Michael Pettis — How much investment is optimal?

In the May 10 issue of my blog I referred to a very interesting IMF paper written by Il Houng Lee, Murtaza Syed, and Liu Xueyan. The study, “China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency”, attempts among other things to evaluate the efficiency of investment in various provinces within China. I argued in the newsletter that the paper supported my contention that China has overinvested beyond its capacity to absorb capital.

This argument is in opposition to claims made by many analysts that China has not overinvested systematically, and that in fact, with much less capital stock per worker than advanced countries like the US or Japan, China has a long ways to go before it begins to bump up against the productive limits of investment.

China Financial Markets
How much investment is optimal?
Michael Pettis

Is it the amount of investment or the amount of investment in the export industry and FIRE ("extractive") rather than "rebalancing" by increasing domestic consumption ("inclusive")?

As an aside, what strikes me about the debate that Pettis is describing is the assumption that the factors taken into consideration by the models are exclusively determinative rather than simply some of many, others of which may be more significant to the overall situation — social and political, as well as economic. They are puzzled, for example, that a model fits one country and not another with different conditions. Doh.

Economists are unbelievably self-centered, totally disregarding other social sciences as well as practical considerations outside their narrow purview.

Green’s points are that there is a large difference between the richer and poorer provinces, and that the same set of policies that drove up income levels in the richer provinces can, presumably, be applied to the poorer provinces in the same way and for the same effect as their income levels converge with those of the richer provinces. This convergence alone will guarantee that China will grow by 7-8% for many more years.

Green may be right, but I think it is worth pointing out under what conditions he would be right and under what conditions he would be wrong. If the difference in wealth between the richer and poorer provinces is indeed caused mainly by the difference in capital stock per worker, and if otherwise there are no significant institutional differences between the two that prevent the poorer regions from catching up, then it is probably true that the policies that worked in the coastal regions can be successfully applied to the inland regions with much the same economic impact. Beijing can turn all of China into Guangdong and Zhejiang.

But if the poorer regions are poorer not because they lack investment but rather because they are institutionally more “backward” and so lack the ability to absorb investment efficiently, then it is not so clear that their income levels can converge with those of the richer regions within China except under conditions of significant social and political change.

Pettis goes on to add:

As an aside I am struck by the fact that the disparity between richer and poorer regions in China has existed in very much the same way for many centuries, and wonder if this isn’t due at least in part to dramatic differences in what I am calling social capital.

Exactly, and that we the choice of the extractive elites. The present regime knows that it has to be perceived as correctly that imbalance if it is to maintain credibility as a socialist government representing labor and not capital as the chief factor. For the leadership this is an existential choice. The Party is walking a fine line and they know it. They also realize that a widespread perception of crony capitalism and corruption will do them in.

I believe that in the past two to three years there has been a significant and welcome shift in Beijing’s attitude towards maintaining growth, and that this shift implicitly represents a shift from the capital frontier model of optimal investment levels to the social capital model. Keynes famously reminded us that “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist,” and I would argue that in this sense models do matter. The economic model that we implicitly use to justify policy can result in hugely different policies with hugely different outcomes.

China needs to increase social spending to increase "social capital," especially in regions where social capital is lacking. But one area that immediately suggests itself is creating a social safety net that would encourage less domestic saving and more domestic consumption, which would drive investment in domestic enterprise. The other low hanging fruit lies in improving the legal system, reducing the corruption that has traditionally been endemic in China, and improving public education.