China’s Troubled Transition to a More Balanced Growth Model

In the morning of March 16, 2007, in Beijing’s Great Hall of the People, Chinese Premier Wen Jiabao held a press conference just before the end of the Fifth Session of the Tenth National People's Congress.  After questions from reporters from several different media organizations, a reporter from China News Service asked the Premier the kind of question that should have been a layup:

“China's growth rate has exceeded 10% while the inflation rate has been kept below 3% for four years running. This is rare both in China and the world. Some scholars believe that China's economy will reach a turning point in 2007. What's your view? What do you think are the major problems in China's economy? Will China be able to maintain such a momentum of high growth and low inflation?”

Premier Wen’s response was surprisingly frank, and his characterization of the economy caused a sensation:

“China's economy has maintained fast yet steady growth in recent years. However, this gives no cause for complacency, neither in the past, nor now, or in the future. My mind is focused on the pressing challenges…There are structural problems in China's economy, which cause unsteady, unbalanced, uncoordinated and unsustainable development.”

Within minutes of his ending the press conference headlines flashed around the world proclaiming that Premier Wen had called China’s development “unsteady, unbalanced, uncoordinated and unsustainable.”  This was the strongest confirmation of what skeptics had long been arguing – China’s growth model was seriously lopsided and for all its seeming success could be storing important adjustment problems for the future. 

Premier Wen went on to elaborate what he meant by those words:

“Unsteady development means overheated investment as well as excessive credit supply and liquidity and surplus in foreign trade and international payments. Unbalanced development means uneven development between urban and rural areas, between different regions and between economic and social development. Uncoordinated development means that there is lack of proper balance between the primary, secondary and tertiary sectors and between investment and consumption. Economic growth is mainly driven by investment and export.  Unsustainable development means that we have not done well in saving energy and resources and protecting the environment.”

For the next several days and weeks commentators applauded the Premier’s forthrightness and discussed the meaning of the phrase “unsteady, unbalanced, uncoordinated and unsustainable”.   But within the most senior policy-making circles it was not just Wen Jiabao who worried.  In June, 2010, writing in the government-owned Qiu Shi magazine, Vice Premier Li Keqiang – widely rumored to become the next premier after the change in leadership in 2012 – said that China’s past development has created an “irrational economic structure” and “uncoordinated and unsustainable development is increasingly apparent.”  He added that China’s long-term dependence on investment and exports for growth “will grow the instability of the economy.”

Pushing for Growth

Is China’s growth “unbalanced”, and if so, in what sense is it unbalanced?   Most commentators pretty much agree that it is indeed unbalanced, and they agree on the nature of the fundamental imbalance. Chinese growth is unbalanced because the very rapid GDP growth generated especially in the past decade has relied too heavily on net exports and investment and too little on domestic household consumption.

The most striking expression of this imbalance is the declining share of GDP represented by household consumption.  A decade ago household consumption represented about 45 percent of GDP.  This is not an unprecedented number, but it is very low.  In most countries households typically consume around 60-70 percent of GDP, and even the countries of East Asia that have followed a growth model similar to that of the Chinese, and whose economies are consequently characterized by high savings and low consumption, household consumption typically represents 50-55 percent of GDP.

But the story doesn’t end there.  Five years ago household consumption in China declined to around 40 percent of GDP.  This is probably unprecedented, and certainly is for a large economy in times of peace.  Beijing’s response to this very low number, not surprisingly, was a worried one.  Policymakers pledged to take every step necessary to raise household consumption growth and to help rebalance the economy.

While most observers hailed the new resolve and excitedly reported that with these new initiatives it was pretty clear that the low household consumption problem was about to be resolved, a few economists remained skeptical.  They argued that Beijing would not be able to raise the consumption level because doing so would require fundamental change to the growth model, and there was as of yet no political consensus in favor of taking the necessary steps.  They warned that consumption would barely grow from the 40 percent level for many years.

