On Civilization and China in Li Lu’s New Book 《文明、现代化、价值投资与中国》

July 21, 2020

(Part 1 of 2)

Li Lu has always been someone who I admired greatly: intelligent, articulate, yet forevermore low-profile and down to earth. In the past quarter century, he built one of the most successful investment track records ever. Although already a legend in the circle of value investors, he seems to be very intentional of avoiding fame and thought leadership, rarely appearing in public unless for a lecture at a business school. When his book dropped in April this year, I immediately got my hands on a copy. Here are a few things I've learned after reading it a couple of times.

Civilization

The book starts out by covering a broad topic: human civilization. From attempting to understand our shared two-million-year-old past, Lu hopes to gain some foresight as to what awaits us in our future. A few books that he referenced are also a few of my favorites on the topic:

From these books, Lu introduces our civilization in three stages:

  1. Hunter-Gatherer
  2. Agricultural
  3. Industrial/Technological (modern civilization)

Jared Diamond famously said that the rise of European and Asian powers in the Agricultural Age was predetermined by geography and climate. Out of all the edible grains in the world today, only five (wheat, corn, rice, barley and sorghum) stood out as the main sources of energy consumption for humans. When it comes to animal husbandry, out of 148 mammals on earth, we were only able to domesticate 14 types of animals. In addition, out of the five most important domesticated animals today (sheep, goats, cows, pigs and horses), four could trace their origins to Southwest Asia. Naturally, where these grains grow and harvest the best and where these animals survive the easiest would also determine where humans flourish.

Most of Lu's focus on civilization, however, revolves around "civilization 3.0" -- industrial revolution, technological revolution and modernization. He starts out the discussion at Axial Age, a period between 8th to the 3rd century BCE, named by German philosopher Carl Jaspers. During these years, humans "leveled up" their thinking and understanding of philosophy and religion and achieved cultural and spiritual awakening. The thinkers during these years still influences the way we think today:

Jaspers noted in his book Origin and Goal of History that these great thinkers shared many similarities. They all existed in a period of great struggle and uncertainty, with governments that were autocratic and corrupt. Their audiences were mainly the lowest class of citizens, minorities, and the repressed. Although their teachings were often revolutionary, they weren't actual revolutionists. The intent was often simpler: to understand the meaning of life and what makes a society fairer and better.

Lu's interpretation here is that

human nature dictates that emotionally we pursue the equality of results (resources and money) and rationally the equality of opportunity

I think this is a very important notion. By linking human nature directly with the pursuit of equality and fairness, he is able to explain to his readers that the following are the the greatest innovations of human civilization:

  1. Free market economy
  2. Ke Ju (科举制, civil service examination system based on meritocracy)

Ke Ju (科举制) came first. The Chinese imperial examination system (~220 B.c.) was used to recruit talent from all over the country to make up its governing body. It took both attitude and aptitude into consideration, and promised a fair, open, and transparent chance for all, regardless of family background or upbringing like the systems prior. Because of this universal recruiting method, China was able to incentivize talent to participate in government and politics, provide upward mobility for its citizens, and to economically lead the world for more than ten centuries afterwards.

Fast forward to the 1200s and Magna Carta, then 1689 and the Bill of Rights, Europeans slowly started taking power away from the crown and into the hands of the "people" (represented by the wealthy). In Britain, these important policy changes marked the transition to limited constitutional monarchy, arguably equally significantly, the first "commercial constitutional state" -- one where the House of Commons represents the interests of businessmen and property owners. It sets Britain up to become the indisputable commercial hub of the 17th century.

It was also at this critical juncture in history, a transcontinental trade network was quietly being established in the Atlantic, starting with the discovery of the Americas in end of the 15th century. The Transatlantic Trade Network was the first decentralized market ecosystem not controlled by a single nation state and an experiment of true free capitalism. The pros and cons of such a bold experiment are still being felt today, from social issues like racism in the Americas to economic ones like the impact of globalization and monopolies.

Lu also reiterates the importance of free market economy by pointing out that 1776 was a special year where a series of important events happened that officially transitioned the western world into civilization 3.0:

Adam Smith is well known today as the father of economics and modern capitalism. Almost weekly on CNBC, people still reference the "invisible hand" of the market, a concept Adam Smith coined to describe the automatic pricing mechanism in an economy. Adam Smith's concept of the "invisible hand" was less biased than modern interpretations. Today, the free market ideology largely uses it to justify that while unfettered by the intervention of government regulations, society would flourish organically due to the competition that it naturally fosters. A smaller government should always function better because it leaves room for private ownership and partnerships, and creates as little resistance to the "invisible hand" as possible. Greed of the consumers that demand the best product at the lowest price would drive the market to a point of absolute efficiency.

