Key Trends in the World Economy

New US GDP figures are not 'disappointing' - they confirm long term deceleration in the US economy

The new US GDP data was widely seen as 'disappointing'. But the most important trend is not the short term figure of 2.2% annualised growth for 1st quarter of 2012 but the confirmation of the long term deceleration of the US economy. The charts below show that the moving average for US 20 year GDP growth has fallen to 2.6% and the moving average for 10 year US GDP growth has fallen to 1.6%. In both cases the declining long term trend for growth is clear from the charts.

It is because there is a persistent long term slowing of the US economy that the US growth data is consistently seen as 'disappointing'. In fact the problem is a wrong perception. Analysts are surprised by new data only when they have not internalised or built into their models this long term deceleration of the US economy. A more fundamental and longer term analysis of this long term slowing of the US economy can be found here.

PS for those interested more detailed analyses of the new US GDP figures will be found on my Sina Weibo - the Chinese equivalent of Twitter. Having used both Weibo is a better product than Twitter for economists as it has built in facilities for showing charts. Posts are in both English and Chinese. My Weibo is here.

Figure 1 – 10 year moving average of US annual GDP growth

Figure 2 – 20 year moving average of US annual GDP growth

Analysing China's new 3.6% inflation data and its implications for the world economy

This blog has frequently drawn attention to the extremely close correlation between China’s consumer inflation (CPI) trends and world commodity prices – Figure 1. It is world commodity prices, rather than monetary data, which provides the best indicator of China’s inflation trends. In that light how is China’s 3.6% CPI figure for March to be analysed? As China’s inflation trend is a major determinant of China’s ability, or otherwise, to pursue expansionary economic policies this is a major issue not only for that country but for the world economy.

Figure 1

 

It is evident China’s CPI is not powerful enough to drive world commodity prices. The correlation between the two indicators therefore necessarily shows either, or both, that world commodity prices determine China’s CPI shifts, or more probably that some third factor, for example overall global economic trends, determines both. In either case China’s CPI would be expected to follow trends in global commodity prices.

In that light China’s 3.6% CPI for March is not particularly surprising. Despite the monthly increase from 3.2% in February the overall downward trend in China’s inflation continues – Figure 2. The 3.6% CPI figure in March is a decline of almost half since the 6.5% peak in July 2011 and is within the government’s 4.0% target.

Figure 2

 

The fact that March saw an upward tick within a descending trend of China’s inflation is in line with the fact that, as this blog has analysed, world commodity prices stopped falling between December and the end of March – Figure 3. This, as was noted here, was likely to slow the decline of China’s inflation rate and therefore the March figure was not highly surprising. What is significant, however, is that late in March and so far in April a new downturn in international commodity prices started, probably under the impact of softening in the global economy – Figure 3. If that downturn continues then, as analysed here, it would be expected that China’s CPI would start to decline again.

Figure 3

 

Therefore, to have a perspective on China’s economy, world commodity prices and China’s CPI in April must be watched closely. If global commodity price changes continue their downwards trend it would also be anticipated, on the basis of existing trends, that China’s CPI will also fall – creating further room for expansionary policies. If world commodity prices were to fall, but China’s CPI did not, it would indicate that existing correlations between global commodity prices and China’s CPI no longer held.

April will therefore be a significant month not only for China’s economy but for the theoretical analysis of it.

Commodity price falls suggest global economic slowdown but good news for China's inflation

After stability from December to March world commodity prices have started falling again - Figure 1. This indicates global economic softening but good news for China’s inflation and therefore increased possibilities for China’s economic policy to adopt an expansionary approach.

Figure 1

 

Looking at the trends in greater detail, world commodity prices fell sharply during the second half of 2011. The Dow Jones-UBS spot commodity index fell from a year on year increase of 46.4% in June 2011 to a fall of minus 7.8% in December 2011. However then until mid-March 2012 no further decline occurred. As China’s consumer price index (CPI) is highly correlated with global commodity prices this raised the danger that inflationary pressures in China had ceased lessening - with negative consequences for the ability of China to undertake expansionary economic policies.

However during the latter part of March and the beginning of April 2012 commodity prices resumed their year on year fall. By 5 April the Dow Jones-UBS spot commodity index had fallen 12.9% below its level a year previously.

As commodity prices are an extremely sensitive and up to date indicator of global economic conditions two conclusions may be drawn from this.

• Global economic conditions may be softening – which would be in line with the latest unfavourable US jobs report for example.
• A decline in global commodity prices will significantly reduce inflationary pressures in China – creating more space for expansionary economic policies.

Because of the significance of such trends further development of world commodity prices must be be watched closely.

Globalization not protectionism remains the main trend in the world economy

Protectionist measures by the US government have received considerable publicity. These include tariffs against China's solar panel exports, the dispute over rare earths, a bill against "subsidized" exports passed by both houses of the US Congress and other steps.

These measures are real. But it is also important not to exaggerate them. Protectionism is not the main trend in the global economy. This is shown both by factual economic trends and considering the underlying forces at work. Protectionist measures affect trade at the margins but do not alter the core of world trade which continues to expand.

To show this first consider the facts. The volume of world trade fell severely during the international financial crisis, declining by 19.7 percent between April 2008 and May 2009. But it then more than recovered. According to the latest available data, by January 2012 the volume of world trade was 4.8 percent above pre-crisis levels - Figure 1.

Figure 1

 

After the financial crisis US imports fell sharply, from 15.7 percent of GDP in the third quarter of 2008 to 10.6 percent of GDP in the second quarter of 2009, but then recovered to 14.8 percent of GDP by the fourth quarter of 2011.

Regarding relations between China and the US, frequently seen as the main area of protectionism, in dollar terms China's exports to the US rose 22 percent between their pre-crisis peak in September 2008 and the same month in 2011, well above the 15.4 percent increase to the EU, and not far behind the 27 per cent increase to Japan. In short, US post-financial crisis trends showed trade recovery, not deepening protectionism. Nor was protectionist actions even the main trend in trade between the US and China.

Claims that protectionism is the dominant trend in the world economy are therefore factually exaggerated, and take individual developments out of context without examining their overall weight.

Analysis of fundamental economic forces confirms why protectionism is not the main trend. Modern production is on such a large scale that it cannot find an adequate market for its volume of production, at efficient levels, purely within a national economy. That is why, for example, China's reform and opening-up was necessary, but exactly the same pressures affect the US.

Even in 1929 serious retreat into protectionism led to disastrous economic decline and crisis, culminating in economic and political destabilization of all countries and finally world war. Today, when production is on a far larger scale than 1929, the economic results would be more catastrophic. This is why all major economies have so far rejected large-scale protectionism.

Fundamental economic analysis therefore confirms what the facts reveal, that certainly there will be some protectionist actions, but these will be at the margins, and globalization, not protectionism, will remain the main trend in the world economy.

Nor is protectionism likely to be the main instrument of US 'neo-cons' or a Republican president. US neo-cons have much experience in how to slow Asian economies. This was successfully achieved against Japan and then the South East Asian "Tiger" economies during the 1997 debt crisis. In neither case was protectionism the main weapon.

The first 'neo-con' strategy was to transfer disputes from the economic realm, where the US is gradually weakening, to the military and political fields, where the US remains much stronger.This tactic is followed in the US 'pivot' toward the Asia-Pacific region.

Within the economic realm the main methods US 'neo-cons' used were forcing other countries to overvalue their currency, forcing cuts in investment levels, which slow economies, and lower foreign inward investment to reduce technology transfer. All these methods are being attempted against China. Protectionism is not dominant in any of these methods.

Attention must certainly be paid to real protectionist measures but exaggerating the degree of protectionism is factually incorrect, not based on analysis of the world economy's main forces, and fails to identify the main economic tactics used by US 'neo-con' circles. 

Competition within globalization, not protectionism, is still the world economy's main trend.

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An earlier version of this article appeared, in Chinese and English, in Global Times.

