The four stages of Chinese growth

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 discussed elsewhere. 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.

 

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63 Comments

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  1. I’ve just finished Steve Jobs bio and now Irealize that Prof. Pettis is the Steve Jobs of Economics. I have no academic economics background whatsoever yet I can actually understand what he is writing, and it is beautiful!

    P.S. I’m suggesting a new twitter hashtag #JiaYouXi

    P.S.S. An easy way that he can succeed is by starting a war with some country and than blaming any elite who is against him as siding with the enemy then pushing them out. Oldest trick in the book. Just has to be a small war and a war he can win for sure. (OK I’m not really suggesting that, just as a thought experiment, but if he only has one or two years, desperate times call for desperate measures…)

    • Starting a war is a terrible. The last thing China needs in a geopolitical sense is more pressure from the United States. Flying under the radar has worked for 30 years and is still the best option. If China starts a war with one of the Southeast Asian countries over the South China Sea, for instance, the US *will* intervene and China *will* lose.

      • You miss the point and the time-frame.
        China won’t start the war NOW .
        I have to mention that based on the past 100 years Chine is one of the most peaceful countries on the earth.As far as I concern they simply don’t care about other countries.

        BUT if the current leadership choose to transfer the workers/capital from the infrastructural investment into the military production ,then in 7 years Chine capable to be “the” global power, with higher military capacity than the US.
        Currently the 2.5% of the GDP flowing into the military, considering the sheer size of the population,5% should be on par with the US spending , and China can tune up the military spending to the 25% of the GDP ,and with this level even they can manage improvement is the level of living at the same time.

        25% for a seven years period should make twice as capable military than the US one.It can make a military powerful as the NATO.

        And the million $ question:
        IF Chine go down on the military road (like the US did it in the II. WW) then at the end of the road, will they stop?

        I think the chance for this is quite slim.Chine is not so interested to start or prepare for a war.Probably 5-10% chance?

        • The problem with China’s future productive capacity towards war is its population demography. The population workforce size has already started to fall even though the population will grow until 2030 or so. The current economic transition will probably turn China’s focus inward. Even after this rebalancing (which will be over in about 15-20 years), China will have new problems from a quickly decaying demography.

          Another point of note is that the US has access to two different oceans with no country near it able to match its naval and air capabilities. China only has access to one ocean where it’s surrounded by lots of different countries who are very hostile towards it (ex. Vietnam, Taiwan, Japan, Korea). I also doubt that North and South Korea will remain separated for too much longer, which could become a problem for China.

          • Suvy

            The demographics is a long term problem, the lack of sensible investment is a current one.

            So in the long term they won’t spend too much for military, however if you analysed Germany in 1930 you said that (correctly) in 20 years time Germany will spend small amount of the GDP for weapons.And it is true, in 1950 Germany spent next to nothing for military :)

          • The demographic problem is a long term problem that’s now starting to become a problem. In 2013, the workforce size of China already started falling and there were 17% more boys born than there were girls.

            Also, Germany in 1930 was coming off the bursting of a massive consumption boom where unemployment eventually reached 55-60%. China is at the end of a production boom with very little unemployment as of right now. The economic circumstances are very different.

            I also think the geopolitical circumstances are very different. China is surrounded by Vietnam, Japan, Korea, and Taiwan–all of whom are hostile towards it. I’m pretty sure the US wants to take a containment policy towards China while Japan is already starting to militarize. India’s new PM, Narendra Modi, is already building alliances with Japan and has sought out Japanese investors for an Indian infrastructure development fund. There’s a good chance India, Japan, Korea, Vietnam, Taiwan, and maybe even Australia form an alliance to contain China with the help of the US. If China tries to fight all of those borders all at once, the country will break from the inside out.

            If China tries to go the US route, starts to militarize, and then becomes expansionist, it will be forced to fight across a very large border with lots of different countries. In that situation, I do not think China will be able to hold together for very long. It’s not easy for a large country to be able to fight wars on all of its borders all at once when all of the countries its fighting are all united.

  2. Very good post. Thank you. I think you are winning the battle for minds finally. And best of all, without being negative towards China, as I know you are not, and never have been. When a GDP growth number is one figure, and “which GDP growth rates, although not necessarily household income growth rates, must fall far more” is a complex thought. Your message has been consistent. Positive.

