China’s Economy: What Deng Can Teach Xi

Deng Xiaoping’s economic reforms beginning in the late 1970s set off a period of nearly forty years of spectacular Chinese GDP growth, surpassed in history perhaps only by Argentina during the four decades that ended roughly 100 years ago. In that earlier period, even with an interruption that included a sovereign default in 1890 which nearly brought down the English banking system, Argentina transformed itself from a marginal economy at the edge of Latin America into one of the richest in the world. 

Referring to Argentina, with its disappointing subsequent history, in an article about the Chinese growth miracle may seem gratuitous, but it should remind us that the expectations generated by even the most spectacular growth miracles have a history of confounding us. This lesson is one best understood in the context of the work of Albert Hirschman, one of the great, and greatly underrated, economists of the last century. 

All rapid growth, Hirschman argued, is unbalanced growth. In fact, any period of significant structural change in an economy is likely to generate imbalances. Successful development models necessarily generate deep imbalances, especially because successful policies, by definition, change the conditions under which the policies were originally implemented. As these conditions change, the original policies tend to lose their effectiveness, often to the point of becoming constraints on further growth.

Long-term development success, in other words, is determined not just by the success of a country’s growth strategies but also, and importantly, by the subsequent adjustment period during which the accompanying imbalances are reversed. In the 1960s and 1970s, when Hirschman first developed his economic framework, he was optimistic enough to focus primarily on the creation of successful growth strategies, assuming that the subsequent adjustment process was likely to be relatively straightforward. Over time, however, as the enormous hopes he and many others had placed on Latin American growth gave way to disillusion and frustration, Hirschman became increasingly pessimistic about the long-term prospects for developing countries, in large part because the adjustment process turned out to be far more difficult than he, and everyone else, had anticipated.

In the early 1980s, Hirschman noted that path-dependency had an especially important role in generating the policy distortions that could undermine long-term development. It is hard for policymakers, he said, to abandon successful policies once these policies have clearly achieved their aims. In fact, even after these policies become counterproductive it is common, and indeed almost always the case, that the policies are retained. They  therefore continue to generate economic imbalances that are usually expressed in the form of an unsustainable increase in debt. This cycle lasts until the imbalances reach a point where they can seriously threaten economic or financial stability. 

Although he is not widely read among China specialists, Hirschman’s concerns have special resonance in China. In March 2007, for example, China’s then-premier Wen Jiabao famously characterized China’s macroeconomic outlook  as “unstable, unbalanced, uncoordinated, and unsustainable.” It was not until 2011-12, however, that China began to take the first serious steps towards unwinding the mechanisms that had worsened the very imbalances that Wen identified. 

The Politics of Adjustment

Why did it take so long? Hirschman never believed he fully understood or could explain the institutional constraints that made it so hard for policymakers to abandon counterproductive policies. Part of the reason of course may simply be that policymakers rely on faulty economic analysis. Economists are notorious for their misuse of mathematical models, and especially for their inability to recognize the implicit assumptions that underlie the models they use. They also tend to undervalue economic history. One of the most obvious consequences of these two weaknesses is that economists rarely understand the shifts in a country’s growth that occur when policymakers either decide, or are forced (usually by debt), to reform and reverse the processes that created the imbalances.

But this cannot be the full explanation. It is true that in 2007, and as late as 2010-11, most China specialists, and virtually the entire sell-side community, misunderstood both the Chinese growth model and the role of debt and implicit transfers in generating economic activity, but this was not true of all of Beijing’s economic policy advisors. A number of prominent and influential Chinese economists understood the urgency of rebalancing. Wen’s speech itself showed that Beijing’s understanding of its growth model was far more sophisticated than the consensus among China specialists.   

The answer to Hirschman’s question about why policymakers are so slow to begin the adjustment process probably has more to do with politics than with economics. Successful growth policies nearly always create institutions that develop around powerful vested interests, and just as these vested interests oppose any substantial change in the growth model, the institutional structure that develops around the growth model – including the financial system, the distribution of power between the central government and other important agents, the allocation of the benefits of growth, and so on – constrains the ability of the system to adjust. Hirschman additionally worried that in the case of a difficult adjustment the subsequent disappointment may even lead to a wholesale rejection not just of specific policies but of the entire development framework, in part because adjustment processes throughout modern history have usually been politically and socially destabilizing.

