Key Trends in Globalisation

To become a 'high income' economy China needs to study facts not myths

Unfortunately some discussion in the media of how China can become a 'high income' economy fails to follow the fundamental Chinese saying ‘seek truth from facts.’ Instead it follows a method of ‘ignore the facts, focus on inaccurate dogma.’

In particular, as usual, neo-liberals avoid dealing with the facts. They suggest that to avoid the ‘middle income trap’ China should follow the policies advocated by the World Bank and IMF - known internationally as the ‘Washington Consensus’ and which Justin Yifu Lin refers to as ‘Western mainstream development theory.’ But as Lin entirely accurately notes factually of this Washington Consensus: ‘I have not seen a developing economy implement Western mainstream development theory with success. The few examples of superior development performance… are the result of implementation of policies which from the perspective of mainstream economic theory are wrong.’

More precisely, as was noted in November 2015 from the Counsellors Office of the State Council of the People’s Republic of China: ‘Lin believes that over 20 years has passed and the countries that have promoted personalization, marketization and liberalization based on neo-liberalism have not been successful. Instead, they have experienced economic meltdown or stagnation and continuous crises and their average economic growth rates are even lower than the structuralism era in the 60s and 70s, with crises happening more frequently than in the 60s and 70s.’

Which economies have achieved rapid development

The present author would have some terminological differences with Lin, as there were always alternative development theories to the Washington Consensus in the West, and even more importantly China’s economic reform deriving from Deng Xiaoping was still more successful – this is analysed in ‘Deng Xiaoping and John Maynard Keynes.’ But terminological issues aside Lin’s fundamental point is entirely correct factually. Indeed, as the data given below will show, the situation is even worse than Lin indicated. The majority of countries which have followed the ‘Washington Consensus’ have become more ‘undeveloped’ in relative terms – that is they have actually fallen further behind the most advanced economies.

As confirmed by the data below, only an extremely small number of developing countries have achieved sustained rapid economic growth and/or made the breakthrough from ‘low’ or ‘medium’ income to ‘high income’ status. However, the fact that all the economies which have achieved this most rapid growth are in Asia makes it easy for China to study them.

This fact that so few developing countries have achieved sustained rapid growth, and made the transition to ‘high income’ status, necessarily has the corollary that the overwhelming majority of developing countries have failed in this – and therefore that the neo-liberal Washington Consensus, which was dominant outside Asia, has been factually shown to fail as a development theory. Instead of studying a failed theory the method of ‘seek truth from facts’ therefore requires that:

• the focus from a positive perspective should be on analysing those few developing countries which have achieved very rapid economic growth and become high income economies;
• from the negative perspective an analysis should be made of why those countries which followed the World Bank/IMF Washington consensus failed to achieve rapid economic growth and make a successful transition to high income status.

The aim of this article, therefore, is to establish the actual international facts on economic growth achieved by developing economies. Such a factual study naturally leads to theoretical conclusions. However, the method of ‘seek truth from facts’ is the only correct one not only for China but all countries. Factually demonstrating factually which development strategies have been successful and which have not is the indispensable prerequisite for any theory. A theory must correspond to the facts; the facts cannot be ignored or altered to fit a (false) theory. If any theory fails to fit the facts, it is wrong and should be abandoned.

This has crucial practical significance for China. China can no more escape the laws of economics than any other country. If China bases policy on a factually false theory of how to make the transition to a high income economy it will fail - with negative consequences for over a billion people in China and halting China’s national rejuvenation. Therefore, establishing the facts of success and failure in developing economies is a prerequisite for judging theories which explain them.

What is a high income country?

As a preliminary aside, it should be noted that there is a significant discussion as to whether the ‘middle income trap’ actually exists. For example, reviewing the issue, The Economist concluded regarding the middle income trap: ‘Some of its proponents argue that middle-income countries typically grow more slowly than richer and poorer economies. That is claptrap. If anything, they grow faster… from 1950 to 2010… Economies with an income per head of $13,000-14,000 (at purchasing-power parity) achieved per-person growth of almost 2.9% over the next ten years on average. That is faster than the average for any other income level... Development is a long and arduous process, during which economies continuously evolve in scope as well as size. Potential traps lurk at every level of income. There is no reason to single out the middle levels.’

However, this dispute will be disregarded here. It will be demonstrated that it is extremely difficult for a developing country to break through to high income status. Therefore, the issue will be treated as a factual examination of why only an extremely small group of countries have undergone very rapid economic development and broken out of low or medium economy status and become high income economies.

What is a high income economy?

A first issue is evidently what is the criteria for an economy to become ‘high income’? Internationally there are 68 countries or regions of countries which meet the World Bank official definition of a ‘high income’ economy - a per capita GDP of $12,736. This, however, presents a significantly misleadingly favourable picture for drawing lessons for China for two major reasons.

• First, the majority of these 68 high income economies are in very small countries - 35 out of 68 have populations of under five million. Only 22 high income economies or regions have populations of more than 10 million.
• A number of countries have ‘high income’ status exclusively due to their simultaneously having very small populations and being havens for tax evaders (Cayman Islands, Monaco, Liechtenstein, Bermuda, Isle of Man, etc.) or due to possession of large quantities of the single commodity oil (Saudi Arabia, United Arab Emirates etc).

Evidently neither of these types of economy can provide a development model for China - which has neither a small population, nor a strategy based on being a haven for tax dodgers, nor is an essentially oil dominated economy. Such realities, however, demonstrate that the method sometimes followed in media discussions of looking at China’s ‘ranking’ in a list of countries which takes no account of population, economic size, or whether a country’s economy is essentially exclusively an oil exporter is extremely misleading. Such a serious issue as China achieving high income status cannot be dealt with on the basis of sloppy statistics but instead requires accurate information.

Which countries have achieved high income status?

Turning to the facts of economic development, the most important ‘high income’ economies have been so for many decades (UK, US, Germany, France etc.). They achieved this status by relatively slow growth over many decades - usually more than a century. For example, average annual per capita GDP growth over the entire 20^th century was only 1.9% in the US, 1.8% in Germany and 1.5% in the UK. Evidently such a slow growth path cannot provide a model for China - which aims to achieve ‘moderate prosperity’ by 2020 and ‘high income’ status by international standards in the next 5-10 years.

Turning to the conditions facing China’s development in the period since it began ‘reform and opening up’ in 1978, it can be noted that the majority of large developing economies actually fell further behind the US in this period. Taking as a criterion a country having a population of at least five million, and 40% of US per capita GDP in 1978, then of the 53 economies in this category 28 fell further behind the US in per capita GDP in 1978-2015 and 25 improved their position in comparison to the US. The majority of large developing economies therefore ‘undeveloped’ relative to the US in this period. This emphasises the difficulty of sustained rapid economic growth.

Over a longer period, it should also be noted that a number of previously advanced economies fell back into the ranks of developing economies or suffered disastrous setbacks. For example, Argentina’s per capita GDP fell from 67% of that of the US in 1938 to 30% by 2015, Chile’s per capita GDP fell from 60% of the US in 1910 to 50% by 2015, Russia’s per capita GDP fell from 43% of the US level in 1975 to 28% by 2015.¹

It is also particularly striking that of countries that have gained in per capita GDP compared to the US only a few have gained greatly. Since the beginning of China’s economic reforms in 1978 only six countries or regions with a population of at least five million have closed the gap on the per capita GDP of the US by at least 20% – Mainland China, Malaysia, Taiwan Province of China, Hong Kong SAR, Singapore, and South Korea. All six are in Asia. Of these Mainland China achieved the fastest per capita GDP growth of any country not only in 1978-2015 but over the total period 1950-2015. Four of these economies - the ‘Asian Tigers’ of South Korea, Singapore, Taiwan Province of China, and Hong Kong SAR - all starting from a far higher per capita GDP than Mainland China, have already achieved China’s goal of transition from a ‘low’ or ‘medium’ to a ‘high’ income economy.

Asia’s dominance in rapid growth economies is overwhelming. As Table 1 shows all 10 of the world’s fastest growing economics are Asian – indeed the top 13 are. It is therefore Asian economic development, not the Washington Consensus of the World Bank and IMF, which has been an overwhelming success. It follows that what China has to study to ensure it breaks through to high income status is not the dogmas of the World Bank but the forces which led to China’s own economy outgrowing all others and, after that, what forces produced rapid economic growth in Asia.

Table 1

 

China and the ‘Asian Tigers’

If China’s per capita GDP has grown more rapidly than any other economy, why has it not yet achieved ‘high income’ status by international standards? The answer, of course, lies in the difference in the starting points of different economies.

China in 1929 was already one of the world’s least developed countries, with a per capita GDP only 8% of the US - at that time India’s per capita GDP was 30% higher than China’s. This was a testimony to the failure of both the Qing dynasty and the post-1911 Republic to produce economic development capable of catching up with the advanced economies – China’s per capita GDP had been 13% of the US in 1900 and 10% in 1913. By 1950, after invasion by Japan and civil war, China was almost the world’s poorest country with a per capita GDP only 5% of the US. In 1950 of 141 economies in the world for which data can be calculated only 10 countries - eight in Africa (Botswana, Burundi, Ethiopia, Guinea, Guinea Bissau, Lesotho, Malawi, Tanzania) and two in Asia (Myanmar, Mongolia) - had lower per capita GDP’s than China.²

To give a comparison on the calculations of Maddison India’s per capita GDP in 1950 was almost 40% higher than China’s and on the latest calculations of the Conference Board it was 80% higher. By 1978 China’s had outstanding social achievements, shown in the fastest increase in life expectancy in any major country in world history. China had also laid the basis for industrialisation and greatly narrowed the lead in per capita GDP of the other very large developing economy, India, which had existed in 1949. By 1978, compared to 1950, India’s lead in capita GDP over China had been reduced from 80% to 30% based on Conference Board PPPs, and from 40% to zero on Maddison’s calculations. These were very considerable economic achievements, and the social ones were absolutely outstanding, but China’s per capita GDP was still far behind that of other rapidly growing economies.

Since 1978 China has shown the world’s fastest economic growth, rapidly closing the gap in per capita GDP with all advanced and fast growing economies. As shown in Table 2 in 1978 US per capita GDP was 30 times that of US while by 2015 this gap had been closed to four times. As also shown China has closed the gap on, or overtaken, all other rapidly growing developing economies – in many cases dramatically. Nevertheless, the far higher per capita GDP starting point of the ‘Asian Tiger’ economies explains why they have already achieved ‘high income’ status by international criteria, while this is still 5-10 years ahead for China. Taking each ‘Asian Tiger’ since 1978:

• Mainland China has closed the gap on Taiwan Province’s per capital GDP from over eight times to only slightly over three times.
• Mainland China has closed the gap on Hong Kong SAR from Hong Kong’s per capita GDP being 15 times Mainland China’s to four times.
• China has reduced the gap from Singapore’s per capita GDP from being over 20 times Mainland China’s to being less than six times.
• Mainland China has closed the gap on South Korea from South Korea’s per capita GDP being almost six times Mainland China’s to under three times;

In summary, since 1978 China’s economy has far outperformed the ‘Asian Tigers.’ Nevertheless, the ‘Asian Tigers’ themselves have continued to grow much rapidly than the established advanced economies, and consequently for China to finally close the per capita GDP gap with the Asian Tigers China must continue to outperform them for a prolonged period – several decades.

Table 2

China – comparison with advanced economies

Finally, so far China has primarily been compared to rapidly growing developing economies. However, it also casts a clear light on China’s development strategy to make a comparison with advanced economies.

It was noted earlier that the most important advanced economies achieved that status by very slow per capita GDP growth, of under two percent a year, over very prolonged periods – typically more than a century. Table 3 shows that this fundamental model has not changed. Taking the most important advanced economies over the period 1978-2015, annual average per capita GDP growth was 1.7% in the UK, 1.6% in the US, Germany and Japan, and 1.2% in France. China’s growth was approximately five times as fast as all these economies. The result was China’s catch up in terms of per capita GDP. It may also be clearly noted that the major advanced economies all had essentially the same per capita GDP growth rate of under two per cent – the maximum being 1.7% and the minimum 1.2%. As a result, over the period 1978-2015:

• China closed the gap in per capita GDP compared to the US from US per capita GDP being 30 times China’s to being four times.
• China closed the gap in per capita GDP compared to Germany from Germany’s per capita GDP being 26 times China’s to under three and a half times.
• China closed the gap in per capita GDP gap compared to the UK from 21 times to under three times.
• China closed the per capita GDP gap compared to France from 25 times to under three times.
• China closed the per capita gap Japan from slightly under 21 times to under three times.

This rapid catch up by China has a clear corollary and also historical context. The very slow growth rates of the advanced economies is not a new phenomenon but has existed throughout their entire history - including when they had per capita GDPs which were only a fraction of their present ones. The average slow growth of advanced economies is therefore not due to their current high levels of per capita GDP but existed also at an earlier stage, when they had levels of per capita GDP comparable to or even significantly below China’s present one. As all the advanced economies have had essentially the same, and very low, growth rates for over a century if China adopts their growth model it will also have low growth.

Table 3

Conclusion

The global facts of economic development are therefore clear. Any economic theory and strategy for breaking through the ‘middle income trap’ must therefore correspond to these facts. It may be seen:

• Any model based on copying advanced economies is erroneous if the aim is to catch up with the advanced economies. The model of the main advanced economies is based on slow growth maintained over very many decades – over a century. China using such a slow growth model could not achieve ‘high income’ status by international standards in 5-10 years or close the gap with the advanced economies. China must therefore use economic methods which have been shown to generate rapid growth – those used by successful developing economies.

Of these methods used by developing economies:

• China’s has been by far the most successful strategy in generating rapid economic growth. China’s rate of per capita GDP increase has outperformed all other economies both over the entire period 1950-2015 and in 1978-2015. An examination of the superiority of China’s economic theory compared to Western analysis has been made in ‘Deng Xiaoping and John Maynard Keynes.’
• The second most successful economic development strategy after China’s has been what is generally referred to as the ‘Asian development model’ – the main features of this Asian model are analysed in ‘Why Adam Smith’s ‘classical theory’ correctly explained Asia’s growth - and how this clarifies why Paul Krugman’s critique of Asian growth failed to predict events.’
• The neo-liberal Washington Consensus of the World Bank and IMF, has been a failure compared both to China’s development model and those of the rapidly growing Asian economies - precisely as was noted by Justin Yifu Lin.

These are the facts on which any theory and policy for China’s economic development must be based including for overcoming the ‘middle income trap’. All three of these fundamental facts regarding of global economic growth must be explained by any economic theory and development strategy. They obviously lead to three decisive questions.

• Why did China outperform all other economies in per capita GDP growth?
• Why did a small number of Asian economies not perform as well as China but nevertheless outperformed all other developing economies and in some cases, aided by their starting points, have already achieved high income status?
• Why did most developing economies, those that followed the Washington Consensus, fail to achieve rapid economic growth, or make the breakthrough to high income status, and indeed in the majority of cases actually fell farther behind the most advanced economies?

Any policies for China’s economic development must be based not on dogma’s of the Washington Consensus, which global growth data shows has failed as a development strategy, but on the facts of those countries which have achieved successful rapid economic development. As always the only correct method in dealing with such a serious question as how to overcome the ‘middle income trap’ is to ‘seek truth from facts’.

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This is an edited version of an article which originally appeared in Chinese at Guancha.cn.

 

Notes

1. All figures calculated at 1990 price Geary Khamis PPPs to allow comparison with the data in Maddison Historical Statistics of the World Economy 1-2008 AD, which is used for dates before 1950. Data for 2015 is from The Conference Board for the Total Economy Database 2015.

2. The preceding data is calculated from Maddison Historical Statistics of the World Economy: 1-2008 AD. On revised data calculated by The Conference Board for the Total Economy Database 2015 Ethiopia and Tanzania in 1950s had per capita GDP’s marginally above China – this clearly makes no significant difference to the results.

Why China can achieve its 6.5% growth rate target

Economic targets for China were announced during the National People’s Congress of at least 6.5% annual GDP growth during the 13th Five Year Plan in 2016-20 and 6.5%-7.0% for 2016. Some Western economists claim such targets cannot be achieved. In fact, analysis of supply side factors, which will primarily be relied on to achieve this goals, shows clearly why China can achieve its 6.5% minimum growth goal.

Current international economic trends, particularly trade, are undoubtedly unfavourable owing to slow growth in the advanced economies. Slow trade growth negatively affects China’s supply side, as with all countries, by limiting its ability to benefit from international division of labour. In the next period China will consequently have to rely primarily on domestic supply side factors to achieve its growth targets. Data on global growth in turn shows clearly which are the most powerful economic supply side forces and why these can successfully allow China to achieve its targets.

To understand clearly the fundamental reason China can achieve its economic goals the starting point is that an economy’s growth rate is strictly determined by the percentage of fixed investment in GDP divided by what is known as the Incremental Capital Output Ratio (ICOR) – the latter being a measure of the efficiency of investment, and equal to the percentage of GDP that has to be invested for the economy to grow by 1%. For China the latest internationally comparable World Bank data for these, for 2014, showed that China’s percentage of fixed investment in GDP was 44.3% and its incremental capital output ratio was 6.1. China’s GDP growth rate was therefore 7.3%.

Since 2014 the percentage of fixed investment in China’s GDP has fallen, probably to around 42-43% of GDP, which will be assumed to show why China can achieve its 6.5% growth target. Supply side factors may then be divided into the rate of fixed investment and those which determine the efficiency of that investment (ICOR).

The most powerful supply side factor for all countries studied is what are known technically as ‘intermediate products’ – one industry’s inputs into another which reflect increasing division of labour throughout the economy’s supply chain. In the US, the world’s most advanced economy, 52% of economic growth is due to growth in such intermediate products.

Growth of intermediate products is also crucial for understanding the role of innovation. Innovation is not just a few ‘big bang’ inventions. As an economy is an interconnected network it can only be as strong as its major weakest links. For example, merely installing the most modern machinery in a factory will not yield optimal results if there is not an adequate supply of component parts, if there is not sufficiently skilled labour, if the logistics system does not efficiently take products to and from the factory etc. Given the economy’s interconnectedness every part must function efficiently for successful operation. China has therefore stressed applying innovation across the entire economy.

Such a supply side division of labour requires a multitude of factors ranging from infrastructure to product standardisation – all of which China has to develop further for its supply side to function efficiently.

The second most powerful supply side factor is fixed investment – which is above all required to incorporate technological upgrading. Leaving aside intermediate products, internationally fixed investment accounts for 61% of economic growth.

The third most powerful supply side factor is growth in quantity and quality of labour – accounting for 29% of GDP growth globally. Given China’s working age population is not expanding improvements in education and skill are a decisive factor in this area.

Other inputs (scale of production, individual entrepreneurship etc) account for an average 10% of growth globally. These are technically termed Total Factor Productivity (TFP) and contribute to China’s supply side development.

Taking these factors together shows why China’s 6.5% growth rate is entirely realistic and why the claims of Western critics are erroneous. Given the fundamental ratios already outlined then for China’s economic growth rate to fall below 6.5%, from its 6.9% level in 2015, one or both of two things would necessarily have to occur.

• Either China’s ICOR, its efficiency of investment, would have to deteriorate substantially, or

• The percentage of fixed investment in China’s GDP would have to decline in a major way.

Without one or both of these occurring it is simply numerically impossible for China’s growth rate to fall significantly. Those critics claiming that China’s economy will not meet its 6.5% growth target, and who either do not explain why China’s level of investment or its efficiency of investment are going to drastically decline, are engaging in economic ‘hot air’ – unwarranted claims without any serous factual basis.

Given China’s current investment level and the efficiency of that investment it can achieve its 6.5% growth rate.

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An edited version of this article originally appeared at China Daily.

 

World economic prospects and the '4th Industrial Revolution'

My TV interview on prospects for the world economy and the '4th Industrial Revolution''

How the influence of World Bank policies damaged China's economy

Present negative trends in China's financial system and economy were accurately predicted by me three years ago as occurring if there was any influence of policies of the World Bank Report on China.

While China has made major steps forward in areas such as the Asian Infrastructure Investment Bank and New Silk Road ('One Belt One Road') unfortunately in some areas World Bank policies did acquire influence. As predicted they led to present negative trends.

There should also be clarity. China has the world's strongest macroeconomic structure so these trends will not lead to a China 'hard landing'. But they are a confirmation that no country, including China, can escape the laws of economics. As long as there is any influence of World Bank type policies, which are also advocated by Western writers such as George Magnus and Patrick Chovanec, there will be problems in China's financial system and economy.

The article I wrote in September 2012 which was published under the original title 'Fundamental errors of the World Bank report on China' is republished without alteration. 

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The World Bank's report China 2030 has, unsurprisingly, provoked major criticism and protest. I have read World Bank reports on China for more than 20 years and this is undoubtedly the worst. So glaring are its factual errors, and economic non-sequiturs, that it is difficult to believe it was intended as an objective analysis of China's economy. It appears to be driven by the political objective of supporting current US policies, embodied in proposals such as the Trans-Pacific Partnership.

Listing merely the factual errors in the report, of both commission and omission, as well as the elementary economic howlers, would take up more column inches than are available to me. So what follows is just a small selection, leaving space to consider the possible purpose of such a strange report.

The report has no serious factual analysis of the present stage of China's economic development. On the one hand it is behind the times and "pessimistic", saying China may become "the world's largest economy before 2030". This is extremely peculiar as, by the most elementary economic calculations, (the Economist magazine now even provides a ready reckoner!) China will become the world's largest economy before 2020.

