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A lot has been said of China’s profoundly imbalanced, investment-driven growth strategy. Paul Krugman thinks that China’s eaten its free lunch and will face its “Minsky Moment” anytime now. Stephen Roach dissents that “doubters in the West have misread the Chinese economy’s vital signs once again”. In fact, while Krugman’s borderline-Austrian language is too harsh, he’s far closer to reality than Roach. And both of them are off mark.

The best way to think about China is an economy that’s about to exit the (in this case very long) Keynesian short-run into a Classical long-run. Hear me out. China is today an industrialized economy with the world’s best supply-chain infrastructure placing it at the forefront of international manufacturing. But it wasn’t always – and understanding this is key to observing the inherently Keynesian dynamic.

China was in – more or less – a Classical long-run with rather underwhelming growth at the time of the Xiaoping Reforms. The agrarian infrastructure supported a rural, labor-intense workforce and there was no excess capacity. However, after supply-side reforms, China’s infrastructure advanced far more rapidly than its labor force. There are many reasons for this, but the most compelling may be an extension of Paul Krugman’s strategic trade theory – emphasizing the importance of economies of scale in international trade. Suddenly, with respect to potential output, there was a huge excess supply. Of labor. To reiterate – this is not a vanilla Keynesian argument of excess supply of roads and factories. Rather, for the first time, the potential output of the average Chinese laborer has increased exponentially, because of the roads and factories. Therefore it is the excess capacity of human and not physical capital. Without this distinction the somewhat unorthodox interpretation that follows is lost.

There is no such thing as an absolute supply of labor. If the United States could tolerate wages measured in pennies and majority people involved in the production of rice we would have no unemployment because of labor-intense comparative advantage. But given our vast social, economic, and physical infrastructure capital-intensity reduces the absolute demand for labor.

The past two decades have been kind to China not only because aggregate supply has been expanding, but also because aggregate demand has been catching up. One, very perverse, way to think about it is that there was a discrete time period at which China entered a deep recession – with its future self – and has been in a frantic, Keynesian catchup ever since.

Having millions of peasants not introduced to its urban economy meant that what was once a Classical long-run in a crappy growth trajectory became a Keynesian short-run with an excess supply of workers relative to new infrastructure. Recoveries – Keynesian and otherwise – provide a period of above-trend growth. This dramatically changes how we might understand the last few years: much like how advanced economies (used to) climb out of economic slumps.

But excess supply can only last so long. In this case China is about to hit what we should colorfully call “Peak Peasant”. That implies the following:

  • There will be – further economies of scale aside – diminishing returns from the marginal unit of labor.
  • Wage inflation will be significantly emergent as the aggregate supply – vis a vis a once future economy – becomes inelastic.
  • China’s growth rate will mean revert: not to its historical mean but back to a trend defined by the expansion of long-run aggregate supply.

That, mostly, supports the Krugman interpretation which, however, wildly misses the mark here:

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.

Nope.

There is no day of reckoning. That would imply China has – for some period of time – been in a Classical long-run and increases in aggregate demand fueled by cheap credit and an undervalued Renminbi are reflected only as an increase on short-run aggregate supply whose coincident growth will be eaten by inflation.

But China is only now entering the Classical long-run. Until now, Chinese growth has been entirely real without any money illusion.

That means there’s no big “reckoning” coming. If our framework is a China that’s been in (conceptual not technical) recession due to excess supply relative to a discretely improved infrastructure, we are now entering normal times where growth won’t be nearly as rapid.

This means Roach himself has misdiagnosed China’s position. While he’s right that a sectoral shift to tertiary, service-oriented industries is an important component of China’s future, his reasons are wrong:

Why are services so important for China’s rebalancing? For starters, services are far more labor-intensive than the country’s traditional growth sectors. In 2011, Chinese services generated 30% more jobs per unit of output than did manufacturing and construction. This means that the Chinese economy can achieve its all-important labor-absorption objectives – employment, urbanization, and poverty reduction – with much slower GDP growth than in the past. In other words, a 7-8% growth trajectory in an increasingly services-led economy can hit the same labor-absorption targets that required 10% growth under China’s previous model.

