Should China Kill The Electric Car? A Study in Capital Misallocation.

By Dan Harris on December 5th, 2011 Posted in China Business

I know I have been writing too much lately regarding China’s economy and I know that much of what I have written has been negative. But I have to tell you that I am starting to see all sorts of fissures breaking out in China’s economy and they are scaring the hell out of me. I am not writing to jump on any bandwagon (as one e-mailer accused me) but because I am really worried.

I am worried not just from what I am seeing, but because the real economists out there (not the people who claim to be economists just because they live in China) are also saying some pretty scary things. One of those real economists, Michael Pettis, just came out with what I see as a brilliant piece on how China has overinvested in capital and how its capital investments have been misallocated. It is entitled, “How do we know that China is overinvesting” and I strongly urge you to read the whole thing.

I love Pettis’s piece for three reasons. One, I have never bought into the idea that a bunch of geniuses sitting in Beijing are betting at allocating funds than the invisible hand. And I certainly have never bought into the idea that the local governments spending funds are either. Two, I have been seeing with my own eyes what I thought to be misallocations, but at least half the time when I raise them to people, I get a response like, “well surely the people in Beijing are better equipped to know whether 3 million vacant condos, bridges to nowhere, and train stations in nowhere make economic sense than you are.” I have never thought that is the right question and I have always felt that many of those who refuse to admit China can do no wrong economically are so tied to the system as to have lost any real perspective. Three, the analysis is absolutely first rate and it has been a long long time since i have seen an analysis of Chinese economy of which I could say that.

The article focuses on China’s investment in electric car technology as an example of misallocated capital and it does a great job of explaining why even an investment so initially appealling as that can be a big mistake.

Pettis explains why he sees China having missollacted its capital:

Of course the question of whether or not China is misallocating capital can be endlessly debated because it is very hard to prove except in retrospect. I would argue that there are several reasons why we should believe that capital has been wasted on a large scale for many years. The first reason is simply historical precedents, something which unfortunately rarely enters into most economic analysis. No country in history that has had anywhere near the growth in investment as China has not had a serious problem in subsequent years, in which debt rose to crisis levels and growth ground to a stop.

The fact that China is so poor is often proposed as an argument as to why this cannot also be the case for China, but of course this is a nonsensical argument. Poorer countries with lower levels of worker productivity are less able, not more able, to absorb very high levels of investment. This may seem counterintuitive at first, but only if you believe that there is a single optimal level of investment for every country regardless of its specific conditions. If the purpose of investment is to save labor and labor cost, then it should be clear that the lower the level of worker productivity and the cheaper and more abundant the amount of labor, the less investment in capital stock is justified.

This is why when so many analysts compare the per capita capital stock of China with that of the US or Japan, and then announce that this proves China has a long ways to go before it runs out of investment opportunities, I am always surprised, and even a little skeptical about their economic backgrounds. This comparison simply does not make sense.

If it did, overinvestment crises would be largely limited to rich countries, not poor countries – something that is certainly not confirmed by history. Anyway I find bizarre the idea that the best comparison for China, one of the poorest countries in the world even if you accept the validity of GDP numbers and ignore the very low GDP share of household income, is the US or Japan, two of the richest and most technologically advanced countries in the world.

But I think there are more formal reasons to believe that China is misallocating capital. Common sense suggests that when there is massive investment with

very little accountability,

severely distorted prices,

an incentive structure that concentrates the benefits of investment in specific jurisdictions and over a short time period while spreading the costs throughout the national banking system and over the debt repayment period (which can be decades),

no or very limited budget constraints,

factional and regional conflicts, and

shifts in responsibility as the instigators of the investment are promoted (often because of the positive impact of their own investment initiatives),

it would be a rare system in history that did not tend towards substantial capital misallocation.

Certainly the evidence on SOE investment suggests that this is indeed what happened. A number of studies have suggested that if over the past decade you add up direct subsidies, the impact of monopoly pricing (which is of course simply a tax on households) and the interest rate subsidy, they total anywhere from six to ten times the aggregate profitability of the SOE sector. This means that unless the externalities associated with the SOEs are also at least six to ten times their aggregate profitability, they are actually value destroyers.

If you have any interest at all in China’s economy, you really should read the whole article. I buy it. Do you?

http://www.eastasiaforum.org Dominic

Dan, I’d suggest you’re reading too many blogs and not enough else if you think the quality of this piece is rare. It may be rare for the blogosphere, but there are many parts in the piece where the logic is faulty, the economic reasoning overlooks all sorts of issues and doesn’t match up with the data (especially in regards the emphasis he gives to bank loans as a driver of investment – they’re small potatoes). Its an interesting piece, but its just a newsletter.
I don’t disagree with a lot of what’s in this piece. But I don’t think its cause for so much alarm. The biggest risk factors for a really abrupt stop to China’s economy are probably political.
I you feel like you’re starved for quality China economics reading try this: http://epress.anu.edu.au/titles/cus.html
Its a bit more serious and less hysteric than what you read in the blogosphere and media. Or if you have access to an academic library, get the China Economic Review.
hanmeng

The U.S. has a modicum of transparency and issues such as the Solyndra malinvestment can be at least occasionally be exposed and discussed. How many Solyndras are there in China?
Jaap

I am not an economist so that is why i feel free to see that China is not attempting to follow a free market style economy. They are not concerned about being the best and getting high profits and they are especially not concerned about efficiency.
For years most companies here hardly made any profit. But they are still here.
You see huge staffs everywhere in offices and restaurants that can easily be automated or reduced in number. But they don’t.
So far they never produced anything amazing or exceptionally beautiful in this country unless it involves in being gigantic.
It seems the invisible hand wears a read glove and likes everything to be normal and in low tone. If i would wear that glove i also would be frightened to death whenever i image 3 billion or so real hands that need to be kept busy.
My point is, it is all very remarkable what is happening here and probably it will all fall apart anyhow. But I also believe that re-doing the Western style development on a China scale would definitely be a disaster. If China wants to become a success it should create a new set of rules and by definition our free market rules will not apply.
LH

Prof. Pettis’ writings are the best thing going when it comes to analysis of trade (im)balance, capital accounts, currency, etc. He has a really clear head about economics at a time when a lot of economic writers are pushing a political agenda rather than a purely economic point of view.
Brad Chan

Dominic, I find your comments pretty surprising since Pettis’ analysis is really among the best out there and he more than anyone else has driven the whole debate on China from the extreme ebullience of five years ago to the extreme skepticism of today. It is hard to find many who don’t take him very seriously, and that includes Ross Garnaut who you nonetheless recommend as a much better source on China.
But fine, we can disagree on how smart or dumb he is, but you weaken your argument when you say that he is wrong on lonas because loans as a driver of investment are small potatoes. Say what? This is a mistake which no one who knows the Chinese economy could possibly make. Loans are at the absolute heart of Chinese investment growth and everyone, from the State Council to the local branch manager knows that managing loan growth is the main tool the State Council has for managing investment growth. I suppose next you will argue that consumption levels in the US are too low to make much of a difference and unemployment in Spain is not high enough to be noticeable.
MHB

I think it is without question that capital in China has been misallocated (i.e. it’s not productive), but economic theory on the effect of this is (or was when I studied it a few years ago) at best contentious. More popular business cycle theories focus on the cost fluctuations in inputs – i.e. land, oil, labour, food, credit. Price or supply shocks will cause a bust period of the cycle.
The most important issue is by what yardstick we judge ‘misallocation’ – what better use could it be put to?
1) Increasing productivity? This will (theoretical side) result in real wage rises as the marginal product per worker increases, but it could put many out of work (practical side), depending on the market conditions – the long-term consequences of reducing the work force can be dire. China must be strategic in forcing its way into new markets. The big plus of productivity increases is that (if in the right areas) they should help cool inflation. Sadly, manufacturing productivity increases will not help cool rising food prices, the most urgent inflationary pressure.
2) Increasing living standards? Capital surpluses could be spent on raising living standards. This would increase the cost of labour – although arguably certain social security expenditures could help the work force (healthcare improvements).
3) Massive white elephant projects – these provide temporary labour, do nothing for productivity, and help maintain the political status quo. They are a waste of resources, but China has been experiencing something like a credit glut – it has too much capital. So splashing it around on useless ‘infrastructure’ codpieces is a fairly harmless thing to do.
4) Value-destroying SOEs = mass employers, low productivity per worker keeps wages low.
Dan has been writing about several omens which are worrying, but I don’t think this is one of them. It certainly doesn’t help with inflation, but it’s not the cause of inflation.
Disclaimer – economics was my minor, and I have about 50% confidence in my arguments above. Feel free to put me right.
LH