On the other hand, the report greatly exaggerates the rate at which China will enter the highest form of value added production. As such, the report calls for various changes in China, and bases its calls on the rationale of "when a developing country reaches the technology frontier'. But China's economy, unfortunately, is not yet approaching the international technology frontier, except in specialized defence-related areas. Even when China's GDP equals that of the US, China's per capita GDP, a good measure of technology's spread across its economy, will be less than one quarter of the US's. Even making optimistic assumptions, China's per capita GDP will not equal the US's until around 2040, by which time China's economy would be more than four times the size of the US's! Put another way, China will not reach the technology frontier, in a generalized way, for around three decades, so this rationale can't be used to justify changes now.

The report appears to envisage China's development path differing from that of every other country on the planet. It claims that in China "the continued accumulation of capital… will inevitably contribute less to growth". But one of the most established trends of economic development, first outlined by Adam Smith and econometrically confirmed to the present day, is that capital's contribution to growth increases with development. Deng Xiaoping certainly argued that economic policy must have "Chinese characteristics", i.e. be adapted to China's specific conditions. However, he never argued that China was exempt from economic laws, which is what this report appears to envisage!

The report makes elementary economic mistakes, such as confusing the consequences of high export shares with trade surpluses. It argues: "If China's current export growth persists, its projected global market share could rise to 20 percent by 2030, which is almost double the peak of Japan's global market share in the mid-1980s when it faced fierce protectionist sentiments… China's current trajectory… could cause unmanageable trade frictions." But if China increases its import share at the same rate as exports, this would not create major trade frictions. Japan's problem was trade surpluses, not export share.

It is almost impossible to believe, given such elementary mistakes, that this report was intended as a serious objective analysis of China's economy. What, then, is its goal? , The report spells out its goal clearly enough in calling for China to abandon the policies launched by Deng Xiaoping which brought such success. It says: "Reforms that launched China on its current growth trajectory were inspired by Deng Xiaoping… China has reached another turning point in its development path when a second strategic, and no less fundamental, shift is called for."

What is this new "non-Dengite" economic policy? Deng Xiaoping's most famous economic statement was "it doesn't matter whether a cat is black or white provided it catches mice". Effectively, this means, in economic terms, that a company should not be judged by whether it is private or state owned but by how it performs. The proposed new economic policy overturns Deng's dictum by saying: "Reintroduce judging cats by colour, promote the private sector cat."

The consequences of this are clearly seen in the report's financial proposals. During the international financial crisis, China was protected by its state-owned banking system. The US and European privately-owned banks simultaneously created the financial crisis and were flattened by it, throwing their economies into crisis. China, however, suffered no significant setback.

The reasons for the US and European banking crisis are well understood. Modern banks are necessarily very large, both in order to undertake international operations and because of the inherent risk of large investment projects. They are literally "too large to fail", as the failure of any large bank creates an unacceptable economic crisis. This theoretical point was rammed home by the devastating consequences of Lehman's collapse, following which no government will allow a large bank to fail.

But a situation in which the state is blocking the bankruptcy of a large bank, whose profits are being privately retained, creates disastrous risk. If large private banks are state guaranteed against crippling losses, but retain profits, they are incentivized to undertake potentially profitable but highly risky operations. The disastrous results of this scenario were seen during the financial crisis.

Extraordinarily, this report proposes that China abandon the financial system which brought it successfully through the financial crisis and instead adopt the one which led the US and Europe to disaster. This is the real significance of "privatization would be the best way to make SFIs [State Financial Institutions] more commercially oriented".

This ties in with US TransPacific Partnership pressure for the elimination of China's state-owned companies, which are seen as giving China a completive advantage over the US. The US, of course, does not possess such companies. If the US is worried about the competitive disadvantage created by not having state-owned companies, it should create some, not call for China to abandon its own.

The last World Bank report of this type was published in February 1991 and its Study of the Soviet Economy provided the basis for Russia's economic policies of the 1990s.

The result was that Russia suffered the greatest peacetime economic disaster to befall any country. GDP declined by more than half. Russian male life expectancy fell by four years and we saw the beginning of a population decline, which continues to this day. The USSR subsequently disintegrated, in what Vladimir Putin called the greatest geopolitical catastrophe of the 20th century. Russia has not recovered.

This type of economic program is therefore not simply a "theoretical" model. It has been thoroughly and demonstrably discredited on account of the catastrophes it has produced. Russia was ill advised enough to adopt this type of economic program. It is to be hoped, then, that China does not follow the same course

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This article originally appeared on China.org.cn.

The general significance of China's discussion on the economy's 'supply side'

A major discussion is taking place in China on the issue of its economy’s ‘supply side’. Naturally there are aspects of this which relate to specifically Chinese issues. Discussion in China also differs fundamentally from that in the West in that it takes place simultaneously in both ‘Western’ and ‘Marxist’ economic terms. Nevertheless the overall framework of this discussion equally relates to the key issues of economic policy in Western countries.

The article below, which originally appeared in Chinese at Guancha.cn, therefore is simultaneously a contribution to discussion on China’s growth rate targets, and forthcoming 2016-2020 13th Five Year Plan, as well as overall issues of economic growth. It thereby deals not only with specifically Chinese issues but with ‘growth accounting’ as developed in Western economics, the real positions of Keynes as opposed to the confusions of what is generally referred to as ‘Keynesianism’ and the most powerful factors in economic developed. While its specific focus is China this makes clear why the current discussion in China is crucially related to overall questions of economic analysis and theory applying in other countries.

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Economic laws are objective – China is no more capable of breaking them than any other country. Consequently, policies which do not correspond to these laws and the forces they analyse simply will not succeed. This is the context for discussion of China achieving ‘at least 6.5%’ growth which is necessary to make the transition to a ‘moderately prosperous society’ by 2020. It particularly applies to some recent discussion which took place in China’s media on ‘supply side economics’.

At one level, for reasons analysed below, this focus on the supply side is a positive break with the confused ideas of so-called ‘Keynesian’ economics imported into China from Western economic textbooks – although in fairness it will be seen that such views are not actually those of Keynes. But unfortunately some of this new discussion entirely fails to accurately understand the very different strength of different factors on the economy’s ‘supply side’ - erroneously proposing policies relying on very weak supply side forces which would therefore make it more difficult to achieve ‘at least 6.5%’ growth. This article’s aim is therefore to simultaneously show why concentration on the economy’s supply side is correct, to analyse accurately the most powerful forces on the supply side using up to date official statistical methods, and examine the conclusions which flow from the relative strength of different factors on the economy’s supply side.

Marxist analysis

Demonstration of why concentration primarily on the economy’s supply is correct can be made in either Marxist or ‘Western’ economic terms. The Marxist one is  more succinct, and will therefore be dealt with first, but it will be demonstrated that analysis in either economic framework leads to the same conclusion.

Marx was unequivocal that production, the economy’s ‘supply side’, was dominant: ‘The result at which we arrive is, not that production, distribution, exchange and consumption are identical, but that they are all elements of a totality, differences within a unity. Production is the dominant moment, both with regard to itself in the contradictory determination of production and with regard to the other moments. The process always starts afresh with production… exchange and consumption cannot be the dominant moments… A definite [mode of] production thus determines a definite [mode of] consumption, distribution, exchange.‘

Marx consequently states that other elements of the economy – demand, consumption, exchange etc. – have some influence but that production, the supply side, is the most powerful economic factor. Analysis shows why this is clear. Consumption, for example, can only be undertaken either of one’s own production or with an income to purchase products, and that income necessarily comes, directly (wages, profits) or indirectly (welfare benefits, pensions, support from another family member etc.), from participation in production.

Furthermore, Marx’s analysis does not deny the interaction of supply and demand, which is the focus of ‘Western’ economics, but simply asks a different question: if supply and demand balance, that is there is ‘equilibrium’, what happens, what is the economy’s dynamic and how does it develop?

Marx, in summary, was a thoroughly ‘supply side’ economist.

Confusions of Western ‘Keynesianism’

The economic school which focuses on the economy’s ‘demand side’, as opposed to supply side, is generally referred to as ‘Keynesianism’. The argument associated with this is that if economic difficulties exist this is due to lack of demand, which should therefore be increased – frequently by running a budget deficit and/or monetary easing. This increase in demand, it is argued, will lead to production increases.

This argument is evidently false. In a market economy production is not undertaken simply because something is ‘demanded’, it is only undertaken for profit. If an increase in demand leads to no increase, or even a decline, in profit then it will not result in an increase in production – indeed it can lead to the reverse.

There are numerous conditions in which increasing demand will not lead to a profits increase. One is where the economy has no spare capacity and therefore production cannot be expanded on the basis of existing resources. In this situation increasing demand, with no ability to increase supply, merely leads to inflation and not a production increase.

But an increase in demand can lead to a fall in profitability even where spare capacity exists. For example, if increased demand strengthens the bargaining position of labour, thereby increasing the wages share in the economy, the profits share in the economy must necessarily fall and profits may even decline in absolute terms. In those circumstances increasing demand, through its negative effect on profitability, will have a negative effect on production. Some policies to ‘increase demand’ even directly reduce profitability - for example if the increase in demand is achieved by directly increasing wages then the profits share of the economy will fall.

It is therefore simply false that increasing demand necessarily leads to an increase in production - it may even lead to a fall. In practice methods of stimulating demand may lead simultaneously to the combination of inflation and economic stagnation or decline – the notorious ‘stagflation’. Naturally these facts do not mean there are no circumstances in which increasing demand will lead to an increase in production, but whether this occurs or not depends not on increased demand itself but on its effect on profitability – i.e. the division of incomes between wages and profits resulting from production. Profitability, not ‘demand,’ is therefore the key part of the economic process.

It summary, whether analysed in a Marxist or ‘Western’ economic framework, the most powerful element is the supply side of the economy not the demand side. This does not mean demand has zero effect, but it means that the effect of demand is less powerful than that of supply. Consequently, what is often referred to as ‘Keynesianism’ is false – the point that should be added is that such ‘Keynesianism’ is a distortion of the views of Keynes himself as Keynes perfectly well understood that profits were the element determining production in a market economy. 

It follows that whether considered in a Marxist or a ‘Western’ economic framework the most powerful key to analysis and economic policy lies on the economy’s ‘supply side.’

Production

Turning to which processes are most powerful, and which are weak, on the economy’s supply side it is a testament to genius that modern econometrics has confirmed on this issue the analysis over 200 years ago by the founder of modern economics Adam Smith. Smith set out immediately and unequivocally in the first sentence of the first chapter of The Wealth of Nations that: ‘The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is directed, or applied, seem to have been the effect of the division of labour.’ With his customary clarity the other conclusions of Smith’s magnum opus followed logically from this analysis of the decisive role of division of labour.

Smith’s conclusion has necessary consequences which impact on the all aspects of the economy. This increasing division of labour means that as Spengler notes in his study of The Wealth of Nations: ‘in Bohm-Bawerkian terms... production became more roundabout.’ By ‘roundabout production’ is meant that rising division of labour creates an increasingly interconnected web of production, and therefore that economically ‘indirect’ inputs rise relative to ‘direct’ ones.

To illustrate this with a simple example, 100 years ago an accountant merely used a pen, paper and a simple calculating tool which were the product of, in comparative terms, relatively few people. Today an accountant uses a computer, software, and the internet - collectively the product of hundreds of thousands of people. To take a quantified example, a modern car assembly factory may appear a huge productive unit, but only 15% of the value of the car production process takes place in it: 85% of the value of auto production is in components and other intermediate inputs into car production.

Furthermore, even the 85% of the car’s value due to inputs of components does not exhaust this process of division of labour and of ‘indirect’ inputs. These components were themselves improved by the work of tens of thousands of R&D workers and scientists, who were trained by hundreds of thousands of teachers, university lecturers etc. This process of increasing division of labour perfectly demonstrates the process analysed by Smith.

At this point Marx enters the picture. Marx summarised the numerous different processes of division of labour described by Smith in a single fundamental concept ‘socialised labour’. Marx drew out the conclusions which followed from the fundamental processes analysed by Smith. But for present purposes it is not necessary to deal with these further conclusions or even to distinguish between the terms ‘division of labour’ used by Adam Smith or ‘socialised labour’ used by Marx – they both described the same process. It is merely crucial to note that modern economic statistics has thoroughly vindicated in quantitative terms these conclusions of Smith/Marx and thereby established what are the most powerful forces on the economy’s supply side.

The most powerful forces on the supply side

If the economy’s ‘supply side’ is examined in quantitative terms the conclusions Smith drew from his analysis were that the most fundamental forces of economic development were, in the descending order of quantitative importance established by modern econometrics:

(i) The most fundamental force of economic and productivity growth is increasing division of labour – reflected in the growth of ‘intermediate products’.

(ii) Increasing division of labour requires an increasing scale of production and an increasing scale of market – resulting in globalisation.

(iii) Increasing division of labour, and increasing scale of production, leads to an increasing percentage of the economy being devoted to fixed investment.

(iv) Growing skill of the labour force, i.e. increasing ‘labour quality,’ is economically determined by the resources put into training that labour force. .

(v) Technological progress is itself also a product of increasing division of labour via establishment of specialised R&D and other facilities.

As with all proper scientific propositions Smith’s conclusions are empirically testable. It is a remarkable tribute to Smith’s genius, and that of Marx who understood their power and built on them, that modern economic statistics has confirmed all these points. They will, therefore, be analysed, using modern official statistical methods, proceeding from the most powerful forces on the economy’s supply side to the weaker ones.

Domestic division of labour and Intermediate products

The most direct measure of division of labour is growth of ‘intermediate products’ – i.e. production of one economic sector, either goods or services, used as an input into another (e.g. a hard drive is an output of one industry used as an input into a computer, a steering wheel is the output of the car components industry used as an input into the car industry etc.). Modern econometrics is unequivocal in finding that such intermediate products, directly reflecting division of labour, are the most important source of economic growth.

Taking first the most developed economy, the US, Jorgenson, Gollop and Fraumeni found, using the statistical methods now officially adopted by the US, UN and OECD: ‘the contribution of intermediate input is by far the most significant source of growth in output. The contribution of intermediate input alone exceeds the rate of productivity growth for thirty-six of the forty-five industries for which we have a measure of intermediate input… the predominant contributions to output growth are those of intermediate, capital and labour inputs. By far the most important contribution is that of intermediate input.'

The same result as for the US is found for other economies - specifically including China. Regarding rapidly growing Asian economies:

• For South Korea, Hak K. Pyo, Keun-Hee Rhee and Bongchan Ha found regarding material intermediate inputs: ‘The relative magnitude of contribution to output growth is in the order of: material, capital, labour, TFP then energy.’
• For Taiwan Province of China, analysing 26 sectors in 1981-99, Chi-Yuan Liang found regarding intermediate material inputs: ‘Material input is the biggest contributor to output growth in all sectors during 1981-99, except… seven’.
• For mainland China, Ren and Sun found that in the period 1981-2000, subdivided into 1984-88, 1988-94 and 1994-2000: ‘Intermediate input growth is the primary source of output growth in most industries.’

This analysis that growth of intermediate products is the most important factor in overall economic growth therefore fully confirms Smith’s analysis that rise of division of labour is the single most powerful force on the domestic field for economic growth. This process fully operates in China as in the other economies studied.

Division of labour at an international level

So far analysis of data on division of labour at a domestic level has been given. This clearly shows that use of intermediate products is the most powerful factor on the economy’s ‘supply side’. However, division of labour in a modern economy extends not only domestically but internationally – the phenomenon of ‘globalisation’. Quite sufficient evidence exists to leave no doubt that division of labour increases internationally. This drives both modern industrial structure and China’s ability to insert itself in globalised competition. Taking the chief features of this:

• Intermediate products themselves constitute the largest part of international trade – accounting for approximately 40% of all goods trade.
• Trade in intermediate products is concentrated in advanced economies and East Asia - economies which have intermediate products as the most rapidly growing part of national production.
• International trade has expanded rapidly as a percentage of world GDP.

That international trade is the expression of division of labour of course explains the well-established finding that international economic ‘openness’ is positively correlated with economy growth.

Factors of production

Turning from intermediate products to factors studied in the classic framework of Solow ‘growth accounting’ the trends for both advanced and developing economies analysed by the latest of statistical method of the US, OECD and UN statistical agencies for the period 1992-2014 are shown in Figure 1. This data is for 103 advanced and developing economies together accounting for 94% of world GDP – i.e. the data is comprehensive. The results are clear:

(i) In both advanced and developing economies Total Factor Productivity (TFP) is only a small source of growth. TFP in advanced economies on average accounts for 0.5% annual GDP growth and in developing economies 0.6%.

(ii) Labour inputs account on average for 0.8% annual GDP growth in advanced economies and 1.2% in developing ones.

(iii) Capital inputs are the single most important of the ‘Solow’ factors of growth accounting on average for 1.6% GDP growth a year in advanced economies and 2.5% in developing economies.

The net result of these inputs is that annual average growth in developing economies in the period 1992-2014 was 4.3% compared to 2.9% in advanced economies. This annual growth lead of 1.4% by developing economies allows them to catch up with advanced economies. But only 0.1% of the ‘catch up’ in GDP growth is due to higher TFP growth compared to 0.4% for higher increases in labour inputs and 0.9% due to higher capital inputs. Therefore, 64% of the ‘catch up’ of developing economies is due to a higher rate of capital accumulation, 29% due to higher inputs of labour, and only 7% due to higher TFP growth.

Figure 1

 

Similarities and differences in the growth pattern of advanced and developing economies

To show more clearly the similarities and differences in the growth pattern of advanced and developing economies Figure 2 and Figure 3 show the percentage contributions to growth in advanced and developing economies. To highlight the most significant difference more clearly labour inputs have been divided into their two sources of increase in labour quantity (i.e. total hours worked by the labour force) and increase in labour quality (improvements in education and training). The charts show that the most powerful sources of growth in the two types of the economy are the same with one significant difference regarding the growth of labour inputs.

(i) The role played by Total Factor Productivity is small in both advanced and developing economies, accounting for only 10% of growth in both. TFP is substantially determined by indirect inputs into production - technology advance due to R&D etc.

(ii) The percentage of growth accounted for by labour inputs in both types of economy is not radically dissimilar – 26% in advanced economies, 30% in developing economies. However, the composition of the increase in labour inputs is substantially different in the two types of economy. In developing economies 27% of GDP growth is due to increase in total hours worked by the labour force and only 3% by increases in labour quality, whereas in advanced economies only 15% of growth is accounted for by increases in hours worked and 11% by improvements in labour quality. Therefore, as an economy becomes more advanced the role played by increases in total hours worked falls while the role played by improvements in education and training moves from being small to being a significant growth factor. Put in simple terms the role played by education, training etc. becomes significantly more important as the economy become more developed - a classic example of roundabout/indirect production as the increase in labour quality is due to the work of teachers, training schemes etc.

(iii) Increase in capital investment is by far the most important of the ‘Solow factors’ in economic growth in both developing and advanced economies – accounting for 60% of growth in developing economies and 63% of growth in developed economies. It may be noted that the role of capital investment in an advanced economy is even greater than in a developing one. Capital investment is a pure ‘indirect’ input into production – both intermediate products and fixed investment are capital in accounting terms but intermediate products are used in a single production cycle while fixed investment is used up (depreciated) over numerous production cycles.

Figure 2

Figure 3

 

Sources of growth on the ‘supply side’

The importance of different factors on the supply side of the economy may therefore be summarised:

i. The most powerful factor in economic growth is the development of intermediate products – a direct reflection of increasing domestic and international division of labour.

ii. The second most powerful factor of production is capital investment – accounting for approximately 60% of the growth which is due to ’Solow factors’ of production.

iii. Labour inputs account for approximately 30% of GDP growth due to ‘Solow factors’ of production – but with increases in labour quality rising significantly compared to labour quantity as an economy becomes more developed

iv. TFP plays only a relatively small role in economic growth – accounting for about 10% of growth due to ‘Solow factors’ of production.

Myth of individual entrepreneurship

The above data immediately shows why the views of some of those in China claiming to stand for ‘supply side’ economics are wrong. For example, Liu Shenjun claims that the key factor in economic growth is individual ‘entrepreneurship.’ The data on economic growth clearly shows this is entirely false.

The impact of individual ‘entrepreneurship’ would be part of the growth that is not created by quantitative increases in intermediate products, capital or labour i.e. it would be measured as part of TFP growth. But as already seen TFP increase even taken as a whole is a small part of economic growth – in both advanced and developing economies total TFP increase accounts for only 10% of economic growth. Furthermore, TFP growth is no higher in advanced economies, where individual entrepreneurship is supposedly concentrated, than in developing economies. Consequently, even if the role of ‘individual entrepreneurship’ accounted for the whole of TFP growth in advanced economies, which is a wholly unreasonable assumption given the key role of technology, scale of production, R&D and other factors, it would be only one third as important as growth in labour inputs and only one sixth as important as growth in capital investment.

Therefore, attempting to create economic growth based on TFP increases, let alone ‘individual entrepreneurship,’ is like attempting to drive forward a machine using only a tiny gear wheel, while not attempting to shift it using the far larger gear wheel of capital investment or even labour inputs. For simple quantitative reasons such a strategy evidently cannot succeed.

Conclusions

To summarise again the sources of growth on the supply side of the economy are, in descending order of importance, intermediate products, capital investment, labour inputs, and TFP (with the contribution of individual entrepreneurship being even less than that of TFP). This has evident implications for what constitutes a ‘supply side strategy’ - which includes but is not confined to the following points.