That might have been great with a hugely untapped reserve of peasant labor. Like the Keynesian China of yesteryear. Roach’s writing is slightly misleading. He thinks of it as higher employment created per unit of GDP. I think of it as higher employment required per unit of GDP. Without a perfectly elastic labor supply, this means China will rapidly tempt inflationary pressures.

It’s like someone telling you the 18th century model of American farming – where one hundred men with plows do as much as one man with a tractor today – is better because of its labor intensity. While it “absorbs” more labor, it will also push us against a much harsher supply curve.

Also note, an “excess supply” of labor is very different from what we normally think of as excess capacity (empty factories, unfarmed land, or unemployed PhDs). Excess capital is part of the business cycle, and an intimate component of Keynesian philosophy. It is perennial and hence mundane.

But a country will have excess labor only once. We only shift from labor-intensity to capital-intensity once. In other words, China’s quantum expansion of aggregate supply will be unique in its economic history. It cannot sustain the growth rates it has by any wide margin.

In this sense, the Chinese slowdown will only approximate a “Keynesian” explanation. This is the time for China to pursue sensible, capital-oriented policy. Liberalizing its financial market, privatizing state-owned enterprises, and instituting a rule of law will be chief among any such policy.

It is obvious that corruption and absence of law are what will most lethally damage China’s supply-side future, and hence its economy. Until now China’s excess labor held its aggregate supply so high that anti-supply policies – like authoritarian government – were not felt in the numbers. This will not any longer be the case.

The economic future of the world will be dictated not by how China handles a demand-side rebalancing from investment into consumption, but how it handles a supply-side rebalancing from authoritarian management to liberal democracy.

Neil Irwin ponders the long-run effects of financial liberalization in China. Now that China is the primary trade partner with more countries than America, wonks can’t help but wonder the Renminbi’s role in tomorrow’s economy:

The answer has all kinds of consequences: From a U.S. perspective, that includes the question of whether the dollar will remain the bedrock of the world financial center in the decades ahead, or if the renminbi will become a rival for global trade, particularly within Asia.

China reminds us that liberal democracy is no necessary condition for a free market economy. But the financial system is different. In the long-run there are few things more important for deep and liquid bond markets than a free, voting people with strong Constitutional limits on arbitrary power. It’s also important to note that changes in the preferred reserve usually emerge after currency crises. Further, the geopolitics of oil will play a critical role in the Dollar’s future. China’s unwillingness to accept responsibility today will undermine its market position tomorrow.

Let’s consider the two primary risks entailed by coupons; full default or inflation. The Americans, and British before them, can credibly promise not to cheat creditors. Default or debasement is moderated by a democratic electorate that will throw officials out at any hint of default. America’s commitment to liberal democracy is what kept markets calm during the 2011 and 2013 debt ceiling debacle.

This is easily explained by simple public choice or game theory. Rapid devaluation as a means towards greater export-led growth and hence short-run prosperity is a subgame perfect strategy for Chinese leaders. They will be rewarded lavishly by the business community, as they have been for the past decade. America can never credibly threaten to inflation or default because the the majority of debt is owned by voting citizens and pensioners. Further, a strongly independent Federal Reserve is a powerful drag on inflationary politics.

International markets have no faith in the democratic accountability of the National People’s Congress or the independence of the People’s Bank of China. But there are other important reasons involving our friends in the Middle East. For all the sins of America’s adventurous foreign policy, the quid pro quo relationship with major oil exporting countries adds an important dimension to the Dollar’s mandate. Indeed, certain dictators failed to move oil to a “Euro standard” and China’s restrained Middle Eastern diplomacy will earn it no favors.

Even a grand scale increase in China’s trade cannot improve the Renminbi’s position. Here’s why:

  1. Financial liberalization will if anything decrease net exports and hence demand for the Renminbi.
  2. Deepening Chinese exchange markets will allow traders to hold Dollars and exchange as and when needed.
  3. Today, countries with a bad fiscal position borrow in Dollars (the “original sin”) to benefit from lower rates, as inflation risk is negated. There is no chance that the Renminbi will ever play this role.

Shadows Can’t Hide Forever

The not-so-secret truth is China’s shadow banking system is a known unknown unknown. We know it could be dangerous, but we have no idea how dangerous it might be and how rapt China’s economy is thereof. Institutions are, clearly, more important than trade. Consider the Swiss Franc, a currency of outsized importance relative to trade. But international confidence in the highly stable Swiss banking institutions (did I just say that?) keep it alive.

