Politics & Policy

A Lethargic Dragon

From the May 14, 2012, issue of NR.

Americans have always looked abroad for inspiration. Alexander Hamilton drew on the experience of Britain and France to shape the economic institutions of the early republic. In the early 19th century, Henry Clay championed tariffs, a national bank, and internal improvements in an effort to match Britain’s economic might. As the 19th century gave way to the 20th, Germany emerged as an industrial colossus, and American intellectuals had a new model. During the 1950s, at least some Americans, mainly but not exclusively on the political left, saw the breakneck modernization of the Soviet Union as a clear indication that the old-fashioned market economy was on its last legs.

There have been a variety of fads and fashions in the years since. Once it became clear that the Soviet model was not quite as impressive as it had once seemed, liberals and progressives started looking to northern Europe, and in particular to Sweden, for lessons on how to run an economy. Conservatives have swooned at various times over Switzerland and Chile and Singapore, among other capitalist success stories. And then, of course, there was the 1980s-era obsession with Japan, which in the view of some observers was destined to surpass a declining America.

Some of these enthusiasms proved less harmful than others, and some were even constructive. Hamilton was right: The United States really did have much to learn from Britain. Germany’s scientific breakthroughs were indeed enviable. Sweden, Switzerland, Chile, and Singapore all have their virtues, and not just of the culinary variety. Even Japan, for all its economic pathologies, taught U.S. manufacturers a great deal about how to thrive in a more competitive world.

But the belief that we had much to learn from the Soviets was both dangerous and stupid. And much the same can be said for the current enthusiasm over China’s economic model.

You’ve no doubt heard President Obama cite China’s investments in wind and solar energy, and its gleaming infrastructure and high-speed trains, as a slam-dunk case for devoting taxpayer dollars to similar efforts here. Perhaps you’ve read books such as China, Inc., What the U.S. Can Learn from China, or the colorfully titled Becoming China’s Bitch. You may have encountered the work of New York Times columnist Thomas Friedman, who has suggested that America’s political class could learn a thing or two from the Chinese Communist Party.

What you most likely haven’t heard is that across a wide range of economic, technological, and military indicators, the United States is actually, in the words of political scientist Michael Beckley, “wealthier, more innovative, and more militarily powerful compared to China than it was in 1991.” As Beckley explains in a recent article in International Security, China’s growth in per capita income, value added in high technology, and military spending is impressive primarily because China is starting from such a low base. That the United States has continued to grow across all of these dimensions is making it exceedingly difficult for China to catch up. Beckley thus concludes that China is “rising in place.” That is, while China is improving its economic and military position in absolute terms, it is stagnating relative to America, even in an era of sluggish U.S. growth.

This doesn’t change the fact that China’s economic rise since the late 1970s has been impressive. Hundreds of millions of Chinese have been lifted from poverty over the last three decades, and the country’s teeming coastal cities have emerged as the workshop of the world. But to some extent this rapid growth is an artifact of the suppression of growth in earlier years. Whereas Japan snapped back to growth after the Depression and the devastation that accompanied the Second World War, China experienced a bloody civil war and collective traumas such as the Great Leap Forward and the Cultural Revolution, which led to tens of millions of deaths by disease and starvation in the years that followed. Even after those dark days, autarkic policies limited China’s growth prospects until Deng Xiaoping decided to loosen the Party’s economic grip. Those envy-inducing double-digit growth rates are at least partly the product of the catastrophes that came before, rather than of policies the U.S. could emulate.

China might be worth emulating if its growth trajectory were sustainable. Indeed, if China could keep growing at its current rates indefinitely, Beckley’s thesis regarding its relative stagnation would soon seem ridiculous. But there is no reason to believe that this will happen. While we can expect China at some point to have an economy somewhat larger than that of the United States — after all, China has four times our population — the country is plagued by pervasive corruption and bad debts that are already undermining its growth prospects.

And these maladies aren’t just a blemish on an otherwise sterling economic record. They flow from the very nature of the Chinese economic model.

