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China’s Lost Decade

Stephen Shaver/Polaris
Chinese Premier Wen Jiabao and German Chancellor Angela Merkel, Beijing, July 2010

As for China’s universities, they get high rankings in surveys that apparently don’t value academic freedom.5 But Fallows notes that few in the country who have a choice—not even Politburo members—want their kids educated there; if they can, they send their children abroad, especially to the United States. Meanwhile, a decade after joining the World Trade Organization, the country makes only minimal efforts to protect intellectual property, while the rule of law is often ignored. His conclusion: “A China capable of creating its own Boeing, its own Airbus, would have to be a transformed China from the one we know now.”

That isn’t the government’s view, of course. Along with energy, telecommunications, and defense, aviation is a sector over which the government has announced it will maintain “absolute control.” (It also says the state will maintain “strong influence” over automobiles, machinery, information technology, steel, metals, and chemicals.) In most of these sectors, state-owned firms enjoy monopolistic or oligarchic positions. Private firms, if they exist, face significant discrimination.

Such state planning has a long history in China, which we are reminded of when reading Justin Yifu Lin’s Demystifying the Chinese Economy. Born and raised in Taiwan, Lin is probably China’s most famous economist. For reasons still unclear, he swam over to China from a nearby island controlled by Taiwan in 1979 and was feted as a patriot. (In Taiwan, where he had been on military service, Lin is still officially a deserter and cannot return without facing arrest.) He became an advocate of market reforms and cofounded a research center at Peking University. He recently retired as the World Bank’s chief economist.

Lin’s book requires a fair amount of patience, not because it is particularly technical but because one has to plod through pages of politically correct mumbo-jumbo to get to the interesting bits. The history section is all but useless; his explanations are so flawed as to be interesting only if one wants to be reminded how official Communist historiography is a sequence of gloss-overs and half-truths. We learn nothing about land reform or Mao’s disastrous decision to emulate the Soviet economic model. Instead, Lin blithely concludes that “copying the Soviet model was a smart and practical option.” Even though the book is based on his lecture notes at Peking University, he pulls more punches than most economists inside China. At least for a foreign reader, the book comes across as painfully circumspect.

But another way of looking at his book is that—even though published by a prestigious academic publishing house—it isn’t meant to be a rigorous study; instead it’s to be read between the lines. And indeed with the help of a bit of Pekingology, it has value. His main point is that China first followed a “Comparative Advantage Denying” strategy but under Deng began to follow a “Comparative Advantage Following” strategy. This is Lin’s code for rejecting and then embracing market economics. It’s only toward the end that Lin gets to his point:

Since 2003 the Chinese government has been using macro controls to cool the economy, but it has not worked. Why? For a simple reason: the government failed to take radical action to tackle the cause, the increasingly inequitable distribution of income in recent years.

That has led to a wealth gap that is among the largest in the world, “with the unemployed and retired left behind.” The result is that “discontentment and grievances have begun to simmer in the community.” Policies over the past decade, he implies, have been of the old “Comparative Advantage Denying” variant; in other words, a turning back of the clock to state control.

After making these refreshingly clear statements, Lin then meekly prescribes a few general fixes without discussing the political implications—essentially begging the question of why these issues have languished for a decade. His main prescription is that state enterprises need to be privatized once they are “viable,” although he doesn’t say if most state enterprises are or when this might happen. He has nothing to say about fostering creativity or innovation.

Far more vigorous and systematic is Nicholas Lardy’s take on the past four years. Lardy, one of the preeminent economists working on China and a fellow at the Peterson Institute for International Economics in Washington, has written a fairly technical book aimed at people who really care about the Chinese economy. Like Fallows, Lardy ends up pointing to the country’s political dysfunctionality.

Lardy starts by praising Premier Wen’s team in an opening chapter that will give pause to many China skeptics. He takes aim at foreign criticism of China’s 2008–2009 stimulus package, calling it “early, large, and well designed.” China rolled out a $586 billion stimulus in 2008, months before the Obama administration’s measures were passed into law. He notes approvingly that it was relatively much larger: the US package was $787 billion but for an economy two and a half times larger than China’s. Also, the Chinese plan almost completely focused on infrastructure projects—James Fallows’s airports, for example. By contrast, a third of the US stimulus measures were in the form of tax cuts, which households predictably put toward paying down debt—sensible for individuals but ineffective in stimulating demand. The result is that while the US and the rest of the world plunged into recession, China’s economy chugged along, somewhat slower but avoiding catastrophe.