The Declaration of Independence and the steam engine need no further introduction. Lu highlights the importance of rule of law and technological achievements in the modernization of the western world, the former surrendered by the monarch, and the latter made possible by free market competition.

Monopolies and the Free Market

Monopolies took many forms throughout human history - from forms of governments like city states and nation states to joint stock companies like the EICs (East India Company). There seems to be a natural tendency for humans to form these all powerful entities in order to achieve greater degree of control. Lu proposes another way to look at monopoly that I never considered before: a global market being a monopoly, from which he summarizes the Iron Law for the Civilization 3.0:

一个自由竞争的市场就是一个不断自我进化、自我进步、自我完善的机制，现代科技的介入使得这一过程异常迅猛。这样在相互竞争的不同市场之间，最大的市场最终会成为唯一的市场，任何人、企业、社会、国家，离开这个最大的市场之后就会不断落后，并最终被迫加入。一个国家增加实力最好的方法是放弃自己的关税壁垒，加入到这个全球最大的国际自由市场体系里去；反之，闭关锁国就会导致相对落后。这就是3.0文明的铁律。

The only way to survive is to join in on the biggest global free market. Any entity attempting to create barrier (ie raise tariffs), break away to create smaller regional markets, will eventually become obsolete and will be forced to rejoin the monopoly later.

According to Lu, humans fought for control over land in civilization 2.0 (Agricultural Age). In civilization 3.0, we fight for the control over the global market monopoly. The size of an economy's market determines its longevity. After WWII, United States gave up a lot of land it captured. Instead, it started forming a series of global organizations, such as the United Nations, World Bank, IMF, and Bretton Woods. These international organizations essentially set up a global marketplace. The U.S. also fought hard to hold on to the rights of creating, changing, and enforcing the rules of this marketplace. Initiatives like the Marshall Plan and security treaties with Japan and Korea can also be seen as such efforts. The establishment of a global marketplace also greatly accelerated the effect of globalization.

Globalization is a very unique phenomenon in human history. A completely global free market economy we have today really only existed for 30 years or so, since the end of the Cold War in 1989. During the Cold War, we had two major economic sphere of influences. Both superpowers used trade sanctions, embargoes, and blockage of financial access as means of economic warfare. Eventually, only one market prevailed, and we are living in a world order created by that monopoly today: dollar is the dominant world currency, english is the world's language, Hollywood is the world's culture, and the U.S. military is the world's police force.

China: Past and Future

Economy

To discuss the Chinese economy, it's hard not to talk about John Maynard Keynes. The Keynesian school of economics largely came out of the Great Depression in the 1930s. Contrast to Adam Smith, Kaynes believed that the "visible hand" of the government can help stabilizing the economy through manufactured demand and centralized workforce, thus pulling the U.S. out of economic depressions via increased governmental debt and expenditure. MMT (Modern Monetary Theory) can be seen as an extension of Keynesian Economics. And China has been riding the quasi-MMT train for quite a while now.

Chinese businesses deeply understand the meaning of this "visible hand" from its government. For thousands of years, the Chinese government had always managed its economy, effectively creating a repeated business cycle of opening, prosperity, intervention, lockdown, and reopening. In the past 40 years after Deng, the Chinese economy entered another "opening and prosperity" phase.

Lu noted that even though the exponential growth of China has been impressive, the trend is unlikely to continue unless certain policies are significantly altered going forward. When an economy is transitioning from "developing" to "developed," it's relatively easy to follow the path that others have laid before and copy as much as they can. This playbook isn't new either - almost all Asian countries (Japan, South Korea, Singapore, and Thailand to a lesser extent) rose up in the 90s with the help of central planning. A famous account of Japanese Central Bank's aggressive policies in the 80s and 90s, such as window guidance, can be found in Richard Werner's book Princes of the Yen.