Latin American history is once again especially illuminating in this context. The mid-1990s were a period of tremendous optimism about Latin America’s long-term economic prospects, in sharp contrast to the hopelessness engendered by the decade of debt crisis that began in 1982. This earlier optimism was largely justified by the claim that for the first time in its history, Latin America had abandoned the misguided attachment policymakers had to state intervention – a consequence of their Catholic heritages, we were occasionally reminded – in favor of the liberal economic policies then referred to as the “Washington Consensus.” By embracing liberal capitalism for the first time in their histories, it was argued, most countries in the region would finally shake off their anti-growth institutions.

But once again economists proved to be poor historians. Latin America’s embrace of liberal economic policies was by no means new. On the contrary, throughout the 19th and 20th centuries the region had swung from periods of radical embraces of free-market policies to equally radical embraces of patriarchic state control. Latin America’s failures likely had less to do with their failure to follow the “correct” free-market growth path than their unsuccessful adjustments following many years of unbalanced growth, creating a policy volatility that made long-term growth extremely difficult. This also at least partly explains Latin America’s turbulent political history.

Stages of Growth

The secret to long-term development success, in other words, is not hidden in the quality or extent of the growth miracles that policymakers are able to engineer from time to time. In fact, relatively speaking, growth miracles are the easy part. The subsequent adjustment is always the hard part. Countries that have been economically successful over the long term tend to be countries that have most successfully managed the adjustment process; or to put it another way, countries that have reversed the economic imbalances associated with rapid growth relatively quickly and with a manageable amount of political and social disruption. 

The checkered history of growth miracles followed by failed adjustments is very important to understanding the challenges facing China. Deng Xiaoping was one of the great leaders of the 20th century, and the reforms that he initiated and implemented in China took great daring, imagination and strength, but in order for us to understand China’s future growth prospects we need to place his policies in their proper historical and structural context. Deng Xiaoping did not simply design a successful growth model in the 1980s. What he really did is much rarer and more difficult. He managed successfully to steer China through a very difficult adjustment process. 

This successful adjustment created the institutions and set the stage for the growth model Beijing subsequently implemented and which led to two further decades of rapid growth. It also led to a new set of institutional constraints and the development of significant economic imbalances, not the least of which, as is almost always the case, is a heavy debt burden (although not in 1977). China, once again, must rebalance its economy, and President Xi Jinping must steer the country through another difficult adjustment process. The historical precedents make it clear that China’s long-term development success depends crucially on the extent to which it is able to complete the adjustment process over the next decade or two. 

In order to increase the likelihood of successful adjustment, policymakers must understand what kinds of imbalances have been generated over the past two or three decades and how deeply they are embedded into the structure of China’s economic institutions. But understanding these imbalances has been immensely complicated by the tendency of many analysts to conflate China’s nearly four decades of astonishing reform and growth into a single, consistent growth model. This has led to confusion about the causes of Chinese growth, and a failure to understand both the risks China faces and the difficulty of implementing the necessary reforms. It is much more useful to think about the period since Deng Xiaoping began his historic reforms as consisting of four different stages, the last of which we are, with great difficulty, only just beginning. 

Most economists agree that by the end of the 1970s, Maoist policies had so distorted the production and distribution of goods and services within China that its economic institutions created enormous constraints on the productive capacity of the Chinese people. They also created, perhaps just as importantly, brutal economic volatility. World Bank figures indicate GDP growth rates as low as negative 27 percent in 1962 and as high as 19 percent in 1971.

By the time of Mao Zedong’s death, the Chinese economy had to be substantially transformed in a way that permitted a much smoother and more consistent growth process and that eliminated the growing institutional constraints on economic productivity that had developed over the preceding decades. Deng Xiaoping’s reforms did just that. In 1977 China’s GDP shrank by 1.7 percent. After 1977 it never again suffered an annual contraction and, except in 1982, when China grew by 5.2 percent, and in 1990 and 1991, when it grew by 4.0 and 3.8 percent, after 1977 China has never experienced a single year of GDP growth below 7 percent.

