Will centralizing power solve China’s economic problems, or worsen them?

The relationship between the central government and local authorities is perhaps one of the least understood and most important questions about how China works today.

The past is, as per usual, probably better understood than the present. There is a pretty strong consensus on the importance of local initiative in the 1980s and 1990s–see Yuen Yuen Ang’s book How China Escaped The Poverty Trap for a good recent account. Yukon Huang’s new book, Cracking the China Conundrum: Why Conventional Economic Wisdom Is Wrong, is also good at giving a more top-down macro account of the importance of the decentralized model:

In China’s system, local authorities are motivated to promote growth. By encouraging competition, this has helped China to contain the worst aspects of the distorted signals and “soft budget constraints” that afflicted the other centrally planned economies in the former Soviet Union. Efficiency comes from having different jurisdictions and their affiliated enterprises compete against each other for their relative positions. They also compete to build the new institutions that China needs as it moves toward becoming a more market-oriented economy.

There is indeed a lot of evidence that this competition for growth among local authorities was an important positive feature of China’s system in the past. But the dynamics of that competition are not the same today as they were three decades ago:

When the state and the market complement each other, the results can have a dramatic impact on productivity and living standards, as has been the case during most of the post-Mao era. Since the onset of the global financial crisis in 2008, however, a confluence of events has altered these relationships. The creation of local-government financing vehicles (LGFVs) put local governments into direct competition with existing firms in property-related commercial activities and also enlarged the opportunities for corruption by local authorities. The government’s stimulus program channeled loans through the financial system to SOEs and local authorities, which made such opportunities even more attractive. Initially, these relationships helped redirect resources that were monopolized by the state, such as land, into more productive use in partnership with private agents. Over time, however, this process has become distorted, resulting in wasteful expenditures that the leadership is currently trying to address.

While local competition may have previously made socialist “soft budget constraints” harder than they otherwise would be, the post-2008 changes in the financial system seem to have led to an epidemic of soft budget constraints. These concerns are related to the argument in “The Long Shadow of China’s Fiscal Expansion,” by Chong-En Bai, Chang-Tai Hsieh, and Zeng Song (previously discussed here). Here’s a longer excerpt from that paper:

[Prior to 2010] local governments were actively providing special deals to favored businesses, but could not borrow from or influence the lending decisions of state-owned banks. The effect was that the assistance provided by local governments to favored firms largely consisted of exemptions from the country’s thicket of rules and regulations, but local governments could not provide the private firms they were trying to assist with preferential access to capital. These two institutional features—high-powered incentives to provide special deals, along with restrictions on access to capital—explain how China was able to grow rapidly despite seemingly low-quality institutions.

We show that the off-balance-sheet financial institutions created to fund the fiscal stimulus program changed the nature of the special-deals regime. Specifically, we show that the off-balance-sheet financial institutions continued to grow even after the stimulus program was over, because local governments now had a powerful new tool, the LGFVs, to provide support for favored firms. …

This might have had positive effects on welfare and growth if local governments had used these resources for projects that would have high social returns but had been starved of resources. However, we provide evidence that in addition to funding infrastructure projects, the relaxation of financial constraints also made it possible for local governments to channel financial resources to commercial projects favoring certain firms.

Other observers also see significant changes in the decentralized growth model in recent years. A recent piece by Barry Naughton suggests that the central government is moving away from encouraging local competition for growth and toward more top-down direction of the economy:

Since about 2010, China’s “miracle growth” era has come to an end, due to rapid changes in labor force conditions, incomes, and external markets. In the wake of this change, the complementarity between bureaucratic incentives and the plan appears to be declining.

The Xi Jinping administration has since 2012 reduced the focus put on economic growth in official success indicators, squeezing in new indicators such as managing local government debt, reducing poverty, and improving the environment. At the same time, the most recent 13th Five-Year Plan (2016–2020) GDP target of “more than 6.5%” growth is close to, or perhaps even above, growth potential. The 13th Five-Year Plan seems to have become an instrument to maintain high-speed growth, even as the bureaucratic incentive system becomes less single-minded.

It is a paradox of contemporary China that administrative interventions are increasing in size and multiplying in form just as growth potential is slowing and the benefits to a less-interventionist stance would seem to be increasingly evident.

