Thursday, September 16, 2010

Transaction costs in China: the Chinese economy's biggest problem

OK, story first.  And there's a point to this story.  I just came back from dinner with a co-worker, and I saw this massive cockroach sitting on my couch.  It was maybe 2 or 3 inches long, plus antennae.  I freaked.  I mean, come on, cockroaches in my apartment???  So when I turned on the light, it quickly ran to hide on the backside of the couch, but I could still see its antennae poking up.  Having no clue how to say cockroach or bug spray in Mandarin, I quickly booted up the computer and fired up Google Translate.  End result, I still don't know how to say those words in Mandarin.  Thanks a lot, Google Translate, your Mandarin pronunciation sucks.  Then I went to a neighbour (the first one didn't answer the door, but the second one did) and struggled through an attempt to ask for bug spray.  Eventually, she got it and got some bug spray for me.  Cool.

Back to the couch, I switched on some more lights, and immediately yelped in surprise (it was a yelp, not a scream, I swear!) because I thought I saw a second roach on my bag.  To my relief, my eye had spied my bag's zipper and mistaken it for a roach.  Then I tilted the couch's back (it's foldable), and sprayed like crazy.  The real roach dashed off to a crack between the couch's base and the couch's seat cushions, where I could spray it no longer.  So next I tried lighting up one of those Raid spiral things to hem the roach in, and then relocated the spiral to force the roach out.  I could hear it scattering all around inside the couch's structure, but it never came out.  Finally, it stopped moving.  I don't know whether it went to sleep or it died.  Most likely it died?  But either way, I'm not happy, because I couldn't flush it down the toilet.  A quick web search confirms that cockroaches are cannibalistic, so if it's dead, there's now a clear food source for more cockroaches.  And if it's alive, then dang, it's still alive.  UPDATE:  Halfway through writing this post, the roach escaped the couch, and I was able to trap it into a dustpan and flush it down the toilet.  End score?  PakG1: 1.  Roach: 0.

The thing is, cockroaches enjoy dirty places.  So maybe all of a sudden, I'm going to become a clean freak.  But isn't it interesting that cockroaches are attracted to and thrive in the dirty places?  So here's the question: why can't cockroaches thrive in clean areas?  You can reach your own conclusions with some research.  Let's now talk about economics.

Old Story #1.  I first learned about transaction costs and the Coase Theorem in BUEC 495 while attending my last semester of school at SFU.  BUEC 495 was titled "Economic Analysis of the Law", was led by a professor named Doug Allen, and was easily the most difficult course I ever took.  I never felt so stupid as I did in that course.  Every class, we had to read some major economic paper and come to class prepared to discuss it.  The textbook was written by this guy named Richard Posner, and it was the only textbook I ever read that literally (not figuratively) gave me a headache.  But I came away from that course with two insights: first, economics is really about behaviour, not money, and second, transaction costs and the Coase Theorem are for real.

Old Story #2.  I was attending a one-day annual student conference hosted by the Fraser Institute, an economic think tank in Canada.  The theme that year was about how free markets enable economic development around the world (or something like that); the Fraser Institute is a firm believer in free markets.  One keynote speaker was a journalist from the Vancouver Sun, and a student asked him what was needed to get various 3rd world nations out of poverty.  The journalist based his answer on a study and analysis that had been done by so and so parties about economic development in Africa.  They found that good, long-term, real economic development had three requirements.  I can't remember all three, but the very first one was "respect for the law" (assuming that the law is of course just).

By now you're either asking what's with all the stories, or you've already figured out how to put the puzzle pieces together.

Transaction costs are the costs necessary for a property owner to establish, maintain, and transfer property rights (courtesy of good ole Doug Allen), whether the property be a plot of land, a car, or a trademark.  So for example, the transaction costs of purchasing a new home would be the real estate agent fee, moving costs (unless it's an investment property and you're renting it out), renovation costs (if it's in need of repair or you want to upgrade something), cleaning costs (who doesn't at least clean the carpet before they move in, if not outright replace it?), taxes, insurance, and so on.  The purchase price is really only one part of the equation.  The Coase Theorem states that efficiency (i.e. an optimal state of affairs) is gained when there are zero transaction costs.  Therefore, if transaction costs exist in a transaction, there will naturally be unexploited opportunities that could have created wealth in the absence of said transaction costs.  Or in other words, if we didn't rely on real estate agents, the seller could make some more money and the buyer could save some more money.  Of course, the real estate agent exists because he has a better understanding of the market and thus lowers the search cost and opportunity cost of real estate transactions, which in themselves could have actually turned out to be much more expensive transaction costs for the transacting parties.  So real estate agents will argue that their role actually lowers transaction costs.

