Ben Bernanke has weighed in with an interesting intervention on China, arguing that fiscal policy targeted at household consumption could offer a way out of the current economic problems:

An alternative worth exploring is targeted fiscal policy, by which I mean government spending and tax measures aimed specifically at aiding the transition in China’s growth model. (Spending on traditional infrastructure like roads and bridges is not what I have in mind; in the Chinese context, that’s part of the old growth model.) For example, as China observers have noted, the lack of a strong social safety net—the fact that Chinese citizens are mostly on their own when it comes to covering costs of health care, education, and retirement—is an important motivation for China’s extraordinarily high household saving rate. Fiscal policies aimed at increasing income security, such as strengthening the pension system, would help to promote consumer confidence and consumer spending. Likewise, tax cuts or credits could be used to enhance households’ disposable income, and government-financed training and relocation programs could help workers transition from slowing to expanding sectors. Whether subsidies to services industries are appropriate would need to be studied; but certainly, unwinding existing subsidies to heavy industry and state-owned enterprises, together with efforts to promote entrepreneurship and a more-level playing field, would be constructive.

There are a few things to say about this. First and to be clear, I agree. It would generally be a good thing to switch fiscal priorities from off-budget spending on infrastructure to on-budget spending that supports consumption. But that’s part of the problem: people have been giving China this particular bit of advice for years. And in fact the government has not ignored this advice, and has steadily raised spending on social programs (universal healthcare coverage was more or less achieved in 2011).

Of course, China could do still more. But it may not be that simple for them to do a lot more than they are already doing. China has a fiscal system that is strongly biased toward delivering investment rather than streams of benefits to consumers. It’s worth stopping to think for a bit about just how unusual this is, as most governments around the world are the exact opposite: they are primarily bureaucracies for delivering social programs, not designing investment projects. The World Bank office a while back made a fascinating comparison of China’s fiscal spending patterns with those of OECD countries. The results are summarized in the excerpt and table below:

A large share of government spending supports capital expenditures in transport, housing, and other economic activities, as gaps in providing core public services remain wide. While the size of government expenditures (public finance budget, government fund budget, and social security budget) remains similar to the OECD average, the composition of expenditures differs substantially. First, spending on general public services is under half the OECD average. It is declining due to continuing efforts to reduce wasteful public outlays: in the first half of 2014 it accounted for only 2.4% of GDP, down from 3.0% in 2013. Second, despite gradual increases, expenditures on social services (health, education, and social protection) are far lower than in the OECD countries. Third, outlays on economic affairs, housing, and community amenities are about three times as high as the OECD average.

Note that this bias toward investment spending is very strong in the official government budget–even before any of local governments’ massive off-budget spending on infrastructure is accounted for. So while I don’t think it’s wrong to urge China to shift the composition of its fiscal spending, I also think it’s important to recognize that this might be difficult to do quickly. They have a set of institutions and priorities that are well established and deeply rooted, and making a big shift in those would require both a different way of thinking and extensive practical changes. It’s certainly not impossible, but it’s also not easy.

A final point is that even if they do move to a consumer-focused fiscal stimulus, it might not deliver that much net impact on growth. This is simply because of the size of existing infrastructure-based fiscal stimulus: the IMF estimates that once off-budget local government spending is included, the annual fiscal deficit is on the order of 10% of GDP (compared to an on-budget deficit of 2-3%). Given the already-huge size of infrastructure spending, it seems more likely that consumer-focused spending would replace it rather than add to it over time. This would be a good way to soften the impact of reducing infrastructure spending; it also seems likely that the multipliers from a consumption stimulus would be higher than infrastructure spending at this point, as infrastructure is probably reaching diminishing returns. But expenditure-switching seems more like a strategy for allowing China to wind down its enormous fiscal deficits than one for delivering a lot of additional fiscal stimulus.

