very substantial benefits. Thus, the members became competitors, or even enemies, with each other. The loss of the loser or the victim of the competition constitutes the negative benefit expectation of the whole group of SOE executives, and it is uncertain who the victim is, such that every senior manager who enters the SOE may lose more than he or she gains.

Specifically, in the stage of setting up rents, due to the lack of respect for and implementation of the legislative authority and due process stipulated in the Constitution and the legislative law, there was a habit in China that the administrative departments stipulated the matters that should have been stipulated by the Constitution or an administrative document. The administrative departments related to SOEs often issued administrative documents and provided preferential policies for SOEs, such as not requiring SOEs to pay profits, not limiting SOE salaries and bonuses, or granting monopolistic powers like those granted to PetroChina and Sinopec through “Document No. 38”. Those who transition from roles as executives in SOEs to roles as officials in administrative departments, as well as those who hope to cash in policy dividends from SOEs in the future, will promote institutions and policies in favor of SOEs. Potential SOE members believe that it is in their own interests to do so. Currently, it is impossible to transfer the rent part of interests to certain individuals because such transfers are a naked abuse of public power and constitute corruption. However, these very substantial benefits can be transferred to a group. In addition, in their culture, it is shameful to seek benefits for individuals, but it is heroic to seek benefits for the collective. Therefore, the abuse of administrative power to set up significant interests for SOEs is inevitable.

As long as the senior executives of SOEs and administrative officials are rational economic persons, they are bound to be tempted by the very substantial benefits of SOEs. They compete for “SOE rent”, which is equal to 61.8% of the added value, as farmers compete for 1/3 of the land rent share. However, competition rules are not market rules but political rules. That is, the Party Organization Department appoints the senior managers of SOEs, while the Organization Department of the CPC Central Committee appoints the senior managers of central enterprises. In the organization department, the real rule is not that an enterprise must select excellent leaders, nor is it that democratic voting is required; rather, it is a rule of power. Therefore, competition for SOE executive positions becomes competition for power. However, in the competition for power, there is also a lack of fair and moderate rules, sometimes even in cases of life and death, so it is impossible to have a stable equilibrium in which SOE executives can stay in office for a long time. Equilibrium can only exist in short periods of time; when political personnel change, the original balance is broken. Moreover, as the benefits of SOEs are very attractive, the impulse of administrative officials to break the existing balance is increased. Therefore, there is no real equilibrium in the appointment of SOE executives. In contrast, the instability of the position of SOE executives is normal under this rule.

As a result, as we have observed, the crime rate of SOE executives is much higher than that of private entrepreneurs, and the average term of office is far lower than that of private entrepreneurs. However, because this information is not very clear and lacks statistical support, people tend to believe the information that is beneficial to them and underestimate the information that is unfavorable to them. For example, they overestimate the benefits obtained from SOE senior executive positions and underestimate the probability that they will be punished as a result of engaging in criminal behavior. SOEs are illusory images representing people’s common interests. They think that it is in their common and greatest interest to deliver benefits to SOEs and defend the interests of SOE executives. Therefore, in various political processes, they put SOEs in a politically correct position and above the interests of all people, which causes public decision-making to deviate, but they themselves are ultimately harmed. This kind of ending is inevitable and tragic. If you enter the top management of an SOE, no matter where you are, you cannot get rid of the negative expectations that this group faces. The tragic fate brought about by the SOE system, which SOE members set up, is that, similar to “natural punishment”, no individual can escape from it.

7. Solutions to the problems of state-owned enterprises

When we say that because of their short-sightedness, SOE executives and administrative officials cannot see the real, tragic fate of SOEs, there is a hidden possibility. That is, if some of them break through this short-sightedness and have long-term vision, they will see the unfortunate results and know that the apparently substantial interests of SOEs are, in fact, the reason that they compete with each other and even act with hostility toward each other. In this competition, they will lose more than they will gain, and they will even suffer from extinction. The bright surface of an SOE is actually an illusory image that is a trap full of bait, and the bait is put out by the SOE executives and administrative officials; they set the trap for themselves. They know that it is a trap, but they scramble for it. When someone proposes dismantling the trap, they stand up to defend the trap; in fact, they are defending their tragic fate.

It is possible to see the true face of SOEs. Studies have shown that people with more education are more patient (Burks, Carpenter, Gotte, and Rustichini, 2012). In other words, they have greater long-term vision, and they calculate not only in terms of immediate interests but also in terms of future interests. In the SOE executive and administrative official group, there are a large number of highly educated intellectual elites. They have long-term vision. They will look at the problem from the perspective of repeated games rather than only seeing the result of one game. Moreover, as mentioned above, the higher an individual’s position is, the greater the individual’s risk and the higher the probability of being convicted. We can more clearly see through the bait nature of “SOE rent”. Therefore, they can see through the illusion of SOEs and put forward reform demands from inside SOEs. In this situation, the political dynamics of SOE reform will develop in a positive direction and ultimately make the reform of SOEs politically feasible. Under this premise, the remaining problem is the reform program.