I might even venture to guess that holding Renminbi will become less important as it liquifies. China’s exports are, no doubt, crucial. If I know I can immediately trade on the exchange market as and when needed, it’s not nearly as important I keep it as Reserve.

There’s also a Keynesian Beauty Contest at play. Confidence in America is, in no small extent, aided by confidence in America. Therefore, as I noted, it is unlikely any tectonic shifts on the international finance arena will take place without a massive currency crisis.

India’s Chance

To the extent we discuss vast improbabilities – like a successor to the United States Dollar – it’s worth noting the Indian Rupee is more likely an eventual reserve than the Renminbi. Firmly rooted democratic institutions will build faith in the Rupee. Conditionally:

  1. Indian debt will have to be equitably held and, hence, Indians in general will need to become far richer.
  2. India will need to handle supply-side issues of financial liberalization and inflation.
  3. India will need to become a main trading partner across Asia.

Given its size and commitment to fantastic economic leadership (Kaushik Basu… Raghuram Rajan…) it is not impossible that this will happen before I die. If it does, remember I said this before it went mainstream.

But resource constraints and Confucianism ain’t one!

[Not to say China is resource-rich, but that this isn’t its biggest drawback]

Okay so there’s a kerfuffle about between Noah Smith and Daniel Altman about China’s economic future. They’re right (partially – China will beat Europe) to be bearish on its development, but their reasons are just wrong.

Here’s Altman:

Confucianism is perhaps the leading influence on Chinese business practices. [His] teachings […] are deeply ingrained in Chinese society [yet] are not necessarily conducive to economic growth. Confucian ethics teach that one should value the collective over the individual…A second and related tenet of Confucianism…encompasses the “respect for elders” that is a hallmark of many East Asian civilizations […]Together, these tenets of Confucianism — and the way they have been interpreted by the Chinese authorities in recent times — have helped to maintain rigid hierarchies in Chinese businesses… […] The message is clear: to be united and realize the dreams of a great Chinese nation, the Chinese people need strong rulers who brook little dissent. The message carries through to the boardrooms of Chinese companies, which tend to concentrate the instruments of power in the hands of a single strongman… All of these factors will combine to lower the target for material living standards in China — or, to put it more technically, they reduce the level of per capita income toward which China is converging. With these factors in place, China simply is not in the same convergence club as the United States…

And Smith:

For the record, I’d go with Sumner. Also, Chinese culture seems a lot like American culture to me, but that’s mainly based on my students, who of course chose to move here. If I had to predict, I’d say China will reach 50% of U.S. GDP, but that equaling us will be hard because of global resource constraints.
Of course we could always admit that, well…we don’t really know what’s going to happen to Chinese growth. But we don’t want to admit that. Because we don’t like to not know things. Not knowing things is scary. There is safety in derp.
Update: Altman responds, noting that Japan’s GDP is markedly less than that of the U.S., Canada, and Austrialia. Of course, I could have pointed out that Singapore, with a GDP (PPP) per capital of $60,410, is considerably richer than any of the countries named. But I thought it more appropriate to compare countries of similar population sizes and resource endowments…

And there was a lot more on Twitter about how land and other supply-side constraints have been a drag on this nation or that. For the record, Smith is a lot less wrong. Resource constraints are more defensible than ancient culture. Just at an institutional level, it’s important to understand why the legalists and centralists of Qin, Ming, and Mao so hated Confucius – in his China, the family served as a powerful counterweight to the state, undermining political authority. Indeed, in quarrels between a man and state, he and not the government had his family’s loyalty and trust. As Francis Fukuyama notes, Chinese history can be written as the interplay between family and state.

But few would say the Chinese state is anything near weak. Even at a microscopic level, there is little regard for important Confucian teachings. Profit from domestic migration breaks local structures and quid pro quo patronage permeates all levels of government. As one of Smith’s commenters notes:

Yes, Chinese hold family to be very important, but deference of the servant to master & employee to the employer? Has he seen the rate of job-hopping in China?
If the Chinese like to concentrate power, how come it seems like every third person in Taiwan owns a business?