  3. Excellent article.

    Do you have any suggestions for reading on how China’s legal system is (or is not) transforming into a fair and predictable organization? (any good weblogs on it?) This has always looked like a Sisyphean task to me.

  4. Announcing another round of infrastructure spending, as as done two weeks ago, seems to suggest that there is immense pressure to keep the credit taps flowing.

    • I think QE is also playing a role. I wonder if the Chinese government can keep pumping new credit into the system if the Fed begins to tighten.

  5. Hi Michael

    Li Keqiang recently mentioned in a speech (http://uk.reuters.com/article/2014/06/16/uk-china-economy-premier-idUKKBN0ER01720140616) that China is still aiming for 7.5% growth this year and medium to high growth in the future. Do you think that this means China will still be stuck in stage 3 of the model you described?

    • I think this year they will certainly try to hit the 7.5% target because they have sort of committed themselves to it, and there may even by a certain amount of political signaling going on. We’ll have to see how they discuss GDP targets next year.

  6. I recently read something that is hard to believe. China has used more cement in the past 3 years than the US did in all of the past century. Could this be true? How can China slow down this blistering pace? And has the capacity utilization rate really fallen to below 60%?
    Your post captures this drama quite diplomatically.

  7. I don’t think this will work, in the end. The king is capturable. Domestic opinion is also capturable, but much more expensively so. Ultimately, the second stage of liberalization can’t really happen without substantial political liberalization, since, for good or evil, public opinion can stand on one flank of elite opinion so as to defend changes more efficiently.

    • Yes, this has been one of the big debate topics — can they impose liberalizing reforms even as they tighten politically? This is not an easy question to answer. In the case of Deng’s reform, there was no need to tighten politically so much as to transfer power away from the former supporters of the Gang of Four and the old-style Maoists. More to the point, economic liberalization almost always leads to pressure for political liberalization, especially if it ends up dispersing power. In fact is hard to think of authoritarian countries that achieved a certain minimum level of economic development without experiencing tremendous pressure to open up the political system. Parts of China have already come close to those minimum levels of economic development, haven’t they?

  8. At the Third Plenum they announced the Economic reforms and at the same time announced the crackdown on corruption, supposedly in response to popular demand. Is it not more likely that the crackdown on corruption is a tool being used to subdue the Vested Interests and force them to accept the economic changes that will reduce their power through fear of being investigated if they show any opposition.
    By this means the structural changes can be pushed through faster.
    And in the meantime they can just announce GDP growth rates in the 7′s even if they are not not real, and so reduce public opposition

    • It is not the announced rates that matter. It is the real economic performance of the elite and of unemployment among the workers that matter. Announced GDP growth rates may have some signaling effect, but in the end people want more than signals.

    • or crack down on corruption is Chinese attempt to tackle the unsustainable increase in debt.

  9. Is not the entire emerging world that is in need of liberalization reforms? It is not just China that has been growing since the early 90s, the entire emerging world has been booming since then despise some crises. But now revolts against the elites of these countries have been blowing up all around the emerging world from people that have not benefit much from this grow or new middle classes expecting better services and further social mobility . Is not this case of the Arab spring, protests in Brazil, Turkey and others, the election results in India, as well as the political crisis in Thailand?

    But on the other side of the coin, is not this need for further liberalization in the emerging countries what the developed world needs? As liberalization succeeds and economic repression diminishes consumption should increase in these emerging countries given the global economy the additional demand it needs to restart grow again in the developed countries.

    • Roubini shares some of the concerns expressed here, in If Spain Leaves the Euro and in Economic Consequences of Income Inequality about how a tiny elite systematically concentrates the wealth resulting from economic activity and / or from monetary creation in both developed and developing markets. He calls it The Great Backlash and says it has started. Link below.

      The words of Maurice Allais come to mind: “[...] The analysis shows how cautiously one should consider the prosperity of an economy in real terms as long as potential imbalances are developing, at first sight small in relative terms, but able to trigger, when they crystalize and compound, deep changes in collective psychology.” La Crise Mondiale d’Aujourd’hui, 1999 (my translation).