China's achievement is literally the greatest in world economic history

Economic development’s purpose is to improve the conditions of human beings. Robert Lucas put it eloquently, in frequently quoted words, examining the consequences of different rates of economic growth: ‘I do not see how one can look at these figures without seeing them as possibilities. Is there some action a government of India could take that would lead the Indian economy to grow… If so, what, exactly?… The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.’

In this framework it should be stated, soberly and with due consideration, that China’s economy since 1978 is the greatest economic achievement in world history. This article shows this in the prosaic language of statistics. But of course that is not the real issue. What really counts is the consequences of this for human beings – escape from poverty, improvement in life expectancy, improved health, expanded potential for education, improvement in the position of women, and many other dimensions. Economic statistics, such as GDP per capita, simply underpin this improvement in human conditions.

The scale of China’s economic achievement

A problem in assessing the true scale of China’s economic achievement is that partial statistics are frequently used to state it. Some of these, for example that China has become the world’s second largest economy, or that it has raised 620 million people out of internationally defined poverty, are extremely striking (Quah, 2010). But nevertheless, because they are partial, they do not capture the full scope of what has occurred. Only when systematic data is used does the full magnitude of China’s achievement become clear.

Again, even when systematic comparisons are attempted, the scale of China’s economic achievement is frequently underestimated because inappropriate measures are used. For example when comparing rates of economic growth, in calculating contributions to economic welfare, it is misleading to take individual countries as the unit of comparison, rather than the proportion of world population affected – rapid economic growth in a small country evidently contributes  less to human well being than rapid growth in a large country.

In order to give an initial systematic comparison, therefore, Table 1 shows the percentage of world population affected at the point when sustained rapid growth commenced in major economies. For example the first country to experience sustained rapid economic growth was the UK in the industrial revolution - which was in a country with 2.0 per cent of the world’s population. The sustained rapid US economic growth after the Civil War was in a country with 3.3 per cent of the world’s population.

There are, of course, arguments about some additional individual countries that might be included in the comparison – for example Italy from 1950 (1.9 per cent of the world’s population) or Spain from 1960 (1.0 per cent of the world’s population). But it is evident from the data that introducing such extra countries makes no difference to the essential situation.

No other economy starting sustained rapid economic growth even approaches the 22.3 per cent of the world’s population in China in 1978 at the beginning of its new economic policies. For comparison Japan’s rapid post-World War II growth was in a country with 3.3 per cent of the world’s population, and the growth of the four Asian ‘Tigers’ (Hong Kong, Singapore, South Korea, and Taiwan) was in economies with only 1.4 per cent of the world’s population.

Only India’s sustained economic growth after the late 1980s, in a country with 16 per cent of the world’s population, even begins to approach China’s achievement in scale, but the percentage of the world population affected is still lower than China’s, as is India’s growth rate.

Table 1

 

Introducing the necessary correction of population size also makes clear that the method sometimes utilised of ranking by country size is misleading. To see why it need only be noted that, if current exchange rates are used, on the World Bank tables for 2010, the latest year for which comprehensive statistics are available, 87 of the countries for which data was available have a higher GDP per capita than China and 83 had a lower. This appears to place China about half way up the list of world rankings. As when the People’s Republic of China was created in 1949, or economic reform was launched in 1978, China was one of the world’s most economically underdeveloped countries this might appear a quite good performance, but it wholly understates China’s achievement.

The reason is that ranking by country takes no account of relative population. For example among the countries above China are the Seychelles, Palau, St Kitts and Nevis, Dominica, and Antigua and Barbuda – all with a population of less than 100,000. If the real international position of China is to be assessed then, again, size of population must be taken into account. Figure 1 below, therefore, shows the percentages of world population living in countries with GDP per capita above and below China and shows the real proportions of China’s economic achievement.

In 1978 countries containing only 0.5 per cent of the world’s population had a GDP per capita below China’s, while 73.5 per cent had a higher one – China itself accounted for 25.9 per cent of the world’s population for which data was available. By 2010, using the same measure, the percentage of the world’s population living in countries with a higher GDP per capita than China was 31.3 per cent - given the speed of increase, it is clear that when 2011’s data is published it will show that less than 30 per cent of the world’s population lives in countries with a higher GDP per capita than China.

Figure 1

 

Therefore in only slightly over thirty years China, containing more than twenty per cent of the world’s population, has moved from being one of the world’s least economically developed countries, to a position where less than one third of the world’s population lives in countries with a higher GDP per capita, and where China’s position is rising rapidly.

Checking these current price statistics against international parity purchasing powers (PPPs), which takes into account different price levels in different countries, confirms the same result. Measured by PPPs in 1980, the first year for which World Bank data is available, only 1.3 per cent of the world’s population lived in countries with lower GDP per capita than China and 73.0 per cent in countries with a higher one. By 2010 only 31.5 per cent of the world’s population lived in countries with a higher GDP per capita than China.

Another way of measuring is to compare China to the rest of the world’s population. To do this, the best measure is not the average as, for well known statistical reasons, averages covering wide ranges are excessively affected by small numbers of extreme values. This is confirmed very clearly by world data. Only 25 per cent of the world’s population has a GDP per capita above the global average and 75 per cent have one below it. A better, and the standard, measure of incomes is to make a comparison to the median – the exact mid-point.

In 1978 China’s GDP per capita was only 42 per cent of the median for the rest of the world’s population. By 2010 China’s GDP per capita was 289 per cent of the median.

That since 1978 China, with more than one fifth of the world’s population, has moved from being one of the poorest countries in the world to a situation where less than one third of the world’s population has a higher GDP per capita is without historical precedent. Never before in human history has such a large proportion of the world’s population advanced so rapidly.

A number of conclusions clearly follow from the above data – in addition to the obvious one of simply recognising this as a fact of economic history. But for now it need simply be noted, soberly and with due measure, that China’s is quite literally the greatest economic achievement in world history.

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An earlier and shorter version of this article appeared, in English and Chinese, in Global Times.

Notes

Deng Xiaoping and John Maynard Keynes

 

 

Introduction

The international importance of China’s economy is twofold. The first is practical - the scale of China’s economic growth, its global impact, and the consequences for the improvement of the social conditions of China and the world’s population. The second is theoretical, including the potential international applicability of conclusions drawn from China’s economic policies.

Regarding the latter it is necessary to clearly state that no country can mechanically copy another. As China’s political leaders and economic theorists stress its economy has unique ‘Chinese characteristics’. This was formulated as a cardinal principle by the initiator of China's economic reform, Deng Xiaoping: ‘To accomplish modernization of a Chinese type, we must proceed from China’s special characteristics.’ (Deng, 30 March 1979) Therefore China must: ‘blaze a path of our own.’ (Deng, 21 August 1985). As recently reiterated by Justin Yifu Lin, Chinese Chief Economist and Senior Vice President of the World Bank: ‘we can never be too careful when it comes to the application of a foreign theory, because with different preconditions, no matter how trivial they seem, the result can be very different.’ (Lin, 2012, pp. 66 - emphasis in the original) In that sense, therefore, there is no ‘Chinese model’. However as Lin simultaneously states: ‘Some may think that the performance of a country as unique as China, with more than 1.3 billion people, cannot be replicated. I disagree. Every developing country can have similar opportunities to sustain rapid growth for several decades and reduce poverty dramatically if it exploits the benefits of backwardness, imports technology from advanced countries, and upgrades its industries.’ (Lin, 2011)

There is, however, no contradiction between these different statements. The fundamental structural elements of which an economy is composed (consumption, investment, savings, primary industry, secondary industry, tertiary industry, trade, money etc.) are universal. However the particular way in which these elements combine and are interrelated in any economy is unique and entirely specific both in place and time – which is why no country can copy another’s economic policy, while it can learn from other economies. As analysed below, China has solved in practice problems stated in general macro-economic theory. For that reason such elements, in very different forms and combinations, are of major importance for economic policy elsewhere. However the specific forms and combinations in which such policies are applied are entirely unique both in each country and at different points in time.

The practical impact of China’s economic rise have been considered extensively elsewhere.¹ The focus of this article is on the theoretical economic issues. In particular it aims to relate China’s economic performance to Western economic theory which will be more familiar to most readers.