It’s informative to understand just how rapidly financial profit undermines regressive practices after it takes afoot, however anchored by culture. Fareed Zakaria shrewdly notes that stark preference for Brahmins (scholars) over Vaishyas (merchants) held India back while scientific enlightenment and industry spread like wildfire across the West. Niall Ferguson is known to make this point (and then take it to the illogical, immoral, and idiotic conclusion that British imperialism was a good thing). But once growth picked up late last century nothing, seemingly, could stop it. The Hindu growth rate suddenly became a compliment.

Indians tend to be proud about strong familial bonds absent in the West. But I can barely sense any such thing in the modern, urban, middle-class culture India is moving towards. (And, unlike my grandparents, I think this is splendid). Or as Deng Xiaoping puts it:

Poverty is not socialism. To be rich is glorious.

Confucian China this is not. But Smith does a pretty bang-up job of making my point, so I’m going to tell you why resource constraints aren’t China’s biggest problem. (Note, he is very wrong in refuting Altman’s point by comparing Japan to Western Europe, which isn’t particularly rich and has a high natural rate of unemployment).

For one, I’m pretty cautious about Malthusian bets. People have been making them for a long time, and they’ve always been wrong. Ehrlich, most famously, didn’t get commodity prices right. Despite a huge increase in population, wealth, and demand since 1980, when the wager was made, the preponderance of fibre optics and advanced plastics mitigated the need for copper. Science and technology have always won the day, so it is only sensible that we have a very strong prior against grim predictions from the days of yore. Indeed, considering the number of times Malthusian priors have been updated, it should be near religion that we will not face a supply-side crisis.

For one, Smith qualifies expected per capita output by “similar population sizes and resource endowments” likening Altman’s comparison of Japan and US to that of US and Singapore. Japan might be starved of land, but it’s hard to imagine that resource constraints have held it back. If that were the case, we’d expect a contraction of aggregate supply resulting in cost push inflation. But we know that the Japanese economy has been severely deflationary. Land is also only a problem if Japan had an increasing population, but fertility fell below replacement rate quite some time ago.

Then it’s worth noting that the only “resources” that benefit Singapore are human capital and agglomeration economies. New York State has a per capita GDP of $58,000. The city itself will be notably richer. Of course, Washington DC blows it all away at almost $175,000. Obviously, Smith’s point was that it doesn’t make sense calculating output across population sizes. But the qualification isn’t continuous, as he believes, but binary: is it a city-state, or not. Or, if you like continuity, urbanization rate. Japan is actually 10 percentage points more urbanized than America, implying it should be richer if not for other constraints.

But let’s take this further. Resource wealth helps a country in one of two ways:

  • Exports increasing GDP (Norway, Australia, and Frackamerica)
  • Low price levels decreasing GDP deflator (America: Land of the Free Cheap)

There’s no doubt that Americans are so rich because of comparative price levels. It’s refreshing to compare nominal per capita income ranking against their real counterpart. But doing so also tells us that $3 per gallon of gasoline doesn’t help us that much. (USA moves from 6 to 10 with a few notably irrelevant countries in between). Further, American prices are low because of smart economic practices emphasizing labor flexibility, relatively low minimum wages, huge numbers of skilled and unskilled immigrants, and a highly robust higher education system. Americans abroad often complain about food prices, but should remember that this is already such a small proportion of income that it doesn’t much matter. As for the first point, our export of ideas (Boeing, Silicon Valley, Wall Street, etc.) is far more valuable than actual resources. Though, all said, Texas is pretty rich!

Smith also likes tweeting about the coming solar and wind revolution. In Oregon and Washington, wind is already cheaper than coal. This will be particularly true in the future, after China eats all our coal and asphyxiates its people in the process, but technologists will by then have given us more than enough to move away from coal. A member of the “global south”, China also has a fair bit more sunshine than the Americans. Oil will be a decidedly more tricky subject. When America invested in its interstate highway system (whose value is intimately connected to gas prices) high-speed rail was oxymoronic. The Habitable part of China is substantially smaller and, with modern locomotive technology at hand, China can probably substitute most oil-based transportation with electricity. Cars by that point will also be much more efficient. No doubt the technology, and dollars too, allowing this sustainable development will be traced back to American universities and entrepreneurs.

