Capacity to transform

That is the title of a chapter in Charles Kindleberger’s 1962 book Foreign Trade and the National Economy I immediately loved the phrase, and found that it helped me crystallize some thoughts.

The capacity to transform, in Kindleberger’s formulation, is essentially an economy’s ability to re-allocate resources in response to market signals. He discusses it in the context of exports, but it is clearly broader than that:

Capacity to transform is capacity to react to change, originating at home or abroad, by adapting the structure of foreign trade to the new situation in an economic fashion. … A higher price leads to more labor, land, and capital being attracted to a given product, and more output. A lower price results in reduced production.

The capacity to transform varies. Kindleberger thought that traditional societies with pre-modern economies had a lower capacity to transform, as social strictures prevented people from changing occupations or established business practices. The process of economic development is thus in some sense the process of increasing the capacity to transform:

These reactions require responses to profit and to income differences on the part of entrepreneurs and owners of factors which disregard traditional usage. Entrepreneurs are ready to shift to new occupations, labor to take on unaccustomed tasks. There must be occupational, spatial, and probably social mobility to accommodate the shifts of factors required by evolving economic opportunities. Upward social mobility must be possible through economic success, and not only through the army, church, and politics. A minimum of education and literacy are required–more is better–to permit the retraining of labor and its instruction in new tasks.

But he saw clearly that capacity to transform does not simply rise in a straight line, and varies from place to place and time and time. The mobility of labor, workers moving changing locations and jobs to better their pay, is one of the most obvious indicators of capacity of transform. Yet there are numerous examples of workers who did not respond in that way to price signals:

Underdeveloped economies are not alone in their incapacity to adapt. … Distressed areas, pockets of unemployment, and low-income industries and regions are found in countries of all levels of average income.

The reasons for incapacity to adjust are social in developed countries as well as underdeveloped. In Lowell, Massachusetts, the young do not move away when the cotton mills cut back output; they share the work on short time, or take turns in working full time in the mills and drawing unemployment relief. The green valleys of Wales similarly clung to their youth when coal was depressed in the 1930s. Brittany and the Southwest in France and the South of Italy contained disguised unemployment in agriculture, along with industrial workers at less than average national wage rates who refuse to migrate to increase their earnings.

Similar failures of mobility have gotten increased attention in economics in recent years, as research has shown that in countries as different as India and the US, workers often did not move away from regions with declining industries. Here is a recent op-ed on this point by fresh Nobel laureates Esther Duflo and Abhijit Banerjee: 

When jobs vanish and the local economy collapses, we cannot count on people’s desire to seek out a better life to smooth things out. The United States population is surprisingly immobile now. Seven percent of the population used to move to another county every year in the 1950s. Fewer than four percent did so in 2018. The decline started in 1990 and accelerated in the mid-2000s, precisely at the time when the industries in some regions were hit by competition from Chinese imports. When jobs disappeared in the counties that were producing toys, clothing or furniture, few people looked for jobs elsewhere. Nor did they demand help to move or to retrain — they stayed put and hoped things would improve. As a result, one million jobs were lost and wages and purchasing power fell in those communities, setting off a downward spiral of blight and hopelessness. Marriage rates and fertility fell, and more children were born into poverty.

From that, they conclude that in general, “Financial incentives are nowhere near as powerful as they are usually assumed to be.” And they are surely right that “status, dignity and social connections” are the main motivators for human beings, who are fundamentally social creatures.

But it still seems that it would be more productive to treat capacity to transform as a variable, and try to understand how it changes over time and how it varies among different places. The decline in the mobility of labor over recent decades in the US is well-documented, and surely calls out for some kind of theory.

Kindleberger seemed to think that a weakening capacity to transform in advanced economies–like a loss of labor mobility, or the phenomena Tyler Cowen has grouped under the labels of “stagnation” or “complacency”–was part of the natural course of history. He did not quite offer a theory of this, but he sketched the outlines of a model:

Capacity to transform probably follows a pattern. In traditional societies it is minimal. With exposure to the modern world it increases. At some stage in the growth process it reaches a peak, and then there seems to be some diminution in it.