China and macro-economic theory in Keynesian and Marxist terms

China’s ‘reform and opening up’ process under Deng Xiaoping was, of course, formulated in a Marxist economic framework. It can indeed be clearly outlined in those terms – see the appendix below, for a more detailed account of Chinese discussions on these issues see (Hsu, 1991), but an alternative statement in Western economic terms, those of Keynes, is considered here.

Stated briefly in Marxist terms, China’s reform policy included a critique of Soviet economic policy that this had made the error of confusing the ‘advanced’ stage of socialism/communism, in which the regulation of the economy is ‘for need’, and therefore not market regulated, with the socialist, or more precisely ‘primary’ developing stage of socialism, during which the transition from capitalism to an advanced socialist economy takes place and in which market regulation takes place. This transition should be conceived as extending over a prolonged period. The final formulation arrived at was that China’s was a ‘socialist market economy with Chinese characteristics’. Contrary to suggestions by some writers, for example (Hsu, 1991), such an analysis is in line with Marx’s own writings although, as shown below, it is not necessary to be a Marxist understand it - a more detailed analysis is given in the appendix.

This debate was framed in Chinese terms, without primary reference to previous economic theory in other countries other than Marx himself. The approach, in a Chinese phrase emphasised by Deng, was to ‘seek truth from facts’ (Deng, 2 June 1978). In practical terms in China, such analysis meant abandonment of an administratively planned economy and substitution of a market economy in which the state would control certain key macroeconomic parameters. In terms of ownership it led to ‘Zhuada Fangxiao’ – maintaining large state firms and releasing small ones to the non-state/private sector.

Restatement of Chinese economic policy in terms of Keynesian economics

Most people in the US and Europe are unaware of, or disagree with, Marxist economic categories. To make the essential economic policies clear, therefore, this article will put them in more familiar terms of Western economics – those of Keynes. The proviso is that this is the actual Keynes of The General Theory of Employment Interest and Money - not the vulgarised version in economics textbooks. Geoff Tily’s Keynes Betrayed (Tily, 2007) is one of the best in a series of works outlining the difference between the two. However, there is no substitute for reading Keynes General Theory itself, which differs sharply from the presentation of what is frequently presented as ‘Keynesian’ economics. For example, budget deficits play only a secondary role in both Keynes General Theory and in China’s stimulus packages – even during 2009’s maximum anti-crisis measures China’ s budget deficit was only 3% of GDP. The core of Keynes’ General Theory itself, unlike vulgarisations, centres on factors determining investment. It is therefore through this optic that both Keynes and Chinese economic strategy can be best approached.

The rising proportion of the economy devoted to investment

In the founding work of classical economics, The Wealth of Nations, Adam Smith identified division of labour as the fundamental force raising productivity, stating as the opening sentence of the first chapter: ‘The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is any where directed, or applied, seems to have been the effects of the division of labour.’ (Smith, 1776, p. 13) Smith concluded that a necessary consequence of the increasing division of labour was that the proportion of the economy devoted to investment rose with economic development: ‘accumulation of stock must, in the nature of things, be previous to the division of labour, so labour can be more and more subdivided in proportion only as stock is previously more and more accumulated… As the division of labour advances, therefore, in order to give constant employment to an equal number of workmen, an equal stock of provisions, and a greater stock of materials and tools than what would have been necessary in a ruder state of things must be accumulated beforehand.’ (Smith, 1776, p. 277) A more comprehensive treatment of Smith’s views may be found in (Ross, 2011). Marx reached the same conclusion as Smith, concluding that the contribution of investment rose as an economy developed, which he termed the rising ‘organic composition of capital’ (Marx, 1867, p. 762).

Keynes similarly analysed that the proportion of the economy devoted to investment rose with economic development. His explanation was, however, somewhat different to Smith’s as Keynes rooted this in rising savings levels accompanying development. As the percentage of income consumed fell with increasing wealth, the proportion devoted to saving necessarily rose proportionately: ‘men are disposed… to increase their consumption as their income increases, but not by as much as the increase in their income… a higher absolute level of income will tend… to widen the gap between income and consumption.’ (Keynes, 1936, p. 36) As total savings necessarily equals total investment, a rising proportion of saving therefore necessarily means a rising proportion of investment.

A necessary consequence of an increase in the proportion of the economy devoted to investment is that any investment decline will have increasingly serious consequences: ‘the richer the community, the wider will tend to be the gap between its actual and its potential production… For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak… the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.’ (Keynes, 1936, p. 31)

Failure of attempts to refute Keynes on the rising proportion of investment

In the mid-20^th century attempts were made to dispute this conclusion of classical economics, originally deriving from Smith, of a rising proportion of investment in the economy - Milton Friedman devoted a book, A Theory of the Consumption Function, to attempting to refute Keynes on this (Friedman, 1957). However modern econometrics findings are conclusive in support of Smith and Keynes and against Friedman – the definitive demonstration, as frequently on matters of long term economic growth, being given by Angus Maddison. (Maddison, 1992) Factually, as classical economics and Keynes analysed, the trend is for the proportion of the economy devoted to investment to rise. To illustrate this, Figure 1 shows the percentage of fixed investment in GDP of the leading economies of successive periods of growth over the 300-year period for which meaningful statistics exist.

Figure 1

 

A reason Friedman attempted, unsuccessfully, to refute Keynes over the rising proportion of investment in the economy is that such a trend, as will be seen, is potentially destabilising - Friedman noted: ‘the central analytical proposition of the [theoretical] structure is the denial that the long-run equilibrium position of a free enterprise economy is necessarily at full employment.’ (Friedman, 1957, p. 237)

Effective demand

There is a parallelism between Keynes’s analysis and Marx’s regarding the role of profit and investment. The latter noted that without offsetting factors, a rise in the proportion of investment in the economy would led to a falling rate of profit as a necessary consequence of a rise in capital relative to the profits stream – i.e. Increasing division of labour, through its effect in raising investment as proportion of the economy, as analysed by Smith, created a tendency to a declining rate of profit (Marx, 1894, pp. 317-375).

Keynes also approached economic fluctuations via profit: ‘The trade cycle is best regarded… as being occasioned by a cyclical change in the marginal efficiency of capital.’ (Keynes, 1936, p. 313) However, Keynes specific development was to approach the potentially destabilising consequences of the rising proportion of investment in the economy via effective demand.

Effective demand is composed of both consumption and investment, with the latter, as noted, tending to rise relative to the former over time. Keynes therefore noted: ‘when aggregate real income is increased aggregate consumption is increased but not by as much as income… Thus to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level… It follows… that given what we shall call the community’s propensity to consume, the equilibrium level of employment, i.e. the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment.’ (Keynes, 1936, p. 27)

Keynes noted no automatic mechanism ensures a necessary volume of investment to maintain effective demand: ‘the effective demand associated with full employment is a special case… It can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.’ (Keynes, 1936, p. 28) Put aphoristically: ‘An act of individual saving means – so to speak – a decision not to have dinner today. But it does not necessitate a decision to have dinner or buy a pair of boots a week hence or a year hence.’ (Keynes, 1936, p. 210). In more technical terminology: ‘The error lies in proceeding to the … inference that, when an individual saves, he will increase aggregate investment by an equal amount.’ (Keynes, 1936, p. 83)

Any investment shortfall would be amplified by the well known economic ‘multiplier’ into much stronger cyclical fluctuations: ‘It is… to the general principle of the multiplier to which we have to look for an explanation of how fluctuations in the amount of investment, which are a comparatively small proportion of the national income, are capable of generating fluctuations in aggregate employment and income so much greater in amplitude than themselves.’ (Keynes, 1936, p. 122) Such fluctuations in investment, combined with consumption, in turn determined employment: ‘The propensity to consume and the rate of new investment determine between them the volume of employment.’ (Keynes, 1936, p. 30)

From this analysis Keynes derived key policy conclusions.