Stage 1:
The First Period of Liberalizing Reforms

In the late 1970s, Deng Xiaoping initiated the first stage of China’s growth period by reforming the institutions that  constrained Chinese growth. Beijing relaxed laws preventing unplanned economic activity, freed workers and farmers from their work units, and reduced the role of central planning in favor of localized planning. While these reforms unleashed an explosion of economic activity that generated tremendous wealth creation, it is not helpful at all to think about this period as part of China’s growth miracle. 

Much of the 1980s, instead, is an example of that rarest of events: a hugely successful adjustment from the significant imbalances and institutional constraints developed during the preceding decades. Deng’s reforms, in other words, consisted not so much of policies that created the growth that we typically associate with growth miracles, but rather of policies that rebalanced the economy and created the institutions that permitted subsequent growth while unleashing a new burst of productivity.

We often forget that while China’s GDP growth during the three decades preceding Deng Xiaoping’s administration was extremely volatile, it was not by any means negligible. Average growth rates were held down from 1958 to 1961 by the disaster of the Great Leap Forward, but the problem China faced in 1977 was not that it had suffered from thirty years of no growth but rather that it had locked itself into a set of institutions that seriously constrained future growth prospects. Deng’s difficult task was to reform the institutional character of the Chinese economy, with its deep and seemingly intractable imbalances, without irreparably disrupting the country’s social and political system.

The implementation of the reforms was not easy. It undermined a very powerful party bureaucracy built around its ability to constrain and direct economic activity, and so not surprisingly the reforms met with powerful elite resistance. It was only because Deng had earned tremendous credibility, prestige and power, and because he could count on the loyalty of the military, that Beijing was able to overcome elite resistance and successfully disrupt the many institutional constraints that prevented national wealth creation. Even as late as 1992, however, opposition persisted, and Deng’s famous Southern Tour was organized primarily to stamp out continued provincial resistance.

This opposition to his reforms should not have come as a surprise. Throughout history, because liberalizing reforms almost by definition are aimed at undermining institutional constraints that benefit the elite at the expense of overall productivity, such reforms have always generated political opposition from powerful groups. 

This matters as we consider the challenges China faces today. The few countries that have been able successfully to implement such major economic reforms have always been either politically competitive liberal democracies, like the United States under Franklin Delano Roosevelt, or highly centralized autocracies, like China under Deng. Countries that are not on one end of the political spectrum or the other, from the Ottoman Empire in the 1840s and 1850s to the Soviet Union in the 1970s and 1980s, have never been able to successfully implement liberalizing reforms to any significant degree, except after unleashing tremendous political instability. They are examples, in other words, of failed adjustments.

Stage 2:
The Investment Growth Period

It is really not until the subsequent period of Chinese growth that we can usefully speak about the Chinese growth model, in which rather than eliminate growth constraints, new policies were implemented to generate rapid growth. Of course, inevitably these new policies would also begin to generate the imbalances that the current administration must resolve. The most important of these imbalances in China today is the extraordinarily low share of GDP retained by ordinary Chinese households, and the contraction in the household share of GDP began almost immediately. Before we see how it happened, it is useful to consider the Chinese growth model in the context of work by Albert Hirschman’s friend and occasional colleague, the Ukrainian-born economist, Alexander Gershenkron. 

Developing countries, Gershenkron noted, have historically faced two key constraints. First, for a variety of reasons – often including low income levels, weak property rights, non-credible legal systems, and unstable financial and political systems – they are typically unable to generate enough domestic savings to fund domestic investment. This leads them to rely on very volatile and often unreliable foreign savings to fund their domestic investment needs. The United States in the 19th century is a classic example. Partly because of its extremely unstable banking system, a large part of American savings were typically invested in land, gold or silver, leaving insufficient amounts available for the infrastructure and manufacturing capacity the developing country needed. For much of the century, the U.S. imported British, Dutch and French capital while, of course, running the large current account deficits that are the obverse of net capital imports.  

The second major constraint Gershenkron noted was that, for many of the same reasons, in developing countries the private sector fails to direct investment consistently into productive projects. Gershhenkron argued that this created an important role for the state in development. It had to take the lead in accomplishing what the private sector was unable to do, and direct resources into building the infrastructure and manufacturing facilities that developing countries so obviously needed. Even in the United States, a seeming bastion of laissez-faire, during the 19th century the government, particularly at the local level, played an irreplaceable role in building the canals, highways, ports and railroads that underpinned U.S. growth, along with developing and protecting manufacturing behind import tariffs that were the highest in the world by the end of the century. 