Kindleberger cites the adage “three generations from shirtsleeves to shirtsleeves” (which has an exact counterpart in the Chinese saying 富不过三代 “wealth does not survive three generations”) to illustrate our intuitive understanding that success can weaken the drive to change. So one could posit a “Kindleberger curve” in which capacity to transform first increases as the economy develops, and then decreases.

Such a curve would be close to the mirror image of what James Galbraith proposed, in his 2012 book Inequality and Instability, as the “augmented Kuznets curve,” which shows how inequality evolves as an economy’s level of income rises. Simon Kuznets had originally argued that in the early stages of the transition from traditional agriculture to industry, inequality would first rise as incomes rose, but as that transition advanced further, inequality would decline substantially even as incomes kept increasing. Galbraith recognized that in the decades after Kuznets wrote, inequality in industrialized countries had stopped declining and started to rise again. He argued that another structural transition, involving a rising economic role for finance and high technology, was responsible. Galbraith therefore augmented Kuznets’ original curve by adding an upward swing at the end:

Based on the experience of the US, it seems like the downward slope of the augmented Kuznets curve should roughly coincide with the upward slope of the Kindleberger curve, as should the subsequent rise in inequality and decline in capacity to transform. Since inequality could itself constrain the capacity to transform, and reduced capacity to transform could entrench inequality, these two changes could be related.

But while a declining capacity to transform can be problematic, this does not mean that capacity to transform must always be maximized. Kindleberger also wrote that “Worse than not being able to respond to an economic stimulus may be, under certain circumstances, responding too much.” The examples he gives of “capacity to transform with a vengeance” are less about the re-allocation of labor and more about investment flows: how lags in production of agricultural goods or housing can encourage too much investment in response to higher prices, resulting in a crash later on.

This made me think of China, and its policy-driven booms and busts. Typically, money floods into a sector when it receives government favor and subsidies, leading to a surge in production, and later overcapacity, falling prices, and a shakeout as the government reconsiders subsidies (see: solar panels, wind power, electric vehicles). In terms of labor, the willingness of Chinese migrant workers to uproot themselves and their families also shows no shortage of capacity to transform, but perhaps at too high of a social cost. So while capacity to transform in the US may now be too low, China’s might be too high.

Re-reading the chapter again, it’s still impressive to me how Kindleberger, in this short and quite casual treatment, managed to identify some of the major issues that are still puzzling economists some 60 years on. His concept of “capacity to transform” feels overdue for revival.

Also, here is my previous post on another interesting part of this Kindleberger book.

The afterlife of Marx’s footnote on Chinese currency

The number of times a Chinese person has cited Marx is by now, with the Chinese Communist Party approaching its centennial, surely uncountable. The number of times Marx cited a Chinese person is countable, and small.

It is an interesting piece of socialist trivia that in his Capital, Marx mentions only one Chinese person by name: Wang Maoyin, who held a position something like chancellor of the exchequer under the Xianfeng emperor of the Qing dynasty. He appears in footnote 36 to Volume 1, Chapter 3, the chapter on money and the gold standard, where Marx mentions Wang being reprimanded for a monetary proposal he had made to the emperor.

This mention has not, of course, escaped notice in China. The English-language Peking Review in 1983 excerpted an article about Wang that explains the background:

The debate took place between 1853-54 during the reign of Emperor Xianfeng of the Qing Dynasty. Wang Maoyin, Vice-President of the Board of Revenue and Population, opposed a proposal to mint copper coins in large denominations. During the debate, Emperor Xianfeng was in favour of coining this devalued currency. He and his ministers mistakenly held that the value of metal currency was determined by the state and that the people could not violate it. At the time, the capitalist commodity economy was not developed in China. Wang Maoyin understood that “the state may determine the value of the currency, but cannot impose restrictions on the prices of commodities.” To counter devaluation which results from issuing unconvertible metal currency, Wang suggested that a limited amount of convertible banknotes be issued. The emperor not only refused to accept his suggestions, but dismissed him from office.

The economic historian David Faure, in his China and Capitalism: A History of Business Enterprise in Modern China, also credits Wang for being one of the early Chinese thinkers to be aware of the “independence of the market”: the reality that the state could not simply dictate economic outcomes, because companies and people would respond to its actions. This idea was an independent development out of China’s own “statecraft” tradition of literature on the practical management of resources, taxation and markets. Faure summarizes Wang’s argument as “although the government had the power and means to devalue the coinage, it did not have same power and means to prevent the people from raising prices.”

