A few years ago I wrote an essay on my blog that received a lot of attention and in which I tried to explain what the underlying assumption was for analysts who considered that China’s low level of investment relative to that of, troche say, help the US proved that China could not possibly have reached the point of investment saturation. I then argued that there were two very different models that explained what made advanced economies advanced. One model assumed that there is an optimal capital frontier appropriate to all countries, hospital and that the further a country is from that frontier, the more profitable and productive would be any increase in investment. The other model assumes that each country has a different optimal capital frontier based on its level of what I called “social capital”. Poor countries are usually countries with low levels of social capital and, therefore, a low optimal capital frontier, and any investment past that frontier is likely to be non-productive.
I have found myself discussing this essay a lot recently, both with analysts who had read it back then and wanted to discuss it and with analysts who hadn’t read it and wanted to know why I assumed that investment in China had long ago reached its saturation point. I am working on a new essay on trade for my blog, but I thought it might be worthwhile to some of my readers, especially new readers, to re-post the essay. I made a few changes, mainly because I was not able to reproduce two graphs and a table that come in the original.
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In a May, 2013, entry on my blog I referred to a very interesting IMF paper written by Il Houng Lee, Murtaza Syed, and Liu Xueyan. The study, “China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency”, attempts among other things to evaluate the efficiency of investment in various provinces within China. I argued in the newsletter that the paper supported my contention that China has overinvested beyond its capacity to absorb capital.
This argument is in opposition to claims made by many analysts that China has not overinvested systematically, and that in fact, with much less capital stock per worker than advanced countries like the US or Japan, China has a long ways to go before it begins to bump up against the productive limits of investment. For example in a September 3, 2012, issue of Asia Economics Analyst, Goldman Sachs makes the following point:
China is often criticized for investing too much and too inefficiently, and for consuming too little…However, focus on the investment/GDP ratio risks confusing flows and stocks and we believe is not the right metric for assessing whether a country has invested too much. For that, we also care about the capital stock rather than the investment flow—on this metric, on a top-down approach, China still has a long way to go—its capital stock/worker is only 6% of Japan’s level and 16% of Korea’s.
The Economist has also made a similar argument. This, for example, was published about a year ago:
The IMF says so. Academics and Western governments agree. China invests too much. It is an article of faith that China needs to rebalance its economy by investing less and consuming more. Otherwise, it is argued, diminishing returns on capital will cramp future growth; or, worse still, massive overcapacity will cause a slump in investment, bringing the economy crashing down. So where exactly is all this excessive investment?
…The level of fixed-capital formation does look unusually high, at an estimated 48% of GDP in 2011 (see left-hand chart). By comparison, the ratio peaked at just under 40% in Japan and South Korea. In most developed countries it is now around 20% or less. But an annual investment-to-GDP ratio does not actually reveal whether there has been too much investment.
To determine that you need to look at the size of the total capital stock—the value of all past investment, adjusted for depreciation. Qu Hongbin, chief China economist at HSBC, estimates that China’s capital stock per person is less than 8% of America’s and 17% of South Korea’s (see right-hand chart). Another study, by Andrew Batson and Janet Zhang at GKDragonomics, a Beijing-based research firm, finds that China still has less than one-quarter as much capital per person as America had achieved in 1930, when it was at roughly the same level of development as China today.
Leaving aside the rather strange claim that China today is at roughly the same level of development as the US in 1930, because China’s capital stock per capita is so much lower than that of much richer countries, claim Goldman Sachs, the Economist, and many others, Chinese investment levels overall are still much lower than they optimally ought to be. While it is of course always possible for China to misallocate individual investments, which everyone agrees is a bad for growth, these analysts strongly disagree with the claim that China has overinvested systematically.
Since the newsletter came out I have had a number of conversations with clients who wanted to pursue a little further the issue of how to think about an optimal level of capital stock per capita. In my central bank seminar at Peking University we recently spent a couple of sessions hashing this out in a way that we found very useful, and I thought it might be helpful to summarize those discussions in order to explain a little more schematically how I think about this issue.
The two models of investment
To begin this discussion it is worth remembering what the IMF paper suggested about investment in China. The abstract of the paper is:
This paper proposes a possible framework for identifying excessive investment. Based on this method, it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. By contrast, private consumption has become more self-sustaining in coastal provinces, in large part because investment here tends to benefit household incomes more than corporates.
If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing increasing constraints due to dwindling land, labor, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles. Thus, investment should not be indiscriminately directed toward urbanization or industrialization of Western regions but shifted toward sectors with greater and more lasting spillovers to household income and consumption. In this context, investment in agriculture and services is found to be superior to that in manufacturing and real estate. Financial reform would facilitate such a reorientation, helping China to enhance capital efficiency and keep growth buoyant even as aggregate investment is lowered to sustainable levels.
In contrast to claims cited above suggesting that Chinese investment levels are too low, among other things the paper argues that although investment levels as measured by capital stock per capita are obviously lower in the poor inland provinces in China than they are in the richer coastal regions, in fact investment in the former areas may be less productive than investment in the latter areas. This implies that the regions with less capital are also less able to absorb additional capital efficiently.
Should this be a surprise? For those who argue that China is poor because capital stock per worker in China is much lower than in the advanced countries, and that China should aggressively increase investment to close the gap, the findings in this paper ought to be surprising. If the further an economy is from US levels of capital stock the more appropriate it is to increase investment, then investment in the poor inland regions should have a higher return than investment in the richer coastal regions.
But whether or not the findings of this and other similar studies should surprise us depends on how we decide what the optimal level of capital is for any economy. I would argue that there are basically two different models for thinking about how much investment is optimal:
- The capital frontier constraint. One model suggests that the most advanced and capital-rich countries have developed, perhaps through trial and error, the appropriate level of capital investment given the state of technology, trade, and managerial organization, and they effectively represent the frontier for investment.
According to this model it is pretty easy to figure out what an appropriate investment strategy is for a developing country – more investment is almost always good. Because in this model what separates poor countries from rich countries is primarily the amount of capital stock per worker, poor countries should always increase their capital stock until they begin to approach the frontier. Until they do, an increase in capital stock automatically causes an increase in workers’ productivity that exceeds the cost of creating the capital stock, and so the country is economically better off because the benefit of investment exceeds the cost of investment. This model implicitly underlies claims made by many analysts that because China’s capital stock is much lower than that of the US, Japan or other rich countries, it is meaningless to say that China is overinvesting in the aggregate.
- The social capital constraint. The other model suggests that for any economy there is an appropriate level of investment or capital stock per worker that depends on the ability of workers and businesses in that economy to absorb additional capital stock. I am going to call this ability to absorb capital stock “social capital”.
The implication is, then, that the higher a country’s social capital, the higher the optimal amount of capital stock per worker. The fundamental difference between rich countries and poor countries, in this case, is not the amount of capital stock per worker but rather the institutional framework that gives workers and businesses the ability to absorb additional capital productively. Advanced economies are understood simply to be those economies that are able to absorb high levels of investment productively. Backward economies are constrained in their abilities to do so.
What determines the level of social capital? Lots of things do. The right institutions matter tremendously, but because there is no easy way to quantify what the “right” institutions are, we tend to ignore their importance in favor of more easily measurable factors, such as broad measures of capital stock. I would argue, however, that economies are much better at absorbing and exploiting capital if they operate under an institutional framework that
- creates incentives and rewards for managerial or technological innovation (which probably must include clear and enforceable legal and property rights),
- encourages the creation of new businesses and penalizes less efficient businesses, perhaps at least in part by institutionalizing methods by which capital can quickly be transferred from less efficient to more efficient businesses, and
- maximizes participation in economic activity by the whole population while minimizing distortions in that participation.
Measuring social capital
Perhaps in the early stages of what Alexander Gershenkron called “economic backwardness” these institutions matter less if the there are clear and obvious steps that need to be taken to increase productivity rapidly – if manufacturing capacity and infrastructure levels are non-existent, for example. As economies become large and complex, however, economies with greater flexibility, higher levels of participation, and correctly aligned incentive structures seem to be much better at squeezing value out of investment.
I should point out that the term “social capital” already has a meaning. The World Bank defines it this way:
Social capital refers to the institutions, relationships, and norms that shape the quality and quantity of a society’s social interactions. Increasing evidence shows that social cohesion is critical for societies to prosper economically and for development to be sustainable. Social capital is not just the sum of the institutions which underpin a society – it is the glue that holds them together.
The term was apparently first used in 1916, by the American Progressive Era educational reformer, LJ Hanifan, and he described it in terms of social relationships:
The tangible substances [that] count for most in the daily lives of people: namely good will, fellowship, sympathy, and social intercourse among the individuals and families who make up a social unit. . .. The individual is helpless socially, if left to himself. If he comes into contact with his neighbor, and they with other neighbors, there will be an accumulation of social capital, which may immediately satisfy his social needs and which may bear a social potentiality sufficient to the substantial improvement of living conditions in the whole community. The community as a whole will benefit by the cooperation of all its parts, while the individual will find in his associations the advantages of the help, the sympathy, and the fellowship of his neighbors.
I am using the term much more broadly than either Hanifan or the World Bank, to mean the constellation not just of social relationships that affect the economy but also the full range of legal, institutional, and economic relationships that can make an economy more or less productive. It is this complex mix of institutions, I would argue, and which I call social capital, that drives advanced economic growth, and not simply additional labor or capital.
This is not to say that labor and capital inputs are not part of growth. Of course they are. I am simply arguing that an economy requires both the inputs and the ability efficiently to absorb and exploit those inputs for it to grow. If its level of inputs is too low, as Chinese infrastructure almost certainly was twenty years ago, then the easiest way to achieve growth is to increase the necessary inputs – airports, bridges, roads, factories, office space, and so on in the case of China twenty years ago.
But if social capital is too low or, to put it another way, if capital stock exceeds the ability of an economy to absorb it efficiently, then the best way to achieve growth may be to focus not on increasing inputs, which may end up being wasted and so may actually reduce wealth, but in improving the ability of the economy to absorb the existing inputs. The point is not whether we can easily define these institutions but rather whether there is evidence that they matter to economic growth.
In a sense what I mean by social capital is what William Easterly and Ross Levine might call “something else”. “The central problem in understanding economic development and growth,” they say, “is not to understand the process by which an economy raises its savings rate and increases the rate of physical capital accumulation.”
Although many development practitioners and researchers continue to target capital accumulation as the driving force in economic growth, this paper presents evidence regarding the sources of economic growth, the patterns of economic growth, the patterns of factor flows, and the impact of national policies on economic growth that suggest that “something else” besides capital accumulation is critical for understanding differences in economic growth and income across countries.
The paper does not argue that factor accumulation is unimportant in general, nor do we deny that factor accumulation is critically important for some countries at specific junctures. The paper’s more limited point is that when comparing growth experiences across many countries, “something else” – besides factor accumulation – plays a prominent role in explaining differences in economic performance.
They go on to argue in their paper that
While specific countries at specific points in their development processes fit different models of growth, the big picture emerging from cross-country growth comparisons is the simple observation that creating the incentives for productive factor accumulation is more important for growth than factor accumulation per se.