1. Regarding the most powerful source of economic growth, intermediate products, domestically the maximum conditions have to be created for China to use the advantages of division of labour. The increasing size of China’s economy, by expanding the size of its domestic market, facilitates development of such efficient division of labour. Nevertheless, efficient functioning of the domestic national market, and domestic division of labour, requires large scale material underpinnings. China’s transport system for example, a crucial factor permitting division of labour, remains highly underdeveloped compared with the US. Length of road per capita in China is only 16% of that in the US, and length of railway only 7%. Compared to the US China’s logistics system is therefore extremely underdeveloped. Similarly regarding communications, again indispensable for efficient division of labour, the percentage of China’s population on the internet is only slightly over half that of the US. Programmes such as ‘internet plus vital’ are therefore vital not only for systematic upgrading of production but for permitting efficient functioning of domestic division of labour.

2. In terms of international division of labour. the effect of the international financial crisis has sharply reduced the share of trade in China’s economy. The percentage of exports of goods and services in China’s GDP fell from 35% in 2007 to 23% in 2014 and the share of imports from 27% to 19%. Trade data shows this decline has continued in 2015 – in summary China is making less use of international division of labour than previously. Purely on the basis of exploiting the growth advantages of division of labour the most powerful way to stimulate exports would be via RMB devaluation while simultaneously more rapid GDP growth would be the most effective way to stimulate imports. However, in setting the exchange rate other considerations than trade stimulation also have to be taken into account and therefore these have to be balanced with trade considerations.

3. As fixed investment is the most important ‘Solow factor’ in economic growth it is necessary for China to sustain a high fixed investment level. However, investment requires equivalent savings. The decline in China’s savings as a percentage of the economy since 2009, i.e. a decline in the percentage of the economy developed to supply of capital, has led to China’s interest rates rising significantly above those in the US, with negative economic consequences. Reviving China’s saving rate, above all by increasing corporate profitability, is therefore an economic priority if a high level of fixed investment is to be maintained.

4. The growing importance of labour quality, as opposed to labour quantity, as an economy becomes more developed underlines the importance of China continuing to increase the percentage of the economy devoted to education and training.

5. R&D is a crucial example of an ‘indirect’ input into production and is crucial for innovation. Continuing to increase the percentage of China’s GDP devoted to R&D is therefore important on the supply side.

6. Measures to assist individual entrepreneurship are useful but for the quantitative reasons already cited cannot play a determining or large role in economic growth.

Given the clear facts on economic growth in both advanced and developing economies economists who claim that what is required on the ‘supply side’ is ‘"small government, big market", free competition and firm believe in entrepreneurship’ are both entirely wrong as regards the power of different factors on the economy’s supply side and are merely ‘neo-liberals’ hiding under another name – ‘neo-liberalism’ itself being so discredited that few people now dare to openly advocate it.

The correct starting point for framework for analysing the supply side of the economy flows from the analysis recently set out by Xi Jinping as reported: ‘As the fundamental standpoint of Marxist political economy, the theory of putting people at the center should be upheld while deploying work, setting down policies and promoting economic development.’

Putting people at the centre applies to the productive process as in the other fields of the economy. The most powerful forces on the economy’s supply side is ‘socialised labour’, to use Marx’s terminology, or ‘division of labour’ to used Adam Smith’s – which terminology is used is not critical for present purposes as both describe the same process. The most powerful forces on the economy’s supply side as it becomes more developed – intermediate products, globalisation, rising fixed investment, increased labour quality – are themselves expressions of division of labour/socialised labour.

The recent turn to emphasis on the economy’s supply side, as opposed to the confused ideas of ‘Keynesianism’ imported into some circles in China by Western textbooks, is therefore welcome. But it would be truly absurd if one Western textbook confusion were now replaced by another which constitutes merely a form of ‘neo-liberalism’ in other disguise. This would be particularly ridiculous when China’s Marxist economics and contemporary Western economic statistics come to exactly the same conclusion on what are the most powerful forces on the economy’s supply side.

Developing China's 'supply side'

China recently made two key economic decisions. First, the 13th Five Year Plan from 2016-2020 should achieve "at least 6.5% annual growth for China to become 'moderately prosperous" -- close to the World Bank's criteria for an "advanced economy." Second, December's Central Economic Work Conference announced that China's policy will concentrate on the economy's "supply side."

This latter decision is welcome. Primary concentration on the economy's "demand" side is misapplied in either a "Western" economic framework or China's Marxist one. Switching focus to the supply side introduces greater precision into economic policymaking as specific numbers must be stated to calculate the requirements for at least 6.5% growth.

There are only two fundamental frameworks of analysis of the economy's supply.

• The first is "growth accounting," developed by U.S. Nobel Prize winner Robert Solow, which is the framework of "Western economics." This analyses the economy's "supply side" in terms of three inputs of capital, labour and total factor productivity (TFP) -- TFP being all growth sources not only due to inputs of capital and labour.

• The second is Marx's, the official basis for China's policy, which analyses the economy in terms of capital, labour and surplus value -- the latter being numerically equal to profits, rent and interest.

For present purposes, these may be reduced to one framework as both Solow and Marx in "growth accounting" are concerned with overall input-output levels and their other differences do not affect this.

The study of economic statistics identifies that "supply side" Inputs have very different weights. Therefore, to achieve "moderate prosperity" not only the supply side's "algebra" but its "arithmetic" must be considered. Given that China's aim is to achieve moderately prosperous and even advanced economic status, the driving forces of the world's most advanced economy, the United States, will first be considered and then China's current differences to the United States analysed. The contrast indicates policies China must pursue to become an advanced economy. Figure 1 below therefore shows the sources of U.S. economic growth and these will be analysed in descending order to importance.

The United States, as with all economies, has two capital inputs, the first of which is "Intermediate products" -- one industry's outputs used as another's inputs (e.g. outputs of steering wheel producers provide inputs into the automobile industry). Financially, as Charles Jones noted for the U.S. National Bureau of Economic Research, "intermediate goods are just another form of capital, albeit one that depreciates fully in production" -- they are "circulating capital." Increase in Intermediate products indicates a growing division of labour and accounts for 52% of output increases by U.S. economic sectors -- the largest growth source.

The second capital input is "fixed investment," or the means of production depreciating over numerous production cycles. This constitutes 24% of increases in U.S. output.

Growth in labour inputs account for 15% of U.S. output increases -- this growth being due to both increase in total time worked ("labour quantity") and improvements in training and education ("labour quality").

TFP, increases in production due to technology, entrepreneurship, etc., account for 9% of U.S. economic growth.

Turning to a comparison with China the most detailed study by Ren & Sun found that in China as in the United States: "Intermediate input growth is the primary source of output growth." Developing China's ability to use division of labour, that is growth in intermediate products, is therefore crucial as this is the most powerful factor on the economy's supply side. But China's ability to use domestic division of labour is greatly hampered by shortage of infrastructure compared to the United States -- efficient division of labour requires ability to transport parts, efficiently communicate and coordinate production, identify markets etc.

China's number of per capita Internet users is equal to only 56% of the United States' per capita total. China's lag in "heavy" infrastructure is devastating -- China's per capita electricity consumption is only 27% of U.S. levels, with the country's length of roads 16%, and length of railways at 7%. China cannot benefit from division of labour at U.S. levels with such underdeveloped infrastructure.

Under globalisation, division of labour is international as well as domestic. From the launching of economic reform in 1978 until 2006 the percentage of trade in China's economy rose from 9.7% to 64.8% -- China made greater use of international division of labour. By 2014 this had fallen to 41.5% -- China's economy was making less use of international division of labour. Boosting China's trade is a vital supply side reform.

Turning to the second most powerful factor of economic growth, China's per capita fixed investment is only $3,199 compared to the United State's $10,017 -- China's per capita fixed investment must be tripled to reach U.S. supply side levels.

Regarding labour inputs, due to its one child policy, China's increase in working age population is negligible, and will decline in future, whereas the United State's annual increase is 0.3%. China's long run situation may alter via its new "two-child policy," and more immediately China can partially ameliorate the problem by raising its very low pension age, but the increase in China's total working time will be negligible or negative.

Measuring labour quality, OECD studies show China has a high standard up to secondary school but the United State has an overwhelming advantage in tertiary education -- the U.S. ratio of enrolment in tertiary education, compared to the number in the age group in the five years following secondary education, is three times higher than China's.

In 2009-2014 annual average TFP growth in both the United State and China was high by international standards at 0.6% in the United State and 0.8% in China -- compared to an average decline for all economies of 0.1%. However, as already noted, TFP is too small a proportion of the economy's supply side to generate fast growth.

Analysing numerically the most powerful factors on the supply side therefore yields clear results. To develop towards advanced economy status China primarily requires massive infrastructure investment facilitating development of division of labour, increases in international trade, enormous increases in per capita fixed investment, and huge expansion of tertiary education.

 *  *  *

This article originally appeared on China.org.cn.

The Copernican Revolution in the Study of Economic Growth - Slide Presentation

The Copernican Revolution in the Study of Economic Growth  from John Ross

The Copernican Revolution in the Study of Economic Growth

 

From the 1950s-1990s there was a contradiction between the theory of economic growth and the facts of economic growth

A theory of economic growth said that growth was primarily due to Total Factor Productivity (TFP)  as put forward by Solow.

But the facts of rapidly growing economies, above all in Asia, showed rapidly growing economies were dominated by factor accumulation of capital and labour – as shown by Young and other studies.

The prediction was therefore made by Krugrman that the Asian economies would drastically slow down compared to the US. But the the facts showed they didn't.

Science demands that where facts and theory don’t coincide the theory has to change not the facts.

More accurate methods of measurement now show there no contradiction between the facts and economic theory.

But the analysis and policy that economic development can primarily be driven by TFP has to be abandoned. Or to put it simply Solow quantification was wrong and it is necessary for economic policy and theory to understand this and its implications.

This presentation analyses the developments in the more accurate analysis in the causes of economic growth.

http://www.slideshare.net/JohnRoss21/the-copernican-revolution-in-the-study-of-economic-growth-56094972

The TPP - a slow growth Pacific club

Criticism of the US TransPacific Partnership (TPP) in the US and more generally in 'the West' has concentrated on the entirely accurate point that it enshrines  corporate interests against those of ordinary people, labour, NGOs and is profoundly undemocratic – which is why it had to be negotiated in secret. That is why both US candidates for the Democratic presidential nomination, Bernie Sanders (for genuine reasons) and Hillary Clinton (probably for purely opportunistic reasons of making sure she defeats Sanders) have come out against it. 

But there is another dangerous aspect of the TPP. It is in reality highly protectionist and aimed at imposing rules which would slow down other economies to the anaemic growth rate of the US. In particular the TPP is strategically aimed to slow down China’s economy. But by so doing the TPP will also slow the development of the entire Asian-Pacific and therefore global economies. This reality does not, of course, contradict the reasons for opposing the TPP in the interests of the populations of the US and other advanced economies but gives a further reason for opposing it.

The ways in which the TPP is fundamentally protectionist in character, and aimed at slowing other economies towards the slow US rate, are examined in the following article which also contrasts China’s concept for the Pacific of a Regional Comprehensive Economic Partnership (RCEP). The following is an edited version of an an article which originally appeared in Chinese at Guancha.cn analysing these issues in the context of the Asia-Pacific Economic Cooperation (APEC) summit.

*   *   *  

China’s fundamental economic conception for the Asia-Pacific region is clear. In comprehensive strategic terms it is encapsulated in Xi Jinping’s concept of ‘community of common destiny.’

The specifically economic base of such a conception is that has been known since the first sentence of the first chapter of the founding work of scientific economics, Adam Smith’s The Wealth of Nations, that: ‘The greatest improvement in the productive powers of labour… have been the effects of the division of labour.’ For China’s leadership, which of course analyses in Marxist terms, Marx’s conclusion that the greatest economic power is ‘socialised labour’ builds on this reality first outlined by Smith.

But in a modern economy this division of labour is on such a large scale that it necessarily extends not only domestically but internationally – meaning only a globalised economy can give rise to the highest level of economic development. Consequently no country can create an efficient self-contained economy and each country gains from participating in international division of labour – the economic foundation of Xi’s formula of a ‘community of common destiny.’ This is the fundamental basis of the truth that in economics 1 + 1 is frequently greater than 2.

The optimal relations of China, the US, and the entire Pacific Region therefore flows from this economic reality. China and US are not only world’s largest economies but simultaneously the world’s largest trading nations. Mutually beneficial relations between China and the US are therefore potentially the strongest economic point for the entire Asia-Pacific Region. Such mutually beneficial interaction of China and the US are also consequently optimal not only for both economies but create the strongest possible locomotive for economic development of the entire Asia-Pacific.

Such an interrelation therefore certainly corresponds to China’s self-interest, as it helps constitute the optimal path to achieve China’s goal under the 13^th Five Year Plan of a ‘moderately prosperous society,’ but it simultaneously corresponds to the interests of the maximum economic development of the entire Asia-Pacific.

This is the economic dimension China therefore pursues in its proposal for a RCEP and in the model of the ‘new model of major country relations’ - both of which provide the framework China will put forward at the APEC summit. Such a course corresponds to the needs of achieving prosperity of the Asia-Pacific Region. But unfortunately the facts show that currently the US is pursuing a directly counter path.

TPP – a US ‘slow growth’ Pacific club

The real character of the US TPP becomes clear immediately the fundamental economic data for its 12 intended signatory countries is examined. The potential signatories are dominated by the G7 economies of the US, Japan, and Canada. These, together with Australia, constitute 90% of the GDP of potential signatories. Participating developing economies – Mexico, Malaysia, Chile, Vietnam and Peru – make up only 8%.

Figure 1 also shows that in 1985 economies in the proposed TPP accounted for 54% of world GDP while by 2014 this had dropped to 36%. The TPP therefore does not constitute a comprehensive framework for the Asia-Pacific Region but a group of advanced economies, with a ‘fringe’ of developing countries, whose share in world GDP has been significantly declining.

Figure 1

 

The percentage of world trade accounted for by potential TPP economies is also substantially less than their combined weight in world GDP and is falling – World Banks data showing it declining from 33% of world merchandise trade in 1984 to 25% in 2014 (the claimed figure of 40% published by media agencies such as the BBC is grossly irresponsible as it is entirely inaccurate).

That the percentage of world trade accounted for by the TPP economies is significantly less than their percentage of world GDP shows this is a grouping of relatively ‘closed’ economies in which trade plays a lower than average role. The TPP is therefore fundamentally different to the World Trade Organisation which covered the overwhelming majority of world trade, or China’s proposed RCEP which would cover the great bulk of Asia-Pacific economies.

The declining trends of world GDP and trade represented by the TPP economies clearly contrasts with China, whose role in world GDP and trade has sharply increased but which the US excluded from the TPP negotiations. What, therefore, was the real US rationale in creating a TPP of relatively closed economies with a declining weight in world GDP and trade instead of a far more dynamic grouping, with much greater potential, that would include China?

Decelerating growth of the US economy

The answer regarding US goals in the TPP lies in trends in the US economy itself. The US dominates the TPP accounting for 62% of its GDP. The US promotes a mythology that it is a dynamic economy but the reality is that the US economy has been sharply slowing and its weight in the world economy declining. Such US mythology flows from one of the worst of statistical tricks of taking individual examples, in this case the genuine success of companies such as Apple, to conceal the overall declining trend. In reality from 1984-2014 the US share of world GDP fell from 34% to 23%, at current exchange rates. In the same period the US share of world merchandise trade dropped from 15% to 11%. 

Even more significantly the US economy has been decelerating for over half a century. Taking a 20 year moving average, to eliminate the effects of short term business cycle fluctuations, Figure 2 shows that US annual average GDP growth fell from 4.4% in the late 1960s, to 4.1% in the late 1970s, to 3.5% by 2000, and 2.4% by 2015. Detailed analysis shows this was rooted in the falling percentage of fixed investment in US GDP, but for present purposes it is sufficient to note the impossibility of rapidly reversing a half century long decelerating trend.

Figure 2

 

US goal to slow other economies

Given the impossibility of short term US growth acceleration the only way to maintain US economic and geopolitical supremacy is therefore to slow competitor economies. Once this is understood then the apparently illogicality of grouping a number of relatively slowly growing and closed economies into the TPP becomes clear.

In essence the TPP extends the mechanisms responsible for slowing US growth to cover competitors. To secure this the TPP enshrines that the legal rights of private companies in TPP participating economies are superior to those of member governments. Private companies, therefore principally US ones, have the right under the TPP to sue participating governments in courts which will be dominated by the US but whose decisions are binding on national governments. As the well-known US economist Jeffrey Sachs noted of these TPP provisions: ‘Their common denominator is that they enshrine the power of corporate capital above all other parts of society, including… even governments… The most egregious parts of the agreement are the exorbitant investor powers implicit in the Investor-State Dispute Settlement system as well as the unjustified expansion of copyright and patent coverage. We’ve seen this show before. Corporations are already using ISDS provisions in existing trade and investment agreements to harass governments in order to frustrate regulations and judicial decisions that negatively impact the companies’ interests. The system proposed in the TPP is a dangerous and unnecessary… blow to the judicial systems of all the signatory countries.’

Some features of the TPP are extraordinary. For example, one of the most astonishing is that it de facto gives legal protection to software companies, overwhelmingly US, to essentially spy on signatory states. Article 14.17 states: ‘No Party shall require the transfer of, or access to, source code of software owned by a person of another Party, as a condition for the import, distribution, sale or use of such software, or of products containing such software, in its territory.’ While it is stated this does not apply to ‘critical infrastructure’ it does not exclude banks, commercial companies etc.

In short the conception of the TPP is not to maximise prosperity for the Asia-Pacific Region but to enshrine US supremacy. As Madam Fu Ying, Chairwoman of China's National People's Congress and former Ambassador to Britain put it: ‘The focus of attention in the United States is how to ensure that the United States maintain its leading position in the world.’ Given that the US economy cannot accelerate the only way for the US to maintain its dominant position is to slow down competitors, and that is the purpose of the rules of the TPP.

If the US can succeed in slowing China’s economy this will also have major implications for foreign policy – lessening China’s economic appeal for other countries.

The slowing of competitor economies by the US, is of course, directly against the interests of China, as it seeks to prevent China becoming a ‘moderately prosperous society’ under the 13^th Five Year Plan and then passing on towards a ‘high’ level of prosperity. But by lessening overall economic growth in the Region the TTP is against the interests of the Asia-Pacific as a whole.

Interests of the Asia-Pacific region versus interests of the US

The different conceptions at the APEC summit, therefore, flow directly from the different approaches of China in the RPEC and the US in the TPP. The approach of China in RPEC corresponds both to the interests of China and to the maximum economic development of the Asia-Pacific. The US in the TPP, in contrast, would slow the development of the entire Asia-Pacific region in order to seek to ensure US dominance within it.

The response required by China and other countries to maximising their own development at the APEC summit therefore flows from the fundamentally different character and goals of the RPEC and the TPP. As RPEC corresponds to the maximum development of the entire Asia-Pacific it represents the interest of the people of the entire region – and indeed of global development. As the TPP legally enshrines features which led to slowing US growth, creating negative direct and indirect consequences for the US population, the TPP has domestically become the subject of major US political opposition. The two leading Democratic Party presidential candidates, Hillary Clinton and Bernie Sanders, oppose the TPP as well as the leading populist Republican candidate Donald Trump. It remains to be seen if the US will ratify the TPP.

The degree of domestic US opposition will both determine whether TPP is ratified and hamper further US attempts to extend the present restrictive framework of the TPP. It creates a new situation whereby the interests of China, and the people of other Asia-Pacific countries, are aligned with those of strengthening forces within the US opposing the TPP.

As regards tactics within this overall framework, in addition to China promoting Free Trade Agreements and the RPEC the institutions the TPP imposes on participating economies, and the rights the US and its companies acquire to override participating countries governments, will inevitably lead to rising opposition in TPP participating countries as well as locking them into slow growth. This will necessarily lead participating countries to seek free trade and other agreements with non-TPP members such as China whose economies are undergoing more rapid growth.

Finally, it should be clearly understood that the US strategic aim is not to exclude China from the TPP. Indeed this would defeat the TPP’s purpose as China would then not be subject to TPP constraints which slow other economies. If China remained among more rapidly growing economies outside the TPP this would inevitably lead to other countries seeking agreements with China. The aim of the US is therefore to negotiate with China at a later date. But the intent of the US is to attempt to impose rules on China that would limit China’s growth and therefore ensure it did not achieve prosperity.

Assuming that the TPP is finally ratified then China’s interests, and those of other countries, therefore lie in allowing it to be clearly shown over a period that the TPP will not work to enhance growth. This will then give China the choice, depending on the circumstances, of either negotiating agreements with individual TPP members as part of its RPEC strategy, or negotiating a more general revision to remove the more damaging features of the TPP and to allow China to participate in a wider agreement aimed at more rapid economic development.

But therefore at the APEC summit both politics and global governance, as well as the prosperity of the entire Asia-Pacific region is involved in the different approaches of China and the US. The Asia-Pacific can either adopt the road of maximum prosperity involved in China’s ‘community of common destiny’ or it can accept the economic slowdown, and consequent lower living standards, necessary to seek to preserve the US’s economic supremacy. This is the key economic framework for issues to be discussed at the APEC summit. Given the magnitude of these questions they will not be finally resolved there but will dominate the Asia-Pacific region for several years to come.

China's Five Year Plan to achieve a 'moderately prosperous society'

Western media analysis of the Communist Party of China (CPC) Central Committee Plenum to consider the outlines of the 13th Five Year Plan was dominated by discussion of the possible GDP growth rate to be set, while immediate news reports focused on replacement of the "one child" family planning policy with a "two child" one. Chinese commentary, in contrast, focussed in a more rounded fashion on the plan's goals for living standards together with social and environmental conditions. This was also the main emphasis specified by the CPC's official goal of achieving a "moderately prosperous society in all respects" by the plan's end in 2020.

