Part of the reason for the concerns that my blog has been hacked for political reasons may be the wide-spread belief abroad that no debate is permitted within China about the urgent need for economic reform. In fact this isn’t true. The discussion within China is quite vigorous, and the misperception is probably fueled by the belief – spread often enough, it seems, by China bulls – that the debate about the weaknesses in the Chinese economy is largely a debate between foreigners and Chinese, with some bulls even arguing that it is a debate between those who wish China ill and those who wish it well. The implication, of course, is that only someone who is incapable of understanding China – i.e. a foreigner – could possibly believe that China has problems.
But this is just silly. I will ignore the irony involved in a foreigner’s claiming that it is precisely because they are foreign that it is impossible for the foreign skeptics correctly to understand the Chinese economy, Chinese culture, and the thinking of the Chinese people (those inscrutable orientals!). I suspect the reason they find China so different and alien is because they have little experience of other developing countries, and know almost nothing either about developing countries outside East Asia or about economic history.
The Changing Debate Over China’s Economy
by Michael Pettis
http://carnegieendowment.org/2013/08/07/changing-debate-over-china-s-economy/ghp2
The Chinese growth model is not radically new. It is based primarily on the growth model developed by Japan in the twentieth century, and it has been implemented in various forms by many countries.
Once again I apologize for taking so long to repair my blog, but it hasn’t been easy. We are slowly fixing up the mess on my website. There will be a link on the site directing interested readers to the old site if anyone wants to read older blog entries. I will do this because I have been advised that there might be infected code buried in my site that creates a backdoor that allows the hackers to break into my site regularly. By not transferring anything from the old site to this one, presumably, I lower the likelihood of accidentally importing the virus.
A lot of very kind people have privately and publicly expressed their concerns that my site has been hacked for political reasons, perhaps because I am saying things that they think might anger important people in China. Although I have certainly been the target of sometimes hysterical attacks – more so in the past, when my analysis of the Chinese economy seemed more unlikely than it does now – I have no reason at all to think that my blog was hacked for anything other than commercial reasons having to do with the sale of excitable pharmaceuticals.
Part of the reason for the concerns that my blog has been hacked for political reasons may be the wide-spread belief abroad that no debate is permitted within China about the urgent need for economic reform. In fact this isn’t true. The discussion within China is quite vigorous, and the misperception is probably fueled by the belief – spread often enough, it seems, by China bulls – that the debate about the weaknesses in the Chinese economy is largely a debate between foreigners and Chinese, with some bulls even arguing that it is a debate between those who wish China ill and those who wish it well. The implication, of course, is that only someone who is incapable of understanding China – i.e. a foreigner – could possibly believe that China has problems.
But this is just silly. I will ignore the irony involved in a foreigner’s claiming that it is precisely because they are foreign that it is impossible for the foreign skeptics correctly to understand the Chinese economy, Chinese culture, and the thinking of the Chinese people (those inscrutable orientals!). I suspect the reason they find China so different and alien is because they have little experience of other developing countries, and know almost nothing either about developing countries outside East Asia or about economic history.
The Chinese growth model, as I have pointed out many times before, is not radically new. It is based primarily on the growth model developed by Japan in the 20th Century. It involves policies that can be traced at least as far back as the “American System” of the early 19th Century, and it has been implemented in various forms by many different countries around the world during the past 100 or even 200 years. There is, in other words, actually quite a lot that we know and understand about the model, even if many of us seem to have forgotten much of it – including its typical weaknesses, one of the most obvious of which is the tendency for over-investment in the late stages of the miracle-growth period leading to an unsustainable increase in debt.
More importantly, the claim that “foreign” skepticism lacks credibility precisely because it is foreign has very little historical support. There have been many cases in which foreigners were able, perhaps because they tend to be more objective, to identify risks earlier than locals. The real estate boom in the United States before the 2007-08 crisis, for example, was widely discussed by worried European economists for years, and Paul Krugman, a foreigner, was famously skeptical about the Japanese and Asia miracles at a time when most analysts, local or foreign, regarded such skepticism as evidence of either ignorance or ulterior motives (his work was based at least in part on earlier work by Alwyn Young, another foreigner).
Dismissing the credibility of skepticism about the Chinese miracle because it is foreign, in other words, has little in the history of economic analysis to support it. But the real reason why it is completely nonsensical is that it is simply not true. Among China economists living and working in China there is a great deal of worry about the sustainability of the growth model, and this has been the case for many years – so much so that former Premier Wen groused publicly about these issues long before most foreign analysts had doubts about the sustainability of the growth model, and he did so based on Chinese analysis, not foreign. Just as clearly, Premier Li has made it obvious that he sees the need for reform as urgent, and it is hard to believe that he would consider this to be such an urgent need if Chinese economists as a group were as oblivious to the risks and as optimistic as the traditional China bulls claim they are.
