China’s bumpy new nor­mal

Financial Mirror (Cyprus) - - FRONT PAGE -

China’s shift from ex­port-driven growth to a model based on do­mes­tic ser­vices and house­hold con­sump­tion has been much bumpier than some an­tic­i­pated, with stock-mar­ket gy­ra­tions and ex­change-rate volatil­ity in­cit­ing fears about the coun­try’s eco­nomic sta­bil­ity. Yet by his­tor­i­cal stan­dards, China’s econ­omy is still per­form­ing well – at near 7% an­nual GDP growth, some might say very well – but suc­cess on the scale that China has seen over the past three decades breeds high ex­pec­ta­tions.

There is a ba­sic les­son: “Mar­kets with Chi­nese char­ac­ter­is­tics” are as volatile and hard to con­trol as mar­kets with Amer­i­can char­ac­ter­is­tics. Mar­kets in­vari­ably take on a life of their own; they can­not be eas­ily or­dered around. To the ex­tent that mar­kets can be con­trolled, it is through set­ting the rules of the game in a trans­par­ent way.

All mar­kets need rules and reg­u­la­tions. Good rules can help sta­bilise mar­kets. Badly de­signed rules, no mat­ter how well in­ten­tioned, can have the op­po­site ef­fect.

For ex­am­ple, since the 1987 stock-mar­ket crash in the United States, the im­por­tance of hav­ing cir­cuit break­ers has been recog­nised; but if im­prop­erly de­signed, such re­forms can in­crease volatil­ity. If there are two lev­els of cir­cuit breaker – a short-term and a long-term sus­pen­sion of trad­ing – and they are set too close to each other, once the first is trig­gered, mar­ket par­tic­i­pants, re­al­iz­ing the se­cond is likely to kick in as well, could stam­pede out of the mar­ket.

More­over, what hap­pens in mar­kets may be only loosely cou­pled with the real econ­omy. The re­cent Great Re­ces­sion il­lus­trates this. While the US stock mar­ket has had a ro­bust re­cov­ery, the real econ­omy has re­mained in the dol­drums. Still, stock-mar­ket and ex­change-rate volatil­ity can have real ef­fects. Un­cer­tainty may lead to lower con­sump­tion and in­vest­ment (which is why gov­ern­ments should aim for rules that but­tress sta­bil­ity).

What mat­ters more, though, are the rules gov­ern­ing the real econ­omy. In China to­day, as in the US 35 years ago, there is a de­bate about whether sup­ply-side or de­mand-side mea­sures are most likely to re­store growth. The US ex­pe­ri­ence and many other cases pro­vide some an­swers.

For starters, sup­ply-side mea­sures can best be un­der­taken when there is full em­ploy­ment. In the ab­sence of suf­fi­cient de­mand, im­prov­ing sup­ply-side ef­fi­ciency sim­ply leads to more un­der­util­i­sa­tion of re­sources. Mov­ing la­bor from low­pro­duc­tiv­ity uses to zero-pro­duc­tiv­ity un­em­ploy­ment does not in­crease out­put. To­day, de­fi­cient global ag­gre­gate de­mand re­quires gov­ern­ments to un­der­take mea­sures that boost spend­ing.

Such spend­ing can be put to many good uses. China’s crit­i­cal needs to­day in­clude re­duc­ing in­equal­ity, stem­ming en­vi­ron­men­tal degra­da­tion, cre­at­ing liv­able cities, and in­vest­ments in pub­lic health, education, in­fra­struc­ture, and tech­nol­ogy. The au­thor­i­ties also need to strengthen reg­u­la­tory ca­pac­ity to en­sure the safety of food, build­ings, medicines and much else. So­cial re­turns from such in­vest­ments far ex­ceed the costs of cap­i­tal.

