This is the first of ten articles (not consecutive) I intend to write on Hong Kong’s so-called deep structural contradictions – a common term used to describe the perceived public policy malaise that has inflicted Hong Kong. The central government has, on more than a few occasions, called upon the government of the HKSAR to address these so-called contradictions.

However, the nature of these contradictions is not entirely clear. Indeed, views differ greatly. The most common features I have found are: (1) contradictions within society, for example, disparities in income and wealth, or the conflict between development and environmental concerns, (2) contradictions arising from the need to engage a new external environment, for example, the economic rise of China and the regional or global financial crises, (3) the fragmentation of political life and the inability to build a policy consensus, and (4) a growing sense of the loss of identity and purpose in terms of what the community shares and what it aspires to.

Today the Financial Secretary will deliver his Budget Speech, so this is a good place to start.

Since the time of John Cowperthwaite, financial secretary from 1961 to 1971, Hong Kong’s basic economic policy framework has been a commitment to a limited government. This still shapes our budgetary policy. Cowperthwaite’s world view, and some would say his wisdom, was revealed in his first speech as financial secretary in which he stated: “In the long run, the aggregate of decisions of individual businessmen, exercising individual judgment in a free economy, even if often mistaken, is less likely to do harm than the centralized decisions of a government, and certainly the harm is likely to be counteracted faster.”

Cowperthwaite’s policies attracted the attention of Milton Friedman, whose 1980 television series ‘Free to Choose’ featured Hong Kong’s economic story as its inaugural episode. Friedman gave Hong Kong its most well known brand name as the freest economy in the world and its example inspired numerous nations to dismantle their dirigiste economies. The decision of Brazil, Russia, India and China to abandon their failed economic policies, a move which benefitted large segments of humanity, could not have occurred without the successful examples of the world’s freest economies. In this group Hong Kong stands tall.

Cowperthwaite’s successors Philip Haddon-Cave (1971-81), John Bremridge (1981–86), and Piers Jacobs (1986–91) remained true to his vision. Haddon-Cave christened it ‘positive non-interventionism’ and used it to withstand incessant pressure for government intervention. But the world was changing and Hong Kong’s political system was growing more representative, forcing the financial secretaries’ policies to gradually respond to populist demands. Macleod characterized the Hong Kong model as consensus capitalism, and he was probably the last financial secretary to enjoy the luxury of reasonable consensus.

Since Macleod financial secretaries have found it necessary to articulate a new description of their policy approach. Donald Tsang (1995–2001), emphasized “maximum support, minimum intervention and fiscal prudence”. Antony Leung (2001–03) saw the government’s role as “a proactive market enabler”. Henry Tang (2003-07) upheld the principle of “market leads, government facilitates”. The commitment to a limited government was still present, although its tone was modified. This is perhaps unfortunate for those who believe in limited government, but totally understandable. That they have not further weakened the original policy framework reflects positively on their very considerable skill and wisdom.

Hong Kong’s government is less limited today, but it remains more limited than most governments around the world. And for this stellar achievement the financial secretaries of Hong Kong, since Cowperthwaite, should all be congratulated for a difficult job well done. Cowperthwaite has left a rich legacy for Hong Kong’s public administration which has led to enormous benefits for its people.

In what way has the Hong Kong government become less limited? And might this evolve into a deep structural contradiction? Will it threaten our economic vitality and trigger lower economic growth? I think it will, but let me explain.

Economic Prosperity and the Size of Government

Open markets and the rules and institutions that support them are critical for continuous economic prosperity. Markets may not always be perfect, but they often are, and they have served as the primary source of the global prosperity we have enjoyed over the past two and a half centuries. Sixty years ago many economists were lured into believing that a government-directed economy could work better than an open economy. But the collapse of the centrally-planned economies of the Soviet Union, Eastern Europe and China, as well as the failures of dirigiste policies in many developing countries, should now leave little doubt that open markets are powerful promoters of continuous prosperity.

Some economists argue that governments play a positive role in advancing economic growth. To support their argument they point to the success of some of the mixed economies. I think their argument is misplaced. China is still a mixed economy, but it owes its rapid growth in the past 30 years to its commitment to opening its markets, rather than to more government control and direction. A smaller public sector leads to a more efficient economy and better prospects for long term growth. The success of many mixed economies like those in Erurope, Japan and South Korea would have been greater had their markets, especially service markets, become more open and less directed or regulated. The economic literature strongly supports this view and it is further emphasised by the recent emergence of Brazil, Russia, India and China as the BRIC economies.