The saga begins almost exactly a year ago, when the press was filled with stories of Chinese tourists to Japan returning laden down with fancy Japanese toilet seats. For anyone who has ever actually used one of these wonderful Japanese devices, there is no mystery at all why you might want one in your home. But the story apparently struck a nerve, and the local press, loath to pass up a Japan-bashing opportunity, repeatedly chided Chinese for not buying the domestic varieties. Premier Li Keqiang was even asked about the issue in a public forum; his reported comments were pretty balanced, praising the wide variety of choices that Chinese consumers have but also expressing hope that domestic companies could make products just as good. All pretty standard stuff, and it seemed like one of those little media storms that would simply die down on its own.

But no. The Japanese toilet seat meme has only grown stronger and more powerful. The propaganda campaign around Xi Jinping’s latest economic slogan–“supply-side reform”–has embraced the tale of the Japanese toilet seat as one of its main talking points. Since it was officially launched in December, the media blitz on “supply-side reform” has become inescapable. Famous Chinese economists now repeatedly invoke the Japanese toilet seat. Foreign journalists in Beijing are getting a steady stream of briefings from government officials and/or scholars explaining to them why the new mantra of “supply-side reform” is so great. The Japanese toilet seats come up every single time. I can also testify that the Japanese toilet seats have come up in every private conversation I have had about this “supply-side reform” slogan.

The Economist made a valiant recent attempt to explain this new Chinese concept of “supply-side reform,” though the article ends up describing the ideal program of some liberal economists rather than the actual plan adopted by the government (there is so far little indication that it has anything to do with Reagan or Thatcher). Which is understandable since it is hard to see many changes in actual policies that have resulted from the supply-side sloganeering. But taken on its own terms, the rhetoric of “supply-side reform” argues that the current problems of the Chinese economy arise not from a deficiency of demand, but from a failure of companies to adapt to the changing structure of demand. Here is one official explanation (my translation):

In recent years, the fact that Chinese people are traveling abroad to buy toilets, rice cookers and other appliances has become a hot topic, and has even disturbed the Premier. All these changes reflect the new changes in people’s demand for consumer goods: the demands of our people are changing, upgrading, with demand for high-quality consumer goods increasing. The production capacity that has formed over the years is no longer adapted to this changed demand: there is too much ineffective supply and not enough effective supply. For example, on the one hand the price of steel has fallen so that it costs the same as cabbage, while on the other hand we still need to import ballpoint pens.

(There is a variation on the theme that uses ballpoint pens rather than Japanese toilet seats as the example of alleged Chinese inferiority.) There is some surface plausibility to this account–who would deny that China’s state-owned enterprises are not adapting very quickly to changing economic realities? But as the ever-acerbic Yu Yongding pointed out in a recent interview, the concept of a shortage of “effective supply” makes absolutely no sense as a macroeconomic diagnosis of China today. If there is really not enough supply, then China should be experiencing trade deficits and inflation; instead it has a rising trade surplus and almost no inflation. My translation:

The meaning of insufficient effective demand is very clear. What is the meaning of insufficient effective supply? It seems to mean “selling the wrong things”: no one is buying the stuff that is being produced, and the stuff that people are buying has not been produced. …If there is insufficient supply, whether it is “effective” or “ineffective”, prices should rise. However, what we see is 46 consecutive months of negative growth in the PPI, and the GDP deflator going from positive to negative. It is very difficult to explain these phenomena as “insufficient effective supply.” Again, if we look at the most serious case of excess capacity–the steel industry–we see that the prices of steel products have fallen sharply and profits are shrinking. But it is obvious that this is caused by insufficient demand rather than “insufficient effective supply.” If there is insufficient effective supply of a product, then the price of this product should rise. I ask you: what products are these exactly?

So the example of the Japanese toilet seat is indeed very telling, but probably not for the reasons the officials who invoke it seem to think. To look at Chinese people buying this thoroughly Japanese product and see a woeful tale of domestic industrial failure betrays a particular kind of mindset–one that takes autarky as the norm and views trade as a form of weakness. The thinking seems to be that the economy can be rescued by redirecting to domestic companies the money that Chinese consumers spend on their vacations abroad. It’s hard to imagine any of the Western economists who would call themselves supply-siders making such an argument.

