China and the West 2021932437, 9781800374980, 9781800374973

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Copyright © 2021. Edward Elgar Publishing Limited. All rights reserved.

China and the West

Copyright © 2021. Edward Elgar Publishing Limited. All rights reserved.

China and the West Edited by

Jan Svejnar School of International and Public Affairs, Columbia University, USA

Justin Yifu Lin

Copyright © 2021. Edward Elgar Publishing Limited. All rights reserved.

National School of Development, Peking University, Beijing, China

Cheltenham, UK • Northampton, MA, USA

© Jan Svejnar and Justin Yifu Lin 2021

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2021932437 This book is available electronically in the Economics subject collection http://dx.doi.org/10.4337/9781800374980

ISBN 978 1 80037 497 3 (cased) ISBN 978 1 80037 498 0 (eBook)

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Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

Contents List of figures List of tables List of contributors

vii ix x

1 Introduction Jan Svejnar and Justin Yifu Lin PART I

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1

RECENT POLICIES AND PERFORMANCE Path to prosperity: China’s transition to market economy in the last four decades Justin Yifu Lin

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China’s performance and prospects in the world economy 14 Jan Svejnar

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The role of the state in economic growth Jacob Lew

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Reflections on the global financial crisis: a comparison of US and China policies Frank Song

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Policies for structural reform in China: domestic rebalancing for strong sustainable and inclusive growth within and beyond China Ehtisham Ahmad, Isabella Neuweg, Nicholas Stern and Chunping Xie

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PART II 7

TRADE, TENSIONS AND DIVISION OF LABOR

The potential for cooperation and competition in international trade: recent trade growth and driving factors – a perspective on current global trade tensions Robert Koopman

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Overview of China–US economic disputes in 2018 Feng Lu

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The metabolic nature of changing world order Ping Chen

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India and China in the context of rising trade tensions in the global economy Arvind Panagariya

112

PART III DIGITALIZATION AND LEADERSHIP

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The role of innovation and the digital economy: new opportunities and challenges for Chinese, US and European economic policy Edmund Phelps

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The digitalization of Europe’s economy Debora Revoltella, Philipp Brutscher and Tessa Bending

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Prospects for China’s drive for innovation: from the perspective of demographics Jianzhang Liang

14 Index

Evaluation of local leaders in China Chong-En Bai and Eric Maskin

120 125

135 148 155

Figures 3.1

Structure of world economy in 1978, percentage based on GNI in USD and current prices

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Structure of world economy in 2018, percentage based on GNI in USD and current prices

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History or future of global economy? Shares of global GDP in 1820

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Similarity and systemic relevance of trading countries, 1980–2016

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Ratio of world merchandise trade volume growth to world real GDP growth, 1981–2018 percentage change and ratio

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Evolution of average import content of aggregate demand components for all sample countries

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Metabolic growth characterized by rise and fall of logistic wavelets

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9.2

Four stages of technology life cycles

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10.1

Projected paths of the GDP from 2017 to 2030

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12.1

Firms that report to have under-invested see less of their capital stock as state-of-the-art

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Firms perceiving access to digital infrastructure as an obstacle is negatively correlated with household access to broadband (NUTS2 regional level, innovative firms)

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Share of firms investing in IT correlates with household access to broadband (NUTS2)

130

3.2 3.3 7.1 7.2

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7.3 9.1

12.2

12.3

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viii

12.4

12.5

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Firms perceiving access to digital infrastructure as an obstacle, and growth in households’ access to broadband between 2011 and 2016 (NUTS2)

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Skills as a barrier to investment for firms with different intensities of investment in ICT

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Share of finance-constrained firms and intensity of investment in ICT (left panel); Source of investment finance and intensity of investment in ICT (right panel)

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Tables 9.1

Persistent deficit of US current account and financial account (in $ billions)

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Balance of payments by indicator: current account for major countries (in $ billions)

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9.3

GDP and military spending world ratio (%)

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9.4

GDP, total trade and world reserve ratio in 2017 (%)

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9.5

World GDP ratio by major countries in history (%)

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9.6

Macro factors in trade for major countries (2017)

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9.2

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Contributors Ehtisham Ahmad is Visiting Professor at the Grantham Research Institute at the London School of Economics and Political Science and was the Pao Yu-Kong Professor at Zhejiang University (at the time of writing). He is also Co-Director, New Climate Economy/Coalition for Urban Transition Program on Financing Sustainable Urban Transitions, and Senior Fellow at the Chinese Academy of Fiscal Science/Ministry of Finance Research Institute. Chong-En Bai is Mansfield Freeman Chair Professor and Dean of the School of Economics and Management of Tsinghua University. He is also the Director of the National Institute for Fiscal Studies of Tsinghua University. Tessa Bending is an Economist at the European Investment Bank, Luxembourg.

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Philipp Brutscher is an Economist at the European Investment Bank, Luxembourg. Ping Chen is Research Fellow of China Institute at Fudan University and retired Professor of National School of Development at Peking University. Robert Koopman is the Chief Economist and Director of the Economic Research and Statistics Division at the World Trade Organization. He is also Adjunct Professor at the Graduate Institute of International and Development Studies. Jacob Lew is Visiting Professor at Columbia University’s School of International and Public Affairs. He served as the 76th Secretary of the Treasury and was also the White House Chief of Staff. Jianzhang Liang is Co-Founder and Executive Chairman of Trip.com Group Limited, a travel service provider. Justin Yifu Lin is Professor at Peking University, where he is also x

Contributors

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Dean of the Institute for New Structural Economics and the Institute of South-South Cooperation and Development, and Honorary Dean at the National School of Development. Previously, he served as Chief Economist and Senior Vice President at the World Bank. Feng Lu is Professor of Economics at the National School of Development (NSD) at Peking University, in Beijing, China. Eric Maskin is the Adams University Professor at Harvard University. In 2007, he was awarded the Nobel Memorial Prize in Economics (with L. Hurwicz and R. Myerson) for laying the foundations of mechanism design theory. Isabella Neuweg works for the Organisation for Economic Co-operation and Development on green finance and investment in the Eastern Europe, Caucasus and Central Asia region. At the time of writing the book chapter she was a Policy Analyst at the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Political Science.

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Arvind Panagariya is Professor of Economics and the Jagdish Bhagwati Professor of Indian Political Economy at Columbia University. Edmund Phelps, the 2006 Nobel Laureate in Economics, has, since 2001, been the Director of the Center on Capitalism and Society at Columbia University. He was Honorary Dean of the New Huadu Business School at Minjiang University from 2010 to 2016 and was honored with the China Friendship Award in 2014. He was named one of China’s 40 most influential foreign experts by the State Administration of Foreign Experts (SAFEA) in 2018. Among his most recent books are Rewarding Work (1997), Mass Flourishing (2013) and Dynamism (2020). Debora Revoltella is Director of the Economics Department at the European Investment Bank, Luxembourg. Frank Song is Dean and Professor of Economics and Finance at the School of Economics and Management at Wuhan University, Wuhan, China. Nicholas Stern is the IG Patel Professor of Economics and Government and Chairman of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Political Science. He was President of the British Academy, and was Chief

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Economist at the European Bank for Reconstruction and Development, and at the World Bank. Jan Svejnar is the James T. Shotwell Professor of Global Political Economy and Director of the Center on Global Economic Governance at Columbia University.

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Chunping Xie is a Policy Fellow at the Grantham Research Institute on Climate Change and the Environment at the London School of Economics and Political Science.

1. Introduction

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Jan Svejnar and Justin Yifu Lin In this volume we present 12 chapters on key policy issues confronting China and the West with contributions by leading Chinese and western scholars and former policy makers. Each chapter comes in the form of a policy brief with a focus on the role of state in economic development, trade issues, and the part played by innovation, digitalization and leadership. In Part I of the book, dealing with Recent Policies and Performance, Justin Lin and Jan Svejnar start by providing their perspectives on China’s economic rise and implications for other countries and the global economy. Their briefs are followed by Jacob Lew’s remarks about the role of state in China and the West, focusing on four core responsibilities of government in managing the economy (a) macroeconomic policies, (b) strength of a legal system, (c) investment in common goods such as education, basic research and infrastructure, and (d) managing externalities. Frank Song in turn reflects on the policies and effects of the Global Financial Crisis in China and the United States. He notes that, unlike in many other countries, policies in both China and the US were swift and effective, although both have left some long-term structural problems such as greater income inequality in the US and highly leveraged firms and local government in China. The first part of the book concludes with Ehtisham Ahmad, Isabella Neuweg, Nicholas Stern and Chunping Xie’s discussion of structural reforms aimed at domestic rebalancing that would lead to sustainable growth both within and beyond China. In Part II of the book, dealing with Trade, Tensions and Division of Labor, Robert Koopman leads with an assessment of the potential for cooperation and competition in international trade in light of the current global trade tensions. He illustrates the growth and changing geography of international trade in modern history and the relationship between trade and economic growth. He tackles the issue of what drives the growth in trade and concludes with thoughts on ‘murky protectionism’ and the importance of investment and consumer expenditures in growth 1

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during a trade conflict. Lu Feng follows by analyzing the China–US Economic Disputes, focusing on what has actually happened and what driving forces may be identified in the US policy shift coming in with the Trump administration. He concludes by identifying the key issues in the China–US dispute. Ping Chen in turn examines the changing patterns of development and world order, identifying important shifts in China’s development mode, the world order and economic thinking. He argues that a more inclusive world order needs new approaches in economic and political thoughts. The final brief in Part II is Arvind Panagariya’s view of India and China in the context of rising trade tensions in the global economy. He notes the importance of India as the seventh largest economy in terms of GDP, with the prospect of becoming the third largest economy in a decade if current growth rates continue. He provides a brief economic history and analysis of policies in India, drawing lessons from the public and private sector and stressing the desirability of free trade between India and China in view of the rising protectionism in the US. Part III delves into the important issues of Innovation, Digitalization and Leadership. Edmund Phelps starts by examining the challenges for Chinese, US and European economic policy with respect to innovation and the digital economy. Against the background of the US’s era of great innovation from the 1820s to 1960s, he notes the slowdown in the rate of increase of productivity and compares the policies of Donald Trump, Emmanuel Macron and Xi Jinping. He considers the impact of the development of artificial intelligence and robotization and concludes by arguing in favor of accepting and stimulating disruptive innovations. Debora Revoltella, Philipp Brutscher and Tessa Bending focus on issues related to the digitalization of Europe’s economy. They note that, after what could almost be described as a ‘lost decade,’ Europe was growing again and investment was picking up in the 2010s. The authors warn, however, that Europe’s longer-term prosperity depends crucially on reversing the slowdown in productivity growth and excelling in digitalization and innovation. They examine these issues using a unique data set of firms. Jianzhang Liang examines the prospects for China’s drive for innovation from the perspective of demographics. He posits that the scale effect (country size), agglomeration effect (presence of clusters) and population age effect are key to a country’s ability to innovate. He assesses China’s prospects in light of these effects and draws several policy conclusions. The final chapter, co-authored by Chong-En Bai and Eric Maskin, notes the importance of local leadership and proposes a re-design of the system of evaluation of local leaders in China. The

Introduction

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authors start by presenting local government’s main achievements and failures. They subsequently outline the existing system of evaluation for local leaders and contrast it to some general principles for re-designing the system. They conclude by suggesting specific features that ought to be included in a new evaluation system. In a challenging and rapidly changing world, this volume hopes to provide not only authoritative analyses and perspectives by authors of various chapters, but to stimulate further thinking and debates about the common future in China and the West. This thinking and debates are increasingly important in the world struck by the Covid-19 pandemic.

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PART I

Recent policies and performance

2. Path to prosperity: China’s transition to market economy in the last four decades

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Justin Yifu Lin China celebrated the 40th anniversary of transition from a planning economy to a market economy in 2018. The economic performance since that transition started has been a miracle in human history. In 1978, China was one the poorest countries in the world, her per capita GDP was $156, less than one-third of the average of $490 in Sub-Saharan African countries. Like other poor countries, 82 percent of her population lived in rural areas, and 84 percent was living below the international poverty line of $1.25 a day. China was also an inward-looking economy, with trade consisting of merely 9.7 percent of its GDP. From that humble starting point, China achieved an average annual GDP growth rate of 9.4 per cent and trade growth rate of 14.8 per cent during the period 1978–2018. In 2010, China overtook Japan to become the second largest economy in the world and overtook Germany to become the largest exporter. China became the largest trading country in the world in 2013 by overtaking the USA, and the largest economy, measured by purchasing power parity, in the world in 2014 again by overtaking the USA. More than 700 million people in China have gotten out of poverty, contributing to more than 70 percent of the global poverty reduction in this period. Moreover, China is the only emerging market economy in the world that did not suffer from a homegrown financial crisis. In 2019 China’s per capita GDP reached $10,400. It is most likely that China will cross the threshold of $12,700 and become a high-income country around 2025. If the above prediction is realized, China will be the third, following South Korea and Taiwan, to successfully grow from low-income to high-income economy among nearly 200 developing economies after World War II. In this chapter, drawing on Lin (2012a), I would like to explore why it was possible for China to achieve such an outstanding performance 5

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after the transition in 1978, why it was impossible to have a similar performance before 1978, why China was able to avoid the collapse and stagnation that happened in other transition economies, what price China paid for its success and what lessons are to be learnt.

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1.

WHY CHINA GREW SO RAPIDLY AFTER 1978

A continuous stream of technological innovations in existing industries and the emergence of higher value-added industries is the basis for continuous improvement of productivity and income and thus sustained growth in any economy, both for high-income and developing countries. There are however some important differences between high-income and developing countries. In high-income countries, technologies and industries are already on global technological frontiers. To upgrade, they have to invent new technologies and industries to move these frontiers forward. Invention requires huge capital expenditure and is also very risky. Since the end of the 19th century, the average annual growth rate of per capita labor productivity and per capita GDP in high-income countries has been about 2 percent per year. For developing countries, their technologies and industries are within global technological and industrial frontiers. They can acquire or imitate technologies and industries from high-income countries to achieve technological innovations and industrial upgrading. This way, technological innovations and industrial upgrading in developing countries will have lower costs and risks than in high-income countries. This possibility is the so-called “latecomer advantage” or “advantage of backwardness”. If developing countries are able to tap into that advantage, they can achieve higher rates of technological innovation and industrial upgrading, and thus have a fast rate of growth, a fast rate of improvement in labor productivity and growth in income. Since World War II, 13 economies in the world have found a way to realize the potential of latecomer’s advantage and achieve continuous annual GDP growth rates of 7 percent or more for 25 or more years (World Bank 2008). In high-income countries, per capita output and population increased, yielding average annual GDP growth rates in the region of 3 percent. A growth rate of 7 percent or more was more than twice that of high-income countries. If this rate is sustained for 25 or more years, the gap between the country concerned and high-income

Path to prosperity: China’s transition to market economy in the last four decades

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countries will decline. China became one of the 13 economies after the transition started in 1978.

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2.

WHY CHINA FAILED TO GROW DYNAMICALLY BEFORE 1978

China possessed the latecomer’s advantage long before the transition to a market economy in 1978. Why did China fail to benefit from that potential and achieve dynamic growth before 1979? This failure was because China adopted a wrong development strategy after the socialist revolution in 1949. Mao Zedong and other first-generation revolutionary leaders in China, like many revolutionary leaders in other developing countries, were inspired by the dream of achieving rapid industrialization and modernization so as to catch up with advanced countries quickly. The lack of large-scale, advanced capital-intensive heavy industries that were the basis of military strength and economic power was perceived as the root cause of the country’s backwardness. It was natural for the social and political elites in China to prioritize the development of large, heavy, advanced industries after the Revolution as they started building the nation. Starting in 1953, China adopted a series of ambitious Five-Year Plans to accelerate the building of modern advanced industries, with the goal of overtaking Britain in ten years and catching up to the US in fifteen years. But China was a lower-income agrarian economy at that time. The country did not have comparative advantage in the modern advanced industries and Chinese firms in those industries were not viable in an open, competitive market. To achieve its strategic goal, the Chinese government needed to protect the priority industries by giving firms in those sectors a monopoly and subsidizing them through various price distortions, including suppressed interest rates, an overvalued exchange rate and lower prices for inputs. The price distortions created shortages and the government was obliged to use administrative measures to mobilize and allocate resources directly to nonviable firms in those priority industries (Lin 2009). These interventions enabled China to quickly establish modern advanced industries, test nuclear bombs in the 1960s and launch satellites in the 1970s. But the resources were misallocated, the incentives were distorted, and the labor-intensive sectors in which China had a comparative advantage were repressed. As a result, economic efficiency was low, growth was driven mainly by an increase in inputs, and people were poor.

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China and the West

HOW CHINA AVOIDED TRANSITION COLLAPSE

After World War II, all the socialist countries and most other developing countries, inspired by the same modernization dream and guided by the prevailing structuralism, also adopted a similar strategy and government interventions to accelerate the development of advanced, capital-intensive industries and had a poor economic performance similar to that in China. When China started the transition from a planned to a market economy, many other socialist and developing countries embarked on a similar transition. China achieved stability and dynamic growth, whereas other countries suffered from economic collapse, stagnation and frequent crises (Easterly 2001). The reasons are twofold and related to differences in their transition strategies. First, other socialist countries and many developing countries followed the Washington Consensus of privatization, marketization and liberalization, inspired by neoliberalism. This strategy derived from the argument that socialist countries and other developing countries had not done well because excessive government intervention caused misallocations of resources. This argument led to the recommendation that, to improve their economic performance, these socialist and developing countries should immediately remove all distortions and end government interventions, so as to allow markets to function. However, the purpose of all of these distortions was to protect large-scale capital-intensive industries. If the government eliminated those distortions immediately, these large-scale industries would be bankrupt and large numbers of workers would lose their jobs, undermining social and political stability. Without social and political stability, economic development is impossible. As a result, after Washington Consensus shock-therapy reform many countries reintroduced subsidies and protection for the purpose of preserving jobs. Moreover, many of these large-scale industries were basic needs or defense related. Even after the privatization, governments continued to subsidize them to stay in operation. As a result, whether it was for reasons of social stability, basic needs or national defense, after the privatization, liberalization and marketization, the government reintroduced new types of subsidies and distortions. These distortions were yet more inappropriate and even more inefficient than the explicit subsidies and protections that had been swept away.

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Path to prosperity: China’s transition to market economy in the last four decades

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Before privatization, the managers were state employees. If there were difficulties, they would ask the government for protection and subsidies. If the government were to provide assistance, the managers could at most increase their on-the-job consumption. Putting money into their own pockets, however, was corruption and punishable. After privatization, owners of those large enterprises also asked for subsidies. In this case subsidies could simply be turned into their own wealth, and there was an incentive to ask for yet higher subsidies and assistance. As a result, reform led first to chaos, followed by stagnation and frequent crises. China managed to maintain stability and dynamic economic growth in the transition. The main reason is that China adopted a pragmatic approach. The government provided transitory protection and subsidies to the existing sectors to maintain stability. However, the Chinese government also liberalized and facilitated entry into new labor-intensive and small-scale traditional industries, which were consistent with China’s comparative advantages. In the past, the government discriminated and repressed those sectors. To make those labor-intensive industries competitive, China also needed to provide adequate infrastructure and a good business environment. The infrastructure in China was extremely poor when the transition started. Although it was desirable to improve infrastructure for the whole nation, the Chinese government lacked financial resources to do so, and so it set up special economic zones (SEZs), industrial parks and export processing zones, improving infrastructure in a limited number of areas. China’s business environment was also very poor due to the distortions needed to protect existing industries. In SEZs and other economic zones, however, the government eliminated all of these distortions. In addition, the government provided one-stop service and other incentives to the firms in SEZs or industrial parks. As a result, new industries consistent with China’s comparative advantage quickly became China’s competitive advantage. It was for these reasons that China maintained stability, achieved dynamic growth, and China’s exports rose rapidly in the last four decades. As China grew and accumulated capital, its comparative advantages gradually upgraded from labor-intensive to capital-intensive industries. During the upgrading process, China could benefit from the latecomer’s advantage.

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China and the West

WHAT PRICE DID CHINA PAY FOR ITS SUCCESS?

Although the economic performance during the transition in the last four decades was extraordinary, however, China also paid a very high price for its success. In addition to environmental degradation and food safety issues, which have attracted many public complaints and are the results of rapid industrialization and lack of appropriate regulations, the main issue during the transition is widespread corruption and the worsening of income disparities. Before 1978, China had a rather disciplined and clean bureaucratic system and an equalitarian society. According to the Corruption Perception Index published by Transparency International, China ranked No. 79 among all the 176 countries or territories in 2016; and based on the estimates of National Statistical Bureau and various scholars’ research, China’s GINI coefficient has exceeded 0.45, higher than the international warning level, after 2000 (Li and Sicular 2014). These problems were related to China’s pragmatic, dual-track transition strategy. On the one hand, the government provided transitory protection and subsidies to the nonviable state-owned enterprises (SOEs) in the old, capital-intensive sectors to maintain stability and, on the other hand, liberalized and facilitated the entry to the new, labor-intensive sectors which were consistent with China’s comparative advantages to achieve dynamic growth. One of the most important costs of investment and operation for the old capital-intensive sectors was the cost of capital. Before the transition in 1978, the government used fiscal appropriation to pay for investments and cover working capital, so SOEs did not have to bear any cost for capital. After the transition, the fiscal appropriation was replaced by bank loans. The Chinese government set up four large state banks and a stock market to meet the capital needs of large enterprises. To subsidize SOEs, the interest rates and capital costs were artificially repressed. When the transition started, almost all firms in China were state-owned. With the dual-track transition, private-owned firms grew and some of them become large enough to get access to bank loans or list in the equity market. As interest rates and capital costs were artificially repressed, whoever could borrow from the banks or list in the stock market were therefore subsidized. These subsidies were paid for by the low returns to savings in the banks or in the stock market made by individual households. Those people providing the funds were poorer than the owners of

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Path to prosperity: China’s transition to market economy in the last four decades

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the large firms they financed. The subsidization of the operation of the rich’s firms by poorer people was one reason for increasing income disparities. Moreover, the access to bank loans and equity market generated rents, leading to bribery and corruption of the officials who control the access. Similarly, before 1979 natural resources mining was operated free of concession fees by large-scale state-owned mining companies and the outputs were provided to other SOEs at very low prices. The government allowed private firms to enter the mining sectors in 1983 and liberalized controls over output prices in 1993. Concession fees and output taxes were kept low as a measure to compensate for state-owned mining enterprises’ social policy burden of employing redundant workers and covering the pension of retired workers (Lin and Tan 1999). New private mining companies did not have such burdens. Acquiring a concession promised them overnight enrichment and became a source of income inequality and corruption. In addition, some natural monopoly industries, such as power and telecommunication, were operated by state-owned enterprises. The government liberalized the entry to those industries gradually. Those monopoly rents were also sources of inequality and corruption. For coping with corruption, President Xi Jinping launched an anti-graft campaign after taking office in 2013. However, the root of the widespread corruption was the rents arising from the distortions of the dual-track transition, which protected and subsidized the large-scale SOEs in comparative-advantage defying, capital-intensive industries. In the 1980s and 1990s China was a poor country and capital was scarce. After four decades of rapid economic growth, capital becomes relatively abundant and comparative advantages in China evolved accordingly. Many capital-intensive industries turned from defying China’s comparative advantages to becoming consistent with China’s comparative advantages. As a result, firms in those industries became viable and should have been competitive and profitable in domestic and global markets as long as they had good management. The nature of subsidies and protections to the recipient firms changed from a necessity for survival to a pure rent. It was, and still is, imperative to eliminate all remaining distortions and protections, so as to complete the transition to a well-functioning market economy and to uproot the causes of corruption and income disparity. Indeed, this was exactly the intention of the comprehensive reform agenda adopted in 2013 by the third plenary session of the 18th party congress of Communist Party of China.

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5.

THE LESSONS FOR OTHER DEVELOPING COUNTRIES AND FOR ECONOMICS?

What, finally, are the implications for other developing countries? The analysis in this chapter suggests, first, that every developing country has the potential to grow dynamically and continuously for 30 or more years and to eliminate poverty and become prosperous, if they develop their economy according to their comparative advantage. With the government’s facilitation in a market economy, countries can turn their comparative advantages into competitive advantages. Competitive industries can be profitable, accumulate capital and engage in processes of industrial upgrading that tap into the potential advantage of backwardness, enabling them to grow much faster than high-income countries, maintaining growth rates of 7 percent or more for several decades, as in the case of China in the last four decades. Although there is potential for every country to grow, they need to have the right development strategy in order to tap into their potential. Second, most countries inherit many distortions from previous interventions. Those distortions cause misallocation of resources and rent seeking. Removing those distortions is desirable. However, distortions exist for certain reasons, and are, in economic terms, largely endogenous. Unless the causes of a distortion are removed first, the attempt to eliminate the distortion can do more harm than good. A country embarking on reform should, therefore, be pragmatic employing transitory and transitional protection as China was over the last 30 years. A careful liberalization of entry into new sectors, of a country’s comparative advantages and of government facilitation of growth in those sectors, can allow it to grow dynamically and preserve stability while preparing the ground for the removal of the distortions. A pragmatic approach to step-by-step development, according to a country’s evolving comparative advantage, is of great value to developing countries. At the same time, pragmatism is required in the transition itself. The final goal is the establishment of a well-functioning market economy, but it should be a process managed by the government paying attention to the needs of all sectors and providing business opportunities for them. The analysis in this chapter shows that it is important to examine the reality of the situation in developing countries and to develop new ideas and theoretical understandings based on their experiences. In recent years, reflecting on the weakness of structuralism and neoliberalism,

Path to prosperity: China’s transition to market economy in the last four decades

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I advocate New Structural Economics (Lin 2012b), which is generalized from the successes and failures of China and other developing countries’ development and transition. From the perspective of new structural economics, the secret of China’s success is its use of both the “invisible hand” and the “visible hand”, forming an organic integration, complementation and mutual improvement of the functions of the market and the state. The applicability of a theory generalized from one country to another depends on the similarity of pre-conditions in those countries. I hope that the New Structural Economics will provide useful insights for developing countries in overcoming development challenges in their roads ahead.

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REFERENCES Easterly, William, (2001). ‘The Lost Decades: Developing Countries’ Stagnation in Spite of Policy Reform 1980–1998’, Journal of Economic Growth. 6: 135–57. Li, S. and T. Sicular, (2014). ‘The Distribution of Household Income in China: Inequality, Poverty and Policies’, China Quarterly. 217: 1–41. Lin, Justin Yifu, (2009). Economic Development and Transition: Thought, Strategy, and Viability. Cambridge, UK: Cambridge University Press. Lin, Justin Yifu, (2012a). Demystifying the Chinese Economy. Cambridge, UK: Cambridge University Press. Lin, Justin Yifu, (2012b). New Structural Economics: A Framework for Rethinking Development and Policy. Washington, DC: World Bank. Lin, Justin Yifu and Guofu Tan, (1999). ‘Policy Burdens, Accountability, and the Soft Budget Constraint’, American Economic Review: Papers and Proceedings. 89: 426–31. World Bank (on behalf of the Commission on Growth and Development), (2008). The Growth Report: Strategies for Sustained Growth and Inclusive Development. Washington, DC: World Bank.

3. China’s performance and prospects in the world economy

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Jan Svejnar China’s economic rise over the last 40 years has been truly phenomenal. While at the start of the reforms in 1978 China is estimated to have accounted for only 2 percent of the world Gross National Income (GNI), measured at current exchange rates (see Figure 3.1 below), by 2018 its share stood at 16 percent (Figure 3.2 below). During the same time period, the share of the United States (US) declined slightly from 25 percent to 24 percent, while the share of the European Union (EU) dropped dramatically from 29 percent to 22 percent and that of Japan from 11 percent to 6 percent.1 China is currently the second largest national economy and measured in purchasing power parity, its Gross Domestic Product (GDP) surpassed that of the US in 2014. No other sizable economy in modern history has managed to rise at as fast a rate for as long a time period as China. What accounts for China’s rapid growth since 1978? The rise of a new political leader, Deng Xiaoping, with a vision for fundamental economic reforms was a necessary condition. Among the economic factors that have underpinned the fast growth, the first one to consider is the fact that China started from a very low base. While it was the most advanced economy in the world at the start of the nineteenth century (see Figure 3.3 below), it experienced long-term stagnation that was later exacerbated by conflicts with western countries and Japan, civil war, and the costly economic and social experiments – the Great Leap Forward and Cultural Revolution – after 1949. Since 1978 China has maintained centralized political control, while instituting effective economic reforms that introduced significant economic decentralization and a rapidly growing market economy. The nature of the reforms are discussed by Justin Lin and other authors in this volume. Structurally, China has succeeded in increasing total factor productivity by reallocating labor from low-productivity 14

China’s performance and prospects in the world economy

15

Source: WDI and Maddison Project Database (for Russia)

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Figure 3.1

Structure of world economy in 1978, percentage based on GNI in USD and current prices

Source: WDI

Figure 3.2

Structure of world economy in 2018, percentage based on GNI in USD and current prices

16

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Figure 3.3

China and the West

History or future of global economy? Shares of global GDP in 1820

agriculture to much more productive industry and later also services, maintaining a high rate of capital accumulation, transfer of technology and know-how, and innovation (including investment in research and development), significantly unifying the fragmented internal market by building up infrastructure and establishing faster transportation,2 and taking advantage of strong external demand and liberalization of external trade.3 Recently, it has also started to liberalize and further develop the financial market.

PRINCIPAL CHALLENGES Over time, China started to experience a slowdown in its rapid rate of economic growth. In particular, GDP growth declined from an officially reported average of 9–12 percent in the early decades of the reform, to 7–8 percent at the start of the 2010s and 6–7 percent until 2020. This secular slowdown in the rate of growth, while considered as a warning signal by some observers, is not completely unexpected for a large economy that has moved from a low- to middle-income level. At the time of the writing of this chapter, China is going through a major decline in economic activity on account of the Covid-19 crisis and it remains to be seen how China and the global economy will emerge from this pandemic.

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Throughout the 1978–2019 reform period, China managed to use fiscal expansion to avoid recessions, be it during the Asian Crisis of the 1990s or the Great Recession that started in 2007. Before the pandemic, China’s official GDP growth rate was surprisingly steady (6.6 percent in 2018) despite the ‘trade war’ with the US and the concomitant rise in protectionism in the world, including Europe. Moreover, the 2019 GDP growth is estimated to have been in the 6–6.5 percent range. In this context it is worth noting that while China dominates world trade, it has not been opening up to trade as much as many analysts and policy makers had expected – the share of imports of goods and services in Chinese GDP has in fact been decreasing in the last few years. The recent decline in China’s access to the US market obviously constitutes a serious problem for its export-oriented economy, but as Arvind Panagariya notes in his Chapter 10, it also presents opportunities, for instance to establish a more open trading relationship between the rapidly growing India and China. China has been tackling its structural challenges, but they still include a relatively low rate of consumption, inefficiency of many state-owned enterprises (SOEs), inefficiency and fragility of the financial sector, high level of corporate and provincial government debt, persistent overcapacity in a number of industries, and an unfinished reform of the exchange rate system. They are accentuated by the rising wages, aging population and persistent bureaucratic red tape. From a broader standpoint of economic development, China faces the challenge to avoid what has happened to a number of promising emerging market economies, namely getting stuck in the so-called ‘middle-income trap.’

KEY ACHIEVEMENTS China’s key achievement is obviously its ability avoid the deep ‘transition recession’ that occurred after the fall of the Berlin wall in all the economies of the former Soviet bloc and to sustain fast economic growth for over 40 years. Increasingly China has succeeded in spearheading rapid innovation in a number of key areas, including digital technology and artificial intelligence. These advances point to the rising dynamism of and government support for the entrepreneurial part of China’s economy. In the international arena, China has increased its importance in a number of key institutions, including the G20, IMF and the World Bank. It has also spearheaded the creation of new multilateral institutions, such as the Asian Infrastructure Investment Bank and the Development Bank.

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Moreover, it has succeeded to have Renminbi included in the basket of IMF Special Drawing Rights currencies and it has launched a major foreign investment and assistance program in the form of Belt and Road initiative. Finally, it has gained worldwide recognition and respect for its scientific capabilities by carrying out a number of advanced projects, including the landing of a spacecraft on the far side of the Moon in January 2019.

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PROSPECTS FOR THE FUTURE Given its track record, China has a good chance to avoid the middle-income trap, but the aforementioned reforms are needed, as is a successful conclusion of the ongoing trade war, re-establishment of an open trading system and exit from the Covid-19 pandemic. China has negotiated a number of bilateral and plurilateral trade agreements, including the China–ASEAN free trade area, the China–Chile free trade area and the China–Switzerland free trade area. It is likely that China will successfully proceed further in this direction. As part of its growing integration into the global economy, China has also been releasing more information about its economy. Providing information about China’s foreign exchange reserves in 2015 as part of its effort to have Renmimbi included in the IMF special drawing rights is a case in point. China has very successfully invested in the development of advanced technologies, with firms such as Baidu, Alibaba and Tencent being widely recognized as world leaders in the technology arena. They are followed by a large number of Unicorns, many of which they have created and/or control. In addition to providing global competition, some of China’s technology firms have been in the center of strategic deliberations in advanced economies. Huawei, China’s leading telecommunications developer and producer of the fifth generation (5G) computer and phone network, is a prime example. Given that 5G is becoming the backbone of most modern technologies and their civilian as well as military applications – from virtual reality and artificial intelligence tools to sensors, robots and autonomous vehicles – the strategic discussions in many countries about allowing China’s companies to produce and control the next generation networks continue. More generally, the competition over cyber control is likely to be one of the key features of the upcoming global economic and political development.

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Overall, it is important to realize that even if China avoids major problems, including a protracted crisis brought about by the Covid-19 pandemic, its economic growth is likely to be decelerating, just as has happened in the Republic of Korea, Hong Kong, Taiwan, and Singapore in the past. The key is to avoid the long-term stagnation and slow growth that has plagued Japan, an earlier economic juggernaut, over the last three decades.

NOTES The precipitous decline in the EU and Japan constitutes the most substantial decrease of a ‘leading economy’s’ share in modern history. 2. China has achieved similar (but more hidden) real unification of its internal market as the EU. 3. China benefitted considerably from joining the World Trade Organization in 2001.

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1.