Since the fatal problem of SOEs is the unclear ownership of the very substantial benefits brought about by the price reduction of nonlabor factors, the solution seems to be to clarify the property rights over this part’s interests. There are two ways to do so. The first way is to cancel the price control of all relevant nonlabor factors, that is, to cancel the favored policies that no profit or land rent need be paid, and the control or monopoly of interest rates and interest rate differences. However, this requires SOEs to pay according to market prices. In this way, there will be no weakening of property rights, as Steven Cheung said. In the market, SOEs will become fair competitors of non-SOEs.

The second way is to clearly assign the interests that have no clear ownership, that is, the nonpayment of profits, the nonpayment of land rent, the underpayment of interest and monopoly income, to specific people or enterprises. In fact, this is the privatization of state-owned capital, state-owned land, part of the property rights of banks, and monopoly interests.

There are two options on this path. One option is to assign this part of the substantial interests to the identified individual SOE executives and administrative officials; however, it seems impossible to do so because it is extremely politically incorrect to assign the property rights of SOEs to those in power without compensation. Of course, this action will also be opposed by the overwhelming majority of people and thus is not feasible politically.

The second option is to sell this part of the interests in the markets, and the persons who offer the highest price may obtain them. For example, the value of the income of state-owned enterprises from free state-owned land and free-to-pay profits of state-owned capital is actually the market value of land and capital, which is equivalent to the privatization of state-owned land and capital. More broadly, it is the privatization of all factors of production, including natural resource exploitation rights and low-interest loans, which is an effective and fair privatization. In this way, the new owners of these factors will demand their rights, and the SOEs will have to pay the market price of these factors. As a result, SOEs will become fair competitors in the markets. Politically, this should be acceptable to most people.

The reason why SOEs have not been effectively reformed is mainly because of the opposition of SOE executives and administrative officials. The reason why they oppose reform, as mentioned in the above sections, is that they are confused by the illusion that SOEs offer very significant benefits, believing that it is good for them to safeguard the beneficial interests of SOEs. When we expose this illusion, this interest group can see that what they are trying to maintain is a trap to capture themselves. However, although others have said they want to abolish this trap, they rise up against reform. If they realize that SOE reform is intended to remove this trap, which is an outcome that is actually good for them, they will stand on the side of SOE reform. Perhaps this will eventually promote the reform of SOEs so that China’s reform and opening-up can cross this seemingly insurmountable obstacle.

Reference

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Burks, Stephen; Carpenter, Jeffrey; Gotte, Lorenz; Rustichini, Aldo, Which measures of time preference best predict outcomes: Evidence from a large-scale field experiment, Journal of Behavior and Organization, Volume 84, Issue 1, September 2012.

Cheng Zhen, Lu Mengjun, Guo Chen, “Oil system anti-corruption reaches a climax again, Sinopec’s three consecutive general managers are investigated”, Sohu Finance and Economics, October 8, 2015.

Coase, Essays On Economics and Economists, The University of Chicago Press, 1994.

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Published firstly in Man and the Economy, 2021, vol. 8, issue 1, 21-45

Why May Unconstrained Power Disrupt the China’s Miracle? /Sheng Hong

It is said that in many cities, such as Suzhou, Taiyuan and Kunming, and so on, house prices fell; the cities where houses prices fell more than 3% includes Kaifeng, Handan, Fushun and Dezhou. As an overall trend, China urban housing price 288 index in August 2021 issued by China Real Estate Evaluation Center shows that the new house price index fell by 0.09% month on month, which is regarded as the first decline after rising for seven consecutive months. This is obviously not accidental. Prior to this, there were precursory data. According to the National Bureau of Statistics, from January to August 2021, the land area and price purchased by the real estate industry continued to decline, with a year-on-year decrease of 10.2% and 6.2% respectively in August. Land is the main “raw material” of real estate. The decline in price and quantity is obviously an important reflection of the decline in demand in the real estate market. This is a major omen for China’s economy.

It’s a long story. Nobel laureate Lewis said that the development of modern economy depends on industrialization and urbanization. Not to say industrialization, only say urbanization, which brings huge demand and power to economic development. Due to the implementation of the planned economy for many years, China’s urbanization rate decreased from 19.8% in 1960 to 17.9% in 1978. After the reform and opening up, especially after the second half of the 1990s, urbanization has made great progress. Urbanization has not only brought huge investment, but also accelerated the expansion of market system and demand due to the improvement of agglomeration degree, greatly improved the efficiency of financial, commercial and other service industries and the industry, greatly increased the income of farmers in cities due to their shift of industries, and permanently increased the demand due to the convenience of shopping, The prosperity of industry and the influx of residents promote the further demand for urbanization, which leads to a virtuous cycle of mutual promotion between urbanization and industrialization. By 2020, the urbanization rate has reached 64%. It can be said that China’s rapid and sustained economic growth after the Reform and Opening Upmainly depends on the process of urbanization.