It is these various institutional and social “incentives” for productive factor accumulation that I am calling “social capital”. Daron Acemoglu and James Robinson, the authors of Why Nations Fail, believe that there is very strong evidence in favor of the importance of social (i.e. economic and political) institutions and on their blog they write:
Our theory isn’t that political institutions directly determine economic prosperity. Rather, we claim that economic institutions determine economic prosperity, and explain why the link is between inclusive economic institutions and sustained economic growth — not necessarily short-run economic growth. We then argue that inclusive economic institutions can only survive in the long run if they are supported by inclusive political institutions. On the way, we provide explanations and examples for why for extended periods of time economic institutions with fairly important inclusive elements can coexist with extractive political institutions.
This is all brought together under our discussion of extractive growth under the auspices of extractive political institutions. This is either because, as in the Soviet Union or the Caribbean plantation economies, extractive political and economic institutions can reallocate resources in a way that brings economic growth — typically when the elite expects to be the main beneficiary from such growth. Or because as in South Korea or Taiwan, extractive political institutions permit a certain degree of inclusivity to develop. In both cases the logic is clear: the elite, all else equal, would prefer more output, more revenue and more growth. It is the fear of creative destruction that often prevents it from adopting economic arrangements favoring growth or even blocking new technologies. When it feels secure or deems that it doesn’t have any other option, the elite will encourage economic growth.
Clear rules
To me one of the most obvious pieces of evidence that it takes a lot more than increases in capital stock to achieve sustainable wealth is the experience of previously advanced economies that have been laid low by war. It is noteworthy that – excluding trading entrepôts like Hong Kong and Singapore or small, commodity-rich entities like Kuwait or 18th Century Haiti – very few poor and undeveloped economies have made the transition from poor to rich. The exceptions may be South Korea and Taiwan, both under very favorable circumstances during the Cold War. “Poor” but advanced countries, however, like Belgium and Germany after WW1, or Germany and Japan after WW2, saw their GDP per capital soar after devastating wars as they made the transition from newly poor to rich with relative ease.
The reason, it seems to me, is that although war may have destroyed physical capital in these countries, because it did not destroy social capital these countries were able sustainably to increase investment at a rapid pace after the war and see their per capita incomes soar permanently. Why is this so easy for advanced economies made poor by physical destruction of their capital base but so hard for developing economies?
The most plausible reason I can think of is that the advanced economies already had in place the institutions that allowed them to exploit investment fully, and so once they were able to increase capital stock, they quickly became rich again. This argument is reinforced, I think, by the well-known fact that most cross-border capital flows (over 90%, I think) are to rich countries, not to poor ones. This wouldn’t make sense at all if rich countries didn’t have a greater ability to absorb new capital efficiently and profitably than poor countries. If what mattered on the other hand was distance from the capital frontier, the further a country was from that frontier, the more profitable it would be to invest there, and so more capital would flow to poor countries rather than to rich countries. The opposite is true.
So what kinds of institutions might matter? Economies with clear and enforceable legal systems, to take one factor, tend to have higher levels of social capital because it is much easier for entrepreneurs to take advantage of conditions and infrastructure to build profitable businesses. Without a clear legal framework, business opportunities tend to be monopolized by entities that have the political clout to take advantage of the legal system, and not only is it not obvious that more powerful entities are more economically efficient, but in fact the opposite may be true – these are what Acemoglu and Robinson call “extractive” elites.
Very powerful entities tend to support the status quo, to undermine disruptive new technologies and business organizations, and otherwise often to favor the less efficient (themselves) over the more efficient. As part of social capital, clear ownership rules for land and other assets matter. Here are Acemoglu and Robinson on the subject:
Key to our argument in Why Nations Fail is the idea that elites, when sufficiently political powerful, will often support economic institutions and policies inimical to sustained economic growth. Sometimes they will block new technologies; sometimes they will create a non-level playing field preventing the rest of society from realizing their economic potential; sometimes they will simply violate others’ rights destroying investment and innovation incentives.
I would also argue that the institutional framework around the writing down of overvalued assets, and the liquidation process itself, is an important part of how efficiently an economy is able to absorb the benefits of capital stock. A formalized bankruptcy process that takes assets away from inefficient users, writes them down to a fair market value, and reintroduces them into the economy, creates a much more efficient economic system than one in which bad loans are not recognized, effectively bankrupt companies are allowed to continue in value-destroying activity, and the use of assets is not systematically transferred from the less efficient to the more efficient user.
In fact an efficient and relatively rapid bankruptcy process is, I would argue, of fundamental importance to the ability of an economy to exploit capital stock efficiently. Even very advanced countries without a formal process to transfer resources quickly can have a hard time exploiting its capital and labor factors, especially after a period in which a great deal of labor and capital were directed into unproductive uses. I think Japan’s twenty years of nearly zero growth may be explained in part by the very slow process in Japan by which resources were transferred from “losers” to “winners” after the investment orgy of the 1980s.
In fact more generally the sophistication and flexibility of financial systems are an important component of social capital because these determine the capital allocation process. Financial system capable of taking risk and supporting new and disruptive technologies or organization structures tend to result in a greater ability by a society to absorb capital. In that light, and as an aside, I would suggest that the country that sees the most change in the list of its largest companies from decade to decade – because this list creates a simple way of determining how quickly companies can be created and destroyed as their level of efficiency changes – is probably better at absorbing capital than a country whose largest companies are the same decade after decade.
Crony capitalism
These are probably the most important components of social capital, but I would include a lot more in my definition than just the relative strength of extractive elites and well-functioning legal, ownership, financial and bankruptcy frameworks. The extent of corruption, nepotism, or the importance of what the Chinese call “guanxi”, erodes social capital because in a society in which corruption or guanxi is more important, the winners in business competition are, in the aggregate, not the most efficient but rather the most connected, and in fact they are often the least efficient for the reasons already noted (they profit not from improving efficiency but rather from improving their access to transfers of resources).
The extent of monopoly power or the extent of significant subsidies to favored sectors and companies also limits social capital for the same reasons. Monopolists and the subsidized tend to be more interested in protecting and extending their power to expropriate national resources than in accelerating efficiency – the rewards for the former far exceed the rewards for the latter which, in many cases, may even be negative.
There are many social and political reasons to be concerned about the various characteristics of what is often called crony capitalism – corruption, guanxi, nepotism, limiting access to credit to powerful insiders, protecting national champions from more efficient competitors, etc. – but the important point in our context is that because they limit the ability of economic agents to take advantage of the benefits of capital stock by heavily tilting rewards towards agents that can play the political game better rather than towards those that can play the economic game better, they undermine the economy’s ability to absorb high levels of investment. The purpose of investment, in countries with high levels of crony capitalism, is often not to maximize productivity but rather to reward political access, and so agents that can exploit capital stock more efficiently are undermined in their ability to do so.
This is not to say that crony capitalism cannot deliver growth. Clearly it can. But I would argue that it can deliver growth only when the interests of the elite are correctly lined up with growth. So, for example, I would argue that in the early stages of reform, especially in countries that have suffered many years of terrible economies and weak investment, crony capitalism can be consistent with high levels of growth because the kinds of programs that lead to growth – mostly massive investment programs in countries in which capital stock is excessively low – benefit the elites directly. Once there is a divergence in interests, however, crony capitalism can become inconsistent with rapid growth.
Beyond these measures, which are basically measures of the ability of elites to distort participation in the economy, I would argue that educational levels also matter. More educated societies and, perhaps even more so, societies in which there is limited ability by the elite to block participation by the non-elite, tend to be better at exploiting economic opportunities because they benefit from economies of scale in accessing talent and ideas.
Social trust matters too, as this can sharply reduce frictional costs. It is not an accident, I would argue, that many of the wealthy industrialists in Britain during the first industrial revolution were Quakers. Because their religion forced them to be honest at all times, even in business dealings, they were generally associated with trust and were eager targets for business relationships, which lowered their frictional costs substantially.
The relative lack of bureaucracy matters too, partly because more bureaucratic systems are more open to corruption and to interference by powerful players, and partly because more bureaucratic systems, by imposing higher costs on starting new businesses, tend to favor the richer and more powerful, who have the ability to pay these frictional costs, at the expense of the poorer and less powerful. Even cultural attitudes to business can matter. Recently I read the following about the how doing business in the US is different from elsewhere:
Having essentially run the same company from both countries, Mr Kelleher has found the most important difference to be the attitude. “From the moment I arrived, I knew it to be different. People are more open to hearing about your business idea; they won’t make themselves hard to reach, or dismiss proposals or ideas because they haven’t come through the right channels” he says.
I can go on but I think my point is relatively clear. The social capital model suggests that there is some amount of investment that is wealth enhancing for any economy, depending on its ability to absorb and exploit the benefits of that investment. Beyond this amount, however, it can be difficult for an economy that scores lower in social capital to take full advantage of investment, in which case the additional productivity generated by higher levels of investment are low, and are more likely to be exceeded by the cost of the investment.
Raising the amount of investment, in this case, is wealth enhancing up to some point, beyond which it can become wealth destroying. At that point it is far more efficient to improve the institutional ability to absorb investment than to increase investment itself (although, because this is intimately caught up in social and political power structures, it can be brutally difficult to do so).
The “Doing Business” report
One attempt at measuring social capital as I define it is the World Bank’s “Doing Business Report”, which tries to score countries according to the ease with which businesses can operate. In the latest report China ranks in the middle – number 91 out of the 185 countries ranked, just below Barbados, Uruguay and Jamaica and just above the Solomon Islands, Guatemala and Zambia. In the report China ranks differently according to various sub-rankings, some of which I think are more important (starting a business, protecting investors, resolving insolvency) and some less (paying taxes, trading across borders).
Social capital is a tough measure to score, and I do not want to suggest that the World Bank rankings are a good or even adequate measure. They are merely a rough proxy, and some analysts, for example those associated with labor unions, argue that because labor regulations have a negative impact on the World Bank ranking, these rankings are at least in some cases driven more by ideology than by objective requirements. China itself is opposed to these rankings and is apparently trying to get the World Bank to discontinue them. According to a recent Financial Times article:
China is leading an effort to water down the World Bank’s most popular research report in a test of the development institution’s new president, Jim Yong Kim. According to people close to the matter, China wants to eliminate the ranking of countries in the Doing Business report, which compares business regulations – such as the difficulty of starting a company – in 185 different nations.
…Pushed by China and other critics – including trade unions, international aid charities and some other developing countries – last year Mr Kim set up an independent review of the report chaired by Trevor Manuel, South Africa’s planning minister. But a number of people involved in the process complain that Mr Manuel has appointed two longstanding critics of the report as advisers to the panel, raising doubts about its impartiality.
I do not want to get into the debate about the usefulness of this particular set of rankings because it is not relevant to whether or not there is such a thing as a level of social capital that constrains the ability of a country to take advantage of investment. What is more, in large countries like China or the US, there may be significant variations in social capital even within a country. The key point is that this model presents a very different argument about what an appropriate level of investment is for any country.
I am not going to insist that one model is obviously better than the other at describing reality. This is clearly a subject of reasonable debate and there is nothing approaching unanimity on the subject. My main point here is just to suggest that there are implicitly two very different ways of looking at the world, and they have very different implications for continued investment in China. I of course believe the social capital model is the appropriate one, and I will try to explain why, but I don’t want to suggest that mine is the only reasonable and consistent point of view.
Where this disagreement about what is an optimal level of capital stock comes out most clearly is in the debate about China’s decision aggressively to pursue investment growth in the poorer inland provinces. The inland provinces in China are generally much poorer than the coastal provinces and much more backward economically (and in fact this has been true for centuries). If you believe in the capital frontier constraint, then the policy implications are obvious beyond much dispute: Beijing must encourage as much investment as possible in the poor inland provinces, even to the extent of diverting investment from the richer coastal areas.
