Photo: Simon Song/South China Morning Post via Getty Images
The world’s second-largest economy is awakening from a yearslong stupor. Since the pandemic’s onset, China’s “Zero COVID” policy has imposed harsh side effects on its commerce. Now, the nation’s most stringent public-health regulations are over. But its economy’s worrisome symptoms persist.
China’s grotesquely overinflated property bubble is at perpetual risk of bursting. A youth-unemployment crisis plagues its major cities. A perennially underpaid labor force is struggling to prop up consumer demand. And the demographic collapse wrought by the one-child policy has just begun.
What happens in China does not stay there. The economic trajectory of the world’s most populous country has profound implications for its trade partners and geopolitical rivals. To get a better understanding of what’s ailing the Chinese economy — and what could plausibly heal it — I reached out to Michael Pettis, a senior fellow at the Carnegie Endowment for International Peace. A former Wall Street trader, Pettis is a longtime critic of China’s growth model. In his 2020 book Trade Wars Are Class Wars, co-authored with the journalist Matthew Klein, Pettis argued that China’s economic policies increase global inequality and reduce American prosperity.
We spoke last week about China’s obsolete economic strategy, the growing conflict between Beijing and local government elites, the nation’s declining population, and why Joe Biden’s most nationalistic economic policies are actually “trade-enhancing,” among other things.
What is the biggest headwind facing China’s economy in 2023?
In order to understand what China’s facing today, you really have to look beyond the past two years. COVID did not change the Chinese economy so much as it exacerbated its underlying problems, which are at least a decade old.
Those problems are most visible in the property sector. But they derive from China’s growth model. That model has two parts. First, through a variety of policies, you increase the share of national income that goes into savings and reduce the share that goes into consumption. In practice, this means restricting the amount of GDP that goes to households and increasing the amount that goes to businesses. Second, you channel those savings through the banking system into investment.
This model is not unique to China. Quite a number of countries have followed it. China has just followed it to a greater extent than any country in history.
Is it a good model or a bad model? Well, it depends on the underlying circumstances. When China started this, it was among the most underinvested economies in the world. After five decades of anti-Japanese war, civil war, and Maoism, it was hugely underinvested. So this model was exactly what it needed. Opportunities for productive investment were abundant.
But the trouble with a very successful development model is that, by definition, it resolves the problems it was created to address. A good development model renders itself obsolete. And yet, if such a model eliminates its animating purpose, it does not eliminate the interest groups who’ve come to benefit from it.
The economist Albert Hirschman wrote about this way back in the 1970s. A successful growth model will disproportionately benefit certain constituencies. And it will also make those constituencies disproportionately powerful. Which makes it politically difficult to shift away from the model after it’s become obsolete. So you end up following an outdated economic strategy. What happens is that you try to keep rapid, investment-driven growth going after you’ve exhausted every easy opportunity for productive investment. So you fund nonproductive investments. And then you see debt start to rise. This happened in China between 2006 and 2008.
And debt continues rising until either you decide to adjust or you’re forced by debt constraints into adjusting. And adjustment is always very, very difficult.
So the reason COVID matters is because, if you look at all of the indicators, the consumption share of GDP got even worse during the COVID period, while debt rose very rapidly. And the share of growth attributable to nonproductive investments in the property sector and infrastructure grew. So, COVID accelerated all of the problems China already had. This year, and for many years to come, what China really has to do is find a way to adjust.
So to be clear: China has a growth model that suppresses consumption in order to direct more money toward investment in infrastructure and capital-intensive projects. In the early stages of this model, when China was sorely lacking in infrastructure and housing, this was a very sound approach. But now they’ve reached a point where they’ve picked all the low-hanging fruit. And opportunities for productive investment are actually constrained by the fact that consumer demand is weak, since the household share of income is low. So the government starts investing in projects with little actual utility. And that produces a massive bubble in the property sector.
In the property sector and in infrastructure.
And the specific “adjustment” that they need to make is to redistribute income away from businesses and toward household consumption by promoting higher wages or social-welfare programs?
Exactly. Now, in most countries, almost all income is divided between households and businesses. In China, however, a substantial share of income actually goes to local governments. So technically, the way to solve the Chinese problem is not so much by redistributing from businesses to households but rather redistributing from local governments to the household sector. But, of course, the fact that local governments currently take in a lot of income makes them very powerful. And local elites are dependent on the growth of local government spending.
You’ve written that the Chinese Communist Party is aware of the problem and officially wants to increase consumption. To the lay American, it might seem strange that a one-party government would find it politically difficult to enact a policy that, effectively, makes the vast majority of the population richer. Why can’t a state that has authoritarian powers enact an agenda that has broad popular support?