Given that local governments get the blame, fairly or not, for the rapid accumulation of debt and wasteful investment projects in recent years, it’s understandable that the central government would try to change things. But it’s not really clear yet what model is replacing the old regional growth competition dynamic, and what the effects of this attempted shift might be.

Has regional competition now become a malign force that must be disciplined? Or will the weakening of regional competition sap China’s economic dynamism? Or both?

Here is Huang once more:

President Xi’s consolidation of power has been interpreted by the more optimistic observers as a precursor for bolder economic reforms in the coming years. For them, China will eventually allow the private sector to play a “decisive” role in guiding the economy as stated in the Third Plenum policy statement. But the many pessimists see in recent actions only hesitancy in addressing much needed productivity enhancing measures. Consolidation of authority means more centralized control over economic activities, continued protection of major SOEs and less competitive pressures in the market space. Thus China’s move from its former collective leadership to relying on a single powerful leader might lead to a less dynamic economy and eventually political instability. Only time will tell if either of these two scenarios becomes the reality.

51zr4nonx5l

Is the Manchurian Recession over?

China’s provinces are reporting economic data for the first half of 2017, and the long-suffering northeastern provinces, where the recent economic downturn was most severe, are putting up some better numbers. The main exception is Liaoning, but this is because an anti-corruption investigation found that the province had inflated some statistics and forced them to be marked down–however the historical figures haven’t been revised so growth rates don’t make any sense right now. While Liaoning’s numbers look worse than the others, in reality it’s probably doing the same or better.

manchurian-recession

The downturn in the northeast prompted a national-level effort to boost growth in the region, so the pickup is getting a lot of attention. At least one article declaring the “worst is over” for the northeast has appeared in print, and this cautiously optimistic tone is common in official channels. Here is how, Sun Donghai, the director of the Anhui provincial Development Research Center, summarized the situation:

In the technology-intensive regions, represented by Guangdong, Jiangsu, Zhejiang, Shanghai, economic growth is stable, and there is a lot of momentum for both upgrading traditional industry and developing new industries. … Regions heavily dependent on natural resources, such as the three northeastern provinces, Shanxi, and Hebei, are facing great pressure to transition, but developing new growth drivers will require a long time. At the same time, we can see some positive changes, some resource-dependent provinces have reversed the declining trend since 2013, and economic growth has bottomed out and recovered. Jilin’s GDP grew 5.9% [in the first quarter] for a stable start to the year: economic growth has returned to an appropriate range, and has started to move on a normal track.

A more in-depth view of official thinking comes from Fan Hengshan, a deputy secretary-general of the National Development and Reform Commission who has traveled frequently to the northeast. In May he gave a lengthy interview on the northeast to the China Economic Times. He starts out in the conventional way, attributing the improving indicators to the government’s supportive policies for the region, but also noting the recovery of commodity prices (more significant in my view):

The government’s implementation of the new round of the northeast revitalization strategy is now taking effect, objectively speaking it has provided an effective policy environment and systemic support for the stabilization of the northeastern economy. At the same time, the rollout of supply-side structural reform has had a clear impact on the internal dynamism of economic growth. Following the implementation of supply-side structural reform and the stabilization of international commodity prices, industries that are significant for the northeast, like oil, coal, and steel, gradually returned to stability. For resource-dependent and single-industry cities this alleviated the severe mismatch between fiscal revenues and expenditures.

While maintaining the requisite note of optimism, Fan’s discussion of the problems in the northeast’s economy focuses on deep-rooted structural issues that seem quite difficult to solve. Here are some excerpts (my translation):

The problems faced by the northeast are, on the surface, caused by a lack of external demand and weakness in investment. In fact, they are the manifestation of the institutional, systemic and structural problems of an old industrial base.

From the institutional perspective, the northeast region’s level of marketization is still insufficient compared with the developed eastern region. The decisive role of market mechanisms has not been fully developed, and efforts at economic development still have a pronounced administrative tone. The historical burdens of state-owned enterprises are heavy, their vitality is insufficient, and a modern system of enterprise operation and governance has not been completely established. The old problems of incentives and restraints for state-owned enterprises have not been completely eliminated. Development of the private sector is insufficient, and the spirit of entrepreneurship in society is weak. The northeast has a strong foundation in education and science, but these scientific resources cannot be effectively transformed into real activity.