If you believe in the social capital constraint, the implications are more complex. It makes sense, in this case, to encourage some investment into the inland regions, but only up to a point. Because these poorer inland regions are almost certainly much less able efficiently to absorb the benefits of investment and capital stock, we are also likely to reach the productive limits of investment much earlier. This means we are also likely to waste capital at much lower levels of capital stock per worker.
So which model does a better job of describing reality in China today? The capital frontier constraint implies that because all of mainland China operates more or less under a single legal and political system, every part of China is as likely to benefit from any given level of capital stock per worker as any other part. Very poor Guizhou, in other words, is just as able to exploit Shanghai levels of investment efficiently as comparatively rich and advanced Shanghai. The closer we can bring capital stock per worker in Guizhou to Shanghai levels, according to this way of thinking, the better off China is and the less income inequality there is likely to be.
The social capital constraint suggests that Guizhou should optimally have much less capital stock per worker than Shanghai because it is less able to take advantage for a variety of reasons having to do with local institutions, political and social conditions, and so on. It implies that investment in the poorer parts of China would have been lower absent a government strategy to raise investment levels in the poor regions.
Which way should investment go in China? If you believe in the capital frontier constraint, then clearly we are better off diverting resources from Shanghai to Guizhou. Not only will this reduce inequality within China, but it will increase China’s overall wealth because the total returns to China, including hard-to-record externalities, will be much higher for investment inGuizhou than for investments in Shanghai.
Of course if you believe in the social capital constraint, then you would not want to divert resources from Shanghai to Guizhou. You would in fact want to do the opposite. Diverting resources from Guizhou to Shanghai might increase income inequality but it will make China richer overall. To address the inequality, this model would suggest, either we should keep investing in Shanghai and simply transfer income from Shanghai to Guizhou, or we should work especially hard to reform the social, political, financial and economic institutions in Guizhou so that it can grow not so much by increasing investment but rather by increasing its ability to transform existing investment into more productive uses.
The IMF paper with which I started this newsletter, and other similar analyses, comes out implicitly quite strongly in favor of the social capital constraint. Here is what it says:
This paper reviews trends in investment at the provincial level in China and finds evidence that some types of investment is becoming excessive, especially in inland regions. In these regions, investment Granger-causes consumption on average. By contrast, in coastal provinces, private consumption has on average become more self-sustaining and less dependent on investment. Moreover, in relative terms, investment is more closely associated with higher household income in coastal provinces while in inland provinces it seems to influence corporate income more. This suggests that the share of investment contributing to the productive capital stock in coastal areas is larger than in inland provinces. If this trend is continued, valuable resources are likely to be wasted.
If investment in the inland regions is indeed less productive than investment in the coastal regions, it is hard to justify the capital frontier constraint model. Since Guizhou is much further from the frontier than is Shanghai, investment in Guizhou, according to the model, should in the aggregate be more productive than investment in Shanghai. The IMF says it isn’t. Of course the social capital constraint model would have no problem with the IMF’s findings.
I leave it to my readers to decide which model they think is a better description of reality. One way of thinking about this is to consider why historically some countries that have “gone west” and invested in poorer regions were successful (the US in the 19th Century, for example) and some were not (Brazil in the 1950-80 period and the USSR in the 1930-1960 period, for example). One possible explanation may be that in the successful cases, higher investment followed increases in social capital, and in the unsuccessful ones they preceded them.
But whichever model one finds more congenial, I would insist that whenever anyone discusses the appropriate level of investment in China, he is implicitly using one model or the other to value investment. He should however do so explicitly, since the implications are so radically different.
The capital frontier constraint model says we should continue to increase investment in China as quickly as we can and we should especially direct this increase to the poorest and most backward parts of China. The social capital constraint model says we should slow overall investment growth as much as possible, especially in the poorer inland regions, because they result in a huge cost to China’s economic wealth – although the resulting losses are as of yet unrecognized because capital stock is not being written down to its “correct” value and losses are simply buried in the debt which is continuously rolled forward.
The social capital model also suggests that the most powerful way of increasing Chinese wealth in the next few years is to implement the political, economic, financial and social reforms needed to allow China to increase its ability to absorb and exploit its already too-high level of capital stock. These are the kinds of reforms Beijing may in fact be discussing.
Can convergence be imposed?
Before discussing Beijing’s attitude, I want to digress a little. One sell-side analyst, traditionally a lot more bullish than I am about medium term growth prospects for China, and a lot less concerned about rising debt, recently made a proposal that plays up the very big differences between the two models. According to an article in People’s Daily, there is indeed scope for rapid catch up among the poorest provinces:
China’s regional disparity could bring vast potential for economic growth, a top economist from Standard Chartered Bank said Wednesday. “In the next five years, China’s economy will maintain a growth rate of 7 to 8 percent thanks to the growth opportunities offered by the regional disparity,” said Stephen Green, Standard Chartered’s chief economist for China. China’s economic growth ticked down to 7.7 percent in the first quarter, falling short of market expectations and suggesting a tepid rebound for the economy.
Green said those worried about China’s economic slowdown are overreacting, as the differences in economic development between China’s regions could provide a strong engine for economic growth. Green used data acquired through the bank’s research to categorize Chinese cities into three tiers according to their GDP per capita. Beijing, Shanghai and Tianjin are first-tier cities, with an annual GDP per capita of nearly 80,000 yuan (about 12,903 U.S. dollars), he said.
He described second- and third-tier cities as those with an annual GDP per capita of 50,000 yuan and less than 30,000 yuan, respectively. Green said the research indicates that if second-tier cities reach first-tier GDP levels, the economy will maintain an annual growth rate of at least 7 percent for the next five years.
Green’s points are that there is a large difference between the richer and poorer provinces, and that the same set of policies that drove up income levels in the richer provinces can, presumably, be applied to the poorer provinces in the same way and for the same effect as their income levels converge with those of the richer provinces. This convergence alone will guarantee that China will grow by 7-8% for many more years.
Green may be right, but I think it is worth pointing out under what conditions he would be right and under what conditions he would be wrong. If the difference in wealth between the richer and poorer provinces is indeed caused mainly by the difference in capital stock per worker, and if otherwise there are no significant institutional differences between the two that prevent the poorer regions from catching up, then it is probably true that the policies that worked in the coastal regions can be successfully applied to the inland regions with much the same economic impact. Beijing can turn all of China into Guangdong and Zhejiang.
But if the poorer regions are poorer not because they lack investment but rather because they are institutionally more “backward” and so lack the ability to absorb investment efficiently, then it is not so clear that their income levels can converge with those of the richer regions within China except under conditions of significant social and political change. As an aside I am struck by the fact that the disparity between richer and poorer regions in China has existed in very much the same way for many centuries, and wonder if this isn’t due at least in part to dramatic differences in what I am calling social capital.
If social capital is indeed much lower in the poor regions than in the rich, then it isn’t at clear to me that we can expect much further convergence except at a huge cost to China’s economy overall. Resources, in other words, can simply be transferred wholesale from the rich to the poor regions, so that convergence is achieved not by speeding up growth in the poor areas but rather by reducing it in the rich. At any rate, depending on which model is correct, we will see over the next five years if there is indeed significant convergence and at what cost.
What does Beijing believe?
It is pretty obvious if you consider China’s track record and the statement of government officials that for many years Beijing has implicitly believed in the capital frontier model (although the kinds of reforms pushed in the 1980s by Deng Xiaoping, who seemed to understand intuitively the importance of institutional constraints, were more in the form of institutional reforms than increases in investment). Since the early 1990s the solution to every social or economic problem or crisis has been to increase investment, and in recent years there has been an especially strong push to increase investment in the poorer regions. In my November 7, 2012, piece for Foreign Policy I put it this way:
China’s spectacular growth over the past 30 years, like that of the USSR and Brazil before it, was made possible mainly by the ability of policymakers to control credit and unleash waves of investment when needed. This allowed Beijing to keep growth rates high regardless of the circumstances and no matter how the leadership managed domestic problems.
It was able to avoid a surge in unemployment when it restructured the hugely inefficient state-owned industries in the 1990s by sharply increasing infrastructure investment. Investment spending helped it smooth over the social dislocations caused by its rigid and antiquated political structure. It eased political conflicts and factional fighting by directing billions of dollars into pet projects, much of which the politically connected have since siphoned off. China grew vigorously through the Asian crisis of 1997, the Chinese banking crisis a few years later, and, the collapse of the global economy in 2007-08. In each case, unrestricted access to savings allowed China to power growth by pouring cash into the projects of its choice.
The only way to justify this astonishing increase in investment in the medium term is to argue that even though Chinese investment levels are extraordinarily high (comparing them not to the US or Japan but rather to other developing countries like Brazil, whose per capita income and worker productivity levels are low but still higher than those of China), they are so far from the optimal level determined by the capital frontier that China is always made richer in the aggregate because of the increase in investment.
But attitudes in Beijing may be changing. Consider Premier Li’s statements last week, which some people are claiming (a little prematurely, perhaps) represents a major shift in policy. According to an article in last week’s Xinhua:
China will allow the market to play a bigger role in economic innovation, Premier Li Keqiang said on Monday at a State Council meeting on the reform of government. As more power is delegated to lower levels, the government should shift its focus to three areas — improving the policy environment for development, providing high-quality public service, and upholding social fairness and justice, he said.
There should be a better balance between the government and the market, and between the government and society, the premier said during a videophone conference to launch a new round in transforming the functions of the cabinet and its branch agencies. The reform of government functions is a major effort to help the nation maintain growth, control inflation, reduce risks, and enjoy healthy and sustainable economic development.
According to the premier, the reform will minimize government approval needed to authorize general investment projects and general qualification certificates. It will contribute to fair competition in the market, and to corporate-level efforts to upgrade management and technology. It will ultimately expand employment opportunities, through speeding up the registration of industrial and commercial enterprises, and give more latitude to small and medium-sized enterprises and to service industries. It will also inject greater vitality to development initiatives at local level.
Li stressed that more effective administration should be in place on matters of deep public concern, including food safety alarms, the environment and work safety. Justice should be meted out in a timely manner when the law has been broken in such cases. More should be done to cut redundant capacity in industries that suffer such problems, he said.
The South China Morning Post has him adding “If there in an over-reliance on government-led and policy driven measures to stimulate growth, not only is this unsustainable, it would even create new problems and risks.” Li, in other words, is not suggesting that China should increase investment. On the contrary he wants to slow investment growth. He is instead implicitly suggesting that China should take steps to change the way in which it absorbs investment.
And it is not just Premier Li. The South China Morning Post has an article claiming that President Xi is also very much on board with the need to change the underlying growth model:
Chinese President Xi Jinping has taken charge of drawing up ambitious reform plans to revitalise the economy, sources close to the government said, shunning policy stimulus for fear it could worsen local government debt and inflate property prices. A consensus had been reached among top leaders that reforms would be the only way to put the world’s second-largest economy on a more sustainable footing, said the sources, who are familiar with the plans and Xi’s involvement.
China’s economic growth is at its weakest in 13 years, although still the envy of any major economy. Xi will present the reforms at a key meeting of the ruling Communist Party later this year that will set the agenda for the next decade, signalling his seriousness to see breakthroughs, the sources told Reuters. Some of the sources cautioned that the reforms could face resistance from vested interests, especially state firms.
