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The Politics of Adjustment

by Michael Pettis, China Financial Markets

The past two years have seen a surprising amount of turmoil at the highest levels of the Chinese political establishment. We have seen political alliances re-shuffled, powerful business and political leaders arrested, factional disputes magnified, and an explosion of rumors of more to come. After twenty years of what seemed, on the surface at least, remarkable cohesion within China’s political elite, events of the past two years have come as a great surprise to many.

And yet the historical precedents suggest that none of this should have surprised us. After nearly thirty years of spectacular economic growth and impressive social and political advances, China has probably exhausted the growth model that had once served it so well. It now suffers from many of the internal imbalances that were the near-automatic and easily predictable consequences of the policies associated with the growth model it had pursued, and policymakers in Beijing are very aware of the urgent need to adopt a new set of policies that will allow China both to rebalance the economy so as to protect itself from the consequences of soaring debt and to lay the foundations for another thirty years of solid economic growth and social and political advancement.

China is not the first country to have experienced a long period of miraculous growth. But, as University of Chicago’s Robert Aliber implied in his Warholian quip about growth miracles (“in the future every country will grow rapidly for fifteen years”), the most difficult part of growth miracles has not been the growth miracle itself but rather the subsequent adjustment. Consider the most notable examples of growth miracles: the United States in the 1920s, Germany in the 1930s, the Soviet Union from the late 1940s to the early 1960s, Brazil from the late 1950s to the late 1970s, Japan in the 1980s, and many others.

In every one of these cases, and in many more involving smaller economies, economic growth powered ahead at astonishing rates (relative to the rest of the world in depression in the case of Germany) on the back of investment programs usually, but not always, centrally directed and turbo-charged by institutional distortions that forced up domestic savings rates to levels high enough not only to fund massive domestic investment (and, in many cases, extensive military expenditures) but also to export abroad, which of course is the converse of running large trade surpluses. In each case, too, growth for many years seemed almost unstoppable, to the point where, in the case of the Soviet Union by the early 1960s and Japan by the late 1980s, there was a near-unanimous consensus that it was just a matter of years, or one or two decades at most, before either country would overtake the United States as the world’s leading economic and even technological power.

There is, in other words, plenty of historical context within which to place China’s spectacular achievement, and it is clear from this context that the most difficult part of the process has always been the subsequent adjustment, during which time the imbalances generated by the spectacular growth were addressed and resolved. But they were not always resolved successfully.

In some cases, for example that of the United States and perhaps Brazil and South Korea, the adjustment was brutally difficult but the institutions that evolved during the adjustment period laid the groundwork for many more years of growth and stability (and a shift from military authoritarianism to a robust democracy in the latter two cases). In other cases, for example that of the Soviet Union, the adjustment period was long and protracted, and perhaps because during the adjustment period the country was unable to develop the right set of institutional reforms, it eventually collapsed into the kind of chaos from which it is still struggling to emerge. In still other cases, for example Japan, the adjustment seemed to leave the country locked into stagnation.

Three generalizations

Of course the differences in the ways each country experienced both the growth miracle and the subsequent adjustment make it very hard, and risky, to generalize, but it seems reasonably safe to make three assertions about the adjustment process. First, the investment-led growth miracle always culminated in a period during which debt began to grow at an unsustainable pace, and in every case the miracle was brought to a halt either because of a debt crisis or, most obviously in the cases of Japan and the Soviet Union, because extraordinarily high debt levels locked the country into a long period of stagnant growth during which the financial system struggled to bring debt levels under control.

Second, in every single case even the greatest of skeptics arguing against the sustainability of the growth miracle ended up wildly underestimating the difficulty of the subsequent adjustment. Had those who were most skeptical about the Japanese growth miracle been told in 1990 that Japan faced twenty years of growth under 1 percent, even they would not have believed it. Had any economist who questioned the sustainability of the Soviet economy been told in 1970 that within twenty years the Soviet economy would have collapsed, and with it the state itself, it is unlikely that he would have taken the claim seriously. Even the most pessimistic of Americans in 1929 or Brazilians in 1980 would not have included in their bearish forecasts the possibility that their countries would experience a decade of negative growth. In retrospect the adjustment period would be described as a middle-income trap, a debt trap, or any of a dozen other traps, but it’s virulence would have always come as a shock.

Third, the adjustment period was never just a period of difficult economic adjustment. It was also always a period of tremendous political difficulty, fractious political disputes and, more often than not, a period of radical political transformation. In fact excluding a few, very unique cases (Singapore, for example, whose small size and external orientation gave it a flexibility impossible in a larger country), the adjustment that followed a long period of miraculous growth has always been even more striking as a period of political change than as a period of economic change.

And it is not hard to see why this should be the case. It is a commonplace among historians, almost a truism, that when a country’s governance is structured in such a way that incentives for the political elite are aligned with the economic interests of the country, the country is likely to grow rapidly and in a healthy way. When they are misaligned, there are likely to be significant strains and pressures that resolve themselves through the political system.

