Cautionary fable from 1994 holds good for China today

This year, China's growth is expected to be driven by investment without gains in efficiency and this scenario is not sustainable, says a consultant

PUBLISHED : Tuesday, 27 November, 2012, 12:00am
UPDATED : Monday, 30 May, 2016, 5:00pm

If China's new leaders really want to understand the economic challenge they face, they should dig out an essay published in the November 1994 edition of Foreign Affairs magazine by American economics professor Paul Krugman.

Entitled The myth of Asia's miracle: A cautionary fable, the essay caused quite a stir at the time. In it, Krugman compared the rapid emergence of the Asian "tiger" economies with the fast growth of the Soviet Union in the era of Joseph Stalin and Nikita Khrushchev.

The performance of the Soviet economy might have looked impressive, even intimidating, to outside observers, argued Krugman. But there was nothing miraculous about it. The Soviet Union's rapid output growth could be explained entirely by rapid growth in inputs of labour and, especially, of capital.

Asia's economies had grown in the same way, Krugman explained. Bringing underemployed peasants into the urban workforce, and investing lavishly in machinery and infrastructure had produced an enormous surge in output.

But the growth was based on "perspiration rather than inspiration". Everything was achieved by pouring in more labour and more capital. Nothing was due to improvements in the amount of output per unit of input, or what economists call total factor productivity.

Krugman argued that this posed a problem for the tigers' development. You can double your labour force participation rate from 30 per cent to 60 per cent, but you can't double it again. And you can increase a construction worker's output 10-fold by replacing his pick-axe with a US$50,000 bulldozer. But his output doesn't grow any more if you give him a second.

"Growth that is based on expansion of inputs, rather than on growth in output per unit of input, is inevitably subject to diminishing returns," Krugman wrote, concluding that the growth of the Asian tiger economies must slow as a result.

At the time, China's stood apart. Measuring from the start of economic reforms in the late 1970s, Krugman detected a "dramatic improvement in efficiency", implying that China's high growth rates were more sustainable.

Today the picture is less encouraging. In a study published earlier this month, Charles Dumas, chairman of independent consultancy Lombard Street Research, decomposed China's recent economic growth into its different components.

He found that over the last 10 years capital inputs have become increasingly more important in powering the overall growth of China's gross domestic product, while the contributions of labour and of improvements in total factor productivity have declined.

As the chart below shows, this year Dumas expects capital inputs - investment - to account for all China's economic growth, with efficiency gains contributing nothing at all.

This is unsustainable. If China's new leadership is to maintain even moderately rapid growth over the coming years, Beijing must both slow investment growth and boost the total factor productivity.

Dumas argues that one key to boosting efficiency is to "let failures fail". In other words, the government and banking system must stop supporting well-connected zombie companies with generous subsidies and easy loans.

"Keeping zombies on life support hoards labour and capital resources in the wrong places and takes away the stick of fear in motivating businesses to improve plants, processes and products," he writes.

At the same time the government should break up the state sector's protected monopolies "both to spur them to greater efficiency in themselves and to lower the cost of their products and services".

In short China's new leadership should embrace creative destruction. The initial effect would be a painful period of sub-par growth, extensive loan write-offs and another state recapitalisation of the banking system. But the resulting efficiency gains would position the economy for a new phase of sustainable rapid growth.

It will hurt, but Dumas warns that failure to make the necessary reforms will doom China "to a permanent halving of trend growth to 5 per cent" and a crippling build-up of debt interspersed with debilitating bouts of inflation.

Krugman's is indeed a cautionary fable. Under that scenario, China's new leaders could end up going the same way as the Soviet Union's last.