Who needs the rule of law, anyway?

The Pudong area of Shanghai, as seen from the Bund (Source: Flickr: mclcbooks)The Pudong area of Shanghai, as seen from the Bund (Source: Flickr: mclcbooks)

China is not always known for its adherence to the rule of law.  The judiciary is controlled by the Communist Party, and criminal trials, which 98% of the time result in convictions, “often amount to mere sentencing announcements”, according to Freedom House.  The law that exists is flouted with impunity; provisions against torture do little to undermine China’s network of “black jails”, or unofficial detention centres, where abuse is rife.  Business proceedings are just as messy.  Officials – who have the power to veto projects or withhold resources – are not averse to bribes; the high-profile anti-corruption campaigns of recent years offer only a glimpse into the dealings of a government that is above the law.

The rule of law is not held in high esteem in the country; and the World Justice Project ranks China 13 out of 15 countries in the region in its Rule of Law Index. But economic growth continues unabated – even if at a slower pace in 2014.  Since 1989, China has averaged an economic growth rate of 9.1%.  On occasion, policymakers insist that there is order, and a foreign ministry spokesman is adamant that “China is a country governed by the rule of law”.  But the reality is that Chinese policymakers are a lot more ambivalent; they want “rule by law” more than the rule of law. Their formulation inverts the role of the Chinese Communist Party (the CCP); under the former, the CCP rules with law, while under the latter, the party would be held accountable to the law.  Some Chinese officials feel that the adoption of Western institutions that promote freedom, the rule of law and democracy, are irrelevant in determining future economic growth.  If the policies are right, and there are provisions for a free market, then why bother with tedious and costly overhauls of the legal system?

China is the classic counterexample to a doctrine of economics that has become orthodoxy: that a strong rule of law is key to achieving economic growth.  This idea is responsible for the fact that since the 1980s, economic actors – from the World Bank to individual governments – have made institutional overhaul a pre-condition of receiving aid.  It is behind the fact that the EU requires prospective members, such as Turkey, to show advances in following the rule of law, using indicators such as whether the country has an impartial judiciary.  And such moves have yielded returns. Lithuania – which undertook drastic reforms to the end of joining the EU – is now in the middle of an economic boom, with GDP growth per annum of 4.3%.

Why does it matter?

Why do economists, such as Nobel Laureates Douglass North, in Institutions, Institutional Change and Economic Performance, and Amartya Sen, in Development as Freedom, both stress the importance of the rule of law to economic growth? We can answer this question by first considering what the rule of law is.  The crux of the concept is that government takes decisions in accordance with the law, and is itself bound to obey the law by an independent judiciary. In countries lacking the rule of law, the government makes arbitrary decisions and it is difficult to plan for the future.

The rule of law comes in thin and thick variants. The thin, or formalist, definition is that the law must be well-known and applied without distinction.  A thicker definition is proposed by theorists such as Sen, who insist that the content of the law matters; in other words, the law must enhance the capabilities of the populace by ensuring that basic rights are protected.  Countries like Singapore could be seen as qualifying under the former conception but not under the latter; this is because such countries have a well-enshrined legal system, but one that fails to uphold democracy or individual rights to the same extent as other countries’.

Either way, it is easy to see how the rule of law, in its thin or thick forms, can be good for the economy.  It guarantees property rights, secures contracts and promotes fair competition.  Investors can invest without the fear that their circumstances will change at the whim of a government official.  The application of the law to the government helps to stem corruption and promote fair competition.  Citizens bound by the rule of law are free of political oppression or the imposition of informational asymmetries that harm the functioning of a free market.

A nice idea in theory, but does it correspond with the data? The answer is that it overwhelmingly does.  Irrespective of the measure used for the rule of law, economists have repeatedly found a strong correlation between the rule of law and GDP per capita.  Rigobon and Rodrik insist their regression analysis shows causation goes one way and not the other; that improvements in the rule of law lead to a rise in incomes.  The causal link doesn’t exist solely because richer countries have more government revenue to invest in better institutions. It exists, they argue, because the rule of law causes economic development. This conclusion has dramatic policy implications.  It means that development economics shouldn’t merely be concerned with outcomes in terms of health or education, or the protection of infant industries, but that political reform can be an efficient mechanism for promoting economic growth.