4. The role of the state in economic growth

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Jacob Lew For much of the past 50 years, economic engagement between the United States (US) and China reflected a desire on the part of Chinese participants to learn from the US, and in many ways to be more like the US in order to improve economic performance and reduce poverty. Along with an open discussion of our different systems, there was always a clear recognition that China was on the path from developing to developed economy, and that it wanted to be a full participant in the global economy and, increasingly, to take a leadership role in the governance of international economic institutions. Some of the motivation to learn from the US may have been flattery, but much was a real desire to build a successful, competitive and sustainable economic model in China. It is troubling that over the past few years – including in conversations among scholars and businesspeople, as well as public officials – the question has become, ‘Do we really want to be more like you?’ For the last 75 years US global leadership has come as much from being the economic model others want to emulate as from military might alone. In the context of populist political turmoil in the West and stubbornly widening economic inequality, it is easy to see how some would question whether the US should remain the right model. It would be a mistake, however, to overread the politics of the moment. History will tell whether these trends turn out to be transitory circumstances or inflection points, and much will depend on the course of policy in the US and the West over the next several years. It is important to be clear eyed about history and even current performance, before accepting that this shift is warranted, and to beware of both revisionism and triumphalism. And there has been some of both as this reframing has emerged. Some American observers, distressed with the immediate political climate and the seeming inability to marshal political will to address serious challenges, are too quick to concede failure. 20

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The role of the state in economic growth

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Conversely, some Chinese observers see a moment of opportunity to shift roles with the US as defenders of the international order and even of free trade, and are too quick to overlook past and current practices that are inconsistent with this repositioning. China’s record of economic growth over the past quarter of a century has been remarkable. The reduction in poverty and attainment of advanced levels of technological and manufacturing performance reflect a meteoric rise. At the same time, rapid technological change has revolutionized the workplace around the world, and globalization and technological change have merged in the worldview of those disrupted by change. While technology may explain a large share of the disruption, China’s emergence as one of the two largest economies in the world has come to represent the threat that globalization presents to workers in older developed economies. The backlash in the form of economic nationalism warrants serious reflection, but so do practices in China that create unfair advantage as opposed to comparative advantage. The world, including the US, is safer and more prosperous when China is growing at a sustainable and healthy pace, so that China can fulfill the economic needs of its own people and the growing global stewardship responsibilities that come with being one of the two largest economies in the world. But additional reforms are needed to achieve these objectives, and as in the past, these reforms should continue to move China towards a more open market orientation in the context of China’s different political and cultural traditions. This Columbia/Tsinghua program is focusing on the role of government in economic development, and I will use that lens to consider the factors that lead me to this view. I will look at four core responsibilities of government in terms of managing the economy. First, macroeconomic policies through which government shapes the foundation for growth. Second, the strength of the legal system, which determines whether private parties have confidence that their property rights, including intellectual property, will be protected. Third, investments in common goods that are essential for an economy to thrive: developing a well-educated workforce with necessary skills; investing in basic research to stay at the cutting edge; and building infrastructure to move people and goods efficiently. And fourth, managing the externalities that markets often fail to value fully or manage effectively, whether through environmental or consumer protections; prudent financial practices, or solutions to a range of other issues.

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MACROECONOMIC POLICY Over the past 75 years the US has been the most resilient developed economy, bouncing back even from the 2007–2008 financial crisis and the recession that followed faster than other developed economies. It took a mix of fiscal stimulus through tax cuts and spending, monetary policies that were never fully withdrawn, and major reforms of our financial system. There could have been a bigger and longer fiscal response, which would have relieved the Federal Reserve Board of some of the burden of using monetary tools to the extent that they did, but in the end, the recovery was faster with more jobs created than anywhere else in the developed world. Although the recovery itself was a success story, there is substantial concern that it left many behind because it did not reach all levels of the economy with equal strength. Wages, rising slowly before the recession, have been slow to rise since. Workers with limited skills have had a harder time regaining employment, and the demographic trend of an aging baby boom is amplifying the reduction in the share of able-bodied adults participating in the workforce. Even if an economic model is sound, policy makers have to exercise sound judgment within that system, and the problem in the US today is not the economic model, but the ability of the political process to produce effective policy results. There are clear solutions, many of which command broad bipartisan support, that could alleviate some of the most serious critiques of income inequality. Greater investment in training and apprenticeship programs would bring many on the sidelines back into the workforce; an infrastructure program would lay a foundation for future economic growth while also creating good middle-class jobs and the opportunity for many to gain or use vital skills; enhanced support for child care would ease the burden on families who feel like they are falling behind. These solutions are well within the grasp of our economic system, the problem is with the priorities of policy makers and the capacity of opposing parties to fashion compromises with broad appeal. Early in the Trump Administration, the US turned to tax policies that will widen the deficit, shifting additional burdens to the next generation, while distributing the benefits of a tax cut in a way that will fail to increase long-term investment and will exacerbate rather than reduce inequity, leaving no fiscal space for the kinds of initiatives that would address the legitimate anxieties of workers who feel left behind

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by a rapidly changing economy. I strongly opposed these decisions, but I also see it as a misguided policy that over time can and will be corrected. Similar moves in the 1980s and the early 2000s were revisited in subsequent years as soaring deficits and economic consequences became clear and the political pendulum reversed. This risky experiment in ill-timed fiscal stimulus produced a short-term economic bump, much like pouring kerosene on a fire produces a flare. But the aftermath will likely be higher interest rates, a cooling economy, soaring debt and a struggle to fund critical services. Which is why there is a need to revisit current policies, hopefully sooner rather than later, but I would not write off the economic model because of a round of bad decisions. The track record of the US economy over the last 75 years supports the notion that the trend of long-term growth in GDP is resilient, and the history of shifting political winds suggests that failing policies will not endure. Turning to China, during the global economic crisis China pursued spending policies to help drive global demand at a time when coordinated macroeconomic stimulus was badly needed. This helped sustain high growth rates in China, along with boosting global economic activity. At the same time, China continued building its reserves of foreign currencies, weakening its currency against the dollar in particular, and substantially increased its industrial capacity in areas like steel, aluminum and concrete, without retiring old plants, creating a looming problem in terms of excess capacity. The result was increased tension as the exchange rate made imports from China even more competitive in the US than purchase of US manufactured goods, and excess capacity distorted global markets. When I was at Treasury from 2013–2017, we made significant progress engaging on these issues and urged China to make reforms that would move farther towards more market-oriented practices. We made the case that a weak currency reduced domestic purchasing power, making it more difficult for a growing middle class to increase consumption while also saving for retirement; and that subsidies and excess capacity distorted economic signals, which would inevitably lead to slower economic growth than market-driven decisions. Starting with the release of the report of the third plenum of the Communist Party in 2013, there were important signs that China in principle embraced increasing the influence of market forces in the economy. It was significant in 2015 when China adopted a new exchange rate policy that would be more market oriented, and ultimately led to a policy of spending down foreign currency reserves to defend the renminbi. While the goal of this intervention was to limit capital outflows and currency speculation, the change helped raise the

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China and the West

value of the renminbi closer to a market exchange rate and increased the purchasing power of China’s consumers, while reducing a major irritant in our bilateral relationship. Since then, currency has not predominated as an issue in the US–China relationship, and when it has flared, the current US Administration has largely reached back to prior policies in its critiques. Excess capacity in steel, aluminum and concrete promised to become as much a source of controversy as exchange rate practices, and the economic burden of downsizing would inevitably fall to the state-owned enterprises and workers where closures would be necessary. The environmental and long-term economic benefits of closing inefficient and dirty plants would be broadly shared, and an adjustment program would have to be supported by the central government. This kind of change is hard in any system, and on many occasions, I pointed out that China could look at the model of Pittsburgh, where investment in education, technology and biomedical research sparked an economic renaissance, or Detroit, where the delay in diversifying its economic base cost decades in terms of economic revival. In terms of bilateral tension, after years of competing against currency headwinds, excess capacity made it hard even for modern and efficient US steel mills to compete in a global market glutted with oversupply, a problem shared by many steel-producing countries. While unilateral tariffs may address the emotional frustration of workers who see their industries in decline, they will not solve the problem. The answer should not be a withdrawal from international norms but clear progress through multilateral and bilateral engagement. It was a step in the right direction in 2016, when China moved from denying that excess capacity is a problem, to making commitments to reduce capacity. China also agreed to a G20 process to monitor excess capacity. These steps may not represent a full solution to the problem, but they help. Continued and more visible progress can restore balance to international commodity markets, and over time would lessen the pressure for ill-conceived trade wars. Looking ahead, further movement towards market reforms is needed to strengthen China’s economy and reduce international tension. In addition to excess capacity, reforms should limit subsidies that steer capital to heavy industry and state-owned enterprises, which is both an unfair trade advantage and a burden to emerging Chinese ventures; markets should be more open to increased foreign investment and imports of goods and services. While it will be a challenge to manage short-term disruptions,

The role of the state in economic growth

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continued market-oriented reforms will help shape a stronger future for China and represent the opposite of a trade war.

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RULE OF LAW Rule of law and the protection of property rights in the US has created an environment that fosters innovation and entrepreneurship. Inventors and creators have near absolute confidence that through copyrights and patents, the value they create, including intellectual property, will be secure because of a legal system that ensures neutral fact finding and adjudication when disputes occur. To be sure, we also face challenges, like antitrust concerns and fair market pricing issues, whether in pharmaceuticals or technology, but again there is a system of law to challenge egregious behavior. And if laws are inadequate, they can be modified if outrageous practices produce a strong public response. Overall, in terms of promoting economic innovation and growth, a strong legal system protecting property rights has been a powerful driver for the US to become a leader in innovation. In recent years China has made progress building a legal structure to protect intellectual property rights, creating and expanding courts to deal with copyright and patent challenges. But for most of the period since China entered the WTO this was not the case, and it is one reason that China was slow to develop its own leadership in technology development. Progress here has been a source of growing strength for China, and continued progress will benefit China in the coming decades. There are numerous metrics, ranging from investments in artificial intelligence to robotics technology where China’s indigenous capabilities are growing substantially, but the transition is not complete. China still looks abroad to purchase technologies developed in the US and other highly developed countries. Tension that surrounded questions of whether there was theft of intellectual property are now aimed at technology acquisition, not just in the US but in Europe as well, along with practices that tie the opening of markets for imports to sharing proprietary design and software secrets. Further protecting property rights will help China continue on a path towards becoming a leader in indigenous innovation; and allowing foreign goods and services to come into China without the pressure to forfeit highly valuable intellectual property will give China continued access to the best products available in the world. From a US–China bilateral perspective, rather than stressing short-term trade balances, long-term reforms that would move China closer to the

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group of countries where intellectual property is fully protected would be far more important. And this is another area where continuing to learn from US practices would help China achieve a core strategic objective.

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INVESTMENT IN COMMON GOODS AND MANAGING EXTERNALITIES Since the nineteenth century, the US has moved in fits and starts towards policies that invest in and protect common goods and common interests. Land grants helped finance a national rail network and our public institutions of higher education; federal laws protected consumers and workers from harmful products and conditions; protection of our air and water became a national priority. In terms of public spending, providing universal public education, large-scale public investment in research and development and in infrastructure investments like the interstate highway system helped to build an economy with resilience and great capacity for growth. It would be at our own peril to take a step back from investment policies that have been very successful in the past. And a snapshot of current conditions, for example in the quality of education and research and development, suggests that by market standards we remain a world leader, as demonstrated by global demand for slots in US institutions of higher education. But we cannot take a long break from making critical investments. We need to do better. Failing bridges and ports will not be a strong foundation for economic growth; a workforce that lacks the skills for a modern economy would only worsen the sense that opportunity is no longer available to the working class and the middle class. If we take even a decade off from investing in research and development, others will move in to fill the gap. The good news is that we know how to do this, and for a very long time have done it very well. We need to restore confidence in public stewardship so taxpayers have greater confidence in the value of public investments. While this problem may take years to solve, again it is a problem of politics not the economic system itself. Consumer and worker protections and health and environmental safeguards help to address externalities when markets do not, and decades of progress in the US are not erased even if we take a step back periodically. As we have seen before, when the political pendulum swings in the other direction lost ground can be regained. With the transnational nature of modern environmental challenges, if the world continues to move forward on issues like climate change, it is unlikely that the US will

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slip far behind in a short period of time, especially since beyond federal policy, other key actors like state and local governments and even private sector businesses can continue to make progress. In recent decades China has achieved major accomplishments in terms of the scope and scale of infrastructure undertaken and the number of people brought into the workforce and trained. In the last few years there has been an explosion of investment to advance the objective of establishing leadership in key areas of technology. But the track record is not perfect. China has built a great deal of infrastructure, from rail lines to housing, where the supply now is greater than the demand; adverse environmental impact has been tolerated as a necessary cost, both domestically and internationally. When a rail line runs trains with far fewer passengers than they were designed for, or a housing development – or community – becomes an empty monument to miscalculation, there is an economic and environmental cost. Allocating resources centrally has great efficiency in terms of time, as decisions can be executed rapidly. But without the guardrails of market signals or political accountability, it is easy to make costly mistakes. A great deal rides on whether central planners pick the right winners in a rapidly changing economic and technological landscape. China has demonstrated well the power that thinking big and strategically can have on shaping an economic program, particularly in a political system with the ability to follow through relatively quickly. But there should also be caution about creating potential bubbles or becoming overextended on investments that lack enduring value. For decades addressing environmental concerns was considered a luxury that did not fit into China’s growth model or its stage of development. In recent years public concern about air quality, in particular, has forced these issues to be taken far more seriously and the need to address environmental protection is now being factored into the economic calculus in a different way. It was a positive turn in US–China relations that we joined together to drive the Paris climate process to a successful outcome, and it is important that China remain a part of that global effort. Sadly, the US has taken official steps to withdraw from the Paris accord. Fortunately, at a state and local level and in the private sector, there remains a great deal of focus on addressing climate change, which is why even as federal policy steps back, progress will continue. China would be wise to follow the US legacy of the prior four decades and not the past two years, because China can only address the health concerns of its people and maintain a sound long-term economic trajectory at

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the same time, by retiring old and highly polluting facilities as they are replaced by newer and cleaner ones. Whether the risk is the overhang of credit bubbles; inefficiently allocated public capital or a reluctance to withstand the disruption associated with closing or cleaning up highly polluting facilities, waiting too long can become a drag on continued prosperity. Market mechanisms and public feedback through political processes and civil society are powerful signals that alert decision makers to problems that lie ahead. And even with steps forward and back, this is another area where the US experience offers helpful guidance as China seeks to strike the right balance.

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CONCLUSION Overall, the US model has been a north star that has helped China and many other developing economies to make rapid progress. We face contemporary challenges, as we have in the past, but it would be a mistake to rewrite history through the lens of the current political environment. Even if the US today may fall short on meeting our own traditional standards in some areas, the challenge is for the US is to get back on track, not for the track record to be erased or dismissed. China must also recognize that in important ways its own actions have contributed to international tension and helped fuel populism and calls for economic nationalism, at least in the US. Staying on a path of market reform promises to produce more sustained prosperity and growth in China. While populism of the right and left have not yet run their course in either the US or Europe, long democratic traditions leave me hopeful that the pendulum will swing back, and that this moment of questioning the value of the model of our system will be temporary and not an inflection point.

5. Reflections on the global financial crisis: a comparison of US and China policies Frank Song

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1. INTRODUCTION 2018 was the tenth anniversary of the global financial crisis. Ten years ago, the global financial crisis was initiated as a crisis in the sub-prime real estate lending market, and then spread to the US financial system and the economy. The US financial and economic risks, through links of global financial markets, international trade and investment, further spread to major economies such as Europe and Japan, as well as most emerging economies. China, as the biggest emerging economy, was also unable to escape the negative impact of the crisis. As the crisis became global, the US, China, and other major economies quickly adopted various bailout and stimulation policies. In the US, the government quickly injected liquidity in financial markets and bailed out systemic important financial institutions, which helped to curtail the possible chain reaction caused by the debt links of financial institutions and stabilize the financial market. The Federal Reserve further cut down the federal fund rate to close to zero, and initiated three rounds of Quantitative Easying (QE), namely purchasing various long-term bonds, including Mortgage-Backed Securities (MBS) and corporate bonds, which helped to raise bond prices and reduce long-term interest rates. Japan and Europe even introduced negative nominal interest rate policy to push liquidity into the economy. In facing the big shock to its trade sector, China also introduced one of the biggest stimulation packages, a so-called four trillion investment package, which helped to stabilize the Chinese economy. In all, different countries adopted unprecedented and innovative policies in dealing with the global financial and economic 29

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crisis, which was labeled as the Great Recession, as compared with the Great Depression of the 1930s. This chaper reviews the causes, process, and policy responses of the global financial crisis, with the focuses on the comparison of policy responses of US and China. I first review the economic background of the crisis in the two major economies, and then analyze the causes of the crisis in the two countries. Further, I compare and contrast the policy responses of the two governments. I argue that the different policies adopted by the two countries are deeply rooted in their economic and political institutions. In other words, the US bailout policies and China’s stimulations are each endogenous to their institutional structure, and they were also effective in bringing the economy out of a big downturn as indicated by the economic recovery. However, as both countries relied on short-term bailout and stimulation policies to deal with the financial crisis, they failed to address the long-term structural problems inherent in both countries. Instead, these policies helped to prolong and even aggravate the structural problems such as income inequality in the US and over-capacity in China. To reflect and learn from the mistakes leading to the global financial crisis and its aftermath, it is important for us to understand how the crisis occurred and how policies were conducted in responding to the shocks, and the consequences of the crisis and policies. It helps us to better understand the difficulties of the world economy and prepare us to meet future challenges. Hopefully, both China and the US can learn to understand each other’s policy framework better, so we can reduce some of the conflicts in trade disputes, technology transfer, and others. Together, both countries can help to strengthen their own economies and contribute to the growth of the world economy.

2.

THE DIFFERENT BACKGROUNDS OF US AND CHINA ECONOMIES

Before the global financial crisis started in 2008, the US economy was in a low interest rate environment. This low interest rate policy was a response to the burst of the high-tech stocks bubble in the early 2000s. In the beginning of 2001, the Federal Reserve lowered the federal fund rate by 50 basis points, and it further reduced the rate by 13 times until it went to 1 percent in 2003, the lowest level in decades. The mortgage rate was also greatly reduced; and it reached 3.8 percent in 2003. On the one hand, the lower mortgage rate and prosperous MBS market led to a rapid

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Reflections on the global financial crisis: a comparison of US and China policies

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increase in housing prices. From 1999 to 2005, housing price in the US increased by an average of 11 percent, which far exceeds the growth rate of GDP in the same period. On the other hand, the low mortgage rate helped to increase the leverage of the housing market, as indicated by more than 60 percent of debt to housing value in 2007. As the prime borrowers are exhausted, the real estate lenders began to target sub-prime lenders, namely borrowers without steady income and credit history. In 2006, the ratio of sub-prime real estate lending is already as high as 30 percent. Furthermore, to avoid the capital requirement and leverage constraint, the real estate lending companies pushed financial innovations such as MBS, CDO (Collateralized Debt Obligation), and CDS (Credit Default Swap) to transfer default risks to investment banks, insurance companies, and foreign financial institutions. Unfortunately, financial regulations are lagging behind financial innovations. The spread of the risks in the global financial system is not contained by effective financial regulations. In China, the economy was in the peak of a business cycle in 2007. From the first quarter of 2005 to the second quarter of 2007, officially reported GDP had been growing at more than 10 percent and reached 15 percent in the middle of 2007. The economy was led by strong investment and trade, with total trade growing at 20–30 percent annually for the decade. The over-heated economy raised inflation rates to very high levels, with CPI increasing at 8 percent and PPI increasing at 10 percent. The policy makers were concerned with inflation and over-heating in the economy and initiated some contraction policies. In the beginning of 2008, the government introduced more cautious fiscal policy and tightened its monetary policies. Consequently, China was in a very different state from the US before the global financial crisis hit its trade sector.

3.

GLOBAL FINANCIAL CRISIS: THE US ENDOGENOUS CRISIS AND CHINA’S EXTERNAL SHOCK

The US financial crisis resulted from its lax monetary policies and regulations. As indicated in the previous section, prior to the financial crisis, lower interest rates, financial innovations, and inadequate regulations led to the real estate bubble. Starting from June of 2004, out of the concern for inflation, the Federal Reserve had continually raised the federal fund rate 17 times, and it increased from 1 percent to 5.25 percent in July of 2006. In 2006, real estate prices started to decline. Due

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to higher mortgage rates and declining housing prices, some sub-prime borrowers were unable to afford their mortgage payments. In July 2007, the non-performing loans of sub-prime lending increased to above 15 percent of the total real estate lending, more than three times that of 2005. In April 2007, the second largest sub-prime lending company in the US, New Century Finance, announced its bankruptcy, followed by the exits of Sallie Mae and Freddie Mac from the New York Stock Exchange (NYSE), and investors suffered greatly from their holding of 5 trillion US dollar bonds. Furthermore, the risks spread to investment banks such as Bear Sterns and Lehman Brothers. There was also negative news about Merrill Lynch, Goldman Sachs, Morgan Stanley, and Citibank. What is more important is that over 70 percent of bonds issued by Fannie Mae and Freddie Mac were held by pension funds, mutual funds, commercial banks, and insurance companies, and they suffered greatly in holding these bonds. The crisis spread from real estate lenders, to investment banks, insurance companies, pension funds, and even foreign investors. When almost all big financial institutions suffered from huge losses, they started to curtail their lending to businesses. The resulting liquidity crisis made financing for corporations more difficult, which led to cuts in employment and a loss of confidence in the economy. In 2008, US GDP grew at 0 percent, and 2009 at −2.8 percent, and unemployment at more than 10 percent. Last but not the least, the financial crisis originating in the US spread to other countries through their financial and trade linkages. When the financial crisis started to affect the Chinese economy, China was still busy in containing the over-heated economy and inflation. All of sudden, as a consequence of a sharp drop in foreign demand, China’s export growth rate declined from a level of 20–30 percent to −2.22 percent in November 2008, and −2.93 percent in December 2008, and even from −13.92 percent to −25.75 percent from January to October of 2009. The contribution of net export to GDP changed from 1.4 percent to −1.9 percent during 2005–2007 to −4.0 percent in 2009. The US financial crisis affected the Chinese economy mainly through its impact on the trade sector in China, as China relied on trade as one of main engines in its rapid economic growth.

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4.

POLICY INTERVENTIONS OF THE TWO COUNTRIES

4.1

US Expansionary Monetary Policy and Bailout of Financial Institutions

Because the causes of the crisis are different in the US and China, the governments in the two countries also responded very differently. The US financial crisis originated from the financial system and spread to the economy, so US policy makers mainly used monetary and fiscal policies to bail out the financial system. In the US, because of policy lags in fiscal policy, it relied more on monetary policies to deal with the financial crisis. Unfortunately, prior to the financial crisis, the Federal Reserve System overemphasized free market doctrine and encouraged financial innovation, and it underestimated the effects of the real estate bubble and the excessive development of financial derivatives on the economy. Even when the crisis became obvious, the Fed still stuck to its belief of dealing with inflation as its priority; and ignored the possible consequence of a bursting of the real estate bubble and its impact on financial stability and the economy. When the US government realized the seriousness of the sub-prime lending crisis in the fall of 2008, it started to inject liquidity into the financial market, initiated the bailout of the systemic important financial institutions, and helped to stabilize the financial market. The Fed cut the federal fund rate substantially to increase liquidity in the market, while the Treasury Department injected capital into the so-called ‘too-big-to-fail’ and systemically important financial institutions. From July to September 2008, the US government started to bail out Fannie Mae, Freddie Mac, and AIG. After that, the government further injected about 194 billion US dollars into the Bank of America, CitiBank, Morgan Stanley, and Goldman Sachs. By March of 2009, the Fed provided almost 7.7 trillion US dollars of liquidity. In addition, from November 2008 to December 2013, the Fed went through three rounds of QE and continued to provide liquidity to the market. In these bailout exercises, the government used government credit to replace private credit and successfully strengthened the confidence of the market participants. Notably, in facing the ineffectiveness of the traditional monetary stimulations such as cutting interest rates to almost zero, the Fed creatively used unconventional monetary policy, the so-called QE, to

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provide liquidity and stimulate the economy. In traditional interest rate policy, the Fed uses the open market to purchase short-term bonds to reduce the short-term interest rate, which consequently was transmitted to the long-term interest rate through the term structure of interest rates. However, the interest rate policy faces the following two challenges during a crisis. First, it is difficult to cut the short-term interest rate to below zero (although Europe and Japan creatively used negative interest rates to deal with their economies, the effect on the economy is yet to be seen). Second, even with zero interest rate, out of concerns for weakened asset liability structure, financial institutions may curtail their lending to businesses. Similarly, potential borrowers also have concerns about their own asset and liability and may be cautious in borrowing. Therefore, during this crisis, the traditional interest rate mechanism broke down. The logic of QE is as follows: when the federal fund rate is close to zero, the Fed directly purchases long-term bonds, which raises bond prices and reduces the long-term interest rate. In expanding its asset side, the Fed also created a larger monetary base, so it helps to balance its liability side. The Fed also purchased a lot of MBS and injected liquidity into the real estate finance market, which helped to stabilize the financial market. In all, in the US, monetary authorities responded quickly, preventing collapse of the financial markets. But fiscal response was slow, modest, and generally fritted away. Recovery was relatively slow in historical terms.

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4.2

China’s 4 Trillion Stimulation Package: Replacing External Demand With Internal Demand

Just as China was trying to fight over-heating and inflation in the early 2008, the sub-prime lending crisis hit China through the trade sector. As indicated above, China’s GDP growth rate rapidly declined from the double-digit level to about 6 percent, and the inflation rate also dropped significantly from 8 percent to below 3 percent. In responding to this shock, the government immediately changed its policy package from contraction to expansion. However, as China’s shock came from abroad and its impact led to a decrease in export demand, the response was to increase investment demand and domestic consumption. In November 2008, the State Council announced an investment plan of a 4 trillion RMB stimulation package. In addition, the government also proposed to provide subsidies to farmers as well as provide tax rebate for exports.

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The 4 trillion RBM stimulation package differs from traditional monetary and fiscal policy framework; and is embedded in China’s unique political and economic structure. The decision to enact the stimulation package was by the highest administrative authority, the State Council, and not by Peoples Bank of China or by the Ministry of Finance. The decision was made and implemented very quickly and its effect on the economy also seemed to be swift. The reasons for the rapid action and effects are (1) the process of decision-making is quick due to China’s concentrated political structure; (2) the implementation is also quick as local government officials have incentives to invest because they were evaluated and promoted by the yardstick of GDP growth; (3) China’s banking system is mainly controlled by the government and they are following instructions from higher authorities. The 4 trillion RMB stimulation package was carried out mainly through the state-controlled banking system. For example, in 2009, the four big state-owned banks increased their lending by 4.1 trillion, while the 13 mixed ownership banks increased their lending by 2.23 trillion. In sum, China’s 4 trillion stimulation package is a combination of fiscal policy and direct intervention in the bank lending system. Unlike that of the US, China’s decision to intervene is quick and implementation is swift, and there is no need to go through the interest rate transmission mechanism as in the monetary policy response in the US. Both countries’ policies are embedded in their own political and economic structures. They are effective in responding to unique shocks to their economies but they also create some negative effects for both economies.

5.

THE POSITIVE EFFECT OF A BAILOUT AND STIMULATIONS: THE QUICK RECOVERY OF GDP GROWTH

The US bailout package and quantitative easing played a positive role in stabilizing the financial market and stimulating the economy. Various studies show that QE significantly reduced long-term interest rates. The former Federal Reserve Chairman, Ben Bernanke stated in a speech in 2012 that the first two rounds of QE may increase GDP by 3 percent, and employment by 2 million US dollars. Indeed, the US GDP growth rate quickly rebounded from −2.8 percent in 2009 to 2.5 percent in 2010; and was the first country out of recession among the major economies except China.

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China’s GDP growth also went through similar changes. The growth rate rebounded from 6.4 percent in the first quarter of 2009 to more than 10 percent by the end of the year. In the meantime, the rapid recovery also created employment. China’s position in the world economy has also strengthened as indicated by its contribution to world economic growth from less than 20 percent in 2006 to 34 percent in 2017, surpassing that of the US and Europe. China is now trying to push further economic reform and opening and increasingly playing a much more important role in the world economy.

6.

THE NEGATIVE ASPECTS OF BAILOUT AND STIMULATIONS

6.1

The Negative Aspects of US Bailout and QE

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Although it is widely acknowledged that the US bailout and QE prevented the collapse of the financial system and deflation, they failed to resolve deep-rooted structural problems in the economy. There are at least the following consequences of the US policies: (1) Most of QE money did not go into the real economy. First, the Federal Reserve statistics show that in the total amount of the three rounds of QE, 3.92 trillion US dollars, until the end of 2014, only about 850 billion went to financial institutions’ balance sheets, and the remaining 3.15 trillion dollars were still shown as excess reserves of banks at the Federal Reserve. Second, the increasing balance sheet of financial institutions did not result in an increase in total lending to businesses. During the period of 2008–2013, the total asset of US financial institutions increased by 13.8 trillion dollars, but the total amount of lending decreased by 3.5 trillion dollars, at the rate of 13.5 percent. Third, financial and real estate markets led the recovery, with relatively sluggish economy and labor market. (2) Intensify the logic of ‘too-big-to-fail’. During the crisis, big financial institutions were bailed out, while leaving many small financial institutions to fail. (3) Enhance investors’ dependency on QE. Richard Koo pointed out that, as the economy starts to recover, investors worry that central banks would sell long-term bonds to shrink their balance sheets. This would raise the long-term interest rate and crash the financial

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market and real estate market. Indeed, in June 2013, when the Fed hinted that it would end QE, the US long-term interest rate increased rapidly. To alleviate the anxiety of the market, the Fed decided not to change its QE policy in September 2013. (4) Increase income inequality. First, the government bail out the financial institutions which were responsible for the crisis while leaving other sectors and labor to suffer. Second, the QE seem to help those people with financial and real estate assets, leaving the middle- and lower-income households to suffer. During the period of 2009–2014, the S&P 500 index increased more than 144 percent. From 2007 to 2010, the wealth of the top 10 percent households increased by 5 percent, the top 1 percent increased even more, while the wealth of the middle-income households decreased by 30 percent. (5) Households deleverage and the government increase leverage. As is known, the households’ leverage was high due to sub-prime lending and financial innovations. During the crisis, the government substantially increased its leverage through the bailout. For example, in October 2008, the Congress passed the 700 billion US dollar bailout package. In February 2009, the Congress passed another bailout package of 787 billion US dollars. These actions increased the US government deficit to 1.42 trillion, more than triple of that in 2008. Over the years, this increasing debt amounts to more than 20 trillion in 2017, which greatly restrains the government fiscal policy. 6.2

The Negative Aspects of China’s 4 Trillion Stimulation Package

There is no doubt that China’s 4 trillion RMB stimulation package had a very quick and positive impact on the economy, but we cannot ignore the negative consequences of the policy. As indicated above, China’s unique political structure and local government officials’ incentives ensured that the stimulation was swift and effective, but they also resulted in in excessive investment and structural deficiencies. Studies show that the actual investment was much higher than 4 trillion RMB, perhaps more than 30 trillion. In addition, state-owned banks tend to lend to state-owned enterprises (SOEs), local government projects, or big private companies. As these big companies also faced deteriorations

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in the investment environment, they tend to move money to financial and real estate markets. The lower cost money also prolonged the lives of the ‘zombie companies’, the companies that persistently lose money but are still kept alive. The low-cost money also allows some companies to accumulate debt and results in high leverage of the local governments and these companies. Furthermore, the bias in favor of SOEs and large private companies crowds out small- and medium-size private companies, which further reduces the efficiency of the economy. All of these contribute to China’s systemic risk; in particular, systemic financial risks.

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7.

CONCLUSIONS AND REFLECTIONS

In this chapter, I take a comparative perspective of the US and China to examine the causes, policy responses, and their consequences on the global financial crisis a decade ago. I highlight different causes of the crisis. In the US, the crisis was a consequence of loose monetary policy, excessive financial innovations, and lax financial regulations. In China, the crisis came from an external shock to its trade sector. The policy responses are rooted in each country’s political and economic structure. In the US, the government responded with a quick injection of liquidity and bailout of systemically important financial institutions, followed by three rounds of QE. In China, the government introduced 4 trillion RMB stimulation packages to encourage domestic investment and consumption to replace the drop in net export. The implementations of these policies in both countries were swift and effective in the short run, as indicated by quick recovery in GDP in both countries. However, they both left some long-term structural problems such as income inequality in the US and highly leveraged enterprises and local government in China. Both countries are trying to deal with the side effects of bailouts and stimulations. To review and analyze the causes and consequences of the global financial crisis at its ten-year anniversary is important for us to understand the current challenges facing the two largest economies in the world, which helps us to move in the direction of more collaboration in solving any future crisis to the world economy.

6. Policies for structural reform in China: domestic rebalancing for strong sustainable and inclusive growth within and beyond China Ehtisham Ahmad, Isabella Neuweg, Nicholas Stern and Chunping Xie China is entering a new stage in its structural reforms, as signalled in the 19th Party Congress. In the words of Liu (2018), one of China’s four vice-premiers, this involves transitioning from:

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…a phase of rapid growth to one of high-quality development. It is in this context that China formulates its macroeconomic, structural, reform and social policies for the coming years. The three critical battles which China is determined to fight include: 1) preventing and resolving the major risks (in the financial sector and at subnational levels), 2) conducting targeted poverty reduction, and 3) controlling pollution.

In a change from past practices,1 the China Economic Work Conference in December 2017 formulated a medium-term structural reform programme 2018–2021, to translate these priorities into practical measures for action. The ‘three critical battles’ all relate to making cities, and local governments more generally, fiscally sustainable, inclusive and clean. These themes are expected to also feature strongly in the 14th Five Year Plan Period. The potential disruptions to traditional international trading patterns underline the importance of the structural reforms as China can to a large extent substitute domestic consumption for exports to certain countries. And the investments in the connectivity associated with the Belt and Road Initiative (BRI) open up new trading patterns and value chains, which with new interior hubs could mitigate the risks associated with trade shocks and local debt overhang. The focus on new, clean cities 39

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can also further the rebalancing towards more sustainable patterns of production and consumption to generate sustainable employment and reduce inequalities. We examine three broad action areas for China that could deliver real progress on these fronts as well as strengthening growth and accelerating the reduction in greenhouse gas emissions: i. Innovation and investment in people; creation and management of jobs in an equitable manner. ii. Structural reforms in cities, including in larger metropolitan areas, and new, innovative and clean cities, fostering the building of a high-tech and service economy and linked to new and sustainable value chains. iii. Strengthening local public finances, including taxation and governance measures, to reduce risk while making cities and local governments more responsible for better service delivery and investments for improved quality of life that attract investment for employment generation

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Structural and fiscal reforms and innovation are key elements in building the next stage of China’s development strategy. These reforms could both be complementary with those in partner countries and offer those countries important and relevant examples, particularly in the context of the BRI.

