From the early 1980s until now China has grown at a pace not matched since the four decades Argentina enjoyed before the First World War. In spite of some fairly goofy attempts a few years ago, however, to characterize China during this period as having followed a set of policies called the “Beijing Consensus”, these decades did not involve a unified set of policies, or a set of related polices, that Beijing implemented consistently. It is far more useful, I would argue, to think about the past 3-4 decades as consisting of four very different periods, the last of which we are, with great difficulty, just starting.
The idea of a Beijing Consensus has probably help to prevent or postpone an understanding of the vulnerabilities in the current growth model and the steps China must take to address these vulnerabilities. Among other things this confusion made China’s nearly four decades of growth seem far more exceptional than it was, and so created the very lazy belief among analysts that there are no historical precedents that can guide us in understanding the strengths and the vulnerabilities of China’s economic trajectory.
Before explaining why China’s growth trajectory can best be understood by separating out these different periods I want to re-introduce the idea of social capital, a topic about which I wrote last year. As I use the phrase, social capital is the set of institutions – including the legal framework, the financial system, the nature of corporate governance, political practices and traditions, educational and health levels, the structure of taxes, etc. – that determine the way individuals are given incentives to create value with the tools and infrastructure that they have.
In a country with highly developed social capital, incentive structures are aligned and frictional costs reduced in such a way that agents are rewarded for innovation and productive activity. The higher the level of social capital, the more likely they are to act individually and creatively to exploit current economic conditions and infrastructure to generate productive growth.
It is a hard concept to explain precisely and to quantify, but the idea of differing levels of social capital helps explain why, for example, French entrepreneurs (not to mention Indian, Chinese, Mexican and Nigerian) are more likely to create successful tech startups in the US or the UK than at home, or why it is easier to start a business in Sidney than in Beijing, or why technological innovation is not evenly spread out among countries, even among countries at similar development levels, but rather tends to cluster in a few areas in a few countries where tech entrepreneurs seem to believe that their work is made easier and the rewards greater.
Developed countries are rich because they have higher levels of social capital than backward countries, and not, as is sometimes believed, because they have abundant capital stock. On the contrary, rather than the cause of wealth, abundant capital stock should be, but isn’t always (China may be an example), a consequence of abundant social capital. The resulting higher level of worker productivity makes it easier to justify additional infrastructure that saves the time and labor of productive workers. A high level of capital stock is a “symptom” of wealth, not a cause.
In developed countries, in other words, abundant social capital encourages residents and businesses to use available conditions and infrastructure in the most productive ways possible. Undeveloped countries, on the other hand, are poor because they do not have the often-intangible qualities that allow citizens spontaneously, and without planning, to exploit their economic and infrastructure resources most efficiently and productively.
How to become a developed country
A developing country needs to implement two sets of policies if it is to succeed in advancing to the developed stage. One set is pretty obvious. These are policies aimed at directly improving the environment under which businesses operate – by giving them the resources they need, such as good infrastructure, capital, and an educated work force.
The second set is much harder to prescribe and is aimed at improving social capital precisely so that individuals and businesses can use these resources efficiently and productively. These reforms involves creating productive incentive structures, robust and efficient legal systems with predictable enforcement, financial systems that allocate capital productively, limited political and elite interference in the wealth-creation process, limited rent seeking, clarity and ease in the ability to create businesses or otherwise create economic value for society, etc. It is perhaps worth noting that in every country, reforms that build social capital are likely to be highly idiosyncratic, and dependent on that country’s particular culture and history, which may explain why grand development theories applied uniformly to different countries never seem to work outside their country of origin.
To understand the challenges that face China today it is necessary to understand how these two sets of policies have very different political economy implications. Because the first set of policies often involves the allocation of resources from the center, it tends to receive tremendous support from a rent-capturing elite, and because these policies benefit the elite, this support tends to be self-reinforcing. The more the policies are implemented, the better for the elite, which in turn increases their power, which creates stronger support for the policies.
The second set of policies are much more difficult to implement because they often or usually require a dismantling of the distortions and frictions that create rent for the elite, thus the undermining the ability of the elite to capture a disproportionate share of the benefits of growth. A financial system that allocates capital efficiently and productively, for example, is not one that allocates capital on the basis of power or access. A fair, clear, and predictable legal system is not one in which some groups are privileged relative to others. If anyone can start a business, the benefits of monopoly or oligopoly are undermined.