Source: Kaufmann, Kraay and Mastruzzi 2002

(Source: Kaufmann, Kraay and Mastruzzi 2002)

 

Back to the Middle Kingdom

But what about China, soon to be the world’s largest economy? Corruption is rife, and there are poor levels of formal governance.  Legal codes are under-developed and under-enforced. The CCP acts as though above the law and the constitution.  But fuelled by massive quantities of foreign investment, it seems to be on a non-stop roadtrip to a capitalist utopia, taking a newly built bypass that avoids adhering to the rule of law.  Its economic policies are not perfect, but are well-implemented and come somewhere close to the Washington Consensus – that governments liberalise, privatise and stabilise.  Does the case of China show that policies matter more than the rule of law?  Does it show that the rule of law is irrelevant altogether?

Unfortunately for China, the answer is no. China is considered as a special case.  A number of alternative mechanisms kick in to compensate for the lack of the rule of law. China may not be free, but for its defects it is a surprisingly good place to do business.

First, Confucianism, with its emphasis on trust, acts to secure contracts and give investors confidence.  China has a higher level of social trust than the vast majority of nations.  Furthermore, this means that the formal governance structures that ensure the success of firms in the West are not necessary.  Good management is valued for its own sake in Chinese culture.

Second, the country has lower entry barriers than other comparable nations.  Much of this is due to TVEs (Township Village Enterprises).  Local governments can enter into formal partnerships with private enterprise.  At its lowest levels, the government has an incentive to promote a friendly business environment.  For example, it can streamline the process of applying for a licence.

But with the rule of law, the Chinese economy would grow even faster.  The graph above is a little skewed.  China is growing, but it has not grown as much in recent years.  Kenneth Dam points out that China is not as developed as many believe it is.  Huge swathes of the country remain in poverty.  It still has a long way to go.  The question is whether it can continue to grow without making concessions to the rule of law.  Pessimists point to Argentina.  After World War II, European refugees clamoured to take boats to the prosperous South American country.  Three recessions, sixty years and two dictators later, Argentines, whose prospects of success were scuttled by a failure to improve the rule of law, don’t look so lucky.

Another complication is that a rise in GDP per capita on paper doesn’t necessarily equate to economic development. Equatorial Guinea, with a growth rate to envy and a GDP per capita that places it 31st in the world as of 2013, manages to thwart the rule of law.  Its President and strongman since 1979, Teodoro Obiang Nguema Mbasogo, is notorious for cracking down on opposition figures and the press.  Corruption is rife, and the country is a difficult place to do business, placed 165 out of 189 in a ranking compiled by the World Bank Group.  His son and presumed successor was accused in 2012 by the US Department of Justice of having carried out a “corruption-fuelled spending spree” in the US.  A very deliberate attempt to overlook the rule of law funds his passion for Lamborghinis and Californian mansions. But the spoils of oil, rented out to multinationals, disguises the fact that Equatorial Guinea is incapacitated when it comes to producing goods and services on its own.

China is experiencing more genuine economic development than Equatorial Guinea is; it has increased its productive capacity in a meaningful way, but there are serious questions about the accuracy of its GDP figures and what exactly that represents.  But that doesn’t mean that the impressive figures, fuelled by fortuitous circumstances that are unlikely to continue forever, aren’t disguising some of the serious problems in China.  Businesses still report that there are unreasonably high entry barriers for foreign firms; in other words, the selective application of the law along protectionist lines inhibits the proper functioning of the market.

In any case, it seems that China is getting a move on.  In October last year, the Central Committee vowed to implement “socialist rule of law with Chinese characteristics” by 2020.  In nominal terms, that’s certainly a start.