Naturally, if an economy has lower transaction costs, it will have a healthier economy.  If businesses can be incorporated quickly at low cost, entrepreneurs can create new value and jobs faster.  People with poorer skills would not need to rely on big business to make money, but would be able to even open up a vendor cart on the street to make enough to get by.  The talented people would really be able to fly.  Stuff like that.

Old Story #2 explains how transaction costs can actually end up becoming high, even if there are valiant attempts to lower those same transaction costs.  It all comes down to trust and the integrity required to follow a just rule of law.  If there is little or no trust between two parties, then there need to be huge transaction costs to ensure a successful transaction.  Escrow services to ensure the seller doesn't con the buyer and just run away with the cash.  Lawyers to draw up big fancy contracts to ensure consequences if something goes wrong or if somebody is unfaithful to the expectations of the transaction.  In transactions between gangs or drug lords, you would probably even have a ton of armed bodyguards at the transaction scene, just to make sure nobody pulls a fast one or attempts murder.  When you don't trust the other party, you have to pay a lot more to make sure the transaction gets done.  And if your transaction costs end up being too high, then it's possible you have to consider whether the transaction is even worth it.  This is how transaction costs can kill transactions, and thereby an economy.  And if there is rampant corruption in an economy, trust is almost nonexistent, and transaction costs such as bribes and quid pro pro are epidemic.  A free market cannot create wealth in this kind of environment because products and services that provide the best value are not able to compete on their own merits, let alone be profitable if the transaction costs are too high.  In the worst-case scenario, it'll be the unsafe products that thrive, creating mass social destruction and scandals galore.

In China, you still have big corruption issues.  One of my managers (it seems I have 3 managers, I'm not sure?) notes that 60 years ago, corruption was not a problem.  If a public official so much as accepted a bribe, he was shot.  I don't know if he was serious that it was a small problem back then, and I'm not an expert on Chinese history, but he seemed pretty serious.  My friend who had visited China earlier this year told me about a night-time barbecue restaurant he learned about in Beijing.  Apparently, the owner had to pay off both the police and the local gangs in order to keep operating, and he still made a healthy profit.  Some may say that this is amazing, wow, the guy must be rolling in dough.  But the problem is that those transaction costs prevented the owner from making hard-earned, well-deserved cash.  Many people are resigned to the idea that this is simply the cost of doing business on this side of the world.  Here's some news.  If it doesn't get cleaned up, the cost of trust in transactions will keep rising, eventually forcing the economy to stagnate and maybe even collapse.

Transaction costs that create some semblance of value are good.  They're necessary components of a transaction due to our inability to know all things and see all things.  However, transaction costs like bribery and "protection payments" are simply a drag on the economy.  They transfer wealth from enterprises that create value to enterprises that don't create value, which in turn leads to weak gross economic output per capita.  Everyone needs to be pulling their own weight for an economy to truly grow, and for everyone to participate like that, they need to be trustworthy so that other parties will be willing to transact with them.  Those who don't pull their own weight and simply figure out a way to ride the coattails of those that do, they only create economic and social costs that have long-term impact. But because it's easy money, those with the ability (and the necessary lack of morality) will jump at the opportunity to get a piece of the action.  In this sense, society is like my apartment.  A clean society with clear just laws and citizens that are willing to obey and uphold those laws will be able to create wealth efficiently and will not indulge in a lot of crime.  Meanwhile, a dirty society with unkempt laws and an even poorer social infrastructure and law enforcement will only allow the criminals to thrive, because unclear laws that cannot be enforced will disable truly good transactions from being profitable, forcing those transactions to instead disappear.  The cockroaches will thrive, even though the transaction costs of untrustworthy transactions would be high.  Fact is, they'd still be more profitable than just transactions in such a dingy social environment.

This is a classic chicken or egg question.  Which needs to be first?  The good economy to dissuade people from turning to crime and creating a morally bankrupt society, or the good society, to ensure a good economy?  I think Rudy Giuliani was able to prove with the city of New York that social infrastructure matters.  Even something as simple as keeping the city clean of graffiti was key to telling people that New York was a city where you could walk around freely and safely to conduct legal and just transactions (both social and economic) as you saw fit.  Perhaps the most interesting insight is from a prominent Chinese economist who concluded that economies built on the ethics found in churches thrive better than those that are not build on such foundations.  He's an interesting story, an atheist who set out to disprove the Bible, but ended up giving up and converting; either before or after that, he wrote his seminal paper on the subject of ethics in churches and ethics in economics.  He now believes that Christianity can have a profound impact on China and China's economy.  We'll probably see this coming decade whether that will actually be the case, the way Christianity is growing in China.  I have my own thoughts on the subject, but I'll keep them to myself for now.  One could say that the growing lack of ethics that the US has recently shown (especially at the executive and investment banking levels) is the biggest reason why subprime had the effects it did, to say nothing of people like Madoff.