At the time of the Peking Review article, the idea that economic activity was a realm subject to laws of its own was making a comeback in China. The people who were trying to move China away from arbitrary, politicized decision-making argued that the government had to respect reality and “seek truth from facts.” The idea that there were economic laws, and that China needed to figure them out and respect them, was an important piece of the intellectual framework of the early reform era. It’s interesting how vehement the author of that 1983 piece is on this point:

This footnote by Marx indicates that there is an economic law governing the relationship between currency and commodities, which is independent of man’s will. Marx affirmed the correct view of Wang and jeered at the self-indulgent rulers who knew nothing about the objective laws of economics.

It’s pretty obvious who the author is using Marx to implicitly criticize here, just a few years after the death of Mao, the end of the Cultural Revolution and the trial of the Gang of Four.

But while the invocation of objective laws of economics was, in the political context of the 1980s, usually a way to argue for the government to step back from interference in the economy, it does not have to serve that function. Xi Jinping is himself clearly a believer in such objective laws, but he sees them as enabling rather than preventing a strong government. Because such objective laws exist, they can be understood and mastered; as I put it in an earlier post, Xi thinks that there are laws of history, and they work in China’s favor.

Statue of Wang Maoyin in his ancestral village in Anhui

A very fine reallocation of resources

The launch of China’s reform era is conventionally dated to 1978, when the Communist Party’s Third Plenum agreed on a major change of economic strategy. But a major sign that China was embarking on a new direction came a year earlier, in 1977, when Deng Xiaoping directed universities to restart entrance examinations. Many universities had by that time reopened, after closing for a few years at the height of the Cultural Revolution. But admission was still reserved for “workers, peasants and soldiers” and admission decisions were largely driven by political recommendations. Deng’s instruction to de-emphasize politics and emphasize competence were a welcome sign that rationality and pragmatism were on the way back.

The general outlines of this story are well known, but I enjoyed the details in this account:

Young people, many of whom had seen their schooling opportunities delayed for more than a decade, hastily dusted off their textbooks and began studying to prepare for the college entrance exams. That year, 5.7 million entered their names for the exams, and 273,000 were enrolled. Because the number of applicants far exceeded the expected figure, for a time the authorities could not procure enough paper to print the exam papers. The problem was not resolved until the central authorities made the urgent decision to ship in all the paper previously allocated for the printing of the fifth volume of the Selected Works of Mao Zedong.

I just love that last bit–it perfectly captures how poor and politicized China was at that time. The quote is from Breaking Through: The Birth of China’s Opening-Up Policy, a book by former vice-premier Li Lanqing (in English translation).

The consequences of that decision to reallocate resources away from propaganda and towards education were far-reaching, and the experiences of that first wave of new students have been subject of numerous books and articles. Many of the people who took those 1977 exams and enrolled in university went on to become rather influential figures (see these recollections by longtime foreign correspondent Jaime FlorCruz, who was one of them).

Indeed, we may now be living at the peak of the influence of the so-called Class of 1977. A September press conference ahead of the celebration of the 70th anniversary of the People’s Republic of China gathered together three of China’s top economic technocrats: central bank governor Yi Gang, Finance minister Liu Kun, and National Bureau of Statistics director Ning Jizhe. In an unusually personal moment for such an event, they mentioned that all three of them had taken the college entrance exams in 1977.

September 24, 2019: (l-r) Moderator, Ning Jizhe, Liu Kun, Yi Gang

Rawski on the costs built in to China’s system

Loren Brandt and Thomas Rawski, two of the best economists and economic historians working on China, have a new edited volume out under the somewhat daunting title of Policy, Regulation and Innovation in China’s Electricity and Telecom Industries. It promises to be essential reading for anyone interested in how industrial policy works in China–a topic that, thanks to the massive scale of various subsidy programs like Made in China 2025 and the US trade war that has been launched in response, is now of far more than specialist interest.

