China: Distorted and flexible
Paul Krugman has become very bearish on China:
All economic data are best viewed as a peculiarly boring genre of science fiction, but Chinese data are even more fictional than most. Add a secretive government, a controlled press, and the sheer size of the country, and it’s harder to figure out what’s really happening in China than it is in any other major economy.
Yet the signs are now unmistakable: China is in big trouble. . . .
It’s all very peculiar by our standards, but it worked for several decades. Now, however, China has hit the “Lewis point” “” to put it crudely, it’s running out of surplus peasants.
That should be a good thing. Wages are rising; finally, ordinary Chinese are starting to share in the fruits of growth. But it also means that the Chinese economy is suddenly faced with the need for drastic “rebalancing” “” the jargon phrase of the moment. Investment is now running into sharply diminishing returns and is going to drop drastically no matter what the government does; consumer spending must rise dramatically to take its place. The question is whether this can happen fast enough to avoid a nasty slump.
And the answer, increasingly, seems to be no. The need for rebalancing has been obvious for years, but China just kept putting off the necessary changes, instead boosting the economy by keeping the currency undervalued and flooding it with cheap credit. (Since someone is going to raise this issue: no, this bears very little resemblance to the Federal Reserve’s policies here.) These measures postponed the day of reckoning, but also ensured that this day would be even harder when it finally came. And now it has arrived.
Overall a reasonable article, but I have a few quibbles:
1. Despite saying the data is “unmistakable,” Krugman actually present no evidence at all that China is suddenly in trouble. Or perhaps one piece of evidence; Chinese wages are rising rapidly, indicating that the endless flow of surplus labor is coming to an end. But there’s one problem with this fact—it’s been true for many, many years. Indeed Chinese wages have been rising at double-digit rates for several decades. China may suddenly be out of surplus labor, but Krugman presents no data to support this hypothesis.
2. The interior regions of China are much larger and much poorer than the coastal areas. Krugman presents no evidence that the Chinese growth model cannot keep plugging away in the interior regions for many more years.
3. I actually agree with Krugman that China is reaching a turning point, where it will have to begin shifting toward a more consumer-oriented economy. However, I have a hard time seeing how China is approaching a cliff. One of two things will happen. The new government might cut back on subsidies to SOEs and allow more foreign investment. That would be good. Or they might continue over-investing in certain sectors. That would be wasteful, but not a cliff.
Krugman seems to overlook the fact that the Chinese economy is flexible, despite being highly distorted. If they decide to stop building ships and start building 100,000,000 washing machines per year, there is no country on Earth that can do that switchover as fast as China. Indeed no other country even comes close. The flexibility of the Chinese economy is mind-boggling.
So what could go wrong?
1. Unstable monetary policy–i.e. unstable NGDP growth.
2. Even if monetary policy is sound, they might continue over-investing. That would be wasteful, and reduce living standards in China. But it probably would not lead to an economic cliff.
Chinese growth will slow, but I doubt it will hit a cliff.
PS. China can keep its currency “undervalued”, i.e. it can keep running CA surpluses if it wishes to. That’s a completely separate issue that has no bearing on the “cliff” argument. Indeed if it was running persistent CA deficits people would also be warning about a “cliff.”
PPS. Beware of “pessimism bias” among intellectuals. Intellectuals who are down on the US will tell you that the orgy of housing construction in 2004-06 was “consumption,” not investment. When the same intellectuals are down on China they’ll insist that all the excess housing construction is “investment” not consumption. The only common thread is that intellectuals like to make things look bleak. The US “consumes” too much and China “invests” too much. If that’s your narrative, then just adjust the facts to make it true. (Not saying Krugman is guilty here, but plenty of intellectuals are.)
HT: Tyler Cowen
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19. July 2013 at 16:52
“Even if monetary policy is sound [Geoff: i.e. Stable NGDP]…”
“…they might continue over-investing.”
The former has no causal relation the latter? Over-investment cannot be brought about in part by even stable NGDP expansion?