Even the skeptics were wrong.  For the next five years GDP growth continued to surge ahead of household consumption growth until by last year household consumption represented an astonishing 36% of GDP.

With Chinese household consumption and household income growing so rapidly in the past decade, around 7-8 percent annually, why has it been so difficult to raise the consumption share of GDP and reduce China’s overwhelming dependence on a growing trade surplus and especially accelerating investment to generate growth?  In order to understand the causes of China’s great imbalance it is necessary to consider the development model that generated its tremendous growth in the past two decades. 

There is nothing especially Chinese about the Chinese development model.  It is mostly a souped-up version of the Asian development model, probably first articulated by Japan in the 1960s, and shares fundamental features with a number of periods of rapid growth – for example Brazil during the “miracle” years of the 1960s and 1970.  While these policies can generate tremendous growth early on, they also lead inexorably to deep imbalances.

At the heart of the various models are massive subsidies for manufacturing and investment.  These subsidies make it very cheap to increase investment in manufacturing capacity, infrastructure, and real estate development, generating enormous growth in employment, and they allow investors, whether private or, more typically, the state, to generate great profitability.

But of course subsidies must be paid for, and they are paid for ultimately by the household sector.  In some cases, as with Brazil in the 1960s and 1970s, the household costs are explicit.  Brazil taxed household income heavily and invested the proceeds in manufacturing and infrastructure.   In doing this it managed to achieve eye-pooping growth rates.  As MIT professor Yasheng Huang put it tantalizingly in a June 19, 2010, Wall Street Journal piece (“Chinomics: The Fallacy of the Beijing Consensus”):

“Guess which country boasted the following characteristics: GDP grew at 11% annually for almost 10 years. The authoritarian, one-party state promoted rapid industrialization by relocating workers to coastal urban areas. The government welcomed foreign-direct investment and courted companies through tax exemptions and other benefits. Seventy-five percent of the top 100 largest domestic firms' assets belonged to the state sector. The government's savings rate doubled in less than a decade, while the agricultural share of employment fell by more than one-third over the same period.”

Of course he was talking not about China but about Brazil from 1965 to 1974, during which time it may have been the first country to which the term “miracle” was applied to describe the astonishing growth surge.  That miracle was achieved by using high levels of income tax to confiscate household wealth and use the proceeds not to improve social benefits but rather simply to subsidize the ferocious spurt of growth.

This is not necessarily a bad strategy.  Brazil achieved extraordinary growth and with it, income levels rose quickly.  But the imbalances it created had to be resolved, and with such heavy distortions imposed and maintained by the central government, there was no easy way for the economy to adjust on its own.  Eventually growth was not capable of being sustained except by rising debt, the accompanying debt levels proved to be a limit to further expansion, and Brazil spent much of the 1980s, its famous Lost Decade, reversing a significant part of the growth that occurred during its miracle years.

Hidden Taxes

The Asian variety of this growth model relies on less explicit mechanisms to accomplish the same purpose.  Rather than confiscate household wealth through high income taxes, three much more indirect mechanisms are used for the same effect.

First, wage growth is constrained to well below the growth in worker productivity. In China, for example, worker productivity has grown much faster than wages, especially during the past decade, during which time worker’s wages have slightly more than doubled, while productivity nearly tripled.

There are many reasons for the gap between the two.  One reason might have to do with the huge pool of surplus labor in the countryside available to compete for jobs and so keep wages low.  There are also other, policy-related reasons that limit wage growth.  Workers are not able to organize except in government-sponsored unions that more often see things from the point of view of employers than of workers.  Migrant workers are also unable to get residence permits, called hukou.  What limited protection workers may have is sharply reduced, since living in an urban area without the proper hukou is tolerated but technically illegal.

The important thing to remember from the growth model perspective is that, whatever the reason, lagging wage growth represents an increasing transfer of the share of economic value being produced from workers to employers.  More and more of whatever workers produce, in other words, accrues to employers, and this effective subsidy allows employers to generate excess profit. The fact that productivity grew much faster than wages acted like a growing tax on workers wages, the proceeds of which went to subsidize employers.

