As regular readers know I have
often argued that the Chinese development model is an old one, and can
trace its roots at least as far back as the “American System” of the
1820s and 1830s. This “system” was itself based primarily on the works
of the brilliant first US Secretary of the Treasury Alexander Hamilton
(see especially his report to the Congress on manufacturing and his two
reports on public credit and banks).
This development model was also
implicitly part of the debate in France that led to one of the most
important financial innovations of the 19th Century, the
creation of the Crédit Mobilier in France in 1852. The debate concerned
one of the great economic questions in France, especially after the
defeat of Napoleon: why had England, a country that one hundred years
earlier had been poorer than France, managed to surpass France and all
other countries economically and technologically, even though in the
pure sciences and engineering the French were at least the equal to the
British and perhaps superior?
One obvious reason had to do
with the financing of the commercial application of new technology. The
French banking system, dominated by rentiers and the landed
aristocracy, seemed to specialize in protecting savers, in part by
mobilizing capital and investing in gold or in government obligations.
The English banking system did this too, but it also seemed much more
willing to finance infrastructure and manufacturing capacity.
In fact more generally I have
argued that
the main reason “industrial revolutions” have occurred largely in
England and the United States is because industrial revolutions are not
driven by scientific developments but rather by the commercial
application of scientific developments. For this to happen it seems that
a robust financing system is key. England, and the US later, benefitted
from a financial system that seemed to do better than others in
financing new infrastructure and technological ventures.
A well-functioning financial system, one that allocates capital to
new ventures, in other words, may have been the key difference between
England and France at the end of the 18
th Century, and for this some historians blame the brilliant but erratic
John Law and
his Mississippi Bubble. This concern about the inefficient French
banking system led to the creation of Crédit Mobilier, whose role was to
break the constraints of the existing Rothschild-dominated financial
system, mobilize the savings of the middle classes, and allocate these
savings towards financial projects, such as infrastructure development,
that would, over the longer term lead to more rapid economic
development.
I will come back to this issue of the financial system, but the point
here is that there have been many versions of this development model,
and at least two major economic theoreticians – the German Friedrich
List in the 19
thCentury and the Ukrainian-American Alexander Gershenkron in the 20
th –
have formally described variations on the investment-driven growth
model. Michael Hudson, one of my favorite economic thinkers, wrote
twenty years ago a brilliant and provocative
book (
Trade, Development and Foreign Debt), which traces many aspects of this model to debates in England at the end of the 18
th Century.
Aside from Alexander Hamilton, its intellectual and political
godfather, the main proponents of the American System were figures like
Henry Clay, Henry and Matthew Cary, John Calhoun, and even Abraham
Lincoln himself. Their vision of economic policymaking was looked down
upon as naïve and even foolish by most American academic economists –
schooled as they were in the laissez faire doctrines then fashionable in
England – but I think it is hard for any economic historian not to feel
relieved that neither the academics nor the Jeffersonian
and Jacksonian factions had the clout to force “good” economic policy
onto US development. America got rich in part by doing the wrong things.
Many countries in which the academics had real influence at the time –
Chile in the 1860s under the tutelage of the famous French economist
Jean Gustave Courcelle-Seneuil, for example, or Mexico at the turn of
the century under the expert guidance of José Y. Limantour, finance
minister under President Porfirio Díaz – never achieved the kind of
growth that the less capable student-countries experienced. I write
about some of these cases in my 1996
article for
Foreign Affairs, for anyone who might be interested.
To get back to the main story, in another, also brilliant and provocative,
book (
America’s Protectionist Take-off, 1815-1914)
Michael Hudson refers to a leading member of the second generation of
proponents of the American System, a Columbia University graduate by the
name of E. Pechine Smith. What is especially interesting about Smith in
the context of China is that in 1872 he was invited to Japan to serve
as advisor to the Mikado, becoming the first of a stream of economists
and lawyers – most of them proponents of the American System – to advise
and help shape Japanese development after the Meiji restoration.
Smith thus creates a direct link between the American System and the
Chinese development model. It was of course the post-War Japanese
development model, itself based on Japan’s experience of economic
development during and after the Meiji restoration, that became the
standard for policymakers throughout East Asia and China. I think of
China’s growth model as merely a more muscular version of the Japanese
or East Asian growth model, which is itself partly based on the American
experience.