Dominic writes: “but there are many parts in the piece where the logic is faulty, the economic reasoning overlooks all sorts of issues and doesn’t match up with the data (especially in regards the emphasis he gives to bank loans as a driver of investment – they’re small potatoes)”
I don’t think he is arguing that banks are the driver of investment; I think he is saying that they are the mechanism by which the investment is occurring. In other words, the central gov’t has directed that investment in particular sectors will occur, using the banks to make loans into those sectors at rates that are not commensurate with the actual return on investment. His argument is that since the investment decisions — however they are implemented — are not market-driven, that they are necessarily inefficient and over time this inefficiency will necessarily have larger consequences for the economy, because all misallocation of capital (allocation of capital that does not generate a real economic return, does not create real economic value) will inevitably come home to roost as a slowing GDP, accumulation of bad debt, etc.
-LH
Twofish

I think Pettis is fundamentally wrong, and that his obsession with “capital misallocation” is going to kill the economies of the US and Europe where his ideas are in vogue. The one good thing about Pettis is that no one that matters in China seems to be listening to him, and my prediction is that as time passes and China continues to grow and the US/Europe remained mired in economic doldrums, that fewer and fewer people will be listening to him.
If you want a counterpoint, read Paul Krugman, Brad Delong, and Joseph Stiglitz who argues that the problem is not capital misallocation but total demand. If the most efficient allocation of capital results in massive unemployment that they doesn’t seem terribly efficient.
Part of the reason that I think that Pettis is talking non-sense is that I think that in the long run economic growth depends on science and technological progress, and science and technology research is fundamentally a wasteful process since you don’t know what works and what doesn’t. In the case of the US, much of the science and technology advances came out of Cold War defense spending. In the case of China, massively increasing the defense budget is politically unwise since it would set off an arms race, but what China is doing in putting massive money into the civilian economy will in the long run pay off.
Pettis: The only way to make electric cars economically viable in China, in other words, is to put into place administrative measures that divert buyers, but as any economics student can tell you, these kinds of administrative measures simply shift resources from one sector of the economy to another without creating wealth.
1) There are public goods. If you increase investment in electric cars you decrease use of natural resources and pollution.
2) There are chicken-egg issues. What you get out of massive capital investment is infrastructure. People won’t build electric charge stations without electric cars, and people won’t build electric cars without electric charge stations.
3) Aggregate demand. If you have lots of people doing nothing, then anything that shifts resources from people doing nothing to people doing something is a net positive.
Also the economic theories that “any economic student” knows are the ones that got us into this mess. One thing that I find remarkable about Michael Pettis is that he has been saying the same thing for the last eight years as if the global economic crisis has not happened. Surely the fact that China is doing decently while the US/Europe seem stuck in the doldrums ought to be cause for reflection that maybe your fundamental economic theories are wrong.
Finally if nothing else, putting money in high technology will keep Ph.D.’s fed. I know of several physics Ph.D.’s in the United States that are working as waiters in restaurants which is absolutely ridiculous. In the case of China, all of this spending on high technology is causing anyone with any connection to China to get plane tickets and move, and even if electric cars won’t work, having lots of smart people in one place will be good for building something else.
Twofish

Pettis: No country in history that has had anywhere near the growth in investment as China has not had a serious problem in subsequent years, in which debt rose to crisis levels and growth ground to a stop.
Singapore, Hong Kong, Taiwan
Also in the causes where you *did* have an economic crisis, you still are better off overinvesting. The classical example of this is Japan / South Korea. Both of them had overinvestment crises, but that was after they reached developed country status. If China reaches Japanese (or even Soviet) levels of productivity and then blows up, that’s victory.
The other thing is that no country in the world has been able to develop using the type of low investment policies that Pettis seems to advocate.
Pettis: If the purpose of investment is to save labor and labor cost, then it should be clear that the lower the level of worker productivity and the cheaper and more abundant the amount of labor, the less investment in capital stock is justified.
The purpose of Chinese investment is *NOT* to save labor and labor cost. It’s to *use* labor. If you try to save labor then what ends up happening is that you have massive unemployment, and it’s not surprising that the types of policies that Pettis supports have resulted in 8% unemployment in the US/Europe with no end in sight.
The whole point of this exercise is to increase worker productivity without generating unemployment. Right now you have several hundred million people doing agricultural work that could be done by a few hundred thousand. The goal is to find jobs for these people so that they do something else than farm work. If you build a factory this gets someone off the farm, at which point you can replace them with a tractor.
Pettis: Anyway I find bizarre the idea that the best comparison for China, one of the poorest countries in the world even if you accept the validity of GDP numbers and ignore the very low GDP share of household income, is the US or Japan, two of the richest and most technologically advanced countries in the world.
China is not a poor country. It’s a big country with rich parts and poor parts. There are parts of China with standards of living that are comparable to the US and Japan. There are parts that are comparable to sub-Saharan Africa. China has as many people living at South Korean standards of living as South Korea does. Part of the point of infrastructure investment is so that wealth can flow from the rich parts to the poor parts.
Pettis: It would be a rare system in history that did not tend towards substantial capital misallocation.
Singapore. The problem is that I can provide some examples of real world countries with massive capital investment. One problem that I have with Pettis is that he has never provided an example of a non-oil based country that has developed without massive capital investment.
Pettis: This means that unless the externalities associated with the SOEs are also at least six to ten times their aggregate profitability, they are actually value destroyers.
Nonsense.
This is actually similar to the discussion that we had with the SME. Profitability of SOE subtracts wages. So if SOE’s are creating value, but this value is being used to increase costs (i.e. workers salaries), then this is a good thing. The fact that workers wages in China are rising quickly, but SOE’s are still able to make a profit suggests that something good is happening.
http://jianqchyun.blogspot.com James Long

The pharmacies of Shanghai are a hoot. Ten or fifteen uniformed people standing behind counters ready to sell you a bandaid but the store itself almost always practically empty.
Ethan Shen

It is a good piece, but you should know better.
Purely economic analysis is great, but it is just that, purely economic. And you have been in China long enough that it is not purely economic. Don’t you?
Brad Chan

Twofish says: “The one good thing about Pettis is that no one that matters in China seems to be listening to him.” I know that Pettis once spanked you on another blog and you probably still resent him, but this really isn’t even vaguely true. I am betting you don’t live in China.
http://www.eastasiaforum.org Dominic

@Brad Chan: Brad, you seem to misinterpret me. I didn’t say anything about how good Pettis is in general, nor did I say anything about Ross Garnaut. The book series I linked to is edited by Garnaut but the contributors are about 45% Australian, 45% Chinese and 10% rest of the world. I didn’t say that Ross Garnaut (or the China Update books) are a better source on China than Pettis, but I did say the China Update books offer higher quality analysis than what’s on offer in the bloggosphere.
I did say that I don’t think this exert from the newsletter doesn’t really merit this sort of praise: “The analysis is absolutely first rate and it has been a long long time since i have seen an analysis of Chinese economy of which I could say that.”
I specifically said that there’s not much in it I disagree with, but that its just a newsletter and that its easy to find quality analysis of the Chinese economy if you look beyond blogs. I don’t think this is much of a swipe against Pettis. It may have been a bit cheeky to imply Dan’s reading isn’t wide enough when I know it is, but I was making a point about the availability of quality analysis.
On the comment about bank loans, the idea that “Loans are at the absolute heart of Chinese investment growth” is easily demonstrated to be not true. Just look at the data on sources of funds for investment. In the 2010 China Economic Yearbook, its Chapter 5, table 4. Domestic loans in 2009 were the source of just 15% of investment. Self raised funds were the source of 77%. Most of the growth in investment over the past decade has come from self raised funds. Domestic loans have declined in importance from their recent peak of 20% in 2003.
The fact that this is one of the main mechanisms for the Chinese government to influence investment rates just means there is a large portion of investment that goes on with little government influence. That’s fine, since as a tool of macro policy you only need to influence the margin, but it still leaves bank loans far from being the driver of investment that Pettis argues it is.
I wasn’t trying to be controversial. If you like I can go into more details about why I said the economic reasoning overlooks issues, but I didn’t think the comment section of a blog was really the place that sort of discussion.
As for, “I suppose next you will argue that consumption levels in the US are too low to make much of a difference and unemployment in Spain is not high enough to be noticeable”, I don’t see any reason to be quite this condescending, even online.
Anon

