China’s economic performance in 2014, 7.5% GDP growth or a little less, is satisfactory in current very negative global economic conditions – stagnation or recession in Japan and the EU, below historical average growth in the US, and slowdown in several major developing economies. A well-known short term danger, which must be averted, is any major downward shift in growth – as was emphasised at the recent Economic Work Conference in stating the need for ‘stable growth’ .
But a fundamental danger, as it affects not only the immediate situation but the whole next period of economic development, comes from the introduction into discussion in China of an out of date economic map – that is a wrong analysis of what determines economic growth. As an erroneous economic map can head China in a wrong direction over a whole period, and distort a wide range of decisions, it is therefore necessary to be clear about crucial issues involved and their implications for China’s economic strategy. First the facts will be established and then their significance for practical policy making analysed.
Figure 1 shows the conclusions regarding the sources of economic growth in an advanced economy, the type China wishes to become, using the most modern econometric methods as approved by the international statistical agencies such as the OECD.
To clarify the implications, Figure 2 sets out this data as the percentage contributions to growth in an advanced economy.
· As may be seen the overwhelming bulk of growth in an advanced economy, 57%, comes from capital investment
· Labour inputs provide the second most important source of growth in advanced economies - 32% of the total. This in turn is divided into 19% from an increase in labour hours and 13% from an improvement in labour quality – i.e. improved education, skills training etc.
· Only 11% comes from increases in total factor productivity (TFP).
This conclusion that capital investment is by far the most important factor in economic growth indeed applies not only to advanced but to all economies. Surveying the comprehensive evidence for all countries for which there is data, Vu Minh Khuong recently found: ‘The pattern of rapid growth driven by intensive capital investment… is consistent over time and robust to different types of economies in terms of size, location… and level of development.’
Indeed it is clear that if advanced economies were dependent primarily on TFP for their growth their speed of economic development would be snail like - as the lever of productivity growth is simply too small to be the key motor of economic growth. TFP growth in advanced economies in the period 1990-2010, the most recent for which here is comprehensive growth accounting data, averaged only 0.2% a year - in contrast growth of labour inputs averaged 0.7% a year and increase in capital inputs 1.3% a year.
In the major advanced economies, the G7, the highest annual average rate of TFP growth in any economy in the period 1990-2010, which was in Germany, was only 0.8% a year. The rate of TFP increase in the US was only 0.54% a year. Therefore if the majority of US growth had to come from TFP increases the maximum US growth rate would be only 1.08% a year – compared to actual growth of 2.4%.
Furthermore, the more advanced an economy becomes the more dependent its growth becomes on capital inputs and the percentage of growth accounted for by TFP increases reduces. As can be seen from the Table:
- In non-Asian developing economies 50% of economic growth is due to capital investment;
- In Asian developing economies, which are the most successful developing economies, 55% of economic growth is due to capital investment;
- In advanced economies 57% of economic growth is due to capital investment.
In contrast the percentage of economic growth due to TFP falls from 18-22% in developing economies to only 11% in advanced economies.
The theoretical prediction made by the major economists starting with Adam Smith, through Marx, and including Keynes that the more developed an economy is the greater the proportion of its economic growth accounted for by capital investment is therefore entirely confirmed by modern statistical studies. Regarding the implications for China this means that the more advanced China’s economy becomes the more its economy will depend on capital accumulation and the less it will depend on TFP growth.
To be more precise, in an advanced economy, the effects of changes in investment are on average five times as powerful as changes in TFP. For the same rate of growth to be maintained a 1% fall in investment would have to be compensated by a 5% rise in TFP, and similarly a 1% rise in investment has five times as much effect as a 1% rise in TFP. It is therefore investment, not TFP, which is the decisive factor in growth in an advanced economy.
But given these facts why do some people in China put forward the erroneous idea that TFP can be the main source of growth? The reason is that they are using methods of measuring economic growth which are at least 20 years out of date and which have been formally replaced by international statistical agencies. It is therefore necessary to outline the changes in the methods of measuring the sources of economic growth during the last decades.
The formalisation of the measurement of the causes of economic growth, technically known as ‘growth accounting’, was originated in the 1950s by Robert Solow. Solow however made two errors which were corrected later by others. and which are directly relevant to analysis of economic growth and therefore of the policies required for it in China.