In terms of economic and industrial structure, out of the three growth drivers of investment, exports and consumption, the northeast’s economy is excessively reliant on investment. The investment rate is too high and the efficiency of investment is relatively low, and this kind of growth model is not sustainable. The industrial structure is not adapted to market demand: the leading industries are mainly the investment-facing sectors of energy, raw materials and heavy equipment manufacturing, while new emerging industries are small and undeveloped. Many cities have undiversified industrial structures with only a single pillar industry or two interrelated industries. From the perspective of industrial organization, there are many gigantic enterprises but few small and medium-sized enterprises. A development model based on industrial clusters and the integration of large, medium and small enterprises has not yet formed.

It’s interesting that Fan talks about the northeast in the same way that many foreigners talk about China: the problem is obvious, their economy is too dependent on investment and state-owned enterprises are stifling the vitality of the private sector. It’s all relative I guess.

But the northeast has an additional burden: people are leaving in droves, and companies can’t get them to stay (see my previous post on the emerging demographic crisis in the northeast). Here is more from Fan:

Many enterprises and research institutions in the northeast have told me that in recent years it has gotten more difficult to attract and retain personnel. Some graduates of top universities choose to go elsewhere for jobs, and some local technical and management personnel also leave the northeast to seek better job opportunities.

The northeast still has a “big government, small market” environment, where local governments are still directly allocating resources and micromanaging. This kind of system is a constraint on the development of enterprises and people. Particularly in recent years companies in many traditionally strong industries and sectors have encountered difficulties, so the salary, benefits and career development opportunities they can offer are pretty limited compared to companies in the east. Objectively speaking, their ability to attract mid- to high-level staff has declined.

In addition to salary considerations, people are also increasingly looking at a city’s level of modernization, the convenience of its transport, and social, cultural, ecological and other “soft” environmental factors. It is worth noting that some local governments and businesspeople report that, because the northeast’s winter is cold and long, the low temperatures are increasingly becoming a reason for some people to choose not to stay in the northeast and work. This creates many challenges for high-tech enterprises in the northeast to attract talent, and some companies have no choice but to set up branch offices in the south in order to attract high-level staff.

This all rings true: the northeast  has a brutal climate and a closed economy where it is difficult to get ahead if you don’t have government connections or an SOE job. This is, in my experience, more or less what Chinese people from the northeast say about their home–it is no mystery why they leave.

So I would lean toward viewing the current recovery in the northeast as reflecting the recovery in commodity prices more than anything else–although if China’s government can succeed in keeping prices stable with its many interventions into commodity demand and supply (policies that go by the somewhat deceptive moniker of “supply-side reform”) that unquestionably will help these provinces.

More broadly, I think the current regional problems in the northeast are another reason to see China’s SOE reforms of the late 1990s and early 2000s as incomplete and only partially successful (see a previous post on this topic). The northeast felt the brunt of the layoffs of that era, but once the commodity boom evaporated so did many of the apparent improvements. Here is a nice piece of oral history that gives a worker’s-eye view of the trajectory of a major SOE in Heilongjiang:

It was with honor that a sprightly 19-year-old Wang Dianyu heeded the central government’s call and joined the ranks of China’s heavy industry workers. Almost 60 years later, his eyes still glow with the pride of having worked for one of his country’s largest state-owned factory groups: China First Heavy Industries (CFHI).

Founded soon after the establishment of the People’s Republic of China in 1949, CFHI was a beacon of the country’s industrial ambition, churning out gigantic pieces of machinery both civilian and military from its base in Fularji, a district in Heilongjiang’s second-biggest city, Qiqihar. “We had a lot of catching up to do,” Wang tells Sixth Tone of China’s then-inferiority compared to the might of international rivals. “Heavy industry is the backbone of a country.”

Today, that backbone is buckling. Economic growth in the industrial northeast, once fondly known as “the Republic’s eldest son,” is slowing, and an era of overproduction for the region’s heavy industries has given way to rampant borrowing. For the 2016 fiscal year, CFHI reported losses of 5.73 billion yuan (around $850 million), compared with 2015’s loss of 1.8 billion yuan and 2014’s loss of 25.7 million yuan; it is now scrambling to pay back debt by selling off shares to its parent company, China First Heavy Industries Group Co. Ltd.