It is important to understand why China's, not the Western media's, view of the Plan is correct. Analyzing this also simultaneously clarifies some Western economists' error in saying China does not need Five Year Plans and that a target for GDP growth should be abandoned.

The central economic target of the new plan, around which its key parameters are constructed, is China's goal of doubling the income, and therefore potential consumption, of both its urban and rural population in 2010-2020. This requires essentially similar GDP growth.

But achieving a "moderately prosperous society" includes not only a target for income and consumption but also development of education, health, environmental improvement and other strategic factors. Implementation of the 13th Five Year Plan is intended to constitute the first key milestone in China's overall development as reiterated by Xi Jinping: "We have set the goals of completing the building of a moderately prosperous society in all respects by the centenary of the CPC in 2021 and building China into a modern socialist country that is prosperous, strong, democratic, culturally advanced, and harmonious by the centenary of the PRC in 2049 so as to realize the Chinese Dream of the rejuvenation of the Chinese nation."

In this overall framework a GDP growth target is significant - but as a means and not an end. Achieving GDP growth, in conditions in which China's economy is far more developed than previously, does directly determine the Plan's new economic priorities such as advanced manufacturing, innovation, integration of the internet with other economic sectors and use of "Big Data." But economic growth is simply the Plan's indispensable means to achieve broader human and national goals.

To understand this link between economic development and overall social goals, it should be understood that per capita GDP growth is not socially neutral nor primarily desirable because it results in outputs such as steel and cement. The key point is that per capita GDP growth is highly correlated with extremely desirable human goals such as rising life expectancy, increasing consumption, and improving health and education. Therefore only by closing its gap in per capita GDP with the most developed economies can China achieve the best possible all round living standards for its population.

To illustrate in fundamental terms how economic targets in the new Five Year Plan are correlated with social goals, consider life expectancy - which is the most sensitive indicator of human well-being as changes in this "sum up" the consequences of positives and negatives in overall economic, social, and environmental conditions. Internationally 73 percent of differences in life expectancy between countries are accounted for by per capita GDP differences. Therefore rising per capita GDP produces direct and indirect improvements in social conditions and is why the new Five Year Plan sets the goal of doubling income. It is also why China correctly continues to target a moderate to high growth rate.

But the new parameters created by China's development towards a "moderately prosperous society" substantially affect the new Five Year Plan. Under previous plans China made history's greatest achievements in overcoming poverty. It is staggering fact that since 1981, on World Bank data, China reduced the number of people living in internationally defined poverty by 728 million, while the whole of the rest of the world only achieved 152 million. It remains one of the most important goals to be accomplished during the 13th Five Year Plan that, as Xi Jinping announced, China will lift the final nearly 100 million people from poverty in the country.

But this gigantic historical achievement necessarily creates new challenges. When the decisive task facing China was to overcome low living standards the delivery of essentials such as housing, food and basic products was dominant and almost sufficient. International studies confirm that over 80 percent of increases in a population's consumption are due to GDP increases. Therefore, because economic growth's role in overcoming low living standards is decisive, almost everything became subordinated to it even when, for example, this resulted in environmental damage or unacceptable social inequality. But the social, cultural, environmental and other needs of a population which is achieving "moderate prosperity" are vastly more developed and complex.

There can be direct clashes between GDP growth and human well-being. For example highly polluting factories or power plants are cheaper than those which protect the environment, and can therefore be built more cheaply increasing GDP growth. Under new conditions, with China approaching its goal of eliminating poverty and low incomes, the necessary means of GDP growth remains extremely important but must be subordinated to overall human well-being - the goal. This is why as Hu Angang, one of China's leading economists and an adviser on drawing up the new plan, put it: "In the process of China's reform and opening-up, the five-year plan has been remade… it has become a program for human development, or citizens' needs in all aspects."

Western media failures to admit China's historically unprecedented success in overcoming low incomes means it inaccurately focuses solely on growth rates or individual issues such as the "one child policy" - a classic case of "being unable to see the wood for the trees." In contrast China's analysis of the new plan's role in achieving a "moderately prosperous society in all respects" is spot-on in its framework.

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This article originally appeared at China.org.cn.

Facts confirm that liberalising China’s capital account is dangerous

For some time a debate has been taking place between economists pointing to the dangers of rapid liberalisation of China’s capital account, such as Yu Yongding and internationally Joseph Stigliz, and those supporting it. Recent negative events affecting China’s economy clearly confirm that those opposing rapid liberalisation of the capital account were correct. But it is crucial to understand the reasons for these current trends not only from an immediate but from a fundamental economic viewpoint.

Current trends affecting RMB internationalisation

In superficial terms two apparently contradictory trends regarding RMB internationalisation recently occurred. First, in a positive development, the RMB overtook the yen to become the fourth most used currency in international payments. Second, clearly negative trends developed related to China’s position in the international economy. China’s foreign exchange reserves fell by almost $500 billion in only just over a year, from slightly under $4 trillion in June 2014 to $3.5 trillion in August 2015, international analysts point to clear evidence of exit of capital from China unconnected to fruitful investment, and the small two percent RMB devaluation in August sent shock waves through the global economy and was followed by further losses to China’s foreign exchange reserves to attempt to stabilise the currency.

But the apparent contradiction between these ‘positive’ and ‘negative’ trends is only apparent. Both reflect fundamental features of China and the international economy. If RMB internationalization is pursued as a very gradual and organic process this produces positive trends. If unnecessary forced attempts to internationalise the RMB are made, particularly if these are made in pursuit of other agendas, these can be significantly dangerous to China’s economy. Examination of the experience of other countries and of economic theory explains clearly the processes taking place.

Place of the RMB in international payments

Starting with the facts, Figure 1 shows the RMB’s place within global payments system. The dominance of the dollar and the RMB’s peripheral position is clear. The dollar accounts for 44.82% of international payments. Dollar dominance becomes even clearer if it is understood that the 27.20% figure for the Euro is very artificially boosted by its use for payments within the Eurozone – an economy which is internationally divided but only approximately the size of the US. If Euro payments within the Eurozone were excluded, as are dollar payments within the equivalent size US economy, the true global dominance of the dollar would be still greater.

The dollar’s role has also risen further in the recent period – its percentage use in international payments increasing from 38.8% in January 2014 to 44.8% in August 2015, while the Euro’s share fell from 33.5% to 27.2%.

Turning to the RMB, global payments in dollars are 16 times greater than the RMB’s 2.78%, and payments in dollars and euros combined are 25 times greater than those in RMB. Talking of the RMB being ‘in fourth place’ in international payments behind the dollar, without stating the gap between the two, may be correct but is substantially misleading because it distorts the correct sense of scale - there is no comparison between the position of the dollar and the RMB in international payments, and in these terms the RMB is a very minor currency compared to the dollar.

Figure 1

 

RMB internationalisation and trade

This gap between the dollar and the RMB becomes still clearer, and the explanation of the apparently contradictory economic trends referred to earlier becomes evident, if it is understood that the RMB is primarily used internationally in relation to China’s trade – functioning as a useful ‘hedge’ against currency fluctuations. By April 2015 31% of payments between China (including Hong Kong) and the Asia-Pacific region were in RMB – which primarily accounts for the RMB’s 2.78% of global payments. Such trade operations make limited overseas accumulation of RMBs necessary, and are a soundly based and healthy development reflecting China’s position as the world’s largest goods trading nation. They require, as has been allowed, convertibility of the RMB for current (including specifically trade) transactions.

But aside from this useful function the RMB’s role in international payments is still peripheral and for fundamental reasons analysed below cannot be substantially expanded rapidly. For example by the end of 2014 63% of all countries foreign exchange reserves were in dollars, 22% in Euros, and only 1% in RMBs.

It is sometimes argued that the RMB’s international role is certainly currently small but it is increasing and could grow rapidly, for example, if later this year the IMF during its regular review includes the RMB in the currency basket for its Special Drawing Rights (SDRs).

But this argument confuses holding reserves for the purpose of current operations (including trade) with holdings for capital transactions – including official foreign exchange reserves. The RMB certainly should be included in the SDRs basket of currencies due to China’s position as the world’s second largest economy, at current exchange rates, and the world’s largest goods trading nation. But this will not change anything fundamental in terms of international payments. SDR’s are not a currency nor a claim on IMF funds – they are only a claim on IMF member’s currencies. SDR’s can essentially only be part of countries’ foreign exchange reserves, and constitute less than 3% of their total. In practical terms SDR’s are essentially only an accounting unit, playing virtually no role in actual transactions.

Fundamental features of the monetary system

Confusion on the difference between the requirements for trade and other current transactions, compared to those for establishing the RMB as a major international capital unit, have created destabilising calls for too rapid liberalisation of China’s capital account. These can be best understood by looking at the most fundamental features of the international monetary system.

Economic theory, fully confirmed by the experience of other countries, shows that liberalisation of China’s capital account will not lead to a balanced flow of funds in and out of China, but only to large scale exit of capital from China. This would reduce China’s economic development via simultaneously decreasing funds available for investment in China and raising interest rates, and leading to further falls in China’s foreign exchange reserves if currency interventions are made to try to prevent the RMB’s exchange rate declining faced with these capital outflows.

The reason why in the absence of capital controls there will only be a net one way flow of funds out of the RMB and into the dollar is rooted in the most fundamental features of the monetary system.

All markets, including the global economy, can only operate with a single price standard which requires a single price unit. Money is fundamentally different from all goods and services. A market economy necessarily can only operate according to the ‘law of one price’ – i.e. it operates to produce a single price across a market (once transport and other transaction costs, tariffs and other legal barriers etc are taken into account). The reason for this ‘law of one price’ is that the existence of different prices for the same product entails an ability to make profit by utilising these, and therefore arbitrage operations will develop to exploit such differences - thereby eliminating this profit and ensuring the tendency for a product to be sold at a single price.

But a single price necessarily requires a single price standard – which is its monetary unit. If more than one price standard operated then arbitrage between different prices would either eliminate these differences, creating in reality if not in name a single measuring unit, or if different price standards existed fundamental instability would make it impossible for the market to function efficiently. An efficiently functioning economy therefore can only have a single universal price unit – prices cannot be set 20% by one monetary unit, 35% by another monetary unit, 45% by another unit etc. Consequently no mature country can nor does function with different currency units operating within it.

For exactly the same reason if any attempt were made to introduce different units for measuring international prices then either arbitrage would bring them into a single system, de facto creating a single international currency unit, or the market could not function – different markets with different national currency systems would then have to be prevented from meaningfully interacting. But as international division of labour is one of the most powerful forces increasing economic development any strong limits on different countries economically interacting would produce a huge regression of the productive forces – as was practically confirmed during the only modern peacetime period when such disruption of the international payments system occurred, the 1930s Great Depression.

Demand for the dollar

This necessity of a single price standard in turn determines the demand for foreign currencies, including for foreign exchange reserves. A relatively few individual companies seek to profit from relative movements in currencies, but globally this is a peripheral activity. The goal of most foreign exchange holdings is to possess the unit used to price international transactions – which is the dollar. This is the goal of central banks’ foreign exchange reserves but also the safest form of fundamental currency hedging by companies. Consequently if countries’ capital accounts are liberalised the net flow is always into dollars – as factual global experience since international capital account liberalisation began seriously in the late 1970s confirms.

The fundamental reason the US supports, and strongly presses, for liberalisation of capital accounts is precisely because of this one way net flow of funds into dollars. By the 1970s the US balance of payments passed into a sustained and large deficit which has continued to the present - reflecting a decline in US competitiveness. Attempts to restore US competitiveness by dollar devaluations in the 1970s, however, created political instability due to the reduction in the living standards of the US population this created – Nixon was forced from office in 1974 and Carter lost the election of 1980. The only way for the US to simultaneously run a balance of payments deficit, which other things being equal would lead to dollar devaluation, while preventing that devaluation occurring is to find a source of capital inflows into the US.

Pushing for liberalisation of capital accounts on a global scale was the US means to secure this solution to its combined economic and political problem. Given the fundamental structure of the international monetary system already demonstrated liberalisation of capital accounts necessarily created a one way net flow of funds into the dollar which has continued until the present.

The essential role of capital account liberalisation is therefore to ensure a net flow of funds from other countries into the dollar, thereby solving the US problem of having an internationally uncompetitive economy, shown in a balance of payments deficit, while avoiding the political unpopularity in the US that results from dollar devaluation.

History of the international monetary system

This fundamental theoretical economic principle that the international economy, like any market, must operate according to a single price standard is entirely confirmed by hundreds of years of operation of the global market. Although the world economy, the most complex market, has developed for several centuries during this prolonged historical period only two systems of international payments have existed. The first, from near the origins of the global market until 1931, punctuated by only a short interlude, was the gold standard. The second, from 1945 until the present, was the dollar standard. The only periods in which neither system functioned, the immediate post-1914 period and from 1931-1945, were marked by the most cataclysmic crises in the global economy’s history – the two World Wars.

The fact that there can only be a single price standard also necessarily determined that the transition from the gold standard to the dollar standard took place in historical terms almost instantaneously - the interregnum between the two was marked by the greatest disorder and conflicts in world history, and that the two systems did not overlap in time as it was impossible for two price standards to exist simultaneously.

The US, of course, understands that due to these fundamental economic forces liberalisation of capital accounts could also be a powerful tool for subordinating other countries policies to the US. This can be attempted even for what are in practice relatively small changes. Bloomberg, an overtly US neo-con publication, tried to argue: ‘To win the SDR prize, China will have to press on with plans to open its capital account - a reform that stands to shake up industries and the way Chinese companies do business.’ Martin Wolf , Chief Economics Commentator of the Financial Times, noted: ‘If China’s capital account were to be fully liberalised, the government would lose its grip on the most effective of all its economic levers.’

China cannot cheat on or be an exception to these fundamental economic laws. It is for this reason that as China moved to liberalise its capital account the data shows destabilising movements out of the RMB into dollars began.

China’s foreign exchange reserves should have been increased by China’s trade surplus rising sharply from $306 billion in the year to August 2014 to $540 billion in the year to August 2015. But instead of rising data shows China’s foreign exchange reserves fell at a rate much faster than was caused by productive Foreign Direct Investment (FDI) outflows. During 2015 China’s foreign exchange reserves have fallen by an average $36.5 billion a month and the rate of decline has risen sharply – August’s fall was $94 billion. This demonstrates large scale capital outflows are taking place with negative consequences for China’s economy.

The reasons for the trends noted at the beginning of this article are therefore clear, as is also why their ‘contradictory’ nature is purely apparent. The positive effects of the RMB’s use in relation to international trade has led to it organically becoming the fourth largest currency for international transactions – a healthy process which should be allowed to continue via RMB convertibility for current transactions. But failure to accurately recognise the nature of the international capital system, which can only create flow of into dollars, has led to overhasty relaxation of capital controls with negative effects for China’s economy.

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This article was originally published in Chinese by Sina Finance.

Xi Jinping's visit to Britain - bases for a real & not only formal 'win-win' relation

This article originally appeared at China.org.cn.

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Xi Jinping's state visit to Britain from October 19 to 23 is important in itself, clearly illustrates the basis for mutually beneficial relations between different countries and shows principles for overcoming problems between states.

There are striking differences between China and Britain. China has the world's largest population, the world's largest economy in Parity Purchasing Powers (PPPs), and is a country increasing in global weight and clearly only at the beginning of its rise. The UK has approximately one-twentieth the population of China and a significant economy although outside the 'superheavyweight' league of the US and China - its GDP being 10th in the world in PPP terms.

For many centuries Britain was the world's largest economy and most powerful state, but this position has been taken by the US and increasingly by China. Thanks to Britain's long period of development it retains a standard of living China is still growing towards – Britain's per capita GDP in PPPs is almost three times as high as China's.

However, it can be not national similarities that can create the most fruitful interaction but differences. Xi Jinping's visit will illustrate that.

Starting with the economy, China has become the world's industrial producer, the largest goods trading nation and runs a large surplus on manufactured trade. Britain has undergone one of the world's sharpest declines of manufacturing as a proportion of its economy and has been running deficits on manufactured trade for decades; however, it has a large trade surplus in financial and other services.

Even within manufacturing the contrast is striking - Britain's remaining manufacturing sector is concentrated in very high value added products, such as pharmaceuticals, while China is the world's most competitive producer of an increasingly broad range of manufactured products. The result is the two economies are complementary and vividly illustrate the international trade principles of division of labour and comparative advantage.

Due to these complementary features the economic interaction between the two countries is dynamic. Britain is China's second largest EU trading partner, while China is Britain's fourth largest trading partner. Britain is the second largest recipient of China's foreign investment within the EU and the second largest EU investor in China. Trade between the two countries in 2014 rose by 15 per cent.

The UK now sees opportunities to use its position in global financial services to win Chinese business. London is the world's largest foreign exchange dealing centre - bigger than New York and Tokyo combined. This puts London in a strong position to help establish the RMB as an international currency, a development also in China's interest. It is reported London will become the first centre outside China in which Chinese government RMB denominated debt will be issued.

China is highly interested in using its expertise and finance to invest in UK infrastructure projects. Over a fifth of Britain's power generation capacity will be replaced in the next decade, and on a recent trip to China British Chancellor of the Exchequer George Osborne announced opening of bidding for the country's projected $17 billion High Speed Two rail link - contracts potentially of great interest to China which now has the world's largest high speed system.

The opportunities for cultural, educational and 'people to people' exchanges are also enormous. Shakespeare, Agatha Christie, Harry Potter and other classic and modern British icons are well known known cultural imports in China. Britain's knowledge of modern Chinese culture is not yet as good as it should be, but enormous queues for exhibitions such as the British Museum's exhibition of the Xi'an terracotta warriors show deep interest in Chinese classical culture, while China's rise will produce increasing knowledge of China's modern achievements. More Chinese students study in British universities than from any other foreign country, for example.

Unfortunately a few years ago these potential benefits were blocked by ill-judged moves by Britain. Prime Minister David Cameron held a meeting with the Dalai Lama – a person pretending to be a purely religious figure but who actually leads a separatist political movement. This was an intervention in China's internal affairs and contrary to Britain's unequivocal recognition of Tibet as part of China. It was rather like de Gaulle's notorious 'Vive Le Quebec Libre!' declaration regarding Canada. This naturally led to a frost in relations – China refusing to hold high level meetings for over a year.

Both sides lost from this, but as China is a rising economy Britain lost more. Fortunately the British government reversed this approach and no further meetings have been held, and relations warmed. David Cameron visited China earlier this year and on his recent visit George Osborne declared Britain wanted to be China's 'best partner in the West.'

Now, Britain is doing everything possible to overcome previous problems in relations and China has responded. Both sides gain.

From going through a difficult period China-Britain relations currently are a model of how countries should interact. Regarding cultural and human interaction the situation was very accurately observed by China's President:

'Civilizations are equal, and such equality has made exchanges and mutual learning among civilizations possible… No single civilization can be judged superior to another… Every civilization is unique…. All achievements of civilizations deserve our respect and must be cherished. History proves that only by interacting with and learning from others can a civilization enjoy full vitality.'

Fortunately these principles currently inform British-China relations - to the benefit of both countries.

What are the driving forces of US economic growth? Economic background to Xi Jinping’s US visit

The following article was written for the Chinese media as economic analysis of Xi Jinping’s visit to the US. However it also demonstrates that capital investment is the key source of US economic growth. It originally appeared at China.org.cn.

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Chinese President Xi Jinping's forthcoming state visit to the U.S. offers an opportunity to understand the great potential for mutually beneficial economic relations between the two countries. This goes well beyond them being the world's two largest economies to revealing their fundamentally complementary economic character.

Analysing their most fundamental economic features demonstrates this clearly, and helps explain why China-U.S. economic relations can be stable and mutually beneficial for decades to come. It also shows why the anti-China attitude of American neo-conservatives damages not only China, but also the U.S.

In 2014, China-U.S.trade, standing at US$650 billion, was the largest between any two countries in the world outside the North American Free Trade Area (Canada, Mexico and the U.S.). For the U.S. it was second only to trade with Canada – the latter now being almost a domestic base for U.S. production.

In the period 2007-14, namely, since the beginning of the global financial crisis, U.S. trade with Canada increased by US$121 billion, but that with China increased by US$237 billion.

The driving force of such rapid trade expansion goes beyond them being the world's two largest economies to the fact that China is by far the largest developing economy, while the U.S. is the world's most advanced economy. They complement each other rather than directly compete.

Measured at current exchange rates, preferred by China, it is the world's second largest economy. Measured in terms of Purchasing Powers Parity (PPPs), as many Western economists prefer, China is the world's largest economy. Whichever you use, the productivity gap between China and the U.S. remains huge.

At current exchange rates, China's per capita GDP is 14 percent of the U.S., while in terms of PPP, it is 24 percent. The fact they are at very different productivity and wage levels, means China provides a gigantic market for U.S. high value added products, while China can supply medium technology products at prices the U.S. cannot match due to its far higher labor costs.

If the latest year's growth rate of per capita GDP for the two countries were maintained, 6.8 percent for China and 1.6 percent for the U.S., China would not be able to reach U.S. per capita GDP until 2043.

The reason this gap cannot be closed rapidly is also clear. Contrary to neo-liberal myths, the U.S. economy is essentially powered by capital investment. Analysed in fundamental terms, an economy's sources of output and growth can be divided into capital investment, labor input and Total Factor Productivity (TFP) – the latter measuring the effects of economic policy, improvements in technology etc.