I have not yet read the book, but I did watch a September 26 event at CSIS in which Brandt and Rawski discuss their work, under the catchier title “Can China’s industrial policy work?” Sadly, if not surprisingly, the book does not provide a simple answer to that question. Here is how Rawski put it:

We have no big theory. We cannot predict which policies will produce success and which policies don’t. We see the same policies affecting the semiconductor industry, which has done very poorly, the thermal power equipment industry, which has done well, and ultra-high-voltage power transmission, which is a world leader technologically. What is the key? Perhaps it is the difficulty of the technical obstacles that these firms confront. Perhaps it is quality of management. It’s hard to say. There’s no simple way of saying what works and what doesn’t work in China’s industrial policy.

If they do not have simple answers, they do provide a lot of important insights into how China’s system, with its hybrid of market mechanisms and top-down political direction, actually works. I particularly liked the concept of “system costs” which Rawksi brings up in his very interesting discussion of the electricity industry (these are my notes from the video, lightly edited):

Another feature that we see across the board is that they prioritize technical objectives over economic objectives. I think this partly reflects the Soviet legacy. One of the lessons of this book, for me at least, is that the legacy of Soviet influence in the Chinese economy is much larger than I thought it was when we started out on this project. The objectives of the Made in China 2025 program read like the first Five-Year Plan. There’s no discussion of markets, there’s no discussion of competition–it’s about physical targets.

Another important conclusion is that this is a system that has very high built-in costs. Electricity provides a vehicle for looking at this because it’s simple: there’s one product, five firms produce half the output, two firms distribute 90% of the output. So by looking at a very small number of firms we can see what’s going on in the whole industry. We can quantify some of the system costs people like Ken Lieberthal associate with China’s “highly negotiated” political system.

Negotiation means time and energy, and to us that means system costs. In the American electricity industry, the share of managers is 6.8%; in China it’s 17.8%. You need this extra manpower to work things out. We find that the cost of generating and delivering electricity is 30% higher in China than it is in the US, even though the ingredients are cheaper in China than they are in the US.

Our authors find many areas in which technical upgrades produce no economic benefit. As one engineer at a power plant said to us: we spent a large amount of money improving our equipment to lower our coal consumption, but of course if we had just increased the utilization of the existing plant, we could have gotten the same reduction in coal consumption at zero cost. Many episodes of this sort. We find low utilization in the telecom networks, in the electricity grid. In the US, engineers recommend 15% extra capacity compared to peak load in power systems. In China, the provincial average is 90%. In Inner Mongolia, which is the biggest power generating province, it’s over 200%.

And finally, quality issues. A deputy minister says that Chinese machinery is useful but not too reliable because of small defects. In high technology industries, this is very dangerous.

So what we’re looking at is a tug of war. We see huge resources being poured into innovation, we see the creativity and entrepreneurship of the Chinese people and Chinese firms. This is good. And we see also system costs and inefficiencies which are moving in the other direction.

The Q&A also covers China’s role in the global productivity slowdown, safety in nuclear power, the use of labor in coal mining, and other interesting topics. Worth watching.

Kindleberger on the loss of technological leadership

The following passage by the economic historian Charles P. Kindleberger, from his slim book Foreign Trade and the National Economy, was written in 1960-61 but feels remarkably relevant to the present moment:

Technology today spreads in some degree through illegal imitation, including the pirating of design and industrial espionage, but mainly through licensing, direct investment, a simple reading of technical literature, foreign education, and so on. There is little doubt that the speed of diffusion of technology has increased not only among developed nations but between developed and underdeveloped. There need be no direct communication. That one country can produce a particular article may be sufficient spur to others, as Russian, French, and Israeli work in atomic energy may demonstrate.

Technological leadership is harder than ever to maintain, although historians may think it was never held long. The result is that trade based on technical leadership must keep changing, for any given technical gap is foredoomed to closure.

As a general principle, to me that seems probably right. China is busy trying to close many technological gaps between its own industries and the global leaders, and the forces of technological diffusion suggest that time is on its side. Does that mean that the US, by imposing export controls on Chinese makers of telecom equipment, semiconductors and supercomputers, the US is engaged in a hopeless strategy doomed to failure? Not exactly. Historical inevitability can take a long time to play out, and the difference between technological gaps closing in 5 years, 10 years or 20 years is very much a nontrivial one for companies and nations.