Broadly, the measures would liberalise interest rates and overhaul the fiscal system for local governments to ensure they had a steady stream of tax revenues rather than relying on volatile land sales to raise funds. The reforms would also free up China’s rigid residence registration, or hukou, system that precludes people from access to basic welfare services outside their official residence area, the sources said.
Notice the direction of these polices. Rather than resolve the problem of slowing growth simply by increasing investment – which is what was always done in the past, and which would “work” again if the capital frontier model is the valid one from which to consider the impact of higher investment – Beijing seems to be going out of its way to preclude this way of dealing with slowing growth. Instead it will try to change other factors, factors that I would argue affect social capital by determining China’s ability to absorb existing investment levels.
The market seems to agree with this new approach. According to an article in Xinhua:
Chinese shares jumped on Friday after the State Council announced fewer economic and investment activities would be subject to central authorities’ approval, extending the rally to three consecutive trading days.
A major change
I believe that in the past two to three years there has been a significant and welcome shift in Beijing’s attitude towards maintaining growth, and that this shift implicitly represents a shift from the capital frontier model of optimal investment levels to the social capital model. Keynes famously reminded us that “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist,” and I would argue that in this sense models do matter. The economic model that we implicitly use to justify policy can result in hugely different policies with hugely different outcomes.
The surge in debt of the past few years has created tremendous concern, but I would argue that this concern would not be justified if investment levels in China were still too low. In that case any credit-fueled increase in investment would likely have resulted in a net improvement in China’s debt servicing capacity, in which case, with government debt at well below 25% of GDP, rising debt would not be a concern.
But if investment is being misallocated, if investment levels are higher than China’s ability to absorb and exploit capital stock, then it should not be surprising at all that debt capacity is becoming a problem. In fact, as I have argued for many years, this is simply an automatic consequence of additional investment in the investment-driven growth model. Debt, in this case, must be rising faster than debt servicing capacity, in which case Beijing’s true debt level is not the nominal debt level but rather the nominal debt level plus estimates of contingent liabilities likely to rise as a consequence of wasted investment.
Let me not overstate my case. The fact that China’s debt is rising much more quickly than China’s debt servicing capacity is consistent with my implicit model – which claims that the optimal amount of capital stock in China is a function of China’s relatively low level of social capital, and that Chinese investment has far exceeded its optimal level – but it doesn’t prove it. The fact that debt may be rising faster than debt servicing capacity is not necessarily inconsistent with the capital frontier model. After all, as the US amply proved in the 19th Century, even countries in which additional investment is economically justified can still run into debt problems and even crises.
Neither model has been proved. China may have too much capital stock, or it might not have enough, in which the current debt worries may simply reflect bubble conditions in the credit market. The policy implications of the two models, however, could not be more different.
If you believe that China can and should continue to increase investment until capital stock per capita approaches US or Japanese levels, then clearly China should continue to invest, and it should invest more in the poorer regions than in the richer ones. Everyone, even among the remaining China bulls, agrees now that Beijing must change some of its credit allocation conditions, but the old growth model will continue to be the right one according to the capital frontier model. There is no need to change the capital allocation process significantly and there is no need to liberalize interest rates.
What is more, according to this model, China’s very low consumption share of GDP mainly reflects the extraordinary growth in GDP. As high investment levels are maintained, it will simply be a question of time, and probably a short time at that, before the household income share of GDP, and with it the household consumption share, begins to surge. GDP growth can remain at 7-10% for at least another decade.
If you believe, however, that China’s very low level of social capital has long ago made its investment strategy obsolete, the consequences and implications are radically different. It suggests that China has overinvested beyond its capacity to utilize these investments economically, and so there are hidden losses on bank balance sheets created by the failure to write down physical capital to its true value. In this case Chinese growth cannot help but drop significantly as these losses are finally recognized and as investment levels are sharply curtailed.
What Beijing must do, in this case, is to ignore GDP growth rates and focus on household income growth rates, which anyway are what should really matter. Rather than continue to increase investment in manufacturing capacity, infrastructure, and real estate, Beijing should find ways to curtail investment growth sharply and to allocate what capital is invested to small and medium enterprises, to service industries, and to the agricultural sector, all of which are sectors whose growth at the expense of the current beneficiaries of high investment growth (SOEs, local and municipal governments, national champions, etc.) are likely to imply improvement in China’s social capital. Doing this will also require significant changes in the legal, social, financial and political institutions that constrain China’s ability to absorb capital efficiently.
What to do?
The real challenges for China, if you believe in the social capital constraint, are not about maintaining high rates of growth in the short term but rather of raising the levels of social capital in China. This is much more difficult and much more likely to be virulently opposed by the elites whose ability to constrain economic efficiency is precisely at the heart of their wealth – which consists of appropriating resources rather than creating resources – and of their power. It is, however, the only real way to sustain growth over the medium and long terms.
In fact, the social capital model suggests that the famous “middle income trap” might just be a social capital trap. Countries can force up economic growth rates (actual the growth rate of economic activity) simply by mobilizing savings and forcing up investment rates, but ultimately their inability to absorb continuously the higher levels of capital mean that they cannot push real wealth per capita beyond some fairly hard constraint represented by their institutional inability to absorb investment.
This hard constraint, in other words, is the “middle income trap”. Reforming social, political, financial and economic institutions in ways that raise social capital quickly would be, in this view, the only sure way to avoid the dreaded middle-income trap. The two sets of policy implications, as I see them, are the following:
The implications of the capital frontier constraint:
- Beijing should not abandon the investment-driven growth strategy, but it should adjust the credit allocation process to slow the growth in “bad” debt, which is a separate issue and not fundamental to the economy. The seemingly unsustainable rise in debt, in other words, is not a systemic problem reflecting a combination of the need to keep investment high with a systemic inability to invest productively. It is simply an accidental result of distorted incentive structures within the financial system and so can be administratively resolved.
- China’s economic growth rate might slow a little, but this is simply the consequence of China’s having gotten much closer to the capital frontier, in which case a lower return on investment should be accepted. Chinese growth will stay in the 7-10% region for many years.
The implications of the social capital constraint:
- China has invested far more than its ability to absorb the investment, which means that for many years GDP growth has been overstated and that this overstatement is hidden in the form of unrecognized bad debt. Rising bad debt is, in other words, a systemic problem and cannot be resolved within the current system. Beijing must constrain investment growth sharply, redirect a much lower level of investment into areas that improve social capital (SMEs, agriculture, services), and engage in significant social, political, economic and financial reforms to force up China’s ability to absorb additional investment.
- Not only will China’s real GDP growth drop as China shifts towards a different growth engine, but it will drop even more as China is forced to recognize the hidden losses buried in its debt levels.
Before closing, I want to mention a seminal 2002 paper by Daron Acemoglu and James Robinson (“Economic Backwardness in Political Perspective”). The paper is important not just because of its explanation of development but also because of its attempt to understand the political implications of technological and institutional changes that promote development. The authors conclude:
In this paper, we constructed a simple model where political elites may block technological and institutional development, because of a “political replacement effect”. Innovations often erode political elites’ incumbency advantage, increasing the likelihood that they will be replaced. Fearing replacement, political elites are unwilling to initiate economic and institutional change. We show that elites are unlikely to block developments when there is a high degree of political competition, or when they are highly entrenched. It is only when political competition is limited and also the elites’ power is threatened that they will block development. We also show that such blocking is more likely to arise when political stakes are higher, and in the absence of external threats.
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michael, what a formidable analysis. i sense a conclusion justified. if the conclusion is based upon what works in the west it might miss that china’s destination is not the western model. so its path will vary. i doubt it wants to build a consumer demand dominated economy. perhaps a consumer satisfied economy but not a stimulated and debt based demand. so…. and it begs the question – what is socialism with chinese characteristics? as we managed a stupendous financial crisis we should be aware that problems are inevitable but very valuable contribution
Thanks, Stephen. I assume most Chinese want what most Westerners want: a decent life and a chance to watch their kids become more successful than they were. The government may not want a consumer-dominated economy as much as Chinese people do, but they do want an innovation-based economy, and there is a lot of evidence that economies driven by consumption, not investment, tend to be much more flexible and innovative. In case you’re interested Josh Feola and I have a regular column in the New York Observer and we have written recently about innovation in China.
I have a request Prof. Pettis. Could you point me to some of the evidence that is there of a consumer dominated economy being more flexible and innovative than an investment driven economy. Within Asia, that would mean that India/Indonesia/Philippines have a more healthy model than China? But it does seem to contradict conventional wisdom because at the end of the day China has been more successful at sustaining very high growth rates for a longer period of time. In any case, why should consumption dominated economy be more innovative? If innovation is helped by investments in human capital, then an investment driven economy should be doing better?
Mitra
Are you assuming a relation between high growth rates and innovation, otherwise not sure why you juxtapose China against India/Phillipines/Etc along those lines. Innovation is innovation; perhaps to be found more in productivity than mere growth, which would be than returns to capital or labor, with China’s increasing debt burden, relative to growth in GDP, in can be assumed that innovation isn’t optimized, even optimizable in the model.
Then innovation, it would be assumed, at least intutitively, to be subject to need to disrupt, there are incremental innovations, which can be little more than product diversification, adding features and attributes, but, then radical disruptive innovation, that disrupts industrries, with a space in between on a spectrum. As consumers have an increasingly substantial set of choices from among which to choose a product to satisfy their desires and needs, I should imagine that companies need become more inventive at seeking to differentiate themselves, or disruptive in altering a space, when the path is possible, or a mistake in the disscovery process enables a new perspective, new methods. That these innovations create new ways to do something more efficiently, or highlight a solution to a problem that few imagined solvable, or even understand that a problem existed. Certainly, increasing debt loads realtive to production of GDp growth would not highlight innoovation.
I have not read Michael’s piece, and and more he might highlight the growing IT space in China, or the many areas in which growth in market based mechanisms have created masses of innovation previously unknown in Chinese society. But government highlighting of an industry, Solar, in which the government then directs resources toward, and such swamps global production, using older modalities of production, do not yield innovation. It yielded bankruptcy. With that being sa, the vast supply of cheap prices for solar, globally, do to over-capacity in supply, has led to a slew of innovations, external to China, retail solar sales, tech/internet based design and sales methods, evolution’s in installation practices, and further, which, each have had a greater impact, in making the installation of solar more affordable, then the production of a mass supply of cheap commodities (solar panels). Maybe that highlights the issue a bit.
Excellent analysis, both in economics and logic, as well as social psychology. I am wondering how many so-called political elites could have time deliberating these problems and have a passion devoting himself to the future of China and Chinese. Most political elites in power are in their 50s with their minds still partly in planned economy era. It takes decades and at least two generations to finish the reforms mentioned in this article. Keep in mind that success is not the mother of success. Nothing is a guarantee of success for China but open-minded responsibility and action.
By the way, as a Chinese, I really appreciate what Mr Pettis has been doing for China.
Thanks, WH. I am glad to say that I always found a lot of support among Chinese economists for my analysis, and especially at PKU.
President Xi, if I am reading the things right (and this is a big “if”), seems to recognize how badly he has been advised, but it is still very difficult politically for Beijing to do the things China needs because of political opposition from his enemies and from the so-called “vested interests”. I suppose he will try to keep the economy growing at current rates for another year or so in order to maximize his chances during next year’s Party Congress of getting his allies promoted, but at this point every wasted year makes the whole adjustment much more difficult. How closely do you follow the politics and how do you interpret last month’s People’s Daily interviews?
