Pettis on China, Part Six

Part five in a series reflecting on a Michael Pettis essay...

Comparing development models

1.       In the US case this seems to have been brutal domestic competition. If China wants to benefit from its own protection of infant industry, it is important that there be similar domestic drivers of innovation and efficiency. Note that access to cheap capital cannot be such a driver, even though it is one of the main sources of Chinese competitiveness. Access to cheap capital is just another way to protect infant industries from foreign competition. 

***I agree 100% with this.  I do wonder at the world “brutal domestic competition.”   Competition means to “strive with” not fight with.  How can competition ever be brutal.  When did we get the idea that life without subsidies or preferences is “brutal?”***

2.      Every country that has become sustainably rich has had significant government investment in infrastructure, but not every country that has had significant government investment in infrastructure has become sustainably rich.On the contrary there are many cases of countries with extraordinarily high levels of infrastructure investment that have grown for a period and then faltered. 

***Except Hong Kong, and if you look more than 200 years, government is irrelevant, and if you calculate government investment and return on investment, you’ll find in the last 200 years, including government investment in war, “government” has been a disaster on every single metric.***

I would argue that the difference is almost certainly the extent of capital misallocation. In some countries it has been much easier for policymakers to drive capital expenditures, and in those countries it seems to have been relatively easy to waste investment. If this is the case in China, as I believe it is, the key issue for China is to rein in its spending and develop an alternative and better way to allocate capital. 

***Yes, in free markets.  Of all the places in the world, China today has less government pound for pound than any other place, and it also has the best government in the world under the aegis of the Communist Party.  Go figure.  But the point is yes, experiment in even less government ...  “protect the borders and deliver the mail, let the people handle everything else."***

The point is that there is a natural limit to infrastructure spending, and this limit is often imposed by institutional distortions in the market economy. When this natural limit is reached, more investment in infrastructure can be wealth destroying, not wealth enhancing, in which case it is far better to cut back on investment and to focus on reducing the institutional constraints to more productive use of capital, such as weak corporate governance and a weak legal framework. The pace of infrastructure investment cannot exceed the pace of institutional reform for very long without itself becoming a problem. 

***Exactly.  Here again LaDany’s book on law might be helpful.  Lex Mercatoria and common law would be a good start. The UCP of the ICC... all private law.***

3.      Any economy looking to achieve sustainable long-term growth must have a “good” financial system that allocates capital efficiently and rewards the correct level of risk-taking. It is hard to determine what the characteristics of a “good” financial system are, but we shouldn’t be too quick to assume that this has to do with stability.

***And certainly it is beyond the ability of government to define characteristics and correct levels. ***

What’s more, while obviously the capital allocation process is vitally important, I would also suggest that the liquidation of bad loans is just as important. Bad loans, as Japan showed us in the past two decades, can become a serious impediment to growth in part because financial distress distorts management incentives in the way widely understood and described in corporate finance theory and in part because they retard the process by which bad investment is absorbed by the economy.

***Yes, as we see in the cases of Cypress and USA, that refuse to liquidate zombie banks, and places like Iceland and Estonia that have already bounced back after repudiating the debts.***

4.      One thing I have not discussed above is the role of wages. The American System was developed in opposition to the then-dominant economic theories of Adam Smith and David Ricardo, in part because classic British economic theory seemed to imply that reductions in wages were positive for economic growth by making manufacturing more competitive in the international markets. A main focus of the American System, however, was to explain what policies the United States, with its much higher wages than in Europe at the time, had to engineer to generate rapid growth Sustaining high wages, in fact, became one of the key aspects of the American System.

***This presumes there was some government policy on wages.  The highest wages in medieval Europe were after the Black Death wiped out 1/4 of the population.  Spanish wages skyrocketed after the gold began pouring in, and Spain has never recovered.  Be careful what you wish for, or what you think you see with only a 200 year view.***

The Japanese version of this development model, as well as many of the various versions implemented in other countries throughout the 20th Century, shared its view of wages not with the American System but rather with classic British economic theory. Rather than take steps to force up wages and keep them high – thereby both driving productivity growth and creating a large domestic consumption market for American producers – many of the later versions of the American System sought to repress growth in household income relative to total production as a way of improving international competitiveness. This is perhaps the main reason why the United Sates, unlike many other countries that have implemented similar development strategies in the 20th Century, tended to run large current account deficits for much of the 19th Century

***Aside form a tendentioous reading of history, Pettis seems ot believe the state should have a wage policy.    There is nothing to show that this is a good idea.***

This different focus on whether high wages are to be encouraged or discouraged is, I believe – although very little discussed in the theoretical literature as far as I know – nonetheless perhaps the most important difference between the American development model and its many descendants in the 20th and 21st centuries. I would even argue, although I cannot prove it, that one consequence of this difference is that growth in demand tends to be more sustainable when it is balanced between growth in both consumption and investment.

***Mr. Pettis would do well to acquaint himself with the Austrian school literature.***

In analyzing China’s growth in the past three decades we seem to forget that there have been many growth “miracles” in the past two hundred years. Some have been sustainable and have led to developed country status but many, if not most, were ultimately unsustainable. Nearly all of the various versions have had some similar characteristics – most obviously infant industry protection, state-led investment in infrastructure, and a financial system that disproportionately favored producers at the expense of savers – but the way these characteristics played out were very different, in large part because the institutional structure of the economy and the financial sector created a very different set of incentives.

***I think it is an error to think we are so advanced and those before the industrial revolution so backward that taking any longer view is unnecessary.  Capitalism will be gone in less than decades, and maybe within the year.  Will we adapt as easily as the communists have as their system folded, that is without violence?  Not unless we know of working alternatives that we can move to...***

I would argue that in understanding China’s growth and its sustainability we need to have a clear understanding of why these characteristics worked in some cases and not in others. Most economists who focus on China seem to know little about economic history, and when they do, their knowledge tends to be limited to a very superficial understanding of US economic history. 

***Wow.  Ummm... pot... kettle... Never mind...***

But there are many precedents for what is happening in China and not all suggest that further Chinese growth is inevitable.

On the contrary, the historical precedents should worry us. In most cases they suggest that China has a very difficult adjustment ahead of it and the closest parallels to its decades of miracle growth suggest unfavorable outcomes. Understanding why the growth model has succeeded in some few cases and failed in most will help us enormously in understanding China’s prospects.

***When our system goes down, or once we realize the game is over, then every country will have it hands full.  The question is do we in the capitalist countries understand what works and what does not?***
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