Supply-Side With Chinese Characteristics

Xinhua: Backgrounder: What is China's supply-side reform?

This article begins with this sentence:
While supply-side economics, as a macroeconomic theory, is nothing new, China's supply-side reforms have some unique features.
You can see where this is going.
Q: What is supply-side management?

A: Supply-side economics holds that the best way to stimulate economic growth is to lower barriers to production, particularly through tax cuts. The wealth-owners, rather than spending on direct "demand" purchases, will then be more enticed to invest in things that increase supply, such as new businesses, innovative goods and services.
So far so good.
To fully understand the supply side, it is easier to first understand the demand side.
Uh oh.
China's three decades of rapid growth were fueled by capital investment, exports and consumption, usually thought of as being on the demand side.

In 2008, following the subprime crisis in the United States, China pushed out a 4-trillion-yuan (620 billion U.S. dollars) stimulus package. The rationale was that pouring money into public works, principally infrastructure projects such as highways and railways, creates jobs and stimulates demand for construction materials like steel and cement. Wages paid to workers are, in turn, spent on necessities and business keeps going.

While this kind of stimulus can keep an economy afloat in times of crisis, problems such as overcapacity and rising home prices emerge. During the infrastructure frenzy, difficult issues such as income distribution were put on the back burner.
Demand side stimulus almost never works. One way it's done is through the crack-hit/sugar-high of a short-term spending boost or tax rebate. As far as policies go, it's not the worst thing a government can do and if there was a temporary blip in growth, it could smooth out the economy. A government should never implement a short-term demand boost though, because it will fail most of the time and when it doesn't fail, it wasn't necessary because the dip in growth was brief and shallow. Another strategy is to create "permanent" demand. See U.S. education and healthcare for examples of this unsustainable demand-side spending, which typically leads to high rates of inflation in the sector.

The reason China has such a big problem today is not solely due to the 2008 stimulus, but it was made worse by it. China directed spending into investment and maybe leaders were thinking in terms of demand as the Xinhua article states. However, the project was so large that it generated supply distortions. Chinese policy makers didn't target their stimulus to absorb excess cement, they created a massive credit fueled infrastructure boomlet that led to increased investment in cement plants. They made the problem worse, not better. They created several trillion dollars worth of debt and ended up deeper in the hole because instead of allowing the market to reallocate capital and labor away from sectors suffering overproduction, they pushed more capital in labor into those very sectors.
Q: What are the reforms?

A: Compared to stimulating demand, which tends to be short-lived, supply-side management is expected to generate sustainable, quality growth.

The Chinese economy is no longer galloping ahead on the back of investment, exports and consumption.

Adjusting banking regulations and interest rates has not been very successful in boosting investment or consumption.

With growth falling below 7 percent, China's economy is in dire need of a makeover. Instead of working on the demand side, attention has turned to stimulating business through tax cuts, entrepreneurship and innovation while phasing out excess capacity resulting from the previous stimulus. Such measures are intended to increase the supply of goods and services, consequently lowering prices and boosting consumption.
Clearly, reform must happen on the supply-side. The failure to this point is due to the avoidance of rebalacing and reallocating capital, instead preserving and growing misallocated resources and its associated debt.
Q: Is supply-side management a substitute for demand-side management?

A: No. Attending to the supply side, albeit belatedly, does not reduce the importance of demand-side management, partly because stimulating the supply side takes time. Enterprises do not become more vibrant, efficient and productive overnight.

President Xi Jinping said last month that China should work more on the supply side "while moderately expanding overall demand." The same line appeared in a statement released on Monday following the Central Economic Work Conference. Demand-side management is not going away.
The United States was suffering from multiple economic problems in 1980. The response was a massive tax cut and deregulation, along with 20% interest rates to tame inflation. The immediate effect was jump in unemployment and an increase in the deficit, along with a soaring U.S. dollar. The effects were long-lasting and global, but in the U.S. alone, there was long-term fallout that sapped the Texas economy. Bank failures followed years later (Memories of '80s oil bust keep bank regulators vigilant). I don't want to draw too many parallels with the U.S. in the 1980s, and not because the 1930s are a more appropriate comparison. What I want to convey is: in a dynamic economy such as the United States, the immediate impact of a major supply-side policy response is negative for GDP, tax revenues, bad debt, etc. China does not want to face this reality. (Another example: if I was in charge of healthcare reform, I would enact supply-side reforms that would lower the price of medicine, that in turn would lead to losses for the industry because healthcare spending/supply is currently misallocated. The result of serious and intelligent healthcare reform would be a recession in the U.S. economy even if healthcare spending remained the same percentage of GDP, though that would be unlikely.)