Pettis is great. Obviously, China bears are controversial and tend to spur a bit of resentment from the bandwagoners. I guess only time will tell, but I certainly find the arguments and reasoning of Pettis and the like to be far more persuasive than the counter arguments, which seem to be completely divorced from reality or reliant on a vague sense of optimism about the Chinese spirit or some such puffery. At some point, something very bad is going to happen in China’s economy. It’s really just a question of when, how, and with what consequences. My perspective may be colored by coming of age in the US over the last decade, but I strongly believe that any form of “this-time-is-different” economic reasoning is always wrong. In my mind, the real question is whether the system can manage the fallout, or whether the crisis will bring about a major, dislocating socio-political transformation and, if so, what that transformation will look like, both domestically and internationally.
LH

Twofish writes: “the types of policies that Pettis supports have resulted in 8% unemployment in the US/Europe with no end in sight”
It is quite a misreading of his work to say that the “policies that Pettis supports” amount to nothing more than not making massive investments. He would almost certainly attribute a large part of the unemployment in the U.S. to its massive imbalance of trade — i.e. to the fact that it has absorbed China’s trade surplus as a trade deficit in the U.S. It’s far from obvious that this trade deficit can be erased by additional government stimulus or public infrastructure spending or the like. In the comments (on mpettis.com) that follow the piece cited by Dan here, he says that countries (he cites Finland as an example) that are technologically advanced may be able to efficiently absorb a much higher level of such investment than a country that is technologically underdeveloped. Nothing wrong with disagreeing with his analysis or conclusions, but what you’ve described as his views don’t strike me as his views at all, and I’ve been reading his writings for quite a while.
-LH
http://wangbo.blogtown.co.nz Chris Waugh

I’m with Twofish on this, especially when it comes to public goods and the chicken-egg problem. The invisible hand is a lie, but peak oil and air pollution are real. Oil needs to be replaced as a transport fuel not just for the good of the environment, but for the future economic and social health of China. This is not any kind of overinvestment or capital misallocation; it’s strategy, and good strategy.
Andeli

@Twofish
I must say I disagree with you this time, so much so that I don´t have the time to finish all of the arguments today.
“Part of the reason that I think that Pettis is talking non-sense is that I think that in the long run economic growth depends on science and technological progress”
This being true there are three ways to science and technological progress. State sponsored, semi-state sponsored or market-driven. China is going for the first and the second. In the long run this does not work because the application of science or technology needs the market to sort out what is useful or what is not. So after 30 years of growth China has become the world´s 2. largeste economy, but still has made extremly few significant contributions to the worlds scientific development. The talent pool is there but the system destroyes every chance of technological development.
“There are public goods. If you increase investment in electric cars you decrease use of natural resources and pollution”
No if they don´t work they increase the waste of natural resources and pollution. Windmills in China are a wasted investment, because the electrical network (the state grid) is not in place to run them and because Chinese powerplants don´t turn off when the wind blows…
“There are chicken-egg issues. What you get out of massive capital investment is infrastructure. People won’t build electric charge stations without electric cars, and people won’t build electric cars without electric charge stations.”
True but as there are limited resources the government could invest in making fuel driven cars more efficient and promote better drivning habits. Take the money for the electric car investment and put them in the agriculture sector instead.
“Aggregate demand. If you have lots of people doing nothing, then anything that shifts resources from people doing nothing to people doing something is a net positive”
No not if they do more harm then good. Then it would be better to keep them on welfare.
“The whole point of this exercise is to increase worker productivity without generating unemployment. Right now you have several hundred million people doing agricultural work that could be done by a few hundred thousand. The goal is to find jobs for these people so that they do something else than farm work. If you build a factory this gets someone off the farm, at which point you can replace them with a tractor.”
True but instead of building a factory you increase their income by letting the price of agricultural products go up significantly. They don´t have to leave the crountry side they could get rch living there. Why does everyone want to force people into the cities why not increase their standard of living where they are? and develop the country side. Electrical cars don´t develop the country side.
“. Part of the point of infrastructure investment is so that wealth can flow from the rich parts to the poor parts.”
This is so wrong on all levels. Massive investment in the agricultural sector, tax cut in some provinces, increase in social benefits for non-urban residents, increasing prices on agricultural products and most important clearing up corruption will let wealth flow from the rich parts to the poor parts. Invest in infrastructure distorts this flow because the farmers pay the price for an infrastructure investment wtth their land.
LH

Dominic writes: “The fact that this is one of the main mechanisms for the Chinese government to influence investment rates just means there is a large portion of investment that goes on with little government influence. ”
Oh gosh, it’s really a stretch to say that bank lending in China is independent of government influence. Both on the lending and on the borrowing side, it’s dominated by government influence. That’s the whole point about the growth of the shadow lending market: companies that are not government-connected can’t secure loans from banks, so they are forced to pay much higher rates by seeking loans either from those who can secure them directly from banks (i.e., from gov’t connected companies) or from other shadow lending sources. The higher interest rate that they must pay *is* the economic inefficiency that Pettis is referring to — it is the cost of government-directed investment (lending, same thing) at low rates to activities that are not selected by the marketplace.
-LH
Twofish

Andeli: This being true there are three ways to science and technological progress. State sponsored, semi-state sponsored or market-driven. China is going for the first and the second
It’s not either/or. In order to create a high technology research system, you need an ecosystem of government, private non-profits, and public non-profits. How those pieces fit together is something that China is going to have to figure out, but there are lots of things that China can learn from the United States, where massive government spending in the form of defense contracts and university research ends up in marketable products.
Andeli: It still has made extremly few significant contributions to the worlds scientific development. The talent pool is there but the system destroyes every chance of technological development.
Give it some time. Rome wasn’t built in a day. It takes decades and billions of dollars of spending to create a technology infrastructure. What is different now is that the Chinese government is putting money into technology that that money is drawing “sea turtles” back home. Once you have enough smart people in one place, they’ll figure something one.
Andeli: Windmills in China are a wasted investment, because the electrical network (the state grid) is not in place to run them and because Chinese powerplants don´t turn off when the wind blows…
And you can argue against building the electrical grid because the windmills aren’t in place. Chicken meets egg. If you don’t do A because B isn’t there, and you don’t do B because A isn’t there, then you’ll never get anything done.
Andeli: True but as there are limited resources the government could invest in making fuel driven cars more efficient and promote better drivning habits. Take the money for the electric car investment and put them in the agriculture sector instead.
Why? If you do that you’ll just have lots of out of work farmers. Take the money for electric cars, put them into electric cars, and then you’ll create jobs for factory people, battery salesmen, etc. Once you do that, and you start moving people off the farm, then you can replace people with (electrically powered) tractors.
Andeli: No not if they do more harm then good. Then it would be better to keep them on welfare.
Keeping someone on welfare is bad. People want to work. Work makes people feel good about themselves.
Andeli: True but instead of building a factory you increase their income by letting the price of agricultural products go up significantly.
Because there is a limit for how much people can eat. Once you mechanize agriculture, the demand for food stays the same, but supply goes up. That means that prices are going to fall and fall a lot.
Andeli: Why does everyone want to force people into the cities why not increase their standard of living where they are?
Because there are just more jobs in the city.
Andeli: Electrical cars don´t develop the country side.
Funny you should mention that. I saw a proto-type for an electric car that was developed by Ford. Once you no longer use gasoline, you can get rid of the transmission, and once you get rid of the transmission, you can create a chassis that works both as a tractor and as a family car. Maybe that won’t work, but if you can build better batteries, I’m sure you’ll find something that someone can use.
Andeli: This is so wrong on all levels. Massive investment in the agricultural sector,
Which will put farmers out of jobs. Great if you have other jobs for them to do. A social disaster if you don’t.
Andeli: tax cut in some provinces, increase in social benefits for non-urban residents,
Cut taxes and raise benefits. That’s not going to work. Rural governments are already broke. Now if you cut taxes in the rural areas and then transfer wealth from rich areas, then that’s fine, but then you have to generate wealth in rich areas.
Andeli: increasing prices on agricultural products
You are advocating policies that are self-contradictory. If you do massive investment in agriculture, prices will drop. Great if you have a nation of city-dwellers. A social disaster with a nation of farmers. If you do massive investment in industrial prices will drop too, but the difference is that I can only consume 2400 calories a day, whereas if the price of computer chips and batteries drop, there isn’t a limit to the number of computer chips or batteries I can use.
Andeli: and most important clearing up corruption will let wealth flow from the rich parts to the poor parts.
Doesn’t work this way. Money flows uphill. Unless you do something, the rich will get richer and the poor will get poorer. To see why, lets assume that Bill Gates or Warren Buffet comes to you and wants to borrow $1000. Now let’s assume that you have some poor person with no skills and who is unemployed and they want to borrow money. Who are you more likely to lend to?
Andeli: Invest in infrastructure distorts this flow because the farmers pay the price for an infrastructure investment with their land.
That’s because rural counties are broke and so they are desperate to raise cash, and land sales are one of the few ways of doing it. Now some of it goes to silly things, but if you look at the budget of your typical rural county, most of it goes to education and health clinics. One problem is that as the urban economy improves, you have to pay people more money to work as a teacher or as a doctor in nowhere-ville.
Ultimately you have to transfer funds from the urban centers to the rural areas, and that involves creating wealth in urban areas. Which is where electric cars comes in.
Twofish