Using the latest statistical methods of international economic agencies such as the OECD, Figure 1 shows that capital investment accounted for 51 percent of U.S. economic growth in 1990-2014, while capital and labor inputs together accounted for 75 percent. Only when it can match U.S. input levels, above all capital investment, can China achieve a U.S. level of development and productivity.

In 2013, China's annual fixed investment per person was US$3,199 compared to the U.S. figure of US$10,017.

To take another example, in 2012, the latest available data, there were 15 km of railway track per person in the U.S. compared to 1 km per person in China, a big factor in the productivity of the logistics system.

It is, therefore, impossible for China to close the gap in capital inputs to reach U.S. levels in the short to medium term. Even if China adopts brilliantly flawless policies, it will not reach U.S. levels of productivity for decades. Equally, even a U.S. economic collapse on the scale of the Great Depression, which will not occur, would not reduce U.S. investment per person and wages to the Chinese level.

As China is by far the world's largest developing economy, the U.S. will also not find any alternative comparable source of supply to China for price-competitive medium technology products.

It can, therefore, be predicted with certainty that, in 10 years' time, when the presidents of China and the U.S. meet, these fundamental parameters will be unchanged – U.S. productivity will still be higher than China's and the two economies will still be fundamentally complementary. The stability of such fundamentals offers a firm foundation for mutually beneficial relations.

China certainly loses by any restrictions on exports of U.S. high value products, but equally neo-conservatives, by limiting trade with China, simply drive up costs for U.S. consumers – and therefore drive down U.S. living standards.

Restrictions of trade between the world's two largest economies also have negative economic consequences for other countries as they slow overall world growth and create a "lose-lose" scenario, for everyone. The stable economic basis of China's concept of a "new model of major country relations" is a win-win for the people of China, of the U.S. and of third countries which results from trade and investment between mutually complimentary economies.

Xiaomi or Apple - two innovation strategies for China

 

‘Innovation’ will be key for China’s economic strategy for several decades. Therefore clarity on this issue is vital. However some discussion of innovation in China fails to understand the core of this issue, imagining that its key is matters such as ‘greater creativity in schools’. In particular such discussion does not distinguish between two fundamentally different types of innovation. The first is ‘cost innovation’ – the use of technology, managerial strength, etc. to reduce costs. The second is ‘product innovation’ – the introduction of entirely new products such as the iPhone, iPad, iWatch etc. This article analyses why ‘cost innovation’, not ‘product innovation,’ will be the key for China for the next several decades. Two extremely successful smartphone companies, the US’s Apple and China’s Xiaomi, will be used to illustrate the general principles.

To understand different innovation strategies in fundamental economic terms, it should be noted that as productivity increases there are two ways to translate this into competitive advantage:

• The same product can be produced at a cheaper price.

• The price can be kept the same and a superior product produced.

Apple is currently the world’s clearest example of the second strategy. Apple’s general policy does not reduce prices on new products - when it has done so, as with the cheaper iPhone 5c, they have generally been a failure. Apple’s strategy is to continuously produce greatly improved, best of all entirely new, products – the iPod, iPhone, iPad etc. This strategy of ‘maintain the price, raise the quality’, is therefore accurately termed ‘product innovation.’

Xiaomi is an outstanding example of the other strategy, ‘cost innovation’. Xiaomi is the world’s most valuable start-up with a value of over $40 billion. Xiaomi does engage in some product innovation - Xiaomi’s use of social media, its timing of product releases etc is superior to Apple. But the fundamental competitive advantage of Xiaomi is price and value. Xiaomi produces a product which in quality is comparable to the iPhone but for less than half the price. The outstanding value proposition of Xiaomi is of quality which is 90% or more of the iPhone for less than 50% of the price.

Success in this strategy does rely from an engineering standpoint on the quality of the product. If the quality of Xiaomi’s phones was only 50% of Apple’s then, even selling at 50% of the price, it would have no competitive advantage. It is only because a Xiaomi phone does deliver more than 90% of the functionality of an iPhone for less than 50% of the price that Xiaomi has a competitive edge. But this does not alter the fact that the fundamental advantage of Xiaomi over Apple is cost not a better product. Xiaomi exemplifies innovation in keeping costs down, ‘cost innovation’, not innovation in producing a superior product – ‘product innovation’.

This difference determines the strategy of the two companies - including marketing. Xiaomi’s style of launching products is similar to Apple – even to the type of clothes of Xiaomi’s CEO Lei Jun resembling those of Steve Jobs. This led to foolish Western criticism of Xiaomi, but in reality it illustrates Xiaomi’s strong strategic sense.

If a company’s strategy is product innovation emphasis must be on how different its product is to any previous one. The classic visual expression of this was the advert announcing Apple’s Macintosh computer at the 1984 Super Bowl - the most famous single advertisement ever. This showed a woman in brightly colored clothes smashing the grey images of a uniform totally regimented society – a visual interpretation of the message ‘the Macintosh is like no other computer before, it is vastly more individual and creative.’

But if the strategy is cost innovation then, in competition in relatively advanced technological products such as smartphones, marketing strategy must be on how similar the cheaper product is to the more expensive one - ideally there should appear to be no difference except price.

The reason for this is that the immediate suspicion of any customer who sees a product only 50% of the price of another is that this is because it is only 50% of the quality! Therefore everything must be done to convince the customer that the quality of the cheaper product is the same as the more expensive one.

Far from Xiaomi to be criticized for the similarity of its product launches to Apple it illustrates the company’s strategic strength – everything about a Xiaomi phone is as good as an IPhone but the price is 50% cheaper.

This explains the branding rationale for Xiaomi’s ‘high quality parties’ for key customers, skillful use of social media etc. It is to maintain the product’s image of high quality - ‘as good as Apple’. Xiaomi’s fatal weakness in marketing would be any suspicion lower price was due to lower quality.

But if Xiaomi’s marketers job is to maintain the high quality image, its engineers job is to keep the price down while maintaining the quality. Xiaomi’s huge success rests on two different strengths: the excellence of its branding in projecting an image of product quality, the excellence of its engineers in ensuring that the product really is of high quality. But the overall strategy remains ‘cost innovation’ – Xiaomi is not fundamentally attempting to produce a better product than the iPhone, it is attempting to produce a product as good as the iPhone at a much cheaper price.

The reason only ‘cost innovation’ can be the foundation of such a successful strategy as Xiaomi’s is because China is no longer a low wage economy. The Economist calculates China’s average factory worker earns $27.50 per day, compared with $8.60 in Indonesia and $6.70 in Vietnam – China’s manufacturing wages are three times as high as Indonesia’s and four times as high as Vietnam’s. China therefore cannot compete on price through low wages, instead it must rely on keeping price down through innovations in technology, management, logistics etc.

This contrast between Xiaomi and Apple exemplifies the necessary strategic direction for innovation in China economy as a whole over the coming period. This is because which innovation strategy is more effective cannot be separated from the overall level of a country’s economic development.

China’s per capita GDP in 2014 in IMF Parity Purchasing Powers (PPPs) was 24% of that of the US. This means, in approximate terms, that the productivity of China’s overall economy was slightly under one quarter of that of the US. Even with the most correct policies in China, and despite the recent overall slowing of the US, it will evidently take China several decades to close that gap. Therefore for several decades China, on average, will be behind the ‘technological frontier’ set by the most productive and advanced economies.

As China will be behind the technological frontier in the majority of economic sectors, it is utopian and unnecessary to believe it will be able to carry out Apple’s strategy of maintaining the same price, or raising it, but producing a superior product. By definition this generally means expanding the technological frontier – which China will not be able to achieve. Instead China’s strategy must necessarily be cost innovation - to produce the same, or more precisely a qualitatively comparable, product but at a lower price.

Xiaomi is therefore so successful because it has a very skillfully executed strategy in line with China’s economic fundamentals. The alternative strategy, ‘product innovation’, the attempt to compete by producing a phone which is qualitatively better than the iPhone could not succeed in China.

To avoid misunderstanding it should immediately be clarified that this is an average. It does not mean China cannot introduce any new products, and China’s companies have become extremely skilled at incremental improvement even of leading products. It merely entails that product innovation cannot be the dominant form for China’s successful competition.

To illustrate this historically China's per capita GDP in 2013 was 21% of that of the US - the ‘technology frontier’ economy. This is equivalent, relative to the US, of the position of Japan in 1951 or South Korea in 1982. At those times, Japan and South Korea, as with China today, were no longer dominated by agricultural populations but had evolved into upper middle-income economies. In the next decade after these dates, Japan and South Korea led the world in steelmaking, shipbuilding, construction equipment and similar mid-technology industries - exactly industries where China is becoming dominant today. But Japan and South Korea at that time were not equaling the US in ‘product innovation’, due to the huge gap in per capita GDP, and it is similarly utopian to believe China can.

The outstanding successes among China’s companies – to take only a few examples Huawei, Wanxiang, CIMC, Xiaomi – are by those which have mastered cost innovation. This is because they have combined innovatory skill with China’s macro-economic fundamentals.

China’s rising wages mean innovation is the key to its economic development. But China’s macro-economic fundamentals determine that it will be ‘cost innovation’ not ‘product innovation’ which will be decisive for China’s companies for several decades.

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This article originally appeared at China.org.cn.

How Singapore achieved a higher per capita GDP than the US

The economic development of Singapore under the leadership of Lee Kuan Yew and those with whom he worked is famous as one of the greatest success stories in history. Singapore has become the only Asian country to achieve a higher per capita gross domestic product than the United States by every measure. To have achieved this from the starting point of a third world country, and during a single lifetime, is a true Asian "economic miracle" meriting close study by every country, and above all by every developing country. This naturally includes China. What, therefore, were the fundamental mechanisms explaining Singapore's stunning economic success?

To start with the facts, by 2013, the latest year for which World Bank data is available, Singapore's per capita GDP was 104 percent of that of the U.S., calculated at current exchange rates. Calculated at Parity Purchasing Powers, Singapore's GDP was 148 percent of that of the U.S. This after Singapore's per capita GDP was less than one quarter that of the U.S. in terms of PPPs - and less than one sixth measured at current exchange rates - when it achieved independence in 1965.

Figure 1

 

In obituaries of Lee Kuan Yew and during his lifetime, emphasis has been placed on his "authoritarian" politics or his espousal of "Confucian values," but what in strictly economic terms was the basis of Singapore's sensational success? Obviously, this is the topic of greatest interest to every developing country. If China could achieve Singapore's level of per capita GDP, higher even than that of the U.S., the "Chinese Dream" of economic development would be more than achieved. What lesson, therefore, can China and every country draw from Singapore's "economic miracle?"

Singapore was a classic example of the success of an "open economy:" Singapore's total trade is indeed considerably higher than its GDP. This is, of course, in line with the ideas behind China's "opening up" policy. But every study shows that Singapore's domestic development was based overwhelmingly on the huge accumulation of capital and labor, with only a tiny contribution coming from productivity growth (technically known as Total Factor Productivity, or TFP).

This reality was first noted in the 1990s by the United Kingdom-based economist Alwyn Young. His finding was used by U.S. economist Paul Krugman in a famous 1994 paper entitled "The Myth of Asia's Miracle" to predict Asia's coming economic failure. Krugman argued that successful economic growth should be based on productivity development, not on accumulation of capital and labor. But, of course, it was Krugman who was proved wrong as Singapore's per capita GDP overtook even that of the U.S.

Young's finding has since been replicated by every major study of Singapore since. The latest, by Vu Minh Khuong of the Lee Kuan Yew School of Public Policy at the National University of Singapore, is summarized in Figure 2 below. This study found that 59 percent of Singapore's economic growth came from capital investment, 34 percent from growth of labor inputs, and only 8 percent from productivity (TFP) increases.

Figure 2

 

In short, every study has found that Singapore's achievement of the highest level of economic development in Asia - a higher level of per capita GDP than the U.S. - was based on massive accumulation first of capital and then of labor, with productivity growth playing a tiny, almost non-existent, role.

Vu, in the most exhaustive study of the subject so far, also found that Singapore's model corresponded to successful economic development in Asia in general. Successful Asian developing countries showed a pattern of economic growth fundamentally driven by capital accumulation. As Vu summarized, "The secret of the Asian growth model lies not in achieving high TFP growth but in sustaining reasonable TFP growth despite the intensive mobilization of factor inputs over extended periods."

As Dale Jorgenson of Harvard University, whose work has led to the most modern official methods of calculating the sources of economic growth by the OECD and other international agencies, put it, "The emergence of Asia from the underdevelopment that persisted until the middle of the last century is the great economic achievement of our time. This has created a new model for economic growth built on globalization and the patient accumulation of human and non-human capital. Economic commentators, especially those outside Asia, have been reluctant to recognize the new paradigm for economic growth that originated in Asia, since this would acknowledge the failure of Western ideas that still greatly predominate in the literature on economic growth and development."

Indeed, a key reason for Singapore's economic success was that its pattern of economic development corresponded - even more than most Asian economies - to that of a developed economy, with its overwhelming dominance by capital accumulation and labor inputs and the small role played by TFP growth. This can be seen clearly from comparing the data for Singapore with that for advanced economies shown in Figure 3.

In advanced economies as a whole, 57 percent of growth is due to capital investment, while in Singapore that figure is 59 percent. In advanced economies, 32 percent of growth was due to labor inputs, whereas 34 percent of growth in Singapore was due to labor inputs. Furthermore, 11 percent of growth in advanced economies was due to TFP increases, and in Singapore it was only 8 percent.

In short, Singapore's pattern of growth was essentially the same as that of an advanced economy, which is largely the reason why Singapore has achieved the per capita GDP of an extremely advanced developed economy.

Figure 3

 

To put it in blunt but accurate terms, Lee Kuan Yew showed through Singapore's economic development that quantity was far more important than quality in achieving a higher level of per capita GDP than the U.S.

This is indeed a crucial lesson for China and for every developing country to study as they seek to replicate Singapore's success and approach the level of advanced economies.

References

Young, A. (1995, August). The Tyranny of Numbers: Confronting the statistical reality of the East Asian growth experience. Quarterly Journal of Economics, 110, 641-680.

Krugman, P. (1994). The Myth of Asia's Miracle. Foreign Affairs, 62-78.

Vu, K. M. (2013). The Dynamics of Economic Growth: Policy insights from comparative analyses in Asia. Cheltenham, U.K. and Northampton, M.A., U.S.: Edward Elgar.

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This article originally appeared at China.org.cn.

The fundamental economic lesson from Lee Kwan Yew

Under the leadership of Lee Kwan Yew, and those with whom he worked, Singapore became the only country in Asia to achieve a higher per capita GDP than the US by every measure.

Calculated at current exchange rates by 2013, the latest World Bank data, Singapore’s per capita GDP was 104% of the US. Calculated at Parity Purchasing Powers (PPPs) Singapore’s GDP was 148% of the US.

Figure 1

 

Emphasis has been given to Lee Kwan Yew’s ‘authoritarian’ politics but what was the fundamental basis of his economic success? What lesson can be drawn from Singapore’s ‘economic miracle’?

Every major study shows that Singapore’s development was based overwhelmingly on accumulation of capital and labour - with only a tiny contribution coming from productivity growth (technically from Total Factor Productivity - TFP).

This was first found in the 1990s by the UK based economist Alwyn Young.¹ This finding has been repeated by every major study since. The latest, by Vu Minh Khuong of the Lee Kwan Yew School of Public Policy of the National University of Singapore is shown in the chart. It found that of Singapore’s economic growth 59% came from capital accumulation, 34% from growth of labour inputs, and only 8% from productivity (TFP) increases. ²

Figure 2

 

In short every major study finds that Singapore achieving the highest level of economic development in Asia, a higher level of per capita GDP than the US, was based on massive accumulation first of capital, and second of labour, with productivity (TFP) growth playing a tiny, almost no, role.

To put it in blunt but accurate terms, Lee Kwan Yew showed by Singapore’s economic development that in achieving a higher level of per capita GDP than the US quantity was far more important than quality.

Notes

1. Young, A. (1995, August). The tyranny of numbers: confronting the statistical reality of the East Asian growth experience. Quarterly Journal of Economics, 110, 641-680.

2. Vu, K. M. (2013). The Dynamics of Economic Growth - Policy Insights from Comparative Analyses in Asia. Cheltenham, UK and Northampton, M.A., US: Edward Elgar.

Strategic significance of China's "New Silk Road"

One of the key recent policies launched by China is the New Silk Road/One Belt and One Road initiatives announced by President Xi Jinping. This simultaneously combines both economic and diplomatic aspects. But the strategic importance of the New Silk Road policy should not be seen as a short term or specific tactical policy by China. Its significance can be particularly clearly understood in the context of current key trends in the global economy.

Globalization remains the overall trend in the world economy. But it is important to be clear that globalization is not an even or undifferentiated international process. In particular, geographical proximity continues to play a significant role in shaping economies.

 

Within the overall framework of rising world trade it is striking that the development of international division of labour has now reached a point where the "classic" sized nation state, on a scale which dominated Europe in the 19th and most of the 20th centuries (Germany, U.K., France), and which exists in large parts of Asia (Thailand, Malaysia, Cambodia) is too small by itself to constitute a sufficiently developed economic unit. This trend itself creates globalization. But instead of a fully "equalized" global economy being created, in which geography does not play a significant role, there is an emerging division into "continental scale" economic units which are replacing "national" ones.

To adapt the terminology of a well-known book, Thomas Friedman was therefore exaggerating in declaring that "The World is Flat." Instead the world is still divided into a number of economic "nexuses" but these are now continental rather than national in size – and are relatively well connected. This global context casts clear light on the One Belt and One Road initiative.

To clarify the original historical starting point of these current economic processes, it is sometimes mistakenly believed that because the United States is not only the world's largest economy, but also has the highest per capita GDP of any major economy, the decisive factor in U.S. economic supremacy is its superior productivity level. This is easily shown to be numerically false. Measured in Parity Purchasing Powers (PPPs) U.S. per capita GDP is 22 per cent higher than Germany, a significant but not overwhelmingly lead. At current exchange rates, the gap is narrower at 18 per cent. But the U. S. population is 380 per cent of that of Germany.

The fact the United States is a much larger country than Germany therefore plays, and historically played, a much greater role in the United States' economic superiority compared to Germany than does the United States' relative advantage in productivity. In political terms the United States is a "nation state" but its size means the United States constitutes a "continental scale" economy.

Seen from this angle, of the historical trend to the creation of "continental scale" economies, the development taking place in the key areas of the world is evident:

• The United States was the world's first continental scale economy;

• The USSR was the second (ultimately failed) continental scale economy – it remains to be seen how much of the former USSR will be reintegrated in the Eurasian Economic Union vision of Putin;

• China is, as with the United States, in political terms a nation state but also history's third continental scale economy;

• India is the fourth continental economy,

• If it succeeds in integrating itself fully, the European Union will be the fifth continental economy.

It is also clear that to gain the advantages of international division of labour, international trade, and other factors, the most successful of these "continental economies" have a tendency to integrate themselves with surrounding regions even in cases where political union is not posed. The United States has therefore created very strong economic links with Mexico and Canada, formalized in the North American Free Trade Agreement (NAFTA). The EU has progressively expanded from its original six-member West European nucleus to form an integrated European economic zone including 28 member states and several closely associated ones.

The willingness of smaller economies to create links with these larger continental scale economic hubs in turn reflects the fact that these smaller economies by themselves cannot achieve the scale of production required for the most efficient operation in a modern economy. The "win-win" outcome is therefore that the continental scale economic hub benefits from expanding further its scale of participation in global division of labour, while the smaller economies benefit from their increased links with a larger economy. This "win-win" outcome is what leads to the mutually beneficial closer links between the smaller and larger economies. Isolation from such trends leaves smaller countries unable to benefit from the developing global division of labour, with negative consequences for their own growth.

 

China's New Silk Road initiatives therefore should not be seen in isolation but as part of the overall global trend. China has the advantage of being a "continental scale" economy, but for success even this requires economic integration with geographically surrounding economies. In turn these smaller surrounding economies benefit from their relation with China's continental scale economy. This creates a win-win outcome even when there is no intention in Asia to follow the EU route of political integration – equally there is no move to political integration of Canada or Mexico with the United States. Such economic relations therefore form part of what China’s President Xi Jinping termed "a new model of international relations featuring cooperation and mutual benefit."

But to sustain these economic links, not only legal initiatives, such as free trade areas and tariff reductions, are required but also the creation of material infrastructure to facilitate trade and growing international division of labour. This is why China's One Belt and One Road is necessarily accompanied by initiatives such as the Asian Investment Infrastructure Bank (AIIB).

A specific and key strategic issue in this process will be that Asia is unusual in containing not one but two such continental scale economies – China and India. For this reason relations between China and India will play a key role in the 21st century – and it is of particular importance that India has both welcomed China's initiatives and become a participant in the AIIB.

Such economic realities of the tendency to create "continental scale" economies also explain processes in other parts of the world economy and have clear geopolitical consequences. For example the last period saw notable increases in intra-Latin American trade, with this eroding or replacing the previous entirely dominant bilateral trade between individual Latin American states and the United States – with China also replacing the United States as the largest trade partner for a growing number of Latin America countries. Similarly, although at an early stage, attempts in Africa, strongly supported by China, to lay the infrastructural basis for a more integrated "continental African" economy lead in the same direction.

Countries outside such evident continental scale units therefore face major choices.

• Recurrent political crises in Japan may be understood in significant part as the clash between an orientation to China's "continental economy," with which it would be economically rational for Japan to develop the closest possible ties, and Japan's military and political ties to the U.S. "continental economy."