————–
Did anyone else notice how “Austrian” Krugman sounds in this article? It might as well have been said by Marc Faber, or Peter Schiff.
19. July 2013 at 18:16
I don’t think that picture is accurate anyway. China’s growth wasn’t fuelled by cheap labor, they had that in the Maoist days too but they were doing crazy things like having people forge iron at home. The growth was fuelled by the greater efficiency of the limited free markets created after Deng threw out the Gang of Four and instituted some sanity.
Now, they are running up against their institutional shortcomings. As Acemoglu might argue, the incentives for the Communist Party are to keep their oligarchic power whatever the cost to growth.
I don’t think China will ever pass Mexico’s PPP GDP per capita. Maybe I should bet Scott a steak dinner or a bottle of Glenmorangie 🙂
19. July 2013 at 18:59
Geoff,
Yes. Actually, this:
“And the answer, increasingly, seems to be no. The need for rebalancing has been obvious for years, but China just kept putting off the necessary changes, instead boosting the economy by keeping the currency undervalued and flooding it with cheap credit. (Since someone is going to raise this issue: no, this bears very little resemblance to the Federal Reserve’s policies here.) These measures postponed the day of reckoning, but also ensured that this day would be even harder when it finally came. And now it has arrived.”
Struck me as very Austrian. I mean I understand – if not necessarily agree – with his analytics and know it’s nothing like the droning about “we must feel pain with tight money for our excesses” crowd in the US, but it was a fresh juxtaposition considering how critical PK has been of this view. (I’m not accusing him of hypocrisy or anything, really).
19. July 2013 at 19:42
I have lived in Thailand for more than a year, been married Thai for 10 years, read Thai newspapers every day. It is hard to understand Thailand, and recently a Brit wrote that he has lived in Thailand since before disco and he still doesn’t understand Thailand.
Why does Thailand now report unemployment under 1 percent and “labor shortages”? No one saw it coming—indeed, only a few years back, there was dread China would undercut Thailand, and Japan and Korea and Taiwan would take the upper-end markets.
Understand China?
Good luck with that.
Right after you make accurate predictions as to the outlook for the USA……
19. July 2013 at 19:59
China is really flexible, otherwise it couldn´t have accomplished in just 12 years (basically after joining the WTO in 2001) the following:
Share of World Output: From 7.3% (2000) to 16.6% (2012) (+9.3%)
Meanwhile, the US, Japan and Germany combined lost 8.6%
Share of World Imports: From 3.3% to 9.8% (+6.5%)
Meanwhile, the US, Japan and Germany combined lost 8.0%
19. July 2013 at 20:39
Scott,
very good points, and it’s hard to know the big picture in China, let alone the detailed one.
Here is how I see the big picture on China:
Generally, yes, China probably has the tools and capacity to turn things around gradually without a major crash, which would, arguably, also be accompanied by social and political turmoil.
However, switching to an economic model that allows a growing portion of its huge population to become wealthier (i.e. to develop a consumer-driven economy) is easier said that done.
Becoming wealthier on a broad basis includes not to just the ability to buy an apartment and fill it with refrigerators, flat screens, and a toiled with running water.
It includes things like the ability to provide for education, health care, good water and food, and all that in an environment with preferably non-toxic air and soil.
But when your developmental model was not designed to do so early on – i.e when there was no political consensus or social awareness on this matter, switching to such a model becomes a tall order.
Who will shoulder the cost of cleaning-up the environment, for example?
To make a point, consider Japan’s development model after WWII. The first thing Japan did after becoming a democracy in the late 1940s was to adopt comprehensive national social, health, and pension insurance for all citizens.
There was also an agreement that corporations would give workers a say in management via corporate labor and employee unions.
This agreement in Japan was unwritten, but it had a similar effect as the more codified and/or legislated “social partnership” models in Austria, Germany, or the Scandinavian countries.
Germany, for example, in 1952, passed a “Corporate Constitutional Law” that gave workers a say in management, and help limit the influence of more radical and ideological labor unions and political/social movement.
