Friday, 1 June 2012

Why China won’t overtake the US

The Chinese growth phenomenon has been puzzling Western academics and politicians for a while now. However, the resurgence of left-wing thinkers over the success of state-driven growth has been all too familiar. It has been too long since the last great “success” of socialism has ended up in the gutter, so the story of Chinese rapid growth under socialist leadership emphatically comes as a reassurance of their ideas and ideology. But things aren’t quite what they appear to be. First of all, China’s growth isn’t export-driven, as many economists tend to believe. The Economist has the story:

Source: "Pedaling prosperity", The Economist, 26th May 2012

Chinese rapid growth is primarily due to high investments, which constitute a stunning 49% of GDP. Consumption accounts for only a bit more than 30%. As comparison, in the West consumption is usually by far the largest component of GDP (around 60%). However, this doesn’t make the West better – in fact, an investment-led growth is usually considered much ‘better’ than any other type of growth. 

But there is a limit to the type of investment-led growth that China practices. These are mostly state-led investments based on a quick allocation of capital to rapidly growing industries. Where the Chinese (allegedly benevolent) dictators have succeeded in is the massive allocation of labour and capital to highly productive industries. The large-scale urbanization and industrialization were initiated by the Chinese state and this strategy worked extremely well so far. This shouldn’t come as a surprise to economists, since China had a lot of catching up to do since Mao’s radical impoverishment of the country. When a large amount of capital and labour are allocated to newly erected industries it is very likely that the productivity of the nation will rise almost as its GDP growth.

But this approach isn’t sustainable in the long run, because it isn’t based on the crucial assumptions responsible for the 300-year growth of the West - creative destruction, property rights and the rule of law. Property rights are arguably the most important thing. The institution of property rights generally leads to irreversible rule of law reforms, more political freedom and more inclusion into the political process (demanding more accountability from the countries' rulers and more representation). This process then consequently leads to a creation of better wealth-creating incentives and greater innovation that will be the basis for future growth. All of these are supported by what Acemoglu and Robinson (2012) refer to as “inclusive political institutions”, or what Mancur Olson (2000) calls a “market augmenting government”. Both these views, and many others on the argument for institutional formation, call on the democratic order to support wealth generating incentives. 

This is the first thing where China fails at – there is no institutional support for innovation or creative destruction. The success of government allocation strategies can only do so much to engineer growth. After this is exhausted, the rapid growth will stop and instability will arise, first in economic terms, then possibly in political. It will be a similar story to the fall of Soviet Russia. Unless, of course China manages to undergo a political reform. But this is also unlikely due to several reasons.
  • First of all, the current model of Chinese growth isn't perceived unstable or unsustainable among China's political leaders. They still see it as a monumental example of a state-led economy. It's hard to opt for change of a system to those who still see it as a great success. 
  • Second, China has few advantages that could turn out differently than the Soviet scenario. It is driven by competition. To get into the top universities in China, the competition is much, much bigger than for any top school in the West. This transcends into the corporate and the business world as well. If you're running a big state corporation it is your results that will keep you in position. If you slip, the party leadership will easily replace you with someone from a pool of thousands of people waiting for your failure. It's not very different in lower ranked positions as well, down to the very lowest assembly line workers - if you refuse to work under the given conditions there's thousands of others who won't refuse. Talk about social Darwinism
  • Third, I've already covered the power of China's enormous labour force and it's supply chain, economies of scale advantages. The competitive advantage of manual labour China has to offer is incomparable to any country except for maybe India. 
So these factors will prevent the need for political restructuring and more political and individual freedom for some time. Even if growth slows down, the need to reform still won't be recognized, not until the country finds itself facing disaster. We've all seen it in Europe. No one want's to reform anything until things get drastic. However, then it's often too late.

More political freedom is needed in China in order to make its growth sustainable. The rulers of the country will oppose this and will oppose innovation and creative destruction as they did so many times before. They will continue with an anti-entrepreneurship climate, censorship of the media and technological growth based on adoption rather than innovation. No matter how big are the advantages of its supply chain economy or its competitive labour force, this won't be enough to prevent a gradual decline in the many decades to come. 


  1. Regarding the growth structure graph, where net exports really had a small role in GDP (particularly compared to investments), does this mean that economies don't usually grow on exports, as is commonly held in the economics profession?

    I mean, if China, which is an exporting powerhouse and has in absolute numbers surely the highest level of exports in the world, had growth mostly driven by investments, than the conclusion is that any growth not based on investments is bound to be short lived.

    1. Yes, export growth can only come as an outcome of a strong investment and production basis. This is why I believe that currency depreciation to support an export-led growth makes no sense unless a country has a strong production-based economy to support it.

      As for the second part of your comment, yes, investment-led growth tends to be the one guaranteeing development, but even then the question of its sustainability depends on the scope of innovation and creative destruction following that growth. And this can only be achieved through proper incentive creation enabled by more political and individual freedom.

  2. The sustainability issue is left to be seen, but you have to agree that the current levels of growth have indeed been astonishing in China and some other countries experiencing "state capitalism" (like S. Korea or Vietnam). This makes you wonder that there might be something in this type of governance. An initial democratization cannot be enough in poor countries as it is too fragile to achieve growth and stability. The benevolent dictator approach can provide a much better solution to get the country started.

    1. There is nothing magical about State capitalism. The remarkable growth rates in China are quite natural considering that they started so far behind. When a backwards agrarian nation modernizes and industrializes we see this type of growth.

      India also is showing remarkable growth rates now and they have a totally different system. Even the old Soviet Union showed similar rates of growth back during Stalin's time. That does not mean that the communist system was superior as some useful idiots in America were saying at the time.

      What is more interesting to me is what will happen in China when the rates of growth eventually slow to match the normal rates of growth ween in mature economies. Will the desire for political change then create a crises?

    2. I agree with Kyle, and as I said in the text Chinese rapid growth was due to (1) a lot of catching up and (2) massive industrialization and urbanization. Both of these effects are temporary and China's reluctance to accept necessary political change will soon enough cause a political crisis, as well as an economic one.

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