And using this general principle to make predictions about how leadership in specific technologies plays out is not always going to work. Kindleberger’s own observations about the threat to US technological leadership from Europe have held up less well:

It looked for a time as though the technical gap between the United States and other developed countries was an enduring feature of international trade. Isolation from the battlegrounds of two world wars, plus an economic history of great labor scarcity relative to land, and later to capital, gave the United States an interest in innovation which was more widespread among the populace and among economic sectors than in other countries.

This view can no longer be held with assurance. … Europe and Japan are innovating positively. Major developments in the particularly American field of innovation–the automobile–have mainly been of European origin: the disc brake, the two-stroke engine, independent springing, and so on.

Particularly interesting is the new spirit of innovation in France, which has produced in the 1950s the Caravelle and Mystere in airplanes, the Citroen DS 19 and “deux chevaux” (two horsepower) in automobiles, high-voltage long-distance electric transmission, and direct transmission at 25,000 volts to electric locomotives. These and other equally radical departures from simple imitation of leading technical performance suggest a surge of independent innovation in France…

The general principle that technological diffusion is going to happen does suggest that the best way to combat the loss of technological leadership in one area is to open up technological leadership in a new area. The US did this fairly successfully in the decades after Kindleberger’s book was written. It still seems that the best response to today’s technological challenge from China (and others) is not going to be a bunch of delaying actions, but a renewed push forward.

Housing and the Chinese middle class

I have thought for a while that China’s privatization of urban housing is one of the most important and least understood events in its modern economic history. The entry into the World Trade Organization in 2001 has been exhaustively studied and its effects are still being vigorously debated today. The downsizing of state-owned enterprises in the late 1990s has also been repeatedly dissected and analyzed.

Housing privatization, which like SOE reform had its high-water mark around 1998-2003, has received much less attention. Which is strange, because the launch of a private housing market not only created the Chinese business cycle as we know it–basically all of China’s booms and busts over the past two decades have been driven by housing–but created the major source of private household wealth. So it seems obvious to me that housing reform deserves a comprehensive economic and social history, which I have not yet seen.

I dug into Luigi Tomba’s 2014 book The Government Next Door: Neighborhood Politics in Urban China in hopes of getting closer to that. He seemed to immediately grasp the central role of housing in the transformation of urban Chinese from socialist functionaries to a prosperous bourgeoisie. In the introduction he recalls how his initial fieldwork in Beijing in the early 2000s looking for a “middle class,” he found that

Most of the young people I was talking to did not fit the image of the wealthy entrepreneurs that dominate the mainstream portrait of a glamorous Chinese middle class often presented by the international media. Rather, they seemed to be, in large part, professionals and public employees whose housing careers often owed much to their position “within the system” of public employment.

That initial insight led Tomba to start to piece together the complicated story of just who got housing and how. Still, this book is not a complete account of housing reform, nor does it claim to be. Only one chapter of his book is really about housing reform, and most of the rest is too heavy on political-science jargon and too light on detailed history for my taste. But it does contain some important insights on how housing works in China, particularly its political implications:

Housing privatization, which began with a massive transfer of housing stock from public to private hands in the 1980s and 1990s, has provided an opportunity to engineer a middle class systematically, through selective incentives and subsidization. It also built on the converging interests of local governments and developers in selling and developing their land, which remains the main source of income for urban governments to balance their budgets and finance infrastructural projects. These policies have inevitably favored those who had already been privileged by the unequal redistribution of housing in the socialist period because of their employment in the public sector. The resulting boost for a property-holding middle class went therefore mostly toward employees and families actively employed in the public sector, who became the first large cohort of Chinese homeowners during the housing reform of the late 1990s.

