Over at the ChinaFile site, I have a contribution up to a conversation on How Much Consumerism Can China Afford? It’s a short piece, and the gist of it is in the passage below–I call it the “two economies” theory of China.

The big story in the Chinese economy over the past decade was the boom in Industrial China, led by housing, with Consumer China tagging along. The big story over the next decade will be the decline of Industrial China, and the continued growth of Consumer China. Industrial China will falter largely because the demand for new housing and infrastructure in China is getting met, and is very unlikely to grow further from its current enormous size. Consumer China, however, is continuing to grow at a decent pace while this big adjustment is going on. But because the gains in Consumer China are not enough to offset the losses in Industrial China, overall economic growth will slow.

Reading the transcript of Jeff Sachs’ very interesting talk with Tyler Cowen, I had to stop myself from cheering aloud at the following passage. It captures perfectly the reaction I had myself when reading Why Nations Fail. Overall I found it a disappointing, wrongheaded and generally overhyped book, and the way Acemoglu and Robinson deal with (or, really, fail to deal with) China lays bare the problems in their approach. Sachs puts it better than I could, so I will just quote him in full:

Acemoglu and Robinson’s book Why Nations Fail was one of my least favorite books. I think it is just a bad book, because it takes one thought and tries to drive it as the only explanation of history. That’s not a good approach in my view to history, which is a very interesting, complex tableau.

They missed one fundamental point right from the start, which is that when you look at development, there are at least two fundamental drivers, not just one. The one that they talk about is innovation, and innovation as being a fundamental driver of growth. There’s a lot of truth to that in the history of the world.

But there’s a second fundamental aspect when we look out in the world and say, “Who’s doing well? Who’s doing badly? Why?” and so forth. That’s what is sometimes called “catching up.” The phenomenon of catching up is very different from the phenomenon of forging ahead at the front of the technology horizon.

When you take that simple distinction, it helps to explain a lot of the post-1960 question that you’re asking. The most successful countries in the world in the last 50 years have been basically the East Asian economies and Southeast Asian economies.

Very rarely do they look like the textbook model of Acemoglu and Robinson of the free market economy and so forth. In fact, the People’s Republic of China they characterize as just — that’s an anomaly that is going to collapse in the future so we don’t have to explain it now.

I think that’s a huge mistake and a misunderstanding of the basics. China’s in a catching-up mode. The institutions of catching up are quite different from the institutions of being the technology leader, for example. Just understanding that would give them a little more clarity about institutions, per se.

For more than a decade, one of the big economic questions about China has been: why is the household savings rate so high, and still rising? We may now be getting to a point where the conventional wisdom on this question is changing. I have thought for a while that the evidence for the old conventional wisdom was unconvincing; I’m glad to see that a lot of good research is now providing an alternative.

For those who can recall the big debates about the Chinese economy ten or so years ago, the high household savings rate and the low share of consumption in GDP were central issues. And the preferred explanation, the precautionary savings hypothesis, held that these problems were the result of government policy, and could be fixed. If there was one piece of advice that well-meaning outsiders like the IMF, ADB and World Bank all agreed on, it was that China’s government needed to increase spending on social programs. The hypothesis was that China’s inadequate social safety net meant that households needed to save a lot in order to pay for future healthcare and education expenses, not to mention their own retirement and that of their parents. Once a stronger safety net was put in place, those worries would diminish, and Chinese consumer spending would blossom. Here’s just one of many examples from the period, from the IMF’s 2006 Article IV report on China: “The government also needs to raise social spending in the areas of education, health care, and pensions, which will serve to reduce precautionary saving and boost consumption over time.” (The standard research presenting the precautionary savings hypothesis is this IMF paper from 2008 by Marcos Chamon and Eswar Prasad.)