INVESTMENT IN SKILLED LABOUR FOR SUSTAINABLE GROWTH A more sustainable, clean growth model of the kind China is seeking will involve different skills and industries. China plans to phase out inefficient and polluting activities, given the objectives in the three-year economic plan of the government (Liu, 2018). However, the timing of the phase out of coal appears to have been affected by considerations linked to responses to trade shocks, minimising adjustment costs, and addressing long-term security of energy supplies. Nevertheless, actions have been taken to phase out small coal mines and there has been a shift towards supercritical and ultra-supercritical coal plants, which are much more efficient than traditional subcritical plants.2 There are also efforts to introduce renewable sources of energy that will put China into the forefront of the global climate change agenda. For example, China has

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announced a mandatory Renewable Energy Certificate (REC) scheme that sets provincial quotas for renewable energy (CAT, 2019). China generally delivers on its planning targets; for example, commitments for 2020 targets for renewable energy were met in 2017/18.3 In order to stay within global boundaries and lower the systemic risk of a late low-carbon transition, however, China will need to accelerate rapidly its efforts to phase out old, polluting sectors and industries and embrace cleaner, innovative production models. The new growth model holds vast opportunities for employment, in highly skilled jobs associated with investments in services, high-tech, innovation, and renewable energy. The digital economy and artificial intelligence are likely to be central to much of this change, requiring strong and continuing investments in education and training. Indeed, the tech hubs that have grown around Hangzhou-Shanghai and Guangzhou-Shenzhen are linked to cutting-edge research universities and world-class infrastructure. The plans to create the world’s largest silicon-valley metropolitan concentration in the Greater Bay area, comprising Guangzhou-Shenzhen-Zhuhai with linkages to Hong Kong and Macau, will focus on high-tech and financial services, and include over 70 million people. Although ambitious, these plans are clearly feasible given the existing infrastructure and availability of skills, but requires new institutional and fiscal arrangements that will also lead to a cleaner, high-income conglomeration. However, as pointed out in Ahmad, Niu and Xiao (2018), Guangdong already has very high-income inequality levels, and spatial variance in city level GDP and service provision. In order to rebalance this spatial disparity, China would need to build new more compact urban hubs in the interior of Guangdong to accommodate the manufacturing and lower-skill activities that will be moved from the Greater Bay area. Forward-looking, climate-smart design of cities can simultaneously bring about reductions in spatial inequality and poverty and generate strong, efficient and sustainable growth. Alibaba, based in Hangzhou, is revolutionising the way that consumers interact with retail, including in remote and distant rural areas. The growing e-Commerce has the potential to considerably reduce the need for time-consuming and energy-intensive trips to the shopping malls in urban areas, and can transform inner city commuting as well as supply chains. However, many low-skilled jobs in large metropolitan areas will no longer be needed, which means the generation of appropriate alternative employment opportunities will become critical. And the new supply

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chains, shaped by businesses like Alibaba, make it easier for workers and firms to locate nearer population centres and would reduce if not reverse migration trends towards polluted and congested coastal mega-cities. In other overcrowded metropolitan areas such as Beijing, there is a programme to move non-essential civil service departments to less crowded areas in neighbouring provinces. This would make use of enhancements in IT and communication capabilities without loss of efficiency – while resulting in less crowding and congestion and a reduction in associated pollution. And districts such as Haidian with two of China’s leading universities (Peking and Tsinghua), would become the core of an innovative ‘hub’ and science/business park. In the UK, the government has been relocating ‘non-essential’ civil servants from London to ‘cheaper’ locations. However, while there is real housing pressure in London, it is different from cities in emerging market countries including China in that it does not have to handle the challenges of ‘informal’ migrants, typically from rural areas seeking a better living and (non-skilled) employment opportunities that lead to the creation of illegal settlements in many metropolitan areas. It is not easy to make the case for demolishing illegal buildings, even if they are creating health and public safety hazards, as the inhabitants need to be resettled and jobs created for them elsewhere.

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A JUST TRANSITION The major structural transition embodied in the next phase of China’s development will involve substantial dislocation, including in the rust-belt towns of northeastern China, and in the main metropolitan areas. It is important to invest in and manage such a transition carefully; this was clearly recognized and was made a priority in the 13th Five Year Plan (2016–2020). Having achieved a major reduction in the number of people living in poverty, by 700 million between 1993/4 and 2013 and by almost 70 million from 2013–18 (World Bank, 2018), eliminating the existing pockets of absolute poverty has been high on the agenda of the government, and, through education, training and job creation, preventing families and individuals from entering poverty. This will involve reforming social policies and employment patterns in existing cities and the development of new cities that also provide an inclusive, clean environment as well as sustainable jobs. In a very rapidly growing economy, the proportions employed in different activities and sectors can be adjusted without having to significantly reduce jobs in some sectors. However, now that growth has slowed

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in China and the shift to the service sector is accelerating, substantial reductions in jobs in some sectors and locations are inevitable. Policies for ensuring a ‘just transition’ which would reduce the economic vulnerabilities of the affected communities are a high priority. It is not enough simply to say that more jobs are being created in new activities than are being lost in the old, even though this is likely to be true. Those who were in old jobs need new opportunities as well as support during a period of transition.

CLEAR STRATEGY FOR CITY DEVELOPMENT: SUSTAINABLE INVESTMENT FOR DYNAMIC INNOVATION

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China is restructuring rapidly to move to a more service-oriented and high-tech economy. Investment and reforms in the organization and in the infrastructure of cities form a vital part of that process, and will reduce its greenhouse gas emissions, and to clean the environment. These investments and reforms will enable China’s cities to become much more productive, to retain and attract a high calibre workforce, and to act as dynamic centres for the innovation that will drive China forward. As Liu (2018) has stated: As we open up wider to the outside world, this transition to a new model of development will create huge opportunities for many new industries. This may well include manufacturing and service industries related to higher-quality consumption, as well as energy-efficient buildings, smart transportation, new energy and many other green and low-carbon industries in new cities.

How are the new cities to be created? China has undertaken major investment in connectivity infrastructure, including motorways, high-speed trains and airports, over the past two decades. However, as in Italy, improving connectivity with less well-developed regions does not mean that private investment will flow automatically to these regions, or that sustainable employment will be created. In the Chinese context, the Western Region Development strategy of the past two decades did not achieve its anticipated results, largely because exporters had to ship goods to the coastal cities in the East, as well as to the main domestic markets in the metropolitan areas, which are also situated in the eastern coastal provinces. This created additional costs for the western firms. As part of the strategy, some new housing was built in new interior cities,

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but there were few takers as people were not willing to move given the limited public services and employment opportunities. The situation in Spain, for example, illustrates some of the difficulties of recognizing and managing intertemporal liabilities that accrue at a later stage in the project cycle. Local governments in Spain engaged in a great deal of off-budget construction activity through private firms with no public guarantees, in public–private partnerships (PPPs) that were not recorded on local government balance sheets. It was not until the financial crisis of 2008–10 when these ‘off-budget’ liabilities appeared as non-performing loans from the banking sector that the extent of the problem was revealed leading to a sharp increase in the public liabilities and debt (Ahmad et al., 2016). Thus, rebalancing can generate financial and fiscal risks if not properly managed, as we discuss further in the next sub-section. Yet the prospects for new interior cities in China have changed drastically for the better in the recent past for two main reasons. The first is the BRI, as it will enable firms in the interior and western region to export directly to markets in Europe, South Asia, the Middle East and Africa without having to route through China’s eastern coastal hubs. This removes or reduces the cost differentials that prevented firms from taking advantage of the Western Development Strategy in the past. An example of this phenomenon is the development of the dry port Khorgos, on the China–Kazakhstan border, which has largely been financed by firms from the eastern province of Jiangsu. The second reason is the huge advances in information and communication technologies that make it possible for consumers to interact with suppliers, and firms with each other, in a very rapid and efficient way. This opens exciting possibilities to locate warehousing and supply chains closer to where demand and population centres exist. These developments will likely change the dynamics of sustainable cities. At the heart of the new transformation is what Liu He (2018) describes as ‘energy-efficient buildings, smart transportation, new energy and many other green and low-carbon industries in new cities’. However, managing the process without generating risks to the stability of the financial system requires a focus on multi-level finances. The cross-border as well as national connectivity is generally facilitated by the central government. Local governments, nevertheless, need to provide ancillary investments in infrastructure and public services that make it possible to create sustainable ‘hubs’ and the conditions for clean cities. The main mechanisms for financing this local investment over

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the past 25 years have been land sales, typically linked to PPPs and off-budget borrowing by Urban Development Investment Corporations (UDICs). And given the nascent fiscal instruments that were available to the Chinese government in the 1990s, Special Economic Zones (SEZs) were created to ringfence private investors; these played a major role in kick-starting growth, for example in Shenzhen and Pudong (Wang, Jin, 2013). Although this combination of instruments clearly had an impact in the development of the major metropolitan areas, conditions are now very different from the mid-1990s, both in terms of the enabling environment and the cumulative risks inherent in the strategy. Liu and Li (2018) highlight the interactions between fiscal and financial risk and the potential impact on public service delivery and the possibility for social unrest in China. As pointed out in Ahmad (2017a), potentially valuable instrument measures such as local government bonds can actually increase risk in all the dimensions highlighted in Liu and Li (2018) if they are introduced without the necessary preconditions of effective local own-source revenues and monitoring of liabilities. Further, the previous ringfencing of SEZs is becoming redundant with the completion of the national tax reforms (particularly the integration of VAT on services and goods) and can create barriers to the needed development of local and regional linkages. It is not surprising that the barriers around Shenzhen are now being removed in preparation for the Greater Bay Area initiative, which requires rapid transportation between Zhuhai, Guangzhou, Shenzhen as well as Hong Kong.

MULTILEVEL FINANCE—FINANCING LOCAL SERVICES AND MANAGING RISK Recent Developments and Preconditions for Sustainable Growth Before the 1990s, China relied on local governments to collect revenues, with upward revenue-sharing, and to carry out most of the spending. It lacked the fiscal institutions that most developed countries take for granted. Key institutions, including the central State Administration of Taxation (SAT) and a modern Treasury, were established in the early and late 1990s respectively (see Ahmad, 2018). Without these institutions, it would have been impossible to implement instruments such as VAT, track spending through a Treasury Single Account or even monitor liabilities through balance sheets at different levels of government using the IMF’s GFSM 2014 framework. But although first-rate organizations and

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institutions have been created at the central level, the subnational policy framework has evolved slowly, largely in response to the structural reforms undertaken over the past couple of decades. The focus in 1993/4 was on generating revenues, and establishment of the State Administration of Taxation (SAT). The main instrument used was an ‘investment-type’ VAT that did not provide credit for the taxation associated with capital goods. This also left services to be taxed by local governments under the business tax. The second phase, from around 2005, focused on efficiency, and a VAT of the ‘consumption type’ was adopted, with credits for taxation on capital purchases, as well as integration with corporate income tax and rationalization of the rate structure at 25 percent. To further reduce the cost of doing business, enhance competitiveness and remove taxation from exports, the business tax was brought into VAT in 2015 (Ahmad, 2017b). This was expected to lose revenues, but overall collections actually increased because the completion of the information chain with a full VAT base makes it harder for firms to hide transactions. This phenomenon was also seen with the integration of the VAT in Mexico in 2013 (Ahmad, 2017b). While Chinese local governments in aggregate were compensated for the loss of business tax revenues by an adjustment in the revenue-sharing arrangements, there has been a differential impact on the lowest levels, as spending is pushed downwards and shared revenue tends to be disproportionately retained at the higher levels. And the fiscal pressures on local governments created by the revenue-sharing has led to incentives to borrow or run arrears, exacerbated by a lack of transparency. This often results in risky decision-making and spending behaviour, and local governments often do not sufficiently prioritise health care or the environment. A new sustainable urban transition strategy would require an overhaul of the subnational tax and financing mechanisms to reduce risks, including hidden liabilities at the subnational level. A sustainable and clean cities agenda, as proposed by Liu (2018) and the Central Economic Conference Decision (2017), will require coordinated actions on both the public financial management functions and the tax agenda. There are several reasons for this, as we explain below. First, shared revenues do not constitute own-source revenues in the sense that the local jurisdictions have control over the rates or bases at the margin. Thus, shared revenues, while useful in closing vertical gaps, are like transfers from higher levels of government, and are not appropriate instruments by themselves to enable access to credit and other forms of local debt. Hard budget constraints are needed for local governments

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to take responsible decisions on investments and liabilities, but are not credible without the local ability to raise additional revenues in case of need, for example to pay local debt (Ambrosanio and Bordignon, 2015). Central transfers and shared revenues do not do this. The responsibility for risks in these cases remains with the higher-level government, and the incentives at the local level are to indulge in inappropriate spending. The risks increase if there is incomplete information on what is spent, and how the largely off-budget liabilities are incurred (more on this below). A second consideration that becomes even more pressing as local tax bases weaken or disappear is that revenue shares and transfers tend to stick at higher levels, particularly in provincial capitals and metropolitan areas,4 with corresponding pressure on deficits as well as local public services. This is well documented for Guangdong by Xiao (2018). This exacerbates fiscal pressure on local governments as the central government cuts taxes to maintain aggregate demand, e.g., in response to or anticipation of trade shocks. This has become a major problem especially for the lowest tiers of government that find it difficult to finance mandates in education or basic health care, as well as infrastructure. Third, in the absence of adequate city-level taxation instruments land sales have historically played a major role in the development of metropolitan areas. This includes ‘land value capture’ in the SEZs, such as Shenzhen, often taken as a model.5 However, land sales in China have largely run their course and, have resulted in inefficient urban sprawl particularly in Tier 1 cities and metropolitan areas along the east coast. Also, they have resulted in a major loss of prime agricultural land. They have generated risks of property bubbles and possibilities of social unrest (see Wang et al., 2018). Land sales were off-budget operations, and led to possible rent-seeking and corruption as well as hidden liabilities as they are often used in conjunction with PPPs. This could also pose significant problems in the future. Cheap land allocation and subsidies contributed to the financing of Binhai Financial District, established near Tianjin port in 2009. It was also connected by high-speed trains to Beijing and was given numerous tax preferences. However, Tianjin is one of the most heavily indebted metropolitan areas in China (local state-owned enterprise [SOE] debt is more than 700 per cent of local revenues). And, despite the proximity of Tianjin port and connectivity to Beijing, empty office buildings currently mean the city resembles something of a ghost town rather than a thriving new hub. As with its tax reforms, China has been modernizing its public financial management (PFM) architecture since the late 1990s. Two sig-

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nificant reforms were the adoption of the IMF’s Government Financial Statistics Manual (GFSM) 2001 methodology (updated in 2014 to match refinements in the System of National Accounts); and the establishment of a Treasury Single Account to manage the state’s cash and to monitor cash flows and transactions. Although GFSM 2001/14 requires accruals and balance sheets at all levels of government, initially only cash accounting was introduced, local governments were not permitted to borrow directly, and all local borrowing was through UDICs (investment companies owned by local governments) and was off-budget. The distinction between UDIC borrowing and local governments’ transactions was not transparent, and the full extent of public liabilities was not known (despite periodic Audit Office reports). Many of the measures to implement the PFM reforms at the lower levels are at an early stage—for instance, the local government balance sheets are incomplete even in the more advanced provinces and counties, especially for public utilities, PPPs, SOEs and possible accounts payable (Ahmad and Zhang, 2018, based on a People’s Bank of China survey). Fourth, as pointed out by Liu (2018), risks from hidden liabilities, including with SOEs, PPPs and local government, are a matter of increasing concern and are high on the agenda for reform. The poor information on liabilities especially at the lower government levels, magnifies the problems arising from an absence of own-source revenues, and makes it impossible to impose hard budget constraints and increases the chances that a counter-cyclical policy to address trade shocks might contribute to a subnational debt crisis, or weaken local government abilities to provide basic services or respond in a timely manner to shocks, including epidemics. Local Accountability and Feedback Mechanisms Although policies and priorities have been typically decided at higher levels of administration, China is one of the most decentralized countries in the world in terms of actual spending. As discussed in Ahmad et al. (2018), fiscal pressures with the increasing revenue centralization since 1993/4 have resulted in even more spending pressures being telescoped to lower levels, as shared revenues and transfers tend to ‘stick’ at the provincial capitals and ‘unfunded mandates’ arise at the lower levels. The ageing of the population and local financing of pensions adds to the fiscal pressures at the local level. At the same time, there is a strong incentive for local officials to use off-budget special purpose vehicles (urban

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development investment corporations) to conduct activities outside the purview of higher levels of government. None of these tendencies lead to greater accountability for local officials. Off-budget transactions with hidden liabilities reduce accountability and add to risks. The requirement that local governments should complete full balance sheets, including liabilities for PPPs (as required both under the GFSM 2014 and IPSAS 32 standards) is clearly sensible. However, given the difficulties in implementing complete balance sheets using international standards, such as the GFSM 2014, the process is going to be drawn out, while the liabilities and risks may be more short term. Relying on the Audit Bureau’s evaluations of subnational liabilities is time-consuming and not likely to pick up short-term changes in liabilities that may generate national financial risk, or even prospects of local service delivery interruptions with attendant social risks. As Ahmad and Zhang (2018) also stress, the most timely and accurate data on financing is provided by the People’s Bank of China (PBC) monetary survey. This could be organized to produce monthly data on financing of government and SOEs at the county level. Although the method does not capture arrears, changes in credit to different municipalities or counties could signal problems that could be investigated quickly by the Ministry of Finance (by the Treasury, for example, in conjunction with local Treasury Single Accounts), and the Audit Bureau. Again, it is important to stress that this is a shortcut to generate information as part of an early warning system of risk management. In the longer term, the balance sheet data, as well as GFSM 2014-compatible charts of accounts across different levels of government, would provide direct ‘above the line’ information and provide the basis for timely monitoring of risks. The budget law was changed in 2015 to permit local governments to issue bonds, with the expectation that subnational debt would become more transparent and easier to manage. However, without the development of local own-source revenues (over which a subnational jurisdiction can exercise control at the margin) and tighter information on the extent and time profile of liabilities, the intended hard budget constraints are not credible. While clearly needed for the medium term, the existence of local government bonds could give the erroneous impression that local risks have been controlled. However, without significant own-source revenues for metropolitan areas and smaller cities, the risks are effectively passed through to higher-level governments. In some respects, however, social audits being conducted by local finance bureaus provide effective feedback. As Yuan (2018), from

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Guangzhou municipality’s Performance Auditing Division, explains, a social audit of the high-profile Guangzhou bus rapid transport (BRT) system, led to the cancellation of plans to extend the BRT. This was due to responses by users, ancillary congestion, and evaluation of alternative social costs and benefits. The social audit mechanism has considerable potential for Chinese-style administrative governance models and could be generalized quickly to supplement the financial information that may take longer to generate accurately, but cannot be relied on as a solution to the risks emanating from the current levels of local debt, some of which is hidden in off-budget accounts. The State Council (Resolution 8, 2018) has initiated the clarification of spending assignments, including the move to central pooling of social security. However, the greater clarity on local social services and investment requirements will likely need to be linked to sustainable urban transitions. The precise form will vary from the large metropolitan areas, or even larger Silicon Valley development in the Greater Bay Area, to smaller and more compact ‘hubs’ in the interior that will be the core of the urban transitions and ‘rebalancing’ from exports to domestic consumption, together with upgrading of skills and activities. This will form a key part of the greater local responsibilities needed for accountability. But local accountability is not complete without own-source revenues. Even if the Budget Law requires local governments to service their liabilities, the absence of own-source revenues, especially in periods of crisis or economic shocks, could result in a sharp increase in non-performing loans (NPLs) in the banking system. This transmits the problem back to the doors of the Central Government (as happened with local liabilities in Mexico in the 1990s and in Spain following the 2008–10 crisis, see Ahmad, Bordignon and Brosio, 2016). Thus, the spending, taxation and risk management issues are closely interlinked. Central and Local Tax Instruments: Own Source Revenues for Incentives and Accountability In many respects, the completion of the national tax reforms was essential in creating a level playing field and reducing the cost of doing business for all firms. However, a subnational tax agenda is needed as no significant local tax handles remain. Both VAT, which covers all stages of the value chain, and the rationalized corporate income tax structure, improve the business climate, reduce costs, and remove taxation from exports. Also, the integrated VAT provides information that is useful to prevent

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‘cheating’, and as in Mexico has benefitted overall revenue collections. As Ahmad (2017a) proposed, China has established a unified first-rate tax administration for the central and local governments. With a consolidated revenue base, it is relatively simple to impose a local ‘piggy-back’ or surcharge on a national tax base, determined by the National Peoples’ Congress (NPC). There is already a precedent for this with some of the taxes on property transactions—the NPC sets a band, the provinces choose a range within the band and the city can select a range within the band. However, the options for taxation of property sales do not assure a stream of revenues for local governments and cannot be used to anchor a sustainable access to credit or borrowing for infrastructure. The most important and underutilized base is for the personal income tax (PIT), where a provincial/metropolitan ‘piggy-back’, within a band set by the NPC, could: • Generate significant revenues for local governments and form the basis for access to credit markets, such as local government bonds (note that the shared revenues are not own-source, and since the local government does not determine the share, there is no incentive or ability to increase collections); • Increase the incentive for local government to provide information on the assets, lifestyles and spending of rich residents, thereby more effectively increasing the base of the PIT beyond wage incomes; • The piggy-back does not necessarily imply an increase in overall rates of the PIT, as the band would be within the average effective rate of the current revenue-sharing arrangement; • Ensure that subnational revenues are not affected when the central tax rate is reduced to meet macro-stabilisation objectives, thus protecting essential local spending, such as on education or health care. The additional information on assets from a property tax would go a long way towards expanding the base of the PIT, taxing non-wage income thereby increasing the prospects for reducing inequalities, and generate financing to meeting the local governments’ infrastructure and social policy goals. While a PIT is an important instrument for addressing inter-personal inequality, a provincial piggy-back on the tax could, however, increase spatial inequalities, since the very rich live in metropolitan areas. Consequently, the current Chinese equalization system would need to be

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refined, taking into account differential own-revenue bases in estimating disability factors across local governments. The piggy-back could also be used with a national carbon tax (see Ahmad and Stern, 2012, for India) administered by the SAT to ensure that there is no race to the bottom, while providing the possibility that the more congested and polluted metropolitan areas are able to impose a higher tax that might be needed for clean new cities. Indeed, the carbon tax can play a major role, both for revenue and efficiency/sustainability. At the city level, a typical financing mechanism for local infrastructure is user charges. Given the interface with environmental and distributional objectives, the pricing mechanism will typically include a tax/subsidy element depending on the weight given to, for example, environmental externalities (technically speaking the shadow pricing assumptions) and the government’s distributional preferences. Thus, there is an interface of public sector prices and user charges with the intertemporal budget constraints, given the nature of the contracting arrangements involved (e.g., PPPs) and public guarantees, as well as the need to record the build-up of liabilities, as described above. In most countries, a recurrent tax on property is usually the main local tax and underpins basic public services provided at the local level, as well as providing the basis for financing critical infrastructure. Chinese local governments have relied instead on land sales to anchor off-budget access to credit through local government financing vehicles (LGFVs). This has been accompanied by an assortment of well-designed taxes on property sales that however generate a fraction of revenues through land sales. The incentives from land sales lead to urban sprawl and loss of prime agricultural land as well as wetlands in the major deltas, as well as opaque transactions through the LGFVs. Attempts to reduce reliance on land sales have not been very successful in the absence of a significant local tax base, and experiments with a valuation and ownership basis property tax in Shanghai and Chongqing have not been very successful. This model relies on accurate and timely records of ownership and valuation. Neither the baseline cadastre, nor the valuation system, work effectively in many emerging market countries. The valuation-based property tax was abandoned in the UK in the 1990s; instead local councils put in place a system that links flat taxation bands to the average cost of public services provided by the local councils. Since the tax is linked to a set of services delivered at the city/local level, it is possible to begin to establish a link between the tax as a payment for services and the quality of the services provided.

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Alfred Marshall argued over a 100 years ago that this could make for a ‘beneficial tax’, with minimal political economy repercussions.6 At the same time, however, it would be important to build in progressivity for both equity and revenue reasons, while avoiding the complexity of the ownership and valuation model that has not worked very well in the experiments in Shanghai and Chongqing. New approaches with respect to taxing housing in emerging market countries focus on occupancy, number of inhabitants, location and property size, linked to basic public services (Ahmad, Brosio and Gerbrandy, 2017). Simulations of a ‘beneficial’ property tax using data for six major cities in China suggests that it can quickly raise sufficient revenues to replace land sales and improve post-tax income distribution in most cities (see Ahmad, Niu, Wang and Wang, 2020). The linkage of a simple property tax with service delivery is critical in overcoming political resistance, and also achieving better local accountability for infrastructure and basic services, including public health care. As in the UK, a valuation-based system of taxation of property transactions continues to operate in China for businesses, and all other property sales. The adjustments and betterment levies on the business property tax are one of the means of financing new transport infrastructure. Importantly, central setting of bands is used to provide rate setting flexibility for local governments that provides a precedent that can be used for piggy-backed operations on the personal income tax, beneficial property tax and carbon taxes. Business property taxation of this kind is crucial for the issuance of local bonds, and the ability to incur debt on behalf of PPPs. Own-source tax handles are a key element to anchor the spending, provide revenue streams, assure sustainable access to credit, without build-up of liabilities and risk, and to provide signals to the private sector. Without strong focus on the reform of local public finance and services, there could be persistent risks from the fragility of local financial systems. Without the ability to finance investment and clear incentive structures to radically reduce congestion, pollution and greenhouse gas emissions, many cities could remain or become unproductive, unhealthy and unattractive places in which to live and work. They could not provide the strong, sustainable and inclusive growth that China is seeking.

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CONCLUSIONS: CONTINUING DOMESTIC REFORMS AND REBALANCING CAN FOSTER STRONG, SUSTAINABLE AND INCLUSIVE GROWTH WITHIN AND BEYOND CHINA China’s role in developing the global agenda for sustainable growth and managing climate change has been, and remains, crucial. The domestic agenda in China, as articulated in the medium-term work programme of the government (He, 2018), is clearly driven by the objective of improving living standards in a sustainable and inclusive way. Clean and attractive metropolitan areas and new high-tech cities that provide sustained employment and help reduce poverty are vital parts of the strategy. However, it is important that careful attention is given to the risks associated with the high level of leveraging and often hidden subnational debt to ensure financial and fiscal sustainability. Local infrastructure and public services are needed to strengthen, stabilize and reform China’s expanding towns and cities. They are also needed to sustain new ‘hubs’ and for private-sector activities to facilitate a shift in production and employment to the interior, or along international trade corridors. The performance of such infrastructure and services will require local management and creativity. The domestic reform agenda in the 14th Five Year Plan period in China involves improving living standards in clean new cities and restructuring metropolitan areas to foster poverty reduction and the growth of inclusive employment opportunities. A combination of tax reforms and more transparent information on liabilities by local governments and firms, including local utilities and SOEs, can help manage financial and fiscal risks. Tax reforms at the subnational level are needed to generate the appropriate incentives, and to finance investments and anchor sustainable access to credit. The structural reform agenda has at its core the innovation and adoption of new technology in both existing metropolitan areas and new cities in China’s interior. Highly skilled workers in the metropolitan areas will facilitate the adoption of cutting-edge technology. Key locations will be science parks and the Greater Bay Area, and in the potential development of a new ‘silicon valley’ mega hub. There is also a strong focus on the development of financial services as a core element of a modern service economy and one that is vital for innovation. Clean manufacturing can expand in the new interior cities, along with the new value-chains of the

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BRI’s overland connecting infrastructure, with markets in South Asia and the Middle East, Central Asia, Europe and Africa. Increasing trade with countries in the Western Hemisphere, particularly in Latin America, and with South East Asia, will likely continue to be promoted via the existing and enhanced coastal hubs and sea-based connections. This trade is likely to increase significantly, enhanced by China’s stand on open markets and trade. At the same time, in a country the size of China, reforms and innovation to foster strong, sustainable and inclusive growth will depend on policies and reforms for the nation as a whole and not just in hubs and new cities. The national tax agenda, including in relation to the cost of doing business, has advanced strongly following the 2016 VAT for business tax reform, and the rationalisation of the corporate income tax (CIT) structure and rates. Two main remaining national reforms include: (1) expanding the base of the personal income tax to more effectively include non-wage income; and (2) a national carbon tax to raise revenue, promote efficiency, reduce pollution and help achieve China’s 2060 carbon neutral pledge (this could supplement the existing emissions trading system). Pursuing this national agenda, together with the modern tax administration methods now in use in the SAT, could deliver a friendly business climate, create buoyant tax revenues (which are particularly necessary given China’s ageing population), and promote high environmental and other standards. The SAT can then easily administer a ‘piggy-back’ or ‘surcharge’ that could be imposed easily and quickly by provinces and metropolitan areas, or even cities for the carbon tax. Given that China is a unitary state, the legislation of bands by the National People’s Congress is important, and cities that are more polluted and congested could apply rates towards the upper end of relevant ranges—as is already the case with some property transfer taxes. The ‘piggy-back’ or surcharge for provinces and metropolitan areas would also change the current revenue-sharing arrangements into own-source revenue that can be used to anchor access to the credit markets and make the local bond system work more effectively. This is an essential element in managing the potentially significant risks arising from subnational operations. A local piggy-back does not have to increase the overall PIT rates. At the city level, land sales are no longer a viable source of financing local investment. US-style property taxes based on ownership and accurate valuation have not proved easy to implement in China or in any other emerging market economies. A simpler recurrent tax linked to size of

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property, location and local service delivery and including occupancy, could be an option to be developed. The experience of the UK, negative as well as positive, is a potential example to be explored, although it is important to build in progressivity for both equity and revenue reasons. This will be a critical element in the financing of new clean cities and minimizing the risk of default. Finally, the local governance agenda is fundamental. Cities should be accountable for the liabilities they generate. Clear and comprehensive information on liabilities, including from private–public partnerships, should be incorporated in local government balance sheets. While this effort is already under way, it will take time to be implemented at lower levels of government. In the short run, collaboration between the People’s Bank of China and the Ministry of Finance on the (monthly) changes in credit to local governments would provide an early-warning system for potential risks and problems that would form the basis for a deeper audit programme. In short, the reforms in China to further the government’s structural reform agenda in the 14th Five Year Plan period can and, we argue, should also inform the principles and techniques for development and risk management that apply to the BRI over the medium term. In this way, there would be, potentially, a very effective coherence and mutual reinforcement between sustainable and inclusive growth in the BRI countries and in China. That could bring very powerful and valuable benefits in the form of ‘better growth, better climate’ for China and the world.

NOTES 1.

2.

3.

4.

Previously, the Annual Economic Work Conference would announce annual priorities to put into action the priorities established in China’s Five Year Plans. The three-year work plan 2018–2021 sets medium-term priorities for structural change and for guiding the budget process. Coal use in China stabilised in around 2014, recorded a decrease of 2.9 per cent in 2014 and another 3.6 per cent decrease in 2015 (Qi, Ye, et al., 2016). It picked up again slightly in 2017 and 2018, mainly driven by growth in electricity demand. Coal consumption in China is still lower than the 2014 level. The 13th Renewable Energy Development Five Year Plan targets increasing installed renewable power capacity to 680GW by 2020; while China’s renewable energy installed capacity reached a record high of 650GW in 2017 and further rose to 728 GW in 2018 (Amighini, 2019). Note that China has five tiers of government.

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For a history of land ownership by the state, and the changing pattern of conveyance of land-use rights, see Yeh and Wu (1996). However, an early attempt in the UK, the Community Charge (commonly known as the ‘poll tax’), was designed and implemented in a politically troublesome way and was quickly abandoned in the early 1990s. The replacement—Council Tax—rightly has been criticized for its lack of progressivity, as the result of bands which are linked to occupancy, location and cost of local services, rather than the market prices of the respective properties.

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REFERENCES Ahmad, E. (2017a) ‘Rebalancing in China—Fiscal Policies for Sustainable Growth’ The Singapore Economic Review, 63: 1–24. Ahmad, E. (2017b), ‘Political Economy of Tax Reforms—Improving the Investment Climate, Addressing Inequality and Stopping the Cheating’ G24 Working Paper, Washington, D.C. Ahmad, E. (2018) ‘Governance Models and Policy Framework: Some Chinese Perspectives’ Journal of Chinese Governance, doi 10.1080/23812346.2018.1455414. Ahmad, E., Bordignon, M. and Brosio, G. (eds) (2016) Multilevel Finance and the Eurocrisis, Edward Elgar Publishing. Ahmad, E., Brosio G. and Gerbrandy J. (2017) Property Taxation: Economic Features, Revenue Potential and Administration in a Development Context, European Commission Project FED/2016/380/048. Ahmad, E., Niu, M., Wang, L. and Wang, M. (2020) ‘Designing Beneficial Property Taxation for Sustainable Development in China: Evidence from Six Chinese Cities’ LSE/Coalition for Urban Transitions Programme on Financing Sustainable Urban Transitions in China and Mexico. Ahmad, E., Niu, M. and Xiao, K. (eds) (2018) Fiscal Underpinnings for Sustainable Development in China — Rebalancing in Guangdong, Springer Singapore. Ahmad, E. and Stern N. (2012) ‘Effective Carbon Taxation and Public Policy Actions’ in Rao, M.G. and Rakshit, M. (eds) Public Economics: Essays in Honour of Amaresh Bagchi, Sage Press. Ahmad, E. and Zhang, X. (2018) ‘Towards Monitoring and Managing Subnational Liabilities in China: Lessons from the Balance Sheet for County K’ in Ahmad, E., Niu, M. and Xiao, K. (eds) Fiscal Underpinnings for Sustainable Development in China, Springer. Ambrosanio, F. and Bordignon, M. (2015) ‘Normative Versus Positive Theories of Revenue Assignments in Federations’ in Ahmad, E. and G. Brosio (eds) Handbook of Multilevel Finance, Edward Elgar. Amighini, A. (2019), ‘China’s Race to Global Technology Leadership, ISPI Report’, available at: https://​www​.ispionline​.it/​sites/​default/​files/​ pubblicazioni/​report​_china​-global​-technology​-leadership​.pdf, accessed 8 December 2020.