If you redistribute income from local governments to the household sector, that’ll certainly make households very happy. But it will be very painful for local governments. Right now, you could argue that households retain roughly 60 percent of GDP while governments and businesses each retain roughly 20 percent. So one way of looking at it is that households retain about three times the income share that governments do.
In order for China to be — not even a normal country — but a normal low-consuming country, they would need to transfer at least 10 to 15 percentage points of GDP from governments to households. So, at the end of this transfer, households retain not 60 but 70 to 75 percent of GDP, and governments no longer retain 20 but rather 5 to 10 percent. That means the ratio of household income to government income goes up by seven, eight, nine, ten times.
Well, you cannot have such a massive redistribution in relative income without a massive redistribution in relative political power. And again, it is the very ability of local governments to fund enormous amounts of spending that has basically created a lot of local political, business, and financial elites.
There’s a stereotype that to be a millionaire in China, you have to write computer code. But that’s not true. The vast majority of rich Chinese are rich because they were in the property sector or in the construction sector or in other basic parts of the economy that receive lots of government spending. So adjustment requires a major transformation in all of the business, political, and financial institutions that have developed over the last 30 years.
You could argue that the centralization of power under Xi Jinping might be necessary in order to force through such transformations. But certainly those adjustments are not happening yet. We’ve been talking about them for 15 years, but they haven’t happened.
Xi’s government is also quite aware of the problems in China’s property sector. And it’s made some efforts to temper its growth by restricting credit. But in recent weeks, the CCP has walked back some of those restrictions. Why did they change course?
The first thing is to understand how out of control the property sector became. The direct and indirect share of GDP attributable to the property sector is estimated to be between 25 and 30 percent, which is twice the level in other countries. Real-estate prices are equal to between 300 and 350 percent of GDP, which is two and a half to three times what it is in other countries. When you look at household savings, the real-estate component of household savings is between 60 and 70 percent, which is more than twice what it is in other countries. Real estate is always important in any economy. But in China, it is far more important. And this has happened over 20 to 30 years of rapid property expansion and rapid increases in real-estate prices.
When a boom lasts that long, it changes behavior. Whether you’re a business or a household or a bank, you learn to bet on continued expansion in the property sector. If you don’t learn that, you get put out of business. Households that borrow too much and buy too many apartments, instead of getting punished, end up becoming incredibly successful. Property developers that find every way they can to borrow money — including ways that are technically illegal — and use it to buy land outperform the more prudent property developers.
Banks that lend too much to real estate, and even cut corners to do so, are the really successful banks. And those that don’t do that lose market share. So eventually, after so many years, much of the economy is implicitly betting on continued expansion in the property sector. This is not just a Chinese problem. We saw this in Japan and in the U.S. and Spain before the financial crisis.
So when you try to bring the property sector under control, you are reversing this entire process. And that means everybody — households, banks, businesses, local governments — suffer enormously from any attempt to bring the property sector under control. And the pain is so great at some point they try to back away.
This was not the first time that they went after the property sector, although it has been the most aggressive attempt. They’ve gone after it many times before in the last five to six years. But they always pull back when they see the pain.
And the pain is really brutal this time because they really clamped down on it. And it’s particularly brutal for local governments because they’ve depended heavily on land sales for their revenues to pay for everything. And they’re being so heavily squeezed that they’re cutting their expenses, reducing salaries, doing all the things that they shouldn’t be doing, but they don’t have a choice. So now Beijing is trying to “stabilize” the property bubble without reviving it. They want to slow down the contraction.
But we’ve never really seen that happen in a highly speculative market. It keeps going up until it starts to go down, and once it goes down, it’s very hard to get it to stabilize. Speculative markets go up or they go down; they don’t do stability. So there’s a real big question as to whether or not Beijing will indeed be able to stabilize them.
In addition to the problems in the property sector, China also faces really high youth unemployment with nearly one-fifth of young urban workers going jobless. Does that problem also trace back to China’s broken growth model, or is it a function of Xi’s crackdown on the tech sector or other issues?
It has to do with the original problems of the growth model. The private sector, and particularly the service sector, is starved of demand. If you go out and talk to local businesses and you ask them, “What’s your problem?” they’ll tell you the problem is that no one is buying anything and they haven’t been for years. COVID just made it worse. So what you really should be doing is demand-side policies like the U.S. and Europe did in response to COVID. But for ideological and institutional reasons, China just doesn’t seem able to do demand-side policies. So they respond with supply-side ones.