The interesting thing about this recommendation is that the Chinese government actually listened to it: in 2006, government spending on education, health care and social security started to rise sharply. Of course, this did not happen just because the IMF said so. The precautionary savings hypothesis was not only plausible, but also in sync with domestic political trends. A growing chorus of influential domestic scholars were also pushing for a stronger government safety net, since the old one provided indirectly by state-owned enterprises had broken down. The economic argument that this would lower the savings rate and boost consumption was eagerly adopted by this group of people, but, in my experience anyway, they were driven mainly by social concerns. The resulting expansion of the social safety net was the signature accomplishment of the Hu Jintao-Wen Jiabao administration. One thing it did not do, however, was lower the savings rate: social spending went up, and the savings rate kept rising.

On its face then, the data from the past decade presents a rather large challenge to the precautionary savings hypothesis: the policy recommendation has been followed, and the predicted result has not been achieved. Of course, you could still argue that the increase in spending was not enough to really alleviate all the well-founded worries about future retirement, education and health expenses. But to me the results of this very large natural experiment suggest we should be looking elsewhere for explanations. This being economics, there are of course alternative theories to choose from. What most of these explanations share is the idea that China’s high savings rate is not a “distortion” produced by bizarre and unreasonable government policies, but a natural response to changing economic conditions.

A string of recent papers point to demographics and rising incomes as the key drivers of China’s savings rate. These explanations are also reasonably intuitive. The demographic argument is, more or less, that since China now has more people who are in the stage of life where they do most of their saving, the overall savings rate is high. And in fact we can observe that the share of the working-age population rose sharply as savings rates were also marching higher. The income argument flows from the fact that people with higher incomes tend to have a higher savings rate. This is a consequence of the diminishing marginal utility of consumption: when you start earning more money, you also spend more, but not quite as much more. So if in aggregate people’s incomes are going up, their savings rate should also go up. And given China’s rapid growth, incomes have been going up quite a lot.

The excellent Calla Wiemer has been arguing against the precautionary savings hypothesis on these grounds (see this 2010 paper) for some time, but she is now getting a lot more support. An interesting IMF paper from December does a cross-country comparison of episodes when savings rate rose sharply, and finds that such episodes are in fact relatively common, and that they generally followed surges in economic growth. An NBER paper also does a US-China comparison to evaluate the precautionary savings hypothesis, and finds that the difference in savings rates is explained mainly by differences in income growth. Most recently, the latest issue of American Economic Journal: Macroeconomics has a strong paper that comes up with a detailed demographic model for the savings rate (including some factors I skipped over above). And once the authors add rapid income growth into their model, it accounts rather nicely for how China’s savings rate has actually evolved.

There is increasingly strong evidence, in other words, that the reason China has had a high and rising savings rate is that it has been experiencing a major demographic transition and a historic surge in income growth at the same time. The implication is that as the population gets older and economic growth slows down–both trends that seem fairly unavoidable now–the savings rate should start leveling off and declining. Another implication is that dramatic policy interventions aimed at pushing down the housing savings rate are not as urgent (and here we might note that government social spending has stopped rising relative to GDP). Let’s see if this emerging conventional wisdom holds up better than the previous version.

The major financial news agencies (Bloomberg, Reuters, The Wall Street Journal) all have stories today about a new round of state-owned enterprise reforms that Beijing is expected to roll out shortly. (Full disclosure: both a colleague and myself are quoted in these articles). But anyone who bothered to read and compare all three stories might come away a bit confused. The Bloomberg story focuses on a proposal to transfer the government’s ownership stakes in SOEs to asset-management companies, and generally casts a positive light on the move. The Reuters and WSJ stories spin the changes as “industrial consolidation,” and generally take a more skeptical tone. So what is going on, and is it good or bad?

Unfortunately the reform plans have not actually been announced–the stories are based on conversations with officials and scholars–so we can’t evaluate them yet. The agency that manages the central government’s SOEs, known as Sasac, is widely expected to publish its plans later this month. But reading between the lines, the reporters appear to be hearing pretty much the same thing. And in fact most of this speculation has been widely reported in Chinese domestic media in recent weeks and months (reporting that the foreign media, adhering to an unwritten rule, do not acknowledge).