· Solow did not include ‘intermediate products’, the unfinished inputs of one industry into another (e.g steel into the auto industry), in his analysis.
· In the key issue for the present discussion, Solow’s calculations made the error of not taking into account improvements in the quality of investment and labour. This led to the erroneous conclusion that the majority of economic growth came from productivity increases – the error repeated in some discussions of China. This latter mistake was subsequently corrected, and accurate methods of calculating growth were formally adopted by the US, UN and OECD – as is analysed below.
Once the second error is corrected it is clear capital investment is the decisive factor in economic growth, with TFP playing a relatively small role. The facts Professor Dale Jorgenson of Harvard University, the prime statistical authority in this field, noted regarding studies using modern statistical methods for the US are also confirmed by the subsequent studies of other countries:
‘changes in the quality of capital and labor inputs and the quality of investment goods explained most of the Solow residual [TFP]… capital and labor inputs accounted for 85 percent of [US] growth during the period 1945-1965, while only 15 percent could be attributed to productivity growth.’
As a result of these errors in Solow’s methods of calculation the official changes in the formal changes in the methods of measuring economic growth in the last three decades were succinctly summarised by Jorgenson:
‘The final demise of the traditional [Solow derived] framework for productivity measurement began with the Panel to Review Productivity Statistics of the National Research Council, chaired by Albert Rees. The Rees Report of 1979, Measurement and Interpretation of Productivity, became the cornerstone of a new measurement framework for the official productivity statistics… The BLS framework included a constant quality index of capital input, displacing two of the key conventions of the traditional framework of Kuznets and Solow...
‘The official BLS estimates of multifactor productivity have overturned the findings of Abramovitz and Kendrick, as well as those of Kuznets and Solow...
‘The approach to growth accounting in my 1987 book with Gollop and Fraumeni and the official statistics on multifactor productivity published by the BLS in 1994 has now been recognized as the international standard. The new framework for productivity measurement is outlined in Measuring Productivity, a manual published by the Organisation for Economic Co-Operation and Development.’
These changes in the methods of the calculation of economic growth, and its determinants, have therefore been made officially by the most important world’s most important statistical agents – and confirm the finding that capital investment is a far more powerful factor in economic growth than productivity. It is therefore surprising, and damaging, that in China one sometimes finds methods of measuring growth used which have been officially overturned, and false claims made that TFP is the decisive factor in growth, when this has been shown to be false by accurate methods of economic measurement.
The reason TFP rises more rapidly in developing than developed countries is also well understood. It is the ‘advantage of backwardness’ – developing countries can copy technologies and management methods from advanced countries without paying their development costs. As an economy becomes more advanced, and approaches the technological frontier, the costs of productivity development increase and TFP growth slows. Therefore as China becomes a more advanced economy the role played by TFP in its growth will decrease and the role played by capital investment will increase.
Indeed, the idea that economic growth in an advanced economy can be propelled primarily by TFP growth, is even more erroneous than the simple fact that merely a small, only 11%, of growth in advanced economies is constituted by TFP increase. Studies show that there is no significant correlation between the rate of TFP growth and the rate of economic growth in an advanced economy – i.e. even if a relatively high rate of TFP growth is achieved this does not make it likely a high rate of economic growth will result. This is unlike the situation with both increases in capital investment and increases in labour inputs – both of which show a close and positive correlation with economic growth in advanced economies. To put precise numbers on this, as shown in the charts at the end of this article:
- The correlation between growth of capital investment and growth of GDP in advanced economies is 0.64 – a strong positive correlation.
- In advanced economies the correlation between growth of labour inputs and growth of GDP is 0.66 – also a strong positive correlation.
- The correlation between TFP growth and GDP growth is 0.01 – essentially a zero correlation..
Increases in capital investment, and increases in labour inputs, would therefore be reliably expected to lead to, or be associated with, increases in economic growth. There is, however, no reason to suppose in an advanced economy that even if rapid TFP increase were achieved this would lead to high economic growth.
The consequences of these realities for China’s economic strategy are evident and profound. Taking into account China’s specific economic features the following conclusions flow.
- Because as China develops towards being a developed economy its economic growth will depend more, not less, on capital investment therefore maintaining a high level of capital investment is the most important domestic goal for China’s economic development.