Gershenkron’s conclusion was that to encourage rapid development, policymakers should implement policies that, first, force up the domestic savings rate and, second, direct resources into the investment projects that the country most urgently needed. In every investment-driven growth “miracle” of the past two centuries the government has resolved these constraints exactly as Gershenkron explained. 

How does a country force up its savings rate? A country’s total savings is equal to the total amount of goods and services it produces less its total consumption. Forcing up the savings rate is the same thing as forcing down the consumption rate, and because most consumption is household consumption, the most effective way of doing so is by repressing the growth of household income relative to GDP. In other words, the Gershenkron-inspired investment-driven growth model consists mainly of implementing policies that directly or indirectly tax household wealth and transfer the proceeds into subsidizing the production of goods and services. 

This growth model characterized the second stage of Chinese growth. Following Japan’s lead, whose investment-driven growth policies became the model for much of the Asian growth “miracle,” Beijing implemented a number of mechanisms that implicitly transferred wealth from the household sector to subsidize the production of goods and services. The three most important of these mechanisms are: currency undervaluation, declining unit labor costs, and financial repression. Although these may seem like very different policies, it is important to understand how they ultimately function in the same way.

An undervalued currency is the equivalent of a consumption tax on imports, the proceeds of which are used to subsidize the tradable goods sector. This “tax” reduces the real value of household income and increases the production of tradable goods. It forces up GDP growth, in other words, while constraining growth in household income. Declining unit labor costs – wages growing more slowly than productivity – have the same effect. Workers retain a declining share of their growing production, which itself is subsidized by the effective reduction in the cost of workers.

For China, financial repression was the most important of the three policies, and it is crucial to understanding both China’s astonishing growth, especially in the first decade of this century, as well as China’s astonishing imbalances. Financial savings in China were largely restricted to deposits in the banking system, with lending and deposit rates set by the government at extraordinarily low levels (in fact lending rates were often negative in real terms while deposit rates always were). These low rates acted as a hidden transfer from households, which were net savers, to borrowers, who consisted mostly of state-owned enterprises, large manufacturers, infrastructure developers, real estate developers, and local and municipal governments. This transfer of wealth was equivalent to at least 5 percent of GDP every year during the first decade of this century. 

The cumulative effect of these three mechanisms, along with others, was to force up the country’s savings rate to perhaps the highest ever recorded in history. It did so by lowering the share of GDP retained by ordinary Chinese households to perhaps the lowest ever recorded in history. These savings funded a massive program of investment in badly needed infrastructure and manufacturing capacity, the result of which was a surge in productivity growth.

China, of course, is not the first country to have followed this kind of investment-led growth strategy. So did Germany in the 1930s, the U.S.S.R. in the 1950s, Brazil in the 1960s, Japan in the 1980s, and many others. In some cases, such as Germany and Brazil, the transfers from the household sector were explicit, in the form of high income taxes. In others, like Japan and China, they involved implicit transfers. In every case economic activity grew so rapidly that even with policies that repressed household income growth, ordinary households benefited nonetheless from extraordinary growth in their incomes. In China, for example, GDP grew at roughly 10 percent a year, while household income grew by 7-8 percent.

But there was another important consequence of this model that was easily predictable from the historical precedents: The relationship between Beijing and the country’s elite was transformed. Because this growth model collects national resources and allocates them into favored projects, a powerful new group, including many members of the old elite, coalesced around these policies, and while all Chinese benefit from the resulting wealth creation, the new elite, widely referred to in China as the “vested interests,” benefited disproportionately, in large part because of the constraints aimed at generating higher savings to subsidize growth by constraining the rise in household incomes.

Stage 3:
The Overinvestment Period

The third stage of Chinese growth, which probably began some time early in the last decade, was characterized by continued rapid GDP growth, but now this growth in GDP was underpinned by an even more rapid growth in debt. Again, this should have been easily predictable, and is in fact a classic example of Hirshman’s concern that as successful policies change the conditions that originally made them successful, at some point they become counterproductive and degenerate into imbalances that require their unwinding and reversal. 