LH: companies that are not government-connected can’t secure loans from banks, so they are forced to pay much higher rates by seeking loans either from those who can secure them directly from banks (i.e., from gov’t connected companies) or from other shadow lending sources.
And the fact that they have to pay higher rates is a rational reflection of the fact that the person lending the money is less likely to get their money back. It’s a hard problem. One problem is that it’s pretty much impossible to revoke an implicit government guarantee. You can swear up and down, left and right, that there will be no bailouts, but if you are TBTF, no one will believe you, and after what happened to GM and Citigroup, no one should believe you.
You could try to even the playing field by extending government guarantees to SME’s, but then the government has to make some decisions about what sectors they want to support and which ones they don’t.
LH: The higher interest rate that they must pay *is* the economic inefficiency that Pettis is referring to — it is the cost of government-directed investment (lending, same thing) at low rates to activities that are not selected by the marketplace.
Tbe trouble is that after what has happened in the US, I’m not thrilled with “trust the market.” In 1998, you could have gotten me to believe that “markets good, governments bad”, but it’s 2011, and I just don’t believe this.
People have argued that the US wasn’t really market driven, but at that point you are selling fairy dust rather than looking at real economic systems.
One thing about the Chinese financial system is that for the most part we know where the money is coming from, where it’s going, and why. This wasn’t the situation with the US pre-2007 since people got really, really good at using the marketplace to hide where the money was coming from and where it was going. So in China we know that people are using loans that are implicitly backed by the government to fund riskier things, and we have a good idea about the volume of the loans, and if it gets too high, then the government will crack down.
Whereas in the US, people were using funds implicitly backed by the government for riskier things, able to use the market to hide this, and when it all flew apart people were just shocked at where the money was coming and going.
One thing that has happened in China is that you have had capital misallocations in the form of a real estate bubble, but over the last few months the government has stepped in to pop the bubble through those awful administrative means. You might argue that the real estate bubble is the result of government policy, and you may be right, but rather than do “hands off” you might think of government intervention as balancing out this other bad thing that happened because of government intervention.
Personally, I’m not that worried about China. I’m not that worried because no one that matters in China seems to care what Michael Pettis thinks, and if he says go left, the Chinese government will march right. Maybe he would be more interesting if he addressed the real reasons why his economic ideas have no credibility in China, but I haven’t seen anything in his posts that is in touch with the reality that the Chinese economy is in decent shape, whereas the US and Europe are just stuck and going nowhere.
The only thing that I’ve heard is that “the shoe hasn’t dropped.” That the Chinese economy is *really* in serious trouble, and that it’s only a matter of time before things fall apart. However, the longer things go on, and the Chinese economy doesn’t collapse, the less credible that is, and if you wait a decade, and things go on with the Chinese economy moving ahead, and the US/Europe in doldrums, and then you change your mind, then you’ve just destroyed a generation in the meantime.
The thing about the Chinese economy is that I can give you a dozen problems with the Chinese economy, and then we can go through the list and look at how to fix things. We’re not even at that point with the US/Europe.
I *am* very worried about the US and Europe because his economic ideas (which I think are disastrous) have much more support in US and Europe, and we are well on our way to creating a lost decade. People always wonder when the revolution will come in China, but one thing that people haven’t been talking about is how much economic pain and agony people in the US will endure before something breaks.
Also there is a personal element in all of this. I’m come from a technology background, but I’m a member of the 1% that people have been protesting against. On the one hand, I make no apologies for taking money when it is offered to me. On the other hand, if you ask me whether it’s a more socially useful use of my skills to work on doing financial calculations rather than on working on electric cars, doing climate change calculations, teaching high school, or trying to colonize Mars, I can’t honestly say that my intellectual capital isn’t being wildly misallocated.
http://www.eastasiaforum.org Dominic

@LH,
I didn’t suggest that bank lending in China is independent of government influence.
This is getting a bit far afield from my original point, but let me restate my point about the government and bank loans clearly as I can:
Government influence over bank loans is one of the main strategies for the government to influence aggregate demand. Bank loans provide just 15% of the funds for investment in China. 85% of investment is made with funds not loaned from banks. That leaves government without much influence over 85% of investment funds.
I agree with all of your other comments so I wont address them.
Twofish

Harris: But I have to tell you that I am starting to see all sorts of fissures breaking out in China’s economy and they are scaring the hell out of me.
I’m trying to figure out what is so alarming. The government just popped a real estate bubble and it’s going to have to clean up the massive injection of local government debt that they injected into the system on 2008. Been there. Done that.
The fact that they are stepping on the brakes right now is a *good* thing. Pop the bubble, clean up the mess, go on with life. Also there are a lots of things wrong with the Chinese economy, but investing in electric cars isn’t one of them.
Harris: I am worried not just from what I am seeing, but because the real economists out there (not the people who claim to be economists just because they live in China) are also saying some pretty scary things.
Half the economists will tell you one thing, half of them will tell you something else. Ultimately you just have to decide who you believe based on what you see. One reason I tend to mistrust the “China is doomed” crowd is that they’ve been saying the same thing for the last twenty years.
Also as far as bridges to nowhere, you need to read Paul Krugman (and his Nobel Prize says that he is a “real economist”) suggests that the way to fix the economy is to have a fake alien invasion,
http://www.huffingtonpost.com/2011/08/15/paul-krugman-fake-alien-invasion_n_926995.html
There’s also Joseph Stiglitz who also has a Nobel Prize in economics.
Dominic: Government influence over bank loans is one of the main strategies for the government to influence aggregate demand. Bank loans provide just 15% of the funds for investment in China.
But there is a knock-on effect. When the government reduces the reserve rate, banks can lend out more money, and once it gets to the SOE’s a lot of those will relend which injects money into the shadow lending system. Also the Chinese government not only controls lending supply, but lending demand. What happens when the government wants to increase demand is that it gives administrative permission for local governments to use SPV’s to borrow money from the banks, and this also has a multiplier effect since a lot of these SPV’s are essentially mini-banks.
What is happening is that as the economy cools, the government will be forced to repay those loans through transfer payments. Oh well.
This is wildly different from how the monetary system works in the US. In the US, the main control over monetary policy is the short term Fed Funds rate. By moving short term interest rates up and down, you immediately influence the economy through the commercial paper markets.
DaMn