Budget deficits

One, well known, is countering recession with budget deficits, which Keynes dealt with as ‘loan expenditure’ – vulgarisation of Keynes lies in reducing his theories to support for budget deficits, not in the fact that he supported deficit spending. Keynes noted: ‘”loan expenditure” is a convenient expression for the net borrowing of public authorities on all accounts, whether on capital account or to meet a budgetary deficit. The one form of loan expenditure operates by increasing investment and the other by increasing the propensity to consume.’ (Keynes, 1936, p. 128)

Therefore, in a famous passage: ‘If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines… and leave it to private enterprise… to dig the notes up again... with the help of repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater… It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.’ (Keynes, 1936, p. 130)

Such a view of deficit spending naturally did not mean Keynes was indifferent to what deficits should be spent on - today environmentally sustainable investment would be added to his existing list. He had scathing contempt for double standards regarding when deficits were justifiable: ‘Pyramid-building, earthquakes, even wars… may serve to increase wealth, if… our statesmen… stands in the way of anything better… common sense… has been apt to reach a preference for wholly “wasteful” forms of loan expenditure rather than for partly wasteful forms, which because they are not wholly wasteful, tend to be judged on strict “business” principles. For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest…wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable.’ (Keynes, 1936, p. 129)

Interest rates

While Keynes supported deficit spending, the causes of recession lay in more fundamental factors affecting investment, which in turn were affected by interest rates: ‘the succession of boom and slump can be described and analysed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.’ (Keynes, 1936, p. 144) This was because marginal efficiency of capital was ‘equal to the rate of discount which would make the present value of the series of annuities given by returns expected from the capital-asset during its lift just equal to its supply price.’ (Keynes, 1936, p. 135) Consequently, ‘inducement to invest depends partly on the investment-demand schedule and partly on the rate of interest.’ (Keynes, 1936, p. 137)

As investment was affected by interest rates, therefore, a crucial issue to maintain investment at a sufficient level to sustain effective demand was a low interest rate. This problem, in turn, tended to become more acute because of the rising proportion of the economy devoted to investment: ‘Not only is the marginal propensity to consume weaker in a wealthy community, but owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate; which brings us to the theory of the rate of interest and… reasons why it does not automatically fall to the appropriate levels.’ (Keynes, 1936, p. 31)

The aim of low interest rates was to relaunch investment by ensuring that the return on investment was above the rate of interest plus whatever was the required premium to overcome liquidity preference. But, as Keynes openly acknowledged, such low term interest rates destroy the ability to live from income from interest – which is why, in his famous phrase, Keynes foresaw ‘euthanasia of the rentier.’ (Keynes, 1936, p. 376) He concluded: ‘I see… the rentier aspect of capitalism as a transitional phase which will disappear.’ (Keynes, 1936, p. 376)

‘A somewhat comprehensive socialisation of investment’

Nevertheless, despite support for low interest rates Keynes, did not judge these would be likely by themselves to overcome the effects of an investment decline. It would therefore be necessary for the state to play a greater role: ‘Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment.’ (Keynes, 1936, p. 164) Consequently Keynes believed that regulating the level of investment would have to be undertaken by the state and not by the private sector: ‘I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.’ (Keynes, 1936, p. 320) It was necessary, therefore, to aim at ‘a socially controlled rate of investment.’ (Keynes, 1936, p. 325)

If, however, the state were to determine ‘the current volume of investment’ then this led Keynes to the conclusion: ‘It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.’ (Keynes, 1936, p. 378)

Keynes noted that this ‘somewhat comprehensive socialisation of investment’ did not mean the elimination of the private sector, but socialised investment operating together with a private sector: ‘This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.’ (Keynes, 1936, p. 378)

The conclusion

It is now possible to clearly see the structure of Keynes’s argument. The rising proportion of the economy devoted to investment meant any downturn in the latter would have increasingly destabilising consequences. Budget deficits could deal with this to some degree, but as the key element was investment, which was determined by interaction between profits and interest rates, low interest rates was necessary. This would lead to the ‘euthanasia of the rentier’. However it was unlikely interest rates would be sufficient themselves and therefore the state would need to step in with ‘a somewhat comprehensive socialisation of investment’ which would however work alongside a private sector.

Tracing this argument one has now arrived at a ‘Chinese’ economic structure - although approaching it via a Keynesian and not a Marxist framework. ‘Zhuada Fangxiao’, grasping large state firms and releasing small ones to the non-state/private sector, coupled with abandonment of quantitative planning, means that China’s economy is not being regulated via administrative means but by general macro-economic control, including centrally of the level of investment – as Keynes advocated.

Implications

What is the overall significance of this? Deng Xiaoping’s most famous economic statement is ‘cats theory’ – ‘it doesn’t matter whether a cat is black or white provided it catches mice’. But ‘cats theory’ can be applied to economics itself – it doesn’t matter whether something is described in Marxist or Western economic terms provided the same economic policies exist. ‘Zhuada Fangxiao’ may be arrived at from either a Keynesian or a Marxist framework.

But while one may be indifferent to the colour of theoretical cats it is not possible to be indifferent as regards the policy measures to be taken – steps in budget deficits, interests rates, investment etc are material and precise. Here there is a radical difference in between the US and Europe on one side and China on the other.

In the US and Europe budget deficits have been utilised – although they are under increasing attack. Low central bank interest rates have been pursued and some forms of quantitative easing, driving down long term interest rates through central bank purchases of debt, have been used. But no serious programmes of state investment have been launched – let alone Keynes’s ‘somewhat comprehensive socialisation of investment’.

In China, in contrast, relatively limited budget deficits have been combined with low interest rates, a state owned banking system (‘euthanasia of the rentier’) and a huge state investment programme. While the West’s economic recovery programme has been timid, China has pursued full blooded policies of the type recognisable from Keynes General Theory as well as its own ‘socialism with Chinese characteristics.’ Why this contrast and why has China’s stimulus package been so much more successful than the West’s?

Because in the US and Europe, of course, it is held that the colour of the cat matters very much. Only the private sector coloured cat is good, the state sector coloured cat is bad. Therefore even if the private sector cat is catching insufficient mice, that is the economy is in severe recession, the state sector cat must not be used to catch them. In China both cats have been let lose – and therefore far more mice are caught.

The recession in the Western economies, as foreseen by Keynes, is driven by decline in investment – in most countries decline in fixed investment accounted for two thirds to more than ninety per cent of the GDP fall (Ross, Li, & Xu, 2010). Keynes’s calls for not only budget deficits and low interest rates but also for the state to set about ‘organising investment’ are evidently required. But this is blocked because the state coloured cat is not allowed to catch mice.

To put it another way, the US and Europe insist on participating in a race while hopping on only one leg – the private sector. China is using two legs, so little wonder it is running faster.

To turn from metaphors to economic measures, a large scale state financed house building programme, or large scale expansion of transport, of the type China is following as part of anti-crisis measures not only delivers goods that are valuable in themselves but boosts the economy through macro-economic effects in raising investment. But in the West such state investment is blocked as it creates competition for the private sector. As the top aim in the US and Europe is not to revive the economy, but to protect the private sector, therefore such large-scale investment must not be undertaken.

It is an irony. Keynes explicitly put forward his theories to save capitalism. But the structure of the US and European economies has made it impossible to implement Keynes’s policies even when confronted with the most severe recession since the Great Depression. The anti-crisis measures of China’s ‘socialist market economy’ are far closer to those Keynes foresaw that any capitalist economy. Whereas in the US, for example, fixed investment fell by over twenty five per cent during the financial crisis in China urban fixed investment rose by over thirty per cent. Consequently, there is no mystery why China’s economy has grown by 41.4 per cent in the four years since the peak of the last US business cycle, in the 4^th quarter of 2007, while the US economy has grown by 0.7 per cent.

Deng Xiaoping famously said his death was ‘going to meet Marx’. But Deng may also be having an intense talk with John Maynard Keynes. And Keynes would be interested to discuss with Deng’s two cats – who appear to have read the  General Theory more closely and accurately than any administration in the West.