To realize urbanization, we need to invest in urban infrastructure and urban service functions. This requires huge investment. In this regard, it is a key reform for the urban government to sell the land multi-years use right in the form of lease and marketize the factor of land. After years of evolution, a relatively mature land financing and operation mode has been formed, that is, the government uses land as collateral to obtain bank loans, the bank lends funds based on the appreciation expectation after land urbanization, the government uses loans for primary land development, and then sells land to developers in the form of bidding, auction and listing, so as to obtain appreciation income and repay bank loans, And further land development. Developers can also borrow money from banks with the purchased land as collateral, then carry out secondary development, and finally sell commercial houses, office buildings, commercial facilities or industrial plants to earn income and repay the loan. Ordinary consumers obtain bank loans with their purchased houses as collateral, and then repay the bank loans in installments over the next ten years or decades.

This financing model not only makes the urbanization process smoothly, but also constitutes an important part of the current economy. According to the estimation that the existing urbanization rate increases by an average of 1.4 percentage points per year, China’s new urban population is about 20 million every year. The resulting huge investment in urban municipal infrastructure is about 2.5 trillion yuan in new urban areas every year; if it increases by 5% a year, it will be 6 trillion by 2035. This is obviously the largest single industry investment and is stable and sustainable.

Figure 1 growth of municipal infrastructure investment (100 million yuan)

In a broad sense, in 2017, the total investment in infrastructure around urbanization, including transportation, storage and postal industry, water, electricity and gas production and supply, water conservancy, environment and public facilities management industry, resident services and other services, education, medical treatment, culture and sports, public management and social organizations, and construction industry, was about 21.5 trillion; If commercial supporting urban service functions are considered, including wholesale and retail, accommodation and catering, finance, leasing and business services, the total investment is about 3.7 trillion; The investment in real estate is 14.6 trillion. These investments add up to about 40 trillion yuan. It accounted for 62% of the fixed investment of the whole society in that year. Such huge investment funds, coupled with operating funds, make the demand for urbanization constitute the largest part of the financing of China’s financial system. According to China Financial Yearbook 2019, in 2018, the bank loans of the above industries around urbanization reached 66783.8 billion, accounting for 48.2% of the total loan balance of the year. According to the National Bureau of Statistics, in 2020, the proportion of industries related to generalized urbanization in GDP is conservatively estimated to be about 48%.

Figure 2 infrastructure investment in generalized urbanization in 2017 (100 million yuan)

As mentioned above, the financing mechanism to realize such a huge investment is a financing mechanism based on land mortgage and financial marketization. There are two main points. One is that the land price must continue to rise, and the other is that the financing cost must be determined by the market. Now it seems that the price of the land market has begun to decline, and the first key point no longer exists. For banks, as long as house prices fall, the collateral value of their loans will be lower than the loan amount. Once borrowers default, banks will face losses. For developers, the decline in house prices means that the market prospect is bleak. According to the existing costs, they will reduce profits or losses, and lack the power to continue investment. For local governments, the decline in land prices caused by the decline in house prices will also make them unable to repay bank loans and even bankrupt their finances. Especially in these years, the bank’s estimation of land value is based on the expected appreciation of land. For example, in 2014, the average mortgage loan per mu of land was about 1.4 million yuan, while the price of land sold in the same period was about 1.29 million yuan per mu (calculated according to the data of Yu Jingwen, Wang Min and Guo Kaiming (2019)), and the bank’s valuation of land was higher than the land price in the same period. Once the land appreciation is lower than the loan interest rate, the local government will be unable to repay the loan.

The decline in land prices is due to the reduction in the final demand for real estate, and the most sensitive real estate developers began to have problems. Evergrande real estate, a behemoth, has begun to have a debt crisis. It is said that the debt is as high as 1.9 trillion. In the face of the slowdown of the real estate market in 2021, “commercial bills are overdue every day, bonds are stopped from financing business, and 60% of staff are laid off, The two trusts require early repayment of loans”; Many large developers have also been insolvent, such as Huaxia happiness, “the principal and interest of default debt totaled 87.899 billion yuan”; Xinhualian, “the total book value of assets mortgaged, pledged, sealed up, seized and frozen in case of debt default is 45.458 billion yuan”; Hongkun real estate, “the operating cash flow has been cut back, the financing cost is high, the financing environment continues to deteriorate, and the debt pressure and liquidity problems begin to appear”; Field Real Estate, “large scale commercial bills overdue”; …… There are still about 25 similar-level developers to be insolvent (Longitude and Latitude Observation, 2021). As of July 20, 203 real estate developers had submitted bankruptcy documents. The debt problems of these real estate developers are obviously related to the bleak prospects of the aforementioned real estate market.