• Australia attempts to resolve tensions between its dominant economic relations with China and its military and political ties with the United States.

• The U.K.'s regular political crises in relations with the EU, constitute the contradictory tensions of its relations with the continental scale economies of the United States and EU.

Countries in Southeast Asia, similarly, face important choices between the continental scale economy of China, which forms the economic centre of the Asian region, and non-Asian states – particularly the United States. Some, for example the Philippines, currently attempt to resolve this through subordination to the United States. Others, such as contemporary Indonesia, attempt to balance various trends through a "non-political" stance. Some, such as Thailand, have experienced internal differences on the issue.

China is in the fortunate political position that it faces no such choice. China's fundamental strategy for national renewal continues to be to build up its own continental economy. But this, in turn, requires building mutually beneficial relations with its surrounding neighbours.

It is clear for these reasons why the New Silk Road/One Belt and One Road is not a short term initiative but of such major strategic significance for both China and its neighbours.

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The original version of this article appeared at China.org.cn. 

China crucially needs an accurate analysis of the sources of economic growth

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.

Figure 1

 

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).

Figure 2

 

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,

Figure 3 

Figure 4

Figure 5

How a pseudo theory of 'consumer led growth' damages China's economy

China’s extremely high interest rates, which seriously damage the economy, are a result of the fall in company profitability and overall savings. Central bank rate cuts will therefore not be enough to reduce interest rates unless company profitability and China’s savings can be increased – which requires throwing out the false theory of ‘consumer led growth.’

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When the People’s Bank of China recently announced the first interest rate reduction for two years this reflected an understanding that excessively high interest rates are a decisive problem for both private and state companies - and therefore for the economy as a whole. But, as will be analysed below, Central Bank action by itself will be unable to produce a substantial reduction in real interest rates without an overall correct macroeconomic policy. In this framework it is crucial to realise that China’s high interest rates are an inevitable consequence of the policies flowing from the erroneous theory of ‘consumer led growth’. Therefore, to ensure a serious interest rate reduction, it is necessary to understand clearly how this erroneous theory both damages the economy in general and in particular produces the problem of high interest rates.

First, to show how serious is both the domestic and international disadvantage China suffers from its high interest rates, Figure 1 shows the difference, the spread, between China’s interest rates on 10 year government bonds and that for equivalent bonds in the US. As state bonds provide the floor for long term borrowing rates, which are the key ones for company investment, this is the most suitable measure by which to compare Chinese and US interest rates.

As may be seen, China’s interest rates have moved from below those of the US in 2010 to sharply above US levels today. The overall rise in China’s relative rates compared to the US is approximately 2% - from 0.5% below US rates to approximately 1.5% above. China average commercial bank lending rates moved up exactly in parallel – rising, on average, from 5% in 2009 to 7% in 2014.

Figure 1

 

To understand clearly why China’s interest rates have risen so sharply it is necessary to remove fetishism and mystification regarding interest rates. An interest rate is merely a price – the price of capital. Like all prices, therefore, interest rates express the interrelation of supply and demand - for capital demand being constituted by investment and supply by savings. Therefore, for China’s interest rates to have risen, one of the following must necessarily have occurred.

• The interest rate fundamentally reflecting the balance of supply and demand for capital is the real, i.e. inflation adjusted, one. China’s nominal interest rates could, therefore, have increased if the balance of supply and demand for capital had not altered but inflation has risen. But this has not occurred. China’s CPI today is lower than in 2010 and the PPI has been falling. The real interest rate has risen - there has been no rise in inflation. Consequently there must have been changes in the supply or demand for capital.
• Analysing first demand for capital, that is investment, it may be seen in Figure 2 that in 2008-09, when China’s interest rates were below those of the US, China’s demand for capital was sharply expanding as a percentage of the economy. Total investment (fixed investment plus inventories) rose from 43.8% of GDP in 2008 to 48.1% of GDP in 2010. But despite this increase in the demand for capital China’s interest rates were at or below US levels. In contrast, between 2010 and 2013, the latest full year data, there was a marginal fall in the percentage of China’s investment in GDP – from 48.1% of GDP to 47.8% of GDP. Data for the full year 2014 is not yet available but it is clear that during this period the rate of increase of investment has been falling – the annual increase in fixed asset investment declining from 20.1% in October 2013 to 15.9% in October 2014.

The increase in interest rates in China since 2010, therefore, cannot be explained by an increase in the demand for capital, it must be due to a fall in the supply of capital.

Figure 2

 

• That a fall in the supply of capital in China has indeed taken place can be seen in Figure 3. Total savings (i.e. company savings, plus household savings, plus government savings) fell from 52.7% of GDP in 2009, and 52.0% in 2010, to 50.8% in 2013. Given this drop in the supply of capital, as demand had not fallen, a rise in real interest rates was inevitable – precisely as has occurred.

Figure 3

 

Taking a long term trend, it can be seen from Figure 4 that until 2009 the proportion of China’s economy constituted by savings was rising – this paralleled an increase in the percentage of GDP constituted by company profits. This period, as is well known, was accompanied by rapidly increasing living standards and fast economic growth. After 2009, however, the proportion of China’s economy consisting of capital supply, that is savings, declined. This paralleled the end of expansion of company profitability as a percentage of GDP, and was accompanied by a substantial deceleration in economic growth.

Figure 4

 

The rise in China’s interest rates is simply an inevitable expression of this fall in the supply of capital. As high market interest rates for long term capital are a necessary result of the fundamental shift in the relation between demand and supply of capital they cannot be lowered by technical means such as alterations in the types of financial instruments available. Furthermore, while a Central Bank can set and control short term money market rates, it cannot set long term lending interest rates as these are determined by this market balance of supply and demand. This firm prediction of theoretical economics has been repeatedly confirmed even in the case of the world ‘s most powerful Central Bank, the US Federal Reserve, while in China in the last two years short term money market rates have fluctuated strongly under the impact of Central Bank interventions but the average rate for lending to companies has remained at 7%.

Given that the rise in interest rates is due to the fall in the supply of capital the key question for reducing interest rates is, therefore, how to raise the supply of capital, i.e. savings. As total savings have three potential sources – from households, companies and the state – each must be examined.

• Household savings are determined by two key factors – first by total household income, second by the division of income between consumption and saving. As household income is received by individuals, who can therefore decide whether to spend or save, it is difficult to directly influence how households divide income between consumption and savings - unless compulsory savings schemes are introduced, as were used in Singapore. Theoretically, increasing interest rates for individual depositors might increase savings, but evidence does not show a close correlation between interest rates and savings. Furthermore, as the aim is to reduce interest rates, raising rates to household savers would tend to put upward pressure on overall interest rates in the economy as a whole rather than secure the key goal of reducing them.
The concept of ‘consumer led growth’ seeks to increase the proportion of the economy devoted to consumption by one of two routes - or both. The first is to increase the share of wages in the economy. The second is to reduce the proportion of household income which is saved – i.e. people should be encouraged to spend a higher proportion of their income. Which of the two is followed does not matter for the direct issue of household savings – other things being equal, either shift will increase the percentage of the economy devoted to consumption, thereby reduce the savings level, and therefore, other things remaining equal, put upward pressure on interest rates.
• Which of the two methods of increasing household consumption is followed, however, has a very strong effect on the second source of savings - companies. The theory of ‘consumer led growth’ typically argues that the economy’s wages should be increased so as to raise the purchasing power available for consumption. But increasing the economy’s wages share, via wages growing more rapidly than GDP, necessarily means reducing the profits share – thereby putting downward pressure on company profitability.
It has recently been pointed out that for somewhat different reasons excessive wage increases damage China’s companies. However downward pressure on profits from excessive wage rises directly reduces company profitability – a key explanation of the low rate of growth of profits in the recent period. From 2000 to 2007 the percentage of profits in GDP rose from 19% to 31%. Since that time the percentage of profits in GDP has ceased increasing – constituting a key reason the overall share of savings in the economy stopped rising.
• Government savings are the smallest source of total savings, indeed they are normally negative as the state runs a budget deficit - although China’s deficit is small compared to most countries. However, the budget deficit is one of the easiest determinants of savings to adjust, as this can be achieved by administrative decisions increasing taxation or lowering spending. Regarding which of these two to choose in order to increase the savings level, it should be noted that China’s state spending level is very low compared to advanced economies – primarily reflecting the lack of a system of social protection in properly adequate pension, health care etc. provisions. As a result, in 2013, on IMF internationally comparable data, China’s state income was only 22% of GDP, compared to 33% for the US. China’s government expenditure was also only 25% of GDP compared to the US 38% - figures for other developed economies are higher. Therefore reducing the state budget deficit by reducing expenditure would cut across China’s path of economic development – making it impossible to create the types of systems of social security of the US and other advanced economies, with highly undesirable economic and social consequences. China’s tax system, in contrast, is very undeveloped compared to advanced economies. Many taxes taken for granted in advanced economies, for example property and inheritance taxes, do not even exist in China.
An increase in taxes would therefore be one of the quickest ways to increase China’s savings level. In order to avoid social unrest, tax increases should of course be concentrated on the best off – which, in addition to its economic benefits, would also have the desirable social goal of reducing inequality.

The alternative ways to reduce interest rates, as opposed to raising savings, are all damaging for China’s economy, living standards and social stability.

Regarding fixed asset investment, the substantial fall in the rate of increase of this is already the primary reason for the major downward pressure on economic growth in the last two years. Beyond this purely short term, modern econometrics shows that capital investment is overwhelmingly the most important source of economic growth. On average in advanced economies 57% of growth is due to capital investment, 32% to increase in labour inputs, and only 11% to increases in total factor productivity (TFP). China’s economy is already decelerating, and reducing investment levels would, therefore, necessarily lead to a further substantial slowdown in economic growth with extremely undesirable consequences for both companies and individuals.

• For companies, slower revenue growth, an inevitable consequence of economic deceleration, will put further downward pressure on profits - recent data shows profit of China’s industrial enterprises actually fell 2.1% in the year to October. This reality illustrates, once again, that those who argue for a theory of ‘consumer led growth’ do not actually understand the nature of a market economy. An increase in consumption, if it does not lead to an increase in profits, will not lead to strong ‘growth’ but on the contrary, at best, to slower economic growth - or even more negative trends. In a market economy nothing is produced because someone wishes to consume it, it is only produced if it produces a profit. A market economy can therefore necessarily only have ‘profits led growth’ – not ‘consumer led growth.’ Wage increases which decrease profits share in GDP may lead to a higher desire to consume but, by reducing profits, they will actually weaken economic growth.
• Regarding individuals, internationally 86% of increases in consumption are due to economic growth. The false idea that living standards in China can primarily be raised by redistributing existing GDP to consumption is merely a ‘rightest’ version of the ultra-left fallacy that ‘prosperity can be achieved by sharing out poverty.’ China’s per capita GDP in 2013 was only 13% of US levels at current exchange market rates, and 22% measured in PPPs. This means that even if the share of consumption in China’s GDP were raised to US levels, China’s consumption per person would only be one eighth of that of the US at market exchange rates and less than one quarter in terms of PPPs. The idea that a level of consumption in China of only one eighth/one quarter of the US is satisfactory, or constitutes prosperity, is ridiculous. China can only draw closer to advanced economies’ living standards by growing more rapidly than they do for a prolonged period. And the key to GDP growth, as already shown, is investment. Increasing consumption’s percentage of GDP, which necessarily means reducing the percentage of investment, would by slowing economic growth, even if it raised living standards in the very short term, therefore lead to substantially lower living standards over the medium and long term.

The claim, which is sometimes made, that increased savings are undesirable because they decrease demand, an argument which it is said flows from ‘Keynesianism,’ is entirely fallacious– and has nothing to do with the ideas of Keynes. Demand, as Keynes understood, consists of two components – consumption and investment – and does not just consist of consumption. Increased saving, provided it is invested, therefore leads to no decrease in demand at all.

Finally, in addition to its damaging structural consequences, economic trends in line with the false theory of ‘consumer led growth’ also explain why monetary stimulus has become decreasingly effective in China – i.e. any given increase in credit produces less growth than previously. As company growth can only be ‘profits led’, attempts to pursue ‘consumer led growth,’ by putting downward pressure on company profitability, therefore means companies will respond by less expansion to any credit or monetary stimuli. Decreasing responsiveness of economic growth to credit or monetary expansion is therefore an inevitable consequence of the end of the situation where the economy’s profits and savings share was rising.

In short, the concept of ‘consumer led growth’ was always false from the point of view of economic theory, but it has now become directly practically damaging economically. China faces objective pressure for a decrease in the economy’s profits share, and a fall in the savings level – due to the end to the increase in the working age population, the consequent slowing of the increase in the labour supply, and therefore pressure for wages to increase more rapidly than GDP. But the theory of ‘consumer led growth’, instead of seeking to limit these effects, seeks to amplify them.

The erroneous theory of ‘consumer led growth’ therefore has numerous negative consequences for China’s economy. But one of the most serious, at present, is the way it leads to high interest rates. In order to have a correct economic map, and most immediately to reduce interest rates, it is therefore necessary to abandon the theoretically false and practically damaging concept of ‘consumer led growth’ and instead to begin rebuilding China’s savings level.

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This article was originally publised in Chinese under the title 'Central Bank action alone will not be enough to cut interest rates' on Sina Finance on 1 December 2014. 

 

Why China's population is much more optimistic than that of the US

The US Pew Research Center, one of most important global opinion polling organisations, recently concluded ‘pessimism is pervasive’ in G7 countries. IMF Managing Director Christine Lagarde, in a memorable phrase, characterised the situation as ‘the new mediocre’. Indicating how currently depressed spirits are, a New York Times article immediately seized on this phrase to describe not only the economy but everything in the US from fashion, to books to TV shows. Regarding the economy former US Treasury Secretary Laurence Summers characterised the US and G7 economic situation as ‘secular stagnation’ – a prolonged period of very low growth.

Feeding the depressed state is the reality that even when some economic recovery has taken place it has not turned into improvement in ordinary people’s living conditions. Median US wages are lower than seven years ago, while the UK has suffered the most severe fall in personal incomes in the country’s recorded history.

Such economic trends inevitably created an increasingly bitter political atmosphere. A recent US poll found 65% believed future generations would live worse than the present one, while other surveys showed respect for US political institutions at record lows - only 13% of Americans believed the US government could be trusted to do the right things most of the time. A further poll found only 33% of the US population believed the country was going in the right direction, compared to 62% who believed it was going in the wrong one. Europe is witnessing a rise of racist right wing parties, such as the Front National in France, and separatist and independentist movements – most recently in Catalonia.

The same global polling organisations find China remains the exception among major economies. The latest Pew Research Center survey found 87% of people in China were ‘satisfied with the way things are going in our country’ - compared to the US 33%. At the factual level, the latest economic data shows that in the year to the third quarter of 2014 China’s economy grew by 7.3% compared to 2.3% for the US – China’s economy was growing more than three times as fast as the US.

The correlation between these economic developments and public moods is highly rational. Pew’s research showed almost two thirds of economic optimism or pessimism found in opinion polls in a country is accounted for by how fast its economy is growing.

Taking first the bottom of the economic ladder, the reason for much greater optimism in China than in the West is therefore easily explained. One of the most striking World Bank statistics is that there has been no fall in the number of people living in internationally defined poverty in capitalist countries in the last 30 years. The whole decline in the number of those living in poverty is accounted for by countries describing themselves as socialist – above all China.

Taking middle income bands, while median US wages fell in the last seven years, China’s real urban incomes frequently rose annually by not far short of double digit amounts. Much greater satisfaction by average and low income China’s citizens with the country’s direction, compared to the situation in Western countries, is therefore unsurprising.

But a striking feature is that China’s economic improvement is dramatic not only at the middle and bottom of the income ladder but at the top. This was spectacularly highlighted when Alibaba’s IPO raised $25 billion, the largest for any company in history, instantly turning Ma Yun into China’s richest person.

This was only the tip of the iceberg. By 2012 China had 10.9 million private companies, employing 113 million people, plus 40.6 individual enterprises, employing 86.3 million people. No equivalently rapid expansion of private enterprises took place anywhere else in the world. How, therefore, has China, an avowedly socialist state, produced not only the world’s biggest improvement in living standards for ordinary, and the poorest, people but the world’s fastest development of private companies? This combination helps explain the much higher levels of optimism in China compared to US pessimism.

The reasons for both the objective economic dynamic, and its reflection in popular moods, is the way the fundamental economic structure created by China’s economic reforms has successfully aligned all the major forces in its economy. This, as will be analysed, is strikingly unlike the situation in the West, where the economic structure is currently riven by contradictions, with consequent economic misfunctioning, producing the deeply pessimistic economic moods already noted. As the contrast has major lessons for world economy and politics it is worth analysing in detail.

The G7’s proclaimed media self-image is that they are ‘market economies,’ in which large numbers of companies compete on equal terms to produce fair efficient economic outcomes. Small and medium enterprises are particularly held up as the economic exemplar of this.

But this is image of economies dominated by relatively small scale competitive markets ispure myth. In reality a dominant feature of modern production is that it takes place on ever larger scales. The invention of the railway, in the first half of the 19^th century, created for the first time a large industry in which the investment required was so great it produced an inherently monopolistic character – the cost of railway construction being so huge duplicate competitive lines being impractical. Since then pure monopolies spread into further fields of production - the electricity grid in all countries is so expensive it is impossible to create competing systems, the metro system of modern cities is impossibly costly to duplicate etc. In short, in a modern economy a number of economic sectors, are necessarily monopolistic in character and cannot be made competitive.

Even when pure monopoly does not exist, globalisation illustrates that many branches of modern industry require production of dimensions for profitability that they cannot be carried out a purely national scale. There are only two major civil aircraft manufacturers in the world, Microsoft has overwhelming dominance in computer operating systems, outside China Google dominates search engines, less than 10 companies dominate world automobile production etc. In its most developed form this has created the phenomenon of companies recognised as ‘too big to fail’ – i.e. firms operating on such large scales that no alternative can take over their functions without unacceptably destabilising the economy. This reality is explicit in sectors such as banking but, as the state bailout of the US auto companies after 2008 graphically showed, it extends to a far wider range of industries.

Some industries, of course, still remain characterised by competition between large numbers of companies. In addition to obvious small scale ones such as restaurants, hair dressers etc, in an industry such as tourism, one of the world’s largest, no company holds even a 1% market share. But overall large companies which dominate the economy. To illustrate this with a striking statistics, the turnover of the world’s 2,000 largest publicly listed companies, the Forbes 2,000, is equivalent to more than 50% of world GDP.

In short, the concept that a modern economy consists of huge numbers of small scale competing enterprises is an ideological myth. Equally, the West treating a totally uneven and differentiated economic structure as though it were a single ‘market’ has, as will be seen, dangerously negative destabilising tendencies. It is the consequences of this which creates the pessimistic mood in Western economies.

A key example is the banking and financial system, which has been at the core of economic crisis in the G7 economies. The fact the largest private banks are ‘too big to fail’ necessarily incentivises them to extreme risk taking, and even criminal, activity. In a purely competitive economy company risk taking is constrained by the threat of bankruptcy – the latter automatically halting risky, indeed all, activity. But once a private financial institution receives a state guarantee it is ‘too big to fail’, and therefore it will survive whatever its risk taking, pure pursuit of the highest potential return, and consequently the riskiest financial projects, becomes wholly rational - as the private institution will receive the profit if such projects are successful but the state will absorb the losses if they fail. The continuous series of massive private banking scandals – LIBOR, JP Morgan’s ‘Whale’, foreign exchange manipulation etc. – are therefore an inevitable development, as was the huge asset misallocation seen in developments such as the US sub-prime mortgage crisis prior to 2008.

Such ability to undertake ultra-high risk and ultra-high profit activities necessarily also means an increasing part of profit is taken by such private institutions – contributing to the huge increase in the percentage of total US profits taken by the financial sector. Simultaneously, the absorbing of increasingly high proportions of profits by such institutions permits the financing of extraordinarily high pay rates for their top executives, helping ensure that the gains of increased economic output are almost exclusively taken by the best off sections of society – the now notorious problem of the 1% and the 99%.

Such gigantic inequality of outcomes is therefore an inevitable consequence of the real economic structures which exist in the G7 economies, ands necessarily produces not only economic disfunctioning but pervasive popular pessimism of the type already described.

While the purely private operation of privately owned competitive companies may therefore be sufficient, for example, to maintain order and efficiency among small scale producers it is dangerously destabilising for banks or very large scale industry. Consequently, an undifferentiated economic policy cannot be successfully applied across economic sectors which have totally different economic structures - talk of ‘the market’, as though it were the same for local family shops and for large scale banks, is entirely misleading.

Far from being a single ‘market,’ a modern economy has at least three major types of market – pure monopoly, competition between small numbers of very large companies (oligopoly), and competition between very large numbers of small producers (perfect competition). By maintaining the myth that there is only one single type of market the G7 economies conceal economic reality, with the dangerous consequences already noted.

China’s economic structure, ‘socialism with Chinese characteristics’, sharply differs from such Western myths. The very word ‘socialism’ derives from ‘socialised’, i.e. large scale, production. In China the purest form of large scale production, monopolies, remain firmly in state ownership. But, simultaneously, since 1978 China has rejected a distortion, which originated in the post-1929 USSR, that small scale, i.e. non-socialised, production should be in state hands. The largest sector of small scale production, agriculture, is not collectivised, and purely competitive industries are left to the private sector. In competitive sectors dominated by large scale production (oligopoly) both state and private producers have advantages so the best way to test the relative strengths of these is to let them compete.

