China's Flirtation with Keynesian Economics

China’s economy has made enormous progress since modernization began in 1978 under the direction of Deng Xiaoping. However, while no one expects the transition from communism toward market-based economies to be painless, the full truth is much more brutal in that China’s economic future may be rather bleak.

After nearly 50 years of experimenting with a failed economic system, China is now flirting with another widely repudiated theory, Keynesian economics. The recent National Peoples’ Congress announced plans for a substantially larger budget deficit aimed at stimulating domestic spending to avert an economic slowdown. This attempt to re-inflate China’s domestic economy combines numerous interest rate cuts (at least seven since May 1996) and massive public spending on infrastructure that began during 1998.

Attempts to boost overall domestic spending through credit expansion and pump priming are hallmarks of Keynesian policies. It is worth noting that where applied elsewhere in the post-World War II era, these policies eventually contributed to rising misery indexes (unemployment rates plus inflation rates) and rising public-sector debt, and brought “stagflation” into the economic lexicon. In short, although there were some illusory or, at best, temporary benefits, deficit spending and loose monetary policy tended to make matters worse.

Apart from the dubious record of deficit spending, we might inquire whether China’s economic illness has been properly diagnosed. While there are warning signs of a dangerous deflationary spiral, the proposed remedies are off base. China’s problem with deflation cannot be resolved through Keynesian “reflationary” policies, as they only act as countercyclical measures at best.

China’s current price instability is a symptom of other fundamental problems in its domestic economy. To some degree, trying to play in the global economy on its own terms has exposed these faults. But the basic problem is that China faces a glut of manufacturing inventories and insufficient domestic spending. There has been a decline in retail prices since the first quarter of 1999. This is not surprising since China’s industrial capacity is estimated to be almost double current demand.

Domestic demand is suffering since workers in state-owned enterprises who have kept their jobs are saving more in light of planned downsizing that must eventually lead to cutting 50 million jobs or more. Although always high, China’s marginal saving rate has climbed substantially over the past year to a remarkable 68 percent.

Declining Exports

Meanwhile, export growth is dwindling. In particular, China has lost ground in some crucial product groups like steel and shipbuilding. Devaluation of the Korean won and Japanese yen has eroded China’s comparative advantage in pricing. There are also various signs that foreigners are viewing their presence in China much more critically. In a Japan’s Export-Import Bank survey, manufacturing firms with three or more overseas affiliates identified China as the worst on the basis of foreign direct investment performance. Unsurprisingly, statistics offered by China show that investment by Japanese companies declined by 15 percent in 1998, while their total investment declined by 27 percent.

There may be no escape from continued declines in economic growth. Declining exports and incoming foreign investment combined with collapsing domestic consumption is a recipe for a deep downturn. While public-sector budget deficits may delay the process, history proves that governments cannot buy their way out of recession.

In the end, China’s economy will face the sharp corrections experienced by other communist countries in transition. Communist economies cannot be reformed without first undergoing a substantial collapse in industrial production. The breakdown may be more or less severe, as can be seen in the different experiences of former Soviet bloc countries. Nonetheless, China’s coming collapse is unavoidable owing to imbedded distortions imposed by nearly 50 years of mostly irrational economic policies and political interference. As the internal contradictions of China’s “market socialism” unfold, the economy will continue to unravel.

Central planning combined with state ownership of property and the means of production are the principal sources of China’s distortions. The worst consequences were temporarily delayed by the impressive growth spurt when some of the worst policies were put aside and personal incentives were permitted to operate.

To a considerable degree, China’s experience mirrored the East Asian “miracle” economies in its rapid trajectory. As elsewhere, this high growth phase will wither. Consider the experience of its regional neighbors. As in China, rising costs due to corruption and overspeculation sapped the competitive edge, with domestic economic problems worsened by an overvalued exchange rate. Speculative bubbles led to property developments that far exceed demand, while financial mismanagement contributed to a banking crisis, and so on.

The State Should Retreat

Unfortunately, changing these conditions will not be easy not least because the economic problems facing Beijing’s policymakers are to a considerable degree the outcome of political arrangements. A massive retreat of the state from the Chinese economy is required. Cadres and bureaucrats must have less power.

China’s long march to modernizing its key sectors involves many challenges. Transforming a centrally planned economy to a market-based economy is perhaps the most daunting task. This is because the rapid adjustments demanded by, and vigorous competition arising from, globalized markets require supporting institutions that are generally absent in China. Among these are: the rule of law (including independent judges and reliable enforcement mechanisms), modern accounting and financial procedures, public accountability of corporate and political officials, sound money, and a well-integrated national market along with an openness to domestic and international competition.

Leaving earned income in the hands of consumers and investors is a crucial step toward establishing a sustainable basis for economic growth. The key to future growth in the modern global economy is to open up domestic economies to competition while unleashing creative young entrepreneurs who can produce wealth and jobs by starting small and medium-sized enterprises. Printing more money or throwing public funds and credit at the economy will not be able to accomplish this.