Put in more prosaic terms, China’s economic structure, because it allowed ‘a socially controlled rate of investment’ and a ‘somewhat comprehensive socialisation of investment’, could utilise policy tools developed by Keynes but the US and European economies could not. Although Keynes explicitly wished to save capitalism it turned out that Western capitalism could not use his tools, but China’s ‘socialism with Chinese characteristics’ could. Deng Xiaoping could not fit in the framework of Keynes, but Keynes could fit rather neatly within the framework of Deng Xiaoping.

Appendix – the issues restated in Marxist terms

In the article above an account has been given of China’s macro-economic policy in terms of a theoretical framework derived from Keynes. Deng Xiaoping, however, as a Communist naturally explicitly formulated China’s economic policy in Marxist terms - China’s economic reform policies were seen as the integration of Marxism with the specific conditions in China. More precisely Deng stated: ‘We were victorious in the Chinese revolution precisely because we applied the universal principles of Marxism-Leninism to our own realities.’ (Deng, 28 August 1985) Consequently: ‘Our principle is that we should integrate Marxism with Chinese practice and blaze a path of our own. That is what we call building socialism with Chinese characteristics.’ (Deng, 21 August 1985)

Authors, including (Hsu, 1991), have contended that Deng’s economic policies were not in accord with those of Marx. However while China’s economic policies clearly differed from those of the USSR after the introduction of the First Five Year Plan in 1929, which introduced comprehensive planning and essentially total state ownership, it is clear that China’s economic policies were in line with those indicated by Marx. Whether people wish to formulate Chinese economic policy in Keynesian or Marxist terms may be left to them. What is most crucial is not the colour of the cat but whether it catches mice – that is, the practical policy conclusions drawn. This appendix therefore briefly shows that Deng’s essential concepts in launching China’s economic reform in in 1978 corresponded to Marx’s.

The primary stage of socialism

Regarding China’s economic reform policies Deng noted, as stated in Marxist terms, that China was in the socialist and not the (higher) communist stage of development. Large scale development of the productive forces/output was the prerequisite before China could make the transition to a communist society: ‘A Communist society is one in which there is no exploitation of man by man, there is great material abundance, and the principle of from each according to their ability, to each according to his needs is applied. It is impossible to apply that principle without overwhelming material wealth. In order to realise communism, we have to accomplish the tasks set in the socialist stage. They are legion, but the fundamental one is to develop the productive forces.’ (Deng, 28 August 1985) More precisely, in a characterisation maintained to the present, China was in the ‘primary stage’ of socialism, which was fundamental in defining policy: ‘‘The Thirteenth National Party Congress will explain what stage China is in: the primary stage of socialism. Socialism itself is the first stage of communism, and here in China we are still in the primary stage of socialism – that is, the underdeveloped stage. In everything we do we must proceed from this reality, and all planning must be consistent with it.’ (Deng, 29 August 1987)

The fundamental characterisations by Deng have been maintained to the present – thus for example in July 2011 President Hu Jintao stressed that ‘China is still in the primary stage of socialism and will remain so for a long time to come’ (Xinhua, 2011), while speaking to the UN premier Wen Jiabao noted ‘Taken as a whole, China is still in the primary stage of socialism’ (Xinhua, 2010). The conclusion flowing from this as noted by Hsu, was that: ‘From this perspective, a serious error in the past was the leftist belief that China could skip the primary stage and practice full socialism immediately.’ (Hsu, 1991, p. 11)

The conclusion of such a contrast between a primary socialist stage of development and and the principle of a communist society (which, as noted by Deng above, was regulated by ‘from each according to their ability to each according to each according to his needs’) was that in the present 'socialist' period the principle was ‘ to each according to their work’: ‘We must adhere to this socialist principle which calls for distribution according to the quantity and quality of an individual’s work.’ (Deng, 28 March 1978) In Marxist theory, outlined by Marx in the opening chapter of Capital (Marx, 1867), economic distribution according to work/labour is the fundamental principle of commodity production – and a commodity necessarily implies a market. In this socialist period a market would therefore exist – hence the eventual Chinese terminology of a ‘socialist market economy.’ As presented by Deng Xiaoping and his successors above such Chinese analysis is highly compressed but clearly in line with Marx himself.

It is clear Marx envisaged that the transition from capitalism to communism would be a prolonged one, noting in The Communist Manifesto: ‘The proletariat will use its political supremacy to wrest, by degree, all capital from the bourgeoisie, to centralise all instruments of production in the hands of the State, i.e., of the proletariat organised as the ruling class; and to increase the total productive forces as rapidly as possible.’ (Marx & Engels, 1848, p. 504) The ‘by degree’ may noted – Marx therefore clearly envisaged a period during which state owned property and private property would exist. China’s system, after Deng, of simultaneous existence of sectors of state and private ownership is therefore clearly more in line with Marx’s conceptualisation than Stalin’s introduction ‘all at once’ of essentially 100 per cent state ownership in 1929.

Regarding Deng’s formulations on communist society being regulated by ‘to each according to their need’ versus the primary stage of socialism regulated by ‘each according to their work’ Marx noted in the Critique of the Gotha Programme of the post-capitalist transition to a communist society: ‘What we are dealing with here is a communist society, not as it has developed on its own foundations, but on the contrary, just as it emerges from capitalist society, which is thus in every respect, economically, morally, and intellectually, still stamped with the birth-marks of the old society from whose womb it emerges.’ (Marx, 1875, p. 85)

In such a transition Marx outlined payment in society, and distribution of products and services, necessarily had to be 'according to work' even within the state owned sector of the economy:‘Accordingly, the individual producer receives back from society - after the deductions have been made - exactly what he gives to it. What he has given to it is his individual quantum of labour. For example, the social working day consists of the sum of the individual hours of work; the individual labour time of the individual producer is the part of the social working day contributed by him, his share in it. He receives a certificate from society that he has furnished such-and-such an amount of labour (after deducting his labour for the common funds); and with this certificate, he draws from the social stock of means of consumption as much as the same amount of labour cost. The same amount of labour which he has given to society in one form, he receives back in another.

‘Here obviously the same principle prevails as that which regulates the exchange of commodities, as far as this is exchange of equal values…. as far as the distribution of the latter among the individual producers is concerned, the same principle prevails as in the exchange of commodity equivalents: a given amount of labour in one form is exchanged for an equal amount of labour in another form.

‘Hence, equal right here is still in principle - bourgeois right… The right of the producers is proportional to the labour they supply; the equality consists in the fact that measurement is made with an equal standard, labour.’ (Marx, 1875, p. 86)

In such a society inequality would necessarily still exist: ‘one… is superior to another physically or mentally and so supplies more labour in the same time, or can labour for a longer time; and labour, to serve as a measure, must be defined by its duration or intensity, otherwise it ceases to be a standard of measurement. This equal right is an unequal right for unequal labour... it tacitly recognises the unequal individual endowment and thus the productive capacities of the workers as natural privileges. It is, therefore, a right of inequality in its content like every right. Right by its very nature can consist only as the application of an equal standard; but unequal individuals (and they would not be different individuals if they were not unequal) are measurable by an equal standard only insofar as they are made subject to an equal criterion, are taken from a certain side only, for instance, in the present case, are regarded only as workers and nothing more is seen in them, everything else being ignored. Besides, one worker is married, another not; one has more children than another, etc. etc.. Thus, given an equal amount of work done, and hence an equal share in the social consumption fund, one will in fact receive more than another, one will be richer than another, and so on. To avoid all these defects, right would have to be unequal rather than equal.’ (Marx, 1875, pp. 86-87)

Marx considered only after a prolonged transition would payment according to work be replaced with the ultimately desired goal, distribution of products according to members of society’s needs.

‘Right can never be higher than the economic structure of society and its cultural development which this determines.