I stick with my original and non-posted comment that your economic dalliances are not adding value to this site. First, they are all conjecture without any (or much) factual evidence. Second, the fraud, misallocation and waste in the U.S. is massive and deserve to be brought into the discussion if you are going to characterize China as this massive failing economy.
Its truly amazing seemingly intelligent people can debate these topics point by point.
“these kinds of administrative measures simply shift resources from one sector of the economy to another without creating wealth.” Have you heard of the U.S. capital gains tax rate?
“Despite $535 million taxpayer dollars for loan guarantees and a speech from the President himself praising its success, the solar panel manufacturer Solyndra has gone bankrupt.”
“Mere days after revealing that big Wall Street banks made $13 billion in secret profits off the Federal Reserve’s $7.7 trillion bid to shore up the financial system in 2008-09, Bloomberg Markets is back with a “rather astonishing” scoop on then-Treasury Secretary Henry Paulson’s sharing of insider knowledge with hedge fund chiefs. ”
Congress can do what they deem illegal for everyone else, insider trading. “The US Senate and the US Supreme Court are the only two out of 975 federal entities that seem to have no rules or laws prohibiting them from trading stocks based on nonpublic information they gain on the job. A 2004 study revealed that US Senators’ stock trades performed 12.3% better than the market average.” Of course WSJ will print an outrageous opinion by HOLMAN W. JENKINS, JR. that it’s all fine and dandy.
I know its really really really (frowning sad face) hard not to focus on something other than the truly shameful and idiotic management of the richest countries in the world, who let banks and everyone else milk the cow until its teets bled, but all of this conjecture without credible facts or data is a side show and frankly stupid.
I read your mission statement and it says you will discuss the law. It says nothing about the economy or sex in massage parlors, let alone asking your readers if that’s happened to them. You replied to almost every comment up there on the subject. Too bad I don’t see that kind of attention to people who ask you serious legal questions about subjects in your posts.
Dan

DaMn,
Not sure to what not-posted comment to which you are referring, but maybe it went to junk.
One of the nice things about our having our own blog is that we can write about anything and everything we want to write about.
You say I replied to “every comment up there on the subject” but yours is actually the first and only comment to which I have replied so I have no idea of what you are talking.
As for my not paying “attention to people who ask…serious legal questions,” I will confess two things. One, as much as I would love to respond to each and every comment, I simply do not have time to do so. And two, I virtually never respond to legal questions because I am not going to give legal advice on this blog when I do not have all of the facts on which such advice should be based, nor am I going to conduct the legal research that is typically required.
LH

@Dominic: aha, I misread your earlier post, thanks for the clarification. I think Twofish is right in saying that much of the 85% is indirect bank lending, but still I see what you mean.
@Twofish and others: lots of the comments here are using logic that says, roughly, Pettis is wrong about capital misallocation in China because the U.S. and Europe have even bigger problems. This doesn’t make any sense to me, it’s like saying that your doctor is wrong about his diagnosis because your neighbor has an even worse disease. We ought to be able to read and reason about what Prof. Pettis is describing of China on its own merits. It’s not at all true that finding some or a lot of truth in what he writes is an implicit endorsement of policy or events in another country. And it’s also not at all true that the only alternative to capital misallocation Chinese-style is to copy the ridiculous excesses and errors of the U.S. or Europe.
-LH
Mario Testorini

“(not the people who claim to be economists just because they live in China)”
Whats wrong with economic opinions from people who live in China? And who is claiming to be economist but aren’t? I think the opinion of people who live in China and do business there is valid. Why suggest it isn’t? Pettis is an economist – but doesn’t run a company. His perspective is purely academic and is limited to that perspective and not a practical commercial working view. So why limit or dismiss the “economists who claim to be just because they live in China”? Please explain.
MHB

What Twofish is promoting is the economic theory that is currently taught in universities. ‘Capital misallocation’ theories are extremely outdated.
Paul Krugman and Jo Stiglitz (and see Paul Romer on tech drivers of growth) have more modern theories backed with better evidence – this is why Twofish is banging on about capital misallocation elsewhere. There is little evidence that it affects the business cycle.
Twofish

LH: This doesn’t make any sense to me, it’s like saying that your doctor is wrong about his diagnosis because your neighbor has an even worse disease.
No. It’s like saying that the doctor gave your neighbor one cure, you took another, and you are somewhat ill but your neighbor is near death.
Massive fiscal stimulus *does* led to credit bubbles. When the Chinese government went crazy with spending in 2008, I predicted exactly what would happen, because it’s the same thing that happens whenever you to massive fiscal stimulus. You end up with a credit bubble and massive debts which you have to pay down once the economy improves. What the Chinese government did in 2008 was *bad*, but what US and Europe did by *not* expanding the economy was *much, much* worse.
China is out of the ditch. The economy is growing, and now we can deal with paying down the debt that happened as a result of fiscal stimulus, and as long as we can do that before the next crisis (which I think will happen in three to five years), we’re good. Europe and the US are in much, much worse shape, because they are having persistently high unemployment that shows no signs of going down.
LH: It’s not at all true that finding some or a lot of truth in what he writes is an implicit endorsement of policy or events in another country.
But it is. Pettis economic theories are as far as I can tell, the same basic one’s that got the US in trouble. It’s this idea that 1) markets inherent are better at capital allocation than governments and 2) that efficient capital allocation is the most important function of the economy. Now if Michael Pettis wanted to *argue* those points, then I’d be interested, but his writings seem to just assume that this is true, and after what happened in the US there’s no reason for me to assume that.
Also Michael Pettis is not the only economist in the world. You have Paul Krugman, Brad Delong, Matt Yglesias, all of whom have been complaining about the obsession with capital misallocation, and all of whom are arguing that this is killing the US/Europe economy, and that what China is did is exactly what the US should be doing.
LH: And it’s also not at all true that the only alternative to capital misallocation Chinese-style is to copy the ridiculous excesses and errors of the U.S. or Europe.
It’s the alternative that Michael Pettis seems to be presenting. His economic solution seems to be to let the market handle everything and privatize everything, which I think is just madness. Paul Krugman seems to think (and I agree) that in this sort of situation *capital allocation* doesn’t matter.
We ought to be able to read and reason about what Prof. Pettis is describing of China on its own merits.
This doesn’t make any sense. In 2007, China, US, and Europe had the choice between massively increasing credit or cutting back. You have some economists saying that massive spending was
Twofish

One problem with talking about “real economists” is that talking with economic experts is fundamentally different than talking with doctors, lawyers, scientists. If you ask five doctors a medical question or five lawyers a legal question, the odds are that you will get them to give you more or less the same answers. Economics doesn’t work that way. You ask five economists their opinions and they start screaming at each other.
So what you have to do is to look outside, and then figure out who makes sense. Based on what I’m seeing Krugman makes sense and Pettis is totally disconnected with reality. One thing is that I don’t think that the Chinese economy is falling apart. From my point of view, the Chinese economy is in much better shape than it was six months ago. Six months ago, rents and house prices were going crazy, and each time you went to eat, there would be a new higher price. That’s over.
Exporters are getting killed, but that’s because the US/European economy stinks, and they are competing for workers wages.
The Chinese economy is simply not the biggest thing that people are worried about. Right now the big problem is air pollution. Chinese air is unbreathable, and it’s getting worse, which is why I think it’s crazy to argue that trying to promote electric cars is a “resource misallocation.”
One other thing, that empty train station in Guangzhou is empty because they haven’t finished building all of the track to it. It’s planned to be the major regional transportation hub for southern China, and only the section to Wuhan is operational. By the end of the 2012, high speed trains between Shenzhen and Beijing will go through the station and by 2016, you’ll be able to travel between Hong Kong and Beijing. People in China tend to build big, because past experience is that after a few years, that you get overwhelmed with capacity.
DaMn

“It says nothing about the economy or sex in massage parlors, let alone asking your readers if that’s happened to them. You replied to almost every comment up there on the subject.”
I was referring the the brothel scam post. 29 comments. 13 are from you.
I certainly do not promote offering legal “advice” on a public forum or doing added research. Offering additional resources to use, directions to take to do more research, or references to articles or posts on likely next steps the petitioner of the post should consider taking in order to do due diligence should be able to fit into to the framework though.
Noting in the comments posting section and your replies that this “The materials on this website are provided for informational purposes only and do not constitute legal advice. Transmission of the information is not intended to create, and the receipt does not constitute, an attorney-client relationship between sender and receiver” would certainly be understandable.
China now has a large challenge on its plate, particularly in the legal environment, in order to make the growth that is both possible and necessary, manageable. It is a new era and people will be getting more diligent and focussed on these matters, working to make them better. I think the focus deserves to be there rather than on vague stereotyping about an economic system that gets criticized, mostly, due to the inherent and often incorrect assumptions of “free market” economists and businessmen, especially when, in many instances, the pot is calling the kettle black.
I believe the system is manageable and in integrity, although the timing and depth of the resource allocations may be off. I understand many others disagree. So my preference as a loyal reader is to focus on what you know, what the blog is about, and helping us grow in this environment that is not going away, even if and when a significant shock is or will be felt in the economy.
True, indeed, it is your blog and you get to make the decisions. No argument with that.
Cheers.
LH

