To me this clearly demonstrates the power of China’s incredible economic miracle. A miracle that lifted more than 800 million people out of poverty in just 40 years. However, if you turn on the news right now, this is what you’ll hear.
the world’s second largest economy is stumbling and the alarm is sounding across the globe a t China’s worsening economic outlook
that’s due to a worsening property slump weak consumer spending and tumbling credit growth
and they just stopped releasing youth unemployment data because it’s so bad. Is the economy in China in danger of a serious ongoing downward spiral?
So, what happened? How did China get so powerful so quickly? Why is its economy in trouble now? And, are its troubles so bad that China is no longer expected to overtake the USA as the world’s pre-eminent superpower?
The standard story is that China got rich by abandoning communism in 1978 and is now wasting its chance to become a superpower by turning back to authoritarian communism. But, that story has always seemed overly simplistic to me. After all, there are many c ountries, like for example Russia, that also abandoned communism, and didn’t get so powerful. Similarly, there are countries that have always been more open, like for example India, that didn’t grow as spectacularly as China. Finally, if you look closer, China’s economic miracle looks an awful lot like that of Japan, and other East-Asian nations, like Korea and Singapore, even though China has never been as open as these countries.
So, to find out the real story, I spent weeks reading the research from renowned Chin a exper ts like professor Michael Pettis, dr. Yi Wen and dr. Zongyuan Zoe Liu and combined their insights with those of development economists like Nobel Prize winner Simon Kuznets and professor Ha-Joon Chang.
And, now, I’m happy to report that, I believe that I finally found the story that connects all the dots. The story that can explain how China got so powerful, why it is now stagnating, and, importantly, what we can expect will happen to China’s economy next.
Will it overtake the USA as the reigning global superpower? or will it stagnate like Japan did after the 1980s?
To answer that question, let’s get into the story right away by answering
Ch1 How China Escaped Poverty
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This story starts in 1978, when Deng Xiaoping became the de facto leader of China, he inherited one of the poorest economies in the world, one that had been stagnant for decades, and was even being outperformed by eco nomies like Sudan and Haiti. And yet, as well all know, today, China is the second largest economy in the world, leaving Sudan and Haiti, and many others in the dust when it comes to GDP per person.
In between 1978 and today, China was radically transformed from an agricultural society into the world’s manufacturing hub, with a manufacturing output matching that of Europe and the United States combined. And, even more impressively, the country now dominates advanced industries ran ging from telecommunications, to electric vehicles, to solar panels.
So, how did it do this? What is the secret sauce that it used to achieve this miracle? To answer to this complicated question, I first tried to find out how other economic miracles such as those experienced by West European and North American countries in the had come about.
How did these economies grow rapidly to become advanced economies?
Well, according to Nobel Prize-winning economist Simon Kutznetz the type of rapid economic growth that all of these countries went through was actually characterized by two key characteristics. The first was rapidly rising productivity per person. In other words, th ese countries were primarily able to make more stuff because people got better at making stuff, rather than by just having more people. The second key characteristic Kutznetz found was that these economies first shifted from being dominated by agriculture, to being dominated by industry. And, then, after they industrialized, they eventually became dominated by the service industry, a process that economists refer to as structural transformation.
And, while today some countries have tried to develop by focusing on services right away, their growth has never been as impressive as the Asia n development miracles experienced by Japan, Korea, Taiwan, and Singapore. According to development economists like Cambridg e Professor Ha-Joon Chang the reason for this is that while agriculture has been constrained by nature, and services by human nature, people in the manufacturing sector have been able to become much more productive through automation. On top of that, manufacturing goods can more easily be exported. So, by focusing on manufacturing, you can develop faster by exporting to rich countries, making you richer.
However, as noted by dr. Yi Wen, in his book “The Making of an Economic Superpower: Unlocking China’s Secret of Rapid Industrialization,” the path to prosperity does not end there. You see, in line with Kutznetz’s observation, even today all rich countrie s then transitioned further from a manufacturing economy to a service-oriented economy.
Now, I realize that this second transition might seem counterintuitive. So, we’ll dive deeper into that in the second part of this video.
But, first, knowing now that most economic miracles came about by becoming a manufacturing power, I think we can answer our question about how China dragged itself out of poverty by stating that it did so by making its people more productive by becoming a manufacturing powerhouse. Which, of course, doesn’t really say much, as it raises the question,
how did China become a manufacturing powerhouse? Which get’s us to the standard story that
1.1 China became a manufacturing powerhouse by abandoning communism and embracing globalization
And, sure this story makes a lot of sense at first.