Notice the impact this hidden tax has on the relationship between GDP growth and household income growth.  By effectively subsidizing employers at the expense of workers, it boosted the competitiveness of businesses, increased overall production, and constrained household income, and with it, household consumption.

The second mechanism common among Asian development model countries for transferring income from households to manufacturers is an undervalued exchange rate.  Undervalued exchange rates reduce the real value of household income by raising import costs.  The undervaluation of the exchange rate, in other words, can be seen as a kind of consumption tax imposed on all imported goods, and everyone who is a net importer, which includes all households except perhaps subsistence farmers, must pay the implicit “tax”. 

Manufacturers in the tradable goods sector, on the other hand, receive the opposite “negative” tax, or subsidy, in the form of lower domestic costs relative to higher foreign prices for their goods.  An undervalued exchange rate is simply a mechanism that transfers income from net importers, which is mostly the household sector, to net exporters, and as such it makes it much more profitable to be an exporter.

Again notice the impact this hidden consumption tax has on the relationship between GDP growth and household income growth.  By raising the cost of imports it put downward pressure on real household income, but by subsidizing exporters, thus increasing their competitive strengths vis-à-vis foreign competitors, they boost domestic production.  An undervalued exchange rate is simply another powerful mechanism for increasing the gap between what a country produces and what it consumes.

The third mechanism, and probably by far the most powerful, is what economists call financial repression.  Most savings in financial repressed countries like China, or like most of the countries that followed the Asian development model, are in the form of bank deposits, and the banks are controlled by the monetary authorities who determine the direction of credit, socialize the risks, and set interest rates.

In China, the central bank, the People’s Bank of China, sets both the maximum deposit rate, above which banks cannot pay, and the minimum lending rate, below which banks cannot lend.  If it sets these rates very high, it is effectively transferring resources from borrowers to depositors.  If it sets the rate very low, of course, it does exactly the opposite.

In China, as in all the countries that followed the Asian development model, interest rates have been set extremely low.  Normally under these circumstances we would expect the losers in the system, the depositors, to opt out, but it is extremely difficult for them to do so. 

There significant restrictions on their ability to take capital out of the country.  Local stock and bond markets are likely to be rudimentary, highly speculative, and rife with insider activity – which effectively transfers profits from non-insiders to insiders while leaving them with the full risk.  There are few other legal and safe alternatives to the banking system.  The most common alternative, real estate, generally has very high transaction costs and limited liquidity, so it is not a useful investment alternative for depositors who may need to be able to access their savings quickly.

Depositors, then, have little choice but to accept very low deposit rates on their savings, which are then transferred through the banking system to borrowers, who benefit from these very low rates.  Very low lending and deposit rates create a powerful mechanism for using household savings to boost growth by heavily subsidizing the cost of capital.

The amount of the effective subsidy is huge.  In the case of China every year between 5 and 8 percent of GDP is transferred from household savers to banks and borrowers in the form of repressed interest rates.   By effectively providing this huge subsidy to borrowers, it encourages borrowing and permits borrowers to invest in a wide variety of projects with limited need to generate high returns.

Notice yet again the impact this hidden tax on savings has on the relationship between GDP growth and household income growth.  By lowering borrowing costs substantially, it encourages investment primarily in real estate development, infrastructure, and of course in manufacturing capacity (in China there is very little consumer financing).   But by reducing the amount of interest income depositors receive, it reduces the overall income they should be earning, and this is especially noticeable in a country where savings are so high.   Once again it is another powerful mechanism for increasing the gap between what a country produces and what it consumes

As an aside the resulting low cost of capital explains the seeming paradox of China’s capital-intensive, rather than labor-intensive, growth.  Ask most people what China’s comparative advantage is, and they are likely to say that it is the huge pool of cheap and disciplined labor.  But in fact this isn’t at all the case.  If China’s comparative advantage were cheap labor, we would expect its growth to be heavily labor intensive as businesses loaded up on the most efficient input.