@Twofish: “Pettis economic theories are as far as I can tell, the same basic one’s that got the US in trouble.”
I must say, I really don’t get this from his writings at all. He has been quite forthright (within the bounds of prudence — he is living and working in China after all and must be somewhat measured with his words) in saying that the U.S. must adopt a protectionist stance if it is to correct and reverse the massive trade imbalance that is at the heart of its woes. He has said so both in the context of the German vs rest-of-Europe trade relations as well as the China vs U.S. trade relations.
Pettis is above all concerned with capital accounts and capital flows. This is the foundation of everything he writes. If he has made a mark as an economist (and I think he certainly has) then it is because he has applied very basic accounting identities concerning capital flows rigorously and thought through their implications. He says for example that for one country to consistently run trade surpluses, there must be other countries willing to absorb those surpluses as deficits. He has written at length — sometimes bordering on an exclusive focus — on the implications and consequences of these capital flows and identities concerning balance of payments. If he has a “policy” or a “theory”, then it is this, and not the free-market-knows-best stuff you are ascribing to him. What you are describing is nothing more than the recycled free-trade/free-market/laissez-faire stuff that has been circulating in the American political dialogue for decades. This is not at all what Pettis’ writings are about IMO.
Andeli

@Twofish
“Give it some time. Rome wasn’t built in a day. It takes decades and billions of dollars of spending to create a technology infrastructure. What is different now is that the Chinese government is putting money into technology that that money is drawing “sea turtles” back home. Once you have enough smart people in one place, they’ll figure something one.”
It has been 60 years since the first tech plan….How much time does the system need before someone says it should change?
“And you can argue against building the electrical grid because the windmills aren’t in place. Chicken meets egg. If you don’t do A because B isn’t there, and you don’t do B because A isn’t there, then you’ll never get anything done.”
No that is of course not the case. There is no chicken and egg stuff going on here. The State Grid has mutiple functions and windmills only have one. We end up back with my point on sufficient and necessary conditions. A well developed and regulated state grid is a necessary and sufficient condition to build windmills, but windmills is a necessary but not a sufficient condition to a state grid there needs to be other reasons too.
“Why? If you do that you’ll just have lots of out of work farmers. Take the money for electric cars, put them into electric cars, and then you’ll create jobs for factory people, battery salesmen, etc. Once you do that, and you start moving people off the farm, then you can replace people with (electrically powered) tractors.”
Because an investment in agriculture does not mean people go out of work. It means they move up the value chain and start adding value to agricultureal products in the local areas instead of moving into cities, where they don´t belong and will create slum.
“Keeping someone on welfare is bad. People want to work. Work makes people feel good about themselves.”
True but keeping them on the welfare will give them the choice of what they want to do, so human resources will flow better around society. Forceing people into infrastructure projects leads nowhere and you are forced to keep finding new projects for them, at least with welfare people can try to find something for themselves.
“Because there is a limit for how much people can eat. Once you mechanize agriculture, the demand for food stays the same, but supply goes up. That means that prices are going to fall and fall a lot.”
There is no limit to how much people can eat, what happens now is that the food production becomes more value added. The demand for food is going to increase because there is now multiple uses for foods (energy), stabillity in many developing countries and plus wide spread medical treatment. To invest in food production would show how far sighted the Chinese government are. Not electrical cars or windmills. The least flashly solution is often the best one.
“You are advocating policies that are self-contradictory. If you do massive investment in agriculture, prices will drop. Great if you have a nation of city-dwellers. A social disaster with a nation of farmers. If you do massive investment in industrial prices will drop too, but the difference is that I can only consume 2400 calories a day, whereas if the price of computer chips and batteries drop, there isn’t a limit to the number of computer chips or batteries I can use.”
I don´t contradict myself. Correct investment in agriculture don´t pay off in 1-2 years it pays off in 10 to 15 years and that is when China has become a nation of city-dwellers. So it is a better alternative then electical cars.
“Doesn’t work this way. Money flows uphill. Unless you do something, the rich will get richer and the poor will get poorer. To see why, lets assume that Bill Gates or Warren Buffet comes to you and wants to borrow $1000. Now let’s assume that you have some poor person with no skills and who is unemployed and they want to borrow money. Who are you more likely to lend to?”
Corruption takes away wealth from the state and from private individuals and puts it in the hands of those who does not deserve it. Money flows uphill but can be diverted into society by……taxes. A good taxing system is destroyed by….corruption.
“That’s because rural counties are broke and so they are desperate to raise cash, and land sales are one of the few ways of doing it. Now some of it goes to silly things, but if you look at the budget of your typical rural county, most of it goes to education and health clinics. One problem is that as the urban economy improves, you have to pay people more money to work as a teacher or as a doctor in nowhere-ville.”
True but you could just give them the money for education and health clinics without taking the land because of building infrastructure or real estate. There is no need for more houses or roads but for upgrading and fixing the existing facillities.
“Ultimately you have to transfer funds from the urban centers to the rural areas, and that involves creating wealth in urban areas.”
And that is where we disagree. I want to give wealth to those that don´t have and can make better use of it, and you want to give to those that already have and waste it. The Chinese economical dream was build on the development of the Chinese rural areas in the 1980s It has to go back to that again.
Twofish

LH: I must say, I really don’t get this from his writings at all. He has been quite forthright (within the bounds of prudence — he is living and working in China after all and must be somewhat measured with his words) in saying that the U.S. must adopt a protectionist stance if it is to correct and reverse the massive trade imbalance that is at the heart of its woes.
The problem is that Michael Pettis seems to think that “markets know best” and that “economic efficiency is good and government intervention through administrative efforts are bad” and I think the notion that “markets know best” is at the core of the problem with the US.
LH: Pettis is above all concerned with capital accounts and capital flows. This is the foundation of everything he writes. If he has made a mark as an economist (and I think he certainly has) then it is because he has applied very basic accounting identities concerning capital flows rigorously and thought through their implications.
And that’s precisely why I think that he has got everything all wrong. The approach of starting with accounting identities and assuming that they can tell you anything meaningful about an economy is in my mind, totally wrong headed, because they tell you absolutely nothing about about the numbers that make up those identities. Also there are some assumptions that he implicitly makes in looking at those numbers, that are also wrong. For example, he seems to assume that if you increase investment, you must decrease consumption. Which is wrong. You can increase both investment and consumption if total output increases, and increasing investment is good if it leads to a boost in total output. Now we can argue if it does, but he doesn’t do that, he just assumes.
The problem is that this leads to the *illusion* of rigor, when in fact he is assuming dozens of things which are questionable. Now if he were interested in arguing these points, it would be an interesting conversation, but he doesn’t seem to be.
It’s extremely dangerous to take accounting identities are iron laws of nature, because you can fudge accounting in a million ways. In particular, one reason that Chinese investment rates are so high is that Chinese economic statistics include the price of land as investment, whereas no other country does. Once you remove that number, then the ratios change a lot especially in a credit bubble when the price of land goes crazy.
LH: He says for example that for one country to consistently run trade surpluses, there must be other countries willing to absorb those surpluses as deficits.
And that’s not true. You can have persistent trade flows in one direction if there are transfer payments in the other. One problem with this picture is that it’s not clear how any of this works in a world where there are multi-national corporations. Large corporation builds parts in China and ships it to the US where it is assembled and sold, since the large corporation is both the importer and exporter, they can state what the value of the product is (i.e. transfer pricing). This just messes up the accounting identities.
LH: What you are describing is nothing more than the recycled free-trade/free-market/laissez-faire stuff that has been circulating in the American political dialogue for decades. This is not at all what Pettis’ writings are about IMO.
As far as trade policy, I’ll grant you that. (And on this issue he seems to agree with Krugman, and I disagree with both of them). However the article that Harris posted *is* recycled free-market/laissez-faire stuff. This matters because I *don’t* think that trade policy is at the core of the problems of the US. Productivity and aggregate demand are, and on that issue, Michael Pettis *is* recycling basic freshwater economic theories that I think are a mess.
In particular, if you look look at aggregate numbers, then there is no place for looking at detailed government policy. Pettis seems to think that all you need to know is that a government is spending X% on investment and nothing else matters, whereas I happen to believe that what and how you spend it on makes a difference.
And in the end what matters is that you have a blue wire and a red wire attached to a bomb and you need to cut one. Michael Pettis says cut the blue wire. I say cut the red wire, so we end up with totally different and conflicting views on what China and the US should do.
Also some of the times, a debate doesn’t matter. I think that both Pettis and Krugman have trade policy wrong, but I don’t care because no one that matters in China or the US is influenced by what they have to say on that topic. As far as the idea that China is in dangerous territory because of capital misallocation, no one in China is going to stop electric car programs or high speed rail because of anything Michael Pettis says, so I don’t care.
However, people in the US are using these theories to stop solar energy projects, and the California high speed rail project, and also opposing new fiscal stimulus, and I think that’s going to kill the US economy in the long run. If we are in 2015, and the Chinese economy hasn’t collapsed and the US economy isn’t going anywhere, then then at that point people in the US might be receptive to some of these economic ideas.
Twofish