This is only the prelude to the decline of the whole land market, leading to the plight of the financial system mortgaged by land. Then there will be many local governments facing debt crisis. In the environment of unrestricted power, their first thought is to cut more income and wealth from enterprises and residents, such as levying taxes in advance, squeezing more funds and assets from private enterprises, forcibly demolishing the so-called “small property right” houses under the banner of “planning”, and then developing and selling the robbed land, Enterprises have no incentive to continue production and investment, and the people have reduced their willingness to buy houses because of the lack of protection of property rights and housing rights; The economy will decline further and the land market will worsen. Financial institutions based on land financing will also have a crisis, a large number of bank loans can not be recovered, and there will be a large number of losses. Due to the chain reaction, a large number of debts cannot be repaid, causing the money supply to contract on a multiplier scale. At this time, the central government has only one way to save the current crisis, which is to print more money, but it will lead to inflation. This, in turn, will hit the real economy, which will eventually disintegrate the strong momentum of China’s economic development since the reform and opening up, resulting in economic recession.

The key to the problem is the decline in land prices. How did this happen? Some people say that China’s urbanization has been nearly completed, and the huge investment demand brought by urbanization has decreased. This may have some impact. However, China’s urbanization rate of 64% is far from reaching the level of 90% in European and American countries. Although China’s actual situation will be higher than the figure according to the degree of population agglomeration, it may be lower than this figure in terms of urban infrastructure construction. There is a serious lack of infrastructure construction in rural and small towns with large population agglomeration in China, so it should be said that there is still a lot of space. Judging from the increase of urbanization rate of 1.4 percentage points per year, the urbanization process should take about 20 years. I once estimated that as long as the urbanization process is not completed, China still has a basic growth rate of 5 ~ 6% per year (Sheng Hong, 2019). So what is the reason for the decline of the land market?

We know that urbanization is not only because there is room for urbanization, but also because of the degree of marketization and the rate of economic growth. In the period of planned economy, China’s urbanization rate is very low, but it continues to decline, because urban development does not rely on the power of market mechanism, but the will of the planning authority. At the same time, it is subject generally to the misallocation of resources and lack of incentive in the planned economy. Urbanization is to realize people’s agglomeration under the market system, and people’s agglomeration brings the externality of the market network, that is, the transaction dividend increases much faster than people’s agglomeration, which is the basic principle of urbanization. Market system is that people’s economic decisions are not subject to external control and made according to their own costs and benefits, which is manifested in the migration of enterprises and residents to the center of agglomeration, so as to further promote urbanization. Professor Krugman, Nobel laureate, pointed out that one of the characteristics of modern industrial development is that large-scale production is manifested in agglomeration in space (M. Fujita, Krugman et al., 2005, page 70), that is, in the form of urban development. Those producer services, such as finance and information, are in the form of urban agglomeration. In other words, industrialization and urbanization promote each other in economic development.

From the first half of this year, the economic data is still good. According to the National Bureau of Statistics, GDP grew by 13.6% in the first half of the year, which also reached 3.4% calculated by Keqiang index. According to the data compiled by Dacheng Research Institute, the operating revenue of national industry increased by 25.6% from January to July; The total investment in China increased by 10.3%, and the total export from January to August increased by 33.7%. Since the economic development situation is so good, how could there be a bleak prospect of the real estate market and a decline in land prices? The problem is that among the variables affecting economic development, some are fast variables and some are slow variables. Now the slow variable changes, but there is no time to show the current results. These slow variables are the basic economic institutions. Basic economic institutions refer to property rights institution, contract system and market rules. Douglass North and other institutional economists have long pointed out that these basic economic institutions are the main reason for economic development since modern times. Mancur Olsen pointed out that “as long as a trusted and strong government exists for a long time in the economy and protects individual property rights and contractual exercise rights from infringement, it will be able to reap all potential benefits from investment and long-term transactions” (2009, P. 409)

As for the property rights institution, in recent years, the property rights of enterprises and residents have been violated from time to time, and there is no channel for legal relief. Even the personal safety of entrepreneurs can not be guaranteed. They are often maliciously trapped by the local government and use judicial means to make unjust cases. For example, the Sun Dawu case was clearly a land dispute between Dawu Group and a nearby state-owned farm, which was first provoked by the state-owned farm. However, he was trapped to various charges and sentenced to 18 years’ imprisonment. Another example is that Hubei Xiangda Group took over a chemical plant on the verge of bankruptcy under the guidance of the local government, but the company’s leadership was labeled as a “underworld” due to employee petition (Si Qipu, 2021), and so on. The property rights of ordinary citizens are posed a serious threat due to the prevalence of illegal demolition. In violation of constitutional principles, some administrative departments improperly elevate the so-called “planning right”, so as to deny the constitutional rights of citizens such as housing right, property right and residence right. In recent years, some local governments ignore the restrictions of the Constitution, do not recognize the policies and commitments made by the central and local governments, violate a series of administrative laws and abuse public violence. In 2019, there was a bad situation of driving out the “low-end population” in Beijing; In recent years, there have been a large number of illegal acts of forcibly demolishing residential houses in suburban districts and counties of Beijing, Hebei, Shandong, Hainan and other provinces and cities.

