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Wednesday, September 24, 2003

WILL CHINA'S ECONOMY CATCH UP TO AMERICA'S OR THE THE EU'S? II: Further Reflections

This article is part two of a mini-series on the Chinese economy's long-term economic prospects, and in particular whether China will catch-up to the West --- the US or the EU --- in per capita income, levels of productivity, and technological prowess. The previous article was dubious on this pivotal matter, full of implications for China's relative power potential in the next few decades . . . and whether or not, in particular, China could emerge (as many claim or fear) as a serious peer-rival to the US in overall power and influence. The current article should be read after that earlier article, published on September 23rd hereZ: Will Pacific Asia Overtake the West in Wealth? Will China Become a Super-Power?. Like it, this article began its life as a long commentary at Brad DeLong

THEORETICAL REASONS --- SPECIFICALLY, CONVERGENCE THEORY AND CATCH-UP GROWTH --- WHY THE GROWTH RATE OF CHINA'S ECONOMY IS BOUND TO SLOW DOWN IN THE FUTURE

The current article began as a response to a question left in another post at the DeLong site and the forum on the economic destiny of China and the rest of Pacific Asia. Specifically, a Mark Bahner asked apropos of China's future growth prospects:"Isn't it a stylized fact by now that when a country crosses into first world status (whatever that maybe) growth slows down to match other first world countries?" Updated, the lengthy buggy response --- which draws on some key propositions in economic growth theory, applicable to both developing and highly developed countries --- follows.



I. CONVERGENCE THEORY AND CATCH-UP GROWTH: LEAD AND FOLLOWER COUNTRIES

1) The first answer: yes, sooner or later what in convergence catch-up theory are called follower countries --- which will initially grow much faster than the lead country or countries with their more advanced levels of technology, productivity, and per capita income, and often for decades ---- tend to slow down in growth as they close the gaps in productivity and per capita income and approach the technological frontier.
Hence the US, for decades after WWII, grew slower than any of the other industrial countries in West Europe or Japan --- later, the East Asian dynamos --- until the 1980s.

By the end of that decade, Germany and Japan -- for instance -- had raised their per capita income (calculated in purchasing power terms) to about 85-90% of the US level . . . only to fall back to around 70% since then (for reasons to be discussed momentarily).

2) Not all developing countries will be caught up in steady catch-up convergent growth on the lead country. Essentially, there are institutional and educational pre-requisites: stable government, fiscal responsibility, protection of property (in China, still haphazard), ability to defuse ethnic and class conflicts (in Asia, by authoritarian government after WWII until the 1990s; and still that way in China), and --- not least --- a sufficiently high level of education and literacy so that the country's labor force can use modern technologies with skill . . . almost always, of course, by importing them from the lead country or countries and showing an ability to defuse them over swathes of their economy through positive spillover effects. China's big growth as the poorest country in Pacific Asia, for instance, didn't begin until the post-Mao market-oriented reforms, carried out initially in the countryside, after 1978. Its growth rate since then --- calculated in official figures to be around 8.0% annually --- is probably at least a third lower than that, and maybe lower still. All the same, it's a high GDP growth rate for 25 years (unless, as someone like Thomas Rawski has argued --- see above --- the rate since 1997 has been close to zero.)

3) William Baumol --- who, along with Moses Abramovitz of Stanford, is the pioneer of modeled convergence theory --- calls those countries able to launch themselves onto a path of sustained economic growth "members of the convergence club." The backward economies of Central Asia, Pakistan, the Near and Middle East, and Tropical Africa --- in contrast to North and Southeast Asia and India, plus several countries in Latin America like Mexico, Chile, and Brazil ---- don't meet these institutional and educational pre-requisites, any more than the Communist Soviet union . . . after its initial quantitative-driven GDP in the early Stalinist period.

 



II. WHAT EXPLAINS WHY COUNTRIES QUALIFYING FOR THE CONVERGENCE CLUB WILL GROW FASTER THAN LEAD COUNTRIES?

1) First off, by way of an answer here, the follower countries have more abundant capital investment opportunities, with a higher return on their low levels of cumulative capital stock than the rich leader countries enjoy on their far greater capital stocks. Simple diminishing returns notions explain the gap here.