Whatever the root causes and potential solutions are, it's clear to me that if foundational societal ethics aren't figured out, transaction costs will remain high, which could indeed lead to economic unsustainability, no matter how high the Chinese economic rocket grows (perhaps the higher, the worse it could be).  I'll end my thoughts with an explanation of how a lot of the tax system here seems to be administrated, as an example of how bad things can get.

The tax system here is quite different from North America.  When you buy something (anything from riding a taxi to reloading your mobile phone with minutes to eating a meal at a restaurant), you can ask for fapiao.  For some reason, everyone translates the word "fapiao" as "invoice", but the way it's used in practice seems much closer to the translation "receipt".   Since I don't know what the truth is, I'll just say fapiao.  Fapiao have official government stamps and often come in denominations like currency; they can also be customized to specific amounts.  Official fapiao are purchased by the seller from the government and are the only truly acceptable receipts; this ensures that sellers report their income properly.  The fapiao that come in denominations are also lottery tickets to ensure that consumers ask for them.  If someone wins the lottery, the company pays the money and then gets reimbursed by the government.

I need official fapiao from my landlord to be able to get certain benefits from my employer.  Guess what?  My landlord didn't want to get the official fapiao, because he wanted to avoid tax.  He would rather cancel the tenant contract.  So then I started looking for a new place to live.  Gah!  Luckily, my search had me meet a knowledgeable real estate agent (see, understanding of the market!) who was able to explain to my landlord how the fapiao system worked, and that it was possible to just get me to pay for it.  Which is not bad, considering that every new prospective landlord I met expected the same.  None of them were willing to pay for their own tax.

Hey, I get it if a landlord doesn't want to pay for tax, the natural effect of many taxes is for the seller to pass the tax on to the buyer in the form of higher prices.  What alarms me is that the government has to enact and administrate a paper-intensive lottery system to ensure that business owners and landlords report their income properly.  Can you imagine the added cost of administrating such a system in a country of 1.4 billion people?  How much value does this system add to the economy?  None, really.  It's a drain on the economy.  It's only there to try to convince companies to report their income, and it generates no revenues of its own for investing into social infrastructure.  This kind of system is unheard of in many nations with solid economic infrastructures, and it's one of the canaries in the coal mine that maybe things aren't as bright as they seem.

There are obviously a lot of other issues that can also hold China back.  For example, the education system is primarily rote learning, leading to students who lack creativity and critical analysis.  I know from my experiences of trying to teach kids English here on a volunteer basis, and some of my Chinese co-workers say it's a big problem in elementary and high schools.  And goodness knows what'll happen as the population ages and a much smaller generation of youngsters tries to take up the torch.  Etcetera, etcetera.  But like I said before, if China can get things figured out, wow.  They'll be a force.  Rome wasn't built in a day.  But Rome did last a long long time before crazies like Nero came along.  Can the new China be a civilization with such longevity or will they collapse under the weight of their transaction costs?  Time will tell, but I'm quite interested in having a front row seat to the action.

As for the roach?  As you read in the update above, I triumphed.  I hope it was the only one.  I think I'll give the place a good cleaning later this week.


  1. "backside of the coach" <-- couch?

    oh dear, i've turned into THAT guy. the one who points out spelling errors......sorry.

    re: corruption in china - i think that story is very true because i remember either my chinese teacher or east asian studies teacher saying that once when they were visiting china......many many years ago, (1980s, or earlier?) they recalled leaving a toothbrush behind in their hotel room, and being on their way to their next destination, and someone from that hotel caught up with them somehow, just to return that little cheap toothbrush.
    i doubt that would ever happen in china now, unless perhaps you're in the super-rural part, am i right?

  2. /sigh

    Fixed! There, happy! :p Heh.

    I have no idea whether it would happen today or not, but certainly, I can confirm that there is a higher degree of hospitality and kindness evident in the rural areas, from my visits to such rural areas. There's probably multiple factors that go into it. In rural areas, the "little emperor" phenomenon is rare because minorities are allowed to have up to 3 children; I've also just learned that even the Han majority are allowed to have a 2nd child after a long waiting period (like 15 years or something) if they live in a rural village. As well, there's just something about country folk tending to be more homely and hospitable anywhere in the world, whether rural China or rural Canada, huh?

  3. If I knew I have cockroachs in my apartment I could not fall asleep. I hate bugs so much

  4. LOL, well, I did sweep up the whole place last night and also laid some poisoned bait in various corners of the apartment. The lady at the store told me it is rated to kill the cockroaches in 30 minutes of eating, and attracts them through smell. Woke up this morning, no cockroaches, maybe it was the only the one cockroach after all? /shrug

    You must see a lot of bugs in your line of work. :)