Governments frequently claim credit for the economic benefits of their policies and initiatives. This is so even when they are not justified. We should not envy their claims, but we should neither confuse political rhetoric with analysis. I am, however, unaware of any theory that states governments are more efficient than the market in promoting economic growth. There is, however, a theory to the contrary, one that is supported by a great deal of evidence. I do believe that government has an important role to perform in any economy, but its policies work best by allowing the open market to function, rather than by hampering it. For this reason, much of an economic policy’s success in promoting continuous prosperity can be credited to a limited government.

Governments today use six policy instruments to achieve their economic objectives. They can provide goods and services directly, tax, spend, issue public debt, regulate economic activity, and issue money. The scale and scope of each of these insturments, taken in its totality or in some aggregated form, would be an indicator as to whether the role of government in the economy is a limited one or an extended one, and this will reflect its level of success in promoting continuous economic prosperity.

A limited government would preserve a large share of the economy under private control or ownership, and let the market guide most economic activity. An extended government would leave more of the economy under public control or ownership and let economic activity be governed by public bureaucracy. Hong Kong’s record on limiting the direct public provision of goods and services has been a good one in the past decade or so.

We have seen some high profile public infrastructure works in the areas of transportation, infrastructure to address environment-related concerns, and the development of the West Kowloon Cultural District. The sums involved are not small, and not all projects are well justified, but at least some were unavoidable. A number of opportunities to privatize government assets are no longer even considered – the Post Office and Water Authority are glaring examples. These would be included on the list of missed opportunities for fostering greater prosperity, but as the public is not too upset, why fix it.

More significantly the ending of the Homeownership Scheme and the proposal to establish private hospitals, provide direct subsidy to schools, and set up privately funded higher education institutions are important steps in keeping governments limited. And the administration should be roundly congratulated on these latter initiatives.

Lower taxes, balanced budgets, and no public debt contribute to lowering spending and a smaller public sector. Since public debts must be repaid eventually through higher taxation they are synonymous with extended government. A large public debt hinders the growth of the private economy by crowing out private initiative. Vigorous attempts by government to balance the budget and avoid deficits and public debt are an important factor in preserving the long term growth potential of Hong Kong’s economy. For this reason, the financial secretaries, and especially those who took office as our political system became more representative, should be appreciated for their steadfastness in not yielding to populist political pressures. The conservative budgeting policy that aims for balanced budgets, but often ends in surplus, is a sound policy. It should not be a cause for embarrassment and certainly not be considered a failure.

A quarter of a century ago Japan was touted as one of the world’s leading economies. But it has been mired in close to zero real per capita growth for a generation now because in clearing its huge private debts, after the collapse of its asset markets, it has continued to pile up enormous public debts. As long as these remain unchecked and not reversed, the growth prospects will remain unpromising. The United States today has similarly replaced its private debt with public debt. But it has no appetite for a credible proposal to reduce this. And until this happen its growth prospects will remain uncertain. The drawbacks in both these countries have been divisive politics within government that demands strong statesmanship to make bold and painful decisions and to convince the many interest groups, and their legislative representatives, to accept those decisions. Fortunately, Hong Kong’s public finances have not sunk to such a sorry state.

The Damaging Effect of Regulations

What is not so widely recognized is that fewer regulations also leads to a smaller public sector and a more efficient economy. First, regulations have to be enforced and this would imply a larger public bureaucracy and possibly a busier judiciary.

Second, regulations that are adopted tend to be political compromises between various interest groups. None of the affected parties are fully satisfied with the outcome and often continue to lobby for further regulatory changes. Additional time, effort and resources are inevitably spent on amending and modifying the initial regulations.

Third, adopted regulations, no matter how well conceived, or how thorough the public consultation, inevitably suffer unforeseen third party effects. In other words, parties who have no direct interest may well be affected unintentionally. Further mitigating measures are therefore introduced to correct the unforeseen consequences. This process can continue ad infinitum. Regulations therefore beget regulations. The public bureaucracy expands.

Regulations are essentially another way of redistributing resources within society without resorting to the taxation-spending-deficit financing mechanism. They are rules that force one person pay another directly thus avoiding indirect resource transfers through government. For example, the minimum wage redistributes resources from some firms to some workers. It has third party effects in that very low income workers find it more difficult to secure jobs and small low efficiency firms may lose market share. Affected parties are naturally willing to invest considerable private effort and resources to gain beneficial or favorable regulations. This type of unproductive activity is well known to economists, who refer to it as rent seeking.