China’s growth is actually heavily capital intensive.  It is among the most capital intensive in the world and far more so than any other developing country – even countries that are far richer and with far higher wage levels. Large Chinese businesses behave, in other words, not as if labor is the cheapest input they have but rather as if capital were the cheapest input.  They are right.  Labor may be cheap, but capital is almost free.

Subsidizing Growth

The important thing to remember is that all three of these mechanisms do the same thing, albeit by distributing the costs and benefits in different ways to households and producers.   They effectively tax household income and use the proceeds to subsidize producers, infrastructure investors, real estate developers, local and provincial borrowers, central government borrowers – in fact anyone who has access to bank lending, who employs workers, or who exports locally produced goods.

In essence they are no different than the processes used by the Brazilians during their “miracle” years.  Brasília heavily taxed household income and used the proceeds to promote industrialization and growth.  Beijing does the same thing, but the taxes are hidden.

There are other such hidden taxes.  Environmental degradation, a serious problem with China’s growth model, can also be seen as a transfer of income from households to businesses.   It is certainly cheaper for a chemical producer to dump chemicals in a nearby river rather than to pay to dispose of them more safely, and the cost of this action represents higher future health care and other costs to local households.   This is a tax on households, then, and a subsidy to chemical manufacturers.

Likewise, energy and water subsidies (including the cost of building facilities), the deterioration in the social safety net once provided by work units, subsidized land sales, ease of eminent domain expropriations, and so on are all forms of tax and subsidy.  The three most important and widely used among the Asian development model countries, however, are the three described above – lagging wage growth, undervalued currency, and repressed interest rates.

Not surprisingly, these enormous transfers from have made it very profitable for governments, businesses and real estate developers to invest in infrastructure and productive capacity.  In so doing they ignited an investment boom.  But they have also placed a heavy burden on the household sector.

The result of this enormously successful model is so much investment-driven and employment-generating growth that even with massive transfers from households, household income nonetheless surges.  In China, for the past decade as the country was clocking in growth rates of 10-12% annually, household income, and with it household consumption, grew 8-9% annually.

In a sense it seems like a free lunch.  Household income is taxed heavily in order to generate tremendous growth.  That growth causes employment to surge, and as workers move from subsistence living in rural China to the factories and development sites of the cities, their income surges.  So rapidly does household income grow that even after the huge hidden taxes are deducted the wealth and ability to consume of the average Chinese grows at a pace that is the envy of world.

Constraints to Growth

But there are at least two constraints to this model.  In early stages, when investment is low, the diversion of household wealth into investment in capacity and infrastructure is likely to be economically productive.   After all, when capital stock per person is almost non-existent, almost any increase in capital stock is likely to drive worker productivity higher.  When you have no roads, even a simple dirt road will sharply increase the value of local labor.

The longer heavily-subsidized investment continues, however, the more likely that cheap capital and socialized credit risk will fund economically wasteful projects.   Dirt roads quickly become paved roads.  Paved roads quickly become highways.  And highways too quickly become super highways with eight lanes in either direction.  The decision to upgrade is easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for what economists politely call rent seeking behavior.

It also seems easy to justify the infrastructure upgrades.  After all, rich countries have far more capital stock per person, and those investments were presumably economically justified, so it seems that it will take decades of continual upgrading before China comes close to overbuilding.  The problem with this reasoning of course is that worker productivity and wages are so much lower in China than in the developed world.  This means that the economic value of infrastructure in China, which is based primarily on the value of wages it saves, is a fraction of the value of identical infrastructure in the developed world.