As a billion people move from poverty into comfortable living, from ignorance into (relative) intelligence, we will have many more thoughts competing in the Popperian “marketplace of ideas”. China will (try to) advance science, culture, and scholarship in much the same way that America does today.

Alas, Altman and Smith are right that China will never catch up to the United States. But they are wrong that it won’t catch up to the West. Unless Western Europe seriously reconsiders its failed economic practices, China will render it (more) irrelevant (than they already are). The European Union’s per capita GDP (PPP) is only just over 60% of America’s – people tend to forget how much richer the US really is. This gap will widen substantially to the point where Chinese living standards beat Europe’s, which is destined for a long period of relative stagnation.

But it won’t ever reach America. Not because of oil or stones, or whatever, but the lack of inclusive institutions. State capitalism is great so long as China is the “factory of the world”. But if you want your Wall Street, Silicon Valley, Seattle, or Chicago, you’ll need something seriously better. The US did create small things like the Internet with big government investment, but only on the back of an established system of private universities and entrepreneurs.

And to the extent that Internet and technology is the economic future, China’s citizens are woefully excluded. Weibo is no match for Twitter: in code or theory. The repression of its population will strangle the cross-fertilization of ideas that make America so great. But China faces another huge supply-side factor: immigration. Educated people want to get the hell out of China (unless they are connected enough to open a factory and get rich). Educated people want to get the hell into America.

For all of history, we’ve been the “second-best” place for everyone in the world. Many Indians today want to stay with their family, but America is their next choice. Europeans in the 19th and 20th centuries probably liked their culture, but America was a close runner-up. Smith himself called us the “Alt Europe” (and suggests become the “Alt Asia”). Oh and how rich it has made us. So many economic “movers” – from business titans to engineers – are in America because it’s immigrant-friendly and promises riches.

What does China promise? Smoggy streets, censorship, and a language no one (else) speaks. Great.

People are also seriously scared of China. India, Japan, Korea, Taiwan, and Indonesia have a big interest in making sure China doesn’t become too powerful. Some already have trade and military alliances with America. It’s not unlikely that the rest will follow suit. America, owing to its peaceful and democratic nature, is on good terms with most of the world and definitely its neighbors. We got rich by rebuilding Europe and innovating amazing goods for the rest of the world. There’s a fair bit of disdain for the US, perhaps deservedly so, but it’s hard to dismiss the relatively peaceful path to prosperity exemplified by America. As China gets richer and stronger, American soft power will only increase.

But it’s also fair to say Altman is too bearish on China:

China may just manage to catch the United States and become the world’s biggest economy. But it will hold onto the title for only a few years before the United States, growing more quickly in both population and the productivity of its workers, passes China again.

On second thought, if we don’t screw up our immigration policy, he’s probably right in the long run. But if China’s growth continues as expected, they’ll pass us in total GDP and stay there for a while until American population grows enough. But even then, America and China will be very close. Even America stabilizes at 500 million people (high estimate) and China at 1 billion (low estimate), America would have to be twice as rich to be equal. This seems unlikely.

There’s one more problem. No power that be has stayed that way without controlling the global reserve currency. While China has made moves to liberalize its bond market, it will never be a trusted reserve. Only a democracy in which a majority of government debt is (somewhat) equitably distributed among the electorate can have this status. American politicians know that if they default on their obligations, they’ll be thrown out of office. Self-interest prevents this. The debt ceiling is an artificial, not structural, obstacle to this point. We know that default is not a subgame perfect strategy for America. We can’t say the same about China.

So, as the age-old adage goes, institutions are the problem! I have trust that scientists and entrepreneurs will overcome resource constraints, and that economic factors will destroy regressive culture. But it will be a miracle indeed if Chinese universities rivaled Harvard, if Beijing captures the philosophical imagination of Washington in its ideal, if Chinese entrepreneurs catch up to the Pacific Northwest!

Edit: Scott Sumner has some thoughts too.  I’ll add that I don’t think culture is nearly as important as other factors in the end. Indians, Bangladeshis, and Pakistanis might come from historically similar cultures, but perform very differently in the US, with Indians earning about $90,000, Pakistanis about $60,000 and Bangladeshis about $45,000.