      Of course, 15 years later, the imbalances are not so small anymore…

      http://www.project-syndicate.org/commentary/nouriel-roubini-likens-the-rise-of-nationalism-today-to-that-of-authoritarian-regimes-during-the-great-depression

  10. I believe we should take the advice of Mr. Wing with the Chinese economy. “Don’t get it wet, keep it out of bright light, and never feed it after midnight.”

  11. With the ongoing credit expansions and China’s recent-ish currency devaluation, it would seem that China’s economy hasn’t started rebalancing at all. Doesn’t this just mean the “lost decade” it will face lasts longer than it otherwise would?

    I also have to wonder, if the US decided to impose protectionist measures to resolve (or severely reduce) it’s trade deficit with China, would that end up forcing the rebalancing to come sooner rather than later?

    • Maybe, but in fact the currency has appreciated quite a lot since 2005, wages rose sharply in 2010-11 and wage growth seems to have stayed strong, and , most importantly, the financial repression tax has collapsed in the past four years as nominal GDP growth rates dropped from around 20% to 8-9% currently, so I would argue quite a lot of rebalancing has taken place or is taking place. The key, I think, is how long it takes Beijing to get credit growth down.

      • Could you give a thought to those of us dependent on exports to China when you talk about throttling credit. Some of the Chinese importers who previously were able to access letters of credit are having difficulty doimg so right now. They have customers for their imported product (your rebalancing to consumption) but are taking a hit because of the new restrictions.

        Some people can get credit – perhaps your vested interests are able to take advantage of their access to finance to squeeze out their competitors,, rather defeating the point of the whole exercise.

        I think the current credit restrictions were more to do with fears of runaway inflation than long term rebalancing. The effect of the restrictions has also taken the Chinese govt a bit by surprise I imagine. The aim would have been to slow things down rather than tip the economy over. The fragility of current worldwide growth applies to China as well as everyone else.

        If you want to achieve a successful rebalancing you need to think about how you are going to get income directly to the lower classes. Low income housing, cheaper education, old age pensions, etc needs to be considered.

        • At this point the various measures of credit do not seem to suggest any “throttling” of credit, but with so much “new lending” going to roll over debt that cannot be repaid, it feels like credit in China, at least in certain sectors, is very tight. I think we need to wait out the next few months to see just how the credit markets evolve.

  12. Prof. Pettis,

    What role does QE play in all this and what about the possibility of the EU doing its own QE to roll over sovereign debt of bankrupt nations? Would the possibility of the new QE in the EU allow China to keep rolling over the bad debt for another decade?

    • Not another decade, I don’t think, but it certainly seems to give EM countries more time to postpone reforms (and developed countries too).

  13. Hi, just a suggestion. The term social capital actually has other meanings in the social sciences literature, essentially referring to things like guanxi and who you know, stuff like your Ivy and I-banker friends. For disambiguation, may I suggest you change the term social capital to societal capital?

    Yours,
    a reader

    • Yes, I am not sure I am crazy about the phrase. Perhaps I should have called it institutional capital.

      • Personally, I think using Social capital, qualifying with Institutional, is better, because of the loaded nature of the word Social, in the dialogues of some ideological reviewers. It is better that the true nature, becomes associated more than cultural sociology, or bound up within class power politics. So, yes, Social includes those Societal and Institutional facets of capital that you discuss. Personally, i feel it beneficial to discuss as you do, such that people are introduced to factors that widen the term out of the baseness of many Sociological ideological battle terrains.

    • That’s a very good point, Anon.

  14. Extremely interesting article.. Very curious to know Mr. Pettis’ take on India, where something similar might be afoot..

  15. India could probably use some Gershenkron-style policies, but I am not sure they could ever take their foot off the accelerator once it got going.

  16. Prof. Pettis,
    While the current system has many pitfalls as you pointed out, like rent seeking activities, it probably has also created incentive for the authority at local and municipal level to facilitate economic processes – “get things done”. As you mentioned, consolidating power is very much needed to overcome the resistance of the vested interest. However, “over-concentration” of power might also lead to the unintended consequence of non-cooperative behavior within the admin / political system as incentive disappears. Hence the future problem might no longer be “rent seeking” activities, but bureaucracy and inefficiency. How big is this risk?