The Japanese toilet seat is in fact a perfect example of why you want to have trade in the first place. Japanese people , for their own reasons, have developed this unique tradition of extremely complex and comfortable toilet equipment. Instead of having to replicate the whole variety of cultural and institutional factors that led to Japan’s development of super-luxurious toilets, Chinese consumers who want a more pleasant bathroom experience can just buy one. It’s less about Japanese goods being superior to Chinese goods, and more about Japanese goods being different from Chinese goods.

One of the most interesting things about this whole “supply-side reform” push is how skeptically it has been received. Proponents of the “supply-side” slogan–a term that clearly pays homage to Western free-market ideology–are having to repeatedly fend off charges that they are plotting the return of central planning by another name (see this long piece in the People’s Daily). Perhaps they do not understand that the stories they tell about the Chinese economy are part of the reason those suspicions arise. The obsession with the Japanese toilet seat does not show a sincere desire to rid the economy of regulatory distortions, but rather a distrust of trade and market outcomes and a conviction that the bureaucracy knows better.

I have to confess to some frustration with some of the recent commentary on China coming from academic economists. Usually I value the perspectives from the academy as helping draw some needed attention to longer-term issues and away from the short-term noise that dominates the media and financial-market debates. But I think on China there is a tendency for some people to look past “simple” issues like the business cycle and housing in favor of discussing only complicated structural issues. Again, usually I’m all in favor of complex, historically nuanced explanations–but you can go too far with this stuff. Sometimes it’s really not that complicated.

Exhibit A is a survey of “top UK-based macroeconomists” about their expectations for China’s future growth. Many of the economists surveyed expect China’s GDP growth to be lower than 6% for several years, I view I agree with. The survey also asked for economists to give the reasons why they expect this slower growth, and here is what they came up with: “less space for catch-up growth,” “adverse demographic dynamics,” “problems in the financial sector,” “diminishing flows of rural-urban migrants,” “the ‘intentional’ rebalancing from high-growth industry to moderate-growth services,” “risks from ‘secular stagnation’ in developed economies.”

Exhibit B is a recent piece by Jeffrey Frankel, in which he lists no fewer than six economic forces behind China’s slowdown. Like the respondents to the UK survey, he also cites less space for catch-up growth, adverse demographic dynamics, diminishing flows of rural-urban migrants, and the rebalancing to services, while adding “diminishing return to capital” to the list (he leaves off secular stagnation in developed economies).

What I found amazing about these analyses is that they fail to even mention the most straightforward and direct explanation of why China’s growth is much slower today than it was in say, 2010 or 2007. It’s not like it’s a secret. From about 2003 to about 2010 China had the biggest construction boom of modern times and probably in all of human history. Then in 2011-12 the construction boom ended. That’s it. Really, that’s all you need to know. Well, you might need one more fact: housing and construction account for as much of a third of China’s GDP, once all their indirect linkages to other sectors are considered. I think a housing downturn explains very well the timing, severity and distribution of the economic slowdown that has actually occurred.

The long-term structural explanations favored by many academic economists–like the “middle-income trap,” demographics, etc–by contrast simply do not explain what China has been going through over the past few years. It’s possible that the diminishing return on capital argument is intended as a fancy way of accounting for the obvious downturn in housing investment. But here I have to agree with Michael Pettis when he says that “the deceleration in Chinese growth moreover has been far too rapid to be explained by any normal decline in marginal returns on capital as investment rises.”

As I have previously argued on this blog, the regional pattern of the slowdown is in fact very important. If China were really falling victim to the exhaustion of catch-up growth potential, then it would be experiencing a gradual slowdown, and the provinces slowing down would be those who had caught up the most. And this is not true; the high-income provinces are doing well while low-income provinces are hurting.