There were three key elements of the American System. Historian Michael Lind, in one of his economic
histories of the United States, described them as:
· infant industry tariffs
· internal improvements, and
· a sound system of national finance
These three elements are at the heart, explicitly or implicitly, of
every variation of the investment-led development model adopted by
number of countries in the last century – including Germany in the
1930s, the USSR in the early Cold War period, Brazil during the
Brazilian miracle, South Korea after the Korean War, Japan before 1990,
and China today, to name just the most important and obvious cases. For
this reason I think it makes sense to discuss each of them in a little
more detail.
Infant industry tariffs
The “infant industry” argument is fairly well known. I believe
Alexander Hamilton was the first person to use the phrase, and the
reasoning behind his thinking was straightforward. American
manufacturing could not compete with the far superior British, and
according to the then- (and now) fashionable economic theories based on
Adam Smith and David Ricardo, the implications for trade policy were
obvious. Americans should specialize in areas where they were
economically superior to the British – agriculture, for the most part –
and economic policy should consist of converting US agriculture to the
production of cash crops – tobacco, rice, sugar, wheat and, most
importantly, cotton – maximizing that production and exchanging them for
cheaper and superior British manufactured items.
In this way, as Ricardo brilliantly proved, and assuming a static
distribution of comparative advantages, with each country specializing
in its comparative advantage, global production would be maximized and
through trade both the British and the Americans would be better off.
While most academic US economists and the commodity-producing South
embraced free trade, Alexander Hamilton and his followers, mainly in the
northeast, did not (in fact differing views over free trade as well as
over slavery and state rights were at the heart of the North-South
conflict that led eventually to the Civil War).
Hamilton was convinced that it was important for the US to develop
its own manufacturing base because, as he explained in his
Congressional
report in
1791, he believed that productivity growth was likely to be much higher
in manufacturing than in agriculture or mineral extraction. Contrary to
David Ricardo, in other words, Hamilton believed that comparative
advantage was not static and could be forced to change in ways that
benefitted less productive countries. What is more, he thought
manufacturing could employ a greater variety of people and was not
subject to seasonal fluctuations or fluctuations in access to minerals.
Given much higher British efficiency and productivity, which
translated into much lower prices even with higher transportation costs,
how could Americans compete? They could do it the same way the British
did to compete with the superior Dutch a century earlier. The US had to
impose tariffs and other measures to raise the cost of foreign
manufacturers sufficiently to allow their American counterparts to
undersell them in the US market. In addition Americans had to acquire as
much British technological expertise and capacity as possible (which
usually happened, I should add, in the form of intellectual property
theft).
This the US did, and in fact I believe every country that has managed
the transition from underdeveloped to developed country status (with,
perhaps, the exception of one or two trading entrepôts like Singapore
and Hong Kong, although even this is debatable), including Germany,
Japan, and Korea, has done it behind high explicit or implicit trade
tariffs and stolen intellectual property. The idea that countries get
rich under conditions of free trade has very little historical support,
and it is far more
likely that
rich countries discover the benefits of free trade only after they get
rich, while poor countries that embrace free trade too eagerly (think of
Colombia and Chile in the late 19
th century, who were stellar students of economic orthodoxy) almost never get rich unless, like Haiti in the 18
th Century
or Kuwait today, they are massive exporters of a very valuable
commodity (sugar, in the case of Haiti, which was the richest country in
the world per capita during a good part of the late 18
th Century).
But rather than just embrace protection I would add that there is one
very important caveat. Many countries have protected their infant
industries, and often for many decades, and yet very few have made the
transition to developed country status. Understanding why protection
“works” in some cases and not in others might have very important
implications for China. I won’t pretend to have answered this question
fully but I suspect the difference between the countries that saw such
rapid productivity growth behind infant industry protection that they
were eventually able to compete on their own, and those that didn’t, may
have had to do with the structure of domestic competition.
Specifically, it is not enough to protect industry from foreign
competition. There must be a spur to domestic innovation, and this spur
is probably competition that leads to advances in productivity and
management organization. I would argue, for example, that countries that
protected domestic industry but allowed their domestic markets to be
captured and dominated by national champions were never likely to
develop in the way the United States in the 19
th Century.