After all, while under communism, C hina only made limited progress in manufacturing and it was only after, after Deng Xiaoping opened up China to market forces, and the outside world slowly, via special economic zones, that China’s economic miracle kicked off. So, it makes sense that this is often where the standard story stops, economic growth was simply a matter of opening up to the world.
But, while I agree that it is a crucial first step, I’ve never felt satisfied with that simple explanation alone. After all, if escaping poverty was a simple as doing nothing, you’d surely have a lot more wealthy countries. More importantly, this simplistic narrative is not in line with historical evidence of substantial government intervention in East Asian states like Japan, Singapore, and Korea. Heck, even if you dive into the history of the economic development of the United States, you’ll discover that the first U.S. Secretary of the Treasury, Alexander Hamilton never believed the British free market economists as he wrote that
In countries where there is great private wealth much may be effected by the voluntary contributions of patriotic individuals, but in a community situated like that of the United States, the public purse must supply the deficiency of private resource. In what can it be so useful as in prompting and improving the efforts of industry?
Which means in simpler terms, that in a poor developing nation, the government must actively stimulate industrial development.
So, what did the governments of successfully developed nations do to transform their economies?
Well, according to professor Michael Pettis from Peking University the Chinese government indeed roughly followed the same development model as America, Japan, and the East Asian tiger economies did before it. A model that he classifies as
1.2 The investment-driven growth model.
To illustrate how this model works, let’s have a look at the story of Shenzen, which in the 1980s was just a fishing village, whose only advantages were that it had low labor cost and was situated next to the bustling metropolis of H ong Kong.
In May 1980, it became the first special economic zone created by Deng Xiaoping. This meant that, unlike in the rest of China, foreign businesses could now set-up shop here, and the Chinese made it extra attractive by promising them lax labor regulations and tax breaks. So, as you might have noticed, that part is still in line with the traditional opening up story.
However, there were three key problems holding Shenzhen back from truly becoming an attractive destination of foreign firms and domestic entrepreneurs alike. And to really understand this, I think it is helpful to think about it from the perspective of a Chinese entrepreneur that, for example, wanted to start a car company in Shenzhen. First of all, while it is great that you can have cheap workers there for your factory, you can clearly see that this small fishing village does not currently have the infrastructure needed for your massive factory. Most obviously, there are not enough houses for all of your workers. There is not enough electricity and, yeah ,clearly these sandy roads cannot facilitate the hundreds of trucks that will help bring the goods to the harbor of Hong Kong. And, even if all of this infrastructure was already here, you’d run into a second problem which is about where you will find the money to build a big factory in dirt poor China? Finally, you realize that, even if you are able to get the money, you will still not be able to compete with the Big Japanese and German car makers which have specialized knowledge, and big existing factories.
Luckily for our entrepreneur, China implemented a version of the investment-led growth model which was built around three pillars that aimed to solve these 3 problems with clever government interventions. The first key pillar of this growth model, is that the economy was reshaped to facilitate investment in infrastructure. Not only was the local government instructed to build the necessary infrastructure, such as electricity, water, and roads to the port of neighboring Hong Kong, it was also given the incentive to do so by tying its revenue to the value of the land in its district.
However, given that China was one of the world’s poorest countries, they then still ran into a problem: how to pay for this initial infrastructure? Well, this is where the second pillar of the investment driven growth model comes in. You see, to pay for infrastructure, as well as for factories themselves, and the required equipment from abroad, you basically need two types of money: local money and foreign money.
Local money is in theory infinitely available since the central bank can just print it. However, given that this could be inflationary, most countries have outsourced the business of money creation to private banks, who create money as debt. Debt that is hopefully used to make factories that produce stuff and therefore will not be inflationary and will not increase debt to GDP.
However, to make sure that this is indeed what the debt money is used for, China used the s ame trick as Japan did by forcing banks to create credit only for sectors that it thought were productive, such as housing, and manufacturing. On top of that, China’s central bank and state banks purposefully kept interest rates low, encouraging investment.
Second, to make sure that the right type of foreign money would flow in, China restricted speculative money flows and encouraged direct investment in factories. And while foreigners needed to share some power and technology with the locals when they wanted to build a factory in China, this was still very attractive given that there was such good infrastructure and that wages were kept purposefully low.