Late last year, Andy Stern, former president of the Service Employees International Union and one of the leading lights of the American labor movement, published a short essay in the Wall Street Journal extolling China’s virtues. He contrasted China’s extraordinary economic success since the late 1970s with the failure of “the conservative-preferred, free-market fundamentalist, shareholder-only model,” which, in his view, “is being thrown onto the trash heap of history in the 21st century.” As Exhibit A, Stern cited a visit to a mushrooming metropolis in China’s southwest: “Our delegation witnessed China’s people-oriented development in Chongqing, a city of 32 million in Western China, which is led by an aggressive and popular Communist Party leader — Bo Xilai. A skyline of cranes are building roughly 1.5 million square feet of usable floor space daily — including, our delegation was told, 700,000 units of public housing annually.”

This aggressive and popular leader has, alas, run into some trouble. Bo, the son of Long March veteran and Chinese vice premier Bo Yibo, has been removed from office on grounds of corruption, and there are extensive reports that he used torture and intimidation tactics to eliminate or discredit his political rivals. His wife is currently under investigation for her alleged role in the murder of British businessman Neil Heywood. To be sure, this doesn’t in itself undermine the notion that Chongqing’s people-oriented development has been an economic success. But a closer examination suggests that the glittering Chongqing that so impressed Andy Stern is a kind of overgrown Potemkin village.

As an inland city, Chongqing has far lower labor costs than do cities in coastal regions such as Guangdong, the affluent southern province that borders Hong Kong. So while Guangdong has been working to improve its economic prospects by upgrading the skills of its work force, giving non-governmental organizations greater freedom to do their work, and embracing private entrepreneurship, Chongqing has been generating growth by shifting workers from agriculture to industry. In other words, Chongqing is a throwback to an older economic era.

Bo Xilai made his mark by using substantial state subsidies to build large public-housing projects and to encourage elite firms such as Apple to locate production facilities in the city. But these subsidies weren’t drawn from Chongqing’s local economy. Rather, they came at the expense of other regions. China’s political authorities essentially decided to turn Chongqing into a showpiece to demonstrate that China’s government is committed to developing the country’s poor interior. And the reason China’s government has to press this message is that, for decades, Beijing has been extracting resources from the poor rural interior to subsidize rich coastal regions.

In Capitalism with Chinese Characteristics, MIT professor Yasheng Huang offers a new take on China’s experience since 1979. Whereas most scholars have seen it as a period of uninterrupted growth and prosperity, Huang divides it into two distinct eras. During the first, which lasted roughly from 1979 until 1988, Chinese economic policy was remarkably friendly to homegrown private entrepreneurship. China’s GDP per capita grew at an annual rate of 8.5 percent during these years, and both rural and urban regions made substantial gains in personal income and consumption. During the second period, from 1989 to 2002, the government embraced a more statist economic approach. GDP per capita grew at an impressive 8.1 percent, yet household-income growth fell from 11.1 percent in the previous period to 5.4 percent. Moreover, the rural areas that had thrived in the 1980s experienced a sharp slowdown in the 1990s. The years since have been a muddle; the central government has been unwilling to surrender control over the economy, but there have been fitful efforts, such as the Chongqing experiment, to spread growth to the interior.

One of Huang’s central insights is that the so-called township and village enterprises that fueled Chinese growth during the 1980s were largely private. Scholars have often mistaken them for state-owned enterprises, thus masking the extent to which China’s 1980s-era growth was a bottom-up rather than a top-down phenomenon. This boom in private entrepreneurship had a particularly big impact in the poorest provinces, partly because local Communist elites were less risk-averse. Rural financial institutions were granted wide autonomy, and they proved a crucial source of start-up capital for new firms. At the same time, the CCP allowed a number of political reforms to increase the accountability of local officials and to guard against corruption.

After 1989, however, the Chinese government embraced a different approach. Rather than tolerate the rise of homegrown private entrepreneurs, Beijing decided to channel investment toward coastal regions and large state-owned enterprises. The financial reforms of the 1980s were largely reversed, as were the political reforms. The result has been a form of investment-led growth that has enriched China’s exporters and its political elites at the expense of Chinese workers.

So why is investment-led growth a problem? It’s not — or at least not intrinsically. Much depends on how efficiently investments are used to increase economic output. Economic expansion flows from two sources: increases in inputs, such as growth in employment levels, rising skill levels of workers, and a greater stock of physical capital; and increases in productivity. Increases in inputs alone can go a long way, particularly in a country that starts out very poor.