During this period of prosperity, the Chinese government relied heavily on exporting manufacturing (cheap labor) and smart/effective central planning. They guided investments and capital domestically and internationally into important infrastructure projects and achieved unprecedented progress in a short period of time. However, as China surpasses the U.S. and became the number one export nation in 2019, it now needs to turn inwards to seek additional growth. At the same time, as investments continue to creep up and make up almost half of China's GDP, the government will be forced to let go of some of its control on the economy, and give more leniency to the "invisible hand" of the free market. The takeaway here is simple: a centrally planned economy is a short term, opportunistic band-aid solution; it can never be as effective as free market economy during a time of uncertainty - when there's no more path laid out in front by others, governments tend to react slower and are at a position of disadvantage. Hence, Lu lays out his first prediction of China's future: it has to transition from a government-controlled economy to a government-assisted free economy.

To me, this prediction seems overly optimistic, though still quite fun to think about. As China transforms itself into a domestically service oriented economy, consumers will likely demand a more open and transparent society (or at least a fairer financial market). State-owned enterprises (国企) should not be able to borrow the same way they do today, with basically no obligation to repay debt without fear for bankruptcy. Any citizen should be able to participate in the industries that are traditionally limited to certain state-backed companies (finance, energy, or even defense). Financial markets will have to be regulated to attract more institutional capital and stability. Pension systems and social welfare can then be more privatized and therefore not solely be the burden of the central government.

Culture

The author focused on the issue of culture and tradition abandonment by most Chinese living in China today. He believes that a country's culture is "consisted of centuries of habits and traditions, religions and history." It's an all-encompassing belief and faith system that cannot be replaced, it's "deep in the bones." Through cultural revolution, China had attempted to erase just that. The author predicts that in the near future, we will see a movement of Chinese Culture Renaissance. To him, Chinese people must learn to embrace their own culture again before moving into the civilization 3.0.

On the topic of governance and politics, Lu briefly covered three major schools of thought: Ru(儒) or Confucianism, Dao(道) or Taoism、Fa(法) or Legalism. In Chinese politics, it is often believed that achieving a balance among the three can garantee the success of a dynasty or ruler. Lu believes another school of thought, Mo(墨) or Mohism, should play a more pivotal role as China enters its modernization phase. Mohism emphasized universal love, social order, sharing, and honoring the worthy. Equality is a major theme in Mohism, which may be why it has not gained popularity during the dynastic rules of China.

Lu believes that as society advances, the balance between individualism vs. collectivism will inevitably tilt in favor of the former. In an advance economy, individuals should dictate terms and politics and become the entirety of politics (by the people and for the people). Therefore, individual rights such as freedom, safety, and private ownership of properties must be protected, and should be the only function of a government.

To Lu, a modernization of the Chinese culture is just as crucial as the modernization of the Chinese economy. An example he gave was the idea of traditional cardinal human relations, called Wu Lun (五伦八德). It describes five different sets of relationships and defines the proper societal behavior depends on one's role in such relationships:

中国传统文化中的人际关系有五伦，君臣、父子、夫妻、朋友、长幼。五伦的文化中，各有自己的道德准则，父子有亲，君臣有义，夫妇有别，长幼有序，朋友有信。五伦基本讲的是熟人之间的关系，所以中国的文化是人情文化。

Between the government and citizens ("ruler and subjects"): the government must effectively and intelligently protect the safety of the people and their property, this being the equivalent of the obligation in the olden days of rulers to be "competent rulers", while the citizens must pay taxes to the government, obey the government's laws, serve with loyalty and the utmost diligence when recruited or conscripted by by the government, and when appropriate give opinions to the government or try to dissuade the government, these being the equivalent of the obligation in the olden days of subjects to be loyal; Between parents and offspring: parents must raise and educate the offspring, while the offspring must carry out xiao ("be good to parents") and support and care for aged, weak parents; Between husband and wife: both must be of one heart and mind, and help each other to together build a family life where both the next generation is raised and the previous generation is cared for; Among siblings: older siblings must be kind and helpful to the younger ones, the younger siblings must be respectful to the older ones, and all siblings must help each other; Among friends: friends must help each other, especially with mutual encouragement, mutual advice, and dissuasion from what is wrong.

Lu sees a much needed amendment to these five types of relationships as China enters the modern age - a defined way to treat strangers. He believes that by only having these five types of relationships, Chinese society became too much of a GuanXi-oriented society, where GuanXi is often considered above the law. To Lu, rule of law is what defines that relationship among strangers in a shared society with shared ethics, and is crucial to its social order and stability.

更严重的是，缺乏陌生人之间的道德准则，是导致商业诚信缺失的重要原因之一，而诚信恰是自由市场经济的润滑剂

More seriously, the lack of ethical standards among strangers is one of the important reasons for the lack of business integrity, and integrity is the lubricant of a free market economy.