In fact I think until the recent shift in sentiment abroad, there was even more skepticism about the long-term functioning of the growth model within China than abroad, and one has only to read magazines like Caixin, and even the occasional article in the People’s Daily, to see how vigorous the debate is. It is true that sentiment abroad has shifted remarkably in the last year or two, but this reflects, in my opinion, the fact that foreign observers are not as close to events on the ground as are locals. Until about 2009-10, it was widely believed abroad that China’s growth model was functioning well – brilliantly, in fact – and that China would continue to grow at 9-10% a year for the next decade or longer.
Within China, however, most economists that I speak to were far more pessimistic. I remember meetings as far back as 2008, for example involving senior United States or European government officials looking to be debriefed on the Chinese economy, in which the foreign (and some Chinese) analysts present spoke jauntily about the great success of China’s growth policies and the brilliant future ahead, while many of the Chinese economists present were much more cautious and even gloomy as they discussed the sheer intractability of China’s economic distortions. In those days, I would argue, skepticism was disproportionately to be found among Chinese economists, and not foreign economists.
THE REAL DIFFERENCE IN OPINION
This is a good thing, of course. If Chinese economists were nearly as oblivious to China’s problems as the China bulls claim they are, we would have reason to be truly worried about the country’s prospects. In the last two years as the bull argument has been pummeled into reality by the surge in debt, the persistent failure of consumption growth to close the gap with GDP growth, and the sharp slowdown in overall growth, the mood abroad has turned increasingly bearish, to the point that many people are speaking about a China collapse and the horrible implications this will have for the rest of the world.
It is important to note however that nothing has really changed substantially in the past few years. The problems China is facing today should have all been expected, but we shouldn’t be so quick either to expect an imminent collapse in the Chinese economy or, even as China continues to slow sharply, an awful impact on the rest of the world.
The former bulls are using this shift in global sentiment to shift the goalposts somewhat. They now claim that the fundamental disagreement between China bulls and China skeptics is that the skeptics have been predicting an imminent collapse in the Chinese economy for several years – which of course has not happened – and that they are demanding that Beijing take policy steps which will force an adjustment in the Chinese economy such that consumption will immediately surge and investment immediately drop to “acceptable “ levels.
But the serious debate has not been about whether or not China’s collapse is imminent. The disagreement was whether or not investment misallocation and the repression of household income growth were fundamental to the Chinese growth model. The bulls argued that they were not, and that while poor investment decisions and low consumption growth could indeed exist, these could be addressed administratively within the model and did not require radical reforms that would essentially result in an abandoning of the growth model.
The skeptics argued that these were indeed fundamental to the model, and that worsening imbalances and an unsustainable rise in debt would be the inevitable and automatic outcome of maintaining current policies. For the bulls, although only after it became clear that debt was indeed growing too fast, debt problems are specific and localized problems created by irresponsible behavior on the part of individual actors, and they can be addressed by administrative measures on the part of the regulators. The skeptics, however, disagree. It doesn’t matter how strongly the regulators clamp down on one sector or the other, high growth rates – the skeptics argue – necessarily mean that debt is rising at an unsustainable pace no matter how vigilant the regulators. Our conclusion was that unless the investment-driven growth model were abandoned, it would lead inexorably to a debt crisis.
The heart of the bull argument until one or two years ago was that a radical adjustment was not necessary. The skeptics argued that it was, and, against the fervent advice of the bulls, they warned that the longer it took to implement the necessary adjustments the more difficult it would be. It is precisely that the disagreement over whether or not major structural adjustments were even necessary that separated the skeptics from the bulls.
I wish this were just about bragging rights, but it is not. The bulls have been forced to recognize the inevitable consequences of the existing growth model, although some have resisted longer than others, but many of them still don’t get it. They don’t seem to understand that what is needed is not implementation of the “right” administrative strategies to fix the problems of debt, investment and consumption, and they mistakenly believe that China has plenty of time to implement these strategies.
