Michael Schuman: Contradictions between state and market intensify

Another tumultuous week for China's stock markets has dealt yet another blow to global confidence in Beijing's policy makers. Each tripped circuit breaker and policy reversal has underscored the inherent contradiction China faces - between the leadership's desire for the certainty of state control and the benefits of free markets.

This contradiction has been part of the Chinese economic system since pro-market reform began in the early 1980s. The government's model encouraged private enterprise, foreign investment and international trade while keeping the "commanding heights" of the economy - the financial sector, critical industries - firmly in state hands. The system may have run counter to classical economics, but it was effective, transforming China from an impoverished basket case to the world's second-largest economy, and earning Beijing's policy makers a reputation for sagacity and infallibility.

The problem is that this tension between state and market becomes more dangerous as an economy advances. We know this is true from the experiences of Japan and South Korea, which both used systems similar to China's, produced similar results and then suffered similar problems. China's current woes of high debt, excess capacity and a strained financial sector are all creations of the state-market conundrum. The only way to solve it is for the state to allow the market to hold more and more sway over the economy. It also requires the party to relinquish control.

The Communist Party plenum in 2013 that drew up a long-term road map for economic reform enshrined the state-market conflict as a core principle of Chinese policy. The plenum's communique declares the twin goals of creating an economy "centering on the decisive role of the market" but "with public ownership playing a dominant role."

That conflict is at the heart of the stock-market fiasco. Setting the expansion of capital markets as a priority, the government made the mistake of propagating equity investments on a wide scale. Then, when prices began to tumble last summer, the government, terrified by the instability, jumped in to "fix" the problem. Now policy makers have trapped themselves - attempting to control a market too big and complex to answer to bureaucrats. Instead of developing a respected stock exchange, the state has undermined its credibility.

The same is true with the yuan. Rather than allowing market forces to determine the currency's value, as policy makers keep promising to do, the central bank continues to micromanage it, wary of any dramatic movements. The result is an embarrassing split exchange rate - one onshore, one offshore. Nor are matters much different with the reform of state-owned enterprises. While pledging to make such businesses more competitive and efficient, the government, worried about mass unemployment, has also ordered them to hire army veterans.

Despite endless promises, progress toward more open markets has been glacial, and at times even gone backward. Excessive interference by the government to pump up growth in the wake of the 2008 crisis saddled the economy with the astronomical levels of debt and excess capacity it is burdened by today.

The way China's policy makers can restore confidence in their markets, their economy and their competence is to eliminate the state-market contradiction they've created. This means allowing the stock market to find its own footing, the yuan to discover its real value and state-owned enterprises to compete fairly with the private sector. For a regime that's hitched its legitimacy to its ability to deliver growth, it also means potentially putting their own survival at risk.

The writer is a BloombergView columnist