The key point here is that housing privatization replicated and amplified, rather than overturning, the pattern of inequality inherited from the planned economy. In that system, there was little inequality in wages or money income, but there was greater inequality in living standards, because housing and consumer goods were preferentially allocated to those with higher political status. The combination of SOE downsizing and housing privatization did remove some socialist foundations, particularly the ironclad guarantee of a job and housing for urban residents. But reform replaced them with something that would prove much more valuable over the longer term: privileged access to assets that were rapidly appreciating in value. So rather than weakening political support for the Chinese government, housing reform bolstered and broadened it:

China’s long-term processes of privatization and reform have, in fact, worked to reinforce, rather than reduce, the legitimacy of the authoritarian rulers, as the state and its policies are perceived by the weakest groups as the last line of defense against the deregulation of the market and by the middle classes as the guarantors of newly acquired “rights.” …

It is increasingly becoming clear that the political apparatus of the socialist hierarchical state is still in place; after more than three decades of marketization, there is little sign of the system that would successfully supplant it. Its role in defining the practices of power is still overwhelming, although perhaps more fragmented and not felt as directly by some of its citizens as in the years of mass campaigns and class struggle.

So China’s housing privatization, in addition to being one of the largest transfers of wealth in history, may also have been one of the most successful political strategies.

What triggered the China backlash?

Richard McGregor’s new short book Xi Jinping: The Backlash is a useful summary of how much of the world’s view of China has changed over the last few years, and not for the better. The catalog of the things that have upset foreigners dealing with China is now quite a long one:

The construction, and then militarisation, of islands in the South China Sea from 2013 galvanised hawks in Washington and allies in the region, not least because of its sheer audacity and scale. Foreign businesses, once advocates of engagement with Beijing to open the Chinese market, became disillusioned when they saw their access truncated. The seemingly ceaseless theft of trade secrets and technology hardened cynicism in governments and companies alike. The detention of up to a million Uighurs in re-education camps in Xinjiang in the name of anti-terror from 2017 highlighted human rights abuses in a way the jailing of individual dissidents never could.

And that is even without going into the somewhat different dynamics of the developing world’s backlash against China’s Belt and Road Initiative. Given all this, it may be a fool’s errand to try to identify any single trigger for the world’s reaction to a more assertive China. It is overdetermined, in the social science jargon, with many causes all pushing in the same direction. Nonetheless I very much agree with McGregor’s assertion that:

If there is a period that crystallised perceptions of Xi, and his world view and ambitions, that moment was in late 2017 and early 2018 when foreigners, and many Chinese as well, finally started to take him at his word. Xi was reconfirmed as leader of the Chinese Communist Party in October 2017 and then abolished term limits on his presidency in March 2018, removing any obstacles to his remaining in power in perpetuity. … In one decision, Xi confirmed his critics’ view that he was an unrepentant autocrat willing to take China backwards in the service of his agenda.

This jibes with my own observation of the dramatic shift in the consensus of the US China-watching community (and here is a similar observation from someone with more foreign-policy expertise than me) . As a few people have pointed out, what has really changed over the last couple of years is not the views of the China hawks–it is the views of the China doves. People who had long felt that China, was moving, albeit imperfectly, in a more positive direction over the long term, began to concede that, in fact no, China was not really moving in the right direction anymore. Xi’s decision to abolish term limits helped convince the waverers and solidified this trend. It was a move that was almost perfectly indefensible. After all, abolishing term limits is something only tinpot dictators of third-world countries do.

China clearly did not anticipate the blanket foreign-media coverage and criticism of the move, but its explanations only highlighted how poorly officials understood the perceptions of their system abroad. Chinese official media justified the removal of term limits as being a minor administrative adjustment to bring the term limit for the presidency in line with the other two offices Xi holds (Party general secretary and Central Military Commission chairman), neither of which have term limits. The official argument is that it’s important for the leader in China’s system to hold all three offices (something Jiang Zemin, the first to do so, had also said). What this argument actually implies is that Xi had already decided to stay for a third term as general secretary, and that the rules had to accommodate this decision by not forcing him to give up the state presidency.

Given the consequences that have since flowed from it, Xi’s decision on term limits must go down as one of the greatest geopolitical own-goals of all time. So I was a little disappointed that McGregor, author of the classic and still-relevant The Party: The Secret World of China’s Communist Rulers, did not dig deeper into the background of this decision. Not that anyone in the Chinese system would have any incentive to talk to him about it. The full story of that fateful moment in early 2018 is likely to emerge only after Xi eventually passes from the scene.