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Climate Action Tracker (2019). ‘Comparability of Effort September 2019’, available at: http://​climateactiontracker​.org, accessed 8 December 2020. Liu, H. (2018) 3 Critical Battles China is Preparing to Fight. Speech to World Economic Forum, Davos, January 24 2018. Liu, S. and Li, C. (2018) ‘Public Services Evaluation from the Perspectives of Public Risk Governance’ in Ahmad, E., Niu, M. and Xiao, K. (eds) Fiscal Underpinnings for Sustainable Development in China: Rebalancing in Guangdong, Springer. Marshall, A. (1890) Principles of Economics (8th ed.), Macmillan & Co. Appendix G. Edition used: Principles of Economics (London: Macmillan and Co. 8th ed. 1920), Online Library of Liberty. Qi, Y., Stern, N., Wu, T., Lu, J. and Green, F. (2016) ‘China's post-coal growth’ Nature Geoscience 9, 564–66. Wang, J. (2013) ‘The Economic Impact of Special Economic Zones: Evidence from Chinese Municipalities’ Journal of Development Economics 101, 133–147. Wang, W., Wu, A. and Ye, F. (2018) ‘Land Use Reforms: Towards Sustainable Development in China’ in Ahmad, E., Niu, M. and Xiao, K. (eds) (2018) Fiscal Underpinnings for Sustainable Development in China, Springer. World Bank (2018) China Systematic Country Diagnostic: Towards a More Inclusive and Sustainable Development. Washington, DC.: World Bank. Available at: https://​openknowledge​.worldbank​.org/​handle/​10986/​29422, accessed 8 December 2020. Xiao, K. (2018) ‘Managing Subnational Liability for Sustainable Development: a Case Study of Guangdong Province’ in Ahmad, E., Niu, M. and Xiao, K. (eds) Fiscal Underpinnings for Sustainable Development in China, Springer. Yeh, A.G. and Wu, F. (1996) ‘The New Land Development Process and Urban Development in Chinese Cities’ International Journal of Urban and Regional Research 20(2), 330–53. Yuan, X. (2018) ‘BRTs and Investment Fads: Civic Engagements and Fiscal Discipline’ in Ahmad, E., Niu, M. and Xiao, K. (eds) Fiscal Underpinnings for Sustainable Development in China, Springer.

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PART II

Trade, tensions and division of labor

7. The potential for cooperation and competition in international trade: recent trade growth and driving factors – a perspective on current global trade tensions

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Robert Koopman1 Between 1980 and 2008 global integration proceeded at a rapid pace, with developing countries in particular increasing their share in global GDP and global trade flows. During this period global trade grew, on average, more than two times faster than global GDP, suggesting trade was a facilitating mechanism for both increased integration and a rapid growth in developing country GDP. However, between 2011 and 2016, global trade growth slowed substantially compared to the rapid rate of the long 1990s, but also in comparison to its long-term historical average. Has global integration reached a stopping or tipping point? Can global trade growth recover? Or has increased protectionism and economic retrenchment signaled a long-term slowdown in trade and economic integration. Recent research and economic developments suggest this recent slow trade growth has been largely due to weak investment and consumption growth, and that there is a robust long-term relationship between trade and economic growth. This research also indicates that trade policy plays a not inconsequential, but also not a dominant, role in contributing to trade growth. Keeping the impact of policy in mind, it suggests that policymakers and pundits should be careful in attribution of the various economic effects of trade agreements. While this may be obvious to economists, it does not appear to be obvious to policymakers, pundits and the general public. The role of the World Trade Organization (WTO), various preferential trade agreements, and unilateral liberalization all have contributed to lowering trade costs and uncertainty in the global trading system. Trade 60

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also plays an important role in improving efficiency: its ability to contribute dynamically to faster growth through the spread of technology and knowhow and to allow smaller countries to have access to larger markets, have important macroeconomic effects. But fundamental macro relationships tend to be much more important drivers of trade growth than specific trade policy changes, thus the macroeconomic effects of monetary policy normalization, interest rates rising due to greater inflationary pressures, currency movements due to monetary and fiscal policy positions are likely to have greater effects on trade growth. In recent years at the multilateral level the WTO has seen some progress in the area of negotiations with the Trade Facilitation Agreement, Information Technology Agreement expansion and the elimination of export subsidies. But members have struggled for many years to agree on new rules in areas such as market access, agriculture and services. Challenges in advancing negotiations in these areas have also prevented members from dealing substantially with a fast-changing commercial environment, which includes the rapid expansion of the digital economy and fairly quick and large changes in comparative advantage. The WTO continues to make substantial contributions in the areas of transparency and dispute settlement even if the negotiating function has not performed to expectations.

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THE CHANGING GLOBAL GEOGRAPHY OF TRADE In the last 35 years the global geography of trade has changed substantially. The south is no longer the periphery. And importantly, it’s not the 1980s anymore. In Figure 7.1 below we show a summary of world trading relationships in 1980 (left panel) and 2016 (right panel). As described in the World Bank study, each dot represents a country. The lines connecting the countries represents an ‘active trade connection’ between them. Trade is measured as exports as a share of total exports of the source country, and only shares greater than 1 percent are reported. Similarity in trade, represented on the vertical axis as the distance between countries reflects ‘similarity in the structure of their trade connections’ across other members of the network. That is, the closer countries are to one another, the more alike they are in terms of export shares. Systemic relevance, measured on the horizontal axis, shows that countries that capture a larger share of other countries’ exports – and are connected with a larger

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number of trading partners –appear further to the right and are considered “more systemically relevant countries” in global trade. In 1980 a few countries with similar trading patterns were by far the most systemically relevant for global trade. Those countries were the US, a number of European countries, and Japan. If you knew what was happening in those countries you knew what was happening in global trade. The rest of the world was highly dependent on those countries for their export markets and there was not a lot of diversity in trade. Now, looking at the left panel we can see a substantial shift to the right and a tighter cluster in the middle of similarity. Thus more countries are systemically relevant and increased similarity in trading structures by 2016. In the right panel we can see a substantial shift to the right and a tighter cluster in the middle of similarity. More countries are systemically relevant and increased similarity in trading structures by 2016. In fact, India and China are now on par with the US and large European traders and other countries such as Vietnam, Indonesia, and Malaysia, and Brazil have become much more systemically important.

Source: WTO staff calculations, based on data from the Direction of Trade Statistics (DOTS) updating a chart from the World Bank “The Rising South.” – Special thanks to Magali Pinat (IMF).

Figure 7.1

Similarity and systemic relevance of trading countries, 1980–2016

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In 2016 it is no longer just the US and Europe. The world is much more diversified and it is certainly not 1980. If countries think they are one of a few important trade markets with a lot of implicit market power to negotiate more favorable terms of trade-driven bilateral trading arrangements, these data suggest this is not likely to be an effective strategy.

THE RELATIONSHIP BETWEEN TRADE GROWTH AND GDP GROWTH

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A significant area of interest in the trade community is the evolution of the trade elasticity, i.e. the ration of the percentage change in trade growth to the percentage change in GDP growth (see Hoekman (2015)).

Source: WTO Secretariat for trade, consensus estimates for GDP.

Figure 7.2

Ratio of world merchandise trade volume growth to world real GDP growth, 1981–2018 percentage change and ratio

Figure 7.2 shows the evolution of the WTO’s trade elasticity calculation since 1981.2 During the period 2012–2016 the trade elasticity was about 1, and even fell to below 1 in 2016, one of only three times in 37 years. Thus we see relatively slow growth of trade compared to GDP, particularly compared with the period from 1990 to 2005 when trade was on average growing more than twice as fast as GDP. Many economists and policymakers

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have expressed significant concern about this slowdown in trade growth. Questions have arisen as to whether it indicates an end to, or even a reversal, of globalization. Is there a rise in protectionism, despite repeated G20 pronouncements emphasizing a need for a freeze and rollback in protectionist measures, that is slowing trade significantly (see Baldwin and Evenett (2009))? These are important questions that need to be answered. Before looking at the evidence to date it is useful to reflect on the long run value of the trade elasticity and then consider what influences its evolution. If you look at much longer-term data one sees that the 1990–2005 period was unusual. During this period a number of fairly unique factors seem to have been influencing trade vs GDP growth. The opening up of the formerly planned economies in Europe, the integration of China and India into the global economy, the development and expansion of Information and Communications Technology (from computers and the internet to shipping containers), as well as the negotiation and implementation of specific multilateral and preferential trade agreements. Much of the opening up of countries generated a lot of financial flows in terms of increases in effective domestic and foreign direct investment. Many countries who had isolated themselves from the global economy and from rapid advancements in technology and modern production techniques fairly suddenly opened themselves up to capital, knowhow and trade flows, generating rapid growth and significant changes in the global distribution of comparative advantage. Thus the trade elasticities for that period are likely very unusual. The WTO has calculated the long-term elasticity estimate of about 1.4, while Irwin (2002) has estimated a range of elasticities from 1870 to 2000 ranging from slightly more than 1 to over 3, but with estimates between1870 to 1985 ranging from slightly more than 1 to slightly more than 1.6. Using the WTO long run estimates we find that trade typically grows about 40 percent faster than GDP growth, but with some significant variation, thus we suggest using a long run average in the range of 1.3 to 1.5. However, as noted above, rarely is the trade elasticity below 1. For 2017 the WTO calculates that the trade elasticity recovered to 1.5 and expects to see something averaging in the 1.3 and 1.5 range for the next ten to 15 years, though with a fair amount of variation in any given year. It seems unlikely that we would see another array of forces to reproduce the 1990–2005 outcomes in the near future. It is useful to keep in mind that the trade to GDP elasticity is potentially misleading as trade is typically measured in gross value terms while GDP is measured in value added terms.3 Thus traditional trade

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flows are subject to double counting in a global value chain world where parts, components, and even products can move across borders several times (and therefore be counted several times) before reaching the final consumer. Recent efforts to measure trade in value added terms (see for instance Johnson and Noguera (2012), Koopman, Wang and Wei (2014), and Haugh et al, (2016)) have resulted in consistent data, and Koopman, Wang and Wei found that up to 25 percent of gross trade flows represented double counted trade. Unfortunately trade measured in value added terms tends to face significant lags compared to traditional trade data as they rely on input output tables which are produced with substantial delays. Escaith and Miroudot (2015) used OECD-WTO Trade in Value Added Data to generate a long-term rolling average of the trade elasticity in value added terms and found it was much closer to 1, and much less variable than the traditional measure.

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WHAT DRIVES TRADE GROWTH? In the view of the WTO GDP growth is the most important driver of trade growth. In recent years a debate has been underway around the causes of slow trade growth. There has been an extensive literature examining the determinants of trade growth, particularly what might explain the high trade elasticities observed during the 1990–2005 period. There is also extensive literature examining trade growth that preceded this recent slow growth period, and most of it identifies macroeconomic factors as key determinants of trade growth, particularly GDP growth, and specific components of GDP growth such as investment and consumption of durable goods (see, e.g., Anderson and Van Wincoop (2004), Novy (2013) and Eaton et al (2016), among many others). The role of specific policies, particularly tariff reductions, or other factors affecting trade costs, played a smaller, but still important role in driving trade growth. Despite these fairly robust findings over a number of years the very recent debate, exemplified by Hoekman 2015, reignited interest in the question of drivers of trade growth. Very recent contributions by the WTO, the IMF, the World Bank, the OECD, and researchers at WIOD and other places appear to confirm the earlier findings that macro forces drive the largest part of trade growth, and that the direct effects of actions such as tariff liberalization or protectionist increases in tariffs account for perhaps 25 percent of observed trade growth. One must recognize however that the dynamic, longer run effects of these kinds of trade costs

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could have substantial effects on macro drivers such as investment and consumption and therefore have bigger long run effects. Taking this more recent literature on the whole it appears that investment and consumption (particularly consumer durable) growth explain between 66–75 percent of trade growth, and that explicit trade policy related changes explain perhaps up to 25 percent of trade growth. These empirical insights are important as it often seems that trade policymakers reverse these drivers of trade growth in their minds, and too often seem to associate 100 percent of changes in trade growth with explicit changes in trade policy. Thus the recent run of very low trade growth, of about 1 to 1 to GDP, appears largely due to very weak and/or uneven investment and consumption growth across the globe. With the recent synchronization of global growth in 2017 we see trade picking up and returning to the long term ratio to economic growth because of the recovery in investment and consumption. Why are investment and consumption growth so important to trade growth? Because these elements of demand are particularly trade intensive – that is, domestic investment demand typically includes a high proportion of imported goods. In Auboin and Borino (2017) they use WIOU to estimate the trade intensity of investment, consumption, government expenditures and exports (see Figure 7.3). Similar findings come from the IMF (2016), Bussière, et al, (2013), Haugh et al (2016), and Timmer, et al (2016).

Source: WIOD Input-Output tables and authors’ calculations

Figure 7.3

Evolution of average import content of aggregate demand components for all sample countries

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CONCLUDING COMMENTS Recent slow trade growth, which this past year recovered to a more normal, long-term relationship with GDP growth, reignited a debate about global protectionism in the post global financial crisis trading system. Recent trade tensions between the US and China, as well as other countries raises the prospect that what was described as ‘murky protectionism’ in the immediate aftermath of the GFC has turned into clear and immediate policy calls for increased tariffs and potential retaliation. Should these calls turn into action global trade will clearly be adversely affected, but the literature also tells us that the bigger drivers of trade growth are macro components of GDP. This suggests that the most important factors to watch should trade tensions turn into a trade war are those macro components, particularly investment and consumer durable expenditures. If those expenditures are not too disrupted by trade conflict then the adverse effects on growth will probably be small in the short term. If the conflict causes a great deal of uncertainty for firm investment and consumer durable purchases the effects will be larger and longer lasting.

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NOTES 1. The opinions expressed in this paper are those of its author. They are not intended to represent the positions or opinions of the WTO or its members and are without prejudice to members’ rights and obligations under the WTO. Any errors are attributable to the author. 2. The WTO typically calculates a merchandise trade volume elasticity, leaving out services and trying to account for price changes. Commodity price volatility can have significant effects on nominal value based estimates of the trade elasticity. 3. The results of trade elasticity calculations may be somewhat affected by distortions in GDP measurement. There are often questions about the reliability of China’s reported GDP numbers. If the bias is systematic then the trade elasticity numbers are probably not significantly affected. Should the bias be non-systematic then the pattern of elasticity changes over time may be affected.

REFERENCES Anderson, James, E., and Eric van Wincoop. 2004. ‘Trade Costs’ Journal of Economic Literature, 42(3): 691–751.

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Auboin, Marc and Floriana Borino. 2017. ‘The Falling Elasticity of Global Trade to Economic Activity: Testing the Demand Channel’, No ERSD-2017-09, WTO Staff Working Papers, World Trade Organization (WTO), Economic Research and Statistics Division. Baldwin, Richard and Simon J. Evenett. 2009. ‘Don’t let murky protectionism stall a global recovery: Things the G20 should do’ VoxEu.org, 5 March. Bussière, M., Callegari, G., Ghironi, F., Sestieri, G. and Yamano, N. 2013. ‘Estimating Trade Elasticities: Demand Composition and the Trade Collapse of 2008–2009’ American Economic Journal: Macroeconomics, 5(3), 118–151. Eaton, Jonathan, Samuel Kortum, Brent Neiman and John Romalis. 2016. ‘Trade and the Global Recession’ American Economic Review, 106(11): 3401–38. Escaith, Hubert and Miroudot, S. 2015. ‘World Trade and Income Remain Exposed to Gravity’ in The Global Trade Slowdown: A New Normal? Bernard Hoekman (ed) London: CEPR Press; Florence: European University Institute, VoxEU.org E-book. (pp. 127–160). Haugh, D., et al. 2016. ‘Cardiac Arrest or Dizzy Spell: Why is World Trade So Weak and What can Policy Do About It?’ OECD Economic Policy Papers, No. 18, Paris: OECD Publishing. Hoekman, Bernard M. (ed.), 2015, The Global Trade Slowdown: A New Normal?, London: CEPR Press; Florence: European University Institute, VoxEU.org E-book. (pp. 3–19). International Monetary Fund. 2016. ‘Global Trade: What’s behind the Slowdown?’, Chapter 2, in World Economic Outlook, Washington, October. Irwin, Douglas A. 2002. ‘Long-run Trends in World Trade and Income’ World Trade Review, 1(01): 89–100. Johnson, Robert C. and Guillermo Noguera. 2012. ‘Accounting for Intermediates: Production Sharing and Trade in Value Added’ Journal of International Economics, 86(2): 224–36. Koopman, Robert, Zhi Wang and Shang-Jin Wei. 2014. ‘Tracing Value-Added and Double Counting in Gross Exports’ American Economic Review, 104(2): 459–94. Novy, D. 2013. ‘Gravity Redux: Measuring International Trade Costs with Panel Data’ Economic Inquiry, 51: 101–21. Timmer, M. P., B Los, R. Stehrer and G. J. de Vries. 2016. ‘An Anatomy of the Global Trade Slowdown based on the WIOD 2016 Release’ GGDC Research Memorandum 162, Groningen Growth and Development Center, University of Groningen.

8. Overview of China–US economic disputes in 2018 Feng Lu1

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1. INTRODUCTION When President Trump signed memorandum targeting the so-called ‘China’s economic aggression’ on 22 March 2018, it more or less gave the Chinese general public a surprise. For many people in China, the memory of President Trump’s visit to their country in mid-November 2017 received with ‘the state visit plus’ treatment was still not too far away. The two countries signed numerous bilateral contracts totaling about US$250bn mainly consisting of China’s purchasing goods from and outbound investment to the US. When the US government announced the tariff list of total US$50bn on imports from China on April 4 and the Chinese side responded the retaliatory tariff list of the same amount, a time bomb with a tipping point was set for a possible trade war between the two countries. The dispute further escalated on April 16 when the US Department of Commerce activated the suspended denial order on TZE, the second largest IT equipment company, the measure brought about unprecedented debate about the industrial policies in the high-technology sectors inside China. When people worried further about the deterioration of the situation, the mode of confrontation was changed into consultation, and senior economic officials from the two countries held talks in early May at Beijing. Though the early May consultation did not produce concrete results, the two countries secured a framework agreement through issuing a joint statement after two days of talks in Washington D.C., in mid-May. But the euphoria brought about by the joint statement did not last long, the situation reversed into a confrontational mode again after the US side suddenly announced on 29 May that it would publish the new tariff list of US$50bn against the Chinese imports. 69

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The drastic change in China–US economic relations and the risks of a possible trade war caused wide concerns both inside China and in the international community. For example, it was indicated by IMF in mid-April that the driving forces behind global economic growth could be damaged by possible US–China trade conflicts (e.g., Obstfeld, 2018; Giles, 2018). What happened with regard to the US–China economic relationship that led to such a real roller coaster? What are the changes in terms of the US trade and economic policies towards China? What are the causes of the change and whither will the situation evolve? This chapter provides an overview on changes in both the US policy stance towards China and the recent shaky situation for the economic and trade relationship between the two countries. The organization of the chapter is as follows. After a brief introduction, Section II observes the factual background of the topic in several steps: first, it briefly reviews the actual situation of China and US trade and their economic relationship in the first year of the Trump administration; second, it summarizes the systematic changes of trade and external economic policies adopted by the Trump administration in general and particularly towards China; and third, it observes the implementation of the hawkish trade policy and the evolution of the disputes between the US and China up to the end of June 2018. Section III examines the factors shaping the current situation from four perspectives: the structural difficulties faced by the US economy, characteristics of the Chinese institutional setting and policies that have become increasingly unacceptable for the US, the special personal belief and position of President Trump and his main aides in the economic and trade team towards globalization and trade issues, and short-term factors in the internal political arena of the US. Section IV gives brief concluding remarks.

2.

WHAT HAPPENED?

2.1

China and US Trade and Economic Relationship in 2017

As a prominent candidate in the presidential campaign in 2016, Mr. Trump expressed strong opinions regarding the trade and economic relations with China. He once threatened to impose 45 percent extra tariff on imported goods from China. He also accused China of causing the closure of thousands of factories and making millions of workers unemployed (Time staff, 2016), so he suggested that the US should declare China as the country manipulating the exchange rate.2 Though these extreme poli-

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cies were not implemented immediately after Mr. Trump moved into the White House, the prospects of China–US trade and an economic relationship were dim indeed at the beginning of his presidency. In March 2017, the Office of the United States Trade Representative (USTR) published 2017 Trade Policy Agenda and 2016 Annual Report. The document systematically elaborated ‘a new approach’, crucial goals and priority agenda for the US trade policy (USTR, 2017), signaling the ongoing overhaul of the US trade policy with China as the most important target country. The first positive move came when Mr. Xi Jinping, the Chinese President, met with President Trump at the Mar-a-lago resort at Palm Beach, Florida in early April 2017. The summit announced that the two countries would start 100 days of negotiation under the new dialogue platform, the Comprehensive Economic Dialogue (CED) with a view to reduce bilateral trade imbalance (White House, 2017a). In approximately one month following the Presidential Summit, the two sides reached consensus on addressing issues in areas including agricultural trade, financial services, investment, and energy.3 As reported by media:

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the US and China have reached a ten-point trade deal that opens the Chinese market to US credit rating agencies and credit card companies. Under the deal, China will also lift its ban on US beef imports and accept US shipments of liquefied natural gas. In return, Chinese cooked chicken will be allowed into the US market and Chinese banks can enter the US market.4 In addition, under the new deal, China will issue both bond underwriting and settlement licenses to two qualified US financial institutions by July 16. JPMorgan Chase recently became the first U.S. bank to obtain a bond underwriting license in China outside of a joint venture. Citibank received a bond settlement license around the same time.5

Along with implementation of the ‘the plan of 100 days’, the bilateral trade and economic relationship entered into a brief period of cooperation and stability. China–US economic relationship once again entered into a phase of downturn when the first round Comprehensive Economic Dialogue (CED) held on July 20, 2017 failed. Though the two sides reached some progress, the event did not produce the expected results. They did not issue a joint statement and list of achievements as they had on previous occasions in the earlier Bush and Obama administrations (Heatley, 2017). One signal indicating the worsening environment for the China–US trade relationship was that the US Department of Commerce launched the

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Section 301 investigation into China in mid-August 2017, against which the Chinese side expressed her resolution to defend her own rights and interests. In November President Trump made an official visit to China, and China once again made great affords to stabilize the bilateral relationship. Apart from ‘the state visit plus’ standard adopted by the Chinese government in receiving the President’s visit to China, the two countries signed numerous contracts and Memoranda of Understanding (MOUs) in a wide range of areas such as energy, the chemical industry, environmental protection, culture, medicine, infrastructure, smart cities, etc. totaling US$253.5bn. President Trump expressed his thanks to President Xi and China many times during his official visit to China. As a result, the Chinese media became optimistic about the economic relationship.6

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2.2

Reorientation of the US Policies towards China

In spite of the zig-zag trajectory of the trade policy interaction between China and the US in the first year of Trump’s administration, the major adjustment and reorientation of US trade and economic policies were underway. The turn to a new policy and strategy by the Trump administration in 2017 may be observed through two aspects. On the one hand, a great deal of effort had been made to re-design and re-state the new version of the trade and economic policies, in which China has been focused on as a prime targeting country. On the other hand, the Trump administration initiated a record number of trade investigations against China so as to prepare ample ammunition for the planned trade disputes later. Three events occurred towards the end of 2017 indicating that the reorientation of the new hawkish policy pursued by the Trump administration towards China has largely been completed. First, the US Department of Commerce published a new version of the memorandum on ‘China’s status as a non-market economy’ by November 2017 that expounds the topic of the title in much more detailed compared with the earlier version in 2006. Second, President Trump delivered a speech at the APEC summit at Vietnam immediately following his official visit to China; the speech elaborated the new policy with various explicit and implicit critiques on China’s trade and economic practices. Third, the Trump administration published the new version of the National Security State Report (2017) that re-defines the strategic principle towards China.

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The new policy represented a systematic shift. First, a higher priority was placed on US trade and economic policies related to China and more focus was placed on economic issues at the national security level. Second, the principle of trade policy has shifted from ‘free trade’ to ‘fair trade’ and further to ‘reciprocal trade’ or ‘reciprocity’, with a view to justifying unilateral and protectionist measures that the US government may adopt in the trade area. Third, the Trump administration attempted to divide countries into two categories: those that ‘follow the rules’ and those that ‘do not follow the rules’, encouraging the international community to choose a side. Fourth, it reconfirmed China’s status as a non-market economy in order to justify use of the special policies in dealing with China. Fifth, the administration gave a critical review on the US’s historical decision to support China’s accession to the World Trade Organization (WTO), and reconsidered the role of the WTO’s multilateral rules in the new circumstance. Sixth, it clearly indicated that the US government was prepared to use a variety of measures, including tariffs, investment restrictions etc., to impose pressure on China. Two relevant factors defining the backdrop for the shift of the US trade and economic policies towards China should be noted. First, the change of the trade and economic policy is an integral part of the overall reorientation of the US strategy towards China. In the National Security Strategy of the United States of America published in December 2017, China is labeled as a ‘revisionist’ of the international rule and the major ‘rival’ for the US. It signals a significant departure from the traditional policy towards China adopted by past US governments (White House, 2017b). Second, the shift of US trade policies by the Trump administration towards the direction of protectionism and unilateralism is worldwide in nature, not only confined to the China–US relationship. The Trump administration imposed pressure on Canada and Mexico to re-negotiate the terms of NAFTA. The US trade relationship with other countries such as the EU, Japan and South Korea face problems as a result of the new trade policy adopted by the Trump administration with more emphasis on protectionism under the principle of ‘America First’. It should be nevertheless kept in mind that China is the primary country targeted by US. The US–China trade and economic relationship will provide a testing ground for implementation of the new policies for the Trump administration. Further evidence regarding the Trump administration’s preparation for the new trade and economic policies towards China in 2017 was indicated by the record number of cases of disputes covering both remedy

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and investigation initiated by the US against China. It is indicated by the relevant data that total cases of trade disputes reached record highs at 44 instances in 2016, the presidential election year. The intensity of trade disputes targeting China did not decline as expected after the year of the presidential election in which the trade issue tends to be particularly politicalized. In 2017 the number of cases of trade disputes actually further increased to 51 in 2017 (Lu and Li, 2018). This evidence indicates that the Trump administration actively prepared munition for the upcoming trade war with China.

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2.3

Escalating US–China Economic and Trade Disputes

After President Trump signed a tax reform plan into law on 22 December 2017, the focus of his administration’s economic policy shifted to the area of foreign trade and the protectionist policies started to be implemented vigorously. In early 2018, the Trump administration launched two rounds of peripheral protectionist trade battles. The first round of peripheral battle was launched on January 23 against washing machines and solar cells, with tariffs of 50 and 30 percent imposed respectively. The second was the implementation of measures on the basis of the Section 232 investigation. As a result, 25 and 10 percent tariffs were announced to be imposed on steel and aluminum, respectively, on March 1 2018. Though the measures did not target China exclusively, they nevertheless caused significant damage to China’s economic interests. In response to the US steel and aluminum tariffs, the Ministry of Commerce of the People’s Republic of China (MOFCOM) announced on March 23 that tariffs would be imposed on seven categories of imported US products worth US$3bn. On March 22 2018, the Presidential Memorandum was signed to announce the results of the Section 301 investigation against China. The USTR announced four findings and three proposed sanctions against China, thus escalating US–China trade disputes. On April 3, the US announced a list of products for tariff increase which included 25 percent tariffs on 1333 Chinese products exported to the US worth US$50bn. The products ranged from aircraft and aeronautics, to information and communications technology, to robotics products, to manufacturing equipment. On April 4, the Chinese government announced 25 percent tariffs on 106 US imports from 14 categories including soybeans, automobiles and chemicals totaling US$50bn. On April 5, Trump instructed

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USTR to consider another US$100bn tariffs on Chinese imports under Section 301. During the Boao Forum on April 10, Chinese President Xi Jinping announced about a dozen measures to further open the Chinese market in four areas as an integral part of the further opening up policy. This announcement gained acclaim from the international community, including an immediate favorable Twitter response from President Trump himself. On April 18, the US delegation to the WTO submitted a report to the Dispute Settlement Body, in response to China’s request for consultations under the WTO dispute settling mechanism. This helped create conditions for the two countries to consult and negotiate under WTO rules. On April 16, the US Department of Commerce announced that it would reactivate the suspended denial order on China’s ZTE Corporation, prohibiting US companies from selling components, products, software and technology to ZTE for the next seven years. ZTE purchases a significant amount of chips and semiconductor components from the US, and it would be impossible for the company to find replacement suppliers in the short term. The US export ban would put ZTE, China’s second largest (and the fourth largest globally) communications equipment provider, into extreme difficulty. The export ban was caused by ZTE’s sale of US communications equipment products to Iran, which is prohibited by the US export regulation. The case had been under investigation by the US government since 2012. A preliminary judgment was handed down in 2016, and a settlement was reached in March 2017. Under the terms of the settlement, ZTE accepted a fine of US$892m and a US$300m suspended fine. The company would also fire executives related to the case and discipline 35 employees. ZTE was removed from a list of offenders, but was still facing a suspended ban for seven years, which would be activated if ZTE were found to violate the terms during the next seven years. In early 2018, the US found that ZTE failed to execute punishment on its employees as stipulated, thus resuming the export ban. Although the US has emphasized that the ZTE case is an isolated legal issue, considering the timing of the export ban along with other trade actions and the impact of the ban, the new move on ZTE may be regarded as another round of trade and economic friction. The issue has triggered a wave of policy debate and discussions in China as to how the country should develop its own chip and semiconductor industries.

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2.4

China and the West

Converting to Consultation in Early May

In May 2017 China and the US held two rounds of consultation on the disputed issues. On May 4–5 the US delegation, headed by Secretary of the Treasury Steven Mnuchin, visited Beijing and held a meeting with their Chinese counterparts led by Chinese Vice Premier Liu He. Chinese official news agency, Xinhua News, reported on the event and commented that negotiators reached ‘agreements on some issues’ but did not detail what those agreements were.7 It added that both sides knew that a stable trade relationship is vital for the US and China, and that more discussion was needed. After what it called a ‘thorough exchange of views,’ both sides agree that ‘considerable differences still exist;’ although no overall agreements had been made, the two sides reached consensus in some issues and agreed to having consultations in the near future. The White House issued a ‘Statement on the United States Trade Delegation’s Visit to Beijing’ on May 4 2018 and informed that ‘The delegation held frank discussions with Chinese officials on rebalancing the United States–China bilateral economic relationship, improving China’s protection of intellectual property, and identifying policies that unfairly enforce technology transfers’ (White House, 2018a). It also mentioned that: ‘The size and high level of this delegation illustrates the importance that the Trump Administration places on securing fair trade and investment terms for American businesses and workers.’ But the statement did not give detailed information regarding the two-day talk. The media, both in China and the US, commented comprehensively on a document entitled ‘Balancing the Trade Relationship between the United States of America and the People's Republic of China’ which outlined the US’s official stance. The main points listed in the document included: (i) the US trade deficit with China must be cut by at least US$200bn by the end of 2020; (ii) China must stop ‘market-distorting subsidies’ that harm US innovation and development; (iii) China must cease cyber-attacks on ‘US commercial networks and cyber-enabled theft targeting intellectual property, trade secrets and confidential business information’; (iv) China will not retaliate if the US restricts Chinese investments in sensitive US technology sectors, or areas that are critical to US national security; and (v) by July of 2020, China must cut tariffs on products in most sectors to levels that are not higher than US tariffs.8 The media also released the list of demands by the Chinese delegation. According to The Wall Street Journal, China’s plan ‘demanded that the Trump administration end its investigation into allegations that China

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forces US companies to transfer technology to Chinese partners and to cease its threats to impose tariffs on as much as US$150bn worth of Chinese goods’ (Wei, 2018). It also requested better treatment for Chinese technology companies and asks that the US ‘adjust’ its sales ban on ZTE Corp. and allow US companies and government agencies to buy technology equipment from Chinese firms.

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2.5

Second Talks in Mid-May and the Joint Statement

Based on the directions of Chinese President Xi Jinping and US President Donald Trump, the two sides conducted constructive consultations on trade issues in Washington D.C., on May 17–18 2018. The Chinese delegation was led by Xi’s special envoy and Vice Premier Liu He, and the US officials included Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross and Trade Representative Robert Lighthizer. After intense negotiations, China and the US reached an initial agreement on trade and issued a joint statement on May 19 (White House, 2018b). As indicated in the joint statement, the two sides agreed to take effective measures to ‘substantially decrease the US trade deficit in goods with China.’ China would ‘significantly increase its purchase of US goods and service’ to meet the consumption needs of the Chinese people and propel the high-quality economic development of China, which also helps support the US economic development and employment, according to the statement. The two nations agreed to meaningfully increase the export of US agriculture and energy products. The US side would send a delegation to China for further consultations. The statement said that the two sides highly valued intellectual property protection and agreed to promote cooperation in this regard. China will promote revision of related laws and regulations including the Patent Law, according to the statement. The two sides also agreed to encourage the two-way investment, and committed to creating a business environment for fair competition. The two nations agreed to maintain high-level contracts in this regard and actively seek to resolve their economic and trade concerns. It was also reported by the media that the trade deal that China and the US were near to reaching would stop the ban on US companies supplying ZTE. In exchange, China would buy more agricultural products and also lift the existing tariffs on the US agricultural products.9

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2.6

Return to the Confrontational Path

The joint statement temporarily relieved the tightened nerves for the general public, and was very much welcomed by the Chinese media.10 Unfortunately, the euphoria brought about by the joint statement on May 19 did not last long. While the tune of celebration on the peaceful settlement was still lingering in the room, President Trump again gave the world a surprise when he said on May 29 that his government would publish a new tariff list of US$50bn against the Chinese imports on June 15 (White House, 2018c). It was announced on the same day (White House, 2018d) that:

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to protect our national security, the United States will implement specific investment restrictions and enhanced export controls for Chinese persons and entities related to the acquisition of industrially significant technology. The proposed investment restrictions and enhanced export controls will be announced by June 30, 2018, and they will be implemented shortly thereafter.