‘In a higher phase of communist society… after the productive forces have also increased with the all-around development of the individual, and all the springs of common wealth flow more abundantly - only then can the narrow horizon of bourgeois right be crossed in its entirety and society inscribe on its banners: From each according to his abilities, to each according to his needs!’ (Marx, 1875, p. 87)

It is therefore clear that post-Deng policies in China were more in line with Marx’s prescriptions than post-1929 Stalin policies in the USSR. Given the essentially 100 per cent state ownership of industry in China in 1978 'Zhuada Fangxiao' – maintaining the large enterprises within the state sector and releasing the small ones to the non-state sector – together with the creation of a new private sector created an economic structure clearly more in line with that envisaged by Marx than the essentially 100 per cent state ownership in the USSR after 1929. Deng’s insistence on the formula that in the transitional period reward would be ‘according to work’ and not ‘according to need’ was clearly in line with Marx’s analyses. It is notable that in the USSR itself a number of economists opposed Stalin’s post-1929 policies on the same or related grounds – including Buhkarin (Bukharin, 1925) , Kondratiev (Kondratiev), Trotsky (Trotsky, 1931) and Preobrazhensky (Preobrazhensky, 1921-27) (Preobrazhensky, 1921-27). Their works were, however, almost unknown as these issues were ‘resolved’ by Stalin killing those economists who disagreed with him and banning their works - although several accounts have been published outside the USSR – see for example (Jasny, 1972) (Lewin, 1975). China’s economic debates therefore appear to have preceded with reference to China’s conditions and Marx and not any preceding debates in the USSR.

It is therefore clear that China’s post-reform economic policy is in line with Marx’s analysis and that, as stated in Chinese analysis, post-1929 Soviet policy departed from Marx’s analysis – the argument that the converse is true, by Hsu and others, is invalid.

As China’s economic policy and structure can be understood in either Keynesian or Marxist terms it is a more general issue which is to be preferred. ‘It doesn’t matter whether a cat is black or white provided it catches mice’ might appear an appropriate response.

* * *

An earlier and shorter version of this article appeared in Soundings.

Notes and Bibliography

China and developing economies will determine the chances for world growth in 2012

China’s economic growth has become a key factor not only for itself but for world markets. As the scale of China's impact is still too frequently underestimated it should be noted that, measured in current dollars and at market exchange rates, i.e. in terms of actual effective demand, in the three years following the start of the international financial crisis China contributed 33.4 per cent of global market growth – more than four times as much as the US 8.1 per cent (Table 1). While final data for 2011 is not yet available, it is already clear from the first three quarters figures that China’s market last year expanded by over $1 trillion – approximately twice as much in dollars as the US, despite US growth having resumed. Table 1 makes clear no other economy has approached China in terms of market/global aggregate demand expansion.

It is therefore a key question whether China will continue essentially the same scale of market growth in 2012. The answer is ‘yes’  - but because of the issue’s importance the reasons should be clearly outlined. Interlinked with this is the decisive role played by developing economies in recovery from the financial crisis – the interlinking being that China is by far the largest developing economy, while the developing economies have become China’s largest trade partners.

In the three years covering the period from the beginning of the international financial crisis to the latest available annual data, i.e. in 2007-2010, developing economies accounted for 78.6 per cent of world market growth and developed economies for only 21.4 per cent. Considered from another angle, simply taking different classifications, either the BRIC economies (Brazil, Russia, India and China), or China plus Latin America, contributed the majority of world market/effective demand expansion – either of these groupings accounting for more than twice as much market expansion as the developed economies.

Table 1

 

Turning to more detailed trends, the first feature determining China’s continued dominant position in world market expansion, one the consequences of which are insufficiently frequently noted, is that as China’s economy becomes larger a similar percentage yearly growth necessarily turns into an increasingly large annual absolute market increase - in inflation adjusted terms, China’s economy expanded by 2.3 trillion RMB in 2008, 2.4 trillion RMB in 2009, and 3.1 trillion RMB in 2010.

But even frequently cited constant price growth figures underestimate the expansion of China’s position in the world market. Actual sales, and therefore changes in aggregate demand, use real money which is affected by exchange rate shifts and inflation – further figures in this article are therefore at current market exchange rates and prices unless otherwise stated. In 2009, when China froze the RMB’s exchange rate due to the international financial crisis, China’s economy grew by $469 billion – compared to a US contraction of $353 billion. In 2010, when China allowed the RMB exchange rate to rise, its annual economic expansion rose to $935 billion and the figure will be over $1 trillion in 2011 – roughly twice US market expansion.

Table 1 also makes clear the second reason China’s market will continue  its expansion. World growth is now dominated by developing economies and China is their most rapidly expanding trading partner.

Considering trends among developing economies, China accounting for 33.4 per cent of global market expansion. Latin America was second – constituting 17.3 per cent of world growth, with Brazil accounting for 58 per cent of this. China and Latin America together accounted for 50.7 per cent of world market growth..

Among other developing economic regions, South Asia contributed 8.0 per cent to world market growth, with India accounting for 84 per cent of this. Developing East Asian economies, excluding China, accounted for 7.0 per cent of world growth – Indonesia constituting 54 per cent of this. The Middle East and North Africa accounted for 6.1 per cent of world growth with no single dominant regional economy – the largest contributor, Egypt, constituted only 19.9 per cent of the total. Developing countries in Europe and Central Asia accounted for 4.5 per cent of world growth – of which 55 per cent was Russia. Sub-Saharan Africa grew rapidly, but due to its low starting point only contributed 2.1 per cent of world growth.

Turning to developed economies, Japan illustrates the importance of currency movements for shifts in markets measured in dollar terms. Due to the yen’s sharp exchange rate rise, Japan contributed 14.9 per cent of the dollar expansion of the world market despite Japan’s economy contracting in inflation adjusted terms. The US contributed 8.2 per cent to world market growth, despite the US not having grown in constant price terms, due to the dollar rising against other currencies,

The ‘disaster area’ for world markets was the developed European economies with a decline of $668 billion - equivalent to subtracting 9.2 cent from world growth.

It is already clear 2012 will show no fundamental change in this pattern. Developed European economies will again be the worst performing region – suffering a recession possibly magnified by a low Euro exchange rate. The US should expand, but slowly compared to previous upswings in US business cycle. Therefore if the world economy is to grow this will again have to be primarily due to developing  economies.

Fortunately, the large developing economies are slowing but still growing substantially more rapidly than developed ones. China, the dominant factor in the equation, even on pessimistic estimates is likely to grow by at least 7-8 per cent in real terms this year which, after increases in the exchange rate of the RMB and inflation is take into account, means an expansion of its market of probably 12-15 per cent in dollar terms. Minimum real growth estimates for India are at least seven per cent.

It is also clear from the pattern in Table 1 why BRIC economies will again dominate world growth – in 2007-2010 they contributed 52.5 per cent of world market expansion. Not only are the BRICs individually the largest developing economies but each is the centre of a major regional economic area. While Brazil has slowed, Russia’s economy has been accelerating, and it is in any case China and India which are the dominant dynamic BRIC economies.

This overall situation clearly interrelates with China as it already carries out the majority of its trade with developing economies – 54 per cent of total trade, 49 per cent of exports and 60 per cent of imports.

The implications for China’s markets are clear. China has not only the world’s most rapidly expanding domestic market, and declining inflation gives it extra room for domestic economic loosening/stimulus in 2012, but its biggest trading partners are the most rapidly growing regions of the world economy. It is this combination of domestic and international factors which determines that  China will continue to remain the world’s most rapidly expanding market/supplier of increased aggregate demand in 2012. Given the negative prospects in Europe, and slow growth in the US, it will then be the situation in the developing economies, which is increasingly related to the situation in China, which will necessarily determine the overall prospects for world growth in 2012.

*   *   *

This is an expanded version of an article which originally appeared in Shanghai Daily.

China's stronger economic structure than the US and Europe means its fast growth will continue in 2012

The beginning of 2012 is a suitable moment to assess China's economic prospects for the year and coming period. This overall perspective is clear – China will grow strongly, remaining the world's fastest growing major economy, and will continue to substantially outperform Western pessimist predictions. This is the same fundamental analysis maintained by the author over the last two decade period. Factual results during these twenty years have confirmed such projections - as opposed to the opposite perspective. As accurate or inaccurate predictions do not depend on personal characteristics, but on different fundamental analyses, therefore what leads to repeatedly correct and incorrect projections regarding China's economic growth?