  17. Prof. Pettis,

    While the current system has many pitfalls as you pointed out, like rent seeking activities, it probably has also created incentive for the authority at local and municipal level to facilitate economic processes – “get things done”. As you mentioned, consolidating power is very much needed to overcome the resistance of the vested interest. However, “over-concentration” of power might also lead to the unintended consequence of non-cooperative behavior within the admin / political system as incentive disappears. Hence the future problem might no longer be “rent seeking” activities, but bureaucracy and inefficiency. How big is this risk?

  18. Prof. Pettis,
    While the current system has many pitfalls as you pointed out, like rent seeking activities, it probably has also created incentive for the authority at local and municipal level to facilitate economic processes – “get things done”. As you mentioned, consolidating power is very much needed to overcome the resistance of the vested interest. However, “over-concentration” of power might also lead to the unintended consequence of non-cooperative behavior within the admin / political system as incentive disappeared. Hence the future problem might no longer be “rent seeking” activities, but bureaucracy and inefficiency. How big is this risk?

  19. I have been observing chinese development for a long time, and I quite like some o fthe points you make.

    It is amazing that you are aware of the Gerschenkron stories, which have a nice pedigree.

    But my impression is that a large part of that the Chinese policy makers have done is based on:

    * Studying what Taiwan and Singapore have done, especially Singapore. They also studied Japan and Korea, but it seems that they concluded that Japan and Korea are too cohesive to be taken as models.

    * The Chinese leadership are nominally Marxist, and there is a lot of interesting stuff in his works about development economics and the transition from low to high capital in an economy. I suspect that must have impressed the Chinese leaders who have been trained on Marxian literature.

    * Studying other rapid transitions from poverty to riches, such as that happened in Italy a country very similar in some respect to China or Taiwan in culture.

    * I suspect that they also looked at chinese history, as almost every economic and political system has been tried.

    I have also been very impressed by the unofficial memoirs of a former General Secretary who was deposed by Deng. The first half of his book is political, but the second half is mostly about the economy, and some of the aspects of the story you tell, and they are extremely interesting.

    But overall I don’t like an aspect of your terminology: China overall has not been an underdeveloped economy. From a long term, anthropological point of view, it has always been a first class, highly developed society and economy.

    But it has been a *poor* one, a capital poor one in particular as you mention, and a large part of their policies have indeed been about that. Again the memoirs of that deoposed leader have been for me very interesting as to his approach, because before being deposed by Deng, the policy of development was created by him, and it has not been arguably changed since.

    • When people say China is an underdeveloped economy it is based on objective economic measurements. Economic performance like production, income and education all back up this perspective. China probably fell further and further behind the West in economic performance from the 1800s until making incredible strides in closing the gap over the last thirty years. There is no doubt that China has a highly-sophisticated and amazing culture. As I noted below in other comment, I think people confuse culture as a proxy for social capital. In the same way, culture is not a proxy for economic development.

  20. I really enjoy reading Prof. Pettis’s posts and agree with much of his analysis, but I do not share his optimism when it comes to China implementing the next stage of liberalizing reforms. I can identify two major problems as to why any attempts at further reforms cannot go smoothly

    >> If China stops building all those ghost towns and roads to nowhere, tens of millions will be jobless. With so many jobless, hopeless (also mostly single) men running around, how does the leadership prevent Tiananmen II ?

    >> How can household consumption rise to compensate for the lack of investment under such circumstances ? Why will households increase their spending in the face of a huge spike in joblessness and a sense of crisis all around, especially given the fact that there is hardly any social safety net in China to speak of ?

    The Party will not willingly implement these reforms as it will undermine the Party itself. I can see this ending badly. I won’t be surprised if China goes the USSR way in the not too distant future. No wonder so many of China’s corrupt elite is moving to the west these days.

    • You may well be right, Dr. Maulik. They have an incredibly difficult balancing act and might or might not pull it off. What I wanted to do in this piece is not so much predict what would happen but rather discuss what an orderly “good” rebalancing would look like, because even a good rebalancing has some fairly dramatic implications for growth.

  21. Hi prof,

    Do you think education system is a major reason why China social capital is still low?(gaokao system)
    And what are the most efficient way autorithy kept chineese wage low?

  22. Hi prof,

    Do you think education system is a major reason why China social capital is still low?(gaokao system)
    Don’t you also think social capital is very easy to troll. When you see endless debate about global warming or nuclear energy in USA. There are some very powerfullobby out there and they are ready to curb the truth.