The idea of putting the top 100 or so big SOEs under asset-management companies, that would interfere less in day-to-day operations and focus on financial returns, does indeed seem broadly positive. This direction was in fact flagged more than a year ago in some early statements about SOE reform, which referred to a shift from “managing state enterprises” to “managing state capital,” implying a move to a more financially-driven model. The ambiguity is that these asset-management firms will reportedly be grouped by industry, and may in fact be formed on the basis of existing SOEs. In which case the resulting entities may look less like a financial portfolio and more like a forced industrial consolidation. This is I think why the WSJ and Reuters talk about this as a move away from market forces rather than towards them–and with good reason, given the enthusiasm the government has shown for forced consolidation of SOEs in the past.

The WSJ story asserts that the reform plan “takes large-scale privatization off the table,” but doesn’t explain why that would be the case. In fact I think part of the logic of handing ownership stakes to financial investors is to make partial privatization of SOEs easier. And the key slogan of SOE reform to date has been “mixed ownership,” which is hard to understand as anything other than an endorsement of additional privatization, however limited. Though I do expect much more partial privatization to happen at the local government level than at the large, strategic firms in Beijing that are the focus of this discussion. (Indeed, Shandong governor Guo Shuqing alluded a bit indirectly to this possibility recently.)

In the end, whether this upcoming reform plan means a new round of centrally-planned consolidation, or a move to impose more financial-market discipline (or, perhaps more likely, some odd combination of both) depends on a lot of things we don’t know yet. So I am going to make an unhelpful analysis: it depends, and I want to wait to see what the government actually proposes. In any case, we need to keep an eye on what the government is doing in other arenas. And as I’ve suggested previously, the really important reforms are not just to improve the management and ownership of state enterprises, but also to deregulate state-dominated industries and allow more private-sector activity.

The latest round in the seemingly inexorable tightening of restrictions on internet use in China has gotten a lot of press coverage. And indeed, the mass of mechanisms blocking internet users in China from many major global sites and services, collectively known as the “Great Firewall,” hits people like me and foreign journalists hard, since we are physically located in China but have to stay linked to the outside world for professional reasons. It’s a terrible situation that keeps getting worse. While I could complain more about this, I’d rather try to think through some of the questions it raises. The spark for this is some recent Chinese statements justifying the internet controls, not for the usual political and moral reasons, but for economic ones–that they helped create China’s very large and successful internet companies.

The idea that Chinese internet companies are only successful because they can hide behind trade barriers is a pretty common view among foreigners here: how could a Chinese search engine out-compete Google if Google was not blocked? But most of my friends who work in the Chinese internet industry have always dismissed this line as uninformed, biased Western propaganda. They tend to say that the big American internet companies lost the China market because of their own mistakes. I’m a lot more sympathetic to this view than I used to be; my company has published detailed profiles of Alibaba and Tencent (sorry, subscribers only), and their history definitely supports the idea that these firms are successful because they came up with unique services that worked very well in China. People who don’t understand those companies, in my experience, consistently under-estimate how much business-model innovation they have done; in fact Alibaba and Tencent do not do at all the same thing as Google/Facebook/whoever. So it’s funny to see some quasi-official voices now coming out to say, in essence, those critics were right and in fact our internet companies do depend on market barriers erected by government policy.

Here are the two sources for this. Wen Ku, an official at the Ministry of Industry and Information Technology, had to answer a question at a press conference about the tightening of internet restrictions, and came pretty close to saying that can be justified because of how they help domestic companies (my translation):

In China, the Internet sector has developed very well, some good companies have growth rates of around 40-50%. Everyone can see Alibaba’s achievement in getting listed in the US. All of this comes from the Chinese government ensuring there is a good policy environment for the development of internet companies. Internet development in China must be in accord with China’s laws and regulations, and any unhealthy information should be managed according to Chinese laws.