Thanks for your reply, Michael. In fact, I am neither an economist nor a China policy expert, but I do keep a close eye on China economy and politics.
I tend to believe that some kind of agreements have finally been reached at the policy making level according to the interview last month, in spite of conflict and disagreement involved unavoidably. Now most of the economists selected by Xi have work with pre premier Zhu Rongji, which I think is a good signal. However, it doesn’t make any sense due to the absence of execution.At the execution level, it still have a long way to go, which is more challenging and crucial. Reforms are always painful and dangerous for province executives. As I talked with my friends working in either local governments, central government or SOEs, I have a feeling that political elites are reluctant to do anything because they think do nothing is safer, let alone the interest conflict between local governments, SOEs and central government. Everything seems have to go as usual until Xi’s allies take over the local governments. After all, stability is always the toppest priority in China, a black swan will be a disaster nobody wants to see.
I think my ending quote, from Acemoglu and Robinson, is especially apposite:
“In this paper, we constructed a simple model where political elites may block technological and institutional development, because of a “political replacement effect.” Innovations often erode political elites’ incumbency advantage, increasing the likelihood that they will be replaced. Fearing replacement, political elites are unwilling to initiate economic and institutional change. We show that elites are unlikely to block developments when there is a high degree of political competition, or when they are highly entrenched. It is only when political competition is limited and also the elites’ power is threatened that they will block development. We also show that such blocking is more likely to arise when political stakes are higher, and in the absence of external threats.”
We are unlikely to see a high degree of political competition (basically a democracy) and so we will probably need a highly entrenched leadership to see much execution that can evade blocking by the elites.
There seems be a distinct change in Beijing’s policies in 2016, moving from the oft-mantra of “rebalancing to a consumer economy”, and towards the capital stock model of massive SOE investment to re-ignite growth. Did Xi loose his nerve?
The GDP targets were ridiculously lowered to 6.8% from 6.9%, and there is heavy-handed mangement of the Yuan. On the flip-side, there were state announcements of millions of layoffs in the steel, coal and oil sectors, showing some flexibility of letting inefficent investment get written off.
Which way is the Beijing boat tacking today? Hell-bent on stocking the capital infrastructure duing any soft-patch? or more subtly cutting removing support for SOE’s and letting private enterprise invest in technology and services. A delinquent loan book of 1.7% looks much more like the former.
I think there is a real debate, even a ferocious one, taking place away from public view. The rejection of the earlier “demand-side” reforms in favor of the new “supply-side” reforms during the December Economics Conference, or rather the manner in which the change was presented, followed by the two recent People’s Daily interviews about which there has been so much speculation, suggest to me that Xi and the people around him are extremely frustrated by the failed reforms of the past four years. This is only a guess, however, and the truth is that except for a few dozen people, none of whom have ever confided in me or in anyone I know, no one really knows what is happening in the inner circles of power, and we can only guess. I assume there is an enormous amount of frustration — and if there isn’t, I’d be even more worried.
Your discussion of social capital is very illuminating for US politics, too, revealing that the election now underway pits Bernie Sanders and Donald Trump as the agents of redistributing social capital, against Hillary Clinton, the representative of the status quo.
It likewise lends support to the arguments of Thomas Franks in his recent book “Listen, Liberal:” namely, that the programs of the Democratic administrations of Clinton and Obama were, in fact, designed with the goal of reducing US social capital through trade policy (NAFTA, TPP, TIPP); deregulation of the financial industry, refusal to redistribute capital through “cram-downs” in housing loans after the crash, and the extravagant complexity of Dodd-Frank; and, finally, in Obamacare, preserving a wasteful and dangerous medical establishment from reform.
Your thoughts?
I am always skeptical, Walt, about claims by partisans on either side in which nearly everything the other party does undermines everything good about the US. I really don’t think Clinton and Obama, however fiendish, had as their goal to reduce what I describe in this essay as “social capital”. Much political debate in the US is not terribly impressive, and I suspect that it doesn’t improve much until each side recognizes that the two parties differ not because of one loves and one hates the US but rather because each side has legitimate disagreements about what is best for Americans.
One issue we really have to address is immigration. There are many reasons to think that our immigration policies create wealth transfers that hurt the bottom rungs of the economy, and by locking in an underclass we undermine social capital, perhaps even significantly, but there are even more reasons to think that our immigration policies have also been among the greatest sources of the kind of social institutions that make the US the most astonishingly creative country in the world.
Love reading your entries. Keep up the good work.
What you call “social capital” others call “culture”. What development means in our current moment in history is the ability to have an “industrial system”, and that requires a culture that enables, by making it both possible and desirable. As to this culture, I agree emphatically with:
«encourages the creation of new businesses and penalizes less efficient businesses, perhaps at least in part by institutionalizing methods by which capital can quickly be transferred from less efficient to more efficient businesses,»
Because in my cynicism I think that looking at the big picture *bankruptcy* (what you seem to describe here) is the critical institution.
That seems to me the really important institution for material progress via running an “industrial system”, not markets, not the form of ownership, not even the political system. At least in the sense that without it nothing else matters.
Some reasons why I think bankruptcy is so critical:
* Most businesses, private or public, are badly run. This is sort of inevitable, so it is really important that at least the worst at least be closed down.
* Creditors are the best vested interest to empower in closing down the worst run, because in effect they provide the working capital, and they have the incentive to counter the influence of managers and workers of the worst run.
I agree with you, Blissex, that a relatively efficient bankruptcy process with low frictional costs is probably far more important to economic growth than most people realize, but I wouldn’t want to understate the importance of other aspects of an economy’s incentive structures, including legal, financial, and educational. We are all basically pretty good at doing things in ways that are aligned with our social incentives, and so I would want to include a lot more than efficient bankruptcy, which I see really as a kind of “negative” incentive, i.e. it reduces what otherwise might be strong disincentives for productive behavior.
Where I disagree with you is in identifying “social capital” with “culture”. Some aspects of culture are certainly among the many institutions that comprise what I mean by social capital, but culture is only a small part of social capital, and perhaps not even especially powerful. More generally I tend to think “cultural differences” are far less important than most of us all assume. This might seem a very surprising statement and contrary to the overwhelming consensus, a consensus reinforced by the fact that people who have spent a few years “abroad” usually seem to be the strongest believers in the fundamental importance of cultural differences. My take is different however, and I wonder if people who have grown up largely in one culture and then lived in another might not find it too easy, after they have been overwhelmed by how different their new lives are, to attribute differences to “culture” even when these might be the result simply of very different institutions. Of course if “culture” matters as much as they say, the value of their experiences abroad is so much higher, and this perhaps creates an incentive to overstate the importance of getting culture “right”, doesn’t it, or am I getting a little too convoluted?
At any rate my cultural background, as some readers of my blog know, is very different from that of most people. I have more or less grown up simultaneously in six different Asian, European, Latin American, US and North African cultures, made up of the different countries represented by my mother, my father, my place of birth, and the four countries in which I spent my life until I went to university (in New York). Not only does my multiculti background leave me far less impressed by the intractability of cultural differences than it seems to leave most other people, but I find that many of my friends who have similar multiculti backgrounds tend to agree with me.
This might just reflect a completely different set of distortions and incentives on our part, but I am impressed by the fact that while Indians, Chinese, Nigerians, French and people from any other country that sends immigrants to the US seem unable to create at home an economy with anywhere near the levels of technological, cultural or managerial innovation that characterize the US, once they arrive in the US they manage to do just as well as the Americans do. They continue to be subject to all or most of the the cultural characteristics of their home countries, but these characteristics no longer seem inhibitive when they are in the US, so why would we think they are the main constraint at home? The very successful high-tech Chinese entrepreneurs I have met, both those who live in the US and those who live in China, always describe the differences between the two countries mainly in terms of property laws, political connections, financing, and other such institutions, and almost never in terms of differences in the ways Americans and Chinese think.
This suggests to me that what drives US innovation is mainly a set of institutions that create fairly powerful appropriate incentives, and these incentives drive people with very different cultural backgrounds to accomplish more or less the same things in spite of their cultural differences. This isn’t to say that culture doesn’t matter. It certainly does, but only as part of a much larger and more powerful set of institutions. For example US culture, in my opinion, is more centripetal than centrifugal than other cultures, two of which consequences are that Americans who have interesting things to say seem on average far more willing and confident than non-Americans about expressing their thoughts, in the same way that Americans whose opinions come across as totally moronic have the same self-confidence and are altogether too willing to express themselves fulsomely. American culture seems to create a fatter-tailed distribution of opinions than do other cultures, and while Americans do have to cringe a little more often than, say, Europeans over the loudly-expressed opinions of some of their compatriots, it is a trade well worth making, I think, and certainly it must be positive for encouraging “innovative” behavior.
definitions might be important here – to a sociologist culture is simply ‘what people do, think and have’, and as that includes pretty much everything it’s hard to see how it could fail to have significant economic effects. maybe the everyday use of the term focuses much more on the ‘what people think’ bit, tho even then I think it still has to be highly significant. more specifically doesn’t there have to be a kind of positive feedback effect where increasing inclusivity of economic and political institutions make people begin to ‘think’ that this is ‘the way things are/should be done around here’, so that ideas of fairness and meritocracy become more firmly entrenched leading to greater inclusivity, and vice versa?, and presumably something like this happened in Western Europe/the English settler colonies during the early modern period? Why Nations Fail doesn’t really go down this route at all (their thesis seems to suggest that economic development was purely a contingent historical accident?) but I guess I’m trying to say that it’s hard to make a hard separation between institutions and the ‘beliefs and values’ which characterise each society – one will inevitably have a continual influence on the other. and a lot of the people from developing countries who recognise the importance of inclusive institutions might well have been strongly influenced by exposure to the relevant western ideas (which are very attractive and therefore easy to assimilate, I would suggest)
Jonathon
Have you read DeSoto’s “mystery of capital”?
A structural take, rather than values and beliefs focus, on the structural importance of institutions.
Whether or not easily able to be assimilated, structure, matters more than values and beliefs, where it really counts. People can believe, people can value, this requires little action outside the mind. Yet, when able to do, some will do, when the structure exists for them to do. Heck, they will even do, extra-judicially, if the structure doesn’t allow, so….
We have given far too much currency to values and beliefs since the 1850’s, 1930’s, 1950’s and 1960’s.
Perhaps unintentionally, the European Union has run over several decades now a large scale empirical trial about the validity of the capital frontier constraint model.
It has indeed implemented over several decades “structural transfers” from richer to poorer EU members to allow the latter to increase their capital stock and thus facilitate their “convergence” (that was the word used) with the former, in a clear belief that the capital frontier constraint was the correct model. Over several decades since their joining the EU, countries such as Spain, Portugal, Ireland, Greece and since more recently Eastern European members have received hundreds of billions of Euros of transfers.
Now that this real life experiment has run for long enough, I believe it is fair to conclude that, in most cases, the results have largely invalidated the capital frontier constraint model. Which, of course, doesn’t mean the EU has amended the policy. How would extractive political and bureaucratic elites thrive otherwise? Or may be the EU has in fact amended the policy in a certain way. Could it be at least partly because these significant “structural transfers” of a fiscal nature have been largely wasted that we have seen recently some rather intransigent stance on debt relief within the EU?