Property rights not only refer to the material object, but also a group of rights. When the assets as objects are not damaged or less damaged, the restriction and damage to rights are also violations of property rights. For example, Beijing demolishes advertisements on houses in the name of sorting out the skyline, and the greatest damage to advertisers is the forced deprivation of advertising rights. More generally, the interruption of contract execution makes the contractor lose the benefits obtained from the contract, which is equivalent to the infringement of the property rights protected by the contract. For example, the administrative department suddenly closed a large number of farmers’ markets, and the lease of the majority of vendors did not expire; The administrative department suddenly announced that it would not allow out of school training, limit the time of video games, close private primary and secondary schools, and increase the entry requirements of home stay in Beijing. All these are interrupting the performance of the contract of market subjects, which actually infringes on the property rights of these market subjects. If the constitution is regarded as a social contract signed between the people and the government, the administrative departments arbitrarily intervene in the market, infringes on the people’s property rights, and suddenly changes the policy without explanation, it is also a violation of the social contract, resulting in more extensive property rights losses caused by breach of contract.

Of course, administrative departments have their own reasons for intervening in the market, interrupting contracts, and then infringing property rights. For example, for out of school training, they use the excuse of “reducing students’ extracurricular burden”; Limit the time of online games under the pretext of “preventing students from indulging in games”; Stop the enrollment of private primary and secondary schools under the pretext of “adjusting the proportion of private public schools”; Beijing home stays were off from the shelf online, under the pretext of “safety” These excuses seem to have their reasons. However, things in the world are not one side, and any “good” purpose has a price. Therefore, there is what Ronald Coase calls “reciprocal nature of the problem”, that is, “reducing pollution” is a good thing, but in order to reduce pollution, it may increase the cost of production; From a social perspective, both increasing production costs and pollution are social costs, and the choice depends on which is higher or lower. Second, it depends on whether the government should intervene in the solution of these problems. If other methods, such as family, market and non-profit institutions, can be used to solve these problems, it is better than the government’s method, because these alternative methods are non mandatory. Mandatory not only has high implementation cost, but also is easy to go too far due to lack of compromise, resulting in negative results.

Finally, even if it is to be done by the administrative departments, there is a problem of whether they follow the due process of law. First, before issuing a policy or administrative order, the administrative departments should have a constitutional and legal self-examination, and carefully consider whether the policy or order violates the previous policy or commitment. The behavior that causes the losses of economic parties should be avoided, otherwise they should be compensated. When the administrative departments believe that it is really necessary to introduce policies involving the rights of citizens or enterprises, it should fully explain the reasons and obtain the consent of the legislature. In the process of implementation, we should follow the administrative procedures stipulated by law, hold hearings, listen to the opinions of experts and the public, listen to the arguments of the parties, and give buffer time. Only in this way can we ensure that the policies or orders of the departments do not violate the Constitution and laws, do not conflict with their previous policies or orders, ensure the logic and stability of the behavior of the administrative departments, and give people reliable expectations. I am afraid that the abrupt and arbitrary behavior of the administrative departments is the result of listening to the instructions of some individual leaders or simply “guessing the will of leader”. It simply does not take the Constitution, the laws and its own commitments as one thing.

This requirement for the administrative departments is a bottom line requirement. This is true not only in most countries ruled of law in the world, but also in traditional China. If an arbitrary emperor wants to issue an imperial edict, he also need to draw up a draft first, so that the Zhongshu department can draw up an imperial edict. If the Secretary in Zhongshu Department found any problem with the draft, he has the power to put forward modification opinions and return it back, which is called “closing and refuting”. Su Shi did closing and refuting six times when he was a Secretary in Zhongshu Department. Even if it passed the Zhongshu Department, there is still Shangshu Department for inspection. In Song and Ming Dynasties, it needed the Prime Minister or the head of the cabinet to countersign. It is said that the stubborn Zhengde Emperor of Ming was whimsical. Because “pig” and “Zhu” in Chinese were homonymous, he suddenly issued an order not to allow people to eat pork. After Yang Tinghe persuaded him to repent, he didn’t know how to take back his order. Later, it was found that the order was issued not in the name of the Emperor but in the name of “powerful general” because it was unable to obtain the head of cabinet signature, let him get out of the dilemma. Although this system is not perfect, it ensures that absurd and contradictory orders will not appear easily.