These sort of developmental models were rooted on a broad political and social consensus.
It was this sort of basic model design that allowed Japan (and Germany, or Austria) to develop a consumer-driven domestic economy early on.
Such policies may have been based on cultural preferences of social responsibility and cohesion, or even corporatism if you like, but they did also serve the purpose of developing a domestic consumer economy.
It was this sort of model that also addressed, and helped solve, problems with heavy pollution, environmental degradation, and industry-induced mass health problems.
I recently met an Austrian corporate executive who told me that in the early 1960s, when he was a child in his home town of Bregenz, dead fish would pop up in the polluted Lake Constance, bordering Switzerland, Austria, and Germany. Today, you can drink the water.
Success in the export markets came later, after investment had reached a level at which it domestic industries were producing surpluses, and had also reached a certain level of quality and international competitiveness (they also received subsidies in many cases, of course). It was a later stage when surplus production was sold to consumers in even wealthier nations.
Early on, early on, export tailwinds were either co-incidental (e.g. the “Korea boom”, as the Japanese call it, and during which Japan’s munitions (and other) light industries enjoyed a tailwind by selling to the US and UN armies fighting in Korea), or negligible.
By contrast, China’s “some-people-should-get-rich-first” model looks like the exact opposite.
That needs not be a problem for China.
But it may be more difficult to turn it around – i.e. to ask those people who got rich first to share the wealth ex-post, and contribute to developing a broad domestic consumer base to unwind the surpluses they have accumulated by skipping the first stage of developing a balanced domestic economy and going straight for the quick bucks abroad.
In other words, the question whether China can avoid the cliff seems to me is political and social, not just economic.
In the developed economies, reforming the welfare state is difficult enough in the face of interest groups. But China also has interest groups. Will the established elites in China will be more agreeable to reform, which will not come without cost?
19. July 2013 at 21:58
“…Depressions occur after investment bubbles burst. In free-market capitalism, capital generates income for the owners of the capital which in turn is used to create additional capital. This is very good. Sometimes, it can be actually too good. As capital continues to accumulate, its owners find it more and more difficult to deploy it efficiently. The business sector generally must interact with the household sector by selling goods and services or lending to them. When capital accumulates too rapidly, the productive capacity of the business sector can outpace the ability of the household sector to absorb the increasing production.
The capitalists, or if you prefer, job creators use their increasing wealth and income to reinvest, thus increasing the productive capacity of the business they own. They also lend their accumulated wealth to other businesses as well as other entities after they have exhausted opportunities within the business they own. As they seek to deploy ever more capital, excess factories, housing and shopping centers are built and more and more dubious loans are made. This is overinvestment. As one banker described the events leading up to 2008 – First the banks lent all they could to those who could pay them back and then they started to lend to those could not pay them back. As cash poured into banks in ever increasing amounts, caution was thrown to the wind. For a while consumers can use credit to buy more goods and services than their incomes can sustain. Ultimately, the overinvestment results in a financial crisis that causes unemployment, reductions in factory utilization and bankruptcies all of which reduce the value of investments..”.
http://seekingalpha.com/article/1543642-a-depression-with-benefits-the-macro-case-for-mreits
19. July 2013 at 22:21
On topic:
A guy named Joe Studwell had his book “How Asia Works” reviewed in The Economist, and he says economies take off by 1) land reform 2) protecting export industries, and 3) financial repression. That was the model for Asia success stories.
Land reform is a fascinating topic that must flummox ideologues of all stripes.
After all. Japan and Korea took off after ripping property away from legal owners and handing it out to the masses. What is the libertarian answer to a nation where a minute sliver of the population own all the land, and have little interest in developing it? Why should they, they are already rich beyond compare, and decadent in a fashion that can only be obtained and refined after generations….
Protecting export industry is always wrong, the Phds say. Except it works.
Financial repression is artificially low interest rates or forced savings.
This guy Studwell may be on to something…
Heresy!