Of course since risk is socialized – that is all borrowing is implicitly or explicitly guaranteed by the state – no one needs to ask whether or not the locals can use the highway and whether the economic wealth created is enough to repay the cost.    The system creates an acute form of what is called the “commonwealth” problem.  The benefits of investment accrue to the local entity that invests, while the costs are spread widely.

The problem of overinvestment is not just an infrastructure problem.  It occurs just as easily in manufacturing.  When a manufacturer can borrow money at such a low rate that he effectively forces most of the borrowing cost onto household depositors, he doesn’t need to create economic value equal to or greater than the cost of the investment.  Even factories that systematically destroy value can show high profits, and the state-owned sector in the aggregate is probably a massive but profitable value destroyer, thanks to household subsidies.

At some point, in other words, rather than create wealth, capital users begin to destroy wealth, but nonetheless show profits by passing more than 100% of the losses onto households.  The low wages relative to the productivity of the workers and especially the very cheap capital means that a very significant portion of the cost – as much as 20-40% of the total cost – is forced onto depositors just in the form of low interest rates.  This is effectively a form of debt forgiveness granted, unknowingly, by depositors.  Under these circumstances it would take heroic levels of restraint and understanding for investors not to engage in value destroying activity.

The Role of the External Sector

The second constraint is that policies that force households to subsidize growth are likely to generate much faster growth in production than in consumption – growth in household consumption being largely a function of household income growth.  In that case large and growing trade surpluses are needed to absorb the balance. 

This is what happened in China in the past decade.  As Chinese manufacturers created rapidly expanding amounts of goods, the transfers from the household sector need to subsidize this rapid expansion in manufacturing left them unable to purchase a constant share of the goods being produced.   The result was that China needed to export a growing net share of what it produced, and this is exactly what it did, especially after 2000.

As long as the rest of the world – primarily the US and the trade deficit countries of Europe – have been able to absorb rising trade surplus, the fact that domestic households absorbed a declining share of Chinese production didn’t matter much.   Rising consumer financing allowed those countries to experience consumption growth that exceeded the growth in their own manufacture of goods and services.

But by 2007 China’s trade surplus as a share of global GDP had become the highest recorded in 100 years, perhaps ever, and the rest of the world found it increasingly difficult to absorb it.  To make matters worse, the global financial crisis sharply reduced the ability and willingness of other countries even to maintain current trade deficits.

In the US, the combination of high unemployment and a high trade deficit – always a politically combustible combination – has put pressure on the US to bring down its massive trade deficit.  In peripheral Europe, whose aggregate trade deficits were also very large, around two-thirds the size of the US trade deficit, the financial crisis will make it impossible for those countries to run capital account surpluses, and flight capital may even turn them into capital exporting countries.  Since capital account surpluses are the obverse of current account deficits, it is evident that the trade deficits of peripheral Europe are likely to come crashing down.

China in other words has hit both constraints – capital is wasted, perhaps on an unprecedented scale, and the world is finding it increasingly difficult to absorb excess Chinese capacity.  For all its past success China now needs urgently to abandon the development model.

How to Adjust

The sooner it does so the less painful the adjustment, but it will be difficult.  In order for China to rebalance, we need consumption growth to outpace GDP growth by many percentage points for several years.  For example if we wanted Chinese household consumption just to return to the miserly 45 percent of a decade ago, household consumption growth would have to exceed GDP growth by roughly 2.5 percentage points every year for a decade.

Since household consumption growth is a function of household income growth, the only sustainable way to do this would be for household income growth significantly to outpace GDP growth every year for a decade, something that China has never managed in the past decades.

So what would it take to increase household income at a sufficiently rapid pace?  Clearly the hidden taxes must be reversed.  China, in other words, must raise wages more rapidly than productivity growth, it must sharply raise real interest rates, and it must revalue the currency, in order to reduce the subsidy to production and increase the household share of total income.

But this is much easier said than done.  Low wage growth, low interest rates, and an undervalued currency are at the heart of the growth model, and it is precisely these factors that allowed China to generate such rapid growth. 