2) Simultaneously, in the early stages of sustained GDP growth, follower countries have more opportunities at reallocating capital and labor from unproductive subsistence agriculture and unproductive handcraft industries ---- or, in the case of China, a bloated, low-productive collectivized agriculture (where about 2/3 of the Chinese labor force was employed in 1978 at the start of the reform era) --- and shift them to more market-oriented, growth-potential industries. China's reforms leapt ahead in productivity precisely on this score, once a combination of private ownership of land (not legally recognized still) and private and communal-owned manufacturing industries got under way. Within a few years, agriculture output soared; about a third of the peasant labor force streamed into the new manufacturing industries; and all this happened even though the state-owned sector throughout the 1980s and early 1990s continued to grow in employment too. Since 1997, the regime --- despite major social tensions, strikes, and protests --- has pruned the state-enterprises of about a third of the 120 million employees, with the laid-off workers moving into the ranks of the unemployed, of the transient swollen temporary workers moving in and out of towns and cities looking for work, or into the underground economy, including surging crime.

--- A related reason for successful reallocation of capital and labor in China, then, has been the opportunities for higher productivity of reducing the bloated, bankrupt state-owned enterprises, over a million at one time, with the CP party's goal, it seems, to further reduce these to about 10,000 giant firms that it no doubt hopes to use for controlling the economy, including giant private firms with multinational partners --- and of course the banking system --- in ways that paralleled the corporatist authoritarian reign of the South Korean military from the 1950s until the 1990s. The commanding heights of the economy will be ostensibly privatized or told to operate as private firms; but they will have multiple layers of formal and informal protection, get privileged access to capital through the banking system (whether or not its officially nationalized or not), and enjoy higher wages without formal rights of free unions for their labor force as ways to buy off the workers. All the rest will have to fend for themselves.

--- And a final reason for the initial leap in productivity growth in the 1980s has to do with the ways in which service industries weren't counted as part of GDP (or its equivalent in state-centralized economies). The shift to market reforms in the 1980s brought these service industries into official GDP for the first time. The result? Productivity leapt ahead too in line with the newer, higher levels of GDP.

3) On top of abundant investment opportunities and initial opportunities for reallocating capital to more productive uses, China --- like other countries launched onto a path of sustained catch-up convergence --- can import technologies developed abroad, diffuse them, and hence experience technological progress on the cheap. This can be done either by use of royalties or inflows of multinational capital and plants, either wholly owned by the home-country firm or in partnership with Chinese firms. The Chinese government has preferred the latter course. In the upshot, it has become the largest recipient of multinational investment in the developing world; and this year, it has looks like receiving more inflows than even the US, until now the biggest target of such investment.

By contrast, the closer a country that progresses technologically this way approaches the lead countries' levels of advanced technology and hence the technological frontier, the less it's able to rely on such technological transfers, and the more it has to switch to its own technological innovation and breakthroughs . . . a far more intellectual challenge, and much more costly in R&D as well. Japan may be an object lesson. Though its big export-oriented industries have shown a remarkable ability to import US and EU technological innovations --- automobiles, TVs, VCRs (developed by RCA here and Phillips in Holland), DRAM chips, photography etc --- and improve impressively on their production in both quality and cost-reduction, its firms and universities are not known for technological innovation, and Japan's industries have faded in ICT and biotechnology (ICT refers to information and communication technologies).

4) And of course, topping everything else as a way to grow rapidly in the initial stages of catch-up economic growth, a poor follower country can rely on export-led growth, particularly into the rich leader countries markets. In principle anyway. In reality, Japan and even the EU have blocked a great deal of Pacific Asian exports in competitive industries (with Japan's big firms slightly an exception, where the production of inputs is carried out by the cheaper labor forces in their multinational offshoots in China and SE Asia: but without noticeable transfers of their own advanced technologies to them, unlike what US advanced ICT firms have done in transferring large amounts of technology to Taiwanese partners above all). The US market, by contrast, is much more wide open. In consequence, by the late 1990s, Americans were absorbing three times the value of Pacific Asian mfg. exports on a per capita basis compared to the EU, and even more so than that for Japan.