CFHI’s troubles were compounded in 2015 when its chairman, Wu Shengfu, died suddenly just weeks after the state’s anti-corruption watchdog launched an investigation into CFHI’s parent company. Some news outlets at the time quoted sources stating that he was found hanging in his office, a detail that was downplayed in later state media reports. The anti-graft investigation discovered a number of infractions, including mismanagement of state funding, violations of recruitment procedure, and “indifference toward Party principles.”

What I’ve been listening to lately

Been a while since I’ve done one of these–life has been getting in the way.

    • Philip Cohran – On The Beach. May he rest in peace. Although mostly known for his association with Sun Ra, Cohran made wonderful music on his own: I love the gorgeous African Skies, as well as the record with his children, the Hypnotic Brass Ensemble. But I had missed this classic 1968 recording, with a vigorous large ensemble and a great feature for Cohran’s “Frankiphone.” Random fun fact: the New York Times obituary notes that he picked up the Muslim name Kelan, rather unusually, in China (it’s the Chinese transliteration for the Quran).
    • The Skatalites – Foundation Ska. This was the first recording of Jamaican music I ever purchased, and it sucked me in immediately. I’ve been going back to these tracks recently, and they are still absolutely entrancing and, yes, foundational. Active for only about two years, The Skatalites created their own musical world with a combination of propulsive rhythms and moody, interlocking horn parts.
    • Miles Davis – Bitches Brew Live. The classic Bitches Brew album is a long, sprawling mess, clearly a work of genius but still rather exhausting. These versions of the same tunes, performed by stripped-down ensembles, are tighter, punchier, and may actually be better.
    • Joe Henderson – The Elements. The peaks of the “spiritual jazz” subgenre of the 1970s can be pretty wonderful, but the valleys between those peaks tend to be long and deep. But I’m happy to report the ratio is quite good on this rather obscure album. Henderson has a killer band including Alice Coltrane, Michael White, and Charlie Haden, and their peaks are very high indeed.

How the Soviet Union tried to control the growth of large cities

Returning to my theme of socialist urbanization, here is a good overview of the Soviet system for controlling the expansion of large cities. The parallels with China are, at least to my eye, immediately obvious and striking. The passage is from Planning in the Soviet Union by Judith Pallot and Denis J.B. Shaw; it was published in 1981 which is why the USSR is referred to in the present tense:

Many Soviet writers claim that a socialist society’s ability to control the process of urbanization is a demonstration of its superiority to capitalism. Thus [geographer Boris Sergeevich] Khorev writes that the spontaneous and uncontrolled growth of cities in the West has produced such unfavorable consequences that “they militate in effect against the very system of large-scale capitalism.” By contrast, he believes, “only socialism has the possibility of using the best achievements of the modern urban form of settlement for the great masses of workers.”

Early efforts to control the rapid growth of the largest cities date from the 1930s, when rural-urban migration was threatening to produce total chaos for housing and services. Since then, with an increasing concern about regional development questions and the standard of living in cities, the policy has become more clearly defined and now embraces many more cities. The 25th Congress of the Communist Party of the Soviet Union in 1976 once again stressed the need to restrain the growth of large cities as part of a policy of industrial decentralization.

Soviet controls over the expansion of cities have three major aspects. The first is the propiska system, controlling migration into cities. The internal passport system was introduced in 1932 and at the same time a policy was implemented to control the inflow of permanent migrants into Moscow and Leningrad [St. Petersburg]. These efforts were reinforced by the plans for the two cities, promulgated in 1935, which allowed for only modest population expansion. Since that time many large cities have been declared “closed” to voluntary residence. In order to take up permanent residence in one of these cities, therefore, a special permit or propiska is required. For those who residence is temporary, such as university students, there are temporary propiska. Except for those born in a closed city, the propiska is not easy to acquire.

China: hukou system. Check.