The Chinese side responded swiftly to the drastic change in the US policy stance. That night the MOFCOM press spokesman gave a speech on the event that criticized ‘the strategic statement announced by the White House’ for ‘violating the recent consensus reached by both sides at Washington D.C..’11 It was reiterated that ‘the Chinese side will be confident, capable and experienced in defending the Chinese people’s interests and national core interests.’ China–US trade relationship had once again turned back to the mode of disputes and conflicts. Although the US delegation led by the Commerce Secretary Ross had a half-day meeting with senior Chinese officials at Beijing on the morning of June 3, the consultation failed in reversing the deterioration of the situation. On June 15, the USTR announced a list for ‘the imposition of an additional duty of 25 percent on approximately US$50bn worth of Chinese imports containing industrially significant technologies, including those related to China’s “Made in China 2025” industrial policy’ (USTR, 2018). The Chinese government announced the retaliatory measures on the second day following the US action. On June 16, 2018, China’s Customs Tariff Commission of the State Council released a notice to impose extra tariffs on the imported commodities originated from the US. The document claimed that the US action to impose an additional duty of 25 percent on approximately US$50bn worth of Chinese imports ‘violates

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the related rule of the World Trade Organization, contrary to the existing consensus reached through consultation by two sides, severely violating legal rights of our side, and threatening the interests of our country and people.’ On the basis of the Foreign Trade Law of PRC, the regulations on import and export tariff of PRC and other related law and regulations, as well as the principles of the international law, the China’s Customs Tariff Commission of the State Council decided to impose an additional duty of 25 percent on 659 product lines approximately US$50bn worth of imports originated from the U.S., in which additional tariff on 545 product lines approximately US$34bn worth of imports will be collected from July 6, 2018, and the time to collect additional tariff on remaining products will be announced separately.12

As a result, the risk of trade war between the largest two economies became imminent.

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3.

DRIVING FORCES BEHIND THE US POLICY SHIFT

As a result of changes in the US economic policy and strategic principles towards China, the economic and trade relationship between the two countries has experienced growing tensions recently. The changing situation is deeply rooted in the historic transformation in the global economic landscape with regard to the relative power shift among main economies in which China’s economic rise with the Chinese characteristics has played a crucial role. In order to gain a better understanding of the current situation and examine whither it evolves in future, it may be necessary to examine the driving forces behind the change. The causes of the US policy change observed above may include the following factors such as special economic difficulties faced by the US in the new environment, the institutional and policy characteristics with regard to China’s economic development, personal preference and position regarding economic globalization for some members of the Trump administration as well as short-term factors in the US domestic politics. 3.1

Secular Slowing Down of the US Economic Growth

The US potential growth rate has fallen substantially in the 21st century following its trend of gradual decline in previous decades. The US gov-

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ernment is under pressure to try different measures to reverse the weakening trend of the long-term economic growth. Since the secular slowing down of the US economic growth occurred in a globalized environment, external factors can easily be picked up as the main causes for the problems. This serves an important background factor underpinning shifts in the US economic and trade policy towards China. As indicated by the US official data, US economic growth went through three phases after the Second World War (WWII). The first was the ‘4-percent era’ over the period of 1950s and 1960s where the average annual growth was about 4.2 percent. Starting from the 1970s the long-term economic growth rate decreased significantly. Long-term economic growth for the US entered into the ‘3-percent era’ over the period of the 1970s–1990s with the average annual growth rate for the period declining to around 3.3 percent. Long-term economic growth further fell substantially in the 21st century. The annual economic growth rate reduced to around 1.9 percent over the period of 2000 to 2017, indicating the ‘2-percent era’. The average growth rate over 2002–2017 was 2.7 percent and that for the period of 2010–2017 was about 2.3 percent, indicating that the average growth rates in the new century are still in the ‘2-percent era’ even if the years of economic recession are excluded (Lu, 2017). The problems for the US economy was not only the slowing down of the long-term growth rate in the new century but also the fact that the reduced growth rate would not be possible without unusual macroeconomic stimulus policies. From 2002 to 2003, the Fed lowered interest rates twice to stimulate the economy. Although the stimulus policy raised the economic growth rate then, the excessive monetary environment also added fuel to the flourishing of high-risk subprime loans and the bubbles of asset-backed securities that eventually led to the financial crisis in 2008. From 2010 to 2017, the US economy sustained economic recovery. However, the use of fiscal and ultra-easy monetary policy to support asset prices and stimulate consumption through the increased value of household assets is the key feature of economic growth in the US in the post-crisis era. This implies that US economic growth may be difficult to sustain. It may be interpreted that, under an alternative environment with a neutral macroeconomic policy, the long-term US economic growth rate would be even lower. This creates the background for discussion of the concept of ‘secular stagnation’ (Summers, 2014).

Overview of China–US economic disputes in 2018

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3.2

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Anxiety Triggered by the Erosion of Comparative Competitiveness

Another important background for the US policy shift is the quickly changing global economic growth landscape as a result of the rapid growth of emerging economies, in particular China, along with the relative decline of the US economic comparative influence. It may be observed through two main perspectives on bilateral comparison of China and the US, as well as the changing pattern of global growth structure. Using indicators such as the scale of investment and savings and the value-added of industrial and manufacturing goods, China has already surpassed the US. China’s overall economic size measured in purchasing power parity (PPP) has surpassed the US recently. Based on current trends, China may overtake the US in terms of the overall economic size measured by the market exchange rate in about ten years or so. Even for some high-tech sectors, China is making progress quickly. Though the gap in terms of overall economic strength between China and the US may be still substantial, China is catching up at a rapid pace. In terms of changing the relative economic strength, time is clearly on China’s side. As China and other emerging economies are catching up, the driving forces behind global economy in the post-crisis era have undergone a ‘three-fold transition.’ On the basis of IMF data, in the 1990s the US contributed 29.1 percent to global economic growth, the G7 countries (Canada, France, Germany, Italy, Japan, the UK and the US) contributed 56.8 percent. Overall, developed economies contributed 76 percent. A similar situation existed in the previous three decades or so. However, from 2008 to 2016, these figures dropped to 7.4 percent, 11.5 percent and 23.9 percent, respectively. By comparison, in the 1990s China’s contribution to global economic growth was about 9 percent and that of BRICS (Brazil, Russia, India, China and South Africa) was only 12.4 percent; the contribution of emerging and developing economies was 23.9 percent. In the post-crisis era, these economies now contribute 35.6, 49.4 and 77.7 percent, respectively. At present, the US and other major developed economies still maintain an absolute advantage in terms of economic size, but in terms of incremental contribution to the global economy the situation has undergone fundamental changes.

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Growing Structural Contradictions

The shift of the US policy towards China was also brought about by the continuous increase of structural conditions inside the US economy and society in areas such as income inequality, ethnic conflicts and the structural recession in the so-called rust belt regions. For example, the US Gini coefficient increased from 0.4 in 1970 to the current 0.48. Income inequality has always been contentious in the US. Three changes that have happened since the beginning of the 21st century have exacerbated income inequality. The first is the emergence of a large group of high-income workers in the financial and IT industries, which has increased income inequality. The second is the public dissatisfaction with the US government’s post-financial crisis bailout and stimulus policies. Third, globalization has allowed US firms to outsource overseas, thereby restraining the growth of wages of ordinary working class in the US. The problem of immigration and ethnical conflicts have also been highlighted. Legal and illegal immigration to the US decreased from 1.66 million in 2000 to 1.08 million in 2011, but then rose again to nearly 1.6 million in 2015. In the past, rapid economic growth allowed new immigrants to integrate into the society fairly easily, and the US was proud of being known as a ‘melting pot.’ However, as economic growth has slowed down, each year the over one million immigrants flooding into the US has become the focus of social instability. At the same time, racial tensions in the US remain unresolved, which has been shown by the ethnic conflict in Charlottesville, Virginia in August 2017. The US rust belt has caused economic and social problems persistently since the 1970s. This was when industrial decline began to have a significant negative impact on states such as Ohio, Pennsylvania, Michigan, Illinois and Wisconsin. The rust belt’s economic significance is that the leading industries in these areas have lost market competitiveness. The regional economy in these states has faced a structural recession as a result. Similar problems occurred in other developed countries such as the UK, Germany and Japan. Such problems were sometimes one-sidedly attributed the external environment of globalization and competition from foreign countries, which further instigate US policy shift.

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3.4

83

Characteristics of the Chinese Economic System

China’s economic development presents a distinct pattern in terms of the institutional setting. Although the principle that market mechanism should play a decisive role in allocating economic resources has been adopted by the authority and society at large, the government’s involvement in the economy’s operation remains relatively high. The relatively active role of the government is reflected in different aspects such as the government’s direct or indirect control over economic factors such as land and other resources, state-owned enterprises (SOEs) using administrative monopolies to control a significant amount of economic resources, the price mechanism being restricted in selected sectors, imperfection in protection of private property rights, and the government’s use of various industrial policies to reach certain goals including industrial and technological upgrading. There are diverse factors underpinning the phenomenon of government interventions in the Chinese economy observed above. For example, some characteristics reflect the underlying advantages of a ‘latecomer’ economy while others may be modified or improved through reform during the process of institutional transition. However, in the eyes of the hard-liners on the China–US trade and economic relationship, the special institutional setting of China’s economy can easily be interpreted as one of the main causal factors for the trade imbalance and other headache problems faced by the US economy. The ‘Status of Non-Market Economy’ report on China largely reflects the US government’s current position on China’s economic system. This perception and mentality is logically consistent with the shift of the US trade and economic policy towards China in the direction of becoming more aggressive and conservative. 3.5

Some Chinese Policies Worrying the US

To address the problem of ‘capacity deficits’ in the global economic and financial governance that has been particularly revealed in the post-crisis era, the international community recently made cooperative efforts to reform and improve the global governance framework in which China has actively participated. In its domestic economy, China furthered more vigorously an ‘autonomous innovation’ and implementation of industrial policies targeting high technology and high segments of manufacture sectors such as ‘Made in China 2025.’ Due to the existence of mutual

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strategic mistrust, the US side is sensitive to Chinese policy moves and is motivated to adopt a more hard-line policy towards China as a response. In recent years, China has participated actively in the process of the global governance reform and improvement. For example, with the participation of China, the BRICS countries established a cooperative mechanism in June 2009, and in July 2015 the New Development Bank was set up and started to operate. Of special note are the Chinese-led ‘Belt and Road’ initiative and the establishment of the Asian Infrastructure Investment Bank that have received widespread support globally. With the support of major developed countries including the US, China, together with other emerging economies, has become a member of the newly created global governance platform G20 summit in the aftermath of the global financial crisis. China and emerging countries actively engaged with policy dialogue and coordination in the framework of G20 summit, and 2016 China successfully hosted the G20 summit in Hangzhou. By 2015, the International Monetary Fund (IMF) had approved the RMB’s inclusion in the special drawing right (SDR) basket of currencies, effective from October 2016. The Chinese government started to adopt the principle of autonomous innovation at the turn of the century. Departing from the traditional policy emphasis on ‘digestion, absorbing and innovation of the introduced foreign technology,’ the 15th congress of the CPC held in 1997 put forward the idea of ‘enhancing the ability of autonomous innovation’ that has been echoed in the 16th congress of the CPC in 2002. The policy began to be implemented vigorously early in the new century when the Leading Group on the Long-term Development Plan on National Science and Technology was created in 2003. With participation of more than 2000 experts and the input of opinions and suggestions by various government departments and local governments, Guidelines of the Plan on National Long-term Scientific and Technology Development (2006–2020) was finalized and promulgated for implementation on December 31, 2005 by the State Council of China. The document defines objectives of technological catch up in 8 technology sectors, 27 technology areas and more than a dozen issues regarding basic scientific research. It also elaborates specific policies in fiscal, finance, government purchase, talent cultivation etc. There are two major developments in the area of industrial and technology innovation in more recent years. On the one hand, scientific and technological innovation has been further promoted as the core part of the overall economic development. As emphasized in the Guidelines

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on National Innovation-driven Development Strategy promulgated by the Central Committee of the Communist Party of China and the State Council in May 2016, ‘substantially enhancing the capability of autonomous innovation’ was defined as one of the major policy objectives (CCCPC and the State Council, 2016). In the Plan on National Scientific and Technological Innovation in the 13th Five-year Period announced in July 2016, ‘comprehensively enhancing the capability of autonomous innovation’ was set as the policy priority. On the other hand, ‘Made in China 2025’ was designed and implemented in recent years. The concept of ‘Made in China 2025’ was mentioned in the Report on the Work of the Government at the annual sessions of National People’s Congress and Chinese People’s Political Consultative Conference in March 2015 by Premier Li Keqiang. In May 2015, the State Council of China announced the Notice on Printing and Distribution of ‘Made in China 2025.’ The document defines three stages each roughly covering a decade or so in terms of upgrading manufacture with a view to transforming China as a large manufacture country into the leading strong manufacture country by the mid-21st century.

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3.6

Policy Preferences of Key Members of the Trump Administration

The personal opinions and positions of some members of the Trump administration apparently also play a role in pushing forward the policy shift towards China. US academia has diverse perspectives on China, ranging from the so-called ‘China doves’ to ‘China hawks.’ Some left-wing scholars tend to view China’s economic development positively but they have limited influence on mainstream opinion and policy inside the US. Over the past four decades or so since China and the US resumed a normal diplomatic relationship, the mainstream and most influential public view on the US–China trade and economic relationship has acknowledged China’s involvement in the international system and its market-based reforms as positive developments and supports US– China cooperation in trade, economics and geopolitics, while also paying due attention to the potentially divergent interests and systems that exist in each country. This approach facilitates the strategic management of disputes and the use of cooperation and competition to serve US interests. ‘Hedging’ strategy captures the principle underpinning the traditional US policy dealing with China.

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After President Trump assumed power, the China–US economic relationship faced a very unusual situation in terms of ‘collective hard-liner profile’ for key members of the US ruling team in the area of trade and relation with China. President Trump is arguably the most outspoken globalization sceptic of all US presidents since WWII. As the author of several books with fierce criticism of China (e.g., Navarro, 2006, 2015; Navarro and Autry, 2011), the White House National Trade Council Director Peter Navarro is a well-known ‘China hawk’ advocate (Cassella, 2017). The US Trade Representative Robert Lighthizer has been a tough trade war negotiator in the last decades especially in the steel sector, one contentious area regarding the China–US trade relationship. The conservative benchmark character Steve Bannon left his role as the Chief Strategist for President Trump in August 2017, but his special hard-line policy stance towards China did not disappear.

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3.7

Influence of Short-term Political Factors in the US

The domestic political situation in the US also influenced the Trump administration’s policy stance to China. On the one hand, President Trump’s commitment to meeting voters supporting his presidential campaign may influence his handling of the China–US economic and trade relations. A major focus of Trump’s election campaign in 2016 was ‘to appeal to the working class Americans who are at the center of his political strategy.’ As emphasized in his speech at Detroit in early August 2016 and on other occasions, he vowed ‘to disrupt longstanding trade agreements and international economic relationships in hopes of reducing the trade deficit’ (Irwin and Rappeport, 2016). The support from working class Americans and other low-income groups made crucial contributions to Trump’s electoral victory (Brooks et al., 2017). As promised in his ‘contract with the American voter’ announced in the famous Gettysburg speech on October 22, 2016, he vowed that his government would ‘identify all foreign trading abuses that unfairly impact American workers and direct them to use every tool under American and international law to end those abuses immediately’ (Xinhua News Agency, 2016). Looking in retrospect at what happened in the first year of Trump’s presidency, the passage of the tax reform bill was the highlight of policy conduct, but the benefits of the new tax law on the low-income voters in many areas especially the rust belt areas are limited (ITEP, 2017). The interests and psychological appeal of this electorate impose pressures on President Trump to implement a hard-line trade policy towards China.

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Another factor is that the mid-term elections in the US also induced the Trump administration’s hard-line policy in the area of trade relationship with China. The 2018 mid-term elections in November challenged the Republican Party’s current 23-seat majority control of the House of Representatives and its two-seat Senate majority. Statistics show that since the Civil War, the incumbent party of the current president will lose in the mid-term election by an average 32 seats in the House and two seats in the Senate (Jacobson, 2010; Seitz-Wald, 2017). It was clear that the Republican Party was challenged to maintain its majorities in the 2018 mid-terms and, in the current atmosphere in US domestic politics, pursuing a hard-line policy towards China is expected to boost popularity of the ruling party. The above factors influence US policy change in different ways. The influence of the last factor of domestic politics is of short-term in nature, but these short-term factors may reoccur when the political contexts evolves. The sixth factor is obviously important, but one may ask what the root causes are behind the circumstances of US domestic politics enabling a person with such a hard-line position to come to power. In the broader picture, the role of the sixth factor comes after the first three factors, which are more fundamental from a historic view, and stand as the long-term variables that will influence China–US relations in broad areas for many years to come. The fourth and fifth factors relating to China’s institutional features and policy measures often become the crucial issues in disputes between the two countries and define the core topics of negotiations. Some of these institutional characteristics associated with China’s economic development will persist in future, and some will undergo modification and even overhaul in the process of institutional transformation and modernization. In light of all things considered, there is room for negotiation and reconciliation in this area.

4.

CONCLUDING REMARKS

On the basis of my observation of the structural changes to the China–US economic relationship, I commented at the end of 2016 when Mr. Trump won the presidential election that the ‘China–US relationship will face the most severe and complicated challenge since the two countries had a normal relationship almost 40 years ago’ (Lu, 2016, 2017). The systematic adjustments to the trade and economic relationship with China made by the Trump Administration in 2017, and China–US trade and economic disputes overviewed in this chapter are largely consistent with the above

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assessment. The recent disputes signal a structural change in the bilateral relationship between the two countries as a result of gradual transformation of the environment that has evolved in the last decade or so. China–US disputes involve four levels of issues and questions regarding their bilateral relationship. The first is the trade imbalance highlighted by the US’s large-scale trade deficits relative to China. The second is the industrial policies used in China, which aim to promote technological progress and innovation, the sticking point in the current China–US disputes. The third is the widespread characteristics of the institutional arrangements for Chinese economic development that have been increasingly questioned by the US. The fourth relates to a broader issue of the so-called ‘Thucydides Trap’, i.e., how to manage the relationship between China as an emerging power and the established countries when China is undergoing modernization and rising. Modernization is the highest priority for China in the long run and shares wide consensus among the Chinese people. Modernization of a country with more than 1.3 billion of population will make a great contribution to the world economy and human development. The path for modernization is influenced by the internal and external environment, China’s reform and opening up in the last four decades or so paved the way for its modernization. The resolution to achieve the goal of modernization will be uncompromising for China, and this serves the bottom line for all possible choices that China may make in dealing with the changing external environment. The current imbalance in China–US bilateral trade has been mainly the outcome of the interplay of structural factors in the two countries in the open economic environment. When the US attempted to eliminate the deficits through imposing extra tariffs on China’s imports, it was barking up the wrong tree. The Chinese government responded with two aspects of policy measures. On the one hand, China took strong retaliatory measures against the US government’s unilateral tariff policy. On the other hand, China’s government introduced a series of policies cutting down tariffs and reducing market access barriers in selected sectors. Firm resistance against the US unilateral tariff action combined with independent further opening up measures defined a coherent policy on the Chinese side. The main sticking points in the current economic disputes between China and US concentrate on two areas: China’s policies promoting technological progress and innovation, and the characteristics of the Chinese economic system. While the accusations made in the Section 301 inves-

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tigation against China by USTR such as ‘forced technology transfer’, ‘strategic investment’ etc. are unfounded, a case can be made that China may need to review its numerous industrial policies and reform the existing economic regime for the sake of her own interests. Through implementation of a new generation of the long overdue domestic economic reform, China will be better positioned to sustain high-quality economic development in future, face up to the external challenge in a more favorable manner, and eventually secure her ultimate goal of modernization and peaceful rising up.

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REFERENCES BBC, 2017, ‘US and China sign trade agreement’ [online; cited June 2018]. Available at: http://​www​.bbc​.com/​news/​business​-39894119. Brooks, R., P. Nagle and J. Fortun, 2017, ‘Why are red state labor markets lagging?’ [online; cited June 2018]. Available at: https://​ www​ .iif​ .com/​ publication/​global​-macro​-views/​global​-macro​-views​-why​-are​-red​-state​-labor​ -markets​-lagging. Cassella, M., 2017, ‘Trump's attack dog on trade’ [online; cited June 2018]. Available at: https://​www​.politico​.com/​agenda/​story/​2017/​03/​trump​-trade​ -attack​-dog​-peter​-navarro​-000353. CCCPC (the Central Committee of the Communist Party of China) and the State Council, 2016, Guidelines on National Innovation-driven Development Strategy, Beijing: People’s Press (in Chinese). Chappell, B., 2018, ‘U.S. trade team leaves China talks without any big breakthroughs’ [online; cited June 2018]. Available at: https://​ www​ .npr​ .org/​sections/​thetwo​-way/​2018/​05/​04/​608477798/​u​-s​-trade​-team​-leaves​-china​ -talks​-without​-any​-big​-breakthroughs. Customs Tariff Commission of the State Council, 2018, Notice on Imposition of Additional Tariff on US$50bn Worth of Imports with the U.S. Origin by Customs Tariff Commission of the State Council, Customs Tariff Commission of the State Council Notice [2018], No. 5. Giles, C., 2018, ‘IMF chief warns trade war could rip apart global economy’ [online; cited June 2018]. Available at: https://​www​.ft​.com/​content/​c8c4bb22​ -3ccd​-11e8​-b9f9​-de94fa33a81e. Han, J., J. X. Yu and H. X. Liu, 2018, ‘Seeking for the maximum intersection for China–U.S. common interests—Signal of China–U.S. economic and trade consultation’ [online; cited June 2018]. Available at: http://​www​.xinhuanet​ .com/​fortune/​2018​-05/​05/​c​_1122786033​.htm. Heatley, J., 2017, ‘After 100 days and much hype, U.S.–China talks fall flat’ [online; cited June 2018]. Available at: https://​www​.forbes​.com/​sites/​insideasia/​2017/​ 07/​21/​after​-100​-days​-and​-much​-hype​-u​-s​-china​-talks​-fall​-flat/​#148356782010. Irwin, N. and A. Rappeport, 2016, ‘Donald Trump adopts G.O.P. tax cuts, but balks at trade pacts’ [online; cited June 2018]. Available at: https://​www​ .nytimes​.com/​2016/​08/​09/​us/​politics/​donald​-trump​-economy​-speech​.html.

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ITEP (Institute on Taxation and Economic Policy), 2017, ‘Richest Americans benefit most from the tax cuts and jobs act’ [online; cited June 2018]. Available at: https://​itep​.org/​wp​-content/​uploads/​housetaxplan​-1​.pdf. Jacobson, L., 2010, ‘Do presidents always get ‘shellacked’ in midterm elections?’ [online; cited June 2018]. Available at: http://​www​.politifact​.com/​ truth​-o​-meter/​statements/​2010/​sep/​07/​mary​-jordan/​do​-presidents​-always​-get​ -shellacked​-midterm​-electi/​. Lu, F., 2016, ‘Economic background of Trump's shock’ [online; cited June 2018]. Available at: http://​www​.ftchinese​.com/​story/​001070766​?full​=​y​&​archive. Lu, F., 2017, ‘Economic Opinions of Mr. Trump,’ International Economic Review, No. 1, pp. 87–101. Lu, F. and S. S. Li, 2018, ‘Reorientation of the U.S. economic and trade policies towards China and the growing risks of trade war between the two countries,’ International Economic Review, No. 3, pp. 64–86. Navarro, P., 2006, The Coming China Wars: Where They Will Be Fought, How They Can Be Won, New Jersey: FT Press. Navarro, P. and G. Autry, 2011, Death by China: Confronting the Dragon—A Global Call to Action, New Jersey: Pearson Prentice Hall. Navarro, P., 2015, Crouching Tiger: What China's Militarism Means for the World, New York: Prometheus Books. Obstfeld, M., 2018, ‘Global economy: good news for now but trade tensions a threat’ [online; cited June 2018]. Available at: https://​blogs​.imf​.org/​2018/​04/​ 17/​global​-economy​-good​-news​-for​-now​-but​-trade​-tensions​-a​-threat/​. Seitz-Wald, A., 2017, ‘Everything you need to know about the 2018 midterm elections’ [online; cited June 2018]. Available at: https://​www​.nbcnews​.com/​ politics/​elections/​everything​-you​-need​-know​-about​-2018​-midterm​-elections​ -n832226. Summers, L. H., 2014, ‘U.S. economic prospects: secular stagnation, hysteresis, and the zero lower bound,’ Business Economics, Vol. 49, No. 2, pp. 65–73. Time staff, 2016, ‘Read Donald Trump's Speech on Trade’ [online; cited June 2018]. Available at: http://​time​.com/​4386335/​donald​-trump​-trade​-speech​ -transcript/​. U.S. Department of Commerce, 2017, ‘Joint release: Initial results of the 100-day action plan of the U.S.–China Comprehensive Economic Dialogue’ www​ .commerce​ .gov/​ news/​ [online; cited June 2018]. Available at: https://​ press​-releases/​2017/​05/​joint​-release​-initial​-results​-100​-day​-action​-plan​-us​ -china​-comprehensive. USTR (Office of the United States Trade Representative), 2017, 2017 Trade Policy Agenda and 2016 Annual Report [online; cited June 2018]. Available at: https://​ustr​.gov/​sites/​default/​files/​files/​reports/​2017/​AnnualReport/​ AnnualReport2017​.pdf USTR (Office of the United States Trade Representative), 2018, ‘USTR Issues Tariffs on Chinese Products in Response to Unfair Trade Practices’ [online; cited June 2018]. Available at: https://​ustr​.gov/​about​-us/​policy​-offices/​press​ -office/​press​-releases/​2018/​June.

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Wei, L. L., 2018, ‘U.S. and China make scant progress in trade talks’ [online; cited June 2018]. Available at: https://​www​.wsj​.com/​articles/​u​-s​-wants​-200​ -billion​-cut​-in​-china​-trade​-imbalance​-by​-end​-of​-2020​-1525419253. White House, 2017a, ‘Statement from the Press Secretary on the United States-China Visit’ [online; cited June 2018]. Available at: https://​ www​ .whitehouse​.gov/​briefings​-statements/​statement​-press​-secretary​-united​-states​ -china​-visit/​. White House, 2017b, National Security Strategy of the United States of America [online; cited June 2018]. Available at: https://​ www​ .whitehouse​ .gov/​ wp​ -content/​uploads/​2017/​12/​NSS​-Final​-12​-18​-2017​-0905​.pdf. White House, 2018a, ‘Statement on the United States Trade Delegation's Visit to Beijing’ [online; cited June 2018]. Available at: https://​www​.whitehouse​.gov/​ briefings​-statements/​statement​-united​-states​-trade​-delegations​-visit​-beijing/​. White House, 2018b, ‘Joint Statement of the United States and China Regarding Trade Consultations’ [online; cited June 2018]. Available at: https://​www​ .whitehouse​.gov/​briefings​-statements/​joint​-statement​-united​-states​-china​ -regarding​-trade​-consultations/​. White House, 2018c, ‘President Donald J. Trump is confronting China’s unfair trade policies’ [online; cited June 2018]. Available at: https://​www​.whitehouse​ .gov/​briefings​-statements/​president​-donald​-j​-trump​-confronting​-chinas​-unfair​ -trade​-policies/​. White House, 2018d, ‘Statement on steps to protect domestic technology and intellectual property from China's discriminatory and burdensome trade practices’ [online; cited June 2018]. Available at: https://​www​.whitehouse​.gov/​ briefings​-statements/​statement​-steps​-protect​-domestic​-technology​-intellectual​ -property​-chinas​-discriminatory​-burdensome​-trade​-practices/​. Xinhua News Agency, 2016, ‘Trump’s ‘Gettysburg Address’’ [online; cited June 2018]. Available at: http://​finance​.ifeng​.com/​a/​20161024/​14957521​_0​.shtml. Yoon, E., 2017, ‘Here's who wins with the new US–China trade deals’ [online; cited June 2018]. Available at: https://​www​.cnbc​.com/​2017/​05/​12/​heres​-who​ -wins​-with​-the​-new​-us​-china​-trade​-deals​.html.

NOTES 1. 2. 3. 4. 5. 6.

7. 8.

This chapter was published with the title ‘China-US Trade Disputes in 2018: An overview’ in (2018) China & World Economy 26(5): 83–103. See https://​www​.theguardian​.com/​world/​2016/​nov/​24/​china​-trump​-tariff​ -threat​-world​-trade​-organisation. [online; cited June 2018]. See US Department of Commerce (2017). See BBC (2017). See Yoon (2017). As commented in an article in the website of the Global Times, ‘everything goes above the expectation, everything goes extremely smoothly.’ See: http://​military​.china​.com/​important/​11132797/​20171110/​31649921​_all​ .html​#page​_2. [online; cited June 2018]. See Han et al. (2018). See Chappell (2018).

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See https://​thehill​.com/​policy/​finance/​388728​-reuters​-sources​-us​-china​ -nearing​-deal​-to​-lift​-zte​-ban. [online; cited June 2018]. 10. For example, see http://​world​.people​.com​.cn/​n1/​2018/​0520/​c1002​ -30001334​.html. [online; cited June 2018]. 11. See http://​www​.mofcom​.gov​.cn/​article/​ae/​ag/​201805/​20180502749654​ .shtml. [online; cited June 2018]. 12. See Customs Tariff Commission of the State Council (2018).

9. The metabolic nature of changing world order Ping Chen1

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1.

NEW UNDERSTANDING OF ADAM SMITH’S THEORY OF ‘WEALTH OF NATIONS’

The trade war launched by US President Donald Trump raised a fundamental issue on the roots of trade imbalance in the international division of labor. This issue can be traced to fundamental contradictions in Adam Smith’s Wealth of Nations (1787, Book I, Chapter III). The core of Adam Smith’s ideas was the Smith Theorem named by George Stigler (1951) that division of labor was limited by market extent. It implies that market-share competition, not cost/price competition, is the driving force of increasing return to scale that destabilizes the coordination of the global market in international division of labor (Chen 2014). This is the core challenge from economic complexity to neo-classical economics (Arthur 1994). It is known that the supply curve could not be found and the long-term equilibrium may not exist under increasing return to scale. Mathematically speaking, the Smith Theorem implies the break-down of two fundamental theorems in welfare economics (Mas-Colell et al. 1995). There are two reasons for their failure. First, no economic actor could have perfect information without huge information costs because of environment fluctuations and innovation uncertainty. Second, changing scale economy means non-convex set for firm behavior. When new technology is in the take-off stage, the supply curve does not exist at the stage of increasing returns to scale. When economic scale reaches resource limit, the supply curve becomes vertical. This is the fundamental challenge to general equilibrium theory and welfare theorem in microeconomic theory of neo-classical economics, since they refuse to include the non-convex set with changing return to scale. Remember, 93

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Newtonian mechanics is compatible with nonlinearity and deterministic chaos, but not neo-classical economics (Chen 2010). In the history of industrialization, there are conflicting economic forces between erratic micro competition and smooth stabilizing macro coordination. ‘The Smith mechanism of ‘invincible hand’ alone is not capable of maintaining the trade balance and achieving a self-stabilizing ‘efficient market.’ The sustainability of globalization is threatened by the rise of protectionism and discontent (Stiglitz 2017).

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1.1

Persistent Trade Imbalance in History

Scientific theory should start from empirical observations rather than beliefs. There are several economic mechanisms that are behind persistent trade imbalance in international division of labor. First, Smith underestimated the complexity in bilateral trade when his story of ‘invisible hand’ was based on a simple scenario of an Amsterdam merchant that ‘carrying corn from Konigsberg to Lisbon, and fruit and wine from Lisbon to Konigsberg’ (with the same ship) must have same exchanged value (Smith 1776, Book IV, Chapter II). The problem is that the one-way total value may not be equal to the total value of the return trade, which is varied with unit value per volume or unit value per tonnage. Differences in climate and environment created asymmetrical demand in bilateral trade. A notable example is the huge trade deficit between Britain and China in the 19th century. China’s consumers had little demand for British wool products because China’s climate is not wet and cool like Britain. This is why British merchants had a hard time finding tradable goods to balance British demand for China’s tea and silk. Second, imbalance in multilateral trades cannot be adjusted by relative commodity prices when exchange rates are governed by macro policy and geopolitics. Persistent trade imbalances may also be generated by the cluster effect in economic geography (Krugman 1992). Supply chains are shaped by transportation networks and geopolitical blocks, which are important sources of transaction costs and arbitrage barriers in foreign trade. For example, China had large trade deficits with Australia and Brazil, because China needs large quantities of raw material such as iron ore, copper, and agricultural goods. China also had large trade deficits with Germany, Japan, and South Korea in advanced industrial machinery and parts because China’s technology position in these areas had fallen behind for decades. But contrast the US embargo on technology transfer to China since 1950; US technology had little market share in China

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compared to Germany, Japan, and South Korea. The huge trade deficit between the US and China is mainly shaped by the US trade policy rather than by the Chinese trade barrier. Third, trade imbalances in manufactured goods are largely determined by the development stage and labor costs in technology advancement. For production in raw material, grain, and manufactured goods, scale economy is a major factor for low average costs that are less constrained by labor standards and environmental regulation. Fourth, financial powers with high returns in the finance sector could maintain large trade deficits for decades for countries like the UK and the US. Based on the above observation, we can see that the Utopian world of zero-transaction costs implying zero-tariff, zero-barrier, and zero-subsidy in neo-classical trade theory, never exists in modern world history (Irwin 1998). In a real world, cost and price competition does have an equilibrium tendency in the long run within a closed system but not for an open system. The question is how to maintain a market equilibrium for a medium-sized country like Greece or Argentina under frequent shocks from global market. There is a fundamental difference between dynamic complexity dynamics and static neo-classical economics, since a static framework could not predict time trajectory. We can learn a lesson from history. The British Empire spent near 170 years trying to balance the Britain–China trade. The British used strong ‘visible hand’ including launching the Opium War and building Indian railways (to transport newly planted tea in North-East India) by government subsidy and migration policy, etc. (Pomeranz and Topik 2006). Changing a trade imbalance needs long-term structural adjustment rather than short-term price adjustment. Unlike the British Empire, the US balance-of-payments position since World War II made a striking U-turn caused by geopolitical causes. The US had a persistent surplus in trade of goods and services, including surpluses in both current and financial accounts from WWII to 1970. The US dollar was used as the reserve currency after WWII. Large US trade deficits began from the mid-1970s when the Vietnam war resulted in civilian industries outsourcing to Japan and Asian tigers. The US current account deficit began after 1982, and the financial account deficit has persisted since 1983. President Reagan’s tax cut and star-wars project began increasing budget deficit that was financed by external debt. Unfortunately, US dominance in the finance sector did not reverse its

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Table 9.1

Persistent deficit of US current account and financial account (in $ billions)

Year

1980

1990

2000

2010

2018

Sum (2000–2018)

Net of Goods

-26

-111

-447

-649

-891

-13,135

Net of Services

6

30

74

154

269

2,877

Current Acc.