 

III. WHY CHINA'S GDP GROWTH WILL LIKELY SLOW DOWN, NOT JUST MUCH FASTER THAN JAPAN HAS THE LAST 12 YEARS, BUT COMPARED TO THE EAST ASIAN SMALL DYNAMOS LIKE HONG KONG, TAIWAN, SOUTH KOREA, AND SINGAPORE.

1) If you look at Japan's growth rate since 1975 --- the big turning point in post WWII economic growth in the industrial world --- you will find that not only did its rate of GDP annual growth slow down by over 2/3, compared to the US's slow-down by 1/3 over the previous 30 years, but also that the US GDP rate has been slightly higher. Germany's rate slowed down by about 55-60% too. As a result, though both had closed the per capita income gap with the US from around 40-50% in 1950 to close to 85-90% by the late 1980s, they have fallen back to around 70% since then.

2) The simplest explanation? The poorer a follower country is when it begins convergence catch-up growth, the faster it will initially grow in converging on the leader country or countries. Oppositely, when capitalism shifts course radically --- big shifts in the most promising industries, big shifts in technology particularly in a period of general-purpose, radically restructuring technologies like ICT and biotech and now nanotech, and big shifts in market dynamism thank to globalizing activities --- the faster these countries' growth rate, it appears, will slow down.

3) To clarify briefly, what seems to happen to these once fast-growers is that their institutions and cultural habits and policies that worked well in the past turn out --- in such eras of technological flux and globalizing redistribution of economic dynamism and market structures --- to have rigidified and harden and hence to resist market-driven adaptation.

Remember, the poorer a follower country is once it begins sustained GDP growth over several decades or more, the faster it will grow for the reasons mentioned in II. In the process, it develops a series of corporate governance, financial institutions and relations with big corporations (cozy banking and corporate interlocking directorships, with Japan going further and having join ownership of banks and corporations by each other), a larger state role to compensate for a lack initially of large numbers of entrepreneurial middle classes --- a Japanese and German and French pattern going back to the 1870s and 1880s, as Alexander Gerschenkron best explained decades ago --- and various crony relations between financial, corporate, and administrative agencies. A variety of subsidies, protection, and industrial targeting (more so in Japan than in Germany) will likely emerge too as a way of trying to leapfrog technological steps and advance on the front-running lead country or countries. Export-led growth is built into such a system, what with the poor levels of per capita income in the country . . . and of course in the case of Taiwan, South Korea, Taiwan, and Hong Kong, a fairly small population to boot. In short, the institutions, policies, and cultural habits of the fast-growing follower countries embody from the outset a logic contrary to standard free-market assumptions about flexibility, adaptability, and efficiency.

Assume now that these institutions, policies, and informal relations work successfully for decades, despite their conflict with standard market-theories . . . . just as they did in Germany and Japan in the late 19th and early 20th century, then again after WWII, for the first 3 or 4 decades after 1945. They harden into a rigid status quo, the more so if government or corporate welfare leads to increasing rigidities in labor markets, blunted incentives to entrepreneurial innovation, and the lavish use of subsidies or other forms of protection to insulate the economy against change. Germany, of course, is part of an EU free-trade system, and that helps offset some of these features. All the same, its economy as Adam Posen, a specialist on the Japanese economy, has recently noted resembles more and more the Japanese statist-trap, with belated reforms now underway.



4) Can we be more specific? In particular, what explains concretely the rigidities and built-in institutional and cultural resistances to effective adaptability to change?

Apparently, it's largely due to blunted competition in the home market, with a reliance on giant cartel-like elite corporations and on decades on export-led growth behind various kinds of restrictions on such competition --- either domestically or in the form of protection against foreign competitors . . . plus, it's important to add, the need to buy social peace among the masses in the thinking of the political elites. Japan and Germany, for instance, experienced bursting violence and extremist ideological and class-based conflicts in the interwar period, followed by brutal Nazism in Germany and fascist-like militarism in Japan, with whipped-up nationalist frenzy for rallying the masses and ruthlessly aggressive war abroad. After WWII, the fear of similar conflicts pervaded the West German and Japanese political system and its corporate, administrative, and political elites' thinking.