I have never really believed in the idea of the middle-income trap, and I increasingly feel that it is actually counter-productive in current discussions about China. If you think China is succumbing to the middle-income trap (in any of the various manifestations mentioned above) then you think China’s problems are complex and long-term in nature, and the proper response is a set of carefully calibrated structural and institutional reforms. If growth ends up worse than expected, you put the blame on the government for not taking the right policy prescriptions.

But if you agree with me that China is experiencing a lengthy downturn in housing construction that followed a lengthy boom in housing construction, then current rates of GDP growth are not primarily the result of the government’s failure to do structural reforms. That’s not to say structural reforms are not important–I do think the government should be liberalizing service sectors and taking other measures to improve the growth potential of the economy. The benefits of those reforms will however only show up further down the line, once the cyclical pressures from the downturn in housing have let up somewhat. None of the various structural reforms being debated today will do anything to change the fact that in the near term, China does not need to build a lot more housing. And that therefore business for companies related to housing construction (and there’s lots of those) will be poor.

After many years of working on China, I can still be surprised by just how big it is. It’s simple to say “China is huge,” but harder to really think through what it means. Nonetheless, a lot of people seem to think that size does not matter in any fundamental sense–the example I have in mind is the gent who years ago told me that “China is just Japan 20 years later and 10 times bigger,” which in fact is a surprisingly powerful rule of thumb. But I have to say that I suspect that some things do work differently in China because of its size, and that this is not well understood because we have no comparable examples to work with. We might call this the view, sometimes attributed to Stalin, that “quantity has a quality all its own.”

This question came to mind again after I read some interesting comments in a recent paper by the excellent Carsten Holz, the world’s foremost expert on Chinese statistics as well as a generally very thoughtful guy. The paper is not mostly about this question of size but he discusses it in passing:

China’s size is a new phenomenon in the study of developing economies. South Korea tried to develop a broad industrial base but soon began to specialize. Taiwan quickly abandoned plans for broad-based economic growth and focused on developing areas of comparative advantage, in many instances serving niche markets around the world. However, for China there are as yet no signs of significant specialization.

Across virtually all industries in China, the optimal firm size—the firm size with lowest per-unit production costs—is below market demand. I.e., there is sufficient market demand in every sector of the economy for several firms to co-exist and compete. The prospect of historically unprecedented domestic market size may yet lead to innovations in optimal firm size at lower per-unit production costs than hitherto experienced around the world.

Viewed from an international perspective, focusing on comparative advantage makes little sense for China: world demand may simply not be big enough to support any substantial degree of specialization in China. For example, for some electronics products China may already be the dominant world supplier, without, however, the electronics manufacturing industry dominating the Chinese manufacturing sector. In this case, world demand has driven specialization in production by China, except that in the Chinese economy the resulting degree of specialization is barely noticeable. As a result, one can expect to see ongoing investment across virtually every sector of the Chinese economy.

I found this a very striking idea, as one of the (many) things about China’s economy that has puzzled me in recent years is the apparent lack of specialization in its exports. There was fairly dramatic structural change in China’s exports up until about 2007, but since then the export structure has been largely stable. Exports have been growing, and China’s global market share has been rising until very recently. So China has generally been steadily becoming a more successful exporter. But as this has happened it has not shown much sign of becoming more specialized in particular types of products, which is usually one of the things that happens in countries that are successful exporters.

I had speculated that global demand was a limiting factor here: in the aftermath of the financial crisis, global demand for the kinds of things that China wants to specialize in–capital goods and equipment–has probably not expanded rapidly enough for China to have exported a lot more of those goods. But perhaps, as Carsten suggests, the issue is more fundamental, and one we have not really encountered before: China’s export industries might already large enough, relative to total world demand, that even a very successful export performance will not show up as much specialization. This is one to ponder further.

Update. Here is a more precise measure of export specialization — a simple Herfindahl-Hirschman index of concentration, calculated at the 4-digit HS level (it’s the sum of the squares of the share of each product in the total). This actually shows export concentration has been bouncing around in a range since around 2003-04, so it looks less like a cyclical post-crisis phenomenon.