2

-79

-403

-431

-488

-9,576

Financ. Acc.

25

-58

-498

-446

-520

-9,356

Data source: Table 1.1, U.S. International Transactions, BEA (Bureau of Economic Analysis), Department of Commerce, Release date: 21 March 2018.

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Table 9.2

Balance of payments by indicator: current account for major countries (in $ billions)

Year

2005

2008

2010

2015

2018

Sum (2005–2018)

US

-745

-681

-431

-407

-490

-7,100

UK

-49

-114

-78

-143

-110

-1,407

Brazil

13

-28

-79

-54

-41

- 578

India

-10

-30

-54

-22

-65

-508

France

-143

-28

-22

-9

-19

-261

Russia

84

103

67

67

113

968

Japan

170

142

220

136

174

2,047

China

132

420

237

304

49

3,105

Germany

133

213

196

288

291

3,329

Data source: IMF. Balance of Payments Analytic Presentation by Indicator: Current Account Net. IMF Data Warehouse, 11 February 2020.

negative position in international transactions, because the US surplus in service was only about one-third of its trade deficit in goods. A US trade war with Japan and Germany did not solve its chronic problem of a trade deficit since the 1980s. Its outcome was outsourcing US manufacturing first to Asian tigers in the 1970s and 1980s, then to China from the 1990s. The recent records of US international transactions are shown in Table 9.1. The non-equilibrium nature of globalization can be seen from persistent imbalance of payments (Table 9.2). Some countries had persistent deficits while others had persistent surplus for more than a decade.

The metabolic nature of changing world order

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1.2

97

Power and Wealth of Nations

Market power is rooted in unequal competition and unequal exchange when nominal price deviates from real price (Smith 1776, Book I, Chapter V). Market power is also determined by asymmetric bargaining power in international coordination of macro and financial policy. In international finance, exchange rates among major trading partners are constantly changing and remain unpredictable, we have no reliable way to identify real value from fluctuating nominal price history. The deviation between real value and nominal price create a huge space for financial speculation in derivative markets, which are a fundamental source of market power in division of labor. Adam Smith raised the issue of ‘Wealth of Nations’ but fails to answer What is Wealth? This issue is tricky, since bilateral exchange alone cannot create wealth when market exchange theory fails to consider the uncertainty generated by the rise and fall of technologies. Technology advances may or may not increase social wealth when scale economy with mass production often drives down average costs, profit margins, and commodity prices. For example, computer technology made tremendous progress. Ironically, people widely enjoyed the increasing application of computer technology with rapidly decreasing costs, but an obsolete computer rarely had a chance to preserve its original value. In contrast, cooking technology made much slower progress, so the profit margin in the restaurant industry is higher than in the computer industry. Adam Smith himself quoted Thomas Hobbs with some reservation that ‘Wealth is Power’ (Smith 1776, Book I, Chapter V). In market share competition for resources and trade routes, military power would strengthen economic power in competition and bargaining; the American Middle East war is closely related to the power struggle for petroleum dollar (Clark 2005). A good indicator of power of nations is their military budget (IISS 2020). The US military budget in 2020 was $684.6 billion, which is more than the sum of next 11 countries combined, including China, Saudi Arabia, Russia, India, the UK, France, Japan, Germany, South Korea, Brazil and Italy. There are two types of GDP in international statistics. For the study of military power, we use GDP ppp (purchasing power parity) for comparison of military spending in Table 9.3. For currency market, we measure financial power by GDP ex (measured by official exchange rate) and the ratio of reserve currency given in Table 9.4.

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China and the West

Table 9.3

GDP and military spending world ratio (%)

Country

(Year)

US

China

Japan

Germany

France

UK

Russia

India

GDPppp

(2017)

15.3

19.8

4.3

3.3

2.2

2.3

3.1

7.4

Military

(2018)

35.6

13.7

2.6

2.7

3.5

2.7

3.4

3.7

Budget

Data source: GDPppp data (2017) is based on CIA World Factbook. Military spending data (2018) is from SIPRI (Stockholm International Peace Research Institute).

Table 9.4

GDP, total trade and world reserve ratio in 2017 (%)

Area

US

EU

Japan

UK

China

Swiss

Canada

Australia

GDPex

24.3

21.3

6.1

3.2

15.0

0.85

2.1

1.7

Total

12.8

11.4

3.8

2.8

10.6

1.6

2.3

1.2

Currency

Dollar

Euro

Yen

Pound

RMB

SwFranc

CanDollar

AusDollar

Reserve

61.7

20.7

5.2

4.5

1.9

0.14

1.8

1.6

Trade

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Data source: GDPex is GDP in official exchange rate from CIA World Factbook. Total trade is the sum of export and import. Currency names are Pound and Sterling for UK, Swiss currency is Swiss Franc, Canada currency is Canadian dollar, Australian currency is Australian dollar. Reserve currency ratio from IMF:​COFER (World Currency Composition of Official Foreign Exchange Reserves).

From Table 9.3 and Table 9.4, we can see the military and financial power of US outsizes its economic size. However, overexpansion of military and financial power may not sustain its economic power (Kennedy 1989, Arrighi 2010). The rise and fall of great powers in history can be observed from changing GDP ratio in history (Table 9.5). This historical pattern can be better understood by metabolic growth theory, since Solow’s theory of exogenous growth predicts a convergence trend and Romer’s theory of endogenous growth predicts a divergence trend, but only theory of metabolic growth could explain the decline of old powers and rise of new nations during the industrialization. Its fundamental driving force is not population, capital, and knowledge accumulation, but the decline of old technology and the rise of new technology and industries (Chen 2014). Now, we have a clear picture of changing world power in modern history (see Table 9.5).

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The metabolic nature of changing world order

Table 9.5

World GDP ratio by major countries in history (%)

Date

China

India

Japan

UK

Germany

US

USSR/Russia

1500

24.9

24.4

3.1

1.1

3.3

0.3

3.1

1700

22.3

24.5

4.3

10.2

3.7

0.1

4.3

1820

32.7

16.1

3.0

5.2

3.9

5.4

3.0

1900

11.1

8.6

2.6

9.4

8.2

15.8

7.8

1950

4.6

4.0

3.0

6.5

5.0

27.3

3.0

1978

4.9

3.3

7.6

3.8

5.5

21.6

7.6

1990

7.8

4.0

8.6

3.5

4.7

21.4

7.3

2017

18.2

7.4

4.3

2.3

3.3

15.2

4.1 3.1

Data source: 2017 data from CIA World Factbook (2019). Historical data from Maddison (2007).

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From Table 9.5, we see the UK reached the peak in 1700, but was overtaken by the US in 1820. The US GDP ratio peaked at 27 percent in 1950, then continued to decline to the recent 15 percent in 2017, while China’s GDP ratio from 4.6 percent in 1950 steadily increased to 18.2 percent in 2017. This is a historical trend for nearly seven decades, not a recent record when China joined WTO in 2001. 1.3

Possible Factors of Persistent Trade Imbalance in Globalization

Let us exam possible factors that are associated with trade balance, such as saving and industrial ratio (Table 9.6). If we compare Table 9.2 and Table 9.6, we can see that developed countries had persistent imbalance in their current accounts. Strikingly, Germany and Japan had a persistent trade surplus but the US and the UK had persistent trade deficits. Clearly, trade status has little correlation with their income and technology level among developed countries. There is no evidence for Trump’s argument for a trade war, such as government subsidy and stealing technology among developed countries. Among emerging countries, India and Brazil have more geopolitical chances than China to obtain western technology and capital, but their

100

Table 9.6

China and the West

Macro factors in trade for major countries (2017)

Item/Country

US

Japan

Germany

France

UK

Russia

China

India

Growth(%)

2.2

1.7

2.5

2.3

1.7

1.5

6.9

6.7

Saving(%)

18.9

28.0

28.0

22.9

13.6

26.5

45.8

28.8

Industry

19.1

30.1

30.7

19.5

20.2

32.4

40.5

23.0

-449

196

291

-15

-99

35

164

-48

ratio(%) Current Acc. ($b)

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Data source: CIA World Factbook (2019).

current account balance is negative while China is positive. We have to explore other factors to understand the root of trade imbalance between the US and China. The relation between trade balance at a micro level and structure at macro and meso levels can be studied from the following facts: First, industry ratio in GDP matters most in trade balance. For example, four countries have large trade deficits: the US, the UK, France, and India. Their industry ratios in GDP are all below 25 percent. Among them, the US ratio of industry is lowest at 19.1 percent with the largest trade deficit. By comparison, countries with a trade surplus like Germany, Japan, and China, all have an industry ratio above 30 percent. An excessive expansion of the finance sector in the US may play a major role of crowding out manufacture there (Johnson 2009). Second, saving ratio also matters for the trade balance (Feldstein 2008). The UK and the US had very large trade deficits when their saving ratios were as low as only 14 percent and 19 percent. Both China and India have had high growth while they differ in saving rate and trade status. Certainly, a high saving rate alone may not lead to high growth rate. Third, there is no evidence that trade balance can be guaranteed by institutional arrangements such as a property right system, since the US, Japan, and European countries are similar in property right systems, but Germany and Japan had persistent trade surpluses while the US, the UK and France had persistent trade deficits. As large developing countries with high growth rates, China had a large trade surplus while India had a large trade deficit. All these countries are members of WTO, but there is no evidence that trade patterns are determined by WTO rules. We should point out that the tremendous costs of the Cold War may have played a significant role in economic decline of both the Soviet

The metabolic nature of changing world order

101

Union and the US (Stiglitz and Bilmes, 2008). The combined cost of US wars in Korea, Vietnam, the Middle East, and Afghanistan so far is about $8 trillions in 2019 dollars (Harrington and Sunesun, 2009, Macias, 2019). In comparison, the US has built up a cumulative trade and service deficit of US $ 11.5 trillion from 1960 to 2018 (Lou, 2020, BEA, 2020). We speculate that excessive military spending and consumer spending were major causes of persistent trade deficit in the US in these decades. In this regard, we understand one goal of President Trump’s foreign policy change. If the US withdraws from its role as the world’s policeman, the US and China would have a better ground for constructive rather than destructive competition in advancing new technology and peaceful development.

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1.4

Three Constraints that Limit Division of Labor with Changing Returns to Scale

The new science of complexity economics introduces a new approach to comprehend seemingly conflicting features in classical and neo-classical economics (Chen 2014, 2019). We developed a new perspective of metabolic growth to understand the dynamic mechanism behind the rise and fall of great powers. The aggregate economic growth can be de-composited into a series of technology wavelets, as in Figure 9.1. Here, the growth trajectory limited by market extent or resource is described by S-shaped logistic growth. Technology competition leads to rise of new technology and fall of old technology. Their aggregate curve visualizes the macro uneven growth with trend and business cycles. We extended the Smith Theorem to a General Theorem that division of labor is limited by three constraints, i.e., the Market Extent (we often call it Scale Economy), Number of Natural Resources defined by technology (we may call it Scope Economy), and Environment Fluctuations (Chen 2010, 2014). We found a trade-off between stability and complexity for complex systems under ecological constraints. The driving force of economic growth is not so-called endogenous growth based on accumulation of existing knowledge (Romer 1986), but metabolic growth with rise of new technologies and fall of obsolete technologies (Chen 2014). The nature of the international division of labor is non-equilibrium dynamics that generates the rise and fall of great powers. The source of market power is an integration of market share, technology advantage, resource availability, plus finance and military power. That is why economic crisis is often associated with war and conflicts. The Coase

102

China and the West

Note: The old technology (dashed line) declines when new technology (solid line) emerges. The output envelope (dotted line) is the sum of their output of all technologies. Here, the units are arbitrary in computational simulation.

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Figure 9.1

Metabolic growth characterized by rise and fall of logistic wavelets

theorem simply ignored the fact that conflicting interests may not be solved by market mechanism, not because of high transaction costs, but asymmetric game in seeking wealth and power (Coase 1960, Chen 2007).

2.

PARADIGM SHIFT IN MODERNIZATION AND CHINA’S NEW DEVELOPMENT MODE

Now, we are facing a paradigm shift in industrialization. The global warming is caused by mass production with increasing energy dissipation at the cost of destroying biodiversity. The ecological crisis is associated with a financial crisis when rising medical costs that make the fiscal burden on the welfare state unbearable. The rapid progress of labor-saving and resource-consuming technology is not sustainable for population growth associated with the supply of jobs shrinking. The Anglo-Saxon model of laissez-faire capitalism revealed its severe limitations in industrial modernization. The new issue is Coordination

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The metabolic nature of changing world order

103

of Nations in technology changes and global warming. A visionary government with a long-term agenda is essential for this paradigm shift from ‘invisible hand’ to ‘coordinating hands’. China’s model of modernization is characterized by a dual track reform with a decentralized experiment approach driven by local competition and the coordination by central government. The scale economy in mass production in energy, transportation, grain, and basic material have made China a competitive power in manufacturing; the scope economy with many product varieties creates a huge export market for millions of small businesses. Scale production generally has lower profit margins because of the heavy investment burden and the high risk in marketing, while scope economy develops a niche market with fewer competitors and a higher profit margin. Scale economy is capital intensive while scope economy is labor intensive so that a scope economy could create more jobs with less of a social burden in macro economy; low-cost welfare based on collectively owned land provides a social safety net for famers seeking opportunities in urban industry. The mixed economies consist of SOE (state-owned enterprises for long-term investment in infrastructure), private sector (for fast innovation), collective TVE (town and village enterprises for creating low-cost labor-intensive industries), multi-national companies (with advanced technology and management), and free trade in SEZ (special economic zone). All these market forces combined have brought about rapid growth, technology innovation, management progress, and constructive competition. Governments play an active role in industrial policy and environmental regulation in three directions including bottom-up experiment (started from SEZ and TVE), top-down orientation (five-year plan and industrial policy), and horizontal coordination (among competing local regions and industrial sectors). China has long-term development plans in infrastructure investment, green economy, and new integration of urban–rural development. All of the above features in China’s development demonstrates a new way of cooperative (not confrontative) interactions among invisible hand (of market forces), visible hand (of local and central government), and thoughtful mind (of civil society). Both developing and developed countries could learn from China’s experiments. China should give credit for many lessons learned from other market models such as Germany, Japan, Scandinavia, Singapore, Israel, in addition to the UK–US model. For example, Germany and Japan could play a more active role in China’s belt and road project. Scandinavia, Singapore, and Israel’s innovation in technology and education could find a much larger market in China,

104

China and the West

Asia, and Latin America. The US will have better international security with less financial burden if the US considers China as a constructive partner rather than strategical competitor in international affairs. Introducing competition among private and public organizations in the US’s medical industry will greatly reduce its medical costs. Introducing Chinese medicine in western medical practice will also advance our medical knowledge and increase public health efficiency.

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2.1

Changing World Order and New Economic Thinking

From this perspective of metabolic growth, the current US policy of protectionism could not create enough jobs when new IT technology is knowledge intensive but rapidly changing, which destroys more old jobs than creates new ones. We observe increasing numbers of homeless people near the high-tech center in California and major US cities. The EU policy of increasing centralization may increase rather than decrease regional disparities, when less competitive countries have less incentive to develop their competitive industries. The more dangerous trend is using military alliances to solve regional conflicts caused by the increasing unemployment of the younger generation in the Middle East, South Asia, and Latin America, while rapid aging in developed regions cannot maintain their competitiveness in the labor and technology market. Equilibrium thinking has a confrontative picture of good versus evil or white versus black. Complexity thinking means diversity and evolution, such as ‘three implies chaos’ as well as ‘order out of chaos’ (Prigogine 1984). There is a serious threat of a Great Depression created by collapse of the old dominating power in the US. We will return to this issue in section 3 below. 2.2

Life Cycle in Technology and New Perspective on Cooperation and Competition in International Trade

Life cycle of technology can be divided into FOUR STAGES: Infant, growth, mature, and decline stage. See Figure 9.2. From Figure 9.2, we can understand why governments could play varied roles during different stages of technology wavelets (Chen 2014). In the Infant stage I, competition and cooperation in R&D should be beneficial to all countries by reducing uncertainty (Chang 2002). Most of the basic research is open to the public without much commercial

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Figure 9.2

105

Four stages of technology life cycles

incentive. Government and non-profit organizations play major roles in the infant stage. In the Young (growth) stage II, market competition is a driving force for technology application and diffusion. However, competition does not exclude cooperation at different levels of an international division of labor. For example, cars and cell phones can be an integration of R&D in the US, designed in the EU, and manufactured in China. This production mode has been proved to be a win-win cooperation for many products, if the US takes the lead in R&D, the EU is strong in artistic design, and China has comparative advantage in large-market scale, geographic concentration in the supply chain, plus active support from local government in China. Notable examples are Apple and Volkswagen: their research and design is in the US or Europe, parts are supplied from countries in East Asia, and production is in China. In the Adult (mature) stage III, large price swings in commodity markets are harmful for both producers and consumers. An international anti-trust law is needed to stabilize the international commodity market. Long-term contracts for mutual benefits between export and import countries can be achieved by financial engineering, such as a collar option between major commodity export and import countries with profit-risk sharing. Its pricing can be automatically rolled over through a moving time window, so that we may effectively control the magnitude of price fluctuations within a fixed band in commodity market. In the Aging (decline) stage IV, international cooperation among national governments and social organizations is critical for the transition from obsolete industry to rising technology. An energy-saving life-style is essential for adapting climate change. Reforming the rules of the game is necessary, especially for advertising and legal systems. The current

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China and the West

rule of ‘the winner takes it all’ should be changed to a share economy among innovators, investors, managers, workers, and the society as a whole. From this picture, we can understand useful lessons from developed countries. China’s SOE reform could learn from the US’s land grant university and endowment fund that integrates public resources and private incentives. I propose to divide China’s state-owned assets into three groups: one-third used for social welfare, one-third for security and infrastructure, and one-third for university endowment funds, which may integrate research, manufacture, marketing, and local community into an organic organization. Cooperative competition, not exclusive competition, is the key for diversifying risk and stimulating innovation.

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2.3

Opportunity and Risk for the Digital Economy

The main advantage of a digital economy is production based on buyer’s orders that reduces the risk of overproduction. Its main danger is the uncertainty created by the virtual economy plus the cyber currency without proper regulation by governments and international organizations. The root cause of the 2008 financial crisis was the collapse of the derivatives market. Our study indicated that the theory of option pricing in the Black–Scholes model has a fundamental flaw. Its base model is the Brownian motion, which is explosive in nature. A better alternative for financial market is the birth–death process (Chen 2010, Tang and Chen 2014, 2015). This issue is critical to understanding the root of the 2008 financial crisis. The scale of the derivatives market is about 30–50 times that of the US GDP and 8–10 times that of the world GDP (BIS 2019). It could be a financial weapon of mass destruction in the world economy. The reason is that the derivatives market is based on short-term speculation while industrial growth is a long-term development. Macro monetary and fiscal policies only aim to address issues arising from medium-term business cycles. Small countries or weak government of large countries have little means to control huge international speculation flows that trigger recurrent crisis, including Latin America debt crisis in 1980s, Asian financial crisis and Saving and Loan crisis in 1990s, and 2008 Financial Crisis. President Trump’s trade war, financial war, plus financial deregulation could pave the way to a greater economic uncertainty and a new financial crisis. Only history can tell whether invisible hand

The metabolic nature of changing world order

107

could maintain the balance in international division of labor and trade without coordination among major countries.

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2.4

Historical Lessons for Changing World Order

According to Toffler (1980), the resource concentration in the Industrial Revolution created concentrated power in the UK and the US in the 18th to 20th centuries. Regional diversification by the Information Revolution based on computer technology would shape an open economy with multiple centers in technology competition. This new information technology has been rapidly changing the power balance since the end of the Cold War. In his speech at the Conference in Beijing, China in March 2019, Lawrence Summers2 made very stimulating observations from a historical perspective. He pointed out that there were three challenges to the US leadership after the World War II. The first was the Sputnik by the Soviet Union in 1957. The second was when Japan said no to the US in 1980s. The rise of China could be the third in recent history. The US successfully met the first two challenges. What is the outcome for the third? I would like to address this issue for further discussion. From our observation, the Cold War was not one of a symmetric two-player game, that is common in game theory; but an asymmetric multi-player game with time evolution. The first challenge from the Soviet’s Sputnik resulted in the arms race between the US and the USSR. Both the Soviet Union and the US paid a heavy price in economic costs. The rise of Germany, Japan, and the Asian tigers were the real economic winners of the Cold War, while the US claimed to be the political winner. The second challenge was from Japan’s industrial expansion, which did not last long, simply because Japan is a dependent economy in nature. Japan failed to create an Asian dollar during the East Asian financial crisis, since the US would not allow another currency competitor after the Euro. Japan did not form a geopolitical union in Asia like the EU, so Japan’s technological strength could not transfer into a financial power. That is why the EU is much stronger than Japan in political economy. The scale of economy and the independence of finance are essential in the power game of globalization. Summers raised an alarm for ‘the balance of terror’ in financial markets when China holds $1.4 trillion dollars of American debt (Fallows 2008). We had similar doubts as to the sustainability of dollar power in a global market. China has no incentive to replace the US as the world policeman

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China and the West

of globalization, since its financial burden is much larger than economic gain. This is the critical lesson that we learn from the decline of Soviet Union and the US after the Cold War. Certainly, China did benefit from an open trade system to develop its scale and scope economy. We would like to build a new world of international cooperation and networks regardless of the diversity in political institutions and religious beliefs, since we live in the same world village. A multi-center coordination in an international division of labor is essential to solve the global issues, such as climate warming, ecological crisis, financial stability, and poverty. No one country alone is capable of handling all these global crises.

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3.

THE FUTURE OF CHANGING GLOBALIZATION: DANGER AND OPPORTUNITY

From a global perspective, the population spike in the 20th century is the most significant challenge to the world economy, as the aging society in the developed world is not capable of managing globalization under western democracy (Rostow 1998). If advanced countries refuse to transfer technology to developing countries, their protectionism will be unable to resist migration waves from developing countries when Africa and Latin America are failing to create enough jobs for the young population within their countries. The US policy of protectionism could make things worse for the US economy in the long term, because aging America has an increasing demand for low-cost labor for hard work in agriculture, construction, and nursing service. For example, US agriculture depends heavily on seasonal labor from Mexico, and US hospitals have so severe a shortage of nurses, that Philippine immigrants fill the supply gap. Even during the peak of trade war, the US is continuing to outsource service jobs to India, including technical support for the communication industry and accounting and legal data entry. The driving force for continual job outsourcing in the US is corporate greed for profit motivation rather than social responsibility, which is the essential difference between private enterprises and public companies such as SOE in China. The rise of socialism in medical and education reform became one of the main subjects in the presidential campaign in the US. This political change is deeper than the civil right movements in 1970s. There is a lesson from history that the real cause of the Great Depression was lack of emergence of new coordination (Kindleberger

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The metabolic nature of changing world order

109

1986). After the collapse of the British-led globalization, the new big three of the UK, the US and France failed to coordinate so as to avoid a trade war, which was ended by World War II. Today, if the new big three (the US, China and the EU) could coordinate in dealing with global issues, it would greatly reduce uncertainty in this complex world. Consider the worst-case scenario, even if current trade war between the US and China escalated to an all-out scale, such as the recent case of COVID-19 pandemic, China would be more resilient in facing external shocks because of its long history of unifying the country under foreign invasion. From my observation, there was a chance of a divided states of America in trade-war economics encouraged by Brexit. There are regional factors that divide the US from Texas and the southern states that are rich in shell oil and natural gas; their export needs a large and stable market like China when facing strong competition from Russia and OPEC countries. High-tech industries in California and the west coast also need large and growing markets to recover their heavy investment in R&D. If they lost the China market, their profit would significantly decline and their market share in global competition would be lost. The agriculture sector in the Midwest could not be sustained because China is their major market for agriculture export. From my own observation, the trade war would do more harm to the US than to China with regional diversity, since decline in China’s export sector in coastal regions would stimulate the development of inland area. I do not support the trade war, but I am optimistic about the possible outcome of the Chinese economy under the threat of trade war. In Chinese language, the term for ‘crisis’ (‘wei-ji’ in Chinese) implies both danger (wei) and opportunity (ji). If President Trump could reduce military obligation overseas and save money for domestic construction, he may ‘make America great again.’ But Trump could also make America disappointed again if he believes that he could dictate a new world order with his erratic threats and unilateral demands. This dialogue on ‘China and the West’ is fruitful for understanding the new role of the state in economic growth. A related issue is the coordination of nations for a changing world. Current rule-based international order is centered by western values and interests. A coordination-based world order needs new thinking in economics and political thoughts.

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China and the West

NOTES 1. Originally presented at International Conference at Peking University: China and the West: The Role of State in Economic Growth, 22–23 March 2019, Beijing, China. 2. Summers, Lawrence. Speech at this Conference, China and the West: The Role of State in Economic Growth, Beijing, China, 22 March 2019.

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REFERENCES Arrighi, Giovanni, The Long Twentieth Century, Money, Power, and the Origin of Our Times, Verso: New York (2010). Arthur, W. Brian, Increasing Returns and Path Dependence in the Economy, University of Michigan Press: Ann Arbor, MI (1994). BEA, Table 1.1, U.S. International Transactions, Bureau of Economic Analysis, US Department of Commerce (2020). BIS, Table D5.1, Global OTC derivative market (in billions of US dollars). Chang, Ha-Joon, Kicking Away the Ladder: Development Strategy in Historical Perspective, Anthem Press: London (2002). Chen, P., ‘Complexity of Transaction Costs and Evolution of Corporate Governance,’ Kyoto Economic Review, 76(2), 139–53 (2007). Also, in Chen (2010), chapter 14. Chen, P., Economic Complexity and Equilibrium Illusion: Essays on Market Instability and Macro Vitality, Routledge: London (2010). Chen, P., ‘Metabolic Growth Theory: Market-Share Competition, Learning Uncertainty, and Technology Wavelets,’ Journal of Evolutionary Economics, 24(2), 239–62 (2014). Chen, Ping., ‘From Complexity Science to Complexity Economics,’ in Beker, Victor A. (ed.) Alternative Approach of Economic Theory, Chapter 2, pp.19–55, Routledge: London (2019). CIA, The World Factbook (2019), see: https://​www​.cia​.gov/​library/​publications/​ the​-world​-factbook/​. Clark, William R., Petrodollar Warfare: Oil, Iraq and the Future of the Dollar, New Society Publishers (2005). Coase, Ronald H., ‘The Problem of Social Cost,’ Journal of Law and Economics, 3(1), 1–44 (1960). Fallows, James, ‘The $1.4 Trillion Dollar Question,’ Atlantic, February (2008). Feldstein, Martin, ‘Resolving the Global Imbalance: The Dollar and the U.S. Saving Rate,’ Journal of Economic Perspective, 22(3), 113–25 (2008). Harrington, John and Grant Sunesun, ‘What were the 13 most expansive wars in U.S. history?’ USA Today, 13 June 2009. IISS, The Military Balance, International Institute for Strategic Studies, Stockholm, www​.iiss​.org (2020). IMF, Balance of Payments Analytic Presentation by Indicator, Current Account, data.imf.org.

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Irwin, Douglas A., Against the Tide: An Intellectual History of Free Trade, Princeton University Press: Princeton (1998). Johnson, Simon, ‘The Quiet Coup,’ Atlantic, 303(4), 46–56 (2009). Kennedy, Paul, The Rise and Fall of Great Powers: Economic Change and Military Conflict from 1500 to 2000, Vintage (1989). Kindleberger, Charles P., The World in Depression, 1929–1939, Revised and enlarged edition, University of California Press (1986). Krugman, P., Geography and Trade, MIT Press: Cambridge (1992). Lou, Margaret M., ‘The US Dollar’s Woes and the Global Yuan,’ China Institute, Working Paper, No. 20200214, Fudan University: Shanghai, China (2020). Macias, Amanda, ‘America has spent $6.4 trillion on wars in the Middle East and Asia since 2001’, CNBC, 20 November 2019. Maddison, Angus, The World Economy: A Millennial Perspective/Historical Statistics, OECD: Development Center Studies (2007). Mas-Colell, Andreu, Michael D. Whinston and Jerry R. Green, Microeconomic Theory, Chapter 16, Oxford University Press: Oxford (1995). Pomeranz, Kenneth, and Steven Topik, The World That Trade Created: Society, Culture, and the World Economy, 1400 to the Present, 2nd ed., M.E. Sharpe: New York (2006). Prigogine, I., Order Out of Chaos: Man’s New Dialogue with Nature, Bantam (1984). Romer, Paul M., ‘Increasing Returns and Long-Run Growth,’ Journal of Political Economy, 94, 1002–38 (1986). Rostow, W.W., The Great Population Spike and After: Reflections on the 20th Century, Oxford University Press: Oxford (1998). Smith, A., The Wealth of Nations: An Inquiry into the Nature and Causes of the Wealth of Nations, University of Chicago Press (1776, 1977): especially, Book I, Chapter III; Book I, Chapter V; Book IV, Chapter II. Stigler, G.J., ‘The Division of Labor Is Limited by the Extent of the Market,’ Journal of Political Economy, 59, 185–93 (1951). Stiglitz, J.E., Globalization and Its Discontents Revisited: Anti-Globalization in the Era of Trump, Norton (2017). Stiglitz, J.E., and L.J. Bilmes, The Three Trillion Dollar War, the True Cost of the Iraq Conflict, Norton (2008). Sun Tzu, The Arts of War, Basic Books (1994). Tang, Yinan and Ping Chen, ‘Time Varying Moments, Regime Switch, and Crisis Warning: The Birth-Death Process with Changing Transition Probability,’ Physica A, 404, 56–64 (2014). Tang, Yinan and Ping Chen, ‘Transition Probability, Dynamic Regimes, and the Critical Point of Financial Crisis,’ Physica A, 430, 11–20 (2015). Toffler, A., The Third Wave, William Morrow: New York (1980).

10. India and China in the context of rising trade tensions in the global economy Arvind Panagariya

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This volume is devoted to gleaning the likely trends in economic policies through the analysis of the developments in the United States (US), China and the European Union (EU). While the selection of the entities, which together accounted for more than 60 percent of the world GDP, is eminently sensible, it leaves out one important country, India. Going by the GDP data in 2017, India was the seventh largest economy in the world but under the current growth trends, it is expected to surpass the UK and France in 2018, Germany in 2025 and Japan in 2028 (see Figure 10.1). This means that in another decade, India will be the third largest economy in the world, behind the US and China.

Figure 10.1

Projected paths of the GDP from 2017 to 2030

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India is important for two additional reasons. First, it accounts for more than one-sixth of the world’s population. In absolute population size, it currently ranks second behind China but is expected to surpass the latter in less than a decade. Second, India is also the largest democracy in the world by population. It is a rare case of a developing country with an uninterrupted record of democracy for more than 70 years.1 For both of these reasons, the experience of India and where it is headed in the forthcoming decade matters. This is especially true from the viewpoint of China, which has a long common border with India. To understand what the experience of India teaches us and what implications its rise has in the years to come, it is important to first provide a brief history of the evolution of its economy.

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INDIA: A BRIEF ECONOMIC HISTORY India became independent of Great Britain in 1947. After prolonged debates by the Constitution Assembly, it drew up and adopted a democratic constitution with a parliamentary form of government in 1950. Simultaneously, it also launched its economic development program through the Five Year Plans. India placed achieving self-sufficiency at the center of its development strategy. In practice, this objective translated into an effort to align the production basket to the consumption basket and hence an inward looking approach to development in the extreme. Unfortunately, the prevailing consensus among development economists also favored the strategy of import-substitution industrialization (ISI) for the developing countries. Therefore, the path India chose experienced no serious opposition from economists and policy analysts of the day. Because the leadership in India had been highly influenced by the Soviet model of development, it went on to complement autarkic trade policies by a large public sector. In addition, it controlled all private investments beyond a modest threshold through a system of investment licensing. These investments were progressively directed towards highly capital-intensive sectors with the labor-intensive manufactures such as apparel, textiles, footwear, furniture, kitchenware and numerous other light manufactures of daily use reserved exclusively for very small enterprises. When limited production of certain items such as cement, scooters and automobiles due to investment licensing gave rise to excessive profits, price and distribution controls followed.

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This autarkic, license-permit raj model remained in force in India until 1991. There was some relaxation of controls on the margin in the 1980s but this did not represent a fundamental change in the economic philosophy. The impact of the controls and near exclusion of international trade had a serious detrimental effect on efficiency. Over the four decades from 1951 to 1991, India grew just 4.1 percent annually. With the population growing 2.2 percent annually, this growth translated in per-capita income rising at just 1.9 percent annually. In 1991, 40 years after the launch of the development program, India had barely doubled its per-capita income. Given the extremely low per-capita income in 1950, even this doubling of per-capita income yielded at best a tiny reduction in poverty. The fall of the Soviet Union and the rise of China after it began opening its economy to foreign trade and foreign investment in the late 1970s finally convinced at least a few among the top bureaucrats that India had missed the bus and needed a course correction. This shift in thinking also coincided with the coming of a pragmatic Prime Minister, Narasimha Rao, to the helm. A balance-of-payments crisis in 1991 provided Rao the opportunity to change the course of the economy. In one stroke, he ended investment and import licensing, opened the economy to foreign investment and proceeded to systematically lower import tariffs. Between 1991 and 1996, he substantially lowered tariffs, liberalized the financial sector and opened civil aviation and telecommunications to private investors. Unfortunately, Rao lost the election in 1996 and was succeeded by three short-lived coalition governments in less than two years. But in 1998, Atal Bihari Vajpayee of the Bharatiya Janata Party (BJP) became Prime Minister and remained in office until 2004. During these six years, he gave a big push to liberalizing reforms in virtually all areas while also building the country’s infrastructure in a big way. Trade and foreign investment policies were further liberalized, the private sector was given entry in insurance, and the door was opened wider to private and foreign banks, the New Telecom Policy launched a revolution in telecommunications and civil aviation received a major impetus. The result was that beginning in 2003, India transitioned into an 8 percent growth trajectory. During 2003 to 2011, it grew at the average annual rate of 8.2 percent. In the event, Vajpayee lost election in 2004 and the Congress-led United Progressive Alliance (UPA) came to power. The UPA held office for two full terms ruling the country till 2014. The first terms of the UPA saw the reforms come to a near standstill. But with rare exceptions, the government did not reverse the reforms of Rao and Vajpayee. The second

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term of the UPA turned out to be different, however. It saw a return of the socialist policies of the early post-independence decades with many anti-growth policies such as retrospective taxation, a draconian land acquisition act, a fiscally irresponsible food security act and a regressive right to education act put in place. The last few years of the government also saw serious paralysis in decision-making in the central government. Moreover, major infrastructure projects were uniformly denied clearance environmental grounds. The result was that growth rate fell to 5.9 percent during 2012 and 2013 from 8.2 percent between 2003 and 2011. In 2014, a new dynamic government led by Prime Minister Narendra Modi of the BJP came to power. This government brought the process of reforms back on track. It put an end to retrospective taxation, restored fiscal discipline and adopted a 4 percent inflation target to anchor inflationary expectations. It introduced a uniform Goods and Services Tax (GST), which replaced numerous indirect taxes by a single tax on each commodity countrywide. It unblocked the stuck infrastructure projects and accelerated the pace of infrastructure expansion, especially in areas of roads and civil aviation. Further, it eliminated subsidies on gasoline and diesel and substantially reduced the subsidy on cooking gas. The result was a significant decline in the inflation rate and the current-account deficit. Growth accelerated back to the average rate of 7.3 percent from 2014 to 2017.