19. July 2013 at 22:22
http://www.slate.com/blogs/moneybox/2013/07/17/chinese_house_sizes_if_there_s_so_much_overinvestment_why_aren_t_they_bigger.html
Yglesias hits a home run
20. July 2013 at 00:04
Sarcasm On.
They should ask Bernanke for help with the transition, he’s got a lot of experience with rebalancing.
20. July 2013 at 02:00
The whole Krugman narrative here — the idea of a challenge consisting of investment falling and a need to boost consumption to compensate — seems strongly to imply that China’s economy is demand-constrained.
But the overnight interest rate is above 3%. No liquidity trap in sight.
Doesn’t that observation refute the hypothesis of demand-constrained growth?
20. July 2013 at 04:39
TallDave, I’m afraid you are wrong about China and Mexico, they most certainly will pass Mexico, indeed some regions of China already have.
Ben, Good point.
Marcus, Good point.
Mikio, You said;
“However, switching to an economic model that allows a growing portion of its huge population to become wealthier (i.e. to develop a consumer-driven economy) is easier said that done.
Becoming wealthier on a broad basis includes not to just the ability to buy an apartment and fill it with refrigerators, flat screens, and a toiled with running water.
It includes things like the ability to provide for education, health care, good water and food, and all that in an environment with preferably non-toxic air and soil.”
We all agree that the current Chinese model is not a good one. Even the Chinese leadership agrees. However I don’t see why it’s so hard to switch models. China’s already done huge shifts, which hurt important special interest groups, why not do more? As far as I know all the countries that have the material success you describe in paragraph 2 also went on to address the health, education and environmental problems that you address in paragraph three above. Why would China be different?
In fact it’s a mistake to talk about “the Chinese model,” as the model keeps changing, and will continue to keep changing. China is changing at a very rapid rate, which makes all predictions based on continuity with the current system look highly suspect.
Lance, I would say that depressions cause investment bubbles to burst (i.e 1929). When the bubble pops first (as in 2001) then the burst investment bubbles don’t cause depressions.
Ben, There is no evidence that protecting export industries caused rapid East Asian growth. First of all, those industries actually didn’t get all that much protection, and second those East Asian economies that did not protect export industries grew just as fast.
An Igyt, I’d be shocked if that’s his argument. No one believes China’s in a liquidity trap. It seems more like a re-allocation argument.
20. July 2013 at 04:40
Agree with all of Sumner’s points. But I have to point out that China is a classic example of a Rorschach test writ large. It’s so vast that you can support practically any prior. If the government data backs you up, you point to the data. If the government data contradicts what you believe than you can say, as Krugman does, “Chinese data are even more fictional than most.” Well, that’s a pretty convenient state of affairs!
20. July 2013 at 04:49
Jim, Good point.
20. July 2013 at 05:31
But why would reallocation cause any kind of a “slump”? It certainly doesn’t always do so. And in flexible-price models, what happens when investment opportunities run out is that households see there is no longer any great reward to deferring consumption and get down to enjoying the fruits of their earlier investment. There is no problem with whether consumption can rise fast enough.
As far as I’m aware, such problems can arise only in liquidity trap models. The Austrians also describe something similar, but I can’t understand it; and anyway, if Krugman has gone Austrian, that’s the news of the month.
20. July 2013 at 07:24
China doesn’t go off a cliff unless NGDP really slows. The Chinese Communist Party will probably not let that happen. In the 5 year plans the government lays out level targets for the CPI, NGDP, RGDP, IP and so on. They have a level targeting mindset (rather than rate targeting like the Fed, ECB, BOJ).
China is still so far below potential (say Taiwan is their convergence point) that they’d have to really turn back the clock to the Mao days to keep growth below 5-6% in the next decade. This is just my gut feeling.
20. July 2013 at 07:38
An, Good point. I guess Krugman would need to spell out his argument in more detail, especially the role of AD.
Justin. Good comment.
20. July 2013 at 08:02
Not having followed Chinese politics, I remain puzzled about why the Chinese government wants to run current-account surpluses. Shouldn’t they be investing in China, rather than buying U.S. Treasurys? And shouldn’t they be encouraging (rather than discouraging) foreign investment in China, which would tend to produce a CA deficit? I suppose there are political reasons for their behavior. What rationale do they offer for public consumption?