China has seen an extraordinary increase in inputs. High domestic savings rates allowed for massive investments in the stock of physical capital. A growing share of the population has been of working age, increasing the size of the labor force. And the shift of workers from low-productivity agriculture to high-productivity manufacturing has been a huge boon.

But these drivers have all but run their course. Higher domestic savings rates have come at the expense of lower consumption levels, and a resentful Chinese population increasingly wants to spend what it earns. Even more important, capital has been misallocated on an extraordinary scale, owing to tight political control of the financial system. China’s population is aging rapidly, and soon the country will have to carry the weight of tens and eventually hundreds of millions of retirees. Despite the Chongqing experiment, the scope for shifting more agricultural workers into manufacturing is limited, not least because China’s cost advantage is eroding and a weak global economy can absorb only so many of the country’s wares. China’s growth is already slowing as a result. Since 2001, China has grown at an annual rate of 10.1 percent. This year, however, Chinese GDP is expected to grow at 7.5 percent. Further, the official statistics almost certainly conceal the extent of the decline. Scholars such as Huang have found inconsistencies between local and national data, and curious patterns such as rapid GDP growth during periods in which electricity usage, a good hard indicator of economic activity, experienced a sharp slowdown.

What China needs now is not to ramp up inputs even further, but rather to ensure that capital is allocated efficiently. Growth in the advanced market democracies has been driven primarily by productivity-enhancing technological innovation, which refers not just to the invention of new machines but also to the embrace of new ways of combining technology and labor. The advent of new communications technologies is one thing. Walmart’s ingenious use of these technologies to make its employees more productive is quite another.

But this kind of productivity-enhancing technological innovation is far less likely to occur if capital is allocated according to political criteria rather than by investors and entrepreneurs in an open market. For years, Michael Pettis, a professor at Peking University’s Guanghua School of Management, has been arguing that the Chinese economy has been badly undermined by this kind of politicized capital misallocation. As he put it in his newsletter last year, “investment in high-prestige areas such as electric cars, solar panels, and so on for technologically backward countries with low worker productivity may be a little like investment in the space program or in the Olympics.” While these efforts might give a boost to national pride, “they reduce overall wealth and exacerbate domestic imbalances.” Pettis’s predictions are looking sound as the Chinese growth engine sputters.

Last year, the economists Barry Eichengreen, Donghyun Park, and Kwanho Shin published a fascinating survey of growth slowdowns. They found that fast-growing emerging economies tend to see a downshift in average annual growth rates around the time they reach a GDP per capita of $17,000, which China is expected to reach by 2015, and when 23 percent of the work force is in the manufacturing sector, a level China should reach around the same time. Other factors that are correlated with growth slowdowns are higher ratios of retirees to those of working age (a ratio that in China is expected to go from 11.6 percent in 2010 to 38.8 percent in 2050 — higher than the 37 percent the U.S. is expected to reach that same year), undervalued currencies (check), and volatile inflation rates (another problem looming on the horizon). Though Eichengreen, Park, and Shin are careful to note that there is nothing inevitable about growth slowdowns, experience strongly suggests that China is due for one in the very near future. Given that the Chinese Communist Party depends on high growth rates for its legitimacy, this is a profound challenge.

Even in the unlikely event that China does the right thing — if it addresses capital misallocation by placing more of the economy in private hands, if it allows Chinese households to retain more of the wealth they create — the country will still struggle with the bad debts it has accumulated over the last 20 years. Pettis anticipates that China will grow at an average annual rate of 3.5 percent, yet he argues that if China does not address the systematic misallocation of capital, growth could come to a halt. The real threat from China is not that it will grow so economically strong that it will bestride the world like a colossus. Rather, it is that it will become so weak and vulnerable as to collapse, or to lash out at its neighbors.

Consider what those who want America to mimic China are asking us to do. They want to place decisions in the hands of an enlightened elite that will invest heavily in electric cars, solar panels, and fast trains, and in infrastructure in politically favored regions. They want us to follow a course that is leading a great nation down a path of ruin and misery.

No thanks.

— Reihan Salam writes The Agenda and is a policy adviser at the economic-research think tank e21. This article appears in the May 14, 2012, issue of National Review.


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