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PRIVATE VERSUS PUBLIC SECTOR: LESSONS FROM INDIA The experience of India over a period of 70 years within a democratic system testifies to serious limitation of production activity in the public sector and its tight control in the private sector. Until 1991, the Indian economy was heavily dominated by public sector. Several industries including banking, insurance, telecommunications, oil, civil aviation, railways and defense had no or limited private sector participation. Beyond a relatively modest threshold, all private-sector investments were subject to strict investment licensing. The government reserved nearly all labor-intensive products for exclusive manufacture by small-scale enterprises with no investment license given for large-scale enterprises in these products. The average annual growth rate during this period, spanning 1951 to 1991, was a measly 4.1 percent. With the population growing annually at 2.2 percent, per-capita growth in income was just 1.9 percent with the result that per-capita income after 40 years was barely

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twice of its low level of 1951. India had started extremely poor in 1951 and it remained so after 40 years. It was the entry of private sector into products previously dominated by the public sector, the freeing up of private industry from licensing and opening to foreign trade and investment that led to a jump in the growth rate. India has grown at the average rate of 7.6 percent during the last 15 years from 2003 to 2017. This period has seen a sharp decline in poverty. Indeed, the experience during the second UPA term between 2009 and 2014 drove home the lesson that the return to the old socialist ways would not go unpunished as far as growth is concerned. Overstretched food subsidy, a draconian land acquisition act, retrospective taxation of enterprises and excessive government interference in large projects led to a sharp decline in the growth rate during the last two years of the UPA government. It is the concerted effort to restore private incentive subsequently that has returned the economy to sustained growth at levels exceeding 7 percent. Does the Chinese experience consisting of the active role of the government in the process of development and continued importance of the State-Owned Enterprises (SOEs) pull in a direction opposite of what has been suggested above? My answer to this question is in the negative for two reasons. First, the overall Chinese experience points to the importance of the private over public sector and of an open over closed economy. It is true that the SOEs remain important in the Chinese economy and the government continues to play an activist role in giving it direction. But looking at the Chinese experience in this way misses the important point that it has been a shift towards private sector and an outward-oriented economy that explains the spectacular growth of the Chinese GDP since 1980. Loosening the government control has been pivotal to the transformation China has seen. Indeed, much of the economic analysis shows that productivity growth in the SOEs remains low relative to private-sector enterprises. Growth in the most dynamic eastern provinces on the coast of China such as Guangdong, Fujian, Zhejiang and Shanghai has been driven by private enterprises, not SOEs. Second, even if one assumes that it is the activism of the Chinese government and dynamism of the SOEs that must be credited with the country’s spectacular performance, it does not follow that other countries must follow suit. Like South Korea under President Park Chung-hee and Singapore under Prime Minster Lee Kwan Yew during the 1960s and 1970s, China, beginning with Deng Xiao Ping, has been blessed with

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unusually effective leaders at the top. But this should not distract us from the fact that similar activism in the past also produced a very different outcome in China in an earlier period. More importantly, with leadership and government institutions in other countries such as India lacking the same effectiveness, these latter countries are likely to do better by relying on private sector where it can deliver better outcomes. As an example, today, even in areas of education and health, which are the traditional preserves of the public sector, the public sector in India is having difficulty delivering satisfactory outcomes. More than one-third of the public schools in India today have less than 50 students each with the average number of students in these schools being just 29. Poor delivery has led parents to move their children out of these schools into the private sector. Even relatively poor parents have chosen low-budget private schools over free public schools that have better school buildings and better-qualified teachers who are, unfortunately, frequently absent from classrooms or not teaching even if in classrooms. Similarly, although the government has spent vast volume of resources over the years on the creation of sub-centers (SCs), public health centers (PHCs) and community health centers (CHCs) in rural India since the early 1960s, more than 70 percent of patients go to private providers for outpatient care. Even for inpatient care, which can be costly for many poor rural families, 55 percent of the time patients go to private clinics and hospitals. Publicly provided health services have so far been ineffective in India.

IMPLICATIONS OF RISING PROTECTIONISM IN THE US Recent developments in US–China trade relations suggest that China will need to continue to withdraw from the US market. Even if the current posturing does not result in explicit trade restrictions on each other by the two countries, fear of future such outcomes would move China away from the US market. The rise of India in parallel offers it and China an unusual opportunity. Sharing a vast common border as they do, the two countries also have geopolitical reasons to cooperate. With wages rising in China, firms in the labor-intensive sectors there are finding it difficult to remain competitive in the global marketplace. The US pressure to cut bilateral trade surplus constitutes another source of pressure in this regard. Indeed, even India has been complaining about the large trade deficit it has

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with China. Therefore, migration of some of the larger Chinese firms in the labor-intensive sectors to India can kill three birds with one stone. The firms can access lower-wage labor in India to remain competitive. Moreover, the Chinese exports of the labor-intensive products to the US and India can be substantially capped. More broadly, the current developments provide good reasons for a speedy completion of negotiations on the Regional Cooperation for Economic Partnership (RCEP) to China and India. Free trade between India and China would make India an even more attractive location for production in the labor-intensive sectors. In the not too distant future, China would turn from a net exporter to net importer of labor-intensive products. Duty-free access to this market would therefore attract the global firms to the shores of India. In turn, China would have duty-free access to India’s vast and growing market in hi-tech products.

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CONCLUDING REMARKS There is little doubt that in another decade, India will almost certainly become the third largest economy in the world. This would considerably alter the global geopolitical as well as economic balance. With the US and Europe progressively turning inward and considerable pressure on China to cut back its exports to these regions, the time is ripe for greater cooperation between India and China. A successful conclusion of the RCEP in this context can be an effective instrument of promoting prosperity in the region as well as capping the tensions arising out of the inward turn of the US and Europe.

NOTES 1. India did go through a brief period of Emergency Rule during which some of the civil liberties were withdrawn but in the overall scheme of things this was a short-lived aberration with the then Prime Minister Indira Gandhi herself calling for elections. Gandhi lost that election and gracefully exited the office of Prime Minister.

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PART III

Digitalization and leadership

11. The role of innovation and the digital economy: new opportunities and challenges for Chinese, US and European economic policy Edmund Phelps 1.

THE ROLE OF INNOVATION

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The ‘role of innovation’ is important to discuss not only as it relates to a healthy economy but also as it relates to a healthy society. Before continuing, a few definitions are in order: • In any society, I dare say, most people are born with a desire to create: to imagine or conceive new things – consider the Neanderthal who evidently took pleasure in drawing figures on the wall of the cave or the prehistoric Homo sapiens who managed to create a workable flute (found in a south German cave).1 This is artistry and invention. It is typically personal. • A somewhat smaller proportion of society, it appears, desires also to conceive new things that will be realized, or built, for use by others. A composer creates a new musical score, a director realizes it with a stage production and an impresario brings it to the public. If successful – and only then – it is an innovation. It is typically social. What is the ‘role’ of innovation? America’s great era of innovation – from the 1820s to 1970 or so – was pervasive, extending to virtually all industries and enlisting ordinary people from the grassroots up. Abraham Lincoln exclaimed in 1858 that ‘young America has a great passion – a perfect rage – for the new.’2 As argued in my book Mass Flourishing, this innovating was an engaging and sometimes exhilarating experience.3 People were involved in their work and had a sense of taking action and 120

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of achieving things. Now, statistical analyses show that a low rate of innovation in a country is a reliable predictor of low life satisfaction.4

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2.

RECENT CHANGES IN THE US, FRANCE AND CHINA

From this perspective, let us examine the significant shifts over the past year or two in the economic organization and political landscape of China, the US and France. In the US since around 1970, a protracted slowdown of productivity growth – more accurately, growth of total factor productivity – has led to near-stagnation of total labor compensation and national income too, amidst considerable structural change. Life satisfaction, according to household surveys, appears to have been less satisfying to more and more participants. This development ultimately brought a shift in the political landscape. Many of the workers, grown dissatisfied, expressed their frustration by voting against the political parties that had presided over the slowdown. Also, the Democratic Party had been catering especially to several special interest groups – so-called ‘identity politics’ – and at some point the votes the Party gained from special interests came to be offset by the loss of votes from people resentful at not having been included like others.5 The politics of President Trump is opposed to that of traditional Democrats and Republicans. Trump seeks an economy that produces a huge Gross Domestic Product per working age person – with little or no regard to wage rates or other matters of distribution – though he expresses an affinity with the white working class, who constitute his political ‘base.’ At bottom, Trump, like Mussolini in the 1920s, is practicing the ideology that is called corporatism. It is a doctrine that has generally proved to be fruitless for economic growth and personal satisfaction. The corporatist disregard for the inspirations, explorations and discoveries sought and achieved by persons of all walks of life is exacting a further toll on the vitalism prevalent in the people. The view that the role of the company and that of the labor union is to serve the nation, not itself, may further drain the nation of much of its individualism. In France, President Emmanuel Macron has also moved away from preoccupation with distribution. He wants France to regain its rapid growth and prestige. To that end, he has sought to create more competition in French industry by cutting back the ‘social protection’ of

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employees, which has been regarded as having stifled the entry of new firms into industry. Of course, the two leaders differ. Macron hates corporatism! The tools of Macron are institutional reforms while those of Trump are fiscal and budgetary reforms. In China, the government under President Xi Jinping has brought forth several initiatives. The construction of the Belt and Road signals that China will remain fundamentally a trading nation. The reaffirmation of support for the state-owned enterprises (SOEs) signals that China will remain semi-socialist. Finally, the government implies that the purpose of investment is to increase consumption. But these initiatives and declarations are far from the whole picture. The state has taken initiatives aimed at boosting entrepreneurship: shortening dramatically the procedure for forming a new company, building a vast number of additional schools in which Chinese children learn more about the world they will face, and facilitating entry of foreigners lending their expertise. Also, very importantly, the authorities have recognized the importance of allowing competition in the economy.6 Existing companies are freed up to enter new industries, thus forcing inefficient companies to contract or leave the industry. Competition is an invaluable solvent and the government shows its wisdom in opening up the economy to competition. There is measurable evidence that China is going down the road of entrepreneurship and innovation. The government has reiterated its dedication to protecting new patents. As is becoming well-known, the number of new firms registering every week is appreciable. Yet, while new private firm formation is very real, an investigation by Xiaobo Zhang, Ruochen Dai and Xiaoying Liu found it impossible to locate a substantial proportion of the newly registered firms.7 Similar issues arise with measures of research and development (R&D), spending, patents and new products. Nevertheless, we can expect over the next decade to see a very large number of new entrants dotting the Chinese landscape. The unanswered question is what proportion of the new firms will be genuinely new enterprises – not just small shops – and, of those, what proportion will have new ideas and the zeal to develop them and try them in the market.

The role of innovation and the digital economy

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3.

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IMPACT OF THE DIGITAL ECONOMY

How will further development in the ‘digital economy’ impact the nations of the West and beyond? In the West, many technologists worry that the spread of AI in their economies will cause massive layoffs and a long spell of unemployment until wages have finally sunk to a lower growth path. They are worried not only about the development of AI in their own countries but also about the importation of AI-enabled robots developed overseas. The technologists are not well-trained economists, so it is high time we try to take into account the part that some market mechanisms will play in determining the effects on the path of wage rates and employment. Of course, the adoption of robots, whether or not AI-enabled, makes it possible to produce an unchanged level of output with less labor. And, yes, when AI-enabled robots serving to replace labor are introduced in some industries, the immediate impact is layoffs and reduced wages in those industries. But, as I see it, that is just the beginning of the story. What happens after that? (In what I am going to say, I will suppose for simplicity that there is just one kind of labor and workers are all alike.) There is a subsequent effect transmitted to other industries. In an idealized model, the displaced workers would seek employment elsewhere, thus driving down wage rates equally in the whole economy. And this general fall of wages sets in motion an adjustment mechanism. When wage rates go down, the rate of return to investment will go up and investment will pick up in response. The resulting increase of the capital stock will exert an upward pull on wage rates and employment in the other industries. Another adjustment mechanism: Even if, for one reason or another, displaced workers do not move to other industries, the wage cuts in the industries adopting the cost-saving robots will ultimately induce producers there to reduce their prices; if they do not, new firms will enter those industries, thus driving down prices there. And this fall in relative prices means a rise of relative prices in other industries. These higher prices will be a force pulling up output and employment in those industries – even if wage rates had not fallen. Another point: Even if these mechanisms ultimately perform as expected, it will be highly desirable to have more innovation of the old-fashion kind – innovations of a kind that empower workers to be more productive, especially in consumer industries. There are several

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reasons why labor force participation remains depressed in the coal mining regions of the US, Britain and France. For one, the workers are not mobile, having invested their savings in their houses and being dependent on their local government for health care, which cannot quickly be transferred to another province or state. Another reason is that men doing physical labor typically lack the training and education that would make them employable in many other industries. I will close on another note: Particularly in the nations of the West, there is too much focus on stability and the short run. I believe they can look forward to decades of exponential growth if they will come to accept disruptive innovations and to give their moral support to careers of innovation (as well as exploration). They have to understand that venturing into the unknown and the occasional experience of success is what the good life is all about.

NOTES 1. 2. 3.

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4. 5.

6.

7.

Nicholas Conard, Maria Malina, and Susanne C. Münzel, ‘New Flutes Document the Earliest Musical Tradition in Southwestern Germany,’ Nature, August 2009, 737–40. Abraham Lincoln, ‘Second Lecture on Discoveries and Inventions,’ February 11 1859. Edmund Phelps, Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change (Princeton, NJ: Princeton University Press, 2013). Edmund Phelps, Raicho Bojilov, Hian Teck Hoon, and Gylfi Zoega, Dynamism: The Values that Drive Innovation, Job Satisfaction, and Economic Growth (Cambridge, MA: Harvard University Press, 2020). On identity politics, see Mark Lilla, The Once and Future Liberal: After Identity Politics (New York: Harper, 2017); and Francis Fukuyama, Identity: The Demand for Dignity and the Politics of Resentment (New York: Farrar, Strays and Giroux, 2018). Vice-Premier Liu He, ‘3 Critical Battles China is Preparing to Fight’ (speech, World Economic Forum, Davos, January 24, 2018). See also Edmund Phelps, ‘Will China Out Innovate the West?’ Project Syndicate, March 5, 2018. Dai, Ruochen, Xiaoying Liu, and Xiaobo Zhang, ‘Detecting Shell Companies in China,’ paper presented at the annual Allied Social Science Association meetings, San Diego, January 3–6, 2020.

12. The digitalization of Europe’s economy

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Debora Revoltella, Philipp Brutscher and Tessa Bending In Europe, many observe the rapid transformations taking place in the global economy with some trepidation. There is admiration for the way that firms in the United States (US) have been able to take a lead in the first wave of ICT technologies and a desire to catch up. The way the east Asian economies, particularly China, have been able to transform themselves and shift their position within global value chains is perhaps even more impressive. It is clear that there is no room for complacency about Europe’s place in the global economy. There is an increasing attention across Europe to react to this rapidly changing world economy and to ensure that Europe remains one of the global centres of technological progress and economic prosperity. After what could almost be described as a ‘lost decade’ growth in the European Union (EU) is back on track – forecasted at 2.3 per cent in 2018. This has been driven by a substantial pick up in investment in machinery and equipment and in intanglible assets, particularly in the more advanced EU ‘core.’ Unemployment is slowly falling, and labour supply is even increasingly posing constraints in some countries. This positive cyclical situation is turning attention to the structural challenges that Europe faces, revealed in particular by a worrying slowdown in productivity growth. The longer-term position of Europe within the global economy depends on the reversal of this trend, as do issues of debt sustainability and the resilience of the EU economy to future shocks. In this regard, we see not only innovation but the wider issues of digitalisation and innovation adoption as key. It must be remembered that the EU is quite diverse, encompassing not only some of the world’s highest productivity economies at the innovation frontier, but also middle income economies that are still ‘emerging’ and advanced economies that have been less successful at adaptation. 125

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This chapter therefore focuses on the process of digitalisation. Drawing on unique survey data generated by the European Investment Bank (EIB), it examines the barriers and enablers of this process that we can observe in the EU, and the common actions that EU Member States are taking.

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WHAT IS CAUSING EUROPE’S PRODUCTIVITY SLOWDOWN? Many explanations have been offered for the productivity growth slowdown in advanced economies. Debates on secular changes in demand dynamics or the nature of technological change may ultimately be for future economic historians to adjudicate; but we can also look at the more immediate impact of the Great Recession. Even after the formal end of the recession, we have seen a prolonged period of depressed investment, with an unprecedented number of firms hoarding cash or buying back stock. This most certainly affected productivity growth in a negative way. The lagging recovery in investment seems to have been driven by low demand expectations and/or weak incentives to substitute for labour in a slack labour market, leaving the economy mired in a situation of weak demand, low investment and low growth in productivity. Crisis-related frictions in the reallocation of resources have also played a role. For example, housing stock imbalances built up prior to the Great Recession have contributed to credit supply constraints in some economies. Small and young, but often highly productive firms are most vulnerable to such credit constraints, with implications for investment and productivity growth. In addition, regulatory forbearance and inadequate insolvency regimes may also have locked in capital into firms with low levels of productivity, so that the ‘cleansing’ typically associated with recessions has been less effective. The EIB Investment Survey (EIBIS) sheds further light on the negative feedback loop between weak demand and weak investment growth. Initiated in 2016, it provides insights into corporate investment and investment finance issues across the EU, based on representative sampling of more than 12,000 firms. The first two waves of the survey cover a period in which growth, investment and expectations picked up considerably. Yet despite increased investment, firms’ view on the adequacy of their past investment level remained constant, with 15 per cent still indicating that their investment activities over the previous three years had been insufficient.

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A closer examination of why this perceived investment gap did not close shows that part of the answer is that firms revised upwards their needs assessment from the first to the second year, as the economic climate improved. This finding supports the notion that the weak recovery in investment (and, thus, sluggish productivity growth) was in part due to weak aggregate demand. By contrast, one would expect diminishing supply-side constraints to show up in the steady closure of perceived gaps. A second effect of the crisis has been under-investment in the adoption of new technology. Looking in more detail at firms that see their recent investment as inadequate, we find that concerns are related not only to the quantity of the capital stock, but also to its quality. Firms are asked to estimate the proportion of their machinery and equipment that is ‘state-of-the-art’. Figure 12.1 shows that a 12 pp. smaller share of machinery and equipment is seen as state-of-the-art among firms that see their past investment as inadequate. As the number of firms reporting under-investment has not fallen, despite an increase in investment, this suggests a growing realisation, as the recovery proceeds, that competitiveness requires increased efforts to adopt new technologies and keep pace with the technological frontier.

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THE IMPORTANCE OF DIGITALISATION FOR EUROPEAN PRODUCTIVITY GROWTH AND COMPETITIVENESS Adopting new technologies increasingly means digitalisation. In the mid-1990s to the mid-2000s, investments in ICT hardware and software already played an important part in raising labour productivity, but the effect was relatively concentrated in some sectors and types of activity. Now we can observe ICT becoming increasingly integrated and unavoidable in production processes across all sectors, from manufacturing to logistics and retail. In manufacturing, ICT is becoming an essential complement to non-digital; in some service sectors, by contrast, there is evidence of shifting models, so that ‘state-of-the-art’ mostly means ‘digital’. The shifting of retail to online spaces is a clear example of this.

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Note: the Figure shows the share of machinery and equipment that is state-of-the-art as reported, respectively by firms that consider their investment activities in the past three years below needs and in line with needs. Source: EIBIS.

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Figure 12.1

Firms that report to have under-invested see less of their capital stock as state-of-the-art

WHAT IS HOLDING BACK DIGITALISATION IN EUROPE? To reap the benefits of digitalisation, the framework conditions need to be right. The EIBIS survey data suggests some key issues that matter for firms when it comes to the adoption of digital technologies: (i) access to digital infrastructure, (ii) access to appropriate finance; (iii) a skilled labour force; and (iv) a conducive regulatory environment. In a recent analysis, we plotted the quality of digital infrastructure (household access to broadband) by NUTS2 (sub-national) region against firms’ view of whether access to digital infrastructure poses a barrier to their investment activities. What we find is a strong negative correlation: the better the infrastructure, the lower the perceived effect on firms’ general investment activities. Unsurprisingly, this effect is most

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pronounced among those firms most engaged in innovation (see Figure 12.2).

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Note: firm-level statistics are weighted for value added. Firms in DE, GR, PO and the UK are excluded due to missing information at the NUTS2 level. Each dot represents a NUTS2 region. The EIBIS sample is limited to frontier firms in terms of innovativeness. Source: EIBIS 2016 and 2017; Eurostat.

Figure 12.2

Firms perceiving access to digital infrastructure as an obstacle is negatively correlated with household access to broadband (NUTS2 regional level, innovative firms)

Access to digital infrastructure also influences firms’ decisions on whether to invest specifically in digitalisation. Figure 12.3 below, again from our investment survey, plots the quality of digital infrastructure against the share of firms investing in digital assets (defined as software, database, website activities etc). It illustrates a clear positive relationship between the two highlighting the importance of putting in place the right infrastructure for firm adoption of new technologies. EU governments have made efforts to invest more in digital infrastructure in recent years. In ‘new’ Member States in central and eastern Europe, EIBIS provides evidence that firms’ concerns are being assuaged. This is

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Note: firm-level statistics are weighted for value added. Firms in DE, GR, PO and UK are excluded due to missing information at the NUTS2 level. Each dot represents a NUTS2 region. A firm is considered as an IT investor if it has allocated more than 50€/employee to investment in IT and digital equipment. Source: EIBIS 2016 and 2017; Eurostat.

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Figure 12.3

Share of firms investing in IT correlates with household access to broadband (NUTS2)

likely to be a reflection of the slowness of digitalisation process among many firms, as household access to broadband is not particularly high in most cases. In the ‘old’ Member States of western and southern Europe, by contrast, it seems that the need firms perceive for digital infrastructure is racing ahead of efforts to meet this need (see Figure 12.4). Access to a highly skilled workforce is also a barrier to investment. In the EIBIS 2017, ‘lack of staff with the right skills’ was the obstacle to investment most often reported by firms. For firms engaged in a process of digitalisation, this constraint appears to be particularly pressing. As shown in Figure 12.5, we divided firms into quintiles according to the share of their investment going into ICT.1 Although skills is a big issue for firms in all quintiles, it seems slightly less so for quintile 1 (likely to include firms still engaging little in digitalisation) and quintile 5 (likely to include many service sector firms that heavily rely on ICT but not

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Note: firm-level statistics are weighted for value added. Firms in DE, GR, PO and the UK are excluded due to missing information at the NUTS2 level. Each dot represents a NUTS2 region. Source: EIBIS 2016 and 2017; Eurostat.

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Figure 12.4

Firms perceiving access to digital infrastructure as an obstacle, and growth in households’ access to broadband between 2011 and 2016 (NUTS2)

necessarily on a highly-skilled workforce (call centres or online-retailers, for example). Availability of the right skills seems to pose a bigger challenge for firms in quintiles 2–4. These may include many firms, such as in manufacturing, that still invest significantly in non-ICT capital goods but are also engaged in a process of catching up with the digital frontier, thereby facing new needs for workers with competences in areas such as big data, mobile enterprise, cloud computing and cyber-security. The spread of such digital-relevant skills will be essential to safeguard European prosperity. Between 2000 and 2014, job growth in the digital economy in the EU was seven times faster than that for the economy as a whole. Forecasts indicate that, by 2020, Europe will lack more than 800,000 ICT professionals. As part of its Digital Agenda, the EU has therefore put ‘improving professional ICT skills’ right at the top of its list of priorities. Access to finance poses another area of concern for the digitalisation process. This is because digitalisation is associated with relatively high levels of risk and investment in intangible capital. While overall financing conditions continue to improve in the EU, firms investing more in higher risk projects continue to face greater difficulties. The left panel of Figure 12.6 shows that as the share of firms’ investment that is in digital

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Note: The figure shows the share of firms that consider lack of staff with the right skills as an obstacle to their investment activities by quintile of their investment activities in digital assets. Source: EIBIS 2016 and 2017.

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Figure 12.5

Skills as a barrier to investment for firms with different intensities of investment in ICT

technologies increases from the first to the fourth quintile, although the fifth quintile of firms with the largest share of their investment going to digital technologies are less likely to be finance constrained. As mentioned above, many of these fifth quintile firms may be service sector firms with relatively low capital costs. Figure 12.6’s right panel shows that the share of investment funding from external sources decreases as the share of investment in digital technologies increases. This finding is striking because firms that invest most heavily in digital assets are often the most productive and those with the best financial health indicators (in terms of leverage, interest burden, profitability and liquidity). The evidence on finance constraints can to some extent be linked to Europe’s heavy reliance on bank-based funding. Adopters of new technologies and methods – particularly early adopters – suffer from a risk profile that makes them unattractive for bank lending. Amid the uncertainties of the launch phase and in the capital-intensive growth phase, such firms typically have a need for venture capital (i.e., over-the-counter, exit-oriented start-up and growth funding in the form of

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Note: The figures show the share of firms that are financing constrained (left panel) and the share of investment finance raised by source (right panel). A firm is considered financing constrained if it had a finance application rejected; received less than it asked for; declined a financing offer because it considered it too expensive or did not apply because of fear of being rejected. Quintiles are defined on the basis of firms’ investment activities in digital assets (within countries). Source: EIBIS 2016 and 2017.

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Figure 12.6

Share of finance-constrained firms and intensity of investment in ICT (left panel); Source of investment finance and intensity of investment in ICT (right panel)

equity or mezzanine instruments). In Europe, such financing is relatively scarce: about 0.08 per cent of European GDP flows into fledgling companies in the form of venture capital, against 0.36 per cent of US GDP. Lastly, a conducive regulatory environment is essential to encourage firms to take steps towards greater digitalisation. The regulatory environment needs to be simple for firms to navigate, without creating large fixed costs in terms of the need for learning and skills acquisition, particularly for the SMEs that dominate in the European economy. There is also a need for regulatory flexibility in which a ‘sand-box’ approach can be useful: emphasising a light regulatory touch for new and emerging technologies to create space for experimentation and pioneering entrepreneurship, but on the understanding that the regulatory regime needs to be tightened once the benefits and risks of a technology are better understood and creating impacts at a larger scale. In the EU context, regulatory standardisation is also essential. The Digital Single Market aims to allow firms to benefit from the scale of the EU economy without the prohibitive fixed costs of understanding and complying with many different regulatory regimes. A number of signif-

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icant legislative initiatives have already been adopted at the European level, such as on the cross-border portability of online content services and the removal of mobile data roaming charges. Other important legislative measures, such as the removal of geo-blocking, modernisation of copyright rules, taxation of e-commerce and cyber-security, are currently in the legislative process.

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EUROPE’S COORDINATED POLICY RESPONSE IS MOVING IN THE RIGHT DIRECTION Policy action at the EU level is moving in the right direction. While Europe overall lags behind peers in terms of digital uptake, the EU encompasses both economies at the forefront of innovation and digitalisation, but also others that are lagging behind. Indeed, in recent years, the Investment Plan for Europe has shifted the attention from crisis resolution to a new more dynamic competitiveness enhancing agenda. This plan has brought together efforts to achieve a more conducive regulatory environment with technical support services and a new focus on risk-absorbing finance implemented by the EIB Group. By mid 2018, the initial target of 315 billion euros of targeted investment supported within three years, on top of the EIB Groups standard lending. The new proposal for an EU budget, now being discussed in the Multiannual Financial Framework, is proposing a greater focus on competitiveness and innovation. The entire EU budget in fact accounts for 1 per cent of the EU’s annual GDP, with EIB lending representing approximately another 0.5 per cent, so the scale of these interventions should not be overestimated. What they represent instead is a new focus on a more integrated approach to enhancing competitiveness across the EU, one that addresses different enablers, from infrastructure provision, through skills and firms’ financing needs, to realising the potential of a more seamless internal market.

NOTES 1.

To avoid the distortion of results from national differences in labour and financial market conditions, we defined quintiles within countries.

13. Prospects for China’s drive for innovation: from the perspective of demographics

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Jianzhang Liang 1.

‘POPULATION INNOVATION’

1.1

Innovation Theory and the New Demographic Paradigm

Approximately 200 years ago, the English economist Thomas Malthus proposed his famous demographic theory which describes the following chain of logic: Technological progress can generate a short-term increase in per capita income. However, the increased income soon results in population growth and lower agricultural productivity, which, in turn, eventually negates any gain in per capita income. Although Malthus’s theory is an accurate representation of historical events, it is no longer applicable to modern economies. Population growth is much quicker now than it was for agricultural societies, and an increased growth does not result in a lower production for the manufacturing and service industries. Due to technological progress, humans have dramatically increased the efficiency of utilizing resources. Land and natural resources are no longer bottlenecks for the modern economy. Moreover, innovation becomes much more important for solving problems such as global warming. To keep innovation at a high level, a country needs to have a large, young, and highly educated workforce and not a small stable population as prescribed by the Malthusian theory. About 20 years ago, the US economist Paul Romer formalized a model of innovation and economic growth. One of the implications of Romer’s model is that a larger population, under certain conditions, can engage more people in research and innovation, which drives faster technological progress as well as higher productivity. This relation between pop135

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ulation and economic growth implied by Romer’s model is the opposite of the Malthusian theory. With innovation, an increasing population will lead to faster economic growth and higher income. 1.2

Three Demographic Factors for Innovation

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(a) The scale effect For innovation, the advantage of scale for a large country is even greater. This is shown mainly in the following aspects: 1. A larger population means a larger domestic market. It should be no surprise that China has the best high-speed train technology because the amount of research and development it can afford to invest in this area is so much larger than smaller countries. 2. A large population also means a large talent pool. College education is the prerequisite for research and development. The number of college graduate students reflects the amount of human resources that innovative activities can attract. In recent years, as higher education has expanded in China, China has surpassed the US in terms of number of college graduates. This is good for the country’s innovation. 3. With a large market, there will be more competitors too, which will intensify the pressure to innovate and increase productivity. The US and Chinese Internet markets are the most competitive, and venture capitalists sometimes are willing to support even the second and third place players in the market, whereas in a small country, venture capitalists are usually only able to support the market leader. (b) The agglomeration effect In addition to population size, the geographic distribution of the population also matters. For the manufacturing industry, the agglomeration of industry is an important drive for economic development and transformation, and the agglomeration of people provides a foundation for industry agglomeration. China has the largest and the most complete manufacturing industry cluster in the world, with a concentration of many manufacturing companies in its densely populated Southern and Eastern regions. Anybody who invents a new product can find hundreds of suppliers capable of making the product quickly and cheaply. In terms of innovation, it is important not only to gather people but also high-quality talent. The concentration of talents has promoted the flow of talents, and mobility has become an important condition for promoting

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innovation. With many high-tech firms being so close to each other, it is easy for workers to move between firms. Inter-firm mobility is very high in Silicon Valley. If an engineer has a creative idea but is unable to secure funding or support from his company, he can easily take the idea to a different company, or he can start a new company with venture capital funding. High mobility not only enhances the exchange of ideas, but also allows start-up firms to find talents quickly in order to scale their ideas or build on their initial success. High mobility also lowers the cost of failed entrepreneurship because it is easy for people to find new jobs after a failed venture. The necessary condition for high mobility is the agglomeration of many high-tech firms in one place. (c) The age effect Cognitive skills are an important factor influencing technological innovation. In general, a person’s physical ability peaks in their 20s. In a modern economy however, what drives productivity is cognitive skills. As one ages, some cognitive skills hold up very well in old age. However, perceptual speed, which reflects the ability to absorb new information, drops quickly after one’s 20s, which is consistent with the general finding that learning ability usually peaks at a young age. At the same time, innovation is something for entrepreneurs. According to Schumpeter’s theory, it is not enough to have just engineers and scientists, entrepreneurs are critical for making disruptive inventions commercially successful. Entrepreneurship is a long-term, high-risk investment. An entrepreneur typically sacrifices a lot of personal savings and time, and the probability of failure is high. Young people are more willing to take on such a risky investment because they have more time to enjoy the fruits of their success. An aging society is not good for innovation. Talented entrepreneurs tend to be typically in their 30s. If a country is aging rapidly, there will be fewer potential young inventors and entrepreneurs. There is also a blocking effect in an aging society. A young society provides more opportunities for the young to acquire the skills necessary for entrepreneurship. Conversely, in an aging society, young workers are promoted more slowly, are less influential, and have fewer skills, thus are less likely to become potential entrepreneurs. In summary, the role of population in terms of innovation is mainly reflected in three aspects: (1) the scale effect—a larger population provides a larger market, a larger talent pool, and promotes innovation through market competition; (2) the agglomeration effect—the agglom-

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eration of people drives the agglomeration of industries, and the concentration and mobility of people is an important catalyst for innovation; (3) the age effect—a younger population is better for inventions and creations, stimulating entrepreneurship, and transforming technological innovations into commercial successes.

2.