I would also argue that companies that receive substantial subsidies
from the state also fail to develop in the necessary way because rather
than force management to improve economic efficiency as a way of
overcoming their domestic rivals, these countries encourage managers to
compete by trying to gain greater access to those subsidies. Why
innovate when it is far more profitable to demand greater subsidies,
especially when subsidized companies can easily put innovative companies
out of business? Last April, for example, I
wrote about
plans by Wuhan Iron & Steel, China’s fourth-largest steel producer,
to invest $4.7 billion in the pork production industry.
The company’s management argued that they could compete with
traditional agro-businesses not because steel makers were somehow more
efficient than farmers, but rather because their size and clout made it
easier for them to get cheap capital and to get government approvals.
They were able to invest in an industry they knew little about, in other
words, because they knew they could extract economic rent. This clearly
is not a good use of protection.
The lessons for China, if I am right, are that China should forego
the idea of nurturing national champions and should instead encourage
brutal domestic competition. Beijing should also eliminate subsidies to
production, the most important being cheap and unlimited credit, because
senior managers of Chinese companies rationally spend more time on
increasing access to these subsidies than on innovation, a subject on
which, in spite of the almost absurd hype of recent years, China fares
very, very poorly.
There is nothing wrong with protecting domestic industry, but the
point is to create an incentive structure that forces increasing
efficiency behind barriers of protection. The difficulty, of course, is
that trade barriers and other forms of subsidy and protection can become
highly addictive, and the beneficiaries, especially if they are
national champions, can become politically very powerful. In that case
they are likely to work actively both to maintain protection and to
limit efficiency-enhancing domestic competition. It was Friedrich
Engels, not often seen as a champion of capitalist competition, writing
to Edward Bernstein in 1881, who said that “the worst of protection is
that when you once have got it you cannot easily get rid of it.”
Internal improvements
The second element of the American System was internal improvement,
which today we would probably call infrastructure spending. Proponents
of the American System demanded that the national and state governments
design, finance and construct canals, bridges, ports, railroads, toll
roads, and a wide variety of communication and transportation facilities
that would allow businesses to operate more efficiently and profitably.
In some cases these projects were paid for directly (tolls, for
example) and in other cases they were paid for tax revenues generated by
higher levels of economic activity.
It is easy to make a case for state involvement in infrastructure
investment. The costs of infrastructure can be very high, while even if
the benefits are much higher they are likely to be diffused throughout
the economy, making it hard for any individual company to justify
absorbing the costs of investment. In this case the state should fund
infrastructure investment and pay for it through the higher taxes
generated by greater economic activity.
For me the interesting question, especially in the Chinese context,
is not whether the state should build infrastructure but rather how much
it should build. In fact this is one of the greatest sources of
confusion in the whole China debate. Most China bulls implicitly assume
that infrastructure spending is always good and the optimal amount of
infrastructure is more or less the same for every country, which is what
allows them to compare China’s per capita capital stock with that of
the US and Japan and conclude that China still has a huge amount of
investing to do because its capital stock per capita is so much lower.
But this is completely wrong, and even nonsensical. Infrastructure
investment is like any other investment in that it is only economically
justified if the total economic value created by the investment exceeds
the total economic cost associated with that investment If a country
spends more on infrastructure than the resulting increase in
productivity, more infrastructure makes it poorer, not richer.
In China we have problems with both sides of the equation. First, we
don’t know what the true economic cost of investment in China might be.
In order to calculate the true cost we need to add not just the direct
costs but also all the implicit and explicit subsidies, most of which
are hidden or hard to calculate.
The most important of these subsidies tends to be the interest rate
subsidy, and this can be substantial. If interest rates in China are set
artificially low by 5 percentage points, for example, which is a
reasonable estimate, an investment of $100 million receives an
additional subsidy of $5 million for every year that the loan funding
the investment is outstanding – and loans are almost never repaid in
China. Over ten to twenty years of outstanding debt this can add 30-40%
to the initial cost of the investment. This means that the recognized
cost of an infrastructure project is much lower than the true economic
cost, with the difference being buried in explicit and implicit
subsidies.
But the bigger problem is in the value created by the investment. We
can think of the value of infrastructure primarily as a function of the
value of labor saved. In countries with very low levels of productivity,
each hour of labor saved is less valuable than each hour saved in
countries with high levels of productivity. For this reason less
productive countries should have much lower capital stock per capita
than more productive countries.