    • I think there is a great deal of awareness within China about weaknesses in the educational system, including too much rote learning, plagiarism, strong disincentives for encouraging creative thinking, etc. The problem is that it is very hard to change an educational system comprehensively, especially when that change must be driven by the groups who have most benefitted from the system..

  23. Michael, like you said , perhaps a lot of the countries that became wealthy and developed (mostly Asians :Jp,kr, and Taiwan) they were one of the few that managed foreign capital inflow “correctly” . And in hindsight they were successful because survived the liquidity shortage of United States (during the 1980s) , and many other liquidity stopgaps. Perhaps capital inflow management is as important as institutional( social) capital.

    And there are a few countries around the world maybe in small pockets-where social capital is lacking -but have reached the incomes of developed countries; oil producers predominantly.
    And there are countries with high social capital , but bad capital inflow management ,struggle to break into rich nation status , for example modern Argentina .

    • Yes, and you have to remember that Taiwan and South Korea became economically successful under very special circumstances. They are small and their “success” was vitally important to the US during the Cold War, and during their adjustments there was significant political turmoil ending in their becoming robust democracies. It might not be easy to replicate the circumstances of their success for China, and sometimes I think people are too quick to assume that what happened there can easily happen again even under very different conditions.

    • I think some people with argue with the idea that Argentina has high social capital. Parts of Argentina might seem like Europe on the surface, but it’s politics, legal system and economy have been very unstable for a long time. I think people are confusing culture for social capital and economic development. There is more to an economy than watching pretty girls walk by while sipping on a cup of coffee at a cafe in Recoleta (Buenos Aires). (Of course, I wouldn’t discount the value of watching pretty girls.)

      You will definitely find pockets of European/Russian sophistication in Russia and other former USSR states, but for most of them their institutions are corrupt and a disaster post-communism.

      Argentina might seem different because it historically has had a strong populist movement. However, Argentine populism has been messy, corrupt and misdirected. This might be an example for China and other developing countries to avoid. Perhaps this is what Prof. Pettis is concerned about with the political situations in Southern Europe and elsewhere. He has warned of radicalism of the right and left in these countries during their painful economic adjustments.

  24. ….then are most developed country governments are busy destroying social capital by over regulation and by occupying too large a position in their economies?

    • Social Capital low

      I would venture several reasons…..

      Elite Perspectives and Interest

      Some benefit disproportionately and want this benefit to continue.

      Some benefit disproportionately and believe it is in the interest of the Nation.

      Some benefit disproportionately and see a geographically cohesive territory, bound and linked by infrastructure and this is an over-riding desire of them, perhaps sublimating emotional relations to their disproportionate benefit)

      Some realize that others are benefiting disproportionately and will do similarly as the others are doing, knowing there is a better way.

      Others see what is being done and how systemically it is destructive and want to alter, but are challenged by the notions of the previous.

      State of Development (Superficially, the top level notions, and “what the eyes can see”, seem successful, thus why change when so much is going well, especially for those able to benefit from it, the elites)

      Pace of Development (The rapidity of development, under the time-frame where it has occurred, has enabled progress, while creating all sorts of notions, interests, perspectives, problems and opportunity spaces, and risks, that didn’t previously obtain in the Society)

      Ease of Some Types of Development (what has been done, is rather easy to control, thus success is easily gained, from managing relatively few elements in the system, thus progress is achieved easily)

      Michael’s Social capital is how countries achieve escape velocity and move from low-middle, or middle income status to advanced countries.

      Some inhibit that movement because of selfish, parochial reasons, others fear such a movement, and others fear not making the movement. Some would be happy were the movement not made, others would be happy were there to be a disruption, so that other goals, bound up within subjective views of history, politics, ideology, and philosophy can be had.

      So the reason that Social capital has not developed if, it hasn’t, would be to the impact and inter-relations between those perspectival elements and views of members of society.

    • This would be a perspective of some on the socio-politico-economic spectrum.

