1 Understanding China’s Transition to A Modern Contractual Economy

Applying economics of institutions, this paper proposes an analytic framework for understanding China’s transition from a dynastic-central planning system to a modern free market economy. The paper first examines how the contractual nature of modern free market economies is maintained through an array of institutions including free trade, private property, private enterprises, independent judiciary with judge-made law, and democratically elected government. These institutions together ensure that value-seeking is encouraged while rent-seeking discouraged in a contractual economy. Due to the difficulties of establishing these institutions from scratch, transitional economies are prone to both vibrant value-seeking and pervasive rent-seeking. While value-seeking leads to rapid economic growth and rising private income, the associated rent-seeking may lead to various social costs. The social costs would be concentrated in the form of public sector losses and liabilities due to dominant state ownership of enterprises and banks and would lead to financial crisis such as inflation and rising national debt as well as social and political crisis. The public sector losses and liabilities thus are driving the reform cycles during China’s transition from plan to market. Recent intensive exposures to the Western legal and political institutions in the Greater China through international trade and investment may however break the reform cycles and eventually completing China's transformation into a modern contractual economy. 2 1