If you listen to the ministries of Commerce or Industry or Transportation, they’re all saying the same thing. The way to get out of this mess — the way to regain growth — is to keep spending more, supporting manufacturers, and building more infrastructure. Which is another way of saying we need to continue subsidizing the supply side of the economy. The problem with subsidies is that they’re just transfers. If you get subsidized, then I must pay for it. And so, effectively, these supply-side policies require implicit transfers from the household sector. For example, a weak currency hurts households, who are importers, in favor of manufacturers, who are exporters. Low interest rates hurt households who are net savers in favor of, again, manufacturers who are net borrowers, et cetera. So these types of policies end up supporting the wrong part of the economy.
The flip side, of course, is that reversing the direction of subsidies would really hurt manufacturers and exporters. So what’s good for China in the medium and long term may be quite painful in the short term. And again, this isn’t a Chinese problem. The Japanese have been saying the same thing for 30 years: “We have to boost consumption, but we must boost consumption without hurting the export sector.” And that’s a problem because boosting domestic demand will hurt the export sector in the beginning. So they never end up doing it.
Last week, the Chinese government revealed that its population contracted in 2022 for the first time in six decades. And that trend will only accelerate in the coming decades, as the pre-one-child policy generation gives way to its successors. Many analysts have suggested that this will have devastating consequences for the Chinese economy. But you’ve suggested that such talk is “overexcited” and that China could largely resolve its demographic problem by addressing income inequality.
I think people are confusing the geopolitics of economic growth with economic growth. Now, if the Chinese population declines, will it be a smaller economy relative to what it could have been? Yeah, of course. If you cut the United States in half, you’ll have two countries with half the population and half the GDP.
But what really matters for people is their income. People don’t care what national GDP is; they care about their income growth. Now, the population is contracting very slowly. There’s nothing special about this year. It doesn’t really matter that some people think that this year is the first year that the population actually went down. It could have been last year, it could be next year, we’re not really sure. But the population change year-to-year is very small.
In any case, a smaller population does not need to mean weaker demand. Demand is equal to the number of people times their income, minus their savings. So if the population drops slowly by half a percent, but you can increase household income by 2, or 3, or 4 percent, then demand will go up. It won’t go down.
So the key for China, in almost all of its problems, is this redistribution of income. And since Chinese households currently receive a historically low share of income, there’s a lot of room to grow the household share of GDP.
A falling population is a problem for China as a military power. But if you’re thinking about the Chinese economy, it’s much less of a problem.
Even though the country will eventually be faced with the challenge of supporting a very large retired population with a much smaller working one?
Don’t get me wrong, that is a problem. If you’ve got more retired people relative to the number of workers, then that means you need to transfer more income away from workers in order to keep the retired people alive. But that’s a problem many countries have. The U.S. is sort of lucky, but almost every rich country has that problem. Japan has that problem. Spain and Italy have that problem, and we don’t think of it as a collapse in those countries. So I don’t think we should think of it as a collapse in China. It will make China less of a geopolitical power. But it’s just not a big deal from an economic point of view.
Speaking of geopolitics: As tensions between China and the U.S. have risen, America and its allies have sought to reduce their reliance on Chinese commodities, inputs, and goods. For the moment, it’s unclear what the scale of this “decoupling” will actually be in practice. How big a threat does that pose to Chinese manufacturers?
Well, for all the talk of decoupling and tariffs on Chinese goods, the American trade deficit has widened to its greatest level since just before the 2008 crisis. And the Chinese trade surplus has also widened to its greatest amount in history as a share of GDP. So I think a lot of that is based on a real misunderstanding of trade patterns. People think that you have this discretionary ability to buy from wherever you want. But it doesn’t really work that way. Remember that Chinese exports are among the most competitive in the world. Why is that? It’s not because the Chinese are particularly hardworking or China has particular comparative advantages beyond size. The reason is that all of these transfers from the household sector to manufacturers, both implicit and explicit, to subsidize manufacturing and investment makes Chinese labor cheap relative to its productivity.
And that’s true not just of China but of Germany, the Netherlands, South Korea, and Japan. All of these countries that run persistent trade surpluses do so because of the very low household share of GDP; workers get paid less relative to their productivity than among their trading partners. So as long as that’s the case, it doesn’t matter whether you want to have operations in China or not. Whoever does have operations there will be more competitive and its market share will expand. So I’m very skeptical about this decoupling idea. I think it’s going to take a very different understanding of the way trade works in the modern environment before that can happen.
How do China’s economic difficulties impact American consumers and workers? And how will its current policy trajectory impact the U.S. economy this year?
It depends on whether or not China rebalances. I mean this whole issue of rebalancing is so extreme in China, the most extreme in world history, that almost everything, the answer to almost every question depends on how it rebalances.
But what’s your view for the most likely scenario in 2023?
I’m hoping that they are genuinely able to boost the consumption share of GDP. There will be a boost this year, a partial reversal of all the awful stuff that happened last year. But I’m hoping it’s a permanent increase in the consumption share of GDP, in which case Chinese growth will slow significantly as they move away from overspending on the investment side. But that will also mean that Chinese households will consume a larger share of what they produce. Which would be good for the global economy, since it would increase global demand.