The second control to city expansion lies in the ownership and direction of industry and of other forms of economic activity by the Soviet state. In 1931 the government decreed that all new industrial expansion was to take place outside Moscow and Leningrad. These provisions were reinforced by the 1935 plans for the cities and by subsequent government action on decentralization, especially after 1938. In 1939 five more cities–Khar’kov, Kiev, Rostov, Gor’kiy and Sverdlovsk–were added to the restricted list, and by 1956 there were 48 cities in which there was to be no further new industrial construction or expansion by already-existing plant. …In the 1960s and 1970s a whole new generation of development plans was drawn up for major cities, affirming the restrictions on, or prohibition of new industrial developments. Many plans also specify that activities not basic to a city’s economy, and polluting industries, should be relocated to satellites.

China: forced relocation of industry. Check.

The third arm in city control is that over land use. Soviet legislation on land has a special category of “land under populated settlements” and the granting of the right to use urban land is vested in the executive committee of the city soviet subject tot eh guidance of higher authority. In principle, the, industrial ministries and enterprises are unable to acquire new land without the expressed consent of local and higher authority.  …

China: monopoly state ownership of urban land. Check.

The USSR’s three largest cities in 1959 subsequently grow more slowly than other cities with populations over 100,000…the 24 largest cities of 1959 (population 500,000+) had over 25 percent of the total urban population in 1959, but less than 23 percent in 1976. In spite of these favorable trends, Khorev and others believe that the largest Soviet cities are still growing much too quickly and such tendencies are exacerbating urban problems. It is certainly the case that many cities have exceeded the growth rates expected by the planners. In the case of Moscow, for example, the 1970 city plan stressed the necessity of containing the capital’s population within the 7 million mark. At that time, however, the city’s population already stood at 6.9 million, and had reached 7.8 million by 1978. Leningrad’s city plan, approved in 1966, envisaged a population of 3.4-3.5 million people by the latter half of the 1980s, or 4 million including the suburban settlements. This level had already been reached by 1970.

Historically, China’s policies to control the growth of the largest cities only succeeded in slowing population growth rather than halting it–and even that limited success has imposed great human and economic costs. But the most recent and most draconian iteration of these policies may actually be succeeding in capping population growth. Soviet urban planning policies often failed because they were internally contradictory and poorly administered. Is the Chinese administrative state now powerful enough to actually implement the sterile visions of socialist urbanization?

pallot-shaw-planning

 

Mapping China’s 19th century provincial incomes

A passing reference from the encyclopedic Pseudoerasmus sent me to the work of Paul Caruana-Galizia, who has done an impressive series of papers quantifying historical income levels on a regional (rather than the usual national) basis for many countries.

His paper on China, written with Ye Ma, gives us provincial per-capita GDP for the late 19th and early 20th centuries — an essential resource for comparing patterns of development over a longer time period.

The paper inexplicably does not include a map, so I have made a couple myself:

provincial-per-capita-GDP-1873

provincial-per-capita-GDP-1914

(Note: In these maps, Hebei includes the present-day municipalities of Beijing and Tianjin, Jiangsu includes Shanghai, and Sichuan includes Chongqing.)

The decline of incomes across most provinces (with Jiangsu and Xinjiang notable exceptions) is visually very obvious. Regional inequality was also basically stable over this period, probably reflecting the absence of sustained growth. Here is some useful commentary from the paper for context:

How do these per capita income levels compare with Europe’s? In 1873, Heilongjiang was China’s richest province with a GDP per capita of $870. In 1870 Europe, there were eight regions out of a sample of 200 that had per capita incomes between $800 and $950. Of these eight, five were in Austria-Hungary, one in France (Haut-Garonne), one in Germany (East Prussia), and one in Spain (Extremadura). These comparisons add weight to the argument by Pomeranz that some European areas were at similar levels of development to Asian ones. The fact remains, however, that China’s richest province – some 43 per cent above the Chinese average in 1873 – was only as rich as Europe’s poorest regions. … By the close of the period, Jiangsu surpassed Heilongjiang as the richest Chinese province with an income of $853. The only comparable European region is Dalmatia ($874).

On a macro level, the results corroborate histories of national economic decline and stagnation. China’s mean provincial per capita income compound annual growth rate over the period was −0.20 per cent. The internal disorder and continuous shocks to the economy in the forms of rebellions, foreign wars, and natural disasters meant that most Chinese were better off at the end of the nineteenth century than they were at the start of the twentieth.