In case those bureaucratic circumlocutions did not get the point across, the Global Times newspaper, a reliable purveyor of nationalist screeds, then made the claim much more directly in an editorial (again, my translation from the Chinese):

China’s Great Firewall is in fact a success, it has created the reality of China’s internet development today. China has produced network giants like BAT (Baidu-Alibaba-Tencent), they fulfill the vast majority of Chinese internet users’ needs, and are even expanding abroad. This is possibly an unintended consequence of the Great Firewall. If there was not this kind of management, then China today would perhaps be dominated by “Google China”, “Yahoo China” and “Facebook China”.

So here’s the big question: are these folks right? Is blocking global internet companies from offering all their services in China actually a good industrial policy, that is justified because it helps foster Chinese internet companies? And would this in turn mean that the Great Firewall, paradoxically, allows for more innovation and competition in the internet globally, because it is not dominated by an American oligopoly? I think this worth actually thinking about rather than dismissing out of hand. As much as I would like to be able to use my Gmail more easily, it’s not obviously the case that everyone in China would be better off if there was in fact no big domestic internet sector and everyone just used Google.

In essence the argument seems to be one for import-substituting industrial policies; by blocking the import of various internet services, China can create domestic companies and jobs that otherwise would not exist. Yet I do not think this argument is correct, and the reasons go back to the same ones that led import substitution policies to often fail in other industries and other countries. As my old colleague Joe Studwell showed very clearly in his book How Asia Works, the industrial policies that have been successful in Asia have in fact not been about blocking imports; instead, they encourage exports.

Blocking imports typically does not do much to encourage domestic companies to raise their game and improve technology. Particularly in lower-income countries, domestic markets are often small and underdeveloped, and are easily dominated by local tycoons or oligopolies that can turn policy and regulators to their advantage. Rather than increasing competition, import substitution reduces it, and lowers the incentive for domestic companies to meet or match the global technological level–they don’t have to, because they a captive market. So instead of giving domestic companies a free ride, good industrial policies force them to go out and compete in the global marketplace, where they can’t survive solely on the favoritism of regulators and have to adapt and innovate.

This is not to say that some Chinese internet companies do not prosper because of the government’s barriers; there is a whole sub-industry of companies offering local equivalents of global internet services. But it would be a mistake for the Chinese government to think that because they have both 1) some large successful internet companies, and 2) the Great Firewall, that having more of 2) means they will also get more of 1). The history and logic of industrial policy suggests they will not. A better course, again based on parallels with industrial policy for other sectors, might be to reward internet companies that are successful in selling their services outside of China. Though there is probably not much actual need for the government to do this, given the enormous slums sloshing around in venture-capital funds looking for the next big thing in the Chinese internet.

Ultimately, though, I doubt economic or industrial-policy motivations are really behind the policy of restricting access to the global internet, so I wouldn’t expect these criticisms (even when articulated by someone more influential than me) to have much effect. The politics are much more important.

Justin Yifu Lin, the former chief economist of the World Bank, has a piece out on Project Syndicate giving a fairly rosy outlook for China’s future growth. Basically, he thinks China can still grow at 8%, but the government is going to be prudent and conservative and set its growth targets a bit lower. This should be no surprise to anyone who has been paying attention to his public statements over the years: ten years ago he thought China had very high growth potential, and he still thinks that today.

Now Justin is perhaps the best-known Chinese economist in the world, and I am not, but I found his piece troubling in a couple of respects. It’s odd that he expresses so much certainty about a topic–future growth rates–about which there really is not a lot of certainty. What is odder is that Justin seems to be even more certain about future growth than the Chinese government, which has not officially aimed for 8% growth since 2012. I think this focus on delivering a positive message about growth prospects means that his piece ends up not being a particularly good guide to the current economic debates within China, as I’ll try to explain.