Andeli: It has been 60 years since the first tech plan….How much time does the system need before someone says it should change?
China is changing. People try new stuff. If it works, they do more of it. If it doesn’t seem to work, then they do less of it. You can’t stop China from changing even if you wanted it to. The question is *how* China changes.
Also one thing about China is that the technology system *is* working. You have internet startups and cell phone factories starting up all over the place.
Andeli: Because an investment in agriculture does not mean people go out of work. It means they move up the value chain and start adding value to agricultureal products in the local areas instead of moving into cities, where they don´t belong and will create slum.
Most of the value added in agricultural products involves processing and services. If you take the cost of the McDonald’s french fry in the US, you’ll find that the farmer makes a tiny, tiny fraction of the cost, but don’t cry for the farmer (which is this large agribusiness). In the US, agriculture is so productive and farmers are so few that it doesn’t matter.
Also you won’t end up with slums, if people build massive amounts of housing. One thing that China has done is that with all of the problems with hukou, it’s managed to absorb hundreds of millions of people without the slums of Latin America or India.
Andeli: True but keeping them on the welfare will give them the choice of what they want to do, so human resources will flow better around society
No it won’t. Something you have to understand about employment is that its more than a paycheck. Where you work sets up social relationships and a sense of identity. Unemployment destroys those social networks. Also welfare creates stigma. If you’ve been on welfare, that in the US creates a stigma, and people are less likely to hire you. One thing that’s good about Chinese farming or construction work is that *functionally* it does the same thing as welfare, but it makes people feel good about themselves and doesn’t create a stigma.
If you just hand someone a check, people will accuse them of being lazy. If you make someone build a building for the check, it’s good for the worker *even if the building is useless* because no one can accuse them of being lazy.
Andeli: True but you could just give them the money for education and health clinics without taking the land because of building infrastructure or real estate.
Not that easy. Setting up a system for transfer payments takes about a decade. China has managed to do it but it wasn’t easy.
Andeli: And that is where we disagree. I want to give wealth to those that don´t have and can make better use of it, and you want to give to those that already have and waste it.
Actually, I want to create wealth. If you generate enough wealth, then everyone wins. You generate wealth through science and technology. One problem is that unless you create wealth then the people with wealth *will* keep more and more of it until there is a revolution.
One thing that has caused my thinking to change is that in 2000, I though the problem of wealth creation was “solved”. Guess not.
Andeli: The Chinese economical dream was build on the development of the Chinese rural areas in the 1980s It has to go back to that again.
It can’t. The problem with economic growth is that you have to keep pulling new rabbits out of the hat. If you do one economic policy, then you increase wealth, but if you stop doing anything new, then things will just sit there.
What happened in the late-1970′s was that the Cultural Revolution was such a disaster that by reversing the policies, you ended up with massive economy growth in the early-1980′s. But then you are done. You did something that worked, you got the benefits, but then it’s over. People were grateful for getting from 1975-wealth to 1985-wealth, but then it’s a mess if you stay at 1985 forever. Look at the Soviet Union. In 1990, the Soviet Union was far, far richer than it was in 1950 and far, far richer than China was in 1990, but people want more.
To most Chinese living in 1975, 1985 is heaven. To most Chinese living in 2011, 1985 is hell.
Twofish

One thing that I’ve never been able to figure out is that I happen to be a huge fan of Michael Pettis’s book “The Volatility Machine: Emerging Economics and the Threat of Financial Collapse” which I think is a must-read. I’m also a huge fan of Hyman Minsky who Pettis always mentioned in his blogs.
The thing that I haven’t quite figured out is how I manage to agree with everything he wrote in that book and everything he says about Minsky yet at the end of the day, we manage to disagree so sharply on Chinese economic policy. I think what it boils down to is that I trust government bureaucrats more than I do the market for some things.
Also one must read is Krugman’s “How did economists get it so wrong?” and John Cochrane’s response. (Google for it). One thing that I think is a big difference is that people seem to want a version of economics that is “non-partisan” and “politics-free” but I’m convinced that no such a thing exists.
Twofish

In any event the die has been cast, and both the US and China have decided on basic research policy for the next five to ten years.
China is planning on spending US$1.5 trillion (yes that’s trillion and in US dollars) on strategic industries, whereas in the US any sort of funding for clean energy or high speed rail is politically impossible.
see http://www.washingtonpost.com/politics/for-obamas-green-car-revolution-fits-and-starts/2011/11/29/gIQA0FdRdO_story.html
see also http://polizeros.com/2011/10/17/high-speed-rail-is-dead-stick-a-fork-in-it/
Interesting to see what is going to happen……..
LH

@Twofish:
Pettis’ notion of efficiency has nothing to do with whether investment is directed by gov’t or the market or something else altogether. It is, in keeping with the spirit of his writings generally, simply a mathematical notion, like ROI. I think it wrongfully politicizes his piece to say that it amounts to nothing but a championing of U.S. policy. Similarly unhelpful to lump him together with Paul Krugman who is flagrantly and overtly political in his writings. I think Prof. Pettis is trying hard to objectively test for signs of capital misallocation in China, using various measures and indicators. That’s all. I would be most interested to see him turn his analyses on various aspects of the U.S. economy, but he certainly does not purport to be doing so here.
think I’m gonna bow out on this one as the water seems to be getting muddier rather than clearer as we discuss more…
-LH
Twofish

LH: I think it wrongfully politicizes his piece to say that it amounts to nothing but a championing of U.S. policy.
That’s not what I’m saying. I’m saying that his notions of efficiency caused the economic problems that the US is having. What happens is that if you try to make the financial system “efficient” is that you end up decreasing reserves and decreasing interest rate spreads. This causes problems because then you don’t have a buffer that can let you buy time in the case of a financial crisis.
Look at it this way. The Chinese banks were all insolvent in the mid-1990′s yet China was able to avoid a financial crisis for several years until they could do some massive industrial restructuring. Lehman and Bear-Stearns were insolvent, and they were dead within a week. The reason for this is that Chinese banks were (and are) massively “inefficient” whereas US banks were “efficient.”
I don’t think that Pettis is stupid, evil, or ignorant. I think he is wrong. The fact that he is as smart and well-meaning as he is is the problem since I happen to believe that the policies and “mathematical view” that he has is horrible for the US economy.
LH: Similarly unhelpful to lump him together with Paul Krugman who is flagrantly and overtly political in his writings
Which is good. One thing that I happen to believe is that you can’t discuss economics without discussing politics. There is this desire among many economists to make economics like physics in which you can have objective statements that are mathematical metaphysical truths. I do not think it can be done.
LH: I think Prof. Pettis is trying hard to objectively test for signs of capital misallocation in China, using various measures and indicators.
The problem is that I don’t think you *can* objective do a mathematical only test for capital misallocation. I can come up with numbers that say that capital in China are misallocated. I can come up with other numbers that say that it isn’t. In order to figure out which are the right numbers, you have to use human judgement which is inherent subjective.
Also one problem with tests for capital misallocation is that they ignore the lag effect. If you spend a massive amount of money in investment, then a lot of the standard measures for productivity and capital efficiency just die. ICOR is GDP/Investment. If you increase investment, that happens now. GDP doesn’t increase for twenty years, so you end up with numbers that suggest massive capital misallocation. If you respond by cutting investment, you end up going into a death spiral.
And then there is the question, “so what if capital is misallocated?” Why is capital misallocation a bad thing, and if you try to stop it will you create an even bigger problem?
China has no problem with the current rate of growth, so the solutions to “better allocate capital” are to increase consumption. But if you increase consumption and decrease savings, you decrease reserves, which increases financial instability.
The other thing is that people work in reverse. I think that Pettis has a “gut feeling” that capital is being misallocated, and so look for measures that support that “gut feeling.” My “gut feeling” is different, and I don’t have any trouble finding measures that confirm that “gut feeling.” So if we just look at the mathematics, we get nowhere. To figure out who is right we then have to discuss the basis for our “gut feelings.” Mine’s boils down to “yes it’s stupid to have half finished theme parks, but it’s even stupider to have unemployed workers.”
LH: That’s all. I would be most interested to see him turn his analyses on various aspects of the U.S. economy, but he certainly does not purport to be doing so here.
He is trying to come up with a theory of economics, so it’s really important to test the implications of his theories to the United States. Michael Pettis doesn’t talk much about the United States, and Paul Krugman doesn’t talk much about Chinese domestic policies. But once you have a theory of economics, then it’s logical to test your theory in situations other than the one that you designed it for.
Also, I don’t want to be creating strawmen. If I’m misunderstanding the implication of Pettis’s ideas, then corrections would be appreciated. But what I’m doing is applying his thinking to the United States and the answers make no sense.
Curiously his analysis of Latin America is brilliant.
LH: think I’m gonna bow out on this one as the water seems to be getting muddier rather than clearer as we discuss more
That’s a good thing. Sometimes it’s good to be confused. One reason I’m being annoying is that I’m looking for someone to confuse me. One terrible nightmare that I have is that it turns out that Michael Pettis is right after all, 2020 comes, and the Chinese economy is a mess because it followed my suggestions which turned out to be all wrong.
So the question “what if I’m wrong?” is something that deeply, deeply scares me. But then I’m also scared by the question “so what happens if I’m right?”
LH