According to the Constitution, actions affecting the basic economic system must be approved by the legislature. Infringing on the market field is a move to change the basic economic system, which is a violation of the constitutional principle of “market economy”. The administrative departments of the government attempt to create such a fact by its wanton intervention in the market, it can grant itself the power to violate the Constitution and expand itself without the consent of the legislature. What is even more frightening is that the administrative departments of the government regards this behavior as a matter of course and routine. If they continue to issue the so-called policy of restricting or prohibiting the entry of this or that industry without scruples and constraints, it will destroy industries in the market without warning, and even conduct to stop power in sneak-attack style or similar behavior, which will not only affect the technical reduction of production, but also increases the uncertainty caused by the unpredictable behavior of the government. Because people can’t predict the government’s behavior according to the Constitution, laws or its own commitments, all industries in the market are always under the threat of its willful behavior. There is no stable expectation, which greatly increases the cost of preparedness or suffers losses, resulting in enterprises choosing to reduce production or even stop production.

The uncertainty caused by the government’s failure to comply with the Constitution, laws and previous commitments is a kind of uncertainty of institutional environment and policy environment. On the one hand, it is all-round, including various means of government intervention in the market, such as restricting prices, directly restricting supply, directly restricting demand, restricting income, restricting industrial entry, restricting consumer entry, and even directly confiscating assets; On the other hand, these behaviors are not limited to specific industries, but may cover all industries. In addition, this uncertainty is called “immeasurable uncertainty” by Knight, that is, “uncertainty of unknown probability distribution”, which corresponds to the “uncertainty of known probability distribution” of risk (2005, P. 172). For the latter, people can also adopt “specialization” and “integration” methods to reduce risks (2005, P. 176); There is nothing we can do about the former. Therefore, the uncertainty caused by the lack of rules for government behavior is a general environmental uncertainty. Of course, it will bring losses to people at present. More importantly, it has a possibility of damage to people’s future behavior. Aware that future plans may encounter such damage, people will increase the estimation of costs, resulting in the potential investors stay back and the innovators could not focus. This is a bigger negative factor than direct infringement of property rights.

With regard to the protection of property rights and the maintenance of contractual rights, Olson said, “the court system, independent judicial power, and respect for legal and individual rights are also needed to ensure property and contractual rights.” (2009, P. 409) Therefore, a fair and neutral judicial system is important. However, this is what our society lacks, and it is increasingly lacking. What we see is that the judicial trial of unjust cases of entrepreneurs is obviously unfair and wantonly violates the due process of law. For example, in the trial of Dawu case,  it refused Sun Dawu to obtain a guarantor pending trial without justified reasons, abused residential surveillance, and tortured the parties with various illegal means, so that Sun Dawu described it as “life is worse than death” (Wu Lei, 2021), but refused to exclude these illegally extracted testimony from the evidence in the trial, which seriously violated the “no forced self incrimination” in Chinese legal principle; They also ignored the evidences of the defense and convicted them without solid facts and legal basis. Compared with the unjust cases caused by the carelessness of the court and technical reasons, this malicious framing and unjust imprisonment makes entrepreneurs more afraid, because once they offend the local government, they may suffer such retaliation, which entrepreneurs can’t escape and bear.

For the illegal demolition of residential buildings, when the residents receive the notice of demolition threat, they file an administrative lawsuit or administrative reconsideration with the relevant authorities, but they will not be accepted; The local administrative authorities flagrantly violate the provisions of the administrative enforcement law that “the parties do not apply for administrative reconsideration or bring an administrative lawsuit within the legal time limit and do not dismantle” to allow forced demolition (Article 41), and still illegally demolish after the forcibly demolished residents apply for administrative reconsideration or administrative lawsuit; In addition, in violation of Article 43, “administrative organs shall not enforce administrative enforcement at night or on legal holidays.” in the process of illegal demolition, they abuse police power to threaten the personal freedom and safety of victims, illegally employ demolition elements with financial funds, illegally cut off water and power supply, etc. (Sheng Hong, 2020). After the forced demolition, the relevant administrative departments ignored the huge losses and injuries of the victims, insisted that the forced demolition had “no interest” with the victims (Sheng Hong, 2021), refused to accept the administrative reconsideration or administrative litigation of the victims, and put the injured residential owners in a situation of no legal relief at all.