What’s more, there are constraints in China’s ability to move quickly.  If it adjusts these variables too rapidly it could cause severe financial distress to businesses and projects heavily dependent on subsidized costs, and the resulting surge in unemployment could actually cause consumption to decline just as Chinese competitiveness abroad deteriorates.  That doesn’t mean China will not adjust.  Since adjustment requires no more than that household consumption grow more quickly than GDP, a rapid slowdown in household income growth can still be compatible with adjustment, only it would require a much sharper slowdown in GDP growth.

On the other hand, if it reverses these transfers slowly, China will need accommodation from the external sector, which will have to continue absorbing large trade surpluses as China slowly shifts.  But it is not at all clear that the rest of the world, most importantly the US and the trade deficit countries of Europe, will allow their trade deficits to shrink so slowly.  

Global demand growth is likely to be anemic over the next several years, and every country is trying to increase its share of global demand in order to generate more rapid domestic growth.  Obviously not every country can increase its share, and it is usually through trade tensions and restrictions that global growth is apportioned.  This is a struggle that the deficit countries are more likely to win.

The historical precedents for this kind of adjustment are not encouraging, and the adjustment China needs to make dwarfs those of its predecessors.  Like it or not, China must change its growth model, and it must rebalance its economy.  Since the ideal form of rebalancing – one in which consumption surges and pulls GDP growth behind it – is likely to be very difficult as it will require steps that will undermine the very model that has generated so much growth, China’s rebalancing is likely to occur as steady or even diminished growth in household consumption combined with a sharp reduction in GDP growth.

Will the World Suffer?

But if Chinese GDP growth does slow down sharply, what will that mean for the rest of the world?  After all, in recent years well over half of global growth has consisted of Chinese growth.  Most analysts and investors confronted with the prospect of much slower Chinese GDP growth almost always worry about two things. 

First, since China represents by far the largest component of global growth, it seems reasonable to expect that a sharp slowdown in China will also mean a sharp slowdown in growth in the rest of the world.  Slowing Chinese growth, in other words, should be terrible for the world.  Secondly, if growth does slow sharply, this should cause an equally sharp rise in social instability within China and, with it, rising political instability.

By neither claim is necessarily or obviously true, and in fact is probably wrong.  Whether either turns out to be true depends heavily on the way China rebalances.  To see why, it is worth considering what happened to Japan in the past two decades.

In 1990, Japan was 17 percent of the global economy and was easily the second largest economy in the world.  It also accounted for the largest share by far of global growth, having completed two ferocious decades during which time it’s economy had grown annually by eight to ten percent.  Only the most skeptical doubted that within a decade or two Japan would overtake the US as the world’s largest economy.

Imagine at the time that anyone had been smart enough, and foolhardy enough, to predict that over the next two decades Japan’s growth rate would collapse to substantially less than one percent annually, and that by 2010 it would be less than one-third the size of the US.  Had anyone believed the prediction (and of course no one would have believed it), he would have almost certainly made two very obvious predictions.

First, a collapse of that magnitude in the Japanese growth rate would create an enormous drag for the rest of the world.  Without Japan to power it, global growth would be anemic at best.

Second, the Japanese people would have been unwilling to accept with equanimity such a disaster.  At the very least there would be a surge in social instability and Japanese voters would have revolted against their leaders.

Although the first prediction, about a dramatic slowdown in Japanese growth, would have turned out to be completely accurate, the two subsequent predictions would have been completely wrong.  First, in spite of the virtual collapse of the Japanese growth machine, the world experienced robust growth in the 1990s.  Second, the Japanese people turned out to be remarkably docile about the terrible turn the Japanese economy took.

It is worth considering why Japan did not fulfill what seems like such obvious predictions.  The answer, it turns out, may depend crucially on the way the Japanese adjustment took place.  Take Japan’s impact on global growth.  Analysts too easily confuse a country’s share of global growth with its contribution to global growth, but they are very different.