You see, thanks to a registration system that is known in China as the Hukou system, if you work in a city like Shenzen, but you are not originally from that city, then, yes you can live and work in that city. But, you don’t automatically have acce ss crucial social services such as access to education and healthcare. Now, as noted by people like professor Pettis, a crucial side effect of this system is that it entices workers to accept lower pay and crappier jobs, as this system makes them much more vulnerable and therefore much more exploitable by people like our entrepreneurial friend. Of course, this is terrible for ordinary workers. But, in line with China’s investment-driven growth model, it helped keep wages and worker rights low, and therefore China an attractive destination for investment in factories.
So now, fast forward a couple of years, and Shenzen had the money and infrastructure to attract enough firms to become a major manufacturing hub. However, the problem was, for an advanced industry like cars, the knowledge gap just appeared too big and while China did develop a local industry, it wasn’t able to compete with the Japanese and the Germans on the internationa l market for decades to come.
However, as you might have heard, China has recently overtaken both Japan and Germany to become the biggest car exporter in the world, which brings us to the third and final pillar of the investment-led growth model and that is infant i ndustry protection.
The basic idea is that in advanced industries, there are many barriers to enter them. So, for example, our car entrepreneur in Shenzen, might have access to cheap workers, good infrastructure, loans and know -how. But, he still couldn’t compete with Western car makers because they had far more knowledge. So, t o upgrade the Chinese economy, the Chinese aimed to protect their young sectors from international competition, while letting them compete amongst themselves and thereby have the time to learn.
So, how did they do that?
Well, the most obvious way was to use import tariffs . So, for example, if a European manufacturer wanted to export to China in the 1980s, it could expect to pay 50% to the Chinese state for the privilege. But, as China’s industries matured, the country lowered tariff rates. And indeed, because China isn’t super rich yet, Chinese tariffs are generally still higher than those in advanced economies. For example, today our Chinese car entrepreneur, who’s gotten really rich, still only pays roughly 10% to export a Chinese made car to Europe, while his competition in Europe would pay between 15 to 25% to export a car to China.
However, before you get mad at China, I have to say this is normal in our current trading system, where advanced economies accept that developing countries have higher tariffs, precisely so that they can develop.
But, there are more ways that China helped their domestic infant industries. For example, if we stick with our friend in the car industry, he got a running start because China required that all foreign car makers that wanted to sell cars in China did so in a joint venture with a local entrepreneur. Something that was very profitable for all parties involved at first. But, is now causing some headaches in European boardrooms as our entrepreneurial friend started his own car company after having learned all the tricks of the trade from his previous partner.
Crucially though, China did not fall into the trap that many African nations fell into, and that is protecting your infant industries from ALL competition. You see, if China had done that, our friend may just have gotten lazy and his company would never have been able to compete globally.
So, to prevent that outcome, China let its infant industry firms compete ruthlessly amongst themselves. And, as a consequence, the Chinese firms learned quickly.
And, so, just like America and Japan before it, China was able to complete its transformation from agricu ltural economy to manufacturing powerhouse thanks to opening up its economy WHILE at the same time the government pursued the investment led growth model with its three pillars of: investing in infrastructure, setting up an effective financial system, and employing infant industry protection.
And, so, you’d expect China to be just continuing to catch up to America and Japan. However, now we have all of this bad news about.
a worsening property slump weak consumer spending and tumbling credit growth
and they just stopped releasing youth unemployment data because it’s so bad. Is the economy in China in danger of a serious ongoing downward spiral?
Which raises the question, if it was such a good model, then
Ch2 Why did China’s Growth Model Stop Working?
Because, let’s face it, the news anchors have a point. Chinese eco nomic growth has been rather disappointing the last few years, halting its progress towards superpower status. Many investors on Wall Street had expected economic growth to come roaring back after Covid. But, just as people li ke Michael Pettis had been predicting, China’s miracle growth did not come back, as China’s investment-led economic growth model had actually already stopped working around 2007, when China’s Premier at the time, Wen Jiabao, already said that it’s rapi d economic growth had become
unstable, unbalanced, uncoordinated and unsustainable
And the reason was that
China’s economic growth relies too much on investment and export
and therefore the solution should be that, rather than boosting investment further, China should then have switched
to boost domestic consumption
which means that China’s leaders at the time seemingly intended t o follow the development economics of Simon Kuznets, by boosting consumer growth, which should then lead to a bigger service sector.
To understand why that switch is needed, I think it is important to keep in mind that as an economy becomes dominated by services, this does not mean that manufacturing output decreases. For example, as you can see here, while manufacturing output grew faster in China, it still grew in the United States. Similarly, as China transitioned from an agricultural economy to a manufacturing based economy, its food production kept rising.
