James White on the post-capital China paradigm.
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Being a China Bull – China’s Post-Capital Future
By James White
Source – An Abundant World, published December 14, 2012
Michael Pettis’ questions challenged the China Bull to look at three specific issues; the sustainability of China’s debt, the new focus of investment and improving consumption. My response has looked at these questions from different angles. I remain comfortable that being a China Bull is a defendable, though admittedly uncertain position. Uncertain because it means saying:
This time is different.
This phrase has, over decades, led many an economist to an early grave.
The return on capital does not define the economic outlook
My day job and the job of all working in financial markets has been to explain the return on capital for an economy, industry or firm. This is an essential function. Capital markets are about pricing capital and I contribute to that process in a very small way.
The problem comes when the return on capital becomes synonymous with the health of the economy and the welfare of its participants. Yet this is exactly where we’ve collectively arrived. Equity indices have come to reflect the health of an economy. But equity indices are not economic health reports.
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Consider the United States. Very simply the United States economy is ordered towards maximising the return on capital. Capital, historically, has been scarce. The U.S. at various times has come to rely on foreign capital for investment including the present. Historically, this focus on capital returns has created positive returns for the wider economy, specifically for households in rising employment and wages. Capital is very important for an economy.
But similarly, maximising returns to capital can lead to perverse welfare outcomes. As I’ve argued in Patently Wrong – Part I and II protecting capital often comes at a cost to the welfare of the broader economy and it’s not clear to me that that’s not always a good outcome for households. Similarly, we live in a period where, despite strong returns to capital and a low cost of capital, the level of investment in the U.S. remains disappointingly low. Maximising returns to capital has led to under-investment, not over-investment in recent times. This is largely because capital is becoming focused in the hands of a smaller, and smaller group – the 1%.
As Steve Randy Waldman argued at Interfluidity, wealth in America is insurance. The incentive to deploy capital is based on this calculus. At times of risk aversion, capital deployment by individuals (the 1%) into productive capacity, good for the economy and labour, puts at risk the capital allocator’s position (their position in the 1%) in society. What’s perceived to be good for the individual is not good for society broadly.
What would maximising the return to labour look like in an economy
I’d argue China does the reverse. It aims to maximise the return on labour (best thought of as wages and total employment). This has been particularly the case in the last fifteen years. China has an aging problem, most often described as getting old before it gets rich. Relative to capital, of which China has a surplus and has had one for a long time, labour is scarce.
In a labour constrained economy maximising the return on labour demands rapid investment in capital. Capital makes labour more productive, boosting demand for labour and its price.
The personal imperative is to allocate capital aggressively
China’s economy is uniquely placed to achieve this outcome. Indeed, it is ordered in such a way that there is an incentive to allocate capital aggressively.
In China, wealth is not insurance, it’s material well-being. As Bo Xilai has found out and, it seems, more are to follow, wealth does not buy protection. Political power is insurance. Political power comes from being productive. Being productive means adding to the capacity of the economy whether as a private individual in enterprise or as an official in infrastructure. For the individual, private or Party, allocating capital, even at rates below his or her own cost of capital, can make sense from a total utility perspective.
This means that if I control capital I need to deploy it. Allowing it to sit in a bank account won’t add to my political power. This, however, does not discount the value of allocating capital well because doing so creates more capital to be deployed in the future. Both the enterprising individual and the budding official try to achieve this outcome. For the budding official, in a large, hierarchical Party with a strong institutional memory (best described by Richard McGregor), spending capital wisely matters. Failure, increasingly, will not be a path to political success.
Capitals works for the economy
These incentives at the level of the individual translate to aggressive capital allocation at the macro level. Capital can work for the economy, not the economy working for capital.
At a macro level, this aggressive capital allocation begins to eat away at the productivity deficit within the Chinese economy. It has made many Chinese more productive, though as I argued in this piece, there is still a long way to go, particularly when we consider the ability of a slowdown in investment to encourage inequality. The macro level success is helped by two further outcomes of the micro level incentive: benefits from portfolio theory and less of a business cycle.
The model produces duds. White elephants. Ambitious or corrupt or incompetent officials allocate capital where it should never go or to themselves. But, at a macro level these mistakes should be inconsequential.
In a way, infrastructure investment in China should be seen through the prism of portfolio theory and diversification. There are a multitude of projects, if a solid percentage are successful then that’s sufficient for successful investment. Such a process encourages a little more risk-taking and so, in aggregate, produces better outcomes. In the west, infrastructure programs are only ever as good as the last project. Politicians lose their appetite for infrastructure if the last project was a failure.
The focus on capital returns leads analysts to the conclusion that capital losses must bring an end to business cycles. This makes sense in the wake of the Tech Wreck and the Housing Bubble. Both events entailed large capital losses and subsequently led to substantial downturns in economic activity. But it must not always be the case. There was still capital to be allocated (see Treasury markets) and projects with positive NPVs. The missing ingredient and the cause of the downturn was, in the words of Keynes, animal spirits. Capital oriented economies need animal spirits to grow, China does not. China has excess capital, it has productivity improving investments to make and it has an incentive structure which encourages investment regardless of historic or peer capital returns. As a result, the pace of growth and the business cycle is policy determined and good policy works (as of course does bad policy fail).
Being a China Bull does require a leap of faith, a stretching of the imagination. The central challenge of China has always been to understand the allocation of capital. From a developed world perspective it makes little sense. Capital can’t be treated as it is in China (carelessly) without damaging consequences. Yet, perhaps, the orientation of China towards labour has created a different economic order. China has become post-capital. It sees capital as an input into an economy, a means to an end. It is no longer the barometer of a healthy economy. If I am right, there are substantial consequences, many of them positive, for the developed world. But maximising the benefits requires a re-orientation of our own economies and societies. This will not happen quickly.