Wouldn’t that be bad for inflation though? Given the global economy’s supply constraints, wouldn’t an increase in global demand lead to higher prices?
There’s a very complicated argument about the causes of inflation in the U.S. and in the rest of the world and how long this is going to persist. So it depends on all of those issues. But at the end of the day, the world suffers from more of a demand-side problem than a supply-side problem. COVID temporarily interrupted that because it had a significant supply-side impact. But assuming that we’re getting away from COVID and back to more normal conditions, we’ll soon be worrying more about demand than supply. And China has been a huge absorber of global demand. So as its trade surplus contracts, it will absorb less net-demand from abroad, which will be positive for growth.
I think there’s been a real shift in the conventional wisdom about whether the global economy’s long-term problem is one of insufficient demand or supply. Prior to the pandemic, there was a broad consensus among economists that the economy was suffering from a chronic lack of demand, or “secular stagnation.” But now, in the wake of inflation, analysts at BlackRock and Allianz have been suggesting the opposite: that we’re entering a new era of persistent supply constraints. They argue that aging populations in developed countries are shrinking the supply of labor more than they’re shrinking demand, that the green transition will demand lots of commodities and labor, and that deglobalization will make supply chains less efficient. And all this will make inflation a bigger problem than growth. I take it you reject that narrative?
It could happen in the short term. If you start to see a reduction in Chinese net-supply and an increase in infrastructure investment in the U.S. That could put some pressure on prices. But remember, the purpose of infrastructure spending is not to boost demand; it’s to boost supply. And if it’s done correctly, you boost demand at first and then later on you increase supply by more than the increase in demand. So thinking long term, whatever the short-term impacts of an adjustment in China are, what really matters is whether we get back to a period of more rapid growth. And one of the things we have to remember, including from our own history, is that productivity growth is often a function of wage growth. In the U.S. in the 19th century, when you had massive increases in labor productivity, that probably wasn’t unrelated to the fact that American wages were the highest in the world.
So investors had a strong incentive to invest in labor-saving technology. Right. And then, in the last 30 years, we’ve seen a simultaneous slowdown in productivity growth and wage growth. Labor is cheap in the U.S., relative to its productivity. And it’s even cheaper in places like Vietnam or China or Germany. As a result, the way to increase profits is to shift into lower-wage environments, rather than to invest in productivity-increasing technology.
So do we want a world where businesses increase profits by putting downward pressure on wages? Or do we want a world where businesses increase profits by putting upward pressure on labor productivity? I think clearly we want the latter. The transition isn’t going to be easy. But I think that’s the path we need to get back on. The path that we haven’t been following for the last three, four decades.
The Biden administration is arguably trying to get the U.S. back on that path. But its approach has attracted a lot of criticism. Specifically E.U. officials and The Economist magazine have objected to the Inflation Reduction Act’s subsidies for electric vehicles manufactured in North America. They’ve argued that subsidizing domestic production in that manner is protectionism and risks triggering a vicious cycle of “beggar-thy-neighbor policies,” in which nations compete for manufacturing jobs by offering increasingly expensive incentives to multinational corporations.
You’ve argued that this analysis is completely wrong, and that the IRA’s “Buy North American” provisions are actually “trade-enhancing.” What’s your reasoning? The economist John Maynard Keynes made it very clear that big, persistent trade surpluses are always the product of “beggar thy neighbor” policies. Those policies might not have been consciously designed as protectionist measures. But they have the same impact. Depreciating your currency and keeping labor costs down by suppressing trade unions is functionally the same as imposing tariffs on foreign imports. They all lower your workers’ wages relative to their productivity, thereby making your businesses more internationally competitive. In other words, you don’t make your manufacturers more competitive by increasing their productivity but rather by lowering wages. Which puts downward pressure on wages abroad. That is a “beggar thy neighbor” policy. I would argue that we’ve been in an incredibly “beggar thy neighbor” world since the 1980s.
As long as the U.S. is willing and able to run these very large trade deficits — which do not benefit American workers or farmers or producers — then the rest of the world can continue these beggar-thy-neighbor policies, because the U.S. absorbs roughly half of all of the world’s surpluses.
Thus, anything that the U.S. does to reverse its trade deficit actually makes the global trading environment more open and free and less zero-sum. Now, I don’t think that the various industrial policies proposed by the Biden administration are necessarily going to reduce the U.S. trade deficit. But any move that the U.S. makes to try to force a contraction in its trade deficit is by definition not a “beggar thy neighbor” policy. You can’t promote free trade by honoring the norms of the existing trade system. For that, you need to change the system.