The kinds of liberalizing reforms that increase social capital, consequently, are likely to be unpopular with the elites that have benefitted from their absence, unless perhaps the resulting or accompanying surge in wealth or productivity is great enough to allow elites to benefit even as their share of the benefits declines. This might be one reason why, as I discuss in my book, The Volatility Machine, that throughout modern history developing countries often seem to embark on liberalizing economic reforms only during periods of great international liquidity, when money is flowing into risky ventures like high technology, real estate, and developing countries.
While the liberalizing reforms usually undermine the ability of the elite to capture a disproportionate share of growth, in other words, because the reforms often seem to encourage massive foreign capital inflows, and these push up the price of assets largely controlled by the elite, political opposition to the reforms is weakened. If this is true, by the way, it means that attempts at implementing liberalizing reforms are successful mainly during periods of great global liquidity, and this might have implications for China, especially if over the next few years global central banks begin to withdraw the huge liquidity injections that have underpinned asset bubbles around the world.
From social capital to physical capital
With that lengthy preamble, let me return to China’s recent economic history. As I see it, the four periods that characterize China’s long growth spurt can be described this way:
1. The first liberalizing period. In the late 1970s and early 1980s Beijing forced through a series of liberalizing reforms that I would characterize as aimed at building social capital. By eliminating laws that severely constrained the ability of Chinese to behave productively, these reforms unleashed an explosion of economic activity that generated tremendous wealth creation. It became legal, for example, for Chinese to produce and sell as individuals, not just through the relevant and usually badly managed state-controlled collectives or organizations. A limited number of farmers were allowed to keep anything they produced above some quota, and agricultural yields doubled almost immediately. If a man believed there was a shortage of bricks in his town, he could create a company to manufacture bricks, and China’s hopeless jumble of soaring brick inventories in one part of the province matched by severe brick shortages nearly everywhere else was replaced with a system in which the more efficiently you made and delivered bricks, the richer both you and the country became.
But the implementation of the reforms was not easy. It undermined a very powerful party structure (not to mention the managers of the old state-controlled brick manufacturer) that had been built up over the previous three decades around the ability of its members to constrain and direct economic activity, and so these reforms met with powerful elite resistance. It was only, I would argue, because of the credibility, prestige, and power that Deng Xiaoping and the men around him had, and the loyalty they had built within the PLA, that Beijing was able to overcome elite resistance and successfully implement the reforms. Even in the 1990s, Deng struggled with elite opposition and my understanding is that his famous 1992 Southern Tour was arranged mainly to outflank and defeat provincial opposition to continued economic liberalization.
2. The “Gershenkron” period. As Chinese productive activity swelled it soon began, however, to run into infrastructure and capacity constraints. This began the second phase of China’s astonishing growth, one characterized by the marshalling of domestic resources to fund an investment boom aimed at creating infrastructure and capacity. Like the many previous examples of investment-driven growth miracles, China embarked on a program to resolve the major constraints identified by Alexander Gershenkron in the 1950s and 1960s as constraining backward economies: a) insufficient savings to fund domestic investment needs, which had to be resolved by policies that constrained consumption growth by constraining household income growth, and b) the widespread failure of the private sector to engage in productive investment, perhaps because of legal uncertainties and their inability to capture many of the externalities associated with these investments, which could be resolved by having the state identify needed investment and controlling and allocating the savings that were generated by resolving the savings constraint.
Because China’s infrastructure was far below its ability to absorb and exploit infrastructure efficiently and productively (its social capital exceeded its physical capital, in other words), it was relatively easy for the central authorities to identify productive investment projects, and as they poured money into these projects, the result was another surge in wealth creation from the early 1990s to the early 2000s. Although all Chinese benefitted from this wealth creation, the new elite benefitted disproportionately, in large part because of the constraints imposed on the growth of household income aimed at generating higher savings. Of course over time these new elites became politically entrenched. This elite today is famously referred to (in China) as the “vested interests”.
3. Investment overshooting. But China was still an undeveloped economy with “backward” (in Gershenkron’s sense) social, legal, financial and economic institutions that sharply constrained its citizens from achieving the levels of productivity that characterize developed countries. Its social capital was still very low, in some cases perhaps even as a partial consequence of policies that had led to the earlier rapid investment-led growth by allowing elites to control access to cheap capital, land, and subsidies. As investment surged, China’s physical capital converged with its social capital (i.e. its infrastructure more or less converged to its ability to exploit this infrastructure productively), after which additional physical capital was no longer capable, or much less so, of creating real wealth.
Instead, continued rapid increases in investment directed by the controlling elites (especially at the local and municipal levels) created the illusion of rapid growth. Because this growth was backed by even faster growth in debt, however, it was ultimately unsustainable. This period began around the beginning of the last decade, I would argue, and it is the period in which we currently find ourselves.