This should be obvious, but it seems that often it isn’t. When
analysts point to high quality infrastructure in China whose quality
exceeds comparable infrastructure in rich countries, this is not
necessarily a good thing. It might just be an example of the amount of
waste you can achieve when spending is heavily subsidized, when there
are strong political (or pecuniary) incentives for expanding investment,
and when there is limited transparency and accountability.
Other things matter too. If a country has low levels of social
capital – if it is hard to set up a business, if less efficient
businesses with government connections can successfully compete with
more efficient businesses without government connections, if the legal
and political structure creates problems in corporate governance (the
“agency” problem, especially), if the legal framework is weak, if
property rights are not respected, if intellectual property can easily
be lost – then much infrastructure spending is likely to be wasted.
In fact it turns that it may be far more efficient to focus on
improving, say, the legal framework than to build more airports, even
though (and perhaps because) building airports generates more growth
(and wealth for the politically connected) today. Weak social capital
becomes a constraint on the ability to extract value from
infrastructure, and this constraint is very high in poor countries with
weak institutional frameworks,
Journey to the West
This issue of how much investment is enough is a very important topic
that deserves much more discussion, but I think there is a very good
example of why we need to be worried about how useful additional
infrastructure investment in China might be. This shows up most clearly
in China’s push to create development in the western part of the
country.
Often when I question the economic value of China’s push to the
western, poorer parts of the country (by the way economic value is not
the same as social or political value, the latter of which may
nonetheless justify projects that are not economically viable) I am
almost always treated with the story of the American West. In the 19
th Century,
as everyone knows, the US went west, and most economists agree that
this made economic sense for the country and was an important part of
the process that led it to becoming the wealthiest and most productive
country in history.
But we must be very careful about drawing lessons from the American
experience. The US is not the only country in history that “went West”.
Several other countries did so too, but for some reason we ignore their
experiences altogether when we discuss China. Brazil, for example, went
west and north in the 1950s and 1960s as it expanded from the rich
southern coastal areas into the Amazon and the Caribbean. The Soviet
Union did something similar after the Second World War as it went east
into Siberia.
Most economists today agree that the Brazilian and Soviet experiences
were economically unsuccessful and left those countries burdened with
such enormous debts that they were at least partly to blame for Brazil’s
debt crisis in the 1980s and the collapse of the Soviet economy in the
1970s. It turns out, in other words, that there are both successful and
unsuccessful precedents for China’s going west.
What are the differences and how do they apply to China? Again, I
can’t say that I can fully understand or explain them, but one major
difference leaps out. In the US it was private individuals, seeking
profitable opportunities, that led the move into the American West, and
government investment followed. In Brazil and the Soviet Union, however,
there was little incentive for private individuals to lead the process.
It was the government that led, and private businesses followed only
because government spending created great opportunities for profit. Once
government spending stopped, so did business.
My very preliminary conclusion is that large-scale government
ambitions allied to strong political motivation and funded by cheap and
easy access to credit can lead very easily to the wrong kinds of
investment programs. The US experiences of government investment in the
19
th Century, in other words, may be a very poor precedent
for understanding China’s current policy of increasing investment
spending, especially in the poor western part of the country.
Brazil and the Soviet Union may be much better precedents. At the
very least these gloomier experiences should not be ignored when we
think of China’s policies. “Going West” isn’t always a great idea from
an economic point of view and has led to at least as many, and probably
more, bad outcomes as good outcomes. It is not clear why these lessons
cannot possibly be applied to China.
A sound system of national finance
The third pillar of the American System was the creation of an
appropriate financial system. But what does that mean? It is hard to
describe the American financial system in the 19
th Century as
stable and well-functioning. In fact the American banking system was
chaotic, prone to crises, mismanaged, and often fraudulent, and yet the
US grew very rapidly during that time.
China’s banking system, on the other hand, is far more stable – in
fact the favorite cliché of Chinese bankers is that while the system may
not be efficient, it is very stable. What makes the Chinese banking
system stable, of course, is that it is widely believed that the
government stands fully behind the banks. It makes no difference, in
other words, how weak the credit allocation decision is, because by
controlling credit and the deposit rate, and by limiting alternatives
for Chinese savers, the government guarantees both the liquidity and
solvency of the banking system. As long as government credibility is
intact, the banking system is unlikely to fail.