- Due to the fact China’s working age population is no longer increasing there is unlikely to be any significant increase in labour hours worked, indeed the total number of hours worked is likely to fall. As life expectancy increases the pension age will rise, but this will be at least offset by other factors such as increased time in education, increases in leisure time etc. even before the working age population starts to significantly decline. Therefore growth, or stabilisation, of labour inputs will have to come primarily from increases in labour quality – i.e. improvements in education and skills.
- The fact that the role played by TFP increases in China’s economic growth will fall is not an argument for ignoring potential TFP growth, or more probably slowing the rate of decline of TFP growth, but it means that the contribution of TFP increases to China’s economic growth will be small.
Translating these issues is into more precise policy terms:
- A high investment rate requires a high savings rate to finance it. There are three possible sources of increase in savings – to reduce state dis-savings, and to raise household or company savings. Reducing state dissaving, i.e. cutting the budget deficit, strategically cannot be achieved through reduction in state spending, on the contrary areas of social protection such as pensions are already under strain, but requires increases in taxation which, for reasons of social stability, must be focused on those with the highest incomes. Increases in the proportion of profits in GDP requires that wages grow slightly less slowly that GDP growth – but this would be more than compensated for, in terms of living standards, by the more rapid growth of incomes resulting from faster economic growth. Measures to increase the percentage of household incomes which are saved are difficult to implement in almost all countries and, therefore, apart from abandoning erroneous attempts to increase consumption at the expense of household saving, there are few effective policy measures to increase household savings rates.
- The situation of labour inputs is constrained by China’s demography. As no measures can be taken, in anything other than the very long term, to increase labour supply measures to improve labour quality will be crucial – which requires pouring resources into training and education. This, in turn, will require, as in other rapidly growing Asian economies, that government spending rise more rapidly than GDP.
- Measures to maintain TFP – for example increases in competition, where possible lowering the administrative level at which regulation decisions are taken etc. – need to be maintained, but will not yield big results as TFP is too small a part of economic growth to power China’s economic development towards an advanced economy.
Finally, it is important to be clear on what will be the consequences of an erroneous strategy based on the belief TFP increases could be the chief driving forces of China’s economic growth. Even in the case of adoption of such an erroneous strategy, in the short term China’s macroeconomy, and its lever for economic regulation, are sufficiently strong that there will be not be a dramatic crisis – all theories of the ‘China crash’ are wishful thinking by China’s enemies. What instead will happen is that the economy will increasingly fail to achieve its maximum potential and growth of living standards and China’s national power will slow. Periodic pragmatic, and not extremely successful, attempts to stimulate the economy would be made – but these would not halt the damaging slowdown as long as a false overall strategy is being pursued. Instead instability in economic development would result. The economy would slow significantly during periods when impossible attempts were being made to make TFP the main force driving economic growth. These would be periodically interrupted by purely pragmatic and non-strategic boosts to investment as the only effective means to control the slowdown. The efficiency of the economy would therefore decline and it would become less stable as well as growth slowing.
The cumulative results of the erroneous economic strategy would be deeply damaging:
- The next immediate developmental goal of China is to become a high income economy by international standards. With 7%+ growth that should be achieved by the early 2020s, but if the economy slows it will take China longer to become a high income economy.
- As international experience shows GDP growth accounts for over 80% of consumption growth China’s consumption over the medium and longer term would rise less rapidly.
- As life expectancy and other indicators of social and personal well-being are all closely correlated with per capita GDP, China’s quality of life would rise more slowly.
- Slowing economic growth would prevent China building up its national defence capabilities in the way necessary to meet international challenges.
- China would become less attractive to other countries, weakening China’s foreign policy position.
- As a result of any, or all, of these trends internal social tensions could rise.
The result of China adopting an out of date economic map of the sources of economic growth is therefore that inaccurate navigation would threaten its economic development. It might be put in the following way. There is an English saying that parliament can pass a law saying a man is a woman - but as a result of this law not a single man will have a baby. Similarly, if it were decided that the attempt would be made to make China a high growth economy driven by TFP increases it simply won’t happen for the reasons outlined.
For its economic development China needs an up to date economic map – and that will show that capital investment, not TFP increases, is the main factor of economic development even more in an advanced economy than in a developing one. This reality is crucial for China’s economic stability and development,