OK, in that case I’ll bow back in :-)
See, I think that he is not making a value judgement. I think he’s saying that if we define efficiency of capital allocation by this equation, then it appears that China has been misallocating capital. I.e., the equation is satisfied.
I don’t see how it can be said that his analysis makes no sense in the U.S. You don’t mean, I think, that the equations don’t work there. Maybe you mean that if you look for capital misallocation there, you don’t see it, but since the U.S. economy is in the dumper then capital misallocation can’t explain it. But there’s no reason to think apriori that what ails the U.S. economy is capital misallocation.
FWIW, the reason I think Krugman is wrong (since he’s the loudest voice in the economics community concerning the U.S. at present) is that he ignores our trade imbalance. If you stimulate by pouring money into empty theme parks in the U.S., you get an empty theme park and workers get money. So far so good. But when they spend that money, $9 out of $10 go out of the country (I’m exaggerating but you see what I mean) so there is no multiplier effect. The reason that crazy-looking stimulation works better in China is that money spent in China stays in China by and large, and it makes all the difference.
Well, Krugman also ignores the possibility that the bond market will really turn on the U.S. one day on account of its sovereign debt, they way they have turned on Greece. If China is to the U.S. as Germany is to Greece then it seems to me that at least a little bit of attention should be paid to that possibility. Krugman seems to think that’s ridiculous.
The problem with the U.S. is trade deficit IMO. It’s causing the fiscal deficit and unemployment and all the rest. I don’t understand what you mean when you say the problem is productivity. (?) The productivity of American workers has been soaring but there’s not nearly enough employment — the trade policies are all wrong — to see a benefit.
-LH
Andeli

@TwoFish
“China is changing. People try new stuff. If it works, they do more of it. If it doesn’t seem to work, then they do less of it. You can’t stop China from changing even if you wanted it to. The question is *how* China changes.”
The problem is really how it is changing. In 1953 China’s First Five-Year Plan was created to increase production of steel and iron. The first four years of this plan was a stable and slow development of production capacity. Then the leadership wanted to make a Great Leap forward i 1957/58. We all know what happend in 1959, 1960…
In the 1980s, 1990s and early 2000s there was a stable and slow development of production capacity adapted to the world market. Then came the electrical cars, the huge windmill parks, the high speed trains and the great highway system who are all minor great leaps forward.
The mindset has not changed since 1953, but there are now institutions in place to report back to the leadership, so they can stop before the system destroys itself.
The Great Leap Forward is by the way an exemple of capital mislocation and failed management should you doubt capital misallocation exists. The idea of great technological leaps is basically wrong. Technological advances are not forced they occur when many factors are brought together. The products of forced technological advances become detached from society. And don´t forget no Chinese stateown institution will make its scientific findings public, so it has to carry the whole process by itself from idea to competitive product. That why after 60 years it is still standing still.
“Also you won’t end up with slums, if people build massive amounts of housing. One thing that China has done is that with all of the problems with hukou, it’s managed to absorb hundreds of millions of people without the slums of Latin America or India”
No slum in China? not sure you come here that often. The slum rate is increasing everyday please see the term “Urban villages”. No one can pay the price to live in the houses being build.
“No it won’t. Something you have to understand about employment is that its more than a paycheck. Where you work sets up social relationships and a sense of identity. Unemployment destroys those social networks. Also welfare creates stigma. If you’ve been on welfare, that in the US creates a stigma, and people are less likely to hire you. One thing that’s good about Chinese farming or construction work is that *functionally* it does the same thing as welfare, but it makes people feel good about themselves and doesn’t create a stigma”
This is of course all wrong if welfare is backed by a system that guides you into a job. China has this system in place based on the neighborhood committees. This money spend on infrastructure could have been spend on private consumers, the agricultural sector and creating a effective system of job replacement.
“Not that easy. Setting up a system for transfer payments takes about a decade. China has managed to do it but it wasn’t easy.”
You say its not that easy and yet you say the system exists ? which is it ? can it or can it not be done? You are right. The system for transfering payments has been created and works, so there can be a transfer of wealth to people without massive investments in infrastructure.
“If you generate enough wealth, then everyone wins”
No and as you may have guessed I am a socialist. If you generate wealth a small part of society wins, so you have to redistribute wealth. Investment in infrastructure is the worst way to do that.
“What happened in the late-1970′s was that the Cultural Revolution was such a disaster that by reversing the policies, you ended up with massive economy growth in the early-1980′s”
No sorry the Cultural Revolution was not an economical disaster. The Cultural Revolution smashed much of China´s intellectual capacity, but it had little economical impact as China was a rural society. What happend in the 1980s was that the peasents got to keep a small part of their harvest which created a massive rise in food production. The 1980s was a reversal of the politics created in the 1950s. A reinvestment in China rural areas will create a flow of wealth into the poorer areas which will create a stronger base for consumption. China does not need people to buy more L.V bags it needs people to buy the goods its inland industries could produce.
One thing that you (and many others missed) is that China´s great economical development comes from the fact that the CCP included everybody in the society from the 1950s to the 1980s.
Its not because of a few reforms in the early 1980s. Before these reforms there was created a system, where everbody learned how to read and write, everybody got basic health care and everybody could get in contact with the administrativ system. This system created the base for a massive workforce that could be trained, controlled and cared for in a humane way.
This system is breaking up because of wealth distortion, and thus wealth has to be channeled to the rural areas as to create the second wave of rural development.
BC

Twofish is pontificating again on someone else’s blog and as always manages to misunderstand most of what he writes about in economics, but at least he adds lots of comments, which is why he is tolerated since every blogger loves lots of comments. I don’t think he has every been to China but I guess because he is ethnically Chinese he assumes he understand it. Pettis doesn’t use the accounting identities in the way he caricatures. Pettis uses the identities to identify the consequences of changes in any one of the factors. This is classic balance of payments analysis, and it is why he has managed to be right about so much. He was one of the first to explain that according to the analysis the euro could not survive and one by one the European countries would be forced to adjust. He was the first to point out that the Chinese miracle was based on an unsustainable debt build-up and now nearly everyone recognizes that this is true, except a few desperate bulls like Twofish and Kroeber, who both got it massively wrong and can’t admit it. Twofish tries to buttress his arguments by saying that no one in China pays any attention to Pettis but even if it were true it would be irrelevant, and of course it is so far from true that it only shows how ignorant Twofish is. I live and work in China and I can say that it is hard to find serious policy advisors in China who do not know Pettis, and it is becoming even harder to find anyone who does not recognize the problem of debt. I have been a reader of his for many years and I would like to know who got more predictions right.
Robert C.

The question of whether or not China is misallocating capital can be endlessly debated because it is very hard to prove except in retrospect.

Should China Kill The Electric Car? A Study in Capital Misallocation.

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