All worked fine for decades. Specialists and journalists galore, by the late 1980s, saluted the Rhineland model of corporatist capitalism and the even more successful Japanese corporatism, slated, it was said, to overtake the US in GDP in a decade, then in another decade in per capita income . . . with the US, it was further argued, in need of adopting one or other of the models: more welfarism, more regulation, more industrial targeting, more subsidies and protection, much less competition and far more cozy cooperation between government, big finance, and corporate firms.

5) The outcome? In an era of major technological flux and globalizing shifts in capitalist dynamism --- new competitor countries, big changes in growth industries, a need for entrepreneurial creativity, and major policy adjustments in the public sector --- these institutions and cultural traditions, at odds with market efficiencies, have proved unable to adjust effectively. In the process, Japan will be lucky, it seems, if it manages to stay even near the front ranks of industrial countries --- its record in GDP growth since 1991 the worst in the industrial world since the 1930s --- while Germany has emerged as the worst grower in the EU, a big break according to the recent IMF projections, on EU economic recovery in an era of stagnant growth.

 

IV. MORE SPECIFICALLY, WHY CHINA'S GROWTH WILL LIKELY FOLLOW A SIMILAR PATTERN, ONLY AT A FAR EARLIER STAGE OF DEVELOPMENT

1) Japan and Germany, for all their troubles, are advanced industrial countries with a century or more of big economic growth behind them, good universities and a research base, and since 1949, an effective political system in both for dealing with conflict and winning democratic consent. (Japan's, it's true, is dominated by a single party, the LDP itself a brake on change because the electorate really has no way of punishing a government for economic failure as the Germans at least do.) China, by contrast, remains an authoritarian system with far more market inefficiencies --- in fact, an incoherent system of corporatist capitalism and small-firm capitalism on one side and a bankrupt bloated state-owned enterprise system and shaky and probably near-bankrupt state-owned banks on the other --- without built-in safety nets and no effective means other than threats of repression and crackdown on dissent for handling the swelling waves of social discontent, social tension, and social conflicts that have been at work there for well over a decade now . . . along with more and more strikes and street-protests. Only in the rich booming areas of the southern coastal cities is social peace more or less in existence. And the entire domestic market remain fragmented, across regions and within them.

2) On top of that, recall a key point in the argument that was set out earlier in this forum: the government has followed since 1978 an easy-to-hard reform sequence, with all the difficult reforms still lurking in the wings: a drastic pruning of the state-enterprise system, a sanitization of the shaky, debt-plagued banking system, far more decentralization of decision-making to private firms, the need for allocating more and more capital to a social security safety net and environmental protection, the need for a drastic overhaul of education, and the pressing urgency of improving managerial skills and opening up the economy to competition, whether home-grown or foreign-generated. For that matter, the protection of private property languishes; and the legal system hardly protects intellectual property rights, which results in systematic piracy of others' innovations and brakes technological creativity in the home market by undermining the ability to inventers and innovative firms to capture enough profits to implement risky innovations.

3) Nor is that all. The huge gap between urban areas and the countryside persists, with agriculture, where the reform era started, badly neglected since the mid-1980s . . . as does the gap between regions, especially the booming southern coast and the northern rust belt and the interior hinterlands.

Even with an effective, adaptable, and legitimate political system --- which China lacks, and will lack increasingly the more epochal economic upheaval goes on with a CP authoritarian system in place, itself dominated by a privileged powerful elite that's also growing rich in the process --- these institutional and policy reforms and changes would be hard enough. In the existing system, the chances seem slim.



4) Another point. For reasons mentioned earlier about convergence catch-up growth, abundant early investment opportunities, and reallocation of capital and labor to more productive industries at the start of the post-Mao era and into the 1990s, China's GDP growth can't be said to be strictly quantitative. . . a matter of more and more inputs of capital and labor in standard neo-classical form. Productivity did advance, especially what's called total factor productivity, which is captured among other things in the World Bank's outstanding 1997 study, China 2020, especially in the first appendix that sets out a growth accounting model.

