Can the Chinese Economy Make the Phase Transition to Complexity?

The Chinese economy is facing a crisis. Slowing growth, deflation, and financial instability are converging at once. The reaction by the Chinese government, as it has been in the past, is to impose more control as discussed in this Wall Street Journal article. This has worked before but the situation now seems similar in many ways to the challenges Japan faced in 1990 after it briefly became the world's second largest economy. In Patterns in the Dark (1999) I expressed skepticism that China's emerging hybrid approach, making an economy which was both free-market and state-driven, could work. I was wrong, but the issues I brought up over 20 years ago seem to becoming relevant now.

My skepticism was tied to the belief, combining the Austrian School of Economics with Complexity Theory, that neither fully competitive laissez faire nor structured socialism was the optimal model for the economy. Instead a resilient, growing economy needed to balance the extremes of competition and cooperation at what is called "the edge of chaos" where complexity develops. In light of what's happening in China and it's implications for the global economy, I thought it might be a good time to discuss those ideas.

The Complexity Model

The model had three characteristics:

• Structure vs. Uncertainty,
• Level of Innovation, and
• Cooperation vs. Competition

The three characteristics come together and influence one another.

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Structure vs. Uncertainty

A complex process is balanced between a linear, static environment and a non-linear chaotic one. The three states - static, complex and chaotic - represent the three potential states for economies.

The static state is a controlled one. Utopian models as well as authoritarian economies tend to fall into this category. The economy is controlled by a central agency. These are "command" forms of government where the law is basically about what people can do. Anything that is not defined within the law is forbidden. There is little uncertainty in the static form by design. Static systems also tend to be closed. That is, they do not interact with anything that is not internal.

Chaos would be any area governed by anarchy. Basically, there is no law, and no respect for the law. War torn areas, particularly torn by civil war, tend to fall into this category. Uncertainty is, of course, very high.

A complex society is balanced between the two. The laws outline primarily what citizens cannot do, though there are also laws about what is permitted. There is structure, but there is also innovation. Markets are free, but are regulated in order to protect the citizens from the excesses of capitalism. Laws are also necessary to ensure competition continues since the natural outcome of laissez-faire is not more competition, but monopoly. There is enough uncertainty to allow change and evolution, but it is contained. Complex systems are also open systems which in economics means trade and globalization. Most democratic societies fall into this category.

Level of Innovation

The level of innovation depends upon the level of structure and so, the level of uncertainty. In natural systems evolution and adaptation require a complex but uncertain environment. To much structure and too little uncertainty makes the process rigid. With too little structure and too much uncertainty, it becomes chaotic and unstable. The relationship between innovation and structure is non-linear. It depends upon the number of connections within the system building up to a critical mass.

A simple example of this is the "buttons and thread" model. If we randomly begin connecting a collection of buttons to one another clusters start to form. When the threads to buttons ratio crosses 0.50 the size of the largest cluster suddenly increases from 12% to 85% of the buttons. This is an example of a phase transition. We see this when water freezes and changes from a liquid to a solid, and when a column of smoke begins to break up and dissipate. Likewise, when the number of interactions between economic participants increases past a critical point the economy spontaneously self-organizes into the "invisible hand" of Adam Smith.

Too many economic restrictions through structure, suppress both the ability to innovate and the ability to adapt. Too few restrictions, and there is the anarchy and chaos caused by unrelenting competition.

Cooperation vs. Competition

If you do a web search for sayings about cooperation and competition, you will inevitably have many that favor cooperation over competition. The most quoted one is "Competition is the rule of the jungle, but cooperation is the rule of civilization." Unfortunately, this saying only compares the extremes. A fully competitive society would be anarchy. Everyone is out for themselves. But a fully cooperative society would have no individual freedoms, and individual freedom is necessary for innovation and growth.

So the answer is that a healthy economy requires a balance between cooperation and competition. Competition encourages innovation but cooperation encourages working for the common good. Thomas Jefferson said " . . . rightful liberty is unobstructed action according to our will, within the limits drawn around us by the equal rights of others."?So there must be a balance between our individual freedom and the rights of others. Cooperation and competition must coexist.

China, Then and Now

In 1999, when I wrote Patterns in the Dark, China was just emerging from a strict totalitarian regime. But since it was clear that the Communist Party was not going to give up its power, I was skeptical that the Party would allow enough freedom for that threads-to-button ratio to reach the critical level necessary for an innovative, growing economy. But China did manage to grow exponentially without a high level of cooperation. How? They allowed innovation to come from without their borders. Corporations from other countries set up production within China and drove new product development outside of China. Until recently there was very little innovation coming from the Chinese economy. They were very good at producing product, but creating new product? Not so much. But now that's been shifting. In response, the Communist Party is increasing restrictions and reducing freedom as stated in the WSJ article as well as a Bloomberg article that mentions a crack-down on trading. Their leaders have even said their form of hybrid capitalism was just a way station on the path to true Communism.

In addition, the Party is now facing an economic crisis. When free market economies face such a crisis there are multiple organizations, both public and private, working on a solution. But the chances of one, small group of people coming up with the innovation needed to correct the problem is small. Japan faced a similar problem in the 1990s. "Japan, Inc." couldn't find a solution while the rest of their economy waited. The Japanese stock market only recently crossed its previous high in 1989, a wait of 35 years.

So if China continues to restrict freedoms, the chances of it returning to its former economic glory soon are not very good. They are seeing the strains of their hybrid model. It's time to make the phase transition to full complexity, or revert to the static form. It's time to take the invisible hand.

The Outlook

Optimism for a soft landing and return to high growth for the developed world continue to be the norm. At this time downside economic risks still appear to be low, though geo-political uncertainty remains high. So I've maintained my modestly optimistic stance. We are, however, seeing an increase in financial leverage. If market risks remain low, leverage can be a good thing. But if downside risks increase, leverage can turn on you. Best to be aware.

Please comment on this post if you're so inclined. And feel free to forward this post to anyone you think would find it interesting. Thanks for reading!

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