So how can we be so sure that China can grow at 8%? Here is Justin’s explanation, which is based on ideas about convergence and catch-up growth:

In 2008, China’s per capita income was just over one-fifth that of the United States. This gap is roughly equal to the gap between the US and Japan in 1951, after which Japan grew at an average annual rate of 9.2% for the next 20 years, or between the US and South Korea in 1977, after which South Korea grew at 7.6% per year for two decades. Singapore in 1967 and Taiwan in 1975 had similar gaps – followed by similar growth rates. By extension, in the 20 years after 2008, China should have a potential growth rate of roughly 8%.

That is not the only plausible interpretation of the historical evidence, but it is certainly a possible one (I have previously written about research that supports a different and less optimistic interpretation.) My own view is that the track record of other successfully industrializing Asian countries implies that China’s potential growth in per-capita GDP is more likely to be in the 5-7% range for the next several years (see the chart below for the visual evidence). These historical patterns are not iron laws of development, of course, but they are helpful given that there is no particularly good way of estimating a potential growth rate for a rapidly-changing economy like China’s. But the limitations of this technique are obvious, since it is based purely on comparisons of the level of per-capita income and ignores all other factors, including the possibility that China does not end up following the same development trajectory as Korea, Taiwan, etc. The point is that this historical evidence certainly not enough to rule out the possibility that China’s future potential growth is less than 8%, even before we consider all the other factors that could be at play.

The more interesting part of the argument is that Justin supports government growth targets that are below 8%, both last year’s 7.5% and presumably the widely-expected downshift to a 7% target for 2015. (He doesn’t even address the debate about whether government growth targets are a good idea in the first place, which is rather amazing in itself, but let’s leave that to the side for now.) This is a bit confusing: Why should the government deliberately try to run the economy below its capacity, thereby generating less employment and slower income growth than could otherwise be achieved, without the cost of higher inflation? Here’s his answer:

The US, Europe, and Japan are likely to experience continued sluggish performance, inhibiting China’s export growth. As a result, Chinese growth is likely to fall below its potential of 8% a year. As policymakers plan for the next five years, they should set China’s growth targets at 7-7.5%, adjusting them within that range as changes in the international climate dictate.

In other words, he thinks potential growth based purely on domestic conditions should be 8%, but once you take into account weak global demand, potential growth is actually a bit lower. Now it is certainly true that if demand for China’s exports is weak, then China’s growth will be slower than it would be otherwise. But it’s a bit convenient that the only factor he admits that might possibly be a drag on China’s potential growth rate is the poor management of other economies. There are of course plenty of other things going on inside China that could be a drag on future growth–like the end of a decade-long housing boom that is sapping investment growth, or a high debt level that makes it more difficult to run expansionary policies in the future.

Once you recognize that there are in fact big changes happening in China’s domestic economy, another explanation for why slower growth is desirable becomes much more convincing (at least to me). That is the need to encourage structural change. The current structure of China’s economy is not the structure that it will need in the future, mainly because of the end of the housing boom: all the indications are that future demand for housing, and associated goods like construction materials, will be lower in the future than it is today. So to run the economy at full capacity today would mean reinforcing the current industrial structure. But really, government policy should be trying to enable a shift toward the future industrial structure. To put it differently, to run the the economy at full capacity today, given the enormous existing capacity for building housing and supplying the needed materials, would mean stimulating an artificially high level of housing demand. Therefore to allow the economy to run somewhat below capacity is the right decision, because this does not send false signals about future demand to investors in housing and the makers of construction materials.

I think this is in fact the government’s actual justification for targeting lower growth. While decoding Chinese government jargon is not the easiest task, current official statements clearly recognize that there is excess capacity, and that the solution is to change the industrial structure, not stimulate demand. If you squint you can see that argument implied in these lines from the communique of the Central Economic Work Conference in December (my translation):

Currently the supply capacity of traditional industries is far in excess of demand, so the industrial structure must be optimized and upgraded. … The marginal effect of overall stimulus policies is clearly decreasing. We need to deal with excess capacity, and also explore the future direction of industrial development through market mechanisms.