China’s mis­take in the past has been to rely too heav­ily on debt fi­nanc­ing. But China also has am­ple room to in­crease its tax base in ways that would in­crease over­all ef­fi­ciency and/or equity. En­vi­ron­men­tal taxes could lead to bet­ter air and wa­ter qual­ity, even as they raise sub­stan­tial rev­enues; con­ges­tion taxes would im­prove qual­ity of life in cities; prop­erty and cap­i­tal-gains taxes would en­cour­age higher in­vest­ment in pro­duc­tive ac­tiv­i­ties, pro­mot­ing growth. In short, if de­signed cor­rectly, bal­anced-bud­get mea­sures – in­creas­ing taxes in tan­dem with ex­pen­di­tures –could pro­vide a large stim­u­lus to the econ­omy.

Nor should China fall into the trap of em­pha­sis­ing back­ward-look­ing sup­ply-side mea­sures. In the US, re­sources were wasted when shoddy homes were built in the middle of the Ne­vada desert. But the first pri­or­ity is not to knock down those homes (in an ef­fort to con­sol­i­date the hous­ing mar­ket); it is to en­sure that re­sources are al­lo­cated ef­fi­ciently in the fu­ture.

In­deed, the ba­sic prin­ci­ple taught in the first weeks of any el­e­men­tary eco­nom­ics course is to let by­gones be by­gones – don’t cry over spilt milk. Low-cost steel (pro­vided at prices below the long-term av­er­age cost of pro­duc­tion but at or above the marginal cost) may be a dis­tinct ad­van­tage for other in­dus­tries.

It would have been a mis­take, for ex­am­ple, to de­stroy Amer­ica’s ex­cess ca­pac­ity in fiber op­tics, from which US firms gained enor­mously in the 1990s. The “op­tion” value as­so­ci­ated with po­ten­tial fu­ture uses should al­ways be con­trasted with the min­i­mal cost of main­te­nance.

The chal­lenge fac­ing China as it con­fronts the prob­lem of ex­cess ca­pac­ity is that those who would oth­er­wise lose their jobs will re­quire some form of sup­port; firms will ar­gue for a ro­bust bailout to min­imise their losses. But if the govern­ment ac­com­pa­nied ef­fec­tive de­mand-side mea­sures with ac­tive labour-mar­ket poli­cies, at least the em­ploy­ment prob­lem could be ef­fec­tively ad­dressed, and op­ti­mal – or at least rea­son­able – poli­cies for eco­nomic re­struc­tur­ing could be de­signed.

There is also a macro-de­fla­tion­ary prob­lem. Ex­cess ca­pac­ity fu­els down­ward pres­sure on prices, with neg­a­tive ex­ter­nal­i­ties on in­debted firms, which ex­pe­ri­ence an in­crease in their real (in­fla­tion-ad­justed) lev­er­age. But a far bet­ter ap­proach than sup­ply-side con­sol­i­da­tion is ag­gres­sive de­mand-side ex­pan­sion, which would counter de­fla­tion­ary pres­sures.

The eco­nomic prin­ci­ples and political fac­tors are thus well known. But too of­ten the de­bate about China’s econ­omy has been dom­i­nated by naive pro­pos­als for sup­ply-side re­form – ac­com­pa­nied by crit­i­cism of the de­mand-side mea­sures adopted af­ter the 2008 global fi­nan­cial cri­sis. Those mea­sures were far from per­fect; they had to be for­mu­lated on the fly, in the con­text of an un­ex­pected emer­gency. But they were far bet­ter than noth­ing.

That is be­cause us­ing re­sources in sub­op­ti­mal ways is al­ways bet­ter than not us­ing them at all; in the ab­sence of the post-2008 stim­u­lus, China would have suf­fered sub­stan­tial un­em­ploy­ment. If the au­thor­i­ties em­brace bet­ter-de­signed de­mand-side re­forms, they will have greater scope for more com­pre­hen­sive sup­ply-side re­forms. More­over, the mag­ni­tude of some of the nec­es­sary sup­ply-side re­forms will be markedly di­min­ished, pre­cisely be­cause the de­mand-side mea­sures will re­duce ex­cess sup­ply.

This is not just an aca­demic de­bate be­tween Western Key­ne­sian and sup­ply-side econ­o­mists, now be­ing played out on the other wide of the world. The pol­icy ap­proach China adopts will strongly in­flu­ence eco­nomic per­for­mance and prospects world­wide.

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