About Economic Transitions

You've read all about it, I've read all about it. I've talked to the economists and think-tanks in Beijing who wrote the message in the first place, and felt the sincerity and conviction with which they deliver it. I've gone through their numbers, and tried to understand what they actually mean. So yes, everyone is agreed that China is embarking on a change of economic model which will shift the dynamic of growth from investment and exports, to domestic consumption.

But there are three obvious problems. The first is that these transitions are incredibly hard to achieve:  the economic and political history of the last 100 years is littered with examples of economies which tried and failed. The second is that, as they say, 'you wouldn't want to start from here' - the transition China intends is probably the most extreme ever envisaged and even with the best policy-settings and initiatives, would take not years but decades of sustained effort to accomplish. The third is that the immediate and compelling responses to China's current economic challenges can only entrench the existing model deeper than ever.

Let's take these three separately. The pattern of economic history has been repeated several times now. I wasn't around at the time, but the history books tell me unequivocally that in the early 1950s the Soviet Union  had achieved economic miracles and looked economically invincible. People looked at the extraordinary  mobilization of resources, and wondered what the US could offer in response. Richard Nixon's 1959 answer - way-cooler kitchenware  -  hardly seemed plausible, but turned out to be right.  Japan has attempted it at least twice - once in the aftermath of the first oil shock, the second with the implosion of the bubble economy. (Three times actually, if you include the Taisho democracy of the 1920s.)  How's it going?  Well, Japan is determined, organized and deploys an astonishing accumulation of social capital, but its nominal GDP last year was just about what it was in 1992.  South Korea talks a good game about making the transition, but  devalues the Won at the whiff of economic grapeshot.

The reason that these transitions are so rarely achieved is bound-up in the very foundations of economic success. For simplicity's sake, let's say that the transition being attempted is one from an 'exogenous growth model' to an 'endogenous growth model.'  Exogenous growth models are in essence rather simple and can be quite wildly successful. The recipe is this: muster savings ruthlessly and pile them into industry. You'll produce far more than you can consume, but don't worry, because you can always export the surplus (that's the 'exogenous demand' bit of the 'exogenous growth model').  On the assumption that exogenous demand is inexhaustible, you'll be able to do this right up to the point at which adding up-to-date capital, technology and management techniques stop raising productivity levels. Or savings run out.

If you are a political leader, you'll pick up above all on two aspects of this model. First, it justifies enduring financial repression, in which consumption is discouraged, savings encouraged, and the financial system heavily monitored/regulated.  You'll  like that, not least because it'll pay your bills.  Second, in the short, medium and even long term, it can be wildly, unbelievably successful in terms of growth and employment. And everyone'll like that.

So why bother to change? Good question - and one which the Japanese still haven't managed to answer. But we  know that when a country approaches the technological frontier, the going gets a lot tougher. By which I mean, returns on capital fall, cashflows begin to dry, the failures of resource allocation become more noticeable and costly, and finally investment opportunities dry up, and growth with it. (Probably around the time your people are beginning to want that way-cooler kitchenware.)  

But here's the rub. The very success of the exogenous growth model over decades will have taught the political leadership that beyond any shadow of doubt they know how to make things work. Save harder. Invest more.  Keep your currency competitive. Not only does your experience tell you this, so does every businessman and financier who comes through your office door.  To do anything other than double-down goes against every instinct in the body politic.

And so, you double down . . . . and lose. It's the hardest lesson in economics: it is only by ruthlessly repudiating the lessons learned in the decades of success that you can transcend the model's limitations.  More later. . . .