Growth targets are back and stronger than ever in China’s next Five-Year Plan, for 2016-2020. The plan itself is not finalized–the government has just published its “suggestions” for the final document–but it is pretty clear that the main thrust has already been decided. One of the most striking points in the official narrative is the strong emphasis on maintaining a high rate of GDP growth; to me, unrealistically high. Previously, there had been much discussion about abandoning the GDP growth target in the five-year plan, or replacing them with other indicators more directly related to household welfare (maybe China could even do something crazy like target inflation and unemployment). In the event we seem to have an even stronger emphasis on growth targets–the question is why? To start with, here’s Xi Jinping himself explaining the plan (my translation from the Chinese):

The draft suggestions put forth a goal of maintaining medium-high speed economic growth for the next five years. The main consideration is that in order to achieve the goal for 2020 of doubling our 2010 gross domestic product and per-capita rural and urban incomes, we must maintain the necessary growth rate. In order to double GDP, the bottom line for the average economic growth rate for 2016 to 2020 is 6.5% or higher. … Major domestic and foreign research organizations all think that in the Thirteenth Five-Year Plan period our country’s potential economic growth rate is 6-7%. Taking everything into consideration, it is possible for our country to maintain growth of about 7% in the future, but there are numerous uncertain factors.

It’s interesting how Xi presents the growth target as just a necessary consequence of another, more important goal: doubling 2010 GDP by 2020. And indeed there is no problem with his arithmetic: given how much the economy has grown since 2010, to double that level in 2020 requires annual growth of at least 6.5% after 2015. The GDP-doubling target is itself the specific expression of a general slogan: to make China a “moderately prosperous” (xiaokang) society by 2020. Xi has emphasized this target as one of his “two centenary goals“: achieving prosperity by the 100th anniversary of the Party’s founding in 2021, and achieving modernization and national revival by the 100th anniversary of the founding of the People’s Republic in 2049. Official propaganda under Xi has made a big deal out of these two centenary goals, but in fact they are not that new, and indeed were inherited from previous leaders. Xi’s immediate predecessor, Hu Jintao, said in his speech to the 18th Party Congress in 2012:

We need to have a correct understanding of the changing nature and conditions of this period, seize all opportunities, respond with cool-headedness to challenges, and gain initiative and advantages to win the future and attain the goal of completing the building of a moderately prosperous society in all respects by 2020. Basing ourselves on China’s actual economic and social development, we must work hard to meet the following new requirements while working to fulfill the goal of building a moderately prosperous society in all respects set forth at the Sixteenth and Seventeenth National Congresses of the Party. The economy should maintain sustained and sound development. Major progress should be made in changing the growth model. On the basis of making China’s development much more balanced, coordinated and sustainable, we should double its 2010 GDP and per capita income for both urban and rural residents.

But as Hu emphasized, this was not a goal that he came up with himself–it was one set by his predecessor Jiang Zemin. In 2002, at the 16th Party Congress, Jiang said:

An overview of the situation shows that for our country, the first two decades of the 21st century are a period of important strategic opportunities, which we must seize tightly and which offers bright prospects. In accordance with the development objectives up to 2010, the centenary of the Party and that of New China, as proposed at the Fifteenth National Congress, we need to concentrate on building a well-off society of a higher standard in an all-round way to the benefit of well over one billion people in this period. … On the basis of optimized structure and better economic returns, efforts will be made to quadruple the GDP of the year 2000 by 2020, and China’s overall national strength and international competitiveness will increase markedly.

This was actually a more precise formulation of the growth goal than Jiang had given previously. Here is what he said at the 15th Party Congress in 1997:

Looking into the next century, we have set our goals as follows: In the first decade, the gross national product will double that of the year 2000, the people will enjoy an even more comfortable life and a more or less ideal socialist market economy will have come into being. With the efforts to be made in another decade when the Party celebrates its centenary, the national economy will be more developed and the various systems will be further improved. By the middle of the next century when the People’s Republic celebrates its centenary, the modernization program will have been accomplished by and large and China will have become a prosperous, strong, democratic and culturally advanced socialist country.