This structure is why China, a socialist country, also has the world’s most rapidly growing private sector. China has unremittingly affirmed dominance of its state sector. As recently as November 2013, the 3rd Plenum of the Central Committee of the 18th Congress of the Chinese Communist Party, the last top level decision making meeting on China’s economic policy, unequivocally stated: ‘We must unswervingly consolidate and develop the public economy, persist in the dominant position of public ownership, give full play to the leading role of the state-owned sector.’ Furthermore, this is not merely apaper statement - China has by far the largest state sector of any major economy.

But the difference, given the economic structures outlined above, is that whereas in the West the state and private sectors of the economy are seen as counterposed, in China, for structural economic reasons given, they are complimentary.

Western economic experts already concede the results of China’s economic structure isthe greatest economic growth seen in world history. As Nicholas Lardy, one of the most well-known US writers on China’s economy, recently summarized: ‘China’s growth since economic reform began in the late 1970s is unprecedented in global economic history. No other country has grown as rapidly for as long.’ Laurence Summers put it more precisely: ‘China… “already holds the distinction of being the only instance, quite possibly in the history of mankind, but certainly in the data” to sustain super-rapid growth for more than 33 years.’ China simultaneously saw the most rapid rise in living standards of any major economy

The attempt is made in the West to claim that this is nothing to do with China’s specific economic structure and is due only to private companies. But this thesis does not make sense. The great majority of countries in which private companies are dominant - Africa, Latin America, and much of Asia – remained trapped in poverty. As already seen, no major country with an economy based on private ownership has ever achieved China’s rate of economic growth over such a prolonged period.

But, alongside the overall rise in living standards, it is clear why the economic structure outlined explains why China has also produced the world’s most dynamic private sector. While the state should not own the companies in sectors dominated by small scale competition, and it does not in China, this does not mean that such companies do not require the state – not in owning the companies in the sector, but in creating the conditions in which they can best operate. Posed in terms of economic theory a truly (‘perfectly’) competitive market requires strict preconditions – perfect knowledge of market conditions, simultaneous price adjustments, minimal or zero transport costs etc. But these require real material underpinnings. Much of what is popularly referred to as ‘infrastructure’ is in fact the material structures required for efficiently functioning competitive markets – roads, railways, information technology standards and structures, power supply, wholesale markets etc. Many of these, due to their high costs, are monopolistic in character and therefore best supplied by the state. Consequently, even in sectors where the state should not own the operating companies, the state is required to create the conditions for most effective market functioning.

The same applies in sectors where the huge expenditures required are not in production but in research. To take a graphic example, it is a myth that the foundations of the information technology revolution, the cutting edge of US industrial innovation today, were developed by the private sector. They were developed by the US state. As Martin Wolf, chief economics commentator of the Financial Times, put it reviewing the Mariana Mazzucato’s classic study The Entrepreneurial State:

‘innovation depends on bold entrepreneurship. But the entity that takes the boldest risk and achieves the biggest breakthroughs is not the private sector; it is the… state…

‘The US National Science Foundation funded the algorithm that drove Google’s search engine. Early funding for Apple came from the US government’s Small Business Investment Company. Moreover, “All the technologies which make the iPhone “smart” are also state-funded ... the internet, wireless networks, the global positioning system, microelectronics, touch screen displays and the latest voice-activated SIRI personal assistant.” Apple put this together, brilliantly. But it was gathering the fruit of seven decades of state-supported innovation.’

In China, also, the state monopoly on large scale banks is fundamental in keeping down the cost of capital for productive companies. In the West, the high risk strategies which are rational for ‘too big to fail’ private banks mean their assets are most logically deployed in areas offering the highest returns and which therefore typically have the highest risk – derivatives and futures trading, foreign exchange operations, commodities speculation, interest rate arbitrage etc. Such high risk activities can be undertaken on a large scale because fatal losses will be borne by tax payers. To attract savings for such highly profitable, but high risk activities, high interest rates on deposits can be offered. The rates of return on such high risk activities are typically far higher than those achieved by productive companies. Due to such pressure the interest rates for the supply of capital to productive companies is sharply raised. China in contrast, by control of interest rates and restrictions on high profit but high risk financial operations, ensures a lower cost of capital tor productive companies.

By providing both a comparatively cheaper supply of capital plus superior infrastructure, i.e. the material conditions for markets, China’s state dominated economic structures creates particularly favourable conditions for the development of private business. It is therefore by seeing the state and private sectors of the economy as complimentary, not counter posed, that China has produced economic growth never achieved by Western economies. It is this which, in turn, explains the high levels of optimism in China regarding its development compared to the pervading pessimism which currently all studies find gripping the West.

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This article was originally published in Chinese on Sina Finance's Opinion Leaders column.

What the G20 needs to learn from China

Summary

Since 1978 China has seen the most rapid economic growth of any country in world history, and the most rapid growth of living standards of any major economy.

Following the beginning of the international financial crisis China has far outperformed any other major economy – in the six year from 2^nd quarter 2007 to 2^nd quarter 2014 China’s economy grew by 78% and the US by 8%.

In a single generation China has gone from a ‘low income economy’ to the verge of achieving ‘high income’ status by World Bank criteria. China achieving ‘high income’ status will double the number of people living in such economies globally.

This extremely rapid development is sometimes explained in terms of unique ‘Chinese characteristics’, but economic research over the last 30 years shows that the reasons for China’s economic growth are rooted in universal economic processes.

Therefore, while the combination of global forces producing economic growth is unique in China, and produces unique ‘Chinese characteristics’, the forces propelling China’s growth operate throughout the world economy. Other countries can therefore learn from China’s economic success.

The importance of China’s economic success is evident for developing economies – if most other developing economies could achieve the scale of China’s economic success global problems of poverty and its consequences would be solved.

China’s economic success also has decisive lessons for developed economies – China’s policy response to the international financial crisis was far more effective than that of other major economies.

This paper examines the chief strategic lessons to be drawn from China’s success for the G20 economies.

The historical scale of China’s economic success

Since 1978 China has undergone economic growth on a scale unprecedented in world history. To summarise a few key parameters:

• Table 1 shows the percentage of global population in the world’s largest economies at the time they commenced rapid and sustained growth.[1] No other economy remotely approaches the 22% of the world’s population in China in 1978 at the commencement of its sustained rapid economic development. China’s was seven times the relative percentage of the world population of the US or Japan and almost three times that of the USSR at the time of economic ‘lift-off.’
• China’s growth in absolute terms in a single year far exceeds any other country in history. Measured at internationally comparable prices, i.e. parity purchasing powers (PPPs), adjusted for inflation, the greatest absolute increase in GDP in a single year ever recorded outside China was by the US in 1999 when it added $567 billion in output. The highest increase in production every achieved in a single year by Japan, frequently thought of as a post-war ‘miracle economy’, was $212 billion. But in 2010 China added $1,126 billion in output.[2] China’s GDP increase in a single year was more than twice that ever achieved by the US and five times that of Japan.

China’s rapid growth has transformed its place in the world economy. Indeed, the scale of this transition is frequently underestimated, due to use of a misleading method of categorising and ranking countries without taking account of their population. This illogically gives the same weight to Monaco, a country with a population of under 40,000 and a higher per capita GDP than China, and India with a population of 1.2 billion, or Indonesia with a population of nearly 240 million, and lower per capita GDPs than China. This has the effect of confusing, not clarifying, China’s real position in the world economy. Serious calculations of China’s position in the world economy must take population into account.

Making calculations in terms of world population, when China’s ‘reform and opening up’ began in 1978 less than 1% of the world’s population lived in countries with a per capita GDP lower than China’s - 74% lived in countries with a higher GDP per capita measured in current dollars. By 2012 the situation was transformed - 29% of the world’s population lived in countries with a higher GDP per capita than China and 51% lived in countries with a lower GDP per capita – Figure 1. China had therefore moved into the top half of the world’s population in terms of economic development, with less than a third of the world’s population living in more economically developed economies. No comparable improvement in the position of such a large proportion of the world’s population has ever previously taken place in human history.

Figure 1

 

China’s successful response to the international financial crisis

In addition to this long term growth, China has come through the international financial crisis far more strongly than any other major economy. Between the 2^nd quarter of 2007 and the 2^nd quarter of 2014 China’s economy grew by 78% compared to 8% for the US – and the US was the best performing of the major developed economies. Therefore not only was China’s long term growth performance higher than that of other economies but its short term anti-crisis macroeconomic policies were also superior to those of any other major economy.

Figure 2 

Economic laws and specific national situation

This unprecedented scale of China’s economic success evidently leads to the question of how applicable are lessons from China to other countries? This, in turn, immediately encounters the preliminary issue of whether China’s economic development was wholly specific, in which case few if any lessons can be drawn by other countries, or whether it was based on economic forces operating globally – in which case other countries can learn lessons from China.

This issue was well addressed on the opening page of a study by Deng Rong of her father Deng Xiaoping. She notes:

After the People’s Republic was established, we had more than seven years of successful socialist reform and construction. But then, the domestic and international situation, plus the combined influence of our victories, inflated self-confidence, and overheated brains, engendered inside the Party a kind of joyous arrogance. An exaggerated estimation of our accomplishments, plus an eagerness to speed up the progress… further stirred unrealistic thinking and opened a broad avenue for impetuous surges in violation of the laws of economics.[3]

This analysis poses a fundamental question. On the one hand China has insisted on the entirely specific character of its own development – emphasised by its self-characterisation as socialism ‘with Chinese characteristics’, references to a political system ‘with Chinese characteristics’, a legal system ‘with Chinese characteristics’, industrialization ‘with Chinese characteristics’, urbanization ‘with Chinese characteristics’ and the concept of the specific ‘China dream’. [4] As Deng Xiaoping emphasised: ‘To accomplish modernization of a Chinese type, we must proceed from China’s special characteristics.’[5] Similarly Justin Yifu Lin emphasises, discussing practical applications of economic policy:

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.[6]

This emphasis on specificity is correct. In fact, to pose the issue in the most general terms, not merely is each country different, but each country is itself different at each point in time – specificity is not only geographic but chronological. Not only is Germany not China, but China in 1949 is not China in 2014. In the famous and correct dictum of Heraclitus, nobody ‘ever steps in the same river twice’.

Nevertheless, simultaneously with this insistence on the entirely specific character of China’s development, Deng Rong’s passage speaks of ‘laws of economics,’ and ‘laws’ by their nature are universal. Deng Xiaoping stated this clearly by speaking not only of China’s specific character, its ‘Chinese characteristics’, but also that: ‘We have tried to act in accordance with objective economic laws.’[7] Is there, therefore, a contradiction between the simultaneous assertion of the entirely specific character of China and of ‘universal’ economic processes?

A unique combination of universal elements

In reality there is no contradiction between the idea of China’s uniqueness and of universal/global elements. Any practical economic analysis is not of an abstract idea but of a material reality. The fundamental structural elements of every economy (consumption, investment, savings, primary industry, manufacturing industry, service sector, trade, money etc.) are universal. But the specific way in which these universal elements combine and are interrelated in any economy is entirely unique both in place and time.

It follows from this no country can copy another. If one country applies the same policy as another, in what is inescapably its own and therefore a different situation, it is necessarily making a mistake – not only the other country’s situation but its own is specific. But, equally, a country can learn from others, as China did, by analysing the elements of which other economies are composed, and analysing how these elements combine differently in its own specific situation.

Deng Xiaoping, and the other architects of China’s economic reform, were therefore accurate in stating simultaneously that China’s policies were wholly specific and that they were acting in accordance with ‘universal’ economic forces. It therefore follows that other countries can learn lessons from China’s economic development – not in terms of mechanically copying policies, as the specific form of these is determined by the unique situation of China, but in terms of analysing the universal/global elements of which China’s economic policy is composed, and understanding how these combine in the unique conditions of another country.

Universal elements

In order to understand the relation between the universal elements in economic growth and their specific combination in China, and derive lessons for other countries, it is consequently necessary:

i. to study these universal elements;

ii. To analyse the specific combination of these elements in China.

It is this fact that, while China’s economic policy is entirely specific both in time and place, nevertheless it is composed of elements which are universal and global in character, which allows lessons to be drawn by other countries from China’s experience. However to analyse these ‘universal’, that is global, elements accurately it is necessary to grasp advances in understanding of the causes of economic growth, and its measurement, in the last decades.

Modern advances in Western econometrics

In the last three decades major advances in measurement of the causes of economic growth have taken place, leading to clearer understanding of economic growth in general and also the causes of China’s economic growth. These advances, which are now formally recognised by the UN, US, and OECD may be briefly summarised.

The formalisation of the study and measurement of the causes of economic growth, technically known as growth accounting, was carried out in the 1950s by Robert Solow.[8] Solow himself primarily considered two inputs, capital and labour, but a strength of his framework was that other inputs can and have been added.[9] In his ground-breaking papers Solow, however, made two errors which were corrected later by others and which are directly relevant to analysis of economic growth in general, of China and Asia’s economic success, and therefore of conclusions that may be drawn from it.

• First, Solow did not include ‘intermediate products’, the unfinished inputs of one industry into another, in his analysis. This was crucial quantitatively because factual study shows intermediate products grow even more rapidly than capital, labour, and productivity during economic development. This rise of ‘intermediate products’ is an index of the growing division of labour domestically and internationally.
• Second, 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 – an error repeated in some discussions of China.[10] This latter mistake was subsequently corrected, and accurate methods of calculating growth were formally adopted by the US, UN and OECD.[11]

Such corrections are important for economies in general and are of particular relevance for China – many continuing errors in interpreting China’s economic growth turn out to not to be due to problems in China but to people using inaccurate measuring rods![12]

Accurately measuring with the most advanced Western econometric methods, it is easy to show that China’s economic growth follows an entirely comprehensible pattern – confirming Deng Xiaoping’s assertion that China simultaneously follows an entirely specific path of development, its ‘Chinese characteristics,’ and the ‘universal laws’ of economics.

These issues allow a clear understanding of the ‘universal’ elements of China’s growth, and therefore the lessons that may be drawn by other economies.

Division of labour

The first key issue is the notable ‘openness’ of China’s economy – the results of its conscious process of post-1978 ‘opening up’. This, however, in turn is based on the determinants of economic growth in general and therefore applies to all economies.

The significance of Solow’s error in leaving out intermediate products was immediately highlighted by empirical studies confirming that the growth of intermediate products, i.e, increasing division of labour, is the most rapidly expanding factor in economic development. For example, regarding the US, the most developed economy, Jorgenson, Gollop and Fraumeni found:

the contribution of intermediate input is by far the most significant source of growth in output. The contribution of intermediate input alone exceeds the rate of productivity growth for thirty six of the forty five industries for which we have a measure of intermediate input.[13]

Considering findings for the US economy in more detail Jorgenson noted:

Comparing the contribution of intermediate input with other sources of growth demonstrates that this input is by far the most significant source of growth. The contribution of intermediate input exceeds productivity growth and the contributions of capital and labour inputs.[14]

To illustrate this, Table 2 shows Solow’s original growth accounting categories – capital, labour, TFP - together with a column for growth of intermediate inputs. As may be seen, over the period 1977-2000, the median rate of growth of intermediate inputs in the US economy was 115% of the rate of growth of US GDP - far higher than any other input.

The same result as for the US was found for other economies - specifically including China. Regarding rapidly growing Asian economies:

• For South Korea, Hak K. Pyo, Keun-Hee Rhee and Bongchan Ha found regarding material intermediate inputs: ‘The relative magnitude of contribution to output growth is in the order of: material, capital, labour, TFP then energy.’[15]
• For Taiwan Province of China, analysing 26 sectors in 1981-99, Chi-Yuan Liang found regarding intermediate material inputs: ‘Material input is the biggest contributor to output growth in all sectors during 1981-99, except… seven’.[16]
• For mainland China, Ren and Sun found that in the period 1981-2000, subdivided into 1984-88, 1988-94 and 1994-2000: ‘Intermediate input growth is the primary source of output growth in most industries.’[17]

Division of labour at an international level - China’s ‘Opening Up’

This question of understanding the importance of division of labour makes clear, from a global/universal economic perspective, the significance of China’s ‘opening up’ policy. Division of labour is not purely domestic. The key trends in globalisation - rising share of trade in GDP, rising ratio of foreign direct investment to GDP, plus studies of particular industries - are all powerful evidence of increasing international division of labour.

These realities therefore have immediate consequences for China’s ‘opening up’ strategy. In particular, the fact division of labour is the most powerful quantitative factor in economic growth immediately determines which development strategies will and which will not work.

The consequences of division of labour being the most powerful factor in economic growth drives globalization and dooms ‘import substitution’ strategies – the latter being the dominant form of attempts to build up a self-contained national economy.

Success of ‘opening up’

A wide range of empirical studies supports the theoretical conclusion that more outwardly oriented economies achieve significantly higher rates of real growth of GDP. It is China’s rejection of ‘import substitution’ strategies that is the first feature of its economic policy.

The success of China’s ‘opening up’ policy is so evident, and has been stressed by numerous authors, that it is unnecessary to give excessive detail here.[18] It is however highly significant that China is much more open to international trade than the US. As Japan is the world’s third largest economy, it is also illustrative to include it comparisons.

As shown in Figure 3, in 2012 China’s exports were 27% of GDP compared to only 15% for Japan and 14% for the US. Consequently China’s export sector is almost twice as large a proportion of its economy as is that of the US. That China is a much more open economy in trade than the US or Japan gives a competitive advantage over the US and Japan in promoting more rapid growth.

China’s openness to foreign trade is also much higher than a number of other large developing economies.

Figure 3

 

Investment

After division of labour, modern economic research shows capital investment is the second most important source of economic growth. This is of particular relevance to studying China, and economic growth in general, and therefore lessons of this from China are relevant for all economies.

The finding that investment is the second most important force in economic growth, considerably exceeding the contribution of productivity, was seen not only in China but in all rapidly growing Asian economies - Asia being the only part of the world in which countries have gone from poverty to ‘first world’ living standards in a single lifetime. Analysing what created this ‘Asian miracle’ is therefore evidently of great importance not only for China’s but for economic policy of all countries.

The result of applying up to date economic methods to study Asia’s rise to prosperity is clear - and directly underpins drawing lessons from China’s economic success. After division of labour, both domestic and international, reflected in their ‘open’ character, the overwhelming cause of Asian economies rise to prosperity was their huge accumulation of investment. As Vu Minh Khuong finds in his magisterial The Dynamics of Economic Growth, by far the most comprehensive study of Asia’s economic growth: ‘Capital accumulation was… the primary driver of Developing Asia’s lead over other parts of the world in terms of economic growth.’[19]

There were no exceptions in this pattern of successful Asian development: ‘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.’ [20]

Very high capital investment accounted for 54% of the growth lead of developing Asian economies over the Western industrialized economies and for 62% of developing Asia’s lead over other developing economies. High capital investment was almost twice as important as productivity increases in explaining Asia’s growth lead over advanced economies.

China’s pattern of very high capital accumulation was therefore the most advanced case of the ‘Asian miracle’ –a clear illustration of the fact that while the specific combination of elements was entirely unique in China, creating its ‘Chinese characteristics’, the economic driving forces of China’s growth were universal/global in character, and therefore other countries can learn from them. In particular, as Vu notes: ‘The pattern showing the stronger expansion of fixed investment relative to GDP was even more notable for China, which was the most rapidly growing economy in the region during 1990-2010.’ [21]

Again giving exact numbers: ‘the share of the [developing Asian] region in the world’s GDP increased by 14.9 percentage points during 1990-2010, while its share in the world’s fixed investment rose by 29.1 percentage points… China’s share in the world’s GDP increased by 10.1 percentage points, while its share in the world’s fixed investment raised by 24.7 percentage points.’[22]

Capital accumulation as the global driving force of growth

It is crucial to understand that the fact investment was this driving force of Asia’s rise to prosperity was not unusual. Modern econometrics shows clearly that investment is the main factor, after division of labour/intermediate products, in economic growth in all parts of the world economy:

the importance of capital accumulation as the driving force for economic growth is not unique to Asia but pervasive worldwide… This source of growth is important not only for the developing countries, in which the capital stock per capita is low, but also for developed nations, in which the capital stock per capita is relatively high... for the G7 economies, investment in tangible assets was the most important source of economic growth and the contribution of capital input exceeded that of total factor productivity (TFP) for all countries for all periods examined. [23]

The specific feature of China’s rapid economic growth, and the East Asian economies rise to prosperity, was therefore not that it was ‘investment led’ but simply the exceptional quantitative degree to which China mobilised investment. Dale Jorgenson, the world’s leading authority on measurement of the causes of economic growth, whose work led to the changes in the methods of official calculation of economic productivity and growth in the US, OECD and UN, writes in his introduction to Vu’s study:

The emergence of Asia… is the great economic achievement of our time. This has created a new model for economic growth built on globalization and the patient accumulation of human and non-human capital. [24]

The study of Asia also confirms previous findings that as a country moves towards being an advanced economy，the role played by investment in its growth increases. This is shown in the chart below. Taking countries in ascending order of economic development, the percentage of growth due to investment is 50% in non-Asian developing economies, 55% in Asian developing economies and 57% in advanced economies. Growth in advanced economies is therefore more ‘investment led’ than in developing economies, and development to advanced economy status leads to growth becoming more investment intensive.