The core issue is simple but difficult for the majority of non-Chinese analysts to admit, despite constant confirmation by economic facts and repeated falsification of predictions of China's serious slowdown. This core issue is that statements by Chinese analysts that China has a stronger economic structure than the US and Europe, and that this therefore produces stronger economic performance, is not a boast but actually factually correct. As this stronger character of China's economic structure is not understood by many Western analysts, they therefore systematically, and each year, underestimate China's economic growth potential.

Nevertheless, a genuine difficulty for non-Chinese analysts is that explanations of this economic strength are frequently posed only in terms of specifically 'Chinese characteristics'. It is therefore worth spelling out more generally why China has a stronger economic structure than the US and Europe, and how this relates to global economic issues that will be faced in 2012.

 

 A model performance [By Jiao Haiyang/China.org.cn]

 

China self-definition of its system is a 'socialist market economy'. This denotes it differs fundamentally from the economy, modeled on the former USSR, which existed prior to China's 1978 economic reforms, in that economic policy is not run by administrative but by market means. China has a large and vibrant private sector – indeed the world's most rapidly growing private sector. However China differs from the US or Europe in having a sufficiently large state sector, and a nationalised core banking system, that it can directly set the economy's overall investment level – the state sector is too small in the US or Europe to achieve this. This combination of market system and a state sector sufficiently strong to determine the overall level of investment is what gives China its greater economic strength than the US or Europe - such a structure can be understood either from a Chinese 'socialist' point of view or a Western 'Keynesian' one, and for present purposes it  is unimportant which is chosen. 

To illustrate this, consider a key contemporary economic problem – the current situation in the US. The Financial Times on December 15 accurately described the situation in the US economy. It noted that the share of wages in US GDP had fallen to the lowest level since records began and concluded: 'The decline in the labor share, along with a shift of labor income towards higher earners, may be an important part of why the US economic recovery is so sluggish. Workers on lower wages consume much of their income, while higher wage earners and those with capital income are more likely to save. That will not affect total demand if savers lend to those who want to consume or invest in buildings and start-ups – but investment has been slow to recover in the wake of the recession.'

In short, the US economy is growing slowly not because there is a shortage of funds for investment, on the contrary profits are at a record high, but because investment is very low – indeed the entire decline in US GDP in the current 'Great Recession' is accounted for by the investment fall. The problem is that in the US there is no mechanism which ensures that the huge funds available for investment are actually invested.

In China no such problem exists. If funds are not directly invested by companies, then the state owned banking system and state sector can invest them. Therefore no shortfall of demand occurs of the type analysed by the Financial Times in the US. During the entire international financial crisis China, unlike the US, suffered no investment decline – on the contrary investment increased. The problem of accumulation of unused funds of the US type, that is in Keynesian terms a shortage of effective demand, does not arise in China. Equally if China's economy is booming, and companies are utilizing all funds for investment, the state steps back and cuts its own investment – reducing it to cool overheating. That is why China's macroeconomic policy is stronger than that in the US - the problems of either shortage of or excessive demand, which plague the US and European economies, are smoothed in China.

This evidently does not mean China escapes all macroeconomic issues. No policy maker can judge absolutely accurately how strongly the international economy will grow, what will be all the inflationary or deflationary pressures present, exactly how China's own economy will respond to a given measure etc. Therefore there are always issues of overheating, undershooting, inflation, deflation etc. But these are qualitatively smaller fluctuations than in the US or Europe.

The period since the onset of the international financial crisis showed this strength of China's economic structure clearly. Faced with the international financial crisis in 2008, China was able to launch a massive stimulus package which meant its economy did not suffer a recession at all. The recovery of the world economy in 2010-2011 combined with the aftermath of the stimulus package to create some economic overheating and 2011 was therefore mainly spent damping inflation. In 2012, with negative trends dominating the world economy, China will loosen policy.

The overall result is evident. In the four years to the latest economic data, for the 3rd quarter of 2011, the US grew by 0.5 percent, the EU shrank by 0.3 percent, and China grew by 42.2 percent. China's economy therefore suffered some fluctuations on a strong growth path, whereas the US and Europe suffered overall economic stagnation. The stronger character of China's economic system was shown by these facts – those predicting crisis for China, on the same scale as the US or Europe, made the wrong predictions because they failed to analyze that strength.

It is this superior strength of China's economic structure that also makes it clearly possible to predict for 2012 that China's economy will continue to grow strongly, that it will remain the fastest growing major economy in the world, and that it will outperform on the upside Western pessimists predictions – as in previous years the facts of 2012 will confirm that analysis. Not until they understand the greater structural strength of China's economy will current critics be able to make persistently accurate predictions.

 *   *   *

 A shorter and edited version of this article originally appeared on China.org.cn.

The statistical data indicates the population and shareholders have counterposed interests - implications of the negative correlation of economic growth and share prices

Summary

The studies on the relation between per capita GDP growth and returns on shares persistently find that the two are negatively correlated - i.e. a higher rate of growth of per capita GDP is associated with a lower return on shares. Cardiff Garcia and Neil Hume, in the Financial Times, recently logically used this data to deal with the relatively narrow issue of questioning analyses that the high growth rates of emerging markets, for example China, will lead to them displaying superior share performance to developed markets. But the implications of the overall finding are much more widespread and fundamental for economic policy. Specifically the implications of a negative correlation of per capita GDP growth and returns on shares include:

• The population's living standard, i.e its consumption, is on average positively determined by, and positively correlated with, growth of per capita GDP. However the return on shares is negatively correlated with per capita GDP growth. It follows that the interests of the population's living standards and the interests of shareholders are counterposed - the population has an interest in higher per capita GDP growth whereas shareholders, in terms of return on shares, would benefit from lower per capita GDP growth.
• Governments targeting high rates of increase in per capita GDP, that is high increases in living standards, should expect lower returns on shares than those with low rates of increase of per capita GDP, that is living standards. Therefore, high rates of per capita GDP and living standards, and high rates of growth of share prices/total return on shares, are counterposed and not complimentary objectives.
• These issues are in addition to the points made in the Financial Times that over the long run the higher economic growth rates of emerging economies would produce lower growth of share prices and total return on shares - this clearly fits China which has the highest rate of growth of any major economy but an underperforming share market. 

It should be stressed that such processes operate 'other things being equal' and over long periods of time. But they provide a long term determinant of economic developments which underlays, and therefore inflects, more short term trends. 

Given the widespread implications of this issue the present article therefore outlines the data and examines in more detail some of the implications.

*   *   *

Not just emerging but developed economies

The Beyond BRICs section of the Financial Times recently analysed a report by Deutsche Bank's John-Paul Smith which argued that share prices in emerging markets will suffer negative trends due to these countries government policies. The article however failed to provide the essential context that a negative correlation exists between per capita GDP growth and share price growth and total return on shares not only in emerging but in developed economies. It therefore follows, other things being equal, that high per capita GDP growth in some emerging markets would be anticipated to be correlated with underperformance of their shares.

However, this clearly raises a more general issue. Given that the aim of economic policy is to increase sustainable GDP per capita, as this makes possible increased living standards, this goal necessarily means that governments in both emerging and developed economies have to target high GDP per capita growth even although this will be necessarily be associated with lower share price growth and lower return on shares. The opposite course, targeting higher share prices and higher return on shares at the expense of lower GDP per capita growth, and therefore lower living standards, would mean placing the interests of the population lower than that of shareholders - a goal which, if being pursued, should be explicitly stated and would be unlikely to command widespread support. 

More specifically John-Paul Smith criticised governments of emerging markets on the grounds that: ‘GEM (Global Emerging Markets) companies are increasingly seen as “facilitators” for the broader economy, on the Chinese model, across many GEM markets.’ Stefan Wagstyl of the Financial Times paraphrased Smith as arguing: ‘The state will drive the redistribution of resources away from shareholders and in favour of labour.’