Undeveloped economies almost by definition suffer from social, legal, financial and economic institutions that constrain the country’s ability to absorb investment productively. In the early 1990s these constraints did not seem to matter for China when it came to selecting investment projects. The country so desperately lacked infrastructure and manufacturing capacity – even a simple road network, or more than a handful of functioning airports – that it was easy to find productive projects, and the only important constraint on productive investment was the pace of growth of savings. A financial system that was rather indiscriminate in choosing investment projects was not a serious problem. Almost any investment project increased productivity by far more than the cost of the project, and so the best financial system was the one that expanded most rapidly.

After many years of extraordinarily rapid investment growth, it naturally becomes increasingly difficult to identify obviously productive investments. When this happens, any inefficiency in the ability of banks to allocate capital productively becomes a serious constraint. Every investment-driven growth “miracle” in modern history, consequently, even those involving advanced economies like Japan, has eventually reached an investment saturation point after which investment becomes increasingly unproductive. 

But the financial system is designed to expand credit as rapidly as possible, and the costs of investing in infrastructure or manufacturing capacity are so heavily subsidized by financial repression, an undervalued currency, and other hidden or explicit transfers, that there is no mechanism to constrain wasted investment. China, like every country before it that had enjoyed an investment-driven growth “miracle,” began allocating investment on an increasing scale into projects whose values no longer exceeded their costs. When this happens, the debt supporting the investment must rise faster than debt-servicing capacity. 

Rather than adjust the growth policies, however, perhaps because of the power of vested interests who benefit from a continuation of the growth model, in every historical precedent the adjustment was postponed long enough for debt to become a serious problem. China has not been an exception. While overexcited economists justified the demands made by the vested interests with dizzying projections of Chinese investment needs based on completely inappropriate comparisons with advanced economies, by 2010 it was clear even to the most muddled that China was suffering from excessive credit creation. It needed institutional reforms that both changed the way in which investment had been directed for two decades and that created incentives for small businesses and ordinary Chinese to behave in more productive ways free of the constraints that had once made the investment growth model successful.

Stage 4:
The Second Period of Liberalizing Reforms 

China, in other words, must begin the fourth stage of its growth period. It must rein in credit growth, and, with it, investment growth. To prevent growth from collapsing, however, it must create other, more efficient sources of demand. There are only two other meaningful  sources. First, consumption must continue to grow very quickly, even as attempts to rein in investment growth result in much slower increases in total production of goods and services. This means that the share of GDP retained by ordinary households in China must rise, or to put it another way, the share retained by the Chinese state and by China’s elite must decline. The rise in the household share of GDP, in fact, is almost the very definition of rebalancing. Second, China’s very efficient, but politically powerless, small and medium enterprise sector must be given a larger share of new lending and other resources than it has received in the past, at the expense  of powerful state-owned enterprises and local governments.

After roughly one decade of rapid growth generated by the productivity unleashed by the rebalancing of the Chinese economy under Deng Xiaoping, followed by roughly two decades of rapid growth generated by an investment-driven growth model that has also generated huge imbalances, China is once again facing a difficult adjustment and rebalancing. Under its new president, Xi Jinping, Beijing must implement a second round of liberalizing reforms that in many ways will replicate Deng Xiaoping’s reforms. 

There is a fairly broad consensus on what these reforms will imply. The mechanisms that created both the astonishing growth as well as the great imbalances – the implicit transfers from households to subsidize growth – have largely been eliminated. The next, more difficult, step will be to reverse these transfers so that household income can continue growing by at least 5-6 percent a year even as GDP growth drops substantially. How much must it drop? It is difficult to believe that average GDP growth rates during Xi’s administration can exceed 3-4 percent on average. 

Last year’s Third Plenum provided the blueprint for these reforms, but once again they have been strongly opposed by what the Chinese press calls the “vested interests.” Xi and his advisors understand the political opposition to rebalancing the Chinese economy. His first steps in government have been to consolidate power and to weaken and frighten potential opposition. But it will not be easy. It took highly centralized power under Deng Xiaoping to implement the liberalizing reforms of the 1980s, and it will probably take highly centralized power to implement a new series of liberalizing reforms. This is the great challenge that the president faces.