China was better able to afford its hefty stimulus, he argues, because it had low levels of debt. Households and enterprises hadn’t been sucked into dangerous debt quagmires because China resisted Western advice to introduce fancy derivatives and other poorly understood financial products. Derided as too cautious, China’s mandarins began to look pretty smart—something worth keeping in mind when considering today’s predictions of doom.

Having praised China’s economic policymakers, Lardy proceeds to damn them. He writes that China’s leaders are aware that their policies are unsustainable. In 2007, Premier Wen told parliament that “China’s economic growth is unsteady, imbalanced, uncoordinated, and unsustainable.” But it was precisely during Wen’s time in office that China’s economy went awry. Lardy points to political reasons: the leadership, he writes, is “focused on maintaining political stability by keeping inflation low and ensuring steady growth of nonagricultural employment.” These aren’t bad goals but instead of achieving them through reforms, Wen and his advisers resorted to sleights of hand.

Shortly after Wen took office in 2002, for example, China began holding down the rates paid on bank deposits, which kept credit cheap for the state-owned enterprises that get most bank loans. In addition, the exchange rate was held artificially low. Although the yuan has appreciated against the dollar in recent years, on a trade-weighted basis it only moved slightly.

From the government’s perspective, these policies funneled cheap capital (not to mention subsidized power and land) to state enterprises, which kept employment up and prices down. They also had the benefit of solidifying the role of state enterprises in a broad array of industries, which made conservative planners happy. The low exchange rate benefited export industries, which are located in China’s wealthy and politically powerful coastal provinces. This allowed China’s factories to hire the surplus labor that flows out of the countryside each year. All of this was designed to tamp down social unrest.

But as Lardy shows, these policies had many serious costs. Households began to earn an ever-shrinking share of China’s economic output. The low interest rates alone, he estimates, cost Chinese families the equivalent of $100 billion between 2002 and 2008. Unable to earn much by keeping money in the bank, many Chinese put their money in real estate, causing a huge property bubble that has yet to deflate. Other assets, from Yunnanese tea to contemporary art, also exploded in value, rippling across global markets.

Some government measures tried to help households. Over the past decade, China has set up a welfare and health insurance system and abolished many rural taxes that caused local unrest. But he shows that much of this has been eaten up by a “repressive” banking system and is too limited in scope. These measures were politically easy ways to spend money because they did not challenge vested interests.

If policymakers knew these problems were brewing, why didn’t they take course corrections? Lardy is typically succinct:

The emergence of a collective leadership system and the rise of special interest groups is a much more compelling explanation of China’s failure to pursue economic rebalancing policies more aggressively since 2004.

And yet the implication of this statement is bleak: surely no one can wish strongman rule on China. Perhaps, one wonders, the looming crisis may focus minds? These books were written before the current political crisis, when a member of the Politburo was suspended and his wife held on suspicion of murdering a foreign businessman. This Chinese leader, Bo Xilai, symbolized the confluence of statist economics and repressive social politics. In theory, his removal could weaken those forces, allowing the incoming leadership team of Xi Jinping and Li Keqiang to push through a Deng-style revolution. It is possible, but it is equally likely that Bo’s removal will force the new leadership to placate leftists. Already, state propagandists have hit back at economists who propose reforms. That many of them are politically liberal is no coincidence.

Fallows’s book provides an example of what could happen in China if it tries to muddle through. Instead of Boeings or Airbuses, China could produce the equivalent of Russian Tupolevs—second-rate airplanes that will only sell among captive customers at home or client states abroad. Is this China’s fate? Taking the long view, Fallows reminds us that we’ve been asking this question for decades:

The contradictory signals from China…make us eager for the choice to emerge, clearly and definitively, to end the suspense that has been building for forty years, since Richard Nixon’s 1972 visit, so we can know whether to regard China as friend or foe.

Wisely, he refuses to predict.

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