So, one way of looking at economic growth is more that it is sort of a tower, where each layer builds on the next. You have to have enough food first, before you build a manufacturing industry, and, you need to have a manufacturing base, before you build a thriving service sector. Because, the thing with agriculture as well as manufacturing is, the better you get at it, the fewer people you nee d to make food & products. So, if you just stick to these two activities, you are going to end up with a lot of unemployed people.
But, then, who will buy all of these products?
Well, in advanced economies, the people buying food & manufactured stuff, are mostly those people that work in the service industry. For example, in the United Kingdom, while services account for 78% of the economy, the service sector actually employed 95% of all workers.
So, today, China’s investment driven model, with its suppression of worker incomes, and easy credit for factories and construction builders is actually holding China’s economy back because it means that ordinary people simply do not have enough money to buy all the stuff that Chinese producers make. What’s more, if ordinary people have more money, this means they have a way to signal to firms what they need next, and therefore what firms should be investing in next.
Something that is sorely needed given the extreme state of malinvestment in China. For example, some now estimate that enough housing has been built in China to accommodate 3 Billion people. However, there are only 1.4 Billion people in China, and it’s population is set to shrink. But crazy news like this now starts making more sense given that China has actually not changed its growth model since W en Jiabao’s speech in 2007. This can also explain why we now see these ridiculous things such as gigantic mountains of electric vehicles o r ride-sharing bikes that nobody has bought. And it can also explain why China’s trade surplus has just kept going up. It’s not just that Chinese products are so good, it is also that Chinese people are too poor to buy everything the country produces.
It can even explain China’s massive housing bubble. You see, the investment-led growth model kept interest rates low. Combine that with the fact that local governments had to make sure that land values kept going up to keep paying for all the infrastructure that they were building, and you’ll see that they had a big incentive to encourage the housing bubble as rising prices meant that people would buy more housing units.
And, while the scale of overproduction in China is exceptional, the situation itself is not unique. If you look at the history of investment-led growth models, you will see that many of these rapid development miracles ended in a bubble, followed by a crisis or by stagnation. For example, after rapidly growing in the 19th century, America’s economy crashed after it’s stock market bubble popped in 1930. Similarly, Japan’s rapid economic growth in the 60s and 70s was followed by a massive housing and stock market bubble in the 1980s, which popped and lead to three decades of stagnation in the 1990s.
So, is China heading towards a similar fate, and will that look like a USA style depression, or Japan style Stagnation?
In other words
Ch3 What’s Next?
Will China be able to make the switch to a modern economy and reach superpower status as it transitions to a sustainable growth model that fosters a thriving service sector alongside agriculture and manufacturing?
Or, will the country keep pushing and pushing the investment-led growth model until it breaks?
Well, in my research, I’ve basically found three scenario’s.
First, I found some economists which have pointed out that in theory there is still a lot of reason for optimism. After all, China’s population is only at 20% of the wealth of the US and so there is still a lot of room for growth. What’s more, unlike Japan’s government in the 1990s, China’s government does actually recognize that it needs to boost consumption and that it’s current growth is unsustainable.
However, according professor Pettis this optimistic scenario is unlikely because of politics. You see, while switching to more sustainable growth model is the best option for the Chinese people, it will mean that the owners of heavy industry and the construction industry give up their privileges, and in China these crucial sectors are largely controlled by members of the Chinese communist party.
the Chinese Communist Party has always been at the cen ter of a capital allocation and by empowering the household or for that matter the private sector it basically dilute or potentially remove their relevancy
In other words, it is not likely that the Chinese communist party is willing to actually give the power to households that is needed to develop a service sector and thereby loose some of its relative power in the economy. And, this is why I think it is likely that the investment-led growth model will not be radically reformed. And, therefore, the unsustainable growth China has now will continue until it stops naturally, either in the form of an economic collapse, as it did in the United States, or in the form of several lost decades as it did in Japan. And, given that China’s financial system is state-controlled, and therefore cannot collapse as the banks did in the United States, most economists I follow now believe that the stagnation scenario is the most likely, which means that the Chinese economy will have a difficult time catching up to the US one in the next few decades.
In other words, China got out of poverty thanks to the investment-led growth model. But, by now clinging on to that model too long, it’s growth has become unsustainable and therefore it will likely not reach superpower status for the foreseeable future. But, yeah, that is my take, what do you think? Do you think the Chinese leadership will switch growth models or do you think they are too invested in the current growth model that produces so much stuff that people don’t need? Let me know in the comments below, and if you liked this style of video which uses the insights of experts to tell a story that goes deeper than the standard narrative, then consider supporting my work by becoming a Patron or member.