In that sense you can easily make the case the Chinese banks today are sounder than American banks in the 19
th century.
This might bode well for the future of the financial system in the
short term, but in the long term it is not clear to me that monetary
soundness and financial stability are necessarily correlated with more
rapid growth.
I say this because I have seen no evidence that countries with sound
and conservative financial systems grow faster than countries with
looser and riskier financial systems (although they do seem to have
fewer financial crises). In fact I have more than once made reference to
Belgian bank historian Raymond de Roover’s provocative and profound
comment that “perhaps one could say that reckless banking, while causing
many losses to creditors, speeded up the economic development of the
United States, while sound banking may have retarded the economic
development of Canada.” Canada was blessed (or cursed, according to
de Roover) in the 19
thCentury with being part of the Britain, and so inheriting England’s much better managed financial system.
“Reckless” banking is hard to define, and certainly it is easy to
make the case the Chinese banking has been reckless, especially in
recent years, but it is a very different type of recklessness. Once
again I cannot say with complete confidence how China’s version of its
development model differs meaningfully with the American System on the
subject of banking, but I would suggest there are at least two very
important differences.
First, the American financial system then (and now) has been very
good at providing money to risky new ventures. It provides capital on
the basis not only of asset value but, more importantly, on future
growth expectations, and risk-taking has been actively rewarded In China
it isn’t clear that this is the case at all. Chinese banks favor large,
well-connected, and often inefficient giants at the expense of
risk-takers.
Second, although both systems were prone to bad lending, the American
banking system tended to correct very quickly – in the form of a crisis
– and bad loans were written down and liquidated almost immediately.
This was certainly painful in the sort term – especially if you were a
depositor in the affected bank – but by writing down loans and
liquidating assets three important objectives were achieved. Financial
distress costs were quickly eliminated (writing down debt does that in
ways I won’t get into because they are well-known and much discussed in
corporate finance theory), capital allocation was driven by
profitability, not by implicit guarantees, and assets were returned to
economic usefulness quickly.
A classic example of the last of these objectives may be the response
to the railway bubble of the 1860s. During and after the 1873 crisis, a
number of railroads went bankrupt, including major lines like the Union
Pacific and the Northern Pacific, the latter of which even brought down
Jay Cooke & Company, the leading financier of the US government
during the Civil War. After the crisis some major railway bonds traded
as low as 15-20% of their original face value, and so they were
purchased and reorganized at huge discounts. The new buyers were
consequently able to cut freight and passenger costs dramatically, in
some cases by over 50%, while still earning more than enough to cover
the costs of buying the railroads, and this led to a collapse in
transportation costs in the US.
Liquidation, in other words, provides an important economic value to
the economy. It allows assets to be re-priced, which creates a boost to
the economy and prevents those assets from acting as a deadweight loss.
If the railroads hadn’t been liquidated, in other words, any reduction
in costs was likely to be minimal and the railroads would have been far
less useful to the development of the US economy.
Comparing development models
This issue of the newsletter is long, and I plan to write about this a
lot more in the future, but for now I think it makes sense to summarize
some of the important points about the American System and other
similar growth models, like the Chinese version.
1. Infant
industry protection has worked to promote long-term development under
certain conditions and has not worked under other conditions. I would
argue that the key difference is that in the former case there were
powerful forces that drove managerial and technological innovation and
rapid growth in efficiency.
In
the US case this seems to have been brutal domestic competition. If
China wants to benefit from its own protection of infant industry, it is
important that there be similar domestic drivers of innovation and
efficiency. Note that access to cheap capital cannot be such a driver,
even though it is one of the main sources of Chinese competitiveness.
Access to cheap capital is just another way to protect infant industries
from foreign competition.
2. Every
country that has become sustainably rich has had significant government
investment in infrastructure, but not every country that has had
significant government investment in infrastructure has become
sustainably rich.On
the contrary there are many cases of countries with extraordinarily
high levels of infrastructure investment that have grown for a period
and then faltered.
I
would argue that the difference is almost certainly the extent of
capital misallocation. In some countries it has been much easier for
policymakers to drive capital expenditures, and in those countries it
seems to have been relatively easy to waste investment. If this is the
case in China, as I believe it is, the key issue for China is to rein
in its spending and develop an alternative and better way to allocate
capital.