Most dangerously of all, the bulls think that China can fix its problems while growing at 7% or 7.5% – which is better than the 8% they used to think is the minimum acceptable, although worse then the 6% they will undoubtedly cite next year as the minimal acceptable growth rate. But these growth rates, the skeptics argue, are impossible. In order that Beijing get its arms around credit growth and reduce the extent of wasted investment, GDP growth rates – the skeptics argue – must drop considerably, although since rebalancing means that household income must grow faster than GDP, it will not be nearly as painful as the bulls think it will be.
The issue about how much China’s GDP growth must slow in order to accommodate the necessary adjustment is probably the key difference between the bulls and the skeptics. Contrary to the new argument put forward by the old bulls, the problems of debt, investment and consumption in China are not new and unexpected, they are not just the normal growing pains associated with rapid growth in an otherwise healthy developing economy, they are not simply individual problems caused by irresponsible behavior, and they cannot be addressed except with far more radical changes than the bulls acknowledge.
RADICAL CHANGE VERSUS ADMINISTRATIVE CHANGE
What’s more, and the various skeptics’ analyses have explained why, the changes China needs will necessarily create strong political opposition within the system. Arguments by former bulls that the real debate between the bulls and the skeptics is all just about whether China collapses in the next few months or not, weaken the case for reform and will, I suspect, make it harder for Li and the reformers to force through the necessary changes. These changes – and I don’t know if the bulls understand this or not – must come primarily at the expense of the political and economic elite, and I don’t just mean that there must be less corruption, as Friedman, another former bull, and among the most excitable of the lot, is now arguing.
Anyone who understands the fundamental problem with the growth model that China has pursued, which has many historical precedents, and why its great success in the 1980s and 1990s could not be sustained once certain parameters were breached, as they inevitably must be, also knows that until those parameters were breached, the interests of the elite and of overall growth for the economy were more or less aligned. Since then, they are in opposite directions. This is why the period of adjustment after rapid growth has always been the most difficult stage for a developing country, and one that very, very few countries have successfully managed, and why it will be particularly difficult for China, and this is why corruption – although perhaps of enormous social and political consequence – is not the fundamental problem.
The debate about China continues to rage, although it has taken a strange twist. No one doubts anymore that China’s imbalances threaten the success of the growth model and some are even insisting – very prematurely, in my opinion – that China has clearly failed and will face a collapse (whatever that means). I think the key division now, however, is over debt and over the recognition of previous losses. The bulls have retreated from many of their more fantastic predictions but they mistakenly think that the problem of debt is localized, and not systemic, and can be administratively resolved by the regulators. They also seem to ignore the possibility that there is an enormous amount of mispriced assets on the balance sheets of the banks and that these losses have to be assigned to some sector of the economy or the other, and that this assignation is at heart a political process.
The skeptics believe that an unsustainable rise in debt is key to continued growth in the economy and do not believe that it can be resolved administratively. High growth means, by definition, that debt is rising unsustainably. The bulls say that growth has bottomed out at 7% or 7.5% and that China can restructure the economy, rebalance towards consumption, and arrest the credit expansion while keeping growth rates above 7% or close to 7%. The skeptics argue that this is impossible, and to the extent that Beijing takes steps to keep growth rates high, it simply increases the risk of a debt crisis and economic collapse.
Last year in one of my blog posts I argued that although I remained very skeptical about the sustainability of the China growth model I nonetheless believed that China bulls could make a plausible argument but were failing to do so largely because they did not address the three questions that were fundamental to the debate on the sustainability of the Chinese growth model. These questions are:
How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
What mechanism can be implemented to increase the growth rate of household consumption?
I think these continue to remain the key questions if the bulls are going to be credible.
NO MORE STOPPED CLOCKS, PLEASE
Before closing allow me – perhaps a little foolishly – to display a little peeve. For many years before 2007-9 a few analysts have warned that rising consumer credit in the United States and peripheral Europe was unsustainable. They warned that rising debt to support misallocated investment in China was also unsustainable. They warned that soaring United States mortgages backed by little more than the hope that land prices could only rise would lead to a real estate crisis. They warned that commodity-exporting countries that did not hedge their bets would find themselves in serious trouble when commodity prices collapsed.
Of course you could not have had a bubble unless the majority of analysts disagreed with these warnings, and most analysts did indeed disagree. So what happened when the warnings turned out to be right? Obviously enough the mistaken bulls publicly acknowledged that their models were incorrect and promised to hit the economic history books so that they never again would be so foolish.
Just kidding. What actually happened is that the former bulls immediately trotted out the stopped-clock analogy. The reason the worriers turned out to be right, they earnestly explained, is that they are perma-bears, and as everyone knows a stopped clock will always be right twice a day. This doesn’t mean, however, that models used by the worriers were right and the models used by the bulls were wrong, so of course there is not need for the bulls to change their models.