However it is well established in the studies on the correlation between share price growth/total return on shares and per capita GDP growth - for example Siegel's Stocks for the Long Run, Dimson, Marsh and Staunton’s Triumph of the Optimists and Ritter’s Economic Growth and Equity Returns - that a negative correlation between per capita GDP growth and share prices exists in both developed and developing economies. Such negative correlation is not due specifically to government policies in emerging markets but is an overall feature of economic growth.¹ 

The data

Turning first to the data establishing the negative correlation between GDP per capita growth and share prices, Siegel found: 'Real GDP growth is negatively correlated with stock market returns. That is, higher economic growth in individual [developed] countries is associated with lower returns to equity investors. Similarly, the stock returns for the developing countries against their GDP growth are plotted in Figure 81-b Again... there is a negative relation between the returns in individual countries and the growth rates of their GDP.' (Siegel p124) Siegel's findings for developed economies are shown in Figure 1 and those for developing economies in Figure 2.

Figure 1

Figure 2

 

Dimson, Marsh and Staunton found, regarding the total real return on equities and GDP per capita growth: ‘statistically, the correlation is -0.27 for 1900-2000 and -0.03 for 1951-2000.' (Dimson et al p156)

Regarding the correlation of GDP per capita growth and share price increases Ritter found: ‘My calculations for… 16 [developed] countries over the 1900-2002 period get a correlation of -0.37.’

In a recent survey Jain and Kranson's ‘The Myth of GDP and Stock Market Returns’ noted: ‘The data shows clearly that, over long periods and when adjusted for inflation, stock market returns and GDP per capital growth are negatively correlated.’

Goldman Sachs private wealth group, in a review, recently noted that the overall negative correlation between GDP per capita growth and share price growth extended to different groups of economies when ranked by growth rate: ‘Dimson et al have shown that if one invested in the slowest growing quintile of countries during this hundred-year- plus period, the equity returns would have outperformed the fastest growing quintile by 3% a year… Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly 5% a year.’

This relation found by Goldman Sachs is shown in Figure 3.

Figure 3

 

China

Goldman Sachs noted China as illustrating this general trend: ‘China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns… China’s economy has outgrown that of the US by about 8% a year since the end of 1992 (the inception date of the MSCI China equity market index). Its equity market, however, has lagged that of the US by about 8% a year. Over the last 15 years, earnings per share growth in China has been negative 0.9% while that of the S&P 500 companies has been 5.4% a year. Most recently, in 2010, China has outgrown the US by an estimated 7% but the MSCI China Index has returned just 4.8% (the local Shanghai Composite Index is actually down 12.8%). On the other hand, US equities have returned 15.1%. Since the peak of US and Chinese equities in October 2007, China has outgrown the US by an estimated 10% a year, but Chinese equities have lagged the US by 2.7% a year.’ This data is shown in Figure 4.

Figure 4

 

Goldman Sachs survey therefore concluded: ‘Whether it is 1 year, 3 years or 18 years, economic growth has not translated into better investment returns in China … The evidence shows that faster economic growth rates do not result in higher equity returns. In fact, if faster growth is priced into the equity markets, the equity markets are most likely going to lag those of slower growth economies.‘

In a recent update of their study, for the Credit Suisse Global Investment Returns Yearbook, Dimson, Marsh and Staunton concluded: ‘[Our] Figure 2 ranks the real equity return of the 19 Yearbook countries over the period 1900–2009, from lowest to highest…. [our] Figure 2 shows that the supposed association between long-run real growth in GDP per capita and real equity returns is simply not there (the correlation is –0.23).’ This is shown in Figure 5.

Figure 5

 

Dividends, share prices and growth

In their study Dimson, Marsh and Staunton however noted an extremely close correlation between share prices/return on shares and dividend payments: ‘there is a high correlation (0.87) between real equity returns and real dividend growth across the 19 countries.’ 

Such a close correlation between dividend payments and share prices is related to the negative correlation between share prices and economic growth: ‘the claim that real dividends grow at the same rate as real GDP is clearly incorrect. Real dividend growth has lagged behind real GDP per capita growth in all but one country, averaging just –0.1%, and the correlation between the two is -0.30.’ Higher economic growth is correlated with lower dividends and vice versa.

Conclusion

The clearly established negative correlation between economic growth and share price growth has a number of implications:

• It must be understood that correlation by itself does not establish causality - i.e. the negative correlation between share price growth and return on shares and GDP per capita growth does not establish whether rapid economic growth causes lower returns on shares, or higher returns on shares causes lower GDP growth, or some other factor(s) causes both. The negative correlation however does exclude that high share prices cause high GDP per capita growth, and therefore that economic policy should aim to have high share price growth in order to stimulate economic growth. The negative correlation shows that high returns on shares are either irrelevant (i.e. non-causal) for economic growth or if causal then higher returns on shares are negative for economic growth.
• Underperformance of shares in emerging economies with high growth rates would be expected to flow from the negative correlation between GDP per capital growth and share prices. Other things being equal, the more rapid the growth of GDP per capita the greater the underperformance of shares that would be anticipated - this clearly fits China.
• As the negative correlation of GDP per capita growth and share prices exists in both developed and developing economies pointing to underperformance of share prices in emerging markets does not justify the claim that underperformance of shares in such markets is due to government policy – except that such an underperformance would necessarily follow from the (desirable) policy of ensuring high GDP per capita growth.
• If share prices are negatively correlated with GDP per capita growth, but dividend payments are positively correlated with returns on shares, this again fits the case of China. China experiences high GDP per capita growth but low dividend payments due in substantial part to the large role played in the economy by State Owned Enterprises which pay extremely low, or zero, dividends to the state.
• Once again correlation does not establish causality, but the negative correlation of share price growth with per capita GDP growth, while dividend payments are positively correlated with share prices, means either that low dividend payments are beneficial for economic growth, that economic growth creates low dividend payments, or some other factor(s) causes both trends.
• Given the rate of growth of living standards is positively correlated with GDP per capita growth, whereas share prices are negatively correlated with GDP per capita growth, there is no reason to assume a positive correlation between rising living standards and rising share prices - i.e. that rising share prices will enhance living standards. Given that the aim is rising living standards there is therefore no reason for governments to target high share prices.

Taking the specific case of China, the negative correlation between share prices and GDP per capita growth is one reason this blog, which has a positive analysis of the growth of China’s economy, has a negative position as regards any major expectations for China’s share market.

Evidently the Financial Times and John-Paul Smith dealt primarily with short term trends in share prices which can can be affected by very different factors to the long term correlations outlined above. However:

• It is misleading to present underperformance of shares in emerging markets as being due to negative government policies when underperformance of shares in rapidly growing developing economies would be precisely expected to be correlated with their rapid growth.
• The implications of the negative correlation between GDP per capita growth and share prices, in both developed and developing economies, are far wider than those raised by John-Paul Smith and in the Financial Times article.

Notes & References

Financial Times begins to correct its analysis of China's trade

For several years the Financial Times has been giving widespread publicity to an analysis, particularly promoted by its (rightly respected) chief economics commentator Martin Wolf, and US finance professor Michael Pettis, that China was pursuing a 'mercantalist' policy aimed at creating a large trade surplus. This blog has repeatedly pointed out that this is not the case and what China has aimed at is a high degree of openness of its economy, that is of both exports and imports in GDP. This does not necessarily imply a surplus at all. 

At last, confronted with the decline in China's trade surplus, the message seems to be getting through more generally in the FT. Analysing the latest trade data, and a speech by China's president Hu Jintao, Kathrin Hille and Simon Rabinovitch from the FT' in Beijing note:

'China’s trade surplus is set to decline in 2011 for the third straight year and is on track to be about half the size of the record $298bn surplus in 2008. That would amount to less than 3 per cent of gross domestic product, suggesting that China’s trade relationship with the rest of the world is increasingly balanced.

'Critics in the US continue to point to their country’s yawning trade deficit with China as evidence of Beijing’s unfair support for its exporters, especially through what they allege is an artificially cheap renminbi.

'But the US deficit with China appears to be more the result of the global trade structure than Chinese policy distortions. As a major processing hub in the global supply chain, China runs large bilateral trade deficits with producers of raw materials and large bilateral surpluses with importers of finished products.'

This is entirely correct. Let us hope that the FT from now on will drop its wrong analysis.