Ma and de Jong’s numbers show that Chinese real GDP per capita dropped by 10 per cent from 1873 to 1912. Looking to Europe for comparisons, we see that Italian regions enjoyed an annual growth in per capita income of some 1.2 per cent, similar to that in France. These figures fit with Gernet’s claim that China’s ‘tragic period’ coincided with Europe’s ‘acceleration.’

And here’s the original table for reference:

Caruana-Galizia-table

Is China making the right tradeoff between short term and long term growth?

China has since 2008 engaged in repeated rounds of debt-fueled stimulus policies to prop up economic growth–a pattern that has become so entrenched that many people have forgotten that China ever did anything else. Lots of people, including me, have been critical of these policy choices. Most of these criticisms are, at their base, arguing that China is making the wrong trade-off between the short term and the long term. By focusing too much on preventing short-term growth slowdowns, it is creating more longer-term problems.

There are many examples of such arguments, but a couple of the more recent and systematic ones are worth highlighting. In “Local Crowding Out in China,” by Yi Huang, Marco Pagano, and Ugo Panizza, the authors argue that local governments’ reliance on banks to fund the off-balance-sheet stimulus spending crowded out funds for private-sector investment:

In China, between 2006 and 2013 local government debt almost quadrupled from 5.8% to 22% of GDP. … Given China’s geographically segmented financial market, this increase in local debt created imbalances in local financial markets: to underwrite it, banks curtailed financing to private domestic firms, forcing them to cut down on investment. This local crowding-out was more pronounced in the cities that issued more public debt. Public firms were shielded from the funding scarcity, thanks to preferential access to bank credit and almost exclusive access to bond financing. So were foreign firms, which could turn to their home countries’ capital markets. … Given that private companies are the most dynamic component of the Chinese economy, our results suggest that the large-scale local public debt issuance in connection with massive fiscal stimulus may have sapped the country’s longer-term growth prospects.

A related argument is found in “The Long Shadow of China’s Fiscal Expansion,” by Chong-En Bai, Chang-Tai Hsieh, and Zeng Song, an excellent overview of the post-crisis economic environment. This piece focuses not on the constraints imposed on banks by the need to finance large local government programs, but on the power that this expanded spending gave local governments. They argue that political favoritism has increased, leading to worse investment decisions:

This stimulus was largely financed by the creation of off-balance-sheet companies that allowed local governments to circumvent financial controls. About three-quarters of the stimulus spending was done by these off-balance-sheet companies, on behalf of local governments, with only a small increase in the official budget deficit. After the stimulus spending ended, local governments continued to use their newfound power to obtain access to financial resources.

The result has been an increase in off-balance-sheet local government debt and an increase in investment spending. Local governments, which have long faced high-powered incentives to support favored local businesses, have used this newfound power to channel financial resources toward favored private firms. The effects on the efficiency of capital allocation may, in turn, have had important effects on aggregate productivity growth in recent years.

Personally I find both arguments pretty convincing, as they are well-founded in the realities of how China’s political economy functions. But these kind of criticisms are not new, and so far do not seem to be very convincing to the people actually making economic policy decisions in China. The feared long-term economic damage from the stimulus is difficult to quantify, while the short-term economic costs from a more severe downturn are much more obvious. And to be fair, it is usually not obvious how to make the right trade-offs between the short term and long term.

If I was going to defend the Chinese government’s side in this argument, it would be on the grounds that the long-term damage from deep short-term downturns is indeed fairly severe. And therefore that the best way to ensure incomes rise over the long term is to minimize recessions in the short term. Or, as Napoleon reportedly said: “the game is always with him who commits the fewest faults.”