      The word economy comes out of philosophical thought a few hundred years ago to mean, roughly “Rule”, and “Management of Private Affairs”, so, it has to do with an individuals management and rule of their private affairs. The limited forms of this at the Global level would be the Embedded Liberalism of Multi-Lateral governance institutions, a light touch, without much, Sovereign Westphalian interference in the Economy, embodied in Global Society as a Market, that is enabled through a mysterious, ultimately unknowable Invisible hand, that somehow interacts to produce progress, at least enables a higher level existence among sovereign men. Of course this is disagreed with by others, who often conspiratorially, appeal to, criticize the lighter hand, because of beliefs and values they hold otherwise, which revolves around notions of Power, Money and Elite control, or who preference a stronger Westphalian Sovereign system (non-interference in the sovereign affairs of other nations). Some who are influenced by these notion, rahter than a light hand, support Mutli-lateral Redistribution as Liberal cosmpolitans, like those who support the Light Hand of Embedded Liberalism, others, Marxists and Anti-Imperialists, support Mulit-Lateral Redistributionism, stressing bottom up approaches, these notions are often supported by Westphalians, who use ML Redistributionism, to support elite control, for propaganda and Soft power enhancements, and for influencing external and internal dialogues.

      Now to drill down, what is happening in developing countries, with de-regulation memes, is likely a far swing of the pendulum which will see movement back in the other direction. While some still sing the praises, the de-regulated banks have been reconsolidating, as has other deregulated industries. These things swing back and forth on pendulums in all societies, globally.

      I am not sure that all developed countries are doing that, and necessarily there are some ideological trends that are destructive of social capital, as there are some social policies that are destructive of social capital, or the elements supportive of its enhancement, and none of this in truth, is ever found within the dogma’s, of the ideological trenches, of those who make their living and fame of holding perspectives on any side of the dialogues.

  25. Sir,

    In the wake of the discussion around the Piketty book, I see your use of the word rent-seeking and think of Rentier in the Ricardian sense being expanded to include returns on capital in general. Is this what you refer to? Isn’t it much harder in the 21st century to determine whether seeking a high return on capital is mal-productive or whether it creates value through taking on risk?

    For instance earning a return on capital for investment in an entrepreneurial venture seems to obviously create more value than earning a return on capital off a piece of real estate. But do not the increasing complexities of all asset classes make it impossible to declare some rent seeking as parasitic and other as productive investment ?

    Thank You

    • Piketty’s work is rather flawed. Piketty doesn’t look at upward/downward social mobility nor does he ever mention winner take all effects.
      http://uneasymoney.com/2014/06/19/further-thoughts-on-capital-and-inequality/

    • I think of rent-seeking or rent-capture more in terms of the ability of sectors within the political establishment to enrich themselves in part by creating and enforcing constraints on the productive activity of small businesses and individual citizens. For example, companies with preferred access to very cheap capital find it easy to make money, but this money isn’t always a consequence of their productive activity so much as it is a consequence of the implicit transfers from depositors or from businesses that don’t have preferred access to capital.

  26. Acemoglu and Robinson in their book have an analysis similar to that presented by Dr. Pettis here. A set of highly ‘extractive’ institutions in place after the CCP takeover, a contingent turn of history towards some economic inclusion coupled with political inclusion, but later followed by high growth under extractive institutions.

    Their survey of history seems to indicate that economic, social and political inclusion are just too tightly linked for any society to get one or two without the other. Therefore, history points to the necessity of more political inclusion in China. Right now, the losers in China’s stupendous growth over the last two decades, the main constituency that would push and invest significant energy in correcting things is silenced by political repression. It is difficult to see how a change in the current oppressive institutions can be brought without letting this group speak and mobilize.

    The current trajectory of China, if it continues on a stable path points to a society like Singapore. Reasonably rich (China wont be as rich as SG for obvious reasons), but a ‘meritocracy of exams rather than talent’. But due to its size, even this would give the Chinese elites a huge say in global affairs.

  27. Missing the main points. The legitimacy of the Party with the People particularly its middle class was at a low point before President Xi. All economic reforms that are textbook prescriptions to the economy will be compromised or delayed to ensure no social instability. Their start and go implementation of reforms is neither slow or inconsistent, just pull backs on reforms that can derail social stability. The current leadership is in no hurry to repair the economy or to bring about a free market financial sector that directs the main economy. You are dealing with a different mindset. A mindset that is focused on reviving its nexus with the middle class and further growing it so that they will be sparked to stealthily acquire real global resources and technology to go on its journey to be the largest industrial base in the World. The threshold of pain in the dream to be an economic superpower is enormous if Xi deliver on his part in ridding internal corruption (most pressing priority).