Q: What are China's concrete supply-side reforms?

A: Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms.

Viewed as a whole, these measures can also be considered "structural" reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.
Cutting housing inventory is not a supply-side reform. Tackling debt overhang is not a supply side reform. Both are good reforms if the market is allowed to operate and greatly discount the price of homes and debt to reflect real supply-demand dynamics. Eliminating superfluous industrial capacity is a supply-side reform if the market is doing the reallocation of capital and labor. Cutting business costs and streamlining bureaucracy is a supply-side reform. Urbanization is not a supply side reform. Forcibly relocating people from rural to urban in order to sell homes is demand side stimulus! One can see the logic of it given China's current situation, but it is not supply side reform. Where are all the rural people going to work after they move to the cities, if the talent and businesses prefer the first- and second-tier cities? A supply side reform would be, as an example, the creation of Shenzhen. Create an area with low costs for business, business moves in and the people follow. Abandoning the one-child policy is not supply side, particularly since having another child creates demand for 18 years, but no increased supply until the child enters the workforce.

Hopefully, this in English language propaganda explaining the government's policies. If they really believe this is all supply-side reform, odds of success must be marked considerably lower.

Optimists may counter that China can rely on rapid growth in other sectors of the economy. However, the immediate impact of supply-side reform is unemployment and debt default because recognition of failure is immediate. It takes time to shift capital and labor into new sectors. Secondly, as Christopher Balding points out regarding these reforms (Catching up to the Chinese Economy):
However, I believe the likelihood of it [reforms] happening is quite low.

I don’t say this for pure skeptic reasons but a variety of reasons, not least of which is just pure mathematics. Let me give you one example. The plan notes the importance of deleveraging. However, they simply cannot deleverage and maintain GDP growth of anywhere close to 6.5%. Let me give you a slightly oversimplified model that will explain why. (I should re-emphasize this model is using easy ratios in an oversimplified model but it will clearly convey the idea). Let’s assume that that GDP growth is 6% and credit is growing at 12%. If they only want to slow leverage build up, not even delever, and cut credit growth to 8%, in our simplified scenario that would cut GDP growth to 4%. Now let’s add in another wrinkle, one recent report had (again using a nice round number) 50% of credit being used to pay of old debts. Let’s now assume that 6% of credit growth goes to GDP growth and 6% to paying off old debts. If they cut credit growth to 8% (leaving 4% to fall on the 6%/6% division), if the entire 4% reduction fell on credit growth to pay off old debts, that could easily trigger a wave of defaults. Conversely, if the brunt of that credit cut fell on GDP expansion and new capacity expansion (already problematic), that could easily torpedo any growth targets for 2016. Remember, this still assumes total leverage is rising, just slower than before.

This is the key point: I see absolutely no evidence that the Chinese government is prepared to either accept or even recognize that those types of trade offs are necessary. Beijing wants to believe that markets move in one direction and do exactly what you want them to do and that just isn’t reality. One of the most fundamental laws of economics is that man has unlimited wants and limited means. There is a very small number of people, firms, or governments to whom this does not apply in the course of human events. Tradeoffs have to be made and at this point, I see no evidence that Beijing is prepared to recognize that tradeoffs need to be made and then make difficult decisions to make them.
To extend the idea of trade-offs: a steel worker will not become a computer programmer in less than 1 year, if ever. A steel mill doesn't, Transformer-like, change itself into a battery factory. There might be rapid growth in software and electric battery production in the short-run, but it will not match the 100% reduction in capital and labor allocated to a steel mill that closes its doors. What actually happens is capital (or credit) stops flowing into steel, the mill closes and steel investors, entrepreneurs and creditors lose money. New capital flows into new investments which take time to build.

The bill for years of misallocated resources is coming due.

No comments:

Post a Comment