As China’s growth continues to slow and as its debt problems become obvious to even the most bullish, the stopped clock analogy is working overtime. How does it work? First, we must assume that there are only two possible positions one can take on China’s economy. The “bull” position is that China is in very good shape and is more or less doing everything right, even though (the remaining bulls have been adding lately) its economic growth must slow down a little. The “bear” position is that China must collapse within six months.
Second, we point out that China hasn’t collapsed yet, and so the fundamental analysis was wrong. Of course China is slowing, as even the most fervent bulls acknowledge, and just as the bears said it would, but this, they bulls claim had to happen eventually and has nothing to do with the analysis.
Of course this is just dumb. There are other far more likely alternatives for China that involve neither perpetual double-digit growth nor collapse. For example, I have been skeptical about the sustainability of the Chinese growth model since at least 2006-7 but I have never argued that China would collapse, let alone collapse within six months. My argument is that China’s growth model, which is not at all unique and for which there are many historical precedents, is usually wealth enhancing in its early stages, and then becomes wealth destroying once capital is systematically misallocated. When that happens, debt rises at an unsustainable pace until we reach debt capacity limits, in which case the country will have a debt crisis. I have usually estimated that it would reach debt capacity limits around 2016-18 but now I think it is likely to happen earlier.
However I never believed China would hit those limits, or have a debt crisis, because I was fairly sure that Beijing would begin adjusting earlier. It is during the adjustment period that I expected growth to drop sharply, to 3-4% as the upper limit.
Regular readers of my blog know how often I gripe about the superficiality of those analysts who don’t see why describing a growth model that is generating an unsustainable increase in debt is not the same thing as predicting a collapse in six months. Debt can rise unsustainably for many years before the debt burden itself becomes unsustainable – after all it is not true that those who worried about the rise of consumer credit in the United States in the mid 2000s were “wrong” until the stopped clock eventually was right.
This strikes me as an incredibly superficial analysis, explained only by the fact that many of us expect economic analysis merely to predict whether the stock market will rise or fall this week. Those who worried about rising consumer credit in the United States were not wrong every single year until 2007-8, when they accidentally became right. They were right every single year, and were proven right in 2007. Those who have been arguing that China is experiencing an unsustainable increase in debt have not been wrong every quarter that China has not collapsed. They are almost certainly right and it is hard even for the most foolish of bulls any longer to deny it.
An analysis that points to an unsustainable trend is always right if the trend turned out indeed to be unsustainable. The fact that it may have taken many years before the limits were reached is not an indication that the model was wrong. It is simply how the economy works.
This is why I get very annoyed with people who were obviously wrong when they dismiss people who were obviously right by referring to the stopped clock that is always right twice a day. Whenever a bull defends himself with the stopped-clock analogy, it suggests to me that he is likely to be an economic illiterate – and completely wrong to boot.
Slowdown in China Isn’t Bad News
by Michael Pettis
http://carnegieendowment.org/2013/08/13/slowdown-in-china-isn-t-bad-news/gie2
The implications of China’s slowing economy depend on how successful and orderly the rebalancing process will be in the face of domestic opposition from elites who have benefited from three decades of unbalanced growth.
Imagine having predicted in 1990 that the Japanese economy, then widely expected to overtake the US within a decade or two, would grow on average by less than 1 percent a year for the next 20 years. In the unlikely case that anyone believed you, he would probably have drawn two worrisome conclusions.
First, Japan at that time was considered the world’s growth engine, and so a collapse in Japanese growth would likely throw the world into a tailspin. Second, if after several decades of robust expansion Japanese growth were suddenly to drop so dramatically, there was sure to be social and political upheaval in Japan.
Japan did grow slowly for the next 20 years, but the rest of the world did not subsequently stagnate, and the Japanese people did not rise up in anger. Today, as the Chinese economy continues to slow, the world is asking the same worried questions about China. Without a boost from the Chinese growth engine, analysts say, doesn’t the global economy risk stagnating further? Can China tolerate growth below 7 percent without suffering social unrest and perhaps even revolution?
Understanding why these worries were wrong for Japan may help in understanding why they might also be wrong for China. Take the first question. Will a Chinese slowdown cause a global slowdown? Probably not. It turns out that China today, like Japan in the 1980s, is not the global engine of economic growth. It is the largest arithmetic component of global growth.
