We are now in the “third leg” of a world economic crisis that started in 2007. As I said in a recent post, whereas the first leg was provoked by failing subprime mortgages and the second leg by the crisis of European government debt, centered in Greece, this third leg involves the world impact of the deepening economic crisis in China.
Economic crises often provoke policy and political dilemmas. This one is no exception. Whereas economists promote the fiction that “one size fits all”—in other words, that there is an ideal economic solution to every problem that is best for everyone—this blog has argued that capitalism is a two-party system. In other words, what benefits one set of interests may be anathema to others. This is especially true during crises when rival interests become sharply polarized, as is true today.
The economic crisis in China presents a stark dilemma not only for Chinese leaders, but worldwide. The surprising viability of Donald Trump’s campaign for president is one indicator of the extent to which China’s dilemma is being exported to affect the political economy globally. It would be a mistake to underestimate Trump’s campaign as mere name-calling and buffoonery. It is so worrying to the political establishment not merely because of unseemly rhetoric, but because it taps into a viable alternative nationalist policy inimical to the business internationalists that dominate American politics.
The dilemma for China is whether to transition to a consumer-led economy or stay the course, maintaining an export and investment-led economy strategy. Most foreign commentators assume China must make a transition to consumer-led growth. Chinese officials sometimes seem to agree. However, the inertia within the Chinese political economy powerfully resists change.
One of the most powerful inertial forces is China’s relative decentralization. The U.S. has a federal system of government that leaves significant powers to state and local government, but American business is highly centralized and nationally integrated, especially since restrictions on branch banking were eased since the 1980s so that massive interstate financial corporations rose to dominate the credit system. Furthermore, the federal government has been gaining power at the expense of the states.
China was a highly centralized planned economy until the 1980s, when Deng Xiaoping began a series of reforms that significantly decentralized political and economic power. Instead of ministries in Beijing controlling key decisions on investment and production, enterprises were transferred to provincial and local authorities, and were urged to compete through markets rather than producing according to a national plan. Private businesses sprang up alongside the state-owned (but increasingly decentralized) companies.
Deng’s reforms were a huge success in spurring rapid growth of the Chinese economy. China has for decades since been among the fastest growing countries in the world, rising from near universal poverty to have a broad middle class with consumption patterns typical of developed countries and even scores of billionaires. Living standards have increased dramatically for most people, but so has inequality.
Growth throughout this period of reform has been led by two sectors: exports and investment. China developed from having little international trade in 1980 to the world’s largest trading nation today. Chinese manufactured exports dominate in broad range of industrial products. Investment spending as a percentage of gross domestic product has averaged the highest in the world for decades as China developed massive industrial infrastructure, comprehensive high-speed rail and highway systems, and vast construction of residential and commercial properties. On the other hand, consumption spending lagged since Chinese consumers tended to be paid modest salaries and yet save heavily.
This pattern of growth has become self-limiting. When China was a relatively small exporter, it could grow its exports at the expense of other countries’ market share by producing more cheaply. Today, China has such a large share of the world market in so many areas that its export growth has begun to bump up against the limits of the much slower growth of the world market as a whole.
Investment spending has also grown so fast that overcapacity has emerged. That is, China can produce much more than the available demand can purchase. Thus, for example, China produces roughly half the world’s steel, but has sufficient capacity to produce closer to two-thirds. Most of its steel mills are overbuilt and now saddled with excess capacity. Construction of apartment and commercial buildings has outpaced the capacity of consumers and businesses to rent them. For some time, real estate demand has been sustained only by credit-fueled speculation. Investors borrow to buy properties, expecting that ever-rising prices will yield profits in excess of the cost of borrowing, but as price increases slow from growing excess capacity, these investor expectations will eventually be disappointed.
If consumer spending were to rise sufficiently, perhaps domestic demand could begin to absorb idle capacity of industry and fill idle buildings with newly prosperous consumers. However, there are three major limits on consumer-led growth: (1) Chinese wages, although rising, are still quite low; (2) China’s underdeveloped welfare system (ironic for a nominally socialist society) means that many people save money for emergencies that, in developed countries, people would expect to endure by means of various social insurance programs; and (3) consumer credit is developing only now and still has a way to go.
However, solving these problems would create other ones—this is the dilemma. If Chinese wages rise significantly, China’s manufacturing exports will be less competitive. So many other countries are exporting a similar range of products; if costs of manufacturing in China rise, others may gain market share at China’s expense, further eroding China’s important export sector. Increased domestic demand might absorb some of what used to be exported, but probably not enough because many newly rich consumers also want to increase consumption of foreign products.
There is a further problem: local governments all over China have depended on the construction and investment boom to fund their own operations. As it slows down, they have maintained spending only by borrowing heavily. Local officials would mostly prefer to keep the old engines of growth going, including a booming property market. Local governments lack the taxing power that would allow them to gain a share of increased consumer income if growth shifts more toward consumers.
Recently, it seems that the Chinese government has determined that it cannot afford to let the property bubble burst, leading it to extend credit to local governments and increasing the ease of mortgage lending, thereby propping up demand for real estate with ever greater infusions of credit. Prices surged dramatically. Property speculators, including local governments and their cronies, are thus bailed out, but at the cost of ever higher prices that make homes more expensive (if not unattainable) for ordinary consumers. Increased credit can inflate property prices for some time, but eventually they grow too high to be sustainable, as had happened in Japan during its post-1990 real estate crash when prices reached such extreme levels that home buyers had to take out mortgages for as long as 100 years. Consumer-led growth must put more spending power in the hands of ordinary consumers, not real estate speculators.
Meanwhile, both public and private debt in China are growing so fast that many are worrying that the debt bubble must soon crash. This week, Moody’s downgraded the Chinese government debt rating in reaction. How this affects Trump’s candidacy and the U.S. presidential election will be my topic next time.
Originally posted on World Policy Institute blog on March 3, 2016 – The China Dilemma.