In contrast to profit making activity, which increases total value and wealth, rent seeking activity merely results in a redistribution of resources. Since time, effort and resources must still be spent these redistribution measures are not costless. Rent seeking activity, in effect, decreases total value and wealth because it distorts the market place’s incentive-and-reward structure, making it less flexible and responsive. Worst of all it wastes an enormous amount of resources.

Rent seeking is a modern term, but an old idea that was first articulated by the famous Italian economist, Vilfredo Pareto, in Cours d’Economie Politique, as far back as 1896. He painted a vivid picture of how a proposition to levy a franc a year on 30 million inhabitants, and to distribute the resulting sum to 30 of them who would receive 1 million francs each in the name of some laudable pretext, would generate an intense electoral campaign to win political support. He concluded that the proposition would be a political success because the 30 persons who stand to gain would work hard for its success, while the 30 million who stand to lose would be indifferent about the outcome. The late Professor Mancur Olson developed the idea to account for the rise and decline of nations throughout history. He stressed that civilizations and societies that engage in increasing rent seeking activities eventually stagnate and decline.

Hong Kong today is becoming a more regulated economy and is indirectly growing its government. The administration has proven unable to resist the lobbying for more intervention through regulation. Its attention has been focused on resisting attempts to increases taxes and spending, and avoiding deficits, but not the proliferation of regulations, the growing burden of which will inevitably reduce the flexibility of Hong Kong’s legendary open market. As a small city economy this loss of flexibility comes at a huge price, especially at a time when it needs to respond to siesmic changes in the global environment – financial crises and the rise of many emerging economies.

The Record and its Consequences

Since the issue of money in Hong Kong is arranged under a currency board, the list of available policy instruments is reduced to only five. This is a stroke of luck for it avoids politicizing the issuance of money, which would have truly disastrous consequences for the economy.

The Basic Law has provided some credible defense against a direct assault on the policy framework of a limited government through its articles on confining public expenditures to revenues received. Unfortunately its numerous articles, stating the role of government to promote a seemingly endless list of activities – from industry to commerce, and from health to social welfare – is a recipe for regulatory explosion.

Successive generations of Financial Secretaries have been able to uphold Cowpethwaite’s legacy by limiting the public provision of goods and services, taxation, spending, and issuance of public debt; but it has not done well in the area of regulation. In the long run, it is this that will have the most damaging effect on future growth.

Government regulation of the economy is the bread and butter of representative government. It is often the most favored recipe precisely because there is a limit to how much one can ultimately tax the citizen. Keynes legitimized deficit spending as a temporary solution for economies in recession and depression, but its role as a temporary counter-cyclical measure has become a license for irresponsible government, as public debts have exploded first in Latin America and other developing economies. More recently Japan has broken new records as it struggles with economic stagnation. Since 2008, countries in the developed world have been competing for the title of most highly public debt ridden nation.

Francis Fukuyama has pointed to an important plight of liberal democratic regimes in his article, “US Democracy has Little to Teach China.” He states, “The most important strength of the Chinese political system is its ability to make large, complex decisions quickly, and to make them relatively well, at least in economic policy.” That is the record up to this point. But he worries, “There is a deeper problem with the American model……At present it shows little appetite for dealing with the long-term fiscal challenges the US faces. Democracy in America may have an inherent legitimacy that the Chinese system lacks, but it will not be much of a model to anyone if the government is divided against itself and cannot govern.” In its present state the current model gives democracy a bad name.

Hong Kong’s political system is showing signs of a government divided against itself. This bodes ill for the future of our economy. Citizens on the Mainland sometimes misunderstand this as the incompetence of our civil servants and sometimes mistake it as a failure of our system of government. Hong Kong’s democracy advocates blame the problem on a half-baked democractic system. But I am not sure anyone has the correct answer. The problem is a diffcult one and we face an enormous challenge in understanding our predicament and overcoming it.

I think a limited government, with well aggregated expectations, must be part of the answer. In this matter the time tested views of Cowperthwaite have much to teach us. As we move forward in the construction of tomorrow’s political system and build a policy consensus, the task of restraining the explosion of redistributive regulations should be given much greater thought than it has been so far in the Basic Law. We need a responsive government, but we also need well aggregated public expectations.

References:

Francis Fukuyama, “US Democracy Has Little to Teach China”, Financial Times, January 17, 2011

Mancur Olson, The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities, Yale University Press, New Haven and London, 1982

1st of 10

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