4. The second liberalizing period. What China needs now is another set of liberalizing reforms that cause a surge in social capital such that Chinese individuals and businesses have incentives to change their behavior in ways that generate greater productive activity from the same set of assets. These must include changing the legal structure, predictably enforcing business law, changing the way capital is priced and allocated, and other factors that determined the incentives, so that Chinese are more heavily rewarded for activity that increases productivity and penalized, or at least less heavily rewarded, for rent seeking.
But because this means almost by definition undermining the very policies that allow elite rent capturing (preferential access to cheap credit, most importantly), it was always likely to be strongly resisted until debt levels got high enough to create a sense of urgency. This resistance to reform over the past 7-10 years was the origin of the “vested interests” debate.
Most of the reforms proposed during the Third Plenum and championed by President Xi Jinping and Premier Li Keqiang are liberalizing reforms aimed implicitly and even sometimes very explicitly at increasing social capital. In nearly every case – land reform, hukou reform, environmental repair, interest rate liberalization, governance reform in the process of allocating capital, market pricing and elimination of subsidies, privatization, etc – these reforms effectively transfer wealth from the state and the elites to the household sector and to small and medium enterprises. By doing so, they eliminate frictions that constrain productive behavior, but of course this comes at the cost of elite rent-seeking behavior.
The uncertain process of liberalizing reforms
Because of rapidly approaching debt constraints China cannot continue what I characterize as the set of “investment overshooting” economic polices for much longer (my instinct suggests perhaps three or four years at most). Under these policies, any growth above some level – and I would argue that GDP growth of anything above 3-4% implies almost automatically that “investment overshooting” policies are still driving growth, at least to some extent – requires an unsustainable increase in debt. Of course the longer this kind of growth continues, the greater the risk that China reaches debt capacity constraints, in which case the country faces a chaotic economic adjustment.
Beijing must therefore embark as quickly and forcefully as possible upon what I have characterized as “second liberalizing period” economic policies, which in a sense means a return to the “first liberalizing period” reform style of the 1980s. There is by the way no longer much confusion over what these policies entail. Beijing knows more or less, perhaps a little later than optimal, exactly what must be done, although the sequencing of reforms is more controversial, and the proof that it understands the relevant issues is that the Third Plenum clearly and explicitly addressed the relevant issues head on, proposing at the end exactly the kinds of policies we would have expected if China is to embark on a new set of policies aimed at driving sharp increases in social capital.
The problem for China, of course, and as I think nearly everyone understands, is to implement these liberalizing reforms well before the country starts to bump up against its debt capacity constraints. Xi’s administration must do this against what is likely to be ferocious resistance from those who have benefitted enormously from constraints on Chinese productivity growth, and who consequently stand to lose the most from real reform.
I would argue that this is exactly what President Xi seems to be doing, and why even before he was formally in power he sought to consolidate power, undermine and frighten potential opposition, strengthen his relationship with the military, and unify the country’s policymakers behind the need for reforms. This may also be why PBoC Governor Zhou – who was among the first senior policymakers, I believe, to recognize the urgent need for China to rebalance economic growth away from the current debt-addicted model – seems to be among the key economic decision-makers.
Unless President Xi is successful in consolidating power and control over economic assets, an abundance of historical precedents suggests that he is unlikely to overcome powerful elite resistance. If he is successful – and for now I am cautiously optimistic that he will pull it off – he will be in a position to implement the urgently needed liberalizing reforms that will push China onto its next stage of sustainable productivity growth, in which case he is likely to be hailed as China’s greatest leader since Deng Xiaoping – and for many of the same reasons.
Perhaps not everyone in Beijing understands, however, that this will happen only after a difficult and probably long adjustment period, during which GDP growth rates, although not necessarily household income growth rates, must fall far more than they already have, for reasons I have discussedelsewhere. This matters to the long-term success of China’s reforms, because sharply slowing growth may revive or unify political opposition.
In fact I suspect the reason credit growth in the past year or two has not slowed nearly as sharply as it should, or as sharply as required by the economic analysis implicit in the Third Plenum reform proposals, is precisely because of the expected impact of meaningful credit constraint on GDP growth. Any attempt to rein in credit will sharply reduce GDP growth, and there is of course likely to be a positive correlation between lower growth and a stronger and more unified opposition. Xi must take steps to slow growth, but he might not yet be able to do so.
This piece is cross-posted from Michael Pettis’ China Financial Markets with permission.