You may be right, DVD. You might be interested in an article by Acemoglu and Dell called “Productivity Differences Between and Within Countries”, which you can find at http://economics.mit.edu/files/9035
Thinking about deep provincial differences in wealth and development within China — and how absurd it was ever to think that we could count on a sharp narrowing of these differences to drive growth over the next decade — leads almost naturally to think about differences in other large countries, including the US, and the Acemoglu/Dell paper addresses some of these differences. The differences in China have persisted far too long — sometimes hundreds of years in China’s case — not to represent a pretty substantial and hard-to-overcome obstacle. In the US the narrowing of the regional differences in social capital, or the absorption capacity of investment, took over 150 years and probably began after WW1 and accelerated after WW2. I think it narrowed especially quickly after the 1960s, in part I suspect, because of the Civil Rights movement and the Great Society programs.
We probably should think about things like migration patterns and the experience of joining the army, the former perhaps because it causes states and regions to compete for a tax base once migration picked up enough to matter, and the latter because jpoining the army may be important in spreading cultural values. The rising power of federal law relative to state law during the 1930s and thereafter also probably mattered a great deal because this meant that residents of more backward regions could use federal law to enforce the same kind of treatment and institutions that drove the more advanced regions.
I am not sure, however, if Chinese migration will work the same way.The hukou system prevents real migration because when demand for labor is high, hukou restrictions are largely ignored, whereas I am willing to bet that as the economy slows, more and more local governments will deal with unemployment at home by enforcing the hukou. And while in China you have the same fight between local governments and the central government as you do in the US, and in almost any large and many small countries, even if Beijing under Xi Jinping is able substantially to centralize power, as I expect, local residents still cannot benefit the way they did in the US because they cannot appeal to national laws to overcome local laws and conventional practices, the way they can in countries in which rule of law takes precedence.
I haven’t thought too deeply about this until now, but at first blush it seems to me that this may be a very important difference between countries like China, in which appeals to the law can easily be ignored by the powerful and well-connected, and the US and Europe, where they cannot. Europe today, of course, is far more like pre-Civil War USA in the sense that state law and conventions are far more important than their national equivalents except in a few limited cases. This may be another reason why the European Union can only survive in the form of a “United States of Europe”: one of the most powerful mechanisms by which regional disparities are eroded is missing because residents in more backward regions cannot use national laws to accelerate the local adoption of practices that increase social capital.
Except for a few papers like the Acemoglu/Dell piece and an interesting but very short book by Krugman, which I read 10-15 years ago and which does not address these issues directly, I am not aware of any serious study done on how differing levels of social capital in a single large country have historically been narrowed in favor of the highest levels of social capital. It is, however, a truly fascinating topic I am starting to think, with much to teach us about development. I wonder if I can find someone about to start a PhD program in a political economy-related topic to consider it as his research focus.
“The differences in China have persisted far too long — sometimes hundreds of years in China’s case — not to represent a pretty substantial and hard-to-overcome obstacle. In the US the narrowing of the regional differences in social capital, or the absorption capacity of investment, took over 150 years and probably began after WW1 and accelerated after WW2.”
Yea, I do not agree. I suspect the 2016 Presidential election will be split along regional and demographic lines between groups and areas that’ve seen rising social capital and those that’ve seen social capital fall.
This year’s Presidential Election is going straight to the gutter. We’re seeing massive riots at rallies with potential riots at the DNC (and possibly even the RNC) and we’re in June! Things are gonna get real nasty by the time November rolls around.
The Republic is more decentralized now than it’s been in >100 years both financially and politically. The situation has become extremely politicized while you’ve seen a rise of grassroots populism on both sides.
How is the US more decentralized now than pre-Roosevelt times?
The financial system is the most decentralized since before FDR. That is correct. Actually, the financial system became radically centralized under Woodrow Wilson, his actions under the War Finance Corporations, forcing the financial system to lend to small farmers, and a whole bunch of other things. Hell, in the 40’s, 50’s, and probably 60’s as well, you had the Fed basically fixing prices for government bonds.
Usually when you wanna finance a war, you just issue bonds to banks. But Woodrow Wilson’s dumb ass thought that this was “wrong” because “evil banksters”. Therefore, he decided he’d do it in this weird ass way where the people who were issued the debts were the common man instead of in a bank where you could force large banks to hold high capital ratios and just shuffle capital around if things got somewhat screwy. So instead of writing down the debts after World War I while carving up Germany and keeping pressure on the USSR via financing liberal imperial puppets (the Whites) during the Russian Revolution, we had the idiotic bigot Woodrow Wilson run the country into a ditch because “equality”.
It seems to me that the question of how much capital is optimal can only be seen relative to the actual stage of development of a particular country / region and that the notion of an absolute capital frontier is not relevant in practice.
Indeed, investment requires savings, i.e. non-consumption. But people – and especially poor people – derive satisfaction from consumption and hence a certain level of dissatisfaction from not satisfying their needs. What satisfaction, therefore, would it bring to people of a poor country / region that they wait decades if not centuries to accumulate the same capital stock per capita of a developed country and in the meantime curtail the satisfaction of their consumption needs so that the proper amount of savings could be made available for investment purposes?
In that sense, capital accumulation can only be a gradual process in the context of other competing expenditures, of which noticeably household consumption. In that sense, therefore, investment / GDP is a much more relevant metric in practice than capital stock per capita, contrary to what the Goldman Sachs analyst is suggesting.
Yes, DvD, and we must think of social capital as a system and not as a series of linear processes. For example it could easily be the case that the more a country’s health care system is socialized, the higher the country’s social capital, but only up to some income level, after which the relationship disappears or even becomes negative. This is such a politically sensitive subject that I hasten to add that I am not in any way suggesting this is true or not true, only that if we want to think intelligently about ways of enhancing productivity we must be able to recognize that in complex systems there is no reason to assume that relationships between variables are consistent or persistent.
This one of the reasons why I think the structure of balance sheets is far more important than economists realize. In China for example it is fairly obvious that very low interest rates (with lending rates often negative) have over the past two decades reduced the household income share of GDP and encouraged the misallocation of capital, so that for many years it seemed to me that higher rates would have been unambiguously a good thing for China.
Real interest rates are much higher now, and while it is still the case that higher rates would be good for rebalancing because they would help shift income in favor of households, higher rates might no longer improve the capital allocation process, even if we were to agree that real rates are still too low (with CPI inflation above 2%, the GDP deflator slightly negative, and PPI inflation below -4%, I can’t even begin to figure out what real interest rates are in China). Normally, higher interest rates in China would reduce the tendency of large Chinese companies to misallocate capital, but with so many highly indebted Chinese companies and local government entities, raising interest rates might actually have the opposite effect.
Why? Because we know that when debt levels are high enough to raise the probability of insolvency beyond some point, the result is a change in the distribution of the rewards and losses associated with new investment, and especially the symmetry of that distribution, that causes companies to misallocate capital and to undervalue risk. In that case, because there are so many overly-indebted Chinese entities, if the PBoC were to raise interest rates the higher resulting debt-servicing costs would actually push many of these borrowers materially closer to insolvency. This could increase their tendency to misallocate capital by more than it would reduce the tendency of other Chinese borrowers to misallocate capital, so that the net effect within China could be negative. I don’t know what the net effect would be in China, but I am pretty sure that in many provinces higher interest rates would be positive for capital allocation while in many others it would be negative.
Very interesting response Prof Pettis! and quite pessimistic for any Chinese central bank or state council policy makers to read. I wonder if you could go deeper into the implications for this.
The problem you seem to have laid out is that overly low interest rates have caused (at least partly caused) imbalances and problems on corporate balance sheets, and have been allowed to continue for far too long. I don’t think this is controversial any more, and have seen you writing it since Q1 2009 at least (when I first started reading your blog).
Your suggestion that because this situation has continued for so long, that now raising real rates (which would seem to be the obvious medicine) might actually exacerbate the behaviour at least in some provinces. Given that it would seem pretty difficult and odd for there to be different interest rates in different provinces (we may accept different human capital costs across geographies, but am not sure about financial capital costs within an economy), then the implication is that there is no solution…or at least no ‘easy’ (orthodox) solution.
I know you don’t like to go prescriptive in terms of policy, but what could the Central Bank / State Council do? Try and forecast the least bad affect and do that – damaging some provinces and not others? Do half-cocked measures on this as they seem to be doing now? Or bite the bullet and take the massive write-downs even without forcing insolvency onto the economic actors through the interest rate regime?
Great post again btw, even the second time around!
Thanks, Jacques. I think perhaps the first step should be for debt to be transferred from SOEs to the government balance sheet so as to clean up the former and reduce financial distress costs. These debts are contingent liabilities of the government anyway, so the only thing that changes is that macroeconomic uncertainty is significantly reduced and businesses become viable again. Once debt is on the government balance sheet, biting the bullet and finally taking the writedown is less important. The real issue then becomes deciding how optimally to allocate debt-servicing costs to the state sector, which is the only efficient way to resolve the debt, or, if the decision is postponed for too long, being forced into allocating debt-servicing costs very inefficiently and even destructively.
Sorry for a very dumb question, but if the SOEs were able to run up all this debt because of their connections to the government (and implicit future bailout) , doesn’t transferring the debt to the government simply allow the SOEs to continue to run inefficiently and just rack up more debt again in the future? It seems that it would make more sense to first centralize power quckly and only bail out (and perhaps also split up, or whatever) the SOEs once the “vested interests” have been weakened?
(I realize that this may be too close to the political “red line” to be worth answering–I just thought I’d ask in case you could answer.)
Interest rate were negative in real terms in the period during which SOEs massively misallocated capital, and no longer are. I don’t think SOE managers were inefficient at the company level but rather at the macroeconomic level, and this was probably because of the very skewed incentives negative real interest rates create.
The only people who think capital in China has not been allocated far in advance of the ability of the economy to use it efficiently are those who must not have spent any time here. It is a tell.
Michael is making an argument that seems sophisticated at the level of national policy in China, but in fact presents a conclusion that we have seen over and over again in the US and the rest of the world –
– A Chicago suburb called Ford Heights, formerly East Chicago Heights, has long been one of the poorest and least developed parts of the Chicago area. The feeling in this suburb is one of rural poverty. In the 1960s, 1970s, and into the 1980s, the US government literally poured investment in the form of building infrastructure – sewers, water lines, streets, sidewalks, street lights and a city hall; and even new single family houses. What result? No change – the town remained poor. How could this be, if investment determines growth?
– In many Chicago neighborhoods, for decades, the only investment one could see was investment funded largely by the federal government. Street reconstruction, again sewers and water lines, but school buildings and parks and community centers. What result? Why? One can make similar arguments for Appalachia, or Europe post-WWII, as Michael does. One can argue that a certain level of community investment is due people, as members of the community, and so investment need not lead to development. But China is certainly not making that argument, and neither are the China capital investment bulls.
– Acemoglu and Robinson make their institutional argument – really, as Michael points out, a social capital argument – by comparing Nogales, Mexico, and Nogales, Arizona; or one could compare Haiti and Dominican Republic; or North and South Korea; or even China and Taiwan. Brad DeLong does that in his comparison of per capita GDP in market and socialist economies with otherwise similar characteristics. DeLong makes the economic system comparison, but demand everywhere, beyond subsistence, is really a function of social capital. Lack of trust, lack of rule of law, lack of ability to interact with others, lack of ability to plan – all affect aggregate demand.