These may seem the same, but in fact are very different. What the global economy lacks today is demand, and the engine of global growth must be a source of net demand for the rest of the world. China, with its large trade surplus, clearly isn’t. What matters to the rest of the world, ultimately, is not how fast China is growing, but rather how the trade account will evolve as the economy rebalances. Some analysts might argue that China’s central bank purchases of US government bonds also have an important effect on the global economy by restraining US interest rates, but as I show in Chapter 8 of my book The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (Princeton University Press, 2013), this argument is based on a fallacy. China’s export of capital matters not because it affects US interest rates but because of its impact on the trade account.
An orderly rebalancing, in which China’s savings rate declines steadily relative to investment, implies a contracting trade surplus that will add net demand to the world. A disorderly rebalancing might imply an explosion in the trade surplus that would weaken an already struggling global economy. Whether slowing Chinese growth is good or bad overall for the world, in other words, depends on how it affects China’s balance of trade, and this depends on how swiftly and forcefully Beijing is able to constrain credit growth and rebalance the economy.
There are at least three other ways in which China’s rebalancing affects the world: First, China’s disproportionate demand for hard commodities, five to ten times its GDP share compared to the rest of the world, is a consequence of the country’s excessive reliance on investment to generate growth. A rebalancing China means much lower investment growth, which in turn implies a dramatic drop in Chinese demand for hard commodities. This will hurt countries whose growth depends on high commodity prices, but it will help net commodity importers.
Second, China became the world’s manufacturing workshop at least in part because the very mechanisms that led to unbalanced growth also increased export competitiveness – especially its undervalued currency, artificially low interest rates, and lagging wage growth. As China rebalances, by definition its export competiveness will erode, and this will be positive for manufacturers, especially in other developing countries.
Third, Chinese rebalancing means a partial transfer of demand from investment-related spending to consumption-related spending. A reduction in economic growth will have a disproportionately large impact on reducing investment growth, and a disproportionately small impact on reducing consumption growth. German exporters of capital goods, for example, will suffer much more than German exporters of consumer goods.
How a Chinese slowdown affects the global economy, in other words, depends crucially on how China rebalances. The seeming determination of Premier Li Keqiang to come to grips with debt and force a rebalancing even if that brings, as it must, a sharp slowdown in economic growth bodes well for an orderly rebalancing which will benefit most of the world.
What about the social impact of slower Chinese growth – can ordinary Chinese tolerate growth rates much below 7 percent? The same process that determines the impact of slower Chinese growth on the rest of the world will also determine how it will affect ordinary Chinese.
Slower growth after 1990 did not outrage ordinary Japanese largely because it did not result in equivalent contraction in their economic prospects. The average Japanese household, like households everywhere, doesn’t care about changes in its per capita GDP. It cares about real changes in its disposable income. As Japan was forced to rebalance its economy after 1990, one of the implications was, by definition, that household income and household consumption grew as a share of overall GDP, just as it must in China. After many years in which household income growth lagged the high GDP rates of the 1980s, it began to exceed the much lower GDP growth rates of the next decade, and this was magnified by the twin forces of deflation and a declining population.
The growth rate of income for the average Japanese household, in other words, slowed much less than GDP growth rates after 1990. As a result, the shocking collapse in GDP growth was not reflected in an equally shocking collapse in household income growth. Japanese households were not so badly hurt by Japan’s apparent economic stagnation because the slowdown occurred in conjunction with an orderly rebalancing of the economy.
Depending on how Beijing manages its own economic adjustment, the same can happen in China. There should be little doubt that China’s GDP growth rates will continue to drop, and to levels well below the 6 to 7 percent that most analysts now suggest as a worst-case scenario for China. In fact it’s hard to see how a rebalancing China is consistent with GDP growth rates on average much above 3 to 4 percent.
By definition, a rebalancing China means that household income must grow much faster than GDP. This will not be easy and will require significant transfers from the state sector to shore up the social safety net, boost household wages and raise deposit rates. But if the rebalancing is managed well, GDP growth rates of 3 to 4 percent can be consistent with household income growth rates of 6 to 7 percent. This is far from being a disaster for ordinary Chinese.
China’s economy will continue to slow dramatically over the next few years. Of this there should be little doubt. The implications, however, are not as obvious as many think. They depend on how successful and orderly the rebalancing process will be in the face of tremendous domestic opposition from elites who have benefitted spectacularly from three decades of unbalanced growth. An orderly rebalancing in China will be positive for overall global growth – although not positive for every country – and positive for ordinary Chinese, if not for the elite. What matters are the decisions Beijing takes over the next year to direct the pace of China’s rebalancing.