20. July 2013 at 21:12
Scott — I like the 10-year Glenmorangie. Is 2023 too soon?
“Japan and Korea took off after ripping property away from legal owners and handing it out to the masses. What is the libertarian answer to a nation where a minute sliver of the population own all the land, and have little interest in developing it?”
Didn’t work out so well in Zimbabwe.
The libertarian answer is liberty. What you’re describing is an oligarchy that could only arise and persist coercively.
20. July 2013 at 21:29
CC,
Not one of his better efforts. “Something or other is creating ghost cities?” Something or other? It’s called the Chinese government, Matt. They built Ordos expecting a coal mine boom. Instead, coal prices fell and most of the mines closed. So almost no one lives there, despite lots of policies intended to coax/coerce people over there, including closing nearby schools(!).
“But why would that be? Is this average Chinese person living in a mansion?”
What the what? Does the average person in Detroit live in a mansion? And yet we all know there is way too much housing stock in Detroit, it doesn’t make any sense! Obviously the problem is that neither Ordos nor Detroit are attractive enough economically to justify their housing stock, whatever its size.
21. July 2013 at 07:42
Philo, I don’t know, presumably they’d point to the need for foreign reserves in a crisis. But why so much?
TallDave, Make it 2028 and its a deal. Mexico still has a substantial lead. Let’s use the average of the PPP figures from Wikipedia.
Didn’t the developers of Ordos sell the houses at a profit?
The fact that China’s critics constantly refer to Ordos is revealing. It’s like evaluating the US economy by pointing to the Alaskan bridge to nowhere. The average Chinese person considers Ordos to be way out in the middle of nowhere.
21. July 2013 at 16:02
“The interior regions of China are much larger and much poorer than the coastal areas. Krugman presents no evidence that the Chinese growth model cannot keep plugging away in the interior regions for many more years.”
Perhaps not, but Krugman mentioned he reads Pettis rather often because he has been pretty accurate regarding China the last few years and Pettis is himself a rather large skeptic on the whole inland investment theme. He had a very detailed blog post in May centered around the inland investment fervor. Basically saying it is more waseful investment, not more productive.
22. July 2013 at 05:09
Joe, Has Pattis really been all that accurate? He’s been predicting 3% GDP growth.
22. July 2013 at 05:57
Who’s to say they aren’t experiencing 3% growth? Official statistics don’t mean much when other data conflict with it.
No, if you’ve been following Pettis these past few years, it’s not accurate to pin him down to a single number. What he actually says it will have to fall to around 3%, assuming they make the necessary changes to their economy. He doesn’t predict 3% growth as is.
He’s been ahead of the curve in a lot of areas. I don’t think its wise to dismiss his insight.
22. July 2013 at 18:23
TallDave, Make it 2028 and its a deal. Mexico still has a substantial lead. Let’s use the average of the PPP figures from Wikipedia.
Well thought-out as usual. It’s a deal — and I sincerely hope you win! 🙂 I’ll make it official.
23. July 2013 at 07:53
Joe, That’s wrong. Not only did he predict 3% growth, but he made a bet with reporters at the Economist on that point. Using official data.
TallDave, OK, I’m assuming that scotch is not super expensive, right? If it’s $1000 the bet’s off.
23. July 2013 at 08:09
Haha, no worries, if I bet a $1000 bottle of Scotch I’d still be hearing about it from my wife in 2028.
The ten-year is around $50, or since we’re talking about 2028, we could grab the appropriately 15-year-aged version (sold as 18-year) which goes for around $100…
23. July 2013 at 08:12
Some vindication for Abenomics?
http://blogs.the-american-interest.com/wrm/2013/07/22/abe-wins-in-landslide-neighbors-cringe/
There’s actually a wiki for “Abenomics” now, kind of interesting.
http://en.wikipedia.org/wiki/Abenomics