The
point is that there is a natural limit to infrastructure spending, and
this limit is often imposed by institutional distortions in the market
economy. When this natural limit is reached, more investment in
infrastructure can be wealth destroying, not wealth enhancing, in which
case it is far better to cut back on investment and to focus on reducing
the institutional constraints to more productive use of capital, such
as weak corporate governance and a weak legal framework. The pace of
infrastructure investment cannot exceed the pace of institutional reform
for very long without itself becoming a problem.
3. Any
economy looking to achieve sustainable long-term growth must have a
“good” financial system that allocates capital efficiently and rewards
the correct level of risk-taking. It is hard to determine what the
characteristics of a “good” financial system are, but we shouldn’t be
too quick to assume that this has to do with stability.
What’s more, while
obviously the capital allocation process is vitally important, I would
also suggest that the liquidation of bad loans is just as important. Bad
loans, as Japan showed us in the past two decades, can become a serious
impediment to growth in part because financial distress distorts
management incentives in the way widely understood and described in
corporate finance theory and in part because they retard the process by
which bad investment is absorbed by the economy.
4. One thing I
have not discussed above is the role of wages. The American System was
developed in opposition to the then-dominant economic theories of Adam
Smith and David Ricardo, in part because classic British economic theory
seemed to imply that reductions in wages were positive for economic
growth by making manufacturing more competitive in the international
markets. A main focus of the American System, however, was to explain
what policies the United States, with its much higher wages than in
Europe at the time, had to engineer to generate rapid growth Sustaining
high wages, in fact, became one of the key aspects of the American
System.
The Japanese version of
this development model, as well as many of the various versions
implemented in other countries throughout the 20th Century, shared its
view of wages not with the American System but rather with classic
British economic theory. Rather than take steps to force up wages and
keep them high – thereby both driving productivity growth and creating a
large domestic consumption market for American producers – many of the
later versions of the American System sought to repress growth in
household income relative to total production as a way of improving
international competitiveness. This is perhaps the main reason why the
United Sates, unlike many other countries that have implemented similar
development strategies in the 20th Century, tended to run large current
account deficits for much of the 19th Century
This different focus on
whether high wages are to be encouraged or discouraged is, I believe –
although very little discussed in the theoretical literature as far as I
know – nonetheless perhaps the most important difference between the
American development model and its many descendants in the 20th and 21st
centuries. I would even argue, although I cannot prove it, that one
consequence of this difference is that growth in demand tends to be more
sustainable when it is balanced between growth in both consumption and
investment.
In analyzing China’s growth in the past
three decades we seem to forget that there have been many growth
“miracles” in the past two hundred years. Some have been sustainable and
have led to developed country status but many, if not most, were
ultimately unsustainable. Nearly all of the various versions have had
some similar characteristics – most obviously infant industry
protection, state-led investment in infrastructure, and a financial
system that disproportionately favored producers at the expense of
savers – but the way these characteristics played out were very
different, in large part because the institutional structure of the
economy and the financial sector created a very different set of
incentives.
I would argue that
in understanding China’s growth and its sustainability we need to have a
clear understanding of why these characteristics worked in some cases
and not in others. Most economists who focus on China seem to know
little about economic history, and when they do, their knowledge tends
to be limited to a very superficial understanding of US economic
history. But there are many precedents for what is happening in China
and not all suggest that further Chinese growth is inevitable.
On
the contrary, the historical precedents should worry us. In most cases
they suggest that China has a very difficult adjustment ahead of it and
the closest parallels to its decades of miracle growth suggest
unfavorable outcomes. Understanding why the growth model has succeeded
in some few cases and failed in most will help us enormously in
understanding China’s prospects.
This is an abbreviated version of the newsletter that went out
last week. Academics, journalists, and government and NGO officials who
want to subscribe to the newsletter should write to me at
chinfinpettis@yahoo.com, stating your affiliation, please. Investors
who want to buy a subscription should write to me, also at that address.
Lúc
đó, lãnh đạo cứ nghĩ mình có chính sách tốt, luật pháp tốt, rồi nhân
công rẻ, tức khắc các nhà đầu tư sẽ đến, tội gì phải đi cho mất công,
tốn tiền.