There you have it: the original formulation of Xi’s two centenary goals was actually made in 1997. But it is also clear that the history goes back even further, as those goals were very directly inspired by a previous declaration from Deng Xiaoping himself, in remarks on April 30, 1987:

Our goal for the first step is to reach, by 1990, a per capita GNP of US$500, that is, double the 1980 figure of $250. The goal for the second step is, by the turn of the century, to reach a per capita GNP of $1,000. When we reach that goal, China will have shaken off poverty and achieved comparative prosperity. When the total GNP exceeds $1 trillion, the national strength will increase considerably, although per capita GNP will still be very low. The goal we have set for the third step is the most important one: quadrupling the $1 trillion figure of the year 2000 within another 30 to 50 years. That will mean a per capita GNP of roughly $4,000 — in other words, a medium standard of living. That target may not seem high, but it is a very ambitious goal for us, and it won’t be easy to achieve.

We are now confident that we can attain our first goal ahead of schedule, this year or next. That doesn’t mean it will be easy to reach the second goal, but I think we can do it. Our third goal will be much harder to reach than the first two. Our experience over the last eight years or so shows that the road we have taken is the right one. But it is only after the third step that we shall really be able to show the superiority of socialism over capitalism — that’s something we can’t prove at the moment. We shall have to work hard for another 50 or 60 years. By then, people of my age will be gone, but I have no doubt that the younger generations will reach the third goal.

(Deng also made a slightly different statement of those goals on April 26 of the same year). This formula became known as the “three-step” development strategy, and Jiang’s version in 1997 as the “new three steps.” Deng also originated the term xiaokang, now conventionally translated as “moderately prosperous,” which he chose to convey a modest aspiration for ordinary people to have a better life.

This historical context makes it easier to understand why these GDP targets are politically so important: they are a way by which successive Chinese leaders have tied themselves to the legacy of Deng Xiaoping, and thereby increased their own legitimacy. By saying he is committed to the goal of doubling GDP by 2020, Xi Jinping makes it clear that he is carrying on the weighty tasks undertaken by his predecessors, and is continuing the great legacy of the Communist Party. In other words, there is no real economic justification for picking a certain rate of GDP growth to target; it is all about the political symbolism (all that stuff you read about China needing to grow 7% a year to prevent social unrest is total nonsense).

This kind of political symbolism was a mostly harmless feature of Chinese politics in earlier years, because the growth potential of the economy was so high that setting these arbitrary growth targets had little impact on actual economic policy. Until very recently, there has rarely been a year in which actual GDP growth did not exceed the target by a wide margin. China’s problem now is that its growth potential is declining, and failing to meet the growth targets has become a real risk (indeed, a near-certainty). Reformers in Deng’s day promoted fast growth as a way to break free of the legacy of the planned economy; in today’s China, reformers worry that targeting fast growth creates too many costs, environmental and otherwise, and gets in the way of structural changes that would improve welfare over the longer term (even if few are willing to publicly challenge the view that potential growth is still 7%). So the growth targets for 2016-2020 will have a greater and more malign influence on policymaking, because they will start to actually affect decisions on a regular basis.

Was it inevitable for China to end up in this trap, where it is held hostage to unrealistic growth targets inherited from previous generations of political leaders? Of course not. If you look at Deng’s original formulation, it was quite vague about the longer term: he did call for quadrupling the GDP of 2000, but said it might take anywhere from 30 to 50 years. When Jiang initially set his goal for the Party’s centenary in 2021, he did not say that GDP had to exactly quadruple by that date, only that it should rise substantially. It was only later on that Jiang formalized the goal into a quadrupling of GDP over the 20-year period. Even then, his successors could have easily shifted the rhetoric: for instance, retaining the goal of achieving “moderate prosperity” by 2020, but dropping the precise definition in terms of GDP. But China’s leaders have been so desperate to gain the political legitimacy that comes from a link to Deng’s legacy that they have been unable to make even such modest changes.