Figure 4

 

The quantitative determinants of economic growth

These global facts have clear implications for China and for economic growth in general – and therefore for lessons other economies can learn from China. Productivity is too small a part of economic growth, accounting for only 11% of growth in advanced economies, to be the main driver of development compared to capital investment which accounts for 57% of growth. Any policy relying primarily on boosting productivity therefore cannot be successful for basic quantitative reasons

Attention must naturally be given to maintaining the highest possible rate of productivity growth, via a high marginal rate of return on capital, but the largest part of growth will necessarily have to come from investment. As Vu notes: ‘The secret of successful Asian economies, therefore, lies not in achieving high TFP growth but in sustaining reasonable TFP growth despite the intensive mobilization of factor inputs over extended periods.’[25]

Successful and failed strategies for growth

These modern advances in the study of measurement and causes of economic growth, as well as the practical examples of China’s and Asia’s economic growth, settle the issue of the difference between two possible growth strategies, and also explain why the Western economies are relatively stagnant compared to China and the dynamic Asian economies.

(i) The first strategy, the one confirmed by the facts, is that the primary force in economic growth is accumulation of capital and labour (factor accumulation) and that productivity (Total Factor Productivity - TFP), while significant is less quantitatively important than factor accumulation. This growth strategy was pursued in the developing Asian economies and above all in China. It has been a spectacular success, creating the fastest increases in living standards ever seen in human history, lifting hundreds of millions out of poverty, now creating `first world' living standards in a series of what were originally `third world' countries (south Korea, Singapore etc.), and bringing China from a poor country to the brink of ‘high income’ countries by World Bank criteria.

(ii) The alternative strategy says that factor accumulation, of capital and labour, is not nearly as important for growth as TFP. This is the policy that has been applied in the advanced economies, and has accompanied their economic slowdown. As Jorgenson notes: `The growth strategy of many advanced economies emphasizes innovation, which has been quite satisfactory for the past decade, but neglects investment in human and non-capital, which continues to fall.'[26]

The two different analyses have different practical policy conclusions:

(i) if the most important driver of economic growth is factor accumulation then the most important policies are those promoting high rates of factor growth. These include high savings rates (to finance capital investment), policies to widen participation in the labour force (as this increases labour supply), promotion of education (as this increases labour inputs via increasing labour quality) etc. A reasonable rate of growth of TFP is important, but quantitatively not as important as policies which facilitate factor accumulation. As Vu summarizes the results: `the secret of the Asian growth model lies not in achieving high TFP growth but in sustaining reasonable TFP growth despite the intensive mobilization of factor inputs over extended periods.'[27]

Modern econometrics shows clearly also that investment is the main factor in economic growth in all parts of the world economy: `the importance of capital accumulation as the driving force for economic growth is not unique to Asia but pervasive worldwide. For example, Jorgenson and Siroh..., Oliner and Sichel... found that capital input is the most important source of growth in most economies. This source of growth is important not only for the developing countries, in which the capital stock per capita is low, but also for developed nations, in which the capital stock per capita is relatively high... even for the G7 economies, investment in tangible assets was the most important source of economic growth and the contribution of capital input exceeded that of total factor productivity for all countries for all periods examined. This finding is supported by the results... that, on average, capital input accounted for approximately 57 per cent of GDP growth in the industrialized group.'[28]

(ii) Alternatively, if the main locomotive of growth is believed to be TFP growth, then initiatives promoting factor accumulation (high saving rates, widening participation of the population in the work force etc.) are not so important as policies assumed to increase productivity.

The facts confirm that the downplaying of factor accumulation (capital investment and labor development) in the advanced economies has been unsuccessful as a growth strategy. This is inevitable as TFP by itself is too small a part of the economy to create rapid economic growth.

It is therefore inevitable that as Jorgenson notes, the successful growth strategy of Asia, and China in particular, is counterposed to, and has proved itself superior, to those strategies based on TFP growth (innovation, entrepreneurship) in Europe and the US. As Jorgenson notes: `Economic commentators, especially those outside Asia, have been reluctant to recognize the new paradigm for economic growth that originated in Asia, since this would acknowledge the failure of Western ideas that still greatly predominate in the literature on economic growth and development.'

Conclusion

1. China’s economic development has a unique and specific character – its ‘Chinese characteristics’. This unique character is, however, a specific combination of economic forces which are global in character. Those who created China’s economic policy, notably Deng Xiaoping, were therefore correct in their claim to be simultaneously following uniquely Chinese policies and to be operating according to ‘universal laws’ of economics. It follows that other economies cannot mechanically copy China but can draw clear lessons from its economic success.

2. The ‘opening up’ policy of China is rooted in the fact that domestic and international division of labour, reflected in the growth of intermediate products, is the most powerful force of economic development. Only an ‘open’ policy, that is participation in international division of labour, and not import substitution, can be the basis of rapid economic growth in any economy.

3. China’s pattern of growth driven by very high investment levels but corresponds to the general forces propelling economic growth. Capital investment is, after division of labour, the second most powerful force of economic growth. This applies in both developed and developing economies. For basic quantitative reasons, therefore, strategies based on TFP growth (e.g. promoting ‘entrepreneurship’) cannot be successful in generating economic growth – this explains the relative stagnation of the Western economies. This reality also shows the correctness of concepts, such as those of Justin Yifu Lin, that the key goal of development policy should be to alter ‘factor endowments’ so that economies for their development gradually make the transition from labour intensive to capital intensive production.

*   *   *

This paper was presented to the G20 Summit Think Tanks meeting organised by Chongyang Institute for Financial Studies, Renmin University of China in Beijing on 3 September 2014.

Notes

[1] This is of course rapid growth by the standards of the relevant period.

[2] Calculated from (The Conference Board, 2014) Calculated in EKS PPPs

[3] (Deng R. , 2002, p. 1)

[4] The different categories with ‘Chinese characteristics’ are from (Wen J. , 2011). The term ‘China Dream’ is of course from Xi Jinping.

[5] (Deng X. , 30 March 1979)

[6] (Lin, 2012, p. 66) Emphasis deleted from the original.

[7] (Deng X. , 30 March 1979, p. 173) Equally Deng Xiaping spoke of the ‘universal truth of Marxism-Leninism’ (Deng X. , 2 June 1978). This insistence that China acted simultaneously in accord with its specific conditions and universal laws was continuously asserted by Deng Xiaoping in numerous different contexts. For example:

‘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 X. , 21 August 1985)

‘The Chinese revolution succeeded by integrating the universal principles of Marxism-Leninism with the concrete practice of China.’ (Deng X. , 31 May 1980)

‘the Chinese revolution succeeded by integrating the universal principles of Marxism-Leninism with the concrete practice of China, we should not demand that other developing countries, let alone the developed capitalist countries, adopt our model in making revolution. Of course, one cannot demand that they all adopt the Russian model, either.

‘We were victorious in the Chinese revolution precisely because we applied the universal principles of Marxism-Leninism to our own realities.’ (Deng X. , 28 August 1985)

‘Comrade Mao Zedong successfully integrated the universal principles of Marxism-Leninism with the realities in China’ (Deng X. , 13 October 1987)

[8] (Solow, 1957)

[9] For an extended analysis of some of these major changes see (Jorgenson D. W., 2009)

[10] See for example (Zheng, Bigsten, & Hu, 2009)

[11] For a conceptual explanation of the changes see (Jorgenson D. W., 2009). For detailed technical studies see (OECD, 2001) and (OECD, 2009).

[12] See for example (Zheng, Bigsten, & Hu, 2009). The whole framework of this is a false assumption that the majority of world economic growth is due to productivity increases.

[13] (Jorgenson, Gollop, & Fraumeni, 1987, p. 200)

[14] (Jorgenson D. W., 1995, p. 5)

[15] (Pyo, Rhee, & Ha, 2007)

[16] (Liang C.-Y. , 2007)

[17] (Ren & Sun, 2007)

[18] See for example Lardy (Lardy, 1993) and Cao et al (Cao, Ho, Jorgenson, Ren, Sun, & Yue, 2009).

[19] (Vu, 2013, p. 198)

[20] (Vu, 2013, p. 198)

[21] (Vu, 2013, p. 196)

[22] (Vu, 2013, p. 195)

[23] (Vu, 2013, p. 198)

[24] (Vu, 2013, p. vii)

[25] (Vu, 2013, p. 242)

[26] (Vu, 2013, p. viii)

[27] (Vu, 2013, p. 242)

[28] (Vu, 2013, p. 198)

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Why private companies grow fast in socialist China

A striking feature of China's economic development is the breadth of social layers benefitting from it. At the bottom of the economic ladder, China has lifted over 600 million people from internationally defined poverty - accounting for the entire global fall in the number of those living in poverty. Taking middle incomes, while median U.S. wages have fallen in the last seven years, China's real urban incomes rose annually by not far short of double digit figures. At the top income level Alibaba's IPO, raising US$25 billion, the largest for any company in history, turned Ma Yun into China's richest person.

The soaring Alibaba [By Zhai Haijun/China.org.cn]

But Alibaba is the tip of an iceberg. By 2012, China had 10.9 million private companies, employing 113 million people, plus 40.6 million individual enterprises, employing 86.3 million people. No equivalently rapid expansion of private enterprises has taken place in any other country. How, therefore, has socialist China produced not only the world's biggest improvement in living standards for ordinary, and the poorest, people but also the world's fastest development of private companies?

The reason is that China's economic structure successfully aligns all major economic forces. This is strikingly unlike the current situation in the G7 - which was characterised by IMF Managing Director Christine Lagarde economically as "the new mediocre" and Pew International Research polling found the prevailing mood as "pessimism is pervasive." As the contrast, the continued rapid development by China's private companies demonstrates the advantages of China's economic structure, which has major lessons globally.

Taking first the West, the G7 proclaim themselves "market economies," in which large numbers of private companies compete equally to produce fair and efficient economic outcomes. Small and medium private enterprises are held up as their economic exemplar.

But this image of economies dominated by relatively small scale production, with perfectly competitive markets, is a myth. A dominant feature of modern economies is increasingly large scale production. In a number of sectors the investments required are so large they produce pure monopolies - railways, the electricity grid, metro systems in modern cities etc.

Even when a pure monopoly does not exist, globalization illustrates the way that many branches of modern industry require production on an extremely large scale to be competitive - therefore it cannot be carried out purely nationally. The world only has two major civil aircraft manufacturers, less than 10 companies dominate world automobile production etc.

In its most developed form this creates companies recognized as "too big to fail" - firms operating on such large scales that no alternative can take over their functions without dangerously destabilizing the entire economy. This is explicit in sectors such as banking but, as the state bailout of the U.S. auto companies after 2008 illustrated, it extends to far wider ranges of industries.

Some economic sectors, naturally, remain characterized by competition between large numbers of companies - in tourism, one of the world's largest industries, no company holds even a 1 percent market share. But overall, large companies dominate. The turnover of the world's 2,000 largest publicly listed companies is equivalent to more than 50 percent of world GDP.

The ideology put forward in the West that a modern economy consists of huge numbers of small scale competing enterprises is therefore myth. Equally, the West treating a totally differentiated economic structure as though it were a single "market" has dangerously negative consequences - which actually inhibits development by private companies.

A key example is the financial system, which has been the core of economic crisis in G7 economies. The largest private banks being "too big to fail" necessarily incentivizes extreme risk taking, even criminal, activity. In a pure competitive economy, company risk taking is constrained by the threat of bankruptcy, but once a private financial institution receives a state guarantee as "too big to fail," pursuit of the highest potential return, and consequently the riskiest financial projects, becomes rational - the private institution receives the profit if such projects are successful but the state absorbs the losses if they fail. The continuous series of private banking scandals such as LIBOR, JP Morgan's "Whale" trading, and foreign exchange manipulation, are therefore inevitable, as was the huge asset misallocation seen in developments such as the U.S. sub-prime mortgage crisis prior to 2008.

Far from being a single "market," a modern economy has at least three major types of market - pure monopoly, competition between small numbers of very large companies (oligopoly), and competition between very large numbers of small producers (perfect competition). An undifferentiated economic policy therefore cannot be successfully applied across economic sectors which have totally different economic structures.

China's economic structure - "socialism with Chinese characteristics," sharply differs. The very word "socialism" derives from "socialized," i.e. large scale production. In China the purest form of large scale production, monopolies, are state owned. But, simultaneously, since 1978 China has rejected a distorted idea, originating in the USSR, that small scale, i.e. non-socialized, production should be in state hands. China's agriculture is not collectivized, and purely competitive industries are left to private companies. In competitive sectors dominated by large scale production both state and private producers have advantages, so the best way to test their relative strengths is to let them compete - as China does.

This structure explains why China, a socialist country, has the world's most rapidly growing private sector. China affirms the dominance of its state sector, but whereas in the West state and private companies are seen as counterposed, in China, for the structural reasons given, they are seen as complementary.

The economic structure of China has produced the greatest economic growth in world history. As Nicholas Lardy, one of the chief U.S. writers on China's economy, recently summarized: "China's growth since economic reform began in the late 1970s is unprecedented in global economic history. No other country has grown as rapidly for as long."

China's economic structure reinforces the world's most dynamic private sector. While the state should not own companies in sectors dominated by small scale competition, and in China it does not, this does not mean such companies do not require the state. Economic theory shows an efficient competitive market requires preconditions - perfect knowledge of market conditions, simultaneous price adjustments, and minimal or zero transport costs. But these require real material underpinnings to be realized, and a lot of "infrastructure" is actually structures required for efficiently functioning competitive markets such as transport, information technology standards and structures, and wholesale markets. Frequently, due to their high costs, these are monopolistic and consequently best supplied by the state. Therefore, even in sectors where the state should not own the operating companies, the state is required to create the conditions for effective market functioning.

The same applies where research requires huge expenditures. To take a graphic example, it is a myth that the foundations of the information technology revolution, the cutting edge of U.S. industrial innovation, were developed privately. They were created by the U.S. state. As Martin Wolf, chief economics commentator of the Financial Times, wrote in a review of Mariana Mazzucato's "The Entrepreneurial State:"

"All the technologies which make the iPhone 'smart' are… state-funded ... the Internet, wireless networks, the global positioning system, microelectronics, touch screen displays and the latest voice-activated Siri personal assistant. Apple put this together, brilliantly. But it was gathering the fruit of seven decades of state-supported innovation."

Regarding financing of private companies, in China, the state monopoly of large scale banks reduces the cost of capital for productive companies. In the West, high risk strategies, rational for "too big to fail" private banks, mean their assets are deployed in areas offering the highest returns and which therefore typically have the highest risk - derivatives trading, interest rate arbitrage etc. These can be undertaken on a large scale because fatal losses will be borne by tax payers. This has the effect of concentrating profits into the private financial sector. To attract savings for extremely profitable high risk activities, high deposit interest rates can be offered. Due to such pressure interest rates for supply of capital to productive companies is sharply raised. China in contrast, by controlling interest rates and restrictions on high profit but high risk financial operations, ensures a lower cost of capital for productive companies.

By providing both a cheaper supply of capital, plus a superior infrastructure, China's economy creates particularly favourable conditions for the development of productive private business. By seeing state and private sectors as complimentary, China produced economic growth never achieved by Western economies. It is also why socialist China has the world's most dynamic private sector.

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This article originally appeared on China.org.cn.

China and the APEC summit

Video of my TV interview with CNC (Xinhua News Agency TV) on China's rise and its impact on APEC can be watched here.

The changing pattern of foreign investment in China

Inbound investment into China continues to be the highest for any developing economy - US$101 billion in 2013 on UN data. But the pattern of investment in China is changing significantly as the country develops, and this trend will inevitably become more pronounced. China refusing to acknowledge and internalise that only 30% of the world’s population now lives in countries with a higher per capita GDP than China leads to confusion on the key issues in foreign investment.

In the first decades after the start of China's economic reforms in 1978, inward foreign direct investment (FDI) was primarily undertaken by overseas companies to create a base for exports. Although this was helpful in China's early stage of "reform and opening up," the investment was frequently very low value added. For example, a 2009 study found China received only 2 percent of worldwide wages paid for iPod production despite the fact that every iPod, at that time the world's most successful consumer product, was manufactured in China.

As recently as 2010, the majority of China's exports came from foreign-owned companies. Among large exporters, the role of foreign investment was even greater - of the top 200 exporting companies in 2009, 153 were foreign-funded. Only among small and medium size exporters were Chinese companies dominant and Alibaba's original success was creating the Internet systems that connect these Chinese companies to their foreign markets.

But as China's economy has developed, the reason for its attractiveness to foreign companies has radically changed. In comparative international terms, China is no longer a low-wage economy. On World Bank data, only 30 percent of the world's population now lives in countries with a higher per capita GDP than China, and wages will be approximately proportional to this. In Southeast Asia and South Asia, every developing country except Malaysia now has a lower per capita GDP than China.

For many foreign companies aiming at exporting, China's unrivalled skill in major manufacturing fields has become the country's main attraction. A U.S. study, with the self-explanatory title "Why Apple builds iPhones (and everything else) in China," spells this out clearly. The New York Times posed the question, "What does China have that America lacks?" The conclusion was:

"Quite a lot. China has more mid-level engineers, a more flexible workforce, and gigantic factories that can ramp up production at the drop of a hat. China also offers tech firms a one-stop solution. 'The entire supply chain is in China now,' a former high-ranking Apple executive tells The Times. 'You need a thousand rubber gaskets? That's the factory next door. You need a million screws? That factory is a block away. You need that screw made a little bit different? It will take three hours.'"

Indeed, the example of the iPhone, now the world's most successful consumer product, graphically shows how China's manufacturing capability saved what is now a triumph from a potential PR disaster. As the New York Times noted:

"A little over a month before the iPhone was scheduled to appear in stores, Mr. Jobs beckoned a handful of lieutenants into an office. For weeks, he had been carrying a prototype of the device in his pocket. Mr. Jobs angrily held up his iPhone, angling it so everyone could see the dozens of tiny scratches marring its plastic screen… People will carry this phone in their pocket, he said. … 'I won't sell a product that gets scratched,' he said tensely. The only solution was using unscratchable glass instead. 'I want a glass screen, and I want it perfect in six weeks.' After one executive left that meeting, he booked a flight to Shenzhen, China. If Mr. Jobs wanted perfect, there was nowhere else to go."

The result was that when the screens arrived: "the workers were assembling 10,000 iPhones a day within 96 hours. Another example: Apple had originally estimated that it would take nine months to hire the 8,700 qualified industrial engineers needed to oversee production of the iPhone; in China, it took 15 days."

Low wages are therefore no longer China's key attraction for foreign investors.

"Wages actually aren't that big a part of the cost of making consumer electronics… Paying American wages to build iPhones would add only about US$65 to the retail price of each handset, according to analysts' estimates. That's an amount Apple could likely afford. And in fact, China no longer offers rock-bottom wages. But when it did, it used that window 'to innovate the entire way supply chains work,' says Sarah Lacy at Pando Daily. China is now 'a place other countries can beat on sheer cost, but not on speed, flexibility, and know-how.'"

The second fundamental feature of the new situation for inward FDI is that since 2007, China has not only been an export base, but it has also been the world's most rapidly growing market in dollar terms as well as in percentage terms. This will only continue. This is a result of the fact that although the U.S. remains the world's largest economy, at market exchange rates, China's growth rate is almost three times that of the U.S. Consequently, as shown in the chart, in 2013 China's increase in GDP was US$1,038 billion compared to US$555 billion for the U.S., i.e. China's dollar GDP increased by almost twice as much as it did in the United States.

China's unparalleled market expansion presents decisive advantages for potential company growth. In stagnant or more slowly growing markets, such as the U.S. and Europe, to achieve rapid growth most companies have to increase market share. In China, in contrast, rapid growth can be achieved without gaining market share but simply through ongoing market expansion - an easier prospect. FDI is therefore increasingly taking advantage of China's domestic market, not for exports. A further result, consequently, is that FDI increasingly flows into the service sector, which primarily serves China's domestic market and not exports. In 2013, 52 percent of inward FDI went into China's service sector.

But if China's market expansion is the world's fastest, there is no doubt competition for companies engaged in FDI is becoming tougher in certain respects. In its earlier stages of development, China so badly needed FDI that it offered formal tax concessions and regulatory enforcement was sometimes lax. Tax concessions are already largely abolished, and lax enforcement is being tightened.

The latter includes dealing with criminality - in 2010 RTZ employees in China admitted taking kickbacks and recently GlaxoSmithKline was fined US$490 million after it was found to have bribed doctors to sell its drugs. Anti-competitive behavior is also being clamped down on. This year six infant milk powder companies were convicted of price fixing, and fined US$110 million, while 12 Japanese auto-parts makers were also fined US$200 million for the same offence.

Foreign companies investing in China continue to enjoy clear advantages in key sectors. These include in advanced technology industries, apart from defence - for example high end computer services and civil aircraft production; highly concentrated global industries dominated by global producers such as automobiles, and non-financial services in general - for example supermarkets and fast food chains. But in medium technology, or many rapidly growing industries, Chinese companies are increasingly tough competitors - Lenovo not only dominates China's domestic computer market but has become the number 1 PC producer globally, while China's smartphone manufacturers, such as Xiaomi, Lenovo and Huawei, are increasingly effective in domestic competition with Apple and Samsung.

Given the size and growth of China's market, inward FDI will remain at very high levels. But the days of China as a cheap labor export base are ended – because the majority of the world’s population is now at a lower level of economic development than China. Only by accurately analysing its real stage of development, and therefore its real position in the world economy, can China realistically assess its strengths and weaknesses in attracting foreign investment.

In a person modesty is admirable. But in serious economic matters neither boasting nor excessive modesty is a virtue – only realism. To navigate a ship must have an accurate chart – if it does not there is a danger it will hit a reef. The same applies not only to foreign investment but to China’s economic policy in general.

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This article originally appeared in Chinese in ‘Opinion Leaders’ at Sina Finance. An earlier version appeared in English at China.org.cn.