Although Japan comprised a disproportionate share of global growth before 1990, this doesn’t mean that it contributed disproportionately to growth outside its borders.  On the contrary, Japan had at the time possibly the largest trade surplus ever recorded as a share of global GDP.  This meant that it absorbed far more global demand than it supplied.

Since it is largely demand that powers growth, Japan may well have been absorbing more growth from the rest of the world than it contributed.  In that case, the impact of Japan’s declining GDP growth would come about largely as a consequence of the change in net demand it provided to the rest of the world – would its trade surplus grow, in other words, or shrink?

On that score, it is pretty clear that Japan’s contribution in the past two decades to demand growth in the rest of the world was positive.  The combination of the small decline in Japan’s trade surplus as a share of GDP and the large decline in Japan’s GDP as a share of the world (Japan dropped from roughly 17% of the world in 1990 to 8% today) meant that from the late 1980s to the present, as a share of global GDP, the Japanese trade surplus dropped by more than half.

Japan’s net demand more than doubled during this period as a share of global GDP, or more accurately, its deficiency in net demand dropped by more than half.  This would have provided an expansionary boost to the global economy.  Perhaps this is why the world was so easily able to shrug off the almost unprecedented collapse in Japanese growth rates even though Japan was seemingly the great growth engine of the world.

Social Instability

But what about social instability – why were the Japanese so accepting of such a shocking contraction in growth?  The answer here has probably to do with the fact that during this difficult adjustment Japan successfully rebalanced its economy away from one that penalized household income and consumption growth to one that supported it.

If the Japanese measured well-being in terms of GDP per capita, the last twenty years would have come as a brutal shock.  But if they measured it in terms of consumption per capita, the last twenty years were not so bad.  Before 1990, Japanese consumption grew much more slowly than Japanese GDP, as Japanese households, like Chinese households today, were forced to subsidize growth via large transfers of wealth from households to businesses – mainly in the form of very low deposit rates and a seriously undervalued currency.

After 1990, Japanese consumption grew substantially faster than GDP as the country painfully rebalanced its growth model.  One of the forms of rebalancing, interestingly enough, may have been Japanese deflation, which automatically pushed real deposit and lending rates into positive territory and so reversed one of the main mechanisms by which wealth was transferred from Japanese households to Japanese businesses – artificially low interest rates on deposits and loans.

Growth in Japanese per capita household consumption, in other words, did not decline nearly as dramatically as growth in Japanese per capita GDP.  In fact it may have grown in real terms (once you adjust for inflation in the period before 1990 and deflation after, and after you adjust for the decline in population) only a little more slowly after 1990 than it did before 1990.  As Japan rebalanced, wealth was transferred from the state and corporate sector back to the household sector.  Most of the slowdown was consequently borne by businesses and governments.

The Japanese story has important implications for our analysis of China.  If China indeed experiences a rapid slowdown in GDP growth, the impact on the rest of the world may be far less negative than we expect.  The real key is the evolution of the Chinese trade surplus.  If it contracts, it will provide an expansionary boost to the rest of the world, not a contractionary one.

Of course that doesn’t mean that the world will grow quickly – global demand growth over the next several years is likely to be anemic, with or without a contraction in China’s trade surplus.  But it does mean that a sharp slowdown in Chinese growth might not be the disaster for the world that many believe.

Also a rapid slowdown in Chinese growth does not mean a social or political disaster domestically.  It depends crucially on how serious China is about rebalancing its economy.  If policymakers are willing to force up interest rates and wages, and maintain SOE employment and underemployment even in the face of declining profitability, most of the adjustment pain will be borne by the state sector, not by the household sector. 

China’s growth model must change, and there is a developing consensus within Beijing that this change will result in much slower GDP growth rates.  The sooner Beijing engineers the adjustment, the better.  It has already waited much too long.  But depending on how it adjusts, the cost in terms of global growth and social instability might be surprisingly low.