  28. Based on your cogent analysis, you paint a picture seemingly of CCP leaders really understanding what they are doing. How do you square this with some of the issues with respect to “social (institutional) capital” and “democracy” in Hong Kong? Is Hong Kong no longer a model to follow?

    • I don’t think it ever was a model for China, Dirk. At any rate I am always uncomfortable with the idea of a consistent point of view among the leadership. There are many in Beijing who understand how urgent it is to rebalance the economy and get a grip on credit creation, but there are also many who don’t, or who do, but have very different ideas about how the costs of adjustment are to be shared. There is also an inconsistency between the idea that Beijing needs to consolidate power to implement the reforms it must implement and the idea that the necessary reforms imply political liberalization. I don’t know how the inconsistency gets resolved.

  29. If you were Xi, and wanted reform, you might first
    Consolidate power/frighten opposition by attacking/jailing opponents, Bo was perfect opportunity
    Get the military and population behind you by focusing on unimportant islands
    Muffle calls for democracy… Russian example shows how Glasnost distracts, particularly when ship is being turned to a new direction
    Get the military and population behind you by focusing externally on unimportant islands
    Cut a deal with the US, possibly including Japan: throw NK over the side (all Chinese trade is anyway with SK), US does not get involved with island issues.
    Exaggerate growth statistics until reforms pay off
    Model for next phase is not HK but Singapore

  30. Interesting article, but I think your comments about the first period need to be revised. For a start, I used to go to the brickworks quite a bit in that period and bought clay and looked at their production processes. They weren’t at all dynamic at that time, very sleepy, constrained by market and raw materials. Infrastructure development was always the key, even before the reforms but it was public infrastructure rather than private, so roads and rail instead of houses, gravel and cement (iron was a luxury) instead of bricks. The first big buildings were banks, then offices. Housing developed much more slowly. I was involved with a number of Chinese entrepreneurs at that time. It wasn’t a time of getting seriously rich, it was a time of making some money and watching out because no one believed that it was going to last. They were all afraid of the next purge. You have to put the economic developments into a political context of the conflict between reformers and conservatives. The reformers of course came out on top but without that background, it’s hard to understand what was happening.

  31. I like this concept of “social capital” which is very different from the one I use (derived from the work of the Italian Marxists Tronti and Panzieri in the 1970s) and closer perhaps to the New Institutional Economics of Douglass North and Demsetz. From the perspective of political sociology and of political economy, however, it seems to me a little one-sided in that it leaves out the impact of working-class antagonism, even when, as in the New Deal, it is organised by capitalist governments themselves! It is a question of “checks and balances” (Montesquieu) and “countervailing power” (C Wright Mills, JK Galbraith). But another intriguing suggestion that I am exploring on my blog through the work of Schumpeter is that capitalism is not “equilibrium” and it is not even “development” or “growth”. Schumpeter’s original concept of “Entwicklung” is best translated as “development-through-crisis”: in other words, capitalism works best when it produces “crises”, when it promotes antagonism – something that we know inaccurately as “competition”. Good work, and a big cheer!

  32. One might conclude that the Communist Party managed to lead the Chinese economy beyond its capitalistic optimum (stage 2).

    If they could have lived to witness this extraordinary situation, the people involved in the heated debates of the past would think they are hallucinating for this is precisely the situation that communism thought capitalism will inevitably reach if left to its own devices.

    It calls for a lot more tolerance and open mindness for the debates to come.

  33. Leaders of large companies well understand the concept of capital investment limit. The organization (or infrastructure in the lexicon of the article) can only ‘absorb’ so much capital, i.e. employ it efficiently. That this is borne of country level systems is an additional complexity that should be observed, and it makes sense. The issue is whether China can adapt to create the requisite ‘social capital’ within its socio/economic system, or whether they will fail to do so leading to economic malaise or political collapse. I suggest the value of Prof. Pettis’ ideas is in a thought experiment across the global spectrum. Several comments address this w.r.t. other countries. China will play out as it plays out. The answers are far from obvious, and it appears difficult to understand the tensions that will be created between the current system and the desired state, and the resilience of the fabric of government and infrastructure. The simplistic idea that all that is needed is more consumption, the headline in many stories, has been dispelled by Prof. Pettis’ analysis.

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