In 2003 and 2004, when Donald Coxe, BMO Global Strategist and writer of the Basic Point publications, first started describing what was occurring in China, he explained the process in terms of the theories of an well-known urbanist but mostly unknown economist, Jane Jacobs. In particular, in the September 2004 issue of Basic Points he wrote:
China’s macro strategy of encouraging Foreign Direct Investment in building factories based on foreign technology, brand names and global distribution, meant that it became the workshop to the world. Because the Chinese are so skilled at imitating (or just plain stealing) foreign manufacturing techniques and designs, China has been able to continuously diversify its product lines – not just for export, but for import substitution.
This latter fact, according to Jane Jacobs, is the crucial component in national economic development. Her seminal book, Cities and the Wealth of Nations, showed that emerging economies driven overwhelmingly by export growth usually failed, whereas economies that combined export growth with successful import replacement succeeded. Argentina is a perfect example of an inefficient, export reliant economy that sank lower and lower in the global rankings each decade; Korea, a splendid import replacer, progressed from having per capita GDP that was roughly one-fifth of Argentina in 1960 to comparability with Canada today.
Before and since, Donald Coxe has referred to Jane Jacobs in his conference calls and Basic Points publications as being fundamental to understanding what is happening in China and India. In The Economy of Cities and Cities and the Wealth of Nations, Jacobs lays out the process by which cities develop. It is this process that is now being played out on a grander scale then it ever has before in history.
I have read Jacobs' books to the point where their covers have worn off; I am now on my second copy of The Economy of Cities. In this latest blog post, I will try to explain her basic theories, and why those theories help me sleep well at night even as the stock market tumbles and turns. While there are many books that contribute to my thesis of what is occurring in China, India and elsewhere in the developing world, these books describes the dynamic that is taking place better then any others.
Jacob’s Ladder of Growth
It is difficult to do justice to these books in the nutshell of a blog post. But if I were put on the spot, I would do so by stating the basic principles of economic growth put forth in these books:
- One of the great mistakes of economic theory has been its assumption that the nation is the salient entity for describing how an economy works. Jacobs argues that this is not the case. She argues that it is the city, not the nation, which is the essential building block of an economy. To understand the dynamic by which economic growth occurs, you have to look to the individual cities that it takes place in.
- The assertion that cities are the cells of economic growth has consequences. The first consequence is that the formal meaning of exports and imports is lost. To a city, international trade is no different then inter-city national trade. While balance of trade between nations still matters because it effects the value of currency and is still a part of the overall trade to and from a city, what really matters for a city are its overall imports and exports, regardless of whether they are coming from within the national boundaries or not.
- Once your attention is focused on the city, you can begin to investigate how cities grow. Cities are settlements where new work is continuously added to old work. It is a simple proposition, but it is often overlooked. We are describing a process by which new activities are created from those that already exist. There is no such thing as the spontaneous generation of work (a further investigation of this can go far to explaining why so often transplants fail to generate further growth and why company towns remain company towns, but I’ll leave that for another time). This process of adding new work from existing work has an important consequence. It is a positive feedback loop where a greater diversity of existing work leads to a greater potential for new work that can be added. Jacobs explained that “new work multiplies and diversifies a city’s divisions of labour. And this greater diversity of labour (and by labour we mean all of worker skills, productive capacities, and capital available) sets a foundation for more new work to be added and for more innovations to be incubated.” The process feeds on itself.
- The great engine of growth in cities is import replacement. This is not the government mandated import replacement of the 1970s. What Jacobs describes is a capitalist process that naturally evolves because it is the most economical thing to do. The replacement of imports is simply the process by which a good that has been previously purchased outside of a city is now developed within the city.
This simple process has a number of effects:
- It enlarges the economy of the city by creating new divisions of labour to produce the good or service that was previously imported.
- It increases the diversity of the city. There are now more industries available for new innovations and newly replaced imports to draw upon.
- It frees up the capital that was previously used for the importation of the good so that now other new goods and services can be imported in its place. Because the capital is now being used for new imports, while the market abroad for that particular good has decreased, the overall market for goods (in other words the economic activity), has not.
- As Donald Coxe has pointed out, the validity of this theory is illustrated by the successes of Japan, Taiwan and Korea.
- Imports fill a few essential roles in this process. They are the inputs into the value-adding process that takes place in the city. And they present new sources of goods and services that eventually can be replaced by industries existing within the city. Thus they are the raw energy for the next round of growth. So imports themselves create this positive feedback process. When cities use the funds from exports productively to buy imports that they can replace then the cities continue to grow. If imports are not replaced, they do not. This is why all of the export oriented developed plans (like those used in South America) have failed so miserably.
- Exports are, of course, also key to the process. But not all exports are created equally. What is important to a city is to have a high export multiplier. The export multiplier describes the number of jobs and industries that are created as suppliers of the producers of export goods and the consumers who work for them. Inert cities have small export multiplier. This means that the large part of the proceeds from exports do not go into buying raw goods and materials to feed the supplier industries of the export work. They instead go into finished consumer goods and producer goods that are used directly by the export business
Together, these principles underscore what is really Jacob’s basic premise. Cities develop because of these processes, not because of events outside themselves.
Now this is an extremely important assertion. It has far reaching consequences. It helps explain why China did not collapse when the United States went into recession in 2002. It helps explain why China can grow at 10% but not be dependent on exports. It also helps explain why copper prices can stay at $3.85 while the developed world housing market is in a funk. And it helps explain why my investments are sound in this turbulent period.
An Ocean of Imports
The growth of Chinese cities, and all cities, is an internal process of replacing goods that they previously imported. This process is taking place on a grand scale. What’s more, because we in the developed world are so far down the road of development, there are a huge number of goods that can potentially be replaced by Chinese, Indian and the cities of other developing nations. Just go and drive around your own cities industrial regions. You will see makers of fasteners, of ball bearings, of door handles, windows, doors, paper products, home electronics, digital circuitry, financial services, health products, convenience stores, flower shops, dry-cleaning… the list is endless. All of these items, which at one time were either imported by developing nations or were luxury goods not considered at all, are now either being replaced or will be replaced by local industries in Chinese and Indian cities.
As a metaphor, I think of it as a huge ocean of products and services out there just waiting to be fished out by these cities. This ocean will feed the growth of these cities for decades. It has to be understood that this process is timeless. It has happened again and again. That is why I am not overly worried that the credit crisis will derail the Chinese and Indian economies. These economies are already well down the road of positive feedback. And this is the same road by which cities have always grown.
A Memorably Great Moment in the History of Humanity
What is really the only thing unique about the story today is the scale. The number of cities popping up, and the number of potential imports that will be replaced as these cities grow and become diverse, is something we have not seen in history. And that has to put equally historic pressure on the commodities that feed it. Let me end this with a quote from Donald Coxe, taken from the December 22nd, 2003 issue of Basic Points.
What is happening in China, and what will happen soon in India is, quite simply, the most widely-disseminated significant increase in personal wealth and freedom in human history.
Still true, 4 years later.