Some people may say that some cases of infringing on private enterprises account for only a small proportion of private entrepreneurs. Although there are many illegal demolitions in recent years, and the number of houses demolitions is huge, it only accounts for a small proportion of the total. However, an infringement of property rights does not have an impact only on a proportional level. Because property rights are a fundamental economic institution and the most important interest for individuals or enterprises, the infringement of property rights is a fundamental psychological impact. The value of an asset is not only determined by its use value, but also affected by the security of its property rights. For example, there are two physically identical houses, one in New York and one in Gaza, which are different as heaven and earth. I remember that John Commons, the author of Institutional Economics, said that for each individual, only the institutionalized mind can form a judgment on the future (1983, P. 297), which will change with the facts he knows. After Xiangda’s “underworld related” case, the daughter of the chairman issued an open letter asking for the enterprise to be donated to the government (Si Qipu, 2021), which shows that she not only despair that the government can protect property rights, but also regards property rights as negative values. In a questionnaire survey in 2016 / 2017, entrepreneurs believe that they have a 26.8% probability of property safety risk. Now this probability should be higher, the assets will depreciate accordingly, and the land as an integral part of the assets will depreciate equally.

In my article “why the rule of law is a first-order macro policy”, I pointed out that the security of property rights is much more important and more priority than the adjustment of interest rate or tax rate. Generally speaking, the asset value is calculated by discounting the future return of the risk-free interest rate. If the risk-free interest rate is 4%, the asset value is 100%. When the risk of infringement of property rights increases by 10%, it is theoretically equivalent to raising interest rates or tax rates by 10 percentage points. Although the government sometimes introduces new opening policies or expansionary macro policies, both of them are mainly in the form of reducing interest rates or tax rates. As mentioned above, this can not be compared with the threat to the security of property rights and the certainty of institutional-policy environment. Moreover, when the administrative departments interrupt the performance of the market contract, the loss will not only be the benefits covered by the contract at that time, especially when the whole industry is blocked and employees are unemployed, which will cause huge losses to the long-term investment of investors and employees in providing products or services. This kind of investment has what economists call “asset specificity”. Once it cannot be used in the specialized production or service that has always been used, its value will be greatly reduced. For example, once an English teacher can no longer teach English, the value of his or her human capital of English ability will be greatly degraded. If the material or human capital is depreciated, it means that the efficiency of resource allocation is significantly reduced, and the land carrying resource allocation is also depreciated.

The influence process of institutional variables is slow, and there will be no obvious signs in the initial stage. The changes of fast macroeconomic variables, such as interest rate, tax rate and reserve ratio, are relatively clear and directly enter people’s calculation, so the impact is also direct and rapid. For example, the change of interest rate directly affects the financing cost, and then affects the profit. And the policy variable is short-term, it can also change in the opposite direction. The impact of institutional changes on specific individuals or enterprises is only a possibility, but institutional variables will enter people’s judgment of the future in the form of probability and affect their long-term expectations and decisions; And unless there is a major political change, the change of system is usually irreversible, at least it is difficult to change again, so it has a long-term nature, which will affect the estimation of asset value. When there are more and more such cases, people’s evaluation of their own property rights will be reduced, their belief in the performance of the contract will be weakened, and their expectation of obtaining legal relief in case of infringement by the administrative department will be reduced, which will reduce the evaluation of asset value, which is the institutional reason for the reduction of land price. When there are both fast variables and slow variables in a society, the impact of fast variables will appear at the moment, while the impact of slow variables will appear later.

Moreover, due to the control of public opinion, most people know little about those cases of infringement of rights, or think it has nothing to do with themselves. At present, the reason why the macroeconomic data are not bad depends on the institutional foundation laid by Reform and Opening Upand the accidental factors brought by the epidemic. Macroeconomists only see these macro data and put forward policy suggestions based on classical theories. Even if they see some problems, they only suggest adjusting some policy variables, such as interest rate, tax rate, or open market business; If macro decision makers only make macro decisions based on these macro data and accept the suggestions of macro economists, and do not see the situations related to specific individuals such as damage to property rights, forced breach of contract and unemployment reflected in these cases at the micro level, they will continue to ignore the institutional problems reflected in these cases and go towards the coming crisis  in the illusion of “the situation is very good”. These seemingly good macro data are the reason why they make wrong decisions. They continue to believe that it has nothing to do with not restricting power and infringing on the rights of some citizens. They even think that they are right to do so, which can only aggravate the deterioration of institutional variables and worsen the potential recession.

The willful violation or violation of the Constitution or rights begins with individual cases. Any individual or enterprise is weak in front of a strong government. But as Erasmus said, “even the most powerful monarch cannot afford to provoke or despise even the most humble enemy.” (2003, P. 17) the institutional impact of these cases is not individual, but throughout the whole society. As long as such cases continue to increase, the consequences will eventually appear slowly and steadily. Moreover, now it is not only a case, but has been extended to the elimination of one and another whole industries. For example, the ban on out of school training is said to have led to the unemployment of 10 million teachers (small tax, 2021), the closure of private schools has led to the unemployment of more teachers, and the sudden removal of all Beijing home-stay hotels from the shelves has caused significant losses to thousands of home-stay-hotel owners. These situations have a scale that affects macro data. Since the second half of this year, the economic growth rate has decreased month by month; In August, industrial growth decreased by 1.2% month on month (Fan Gang, 2021); GDP grew by 4.9% year-on-year in the third quarter, much lower than 13.6% in the first half of the year. Economic slowdown will directly hinder the process of urbanization and further reduce land prices, thus disintegrating the core mechanism of the existing financial-fiscal mechanism, and the financial crisis is coming. This will have an impact on the real economy and make the whole economy fall into stagflation. The recession won’t be far away. Maybe within two years.

