In 2009 I called China the “Michael Jackson economy,” meaning that it was kept going by artificial stimulants, but that inevitably their cumulative effects would cause serious, and perhaps fatal problems. They mask the effect of the underlying ailment, and have severe side effects. China responded to the 2008 financial crisis by engaging in massive stimulus, and has inflated credit bubbles whenever growth stuttered in the past several years. Moreover, allocation of credit and investment in the economy is subject to substantial direct and indirect government control. Local governments invest massive amounts in infrastructure and housing projects, and the banking system is tilted to direct credit to large state enterprises that invest primarily in heavy industry-steel manufacture and shipbuilding, for instance.
This “investment” can prop up GDP statistics, but they are recorded at cost, not value. (I recommend this David Henderson piece about the perversity of GDP fetishism, and how GDP can grossly mis-measure well-being.)
If the investments are ill-conceived, they will not pay for themselves in the future, and economic output and consumption will suffer. And investments guided primarily by the visible hand in an authoritarian state are almost certainly ill-conceived. They are driven by considerations like political connections, prestige, and the imperative to maintain employment in existing enterprises and regions to buy labor-and political-peace. This latter effect is particularly deleterious, as it means that rather than there being a natural corrective mechanism for past mistakes, mistakes tend to be self-perpetuating.
The Wall Street Journal has a fascinating article about one major malinvestment that fits this story almost perfectly. Yes, it is likely an extreme case, but there are enough similar stories to suggest that that the malinvestment problem in China is severe. Moreover, the bloated fraction of investment to GDP, and the falling delta between changes in credit and changes in income provide some quantitative support for these anecdotes. Add in the dodginess of Chinese economic data, and there is serious reason to believe that China is heading for a very rocky period. When the interactions with the financial system are considered, the prospects look even more dire: when the investments don’t generate sufficient return to pay back the loans, realistic outcomes range from a Japan-like zombie-fication of the banks to a full-blown financial crisis.
China’s new premier is promising 7+ percent GDP growth. That could be the problem: the only way to get it is to double down on the artificial stimulants, thereby exacerbating the malinvestment problem. Living with lower GDP growth, and permitting Chinese businesses and individuals to reallocate resources to those that generate value rather than statistics, would be far preferable in the short, medium, and especially long run.
A major adjustment is needed, but I would have little confidence in the Party and the system that created the mess in the first place to manage this adjustment effectively or efficiently. The political economy suggests that incumbent industries, firms, and interests, all of which have strong political influence, will disproportionately influence government economic policy. This impedes adjustment, and substantially increases the odds of zombie-fication, of the financial system and entire industries. China could use some creative destruction, but I do not believe this is politically feasible.
China is one of those few matters on which Krugman and I agree. Krugman mentions that this could be bad for commodity prices, and that would definitely be true if China goes cold turkey and stops trying to perpetuate its old growth model. That will lead to a substantial decline in the demand for commodities such as industrial metals, iron ore, coal, and oil. But if the political economy story is correct, it will attempt to support the existing commodity-intensive structure of production and delay the adjustment process. In the event, commodity prices will likely fall, because a reprise of 2009’s extreme dosage of stimulants is likely infeasible. But government attempts to cushion the adjustment process will cushion the impact on commodity prices too.
But it is true that the course of commodity prices will depend crucially on how the Chinese government handles the painful withdrawal from its past stimulus binge. Cold turkey would be very bearish (how’s that for a mixed metaphor!?!) Hair of the dog far less so. This implies that a crucial fundamental in commodity markets in coming months and even years, and perhaps the crucial fundamental, will be Chinese politics.