– or think of the development example, from the old days, of “solving” a problem in Africa by buying the farmers a modern American tractor, or harvester. That harvester is heavily embedded in not only a physical capital system, but also a social capital system. Whose jobs are lost, with the harvester? What price to fix a tire, when the only supplier is many miles away? Who fixes the engine when there are no mechanic training schools? What changes to community social structure with addition of only one possible harvester?
Taken to an absurd level, but only to illustrate the point, adding a bathroom in my house should make the US economy more productive, if the investment = growth story were true. This would only be true if the addition could take advantage of changes in institutions, or social capital – who gets to use the bathroom, and when, and how often, and what alternatives it replaces. In short, the old productivity argument. As it stands, my new bathroom does nothing for long term productivity in America.
In some cases, of course, infrastructure development – in the US, in Africa, even in China – does enhance development. Without question. But “If you build it, they will come” is only in a movie. Otherwise, we would see vibrant economies springing up overnight in Ordos, and the European-themed new cities ringing Shanghai, and Binhai, the new district in Tianjin.
Back many years ago, I was doing transportation planning for new expressway projects in northeastern Illinois, new freeway extensions that were much reviled by part of the community and promoted by others. After one of our public meetings on the plans, I asked one of the IDOT engineers, one with a bit of insight, when IDOT decided that it was the proper time to build. After all, one could minimize the cost of acquiring property if the state did that far in advance of construction plans – not a year or two, but ten or twenty. But construction when traffic volumes were already very high created delays and anger. “Not too soon, and not too late” is what I was told, and at the age of 24 I found that unsatisfying as an answer, but now, from my Chinese perspective, I see the engineer’s comment as wise. I don’t think my engineering friend was referring to social capital in his answer, but the inability to make productive use of the capital is what Michael’s article is all about.
In China, the calculus can be different than in the US. When one entity owns all the land, and there is no concern about the environment or rule of law and peasants can be kept in place with chengguan and armed police, the government can more closely align supply and “demand” for infrastructure than in the US, where markets must provide the demand for government supply.
The Chinese problem is partly the hammer problem, and seeing all problems as nails. One tool fits all. In the absence of important features of social capital – independent courts, and rule of law, constraints on leaders, and independent media – it is impossible to tell when one is using the hammer too much, and where “demand” is coming from.
Pettis’ argument is more sophisticated than my infrastructure argument above. The institutions required to use the investment well – not only expressways, but machines and classrooms and law and regulations – are insufficient to make the investment productive.
In a way, Michael is recounting Alfred Marshall, and his comment about industry clusters in which the tacit knowledge of how to make shoes (for example) is “in the air.” Tacit knowledge in an innovative economy is more than knowledge of how to make shoes. It is the willingness to ask questions without fear, it is the ability to challenge superiors, it is the ability to trust other businesses outside one’s family or guanxi network, it is the ability to fail, shake it off and start again, it is the ability to plan for the future because insurance is available to handle unforeseen risks, it is the ability to plan because there is no fear of appropriation or IP theft or enemies that can destroy one’s prospects with an accusation.
The Goldman and other consultants who equate investment with future growth have to ask themselves, among other questions, why the Olympics and Worlds Fairs don’t generate sustained economic growth. Or why prison construction in a small town in the US does not do the same. Perhaps at some point they can graduate to, why new expressways and high speed rails lines – wondrous, to be sure – and new school buildings and new government buildings and new apartment developments and new airports and seaports and the space program don’t seem to promote growth, either.
Sorry. Nothing new above. Just had to get the examples off my chest.
Thanks, William. One of my PhD students told me, only half jokingly, that the problem with the “social capital” thesis is that it is very difficult to quantify in a consistent way that makes comparisons between countries or other economic entities at all possible. For example people are more likely to behave honestly in the US than in Europe (at least according to various studies, like the one involving the return of “lost” wallets), which suggests higher American social capital relative to that of Europe, but people are also less likely to languish in jail in Europe than in the US, which of course suggests higher European social capital relative to that of the US, but how can one possibly come up with a measure for each of just these two factors that we can add together to come up with comparable scores for Europe and the US?
Because it is so hard to quantify in a comparable way, my student said, you cannot subject it to statistical analysis, which seriously limits the research you can submit to peer-reviewed economic journals. This makes it a pretty uninteresting concept for economists, who must pretend economics is a hard science and so can only accept problems and theories as legitimate if they can easily be expressed in terms of “objective” data subject to the kinds of statistical analysis taught in PhD programs. My student wanted to spend more time thinking about how to use this social capital framework to improve productivity in China, perhaps through changes in things like taxation and migration policies, but he does not know how to turn his interest into easily publishable papers, and he absolutely must begin publishing as soon as possible if he is to have a decent career in academia.
But that’s just a grumpy aside about the sorry state of economics as a discipline in which precision takes precedence over accuracy and usefulness. It is more important for us to understand development in institutional terms and to figure out what kinds of institutional changes are most effective in improving the ability of residents to use resources more productively, i.e. in improving social capital. But while you cannot directly measure this thing I call social capital, perhaps there is a way to measure its “shadow”. Economic entities with higher levels of social capital should see these higher levels reflected in some other variable that might be measurable. For example analysts regularly measure the value of brands and rank them in what looks like objective way, even though the value of a brand is a pretty abstract thing that cannot easily be quantified. I know nothing about how this is done, however, or whether these rankings are anything other than spurious, but if not perhaps the process of measuring social capital might be similar.
It is hard however to come up with good “shadow” variables that will not be affected by non-relevant factors. One “shadow”, and I refer to this in the in the essay, might be a list of the 20-30 largest companies in the country at two different times, perhaps twenty years apart, to see how consistent the list is. I would assume that if there is no change in the two lists, the rigidity it implies could be an indication of entrenchment for non-economic reasons. Once a company is powerful enough, in other words, it can change institutions and rules in ways that protect it from being supplanted by economic rivals. This would almost certainly imply a lower level of social capital, but this kind of measure is extremely distorted and clearly overstates the value of certain relevant factors and understates others.
We might also create specific experiments to measure abstract qualities. For example we cannot quantify honesty, but we can take a bunch of wallets that contain some cash along with clearly marked contact information and “lose” these wallets in a lot of different places, and quantify the number that are returned, although even something so seemingly simple can be far more complicated than we think, for example cultural differences may interfere with the measure, so that if meeting strangers or going to their homes is more stressful in some cultures than in others, this would affect the return rate for wallets.
I like the idea of a 20 year list. However you would need to take account of technological changes that have occurred in that 20 years (e.g. internet, mobile phones, mobile internet, VR / AR) – as these could see new companies pop up without actually proving non-rigidity, actually being a false positive.
In Business strategy, Social Capital is seen through the light of human resources, and networks of social relations. So, it would seem appropriate to, as I generally prefer regardless, as to see Social Capital, through Complexity.
I suspect emergent properties within Complexity, and networks, through the notion of complex adaptive systems.
So networks of factors, of relationships, and of emergent properties that have been identified for those who have been qualified to have higher levels of social capital.
In terms of Political Economy, there are any number of indices, reviewed for the purposes of the suitability of foreign investment, that might give indications of what variables might be needed to be included in a model that seeks to highlight Social Capital…..
Ease of Doing Business
Index of Eco Freedom
MDG’s
HDI’s
etc, and so forth….
Do you have any thoughts on so-called premature deindustrialization? Dani Rodrik has done some interesting work in this area and I’m curious about how this affects growth and social capital in a Chinese context. It seem like agriculture-manufacturing-services was the road to wealth (and solid institutions) in the west and maybe this way is just not possible anymore.
Well this is the issue, isn’t it?
The mere ability to have trust, and to be able to work together cooperatively.
In a world filled with too many half-thunk thoughts and ideas; supposed, if often unobserved, beliefs and values in a world ever more filled with loaded aural and visual images.
So, yes, Rodrik is quite right. Where channels of communication multiply, and higher or lessor considerations get reviewed through muddled frames both popular, and contradictory, we find a space, cognitively, that is dysfunctional.
Now, of course, premature industrialization is just a single point of Rodrik’s perspective, but a structure of excess in the world. Importantly in response, he advises the need, for domestic policy space to address the challenges existent. This is decidedly anti-internationalist; reversing movements of recent decades, which likely have reversed, with an ongoing deglobalization, rise in protectionist measures, movements for devolution, rise of populism, altering demographic realities, rise in geopolitical tensions, deceleration of the growth in trade and foreign investment, etc…
Atlanta is what it is because of railroads. Lots of places are what they are because they have sea, lake or river ports. Energetic people move to such places because they can get what they need and sell their wares more efficiently. People live in difficult transportation locals for other reasons than commerce. Investing in such places just makes the residents more comfortable till the investment decays after capital consumption stops. I think this is explained in text books in more technical language.
Social capital seems to be cyclic. At some point population growth and food shortfalls force reform. Mass starvation results if a reform effort fails. Mass starvation results in war. War causes more competent leaders to be given authority. Which results in some degree of effective reform.
Excellent. Articulating the social capital model and giving it the rightful attention as a challenge to the capital frontier model. That China leadership in a common sensical way is paying attention to the elements of social capital i.e. enhancing a system based on property rights, etc. It is going to be an arduous journey.
Apart from the power struggle not diminished by vested interests to deter the reforms based on the key ingredients of the social capital model, there is to me two obstacles. 1) any tear down of crippling quanxi, etc requires a balance of incentives that extracts the passions from the educated urbanites who are growing exponentially. (Walk the talk in instituting meritocracies). President Xi’s unprecedented anti corruption campaign is one right move but lacks the balance of incentives. The fall outs are evident today in many standstills in decisions by the bureaucracies. 2) no mindset change in dismantling a highly planned economy. Just nurture the fundamentals like rule of law fro property rights, etc and let markets pick the winners/losers and not the Politburo.
For the above main reasons and a leadership that is not focused (pursuing many objectives all at the same time with no courage to take trade-offs) will confine the economy to a trajectory of fits and starts as it is happening now. The risk lies in assuming that global markets with increasing globalization will be benign in accommodating the economy and not the contrary in exacerbating its totters towards implosion.
Any organization is only as good as its commissioned (generals and captains) and non-commissioned officers (sergeants and corporals). Civilian organizations have the equivalent of military ranks and tasks. Implicit in this is a system.
I Ching 7. Shih / The Army
These systems have been around for thousands of years and aren’t really that different no matter what country. General Giap would have been welcomed in any army in the world. As would George Washington.
It seems Soros has made his bet about things to come. I have always found Pettis’ arguments to be very similar to Soros’.
Easterley’s “something else” would seem to link, in this, to the hard versus soft infrastructure, insofar, as the set, or confluence, configuration, impact and interaction of forces in society that enable the endowment, evolutionary, factors to be used effectively.
This would point back to my other comment that the various indexes used for the evaluation of an economy, likely would yield the variables for a social capital in political economy model.
http://www.usatoday.com/story/life/theater/2016/06/12/how-many-tony-awards-has-hamilton-won/85803712/
Hamilton just got 11 Tony awards. One would think Pettis is delighted ：）
I haven’t seen it yet but I am delighted that it has inspired a lot of interest in Hamilton.
Mr. Pettis,
I enjoyed reading this when you first published it, and I enjoyed reading it again. I recently re-read Avoiding The Fall and, for the first time, completely ‘got it.’ I truly appreciate your insightful books and blog. Although I do not fluently understand the way balance sheets connect, I have found your writing has fundamentally changed the way I think.