It is right forever that property rights institution, contract rules and rule of law are as the basic institutional structure of economic development. The miracle of China’s 40 years of Reform and Opening Up is mainly the result of establishing and protecting the property rights institution, carrying out market-oriented reform and promoting the rule of law. Until now, the excellent performance of China’s economy has also benefited from the market-oriented reform started in 1978, including the legalization and normalization of government policy-making. Today, the opposite behavior is just under the halo of China’s miracle caused by the above reform, abusing the wealth flow created by Reform and Opening Up and damaging the institutional foundation of reform and opening up, which will eventually make China lose the institutional factors of economic development. The reason why this happens is that power is not constrained. The so-called “unconstrained” means that the administrative department of the government is not bound by China’s existing texts of Constitution and laws. In these texts, there are clearly defined constitutional principles and constitutional rights, and administrative procedures that require administrative departments to strictly follow. As Mr. Liang Zhiping said, the minimum requirement of reform is that the party and government departments follow and implement the Constitution and laws they participate in the formulation. This is to restrict power. Therefore, in order to avoid the collapse of China’s economic development momentum, it is necessary to have a government that abides by the Constitution and laws and whose power is constrained.

Reference:

Mancur Olsen, “Dictatorship, democracy and development”, Modern Institutional Economics, China Development Press, 2009.

Fan Gang, “Soft landing for reducing risks, increasing supply and restraining house prices”, viewpoint real estate network, September 21, 2021.

Jingwei observation, “Ranking list of thunderstorms of real estate companies in September 2021”, Baidu Real Estate Shantou Station, September 17, 2021.

Commons, Institutional Economics, Commercial Press, 1983.

Knight, Risk, Uncertainty and Profit, People’s University of China Press, 2005.

Sheng Hong, “How to reverse the economic downturn?”, FT Chinese, January 22, 2019.

Sheng Hong, “The judicial process should follow the basic rules of communication”, Professor Sheng Hong, WordPress, August 26, 2021.

Sheng Hong, “The road to evil is illegal”, Professor Sheng Hong, WordPress, September 5, 2020.

Si Qipu, “The first case of voluntary confiscation of private enterprises: where does Xiangda group come from?” Baidu, June 4, 2021.

M. Fujita, Paul Krugman, etc., Spatial Economics, China Renmin University Press, 2005.

Wu Lei, “Briefing on the second day of court trial of Dawu case”, Wechat circle of friends, July 16, 2021.

Xiaoshui, “It has become a trend to ban out of school counseling institutions. Where are the 10 million unemployed?” Tax Saving Network, August 4, 2021.

Erasmus, On the Education of Christian Monarchs, Shanghai People’s publishing house, 2003.

Yin Zhongli, “Turning point signal in the real estate market”, Tencent, September 20, 2021.

Yu Jingwen, Wang Min and Guo Kaiming, “Land finance or land finance?”, economic science, 2019, issue 1.

October 21, 2021 in Fivewoods Study

A Feeling of Visit to Small West / Sheng Hong

The prince was traveling with a bowl for begger,
What he got was body's goldern wrapper;
In the west there are thousends of Buddas,
About true law who could give an answer?
王子托钵行,化来金裹身;
西天有千佛,真法问哪尊?

Note: English is not my mother language. As a practice, this poem is translated from my poem in Chinese: 游小西天有感。 I hope the experts who master both English and Chinese to offer me some suggestions.

Clouds and Water in ShenTang Ravine|Sheng Hong

Water is endless along deep ravine,
Clouds are above high mountain;
Water is winding becuase of freedom,
Clouds are amazing while floating.
峪深水不穷,峰险云高起;
自在方婉转,飘逸若神奇。

Note: English is not my mother language. As a practice, this poem is translated from my poem in Chinese: 神堂峪之云和水。 I hope the experts who master both English and Chinese to offer me some suggestions.

A Song of Water When Visiting White Tiger Ravine / Sheng Hong

The great Tao is shapeless,
Water is as if it is;
Its thousands changes are toward kindness,
Conscience is emerging in my mind when facing the falls.
大道本无形,惟水参差是;
千变皆为善,临瀑悟良知。

Note: English is not my mother language. As a practice, this poem is translated from my poem in Chinese: 游白虎涧咏水。 I hope the experts who master both English and Chinese to offer me some suggestions.