All the same, since the initial big reallocative changes, about the only qualitative technological advance to keep productivity growing has come from the huge influxes of multinational investments. Even then, China is not the recipient of advanced technological transfers; and the early hopes of its post-Mao leadership in the 1980s to leapfrog technological progress and join or better the Japanese, the US, and West European levels of technology have proved a big failure. Even today, two decades later and with trillions of dollars invested in highly protected industries, China's main exports are of low and middling-technology, and its firms are used by its multinational partners for cheap, finishing production for the most part.

 

V. THE INEVITABILITY OF SLOWDOWN: In fact it's already occurred and will be more pronounced in the future.

If we pull the various threads of the argument together, what conclusions emerge? Two stand out.

(i) Conclusion One.

Simply put, despite a greater reliance on foreign technology imports, multinational inflows, and exports abroad compared with the Soviet Union (and of course Maoist China), China's economy since the early era of reforms, the 1980s, seems to be dependent more and more on quantitative inputs of capital and labor, particularly with slower qualitative, productivity-driven advances the last decade or so.

In the upshot, diminishing returns will --- without the difficult reforms mentioned a couple of moments ago implemented --- very likely set in as capital accumulation goes on. In fact, compared to the high-flying days of growth in the 1980s and early 1990s --- even on dubious official Beijing national income statistics --- the Chinese economy has lost about a quarter to a third of its initial rate of GDP growth. No surprise really. The same thing happened to the Soviet Union. Early on, in the 1920s and 1930s, it grew rapidly for two decades or so, first in the era of the NEP and then udner Stalin; it then returned to a high growth rate, compared to West Europe and the US, in the 1950s and early 1960s . . . only for diminishing returns to set in and overwhelm its rigid statist economy. From the 1970s on, the economy became a bankrupt wreck, unable to shift to qualitative productivity-driven growth. In the late 1970s and throughout the 1980s, despite Gorbachev's efforts after 1985 to reform the economy without turning it into a market-oriented one, it hardly grew at all, period.

Nor is the Soviet Union's rigidly statist economy the only example, or for that matter other Communist countries in the past. Hard as it may be to believe, Brazil and Mexico grew from 1950 until 1980 or so just about as fast as China has since 1978 --- somewhere between 6.0 7.0% annually over those three decades. Then their institutional, policy, and cultural traditions proved inflexible and increasingly inefficient, and they suffered big setbacks until the more recent restructured forms of development began in the mid-1990s (with NAFTA a big thrust to Mexican growth since then).

On all these grounds --- theoretical, comparative, and historical --- China's economic future looks fraught with problems and threats, not promise and dynamism as recent rhetoric, including apparently Martin Wolf's, seems to imply. That's one side of the convergence theoretical equation.

 

(ii.) Consider now, to cap the argument --- our second conclusion --- the other side of convergence catch-up growth: the economy of the leader country, the US.

Full convergence between follower and lead countries goes on, but that doesn't mean the follower countries will succeed in converging on the leader in per capita income and levels of productivity. If anything, at times, the leader country can actually revitalize itself and not just retain its lead but increase it.

That has happened for the US, the leader country since the 1880s.

As its performance since the 1970s shows, we are experiencing a new era of radically shifting global capitalism. Full of technological flux and tumultuous pressures on national economies to change and adapt, the radical changes have been caused, in particular, by two sets of dynamic influences: 1) a host of radically restructuring technologies in ICT, biotech, and now nanotech, and 2) powerful globalizing shifts in dynamism and market structures as capitalism has spread into Asia and the former Soviet Union. The outcome? As in the 1880s and the big breakthroughs in the radically restructuring technologies of electrification, the internal combustion engine, and mass assembly-line production --- or in the 1930s and late 1940s when new vehicles, air travel, mass tourism, mass credit-installment buying, synthetics, and the new media of radio and later TV first appeared --- a premium in the latest era of radically altering capitalism has been put on economic flexibility, adaptability, and innovation as well as entrepreneurial start-up firm. On all these counts, the winner so far has been the US . . . once more, just as in the earlier pivotal turning points in capitalism since the 1880s. Once more, in an era of flux and relentless economic and technological change, the US has again sustained its lead and even increased it against its rival follower competitors whose institutions, policies and regulations, and cultural habits prove less flexible, less adaptive, and less innovative.

The implications here for the future are easy enough for anyone to draw, no?