Some of the strongest support for this view comes from ideas advanced by the economic historian John Joseph Wallis, a collaborator with the great Douglass North. Their wonderful 2009 book Violence and Social Orders: A Conceptual Framework for Interpreting Recorded Human History argues that the change from slow pre-modern economic growth to fast modern economic growth, and the distinction between poor and rich countries, basically comes down to doing a better job of avoiding economic disasters. Here is a passage from the book:

Economic growth, measured as increases in per capita income, occurs when countries sustain positive growth rates in per capita income over the long term. Over the long stretch of human history before 1800, the evidence suggests that the long-run rate of growth of per capita income was very close to zero. A long-term growth rate of zero does not mean, however, that societies never experienced higher standards of material well-being in the past. A zero growth rate implies that every period of increasing per capita income was matched by a corresponding period of decreasing income. Modern societies that made the transition to open access, and subsequently became wealthier than any other society in human history, did so because they greatly reduced the episodes of negative growth.

The historical pattern of offsetting periods of positive and negative growth episodes is easier to see in the modern world, where we have better data… Strikingly, the richest countries are not distinguished by higher positive growth rates when they do grow. In fact, the richest countries have the lowest average positive growth rates by a substantial amount. …When they grow, poor countries grow faster than rich countries. They are poor because they experience more frequent episodes of shrinking income and more negative growth during the episodes.

Recently Wallis has, in collaboration with Stephen Broadberry, restated and extended this argument using more comprehensive historical data. The idea is being dubbed “shrink theory,” and as one commentator has already noted, its implications are on the face of it very negative for “any kind of theory that holds that economic recessions are purifying, ultimately beneficial to the economy, and even good for the national character.”

So if the Chinese government wanted to make an economically literate defense of its stimulus policies, it could do worse than to embrace the shrink theory of Wallis and Broadberry. Perhaps there is no hard tradeoff between the short term and the long term: keeping growth going in the short term is also the best way to maximize income gains over the long term. Officials could argue they do not need to spend time worrying about measures that might damage long-term productivity growth, since no one really knows what causes long-term productivity growth anyway, and are right to focus on preventing deep and damaging cyclical downturns.

Yet I think it is unlikely that Wallis and Broadberry will be speaking at a Politburo study session anytime soon, as the their main argument is not really about how to do counter-cyclical economic policy, but about the relationship between political systems and economic growth. They argue some societies are better at avoiding damaging economic downturns because they have more open and flexible political systems–ones that are better at decision-making and avoiding instability and violence in power transitions. I don’t know if they have articulated a specific view on China, but it seems likely that they would view China’s political system as still being at risk of generating damaging instability and an associated economic downturn in the future.

The historical roots of China’s industrial clusters

I’ve been interested in industrial clusters in China for a while, since I think they tell us a lot about underlying patterns of private-sector economic activity. Clusters are behind much of China’s decades-long success in exports, and more recently seem to be related to some fast-growing domestic service sectors as well.

A recent working paper by Xiwei Zhu et al., “Entrepreneurship and Industrial Clusters: Evidence from the China Industrial Census“,  makes some interesting points on this topic. The authors do some fancy math to identify clusters from data on the location of industrial firms, which results in the nice map below.

Zhu-cluster-map.png

The results are broadly consistent with more anecdotal approaches to identifying: industrial clusters are most prevalent in the coastal provinces of Zhejiang, Jiangsu and Guangdong (but note that Sichuan far inland also does pretty well). Places with lots of clusters also tend to be places where the private sector is a larger part of the economy.

Why do clusters form in these places? Geography is part of the traditional explanation, and the authors do find that access to ports (i.e., access to world markets) contributes to the formation of clusters. But they also argue that what they call the historical “supply of entrepreneurs” is an important factor.

Since there were few recognized private companies in China before the 1990s, most founders of private-sector firms had to come from somewhere else–and state-owned or collective enterprises were a major source.

Zhu-entrepreneur-table.png

The authors use the number of firms in 1985 as an indicator of this historical potential for entrepreneurship. And they find that the number of all firms in 1985 is closely related with the number of private-sector firms in 2004:

Zhu-firms-scatter.png

The pattern suggests that the places where private-sector businesses flourished after liberalization were in fact those places where disguised private-sector businesses were already most prevalent. This fits in with historical evidence from the 1970s that pre-Communist commercial traditions and patterns often continued in the form of collective enterprises.

Though this particular paper is heavy on data and light on historical interpretation, I think it does contribute to a different narrative about China’s economic development. In such a narrative, China’s growth resurgence, at least in the 1980s and 1990s, is more about the flourishing of long-suppressed indigenous entrepreneurial traditions than the success of top-down development programs.