I recently picked up This Time is Different, and ,again, although I am very far from understanding everything, I was able to highlight implicit assumptions and causality/consequences in capital flow.
Anyway, thank you again. If you’re ever in the CBD or Guomao, the drinks are on me.
Thanks, Pierce
One last thought- it is important to realize how entrenched the capital frontier model is in China. Your analysis is logical and coherent, however you are fighting an uphill battle.
I recently had a talk with a Chinese friend working in the Chinese State Department discussing North Korea. He was delighted to inform me that China had a solution, if only the Americans would listen. Pour investment into North Korea. He assumed that North Korea was limited not by institution and law but by investment levels. South Korea, he maintained, developed ‘better’ due to access to US capital markets in the Cold War.
I think readers in Europe and America could see how this isn’t the case, due to observations about wealth transfers and investment in their respective regions. However, in my limited experience in Beijing, people see the capital frontier model as ‘working’ before their eyes. Why would the capital frontier model be wrong when it has brought us this growth miracle that is the world’s envy?
Antonio Escohotado is a Spanish intellectual who has studied the economy during the last 10 or 15 years and has written the book “Los enemigos del comercio”. In this interview (https://youtu.be/XovckdWCuM8?t=795 ) he expresses your idea about social capital with his own words. It is in Spanish but I will translate here for people who don’t understand this language “I needed many years to finally realize that a country is not rich because they have diamonds or oil, it is rich because it has education. This means that, even though you can steal, you don’t steal; if you walk along a narrow sidewalk you yield in and say “sorry” if somebody is coming in the opposite direction; when you have to pay the bill in a restaurant you say thanks… when in a country people behaves in that way, the country is rich”.
It is an infinitely much more simple way to say what you say here but I couldn’t agree more with both of you. Your text is illuminating and many consequences can be derived from it. Thanks a lot once again for your effort and for posting things like this online
Great piece Prof. Pettis!
Looking back at history (Japan, Brazil, maybe others too), how much more can China keep the debt growing, in terms of GDP, before everything comes to near halt ?
i.e. trying to guesstimate WHEN (accurate to within a year) China reaches that tipping point in terms of too much debt.
Maybe when the central government debt to gdp ratio reaches 200% ?
if you are trying to guesstimate, which framework would you choose to apply ?
Michael,
I have enjoyed reading your work since I worked and lived in China from 2006 to 2008.
I want to suggest a practical barrier that I faced then and now with regards to Capital Investment and the concept of Social Capital.
If I want to invest in a new process or machine that will yield improvements in Quality or Quantity I also need to be able to operate and maintain that process or equipment. If there is no previous experience base or support network for the new process or equipment then the investment will not realise the planned improvements. The lack of context within a population for some machinery types leads to an inability to gain any benefit from purchasing and introducing the machinery. I found that neither Motor Graders nor Wheeled Motor Scrapers were used in road construction in China.
Rather the ubiquitous FAW blue trucks and CAT 320 excavators as owned by local villagers were the available machines for road building. If you purchased a Grader then you needed to go through a full training regime for everyone from the Operators and Maintainers up through the Supervisors and Management. The time to do this and develop the understanding and context is measured in years. Eventually I had to concede that whatever improvements I make have to be incremental and capable of being supported in-country or the outcome would be mal-investment. Better to use the local methods that have a strong supply system behind them and are well understood by locals. In China this has meant lots of investment in leading brands and a few standard models.
Where I am now in Myanmar, the locals are just starting to mechanise farming. Tractors are still very rare and the people using them understand Oxen very well but tractors are not so well understood. I occasionally see tractors bogged, or on their sides in soft ground. Contextual learning is required. If a massive amount of investment were to be made in the Myanmar Farming sector it could not currently be sustained with only local expertise. The human Capital has to be developed, along with the supply and maintenance channels.
Probably the most reliable truck in Myanmar is a TH series Hino truck which has 40 years of in-country service history and support. These units are well-understood and parts are commonly available throughout Myanmar. The equivalent in China is the 350 tonne canal barge.
I have arrived at a point in my life of understanding that some projects cannot succeed without a sufficient base of local context and experience from operator through to Management and Government. The amount of money or technology will have a slight impact on the success of an Investment compared to the amount of local expertise in maintaining, operating and managing the investment.
I am struggling to devise a measure that would make sense to Economists but I know that any Capital Investment that diverges away from local expertise and use is potentially at risk and the further away it is the greater the risk of an investment failure.
It seems to me social capital is mainly about a fair and honest society. In a fair and honest society the benefits of productivity would result in an increase in the quality and quantity of goods and services and the proportion of that society that benefit from them. If this is not the main objective of any investment then the quality of the institutions should be determined by how well this becomes the ultimate result.
Regulatory authorities that prevent tragedy of the commons, ensure equitable rule of law, define and uphold workers rights and support equal opportunity for all underpin a fair and honest society. Lack of such robust institutions results in corruption and that results in extractive investments and negative real returns for society as a whole or in other words the real economy.
As Michael make clear there is lots of grey between the black (say Nigeria or the Philippians) and white (say the Baltic States). Early on in an undeveloped society almost any investment is a good thing and the capital can come from anywhere. At the other end of the scale in developed rich societies it matters where capital comes from and small inequities unaddressed accumulate over time into major social injustices.
This article written recently plots divergence between productive growth and medium incomes in developed nations.
http://www.inet.ox.ac.uk/files/publications/Nolan%20et%20al_%20(2016)%20GDP%20per%20capita%20versus%20median%20household%20income%20INET%20WP.pdf
It seems to me it matters how money is perceived. Money should be more often perceived as a medium of exchange rather than a store of value. If it is seen more as medium of exchange then it benefits society more if it is exchanged more often, doing more work in allowing the exchange of valuable goods and services and providing a source of demand for the productivity gains achieved through investments made.
Its fairly clear that if income inequality is high then demand will be sub optimal. The rich can and do save more of their money and given interest rates clearly it is lack of demand not savings that is the problem in the developed world.
In physics it is some times useful to the limit case when there is doubt about the validity of a model. It seems to me this could be applied to the question of income inequality. If you consider an economy in which only one person has all the wealth then it is highly unlikely that there will be many high quality goods and services to spend the money on. There will be no businesses to supply them because there is no reliable demand. The value of the accumulated wealth will also be questionable since no one will be buying. An easy thought experiment.
I am hopeful that as technology progresses it will enhance peoples knowledge and make opaque transactions more difficult and risky. Take Panama Papers as an example. This I hope will lead to fairer societies. I am interested in the idea of a basic income and in fact in order to improve the perception of money as a means of exchange I think it should be paid in a form of currency that expires. Perhaps bitcoin could be made to do this.
Sorry if I’m hogging your blog Michael and thanks for your very interesting re-post. It really helps in understanding where China is at right now what the future could hold.
I meant to say Scandinavian States not Baltic States…
I am curious what Michael thinks of the data-rich argument by Huang in Capitalism With Chinese Characteristics that 1) the initial reforms under Deng and his successors enabled rural, market-driven entrepreneurship leading to rising household incomes and consumption, but that 2) the 1990 ascension of the “Shanghai” faction choked this off in favor of state-led, urban investment that did not raise household well-being.
I found your article on Social Capital very interesting but it raised a number of questions. I think you argue that the coastal provinces of China, particularly Shanghai fall under the Capital Frontier classification. However, were they not at some point in the past presumably like Guizhou; excepting perhaps Shanghai which could be considered an international trading city for much of its history. If these costal provinces have made a transition to a Capital Frontier classification what are the drivers that prompted the transition and why cannot the same effects apply to those under the Social Capital Classification. If the transition for these costal provinces was associated with the development of a middle class based consumerism driver what might be the tipping point for the poorer inland provinces
The coastal provinces have been relatively wealthy for centuries. In fact there is a cottage industry of historians puzzling out why the UK and not coastal China became the epicenter of the industrial revolution, when the latter had many advantages over the former.
The reason is because of Mongol invasions. They were able to hold off the Mongols initially, but the Mongols were able to get just enough of their technology to blow them to smithereens. There’s no doubt that the Marx-based and Marxist ideas about the “Asiatic mode of production” are BS and about the blatant racism and bigotry that underlies those kinds of retarded ideas, but somehow they’re still taught in our college classrooms more than the financial history material that consistently debunks it.
The Song Dynasty was the first society to produce 100,000 tons of steel annually before 19th century UK. A huge problem for the Song Dynasty is that (if I’m wrong, please correct me) much of Southern China is on low elevation regions. And of course, elevation (especially when you’ve got cavalry archers en masse) used properly was a very advantageous tool in warfare.
Professor Pettis, as you were saying… http://mobile.reuters.com/article/idUSKCN0ZM2KY
I work in the foreign direct investment field in China and I comment from this perspective. All my company’s clients are looking for maximum returns on their investments, naturally. They are not going to Guizhou. They are going to Shanghai, increasingly Suzhou and the cities around Jiangxi / Jiangsu. The economic engine that has been developed in the Yangtze River Delta area is the strongest driver for China at the moment and a lot of the investment there has transitioned to the tertiary sector.
It is fairly apparent why this has happened. The consumer class in that region has reached a level of critical mass and sophistication that means this kind of investment is rewarded by good returns. Maybe this is a component of the social capital Prof Pettis talks about. Certainly government organs are more efficient in and around Shanghai. But that had to be built up over the past 30 years. Suzhou is benefiting from the “gaotie” linking it to Shanghai.
I myself am based in Dalian. Similar levels of investment are not coming to Dongbei. GDP is apparently contracting in Liaoning right now. The critical mass / sophistication of the market is not where it needs to be in this area of China. Nevertheless, high-speed rail connections between cities have been completed. There is a large over-supply of commercial and residential real estate. There are also some examples of appalling white elephant infrastructure projects such as the Dalian – Lvshun light railway project.
What is my point here? The Chinese government has to at least link up these big cities in China and furnish them with the basics necessary for development of the “social capital” that Prof Pettis talks about. That provides the opportunity for change. Having achieved something close to a functioning, consumer-driven economy in the YRD area, it should be possible to replicate that elsewhere. However “good” investment (such as legitimate FDI) is not going to flow into places like Liaoning without the government putting in place some healthy “roots” or “soil” in which the economies of those regions can flourish.
Therefore, the return on these infrastructure projects is likely to be anaemic in the initial years. That’s not an indication that they are necessarily “bad” investments. It could well be that they are necessary investments which lack viability based on commercial concepts of return. It is a kind of chicken and egg situation. The question is, how many of these infrastructure investments make a genuine contribution to the potential development of the regional economy, and how many are simply “white elephants”? Also, especially for the real estate developments, I worry about the quality of the “assets” themselves. A lot of them don’t seem to have been built to last and / or are not maintained properly. That makes them potential “white elephants” as well.
Given the collapse in GDP growth in Liaoning it may be on the frontier of the “hard landing” that might occur in the coming years in China. It is also a much smaller and simpler entity to analyze than the whole of China. Prof Pettis might want to consider analyzing it in more detail as part of his research in the future.
Sorry, prof Pettis. Only now, back from hospital, have I read this excellent piece of yours. At the end, where you enumerated the implications of the social capital constraint, you stated : “Beijing must constrain investment growth sharply, redirect a much lower level of investment into areas that improve social capital (SMEs, agriculture, services)”. Did you mean “…a much higher level of investment…”?
It would make more sense, if I got it right. Many thanks, and congratulations.