How does this apply to China? In the early 1980s when China’s reforms began, the country was seriously underinvested and urgently needed to improve its infrastructure, its manufacturing capacity, and housing and education. As the country’s farsighted leaders engaged in a massive program of investment, there were many opportunities for the state and for the political and economic elite to benefit directly from transforming the country’s capital stock from one of the weakest in the world to one of the best. Among the consequences was that while the lives of ordinary Chinese improved at a pace perhaps unmatched in human history, the share of China’s GDP retained by the state sector and the political elite actually increased for thirty years as they benefited disproportionately from Chinese growth. China produced more billionaires more quickly than anyone in history.

But every country that has experienced a growth miracle has also developed imbalances that had to be reversed, and the adjustment process is simply the process by which these imbalances are reversed. China is no exception. In order to rebalance the Chinese economy we must move from a period during which the elite received a disproportionate share of growing Chinese wealth to one in which ordinary households and small businesses receive a disproportionate share. After thirty years during which Chinese households retained an ever smaller share of the rapidly growing Chinese economy, doing nonetheless very well in the process, we must shift to a period during which ordinary Chinese households receive an ever rising share of a more slowly growing Chinese economy, in fact this is almost the very definition of rebalancing in the Chinese context.

China’s economic adjustment necessarily involves, in other words, a sharp reduction in the rate at which the state and the political elite have been able to grow their assets during the past thirty years, and perhaps even an overall decline. It also requires significant changes in the ways in which the financial system funds economic activity, an increase in the role of small businesses and the service industry, a very different legal framework, and a number of institutional changes that represent a sharp break from the recent past.

Aligning incentives

None of these changes will be easy, and these changes will be all the harder to make by the fact that there must also be, as a necessary part of what it means for China to rebalance, a sharp reduction in the amount of assets and resources to be distributed among the various state and elite players. China’s old economic model, which rewarded both the country and the elite very handsomely, must now be transformed into a model that will reward the country, but at least partially at the expense of the elite. This was the challenge faced by every country as it adjusted from it’s period of rapid, investment-led growth, and it has always been a politically challenging process, whether that process involved the bitter political upheavals and the redistribution of wealth from the rich to the poor forced onto the United Sates by President Roosevelt’s reforms in the 1930s, or the Brazilian rejection of it’s military rulers in the 1980s as they painfully but surely built a robust democracy.

The historical precedents are fairly clear. Every country that has emerged from many years of “miraculous” investment-led growth has either embarked willingly, or been forced by debt, into an adjustment process that turned out to be economically far more painful than anyone had expected. In every case among the greatest challenges has been a very fractious and difficult political environment. China is now beginning it’s own adjustment process and we should be prepared for both tougher economic conditions and a more difficult political environment.

History has a lot to teach us about this process, and it has a lot to teach us about which countries were able to manage the difficult adjustment in ways that created a basis for long term success and which countries were not able to do so. China’s leaders have already demonstrated sufficient foresight and ability to have managed the growth period successfully, and we have every reason to hope that they will manage the adjustment process equally well. But there should be little doubt that thirty years of astonishing growth was the relatively easier part, and that President Xi Jinping and Premier Li Keqiang face a greater challenge than that faced by their predecessors. And there should also be little doubt that the recent political turmoil in China is not an accident. History makes it very clear that the next ten years will be a political challenge for China even more than it will be an economic one.

And how will things evolve politically in China? Of course it is a little foolhardy to make predictions, but work that I have already cited many times before by Daron Acemoglu and James Robinson suggest that most cases of successful adjustment have occurred either in countries with highly competitive political structures (democracies, for example) or in countries with highly centralized decision-making (China under Deng Xiaoping, perhaps). Authoritarian countries in which political decision-making is widely dispersed, like China today, have historically found it difficult to make a successful transition.

So which way should China move? There is a widespread belief that only political reforms that impose rule of law and democratize the political decision-making process will allow China to reform successfully. For example a recent editorial in the Financial Times argues:

Much of this is difficult, for one important reason. It requires the Communist party to loosen its grip. Yet it has little choice. Unless meaningful reform can be implemented, the chances of China’s economy running out of steam are high.

This may be true, but it also may be true that a successful adjustment in China actually requires that China move temporarily “backwards” towards greater centralization of power and a tighter grip on decision-making by President Xi and his allies. After all it took Deng Xiaoping to unleash the radical reforms of the 1980s, and it is an open question as to whether he would have been able to do so had political power in China been as dispersed in the 1980s as it is today. In that sense what seems like an attempt by President Xi to consolidate power more tightly within a small group is perhaps not a step “backwards” in political liberalization but more of a temporary retreat in order to ensure a successful adjustment, which itself might be a precondition to further political liberalization some time in the future.

This is an abbreviated version of the newsletter that went out six weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

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One Response to The Politics of Adjustment

  1. FrankLi1 says:

    (1) Do not compare China with any other countries, because China is very different, from its unique form of government, to the large size of the country, to the culture.
    (2) China screwed up too much before, thanks to communism. It will take another miracle to right the wrongs of the past. Xi is well position to do it! Xi’s moves have been largely correct, so far.
    (3) The Chinese political system has proven to be quite adaptable, which is a good thing, including anti-corruption and occasional purges.
    (4) Democracy has proven to be most incapable of adapting. 3 examples:
    <a> We generate new laws only, hardly abandoning obsolete laws (= offending some people).
    <b> We still have military presence in Japan, after 68 years after WWII!
    <c> A recent poll shows that the majority of Americans wish to recall the entire Congress, which is enjoy a 9% approval rating!!!!!!!!!!!!!!