THE CURRENT STATUS OF CHINA’S POPULATION PROBLEMS

In the previous section, we introduced the demographic conditions needed to promote innovation. But what can we think about and what inspiration can we get from looking at China’s current population? In this section, we will analyze China's current population problems from the perspective of economic demographics and propose corresponding policies in a latter section.

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2.1

The Risk of a Low Fertility Rate

According to data from the sixth census conducted in 2010, the number of births decreased rapidly in the 1990s, a straight-line drop from 28 million in 1990 to less than 15 million in 1999. Starting in 2015, the number of women aged between 22 and 31 will drop by over 40 percent in ten years. Therefore, the declining birth rate that is occurring now can actually be traced back to the 1990s. Evidence of this decline can be found in the 7–8 percent decrease in the number of newly married couples in recent years. From 2016 to 2017, the number of women aged between 15 and 49 dropped by 4 million; of which women aged 22–31 decreased by more than 6 million. The fertility rates in megacities such as Beijing and Shanghai are less than 0.8; some of the lowest in the world. The Beijing Blue Book on Social Psychology: Analysis of Beijing's Social Psychology (2016–2017) released in January 2018 revealed that there is a wide gap between the desire to have children and actually having children among residents in Beijing—although 58.6 percent of Beijing residents claim they would ideally like to have two children, only 10.8 percent of them actually end up doing so. Although the two-child policy has been introduced, the future of the country’s fertility rate is still not very optimistic. The two-child policy was first implemented in 2016 and the number of births increased by more than 1 million compared with 2015. Due to the weakening desire to have

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a second child and the sharp drop in the number of women of childbearing age in the next decade, it is unlikely that China’s population will increase significantly. The number of second children in 2017 was 8.83 million, which actually increased by 1.62 million compared to 2016. However, the number of first children was only 7.24 million, which was a decrease of 2.49 million since 2016. My view on the recent two-child policy is that since it was implemented in early 2016, there was a one-year delay from the time of conceiving to childbirth. So 2017 should be the peak of births caused by this sudden relaxation in the one-child policy. But as this desire to have a second child weakens and the number of women of birth-giving age drops sharply, the number of births will start to shrink rapidly from 2018. It now appears that the number of second children in 2017 is indeed more than the previous year, but it is not enough to make up for the sharp drop in the number of first children. The number of births has declined earlier and faster than predicted, and we underestimated the speed of the society’s declining desire to have more children. The desire to have children is not leading to actual births—the reasons for the low fertility rate are mainly due to a lack of guarantees for education and medical care, as well as difficulties when it comes to childcare. In addition to a child’s basic living needs, China’s exam-oriented education forces parents to spend a lot on extra-curricular education. In a typical middle-class family, the average annual expenditure for raising a child is CNY 30,000, which amounts to more than CNY 500,000 from birth to 18 years old. In fact, this expensive parenting model and the declining birth rate form a vicious cycle of mutual cause and effect. In other words, the lower the fertility rate, the lower the average number of children per family, and the higher the average parenting cost per child. This results in the average family not daring to have more children, which in turn leads to a lower fertility rate. If it became the norm to have two or three children, then the average cost of raising a child would not be so high. The parenting doctrine of ‘don't lose at the starting line’ might stop being the norm, and couples who wanted more children might not be so discouraged. To raise children in China, families bear high direct economic costs and also face more difficulties when it comes to childcare. Compared with other countries, China has a shortage of nurseries. Therefore, if both husband and wife must work before the child turns two or three years old, there are usually only two options for them: to hire a nanny for a long time, or to have grandparents care for the baby. However, grandparents who are already old are now more and more reluctant, or have no energy,

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to help with the babysitting. It is even more difficult for a second child to get this kind of help from their grandparents. Therefore, many parents can only hire babysitters or nannies while they keep on working. In recent years, the cost of nannies has skyrocketed and is almost the same as those of Hong Kong’s Filipino workers.

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2.2

Population Quality and Education Issues

(a) The rural and urban gap in education Stanford Professor Scott Rozelle’s recent article on the low intelligence level of children in rural areas quickly captured wide attention. What worries everyone is that if more than half of rural children do not receive high-quality education, China’s future talent, quality and competitiveness is going to be a problem. Of course, the Chinese government has long known this. In recent years, it has continuously increased investment in rural education and the quality of school buildings in rural schools has improved a lot. But there are still some problems that cannot be solved simply with money—the number of students in rural areas is decreasing, parents of rural children are working in the big cities, and teachers in rural areas are leaving. China’s rural education is facing a huge dilemma—as the proportion of agriculture in the economy continues to fall, rural areas are no longer providing work for large numbers of young people. Young people from rural areas going to work in cities will become an inevitable trend of economic development. Therefore, in terms of policies, the government should not force young people to stay in the countryside, nor should they keep their children in the countryside. Instead, they need to create conditions for them to move along with their children to big cities. What is worrisome is that China still has discriminatory policies against the children of migrant workers. As a result, rural children have difficulty entering the city and attending schools. As a result, they end up being ‘left-behind’ in their hometowns. The gap between the rich and the poor in China is mainly a gap between urban and rural areas. As long as there are policies in place that encourage migrant workers to move to the city and the various restrictions on their children going to school in the cities are removed, the next generation of migrant workers can obtain more equal opportunities and therefore the intergenerational class mobility will be increased. By receiving education in the cities, children from rural areas will not only have better teachers, but also get to broaden their horizons. In the city,

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they will be more likely to form social relationships based on classmates and friendship, more likely to marry urban residents, and this will speed up the integration of urban and rural areas so as to gradually eliminate the difference between urban and rural areas in China.

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(b)

Difficulties in cultivating creativity and the college entrance examination The biggest problem that China has in terms of urban education is the education of innovation. Some people say that the Western education model is more suitable for training innovation than the Asian exam-oriented model. Western education’s strength is in knowledge breadth, promoting the spirit of exploration, and cultivating communication skills. Asian education has advantages in the depth of knowledge and in the mastery of tools. Therefore, the Asian education model is by no means useless. For example, for the knowledge of tools such as mathematics and computers, you must do a lot of exercises. As innovations in all areas increasingly utilize big data and artificial intelligence, the advantages of Asian education in this respect have gradually been recognized by Western educators. The latest education concept is that we need to combine the advantages of the East and West. We must emphasize the ability of students to think independently, but at the same time we must also train them in hard math problems. Therefore, the elite education in the East and West is merging. Private high schools in the US and international schools in China have adopted similar education methods. The amount of homework in top US high school students is no less than that of Chinese students. Students in China’s international high schools are also very active in the classroom. But China’s education trips up when it comes to the college entrance exams. International high schools can allow students to choose courses freely. However, ordinary high schools in China require students to invest 100 percent in preparing for the national college entrance exams. Any reform in the field of quality education is futile as long as the rational choice of schools and parents is to prevent students from learning anything which is not going to be tested on the college entrance exams. In order to avoid the college entrance exams, more and more elite families are now sending their children to study abroad. They often find that students in the US are now becoming as diligent as those in China. They not only do math problems, but also choose a variety of courses and participate in various projects. Students who stay in China are getting less homework and the teaching is getting easier. However, the pressure of the college entrance exams has not diminished. Therefore, the families

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have to spend a lot of time, money, and energy to find their children private tutors.

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2.3

Should Big Cities Control their Populations?

Based on the current policies, it is believed that Beijing is too big and has too many people. Although most people are convinced this is true, how does this view hold up when compared with other cities around the world? More importantly, we should ask if it is beneficial or harmful to strictly control the population of Beijing. Here we will conduct an in-depth analysis. Among the various data sources currently available, we find that Demographia's definition of urban aggregates is the most economically significant and internationally comparable. According to Demographia’s 2013 data, if calculated by population, Beijing’s urban agglomerations (referring to the population of urban areas with connected space, which excludes the population of outer suburbs) ranks 11th at 18.24 million, ranking after Tokyo, Jakarta, Seoul, Delhi, Shanghai, Manila, Karachi, New York, São Paulo, and Mexico City. If calculated by area, Beijing is ranked even lower. In terms of both the size of the population and the size of the city, Beijing is not even in the top ten. Beijing’s congestion ranks just moderate to light when compared with other major cities around the world. In other words, from a worldwide point of view, saying Beijing’s population is ‘too large’ is not a well-grounded statement. Many Chinese people feel that Beijing is crowded because most of their knowledge about the external world is of developed countries which are not crowded in general. Why are cities in developed countries typically not crowded? Cities are formed when people cluster together. On one hand, the concentration of people increases efficiency, but on the other hand, it represses. Therefore, the congestion of cities is the price paid for the improvement of efficiency brought about by people clustering together. When they have the same population size, the degree of congestion in different cities depends on the type of housing and transportation. Economically developed countries usually have more willingness and better conditions to improve their living and transportation standards, so that their lower density cities can also achieve high efficiency. In contrast, cities in poorer countries are generally more crowded, even if they have fewer people. The urban density of Chinese cities 30 years ago was much greater than it is now, even though the urban population was far less than it is now. Therefore, the real way to reduce urban congestion

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is to develop the economy and strengthen financial resources to improve living and transportation conditions.

3.

POLICY SUGGESTIONS

3.1

Do Everything Possible to Boost the Birth Rate

First, remove any and all birth restrictions and open up the family planning policies fully. The first step in promoting births is to remove any and all restrictions. This includes removing the requirement to apply for approval to have a child, removing the social compensation fee, and removing penalties such as firing staff that break the birth policy restrictions. Actually, in almost all countries with a low fertility rate, it is very common to see policies aimed at encouraging population growth, such as granting financial rewards and providing support for raising a child. Financial rewards are usually progressive, especially those which reward a couple with three or more children. Second, use economic means to encourage childbirth. China can learn from international examples. For example, a child born in France will be granted a bonus of €928 at birth, and a monthly subsidy of €185 and €65–231 between birth and three and three–20 years old respectively, as well as an additional monthly subsidy of €169. A child born in Germany is granted child benefits until he or she reaches the age of 18, and can apply for child benefits if he or she is not employed formally nor receiving education at school between the ages of 19–25. The amount of these benefits is adjusted for inflation. Currently, each of the first two children of a family can be subsidized with €184 per month, the third child with €190 per month, the fourth and each additional child €215 per month. What China can do now is to implement income tax reliefs and cash subsidies; both of which are of equal importance. For higher income families, income tax reliefs should be calculated based on the number of children; while for lower income families, a direct cash subsidy would be more beneficial. To boost the fertility rate and reduce financial pressure, these tax reliefs or cash subsidies can be awarded only for a family’s second child as the two-child policy is being put into practice. When the family planning policies are fully opened up, income tax reliefs or cash subsidies can be awarded then for the third and additional children. For each child under six, we suggest the government gives the family around CNY 10,000 per year, and the amount of the tax relief should be up to

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a maximum of CNY 100,000 a year per child. By doing so, the family’s burden to raise one or more children will be alleviated. Third, protect the equal rights of children born out of wedlock. As the level of education and career development improves for women, many working women are unwilling to marry or are unable to find a suitable partner, which has resulted in many countries’ marriage rates dropping year by year. Although the marriage rate in some northern European countries is lower than that in China, Japan, and other East Asian countries, given that 40–60 percent of their children are born out of wedlock, those countries’ birth rates are still higher than that of East Asian countries. Of course, we are not advocating out-of-wedlock birth, but women who are capable of and willing to raise a child on their own should receive the same rights and benefits as those who are married. Therefore, we suggest the removal of any laws or policies that discriminate against these women, and at the same time promote protecting the legal rights of children born out of wedlock.

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3.2

Develop Pre-school Education and Promote Educational Equity

First, construct a large number of nurseries, make preschool education free and compulsory and reduce the costs of raising a child. One of the major reasons younger people are reluctant to have a second child is the time and effort it takes to raise one; this is especially the case when the child enters nursery, kindergarten, and elementary school. There is a severe lack of nurseries for children under three. Figures from the National Health and Family Planning Commission show that just 4 percent of children from birth to three in China are enrolled in some form of nursery. We advise increasing this to around 50 percent, but to get there the government will need to either directly build or coordinate the building of around 100,000 nurseries. Research shows that pre-school education has a high rate of return. Because of this, we suggest that pre-school care should become part of free, mandatory education; i.e., the government should provide free nurseries and kindergartens so that if parents wish, they have somewhere to send their children. Second, remove the education restrictions for non-permanent residents, and solve the education problems for left-behind and foreign children. In a number of major Chinese cities, residents without permanent residency

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already account for a large proportion of the workforce. However, many cities still allocate education resources based on the permanent resident population. This creates a problem for non-permanent residents wanting to get their children into a nursery, kindergarten, or elementary school. As more and more people put greater importance on making money, more children are being left-behind in a family’s hometown while their parents head to the cities to find work. Although a large number of migrant workers both work and pay tax in major cities, their children do not enjoy the same educational benefits. This means many newly married young couples face the dilemma of either leaving the city, or sending their child back to where their residence permit is registered while they stay and work in the city. Many choose to either put off having a child, or decide not to have one altogether. Our suggestions are to remove the restrictions on education for the children of non-permanent residents and allow any Chinese child access to free education in any city. This will allow migrant workers to stay in the city and give their children access to convenient education in a nearby nursery, kindergarten or school. This is not only necessary for the development of the economy and society, but also an important step in boosting the birth rate. Third, reform the current college entrance exam system, and develop an autonomous enrollment system. The existing entrance exam system is not conducive to students from disadvantaged families since millions of students from the families of migrant workers have to attend entrance exams for senior high schools and colleges in their hometown where their residence permit is registered, thus creating China’s unique issue of left-behind children. The national unified entrance exam system has become the biggest barrier for the reform of the household registration system—the root cause for the growing gap between the rich and the poor, as well as urban and rural areas. The college entrance exam system can be retained, but schools need diversified admission criteria; the exams should just be one of the criteria. Schools should have some autonomy and have different criteria for enrolling students. For colleges and universities with poor management, the score on entrance exams can still be used as the single criterion to admit students. But for most well-regulated colleges and universities, a more flexible and autonomous enrollment system should be adopted to discourage students from studying just for the exams, giving students who are gifted and interested in a certain field the opportunity to develop fully. This can also gradually mitigate such

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problems as regional discrimination and urban–rural differences caused by the college entrance examination.

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3.3

Opinions on Population Problems in Large Cities

Attract talents, build innovation-oriented cities, and improve traffic and living conditions by developing the economy and expanding financial resources. More importantly, the difficulty for a family to get their child admitted into a nursery or school is prominent, and remains one of the reasons given for controlling the population in megacities like Beijing. However, it is actually the result of an inappropriate allocation of resources. As a large amount of schools were either closed or merged due to the declining number of children and lack of foresight in the past, it is now proving difficult to provide basic mandatory education to the increasing number of children. The planning and educational authorities should be blamed for this. If those neglecting their duties were held accountable, such issues might no longer be a problem. Even if its population stops growing, Beijing should establish a long-term plan to construct enough schools to accommodate 300,000 students for each grade. Beijing is now suffering from various serious urban issues, which, when compared with other cities around the world have been caused by improper planning and management rather than overpopulation, which is ultimately the effect of wrong concepts on population control. While population agglomeration will undoubtedly introduce all sorts of problems, it also creates opportunities and demands to help promote efficiency. Economic development is fundamentally driven by the full flow of human, financial, and material resources, among which human resources are most important. Strict control of the population size is disrupting this kind of flow, and goes against basic economic laws. Thus, it is not surprising to see that the population and municipal planning formulated based on such thinking are broken by economic reality, causing even greater urban issues. However, few people reflect on why the previous planning repeatedly failed and how to make a better plan. Instead, they treat population as a monster and ascribe all problems to the so-called out-of-control population, covering up the real crux and making no contribution towards—but rather putting obstacles in the way of—resolving these problems.

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4. CONCLUSION

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This chapter starts with the innovation theory, puts forward the necessity of constructing a new economic demographic paradigm, and analyzes the theory and facts in light of China’s situation. The main conclusions are as follows: 1. The population is an important factor constraining innovation. Its role is reflected in three aspects: first is the scale effect, a large population provides a greater market and talent pool for innovation; second is an agglomeration effect, where the gathering and mobility of high-quality talent is an important condition for innovation; and third is the age effect, a younger population has stronger entrepreneurial vigor and potential for technological innovation. 2. The current population problem in China is manifested in both quantitative and qualitative aspects. Quantitatively, we face a serious crisis of a low fertility rate, which is due to the high cost of raising children. It is necessary to adopt policies that encourage fertility, and improve social and public services through economic means. In terms of quality, it is manifested as the backwardness of rural education and the insufficiency of the college entrance exam system. China should focus on solving the education problems of left-behind children and children with no residence permit, reforming the unified enrollment system, and developing autonomous enrollment. 3. With respect to the problem of congestion in big cities such as Beijing and Shanghai, this is the price to be paid in the process of talent accumulation to promote innovation and development. To this end, the fundamental way out is to develop the economy, provide more employment opportunities, and improve transport and living conditions.

14. Evaluation of local leaders in China Chong-En Bai and Eric Maskin Properly evaluating a local leader is important not only to make sure he is the right person for a particular job, but to give him the right incentives to perform that job well. This note makes suggestions for redesigning the system of evaluation of local leaders in China. We will begin in section 1 by describing local government’s main achievements in China and also their biggest failures. In section 2, we outline the existing evaluation system for local leaders. We then turn in section 3 to some general principles for redesigning the evaluation system. Finally, in section 4, we make suggestions for specific features to include in the new evaluation system.

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1.

SUCCESSES AND FAILURES OF LOCAL GOVERNMENT

Local governments have played a critical role in China’s economic development. China is a large and diverse country, and local government has enabled national policies to adapt to local conditions, making them much more effective. Indeed, local initiatives and local experimentation have been important for the very formulation of national policy. Cross-regional policy variations have given enterprises the opportunity to find the environment that best fits their needs. Finally, encouraging competition between local governments has helped promote economic efficiency. Without these critical contributions of local government, the Chinese economy would not be what it is today. However, there are also some serious problems associated with local government. Local governments are eager to promote local investment and to protect the local tax basis. This fosters economic growth but implies that local firms get land and credit too cheaply. It also means that they face soft budget constraints (they are too difficult to shut down when 148

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they fail) and that they are unduly protected from outside competition. These effects have led to productive over-capacity in some sectors, especially in steel, aluminum, cement, construction glass, and solar panels. Local governments do not make sufficient efforts to improve the general business environment. The bureaucratic red tape for getting business licenses and getting business projects approved remains burdensome for many enterprises. Private property owners are often subject to infringement of their property rights. Some businesses face arbitrary levies by the government. Enterprises are treated highly unequally by local governments, and many worry that they will not get a fair judgment or enforcement of that judgment in disputes with other parties. The 2014 World Bank Doing Business Report ranks China only 96th out of 189 countries in the quality of its business environment. Local governments tend to be biased against consumer interests in favor of businesses. In particular, they often do a poor job of protecting the environment and ensuring food safety. Local government spending is often allocated unwisely. There is a good deal of waste, especially in carrying out showcase projects. There is also a severe corruption problem. All these phenomena have their origins in the existing incentive system for local leaders.

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2.

THE EXISTING INCENTIVE SYSTEM FOR LOCAL LEADERS

According to a leading hypothesis, local leaders in China are incentivized by participating in a GDP ‘tournament:’ a leader is promoted only if his region performs well economically relative to others.1 This theory explains some of the salient features of the Chinese economy mentioned in section 1, including strong economic growth, pollution,2 over-investment in industry and local protectionism,3 over-investment in housing,4 and high levies.5 There is also substantial empirical work supporting it.6 However, the theory cannot explain all the failures described in section 1. In particular, it does not predict that local government will treat enterprises unequally or that some government officials will act corruptly. Moreover, it is somewhat at odds with recent empirical studies that suggest that a local leader’s political connections may be more important for promotion than his region’s economic performance,7 or, at least, that economic performance matters a great deal only when a local official is politically well-connected.8

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Accordingly, a complementary theory—based on less formal incentives—has recently been developed to supplement the GDP tournament model.9 In this new theory, a local official will give certain enterprises special treatment (in particular, helping them to secure cheap land or credit) when (i) the businesses of those enterprises fit his personal taste well, or (ii) those enterprises are run by local elites or politically powerful individuals outside the region, or (iii) it is especially easy for him to siphon off resources from them for his pet projects or personal gain. Some of the evidence for this complementary theory includes findings that state-owned enterprises (SOEs) get cheaper credit; that private firms with better political connections get bank loans more easily than others;10 that local protectionism is more severe in sectors where SOEs enjoy a bigger share;11 and that only state-owned auto makers enjoy a home advantage in market share. Together, the two models of incentives account for all the successes and failures of local government depicted in section 1. They also suggest that to eliminate the failures, one must change the way that local leaders are evaluated.

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3.

PRINCIPLES FOR REDESIGNING THE EVALUATION SYSTEM

First, it is important that the powers and responsibilities of local leaders be clearly delineated. Such a delineation is a prerequisite for any reform of the evaluation system. It requires careful consideration of the boundaries between government and the market, between government and society, between different levels of government, and between different branches of government. A detailed discussion of the delineation, however, is beyond the scope of this chapter. It is heartening to note that efforts are made to publish the list of power and responsibilities of different branches of the government. Second, the performance evaluation should be as comprehensive as possible, including aspects such as the extent to which power has been abused and the extent to which responsibilities have been fulfilled. Moreover, because no list of aspects can ever be complete (and even if it were complete, the proper weighting for different aspects would remain ambiguous), there should also be an evaluation of overall performance (which strikes a balance between short-term and long-term considerations).

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Third, both subjective and objective evaluations are necessary. Subjective evaluation is required because objective measures of some aspects of performance are not readily available, and—as already mentioned—the right emphasis to give different aspects is unclear. Fourth, getting a range of informed people involved in making the subjective evaluations is important. In principle, different aspects of evaluation can be handled by different groups of people, but this may be administratively too complicated. It would probably be useful to experiment to see whether creating a single group for all aspects of evaluation or different groups for different aspects is more effective. Regardless of which approach is taken, the group of evaluators should be inclusive enough to be broadly representative of the population and big enough so that the group’s collective opinion cannot be easily manipulated. The group should also be independent of the leaders who are evaluated. In making this reform, one might start by giving the People’s Congress and the People’s Political Consultative Conference the power to evaluate performance of local leaders. The results of such evaluations could be used together with existing subjective evaluations. Fifth, subjective evaluators need better information about local leaders’ performance. They should also be allowed and encouraged to discuss such information among themselves. A first step in this direction would be to improve the transparency of the government budget. Another step would be to make the results of all objective evaluations known to the subjective evaluators. Again, this could start with the People’s Congress and the People’s Political Consultative Conference. Sixth, benchmarking across regions and across time should be considered. To understand why, note that there may be common factors affecting all regions simultaneously. These common factors are not the result of any local leader’s choices, and so no leader should be held accountable for them. Regional benchmarking is a way to ensure this, just as time benchmarking is a way to avoid making leaders responsible for time-persistent factors out of their control. Finally, one should pay particular attention to informal or hidden incentives that may limit the effectiveness of formal performance evaluation. If, for example, higher level officials interfere in local affairs, then holding local leaders accountable for outcomes is not likely to improve their performance. Similarly, allowing higher-level officials to reward or punish local leaders outside the explicit evaluation system will tend to make that system less effective.

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4.

SUGGESTIONS FOR SPECIFIC FEATURES OF PERFORMANCE EVALUATION

4.1

Objective Measures

(a)

Economic performance (i) Economic growth rate (Gross Regional Product and Gross Regional Income) (ii) Unemployment rate (iii) Total employment (iv) Fiscal deficit as a share of GRP (v) Balance of debt to GRP ratio

(b) Environment (i) (ii) (iii) (iv) (v) (vi) (vii)

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(c)

Energy consumption per unit of GDP Fulfillment of emission reduction target Air quality Water quality Soil quality Forest coverage Urban green area

Resident welfare (i) (ii) (iii) (iv) (v) (vi)

Household income growth Poverty rate Education expenditure as a share of local fiscal expenditure Public health expenditure as a share of local fiscal expenditure Infant mortality rate Public expenditure on housing as a share of local fiscal expenditure (vii) Ratio of rental rates to per capita income (viii) Social insurance coverage rate (ix) Social insurance fee collection rate

Evaluation of local leaders in China

4.2 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p) (q) (r) (s)

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Subjective Evaluation: Overall performance of the local leader Ability of the local leader Character of the local leader Diligence of the local leader State of the local economy Long-term health of the local economy Quality of the local business environment (it is important to get the opinion of the business community on this) State of local ecological environment Overall level of residents’ welfare Quality of education Quality of health services Quality of public transportation Quality of other public services Overall quality of regulations that safe-guard consumer benefits State of food safety Overall state of local cultural development Overall level of social harmony Overall quality of local governance Responsiveness by leadership to residents’ demands

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NOTES 1. 2. 3. 4. 5. 6.

An early theoretical analysis is offered by Maskin, Qian and Xu, ‘Incentives, Information, and Organizational Form,’ Review of Economic Studies, 2000. Jia, ‘Pollution for Promotion,’ UCSD Working Paper, 2014. Zhou, ‘Incentives and Collaboration in Promotion Games and a Discussion on Local Protectionism and Repetitive Investment,’ Economic Research, 2004. Gao, Long and Xu, ‘Collective Leadership, Career Concern, and the Housing Market in China: the Role of Standing Committees,’ World Bank Working Paper, 2014. Lu and Landry, ‘Show Me the Money: Interjurisdiction Political Competition and Fiscal Extraction in China,’ American Political Science Review, 2014. For example, Li and Zhou, ‘Political Turnover and Economic Performance: the Incentive Role of Personnel Control in China,’ Journal of Public Economics, 2005.

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For example, Shih, Adolph and Liu, ‘Getting Ahead in the Communist Party: Explaining the Advancement of Central Committee Members in China,’ American Political Science Review, 2012. 8. Jia, Kudamatsu and Seim, ‘Political Selection in China: the Complementary Roles of Connections and Performance,’ Journal of European Economic Association, 2014. 9. Bai, Hsieh and Song, ‘Special Deals with Chinese Characteristics,’ NBER Macroeconomics Annual, 34, 2019: 341–79. 10. Bai, Lu and Tao, ‘Property Rights Protection and Access to Bank Loans: Evidence from Private Enterprises in China,’ Economics of Transition, 2006. 11. Bai, Du, Tao and Tong, ‘Local Protectionism and Regional Specialization: Evidence from China’s Industries,’ Journal of International Economics, 2004.

Index

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absolute poverty 42 advanced technologies 18 advantage of backwardness 6 age effect 137–8, 147 agglomeration effect 136–7, 147 Ahmad, E. 1, 41, 45, 48, 49, 51 AI see artificial intelligence (AI) Alibaba 41, 42 artificial intelligence (AI) 2, 123 Asian education model 141 see also Western education model Auboin, M. 66 autonomous innovation 83–5 Bai, Chong-En 2 bailout of financial institutions 33–4 negative aspects of 36–8 positive effect of 35–6 Bannon, S. 86 Beijing 147 fertility rates 138 populations 142, 146 Belt and Road Initiative (BRI) 39, 45, 55, 56, 84, 122 Bending, Tessa 2 beneficial property tax 53 Bernanke, Ben 35 Bharatiya Janata Party (BJP) government 114–15 bilateral trade 94 birth rates 138, 144 BJP government see Bharatiya Janata Party (BJP) government Borino, F. 68 BRI see Belt and Road Initiative (BRI) BRT see bus rapid transport (BRT)

Brutscher, P. 2 budget constraints 46, 48, 49, 52 budget law, China 49, 50 bus rapid transport (BRT) 50 Bussière, M. 66 capital 11 carbon tax 52, 53 cash subsidies 143 CED see Comprehensive Economic Dialogue (CED) central tax 50–53 changing world order 104 Chen, Ping 2 child benefits 143 childbirth policy 143–4 China advanced technologies 18 autonomous innovation 83–5 childbirth policy 143–4 city development 43–5 and Covid-19 16, 18, 19 economic development 18 economic growth 1, 21 challenges 16–17 economic history 14 economic policy 23–5 economic system, characteristics of 83 education policy 144–6 external shock 31–2 family planning policies 143 financial crisis 32 fiscal policy 35 4 trillion stimulation package 34–5, 37–8 future prospects 18–19 GDP growth 6, 16–17, 31, 34, 36 industrial policies 83–5 155

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infrastructure 27 investment in common goods 27 key achievements 17–18, 27 local governments 148–9 modernization 88, 103 new development mode 102–8 policy interventions 33–5 population problems in big/large cities 142–3, 146 college entrance exams 141–2 low fertility rate 138–40, 147 quality and education issues 140–42, 147 rural and urban gap in education 140–41 private versus public sector 116 recent changes in 122 state-owned assets 106 trade agreements 18 two-child policy 138–9 versus the United States and Europe 14 see also India; United States (US) China’s economy 5, 14, 16–17, 31 failure of growth before 1978 7 growth after 1978 6–7 China’s success 10–11, 13 China–US economic relations 2, 70–72 CIT see corporate income tax (CIT) city development, China 43–5 cognitive skills 137 Cold War 107–8 college education 136 college entrance exams 141–2, 145 comparative advantage 7, 9–12, 105 comparative competitiveness 81 competition 104–6, 122 competitive advantages 12 competitiveness 127 Comprehensive Economic Dialogue (CED) 71 connectivity infrastructure 43

consultations 76–7 ‘consumption type’ VAT 46 cooperation and competition in international trade 104–6 coordinated policy response 134 corporate income tax (CIT) 46, 50, 55 corporatism 121 corruption 10, 11, 149 Covid-19 16, 18, 19 creativity 120 credit supply constraints 126 demographics 2, 136–8, 147 Deng Xiaoping 14, 116 developing countries 6, 8 development and growth 12–13 development 7, 8, 12–13, 103 digital economy 106–7, 123–4, 131 digital infrastructure 128–31 digitalisation 2, 127–34 regulatory environment 133–4 risk and investment 131–2 share of investment 132 skill constraints 130–31 disputes 69, 70, 74–6, 78, 87, 88 distortions 12 division of labor 93 constraints 101–2 persistent trade imbalance 94–6 domestic investment demand 66 domestic reform agenda 54 dual-track transition 10, 11 dynamic economic growth 9 dynamic innovation 43–5 e-Commerce 41 economic growth 6–7, 16 US, secular slowing down of 79–80 economic policy 72–4 China 23–5 US 72–4 economic reforms 14, 89 educational equity 144–6 education policy 144–6 education restrictions 144

157

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Index

rural and urban gap in 140–41 EIB Investment Survey (EIBIS) 126, 128, 130 endogenous crisis, US 31–2 entrepreneurship 122, 137 environmental concerns 27 Escaith, H. 65 ethnical conflicts 82 Europe budget 134 digital economy 131 digitalisation 127–34 Investment Plan for 134 productivity growth 127 slowdown 2, 126–7 European Investment Bank (EIB) 134 European policy 134 expansionary monetary policy 33–4 external shock, China 31–2

trade growth and 63–5 US 32, 35 WTO 65–6 GDP ‘tournament’ 149–50 global economic growth 81 global financial crisis 1, 22, 29–32, 38, 44, 80, 84, 106 global geography of trade 61–3 global governance reform 84–5 globalization future of changing 108–9 persistent trade imbalance in 99–101 Goods and Services Tax (GST) 115 Great Recession 126 greenhouse gas emissions 40 GST see Goods and Services Tax (GST) G20 summit 84 Guangdong 41

facilitating state 9, 10, 12 family planning policies 143 federal fund rate 29–31, 33, 34 Federal Reserve System 29, 30, 33–4 feedback mechanisms 48–50 fertility rates 138–40 fifth generation (5G) 18 financial institutions bailout of 33–4, 37 balance sheet of 36 financial power 95, 98 financial risk 45–8 fiscal appropriation 10 fiscal policy 35 fiscal risk 45 fiscal stimulus 22, 23 14th Five Year Plan 39, 54, 56 4 trillion stimulation package 34–5 negative aspects of 37–8 France, recent changes in 121–2 free trade 118

Haugh, D. 66 high-income countries 6 Hobbs, T. 97 Hoekman, B.M. 65 households deleverage 37

GDP growth 97 China 6, 16–17, 31, 32, 34, 36 industry ratio in 100 ratio 98, 99

identity politics 121 immigration 82 inclusive growth 54–5 income disparity see income inequality income inequality 1, 10, 11, 37, 82 income tax reliefs 143–4 India 2, 112 economic history 113–15 growth rate 114–16 investment 113 population 113 private versus public sector 115–17 India–China trade 2, 117–18 industrial modernization 102–4 industrial policies 83–5 industry agglomeration 136 industry ratio 100 inflation 31–4, 115

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information and communication technologies (ICT) 44, 127 skills 131 infrastructure 9, 27, 43 innovation 2, 41, 84–5, 121–3 and digitalization in the US and China 2 role of 120–21 theory 135–6 three demographic factors for 136–8 interest rate policy 34 international anti-trust law 105 international trade, cooperation and competition in 104–6 Internet markets 136 investment 113, 126–7 and consumption 65–7 gap 127 and innovation 43–5 in skilled labour 40 sustainable 43–5 Investment Plan for Europe 134 ‘investment-type’ VAT 46 Irwin, D.A. 64 Italy 44 IT technology 104 Japan’s industrial expansion 107 Jianzhang Liang 2 job reductions 42–3 ‘just transition’ 42–3 Koopman, R. 1, 65 Koo, R. 36 land sales 47 latecomer advantage 6 Lee Kwan Yew 116 Lew, J.J. 1, 21, 23, 24 LGFVs see local government financing vehicles (LGFVs) liabilities 48–50, 56 off-budget 44 and risks 49, 53 liberalization 12 Li, C. 45

life cycle of technology 104–6 Lighthizer, R. 77 Li Keqiang 85 Lin, Justin Yifu 1, 5, 14 Liu He 39, 43, 44, 46, 48, 76, 77 Liu, S. 45 local accountability 48–50 local governance 56 local government, successes and failures 148–9 local government financing vehicles (LGFVs) 52 local leaders evaluation system 2–3, 150–51 incentive system 149–50 performance evaluation 150–53 powers and responsibilities 150 local tax 47, 50–53 long-term interest rate 36–7 long-term structural problems 1, 30, 38 low fertility rate 138–9 low interest rate policy 30 Lu, Feng 2 macroeconomic policy 22–5 macroeconomics 61, 65, 67 Macron, E. 2, 121–2 ‘Made in China 2025’ 83, 85 Malthusian demographic theory 135–6 managing risk 45–53 Mao Zedong 7 market power 97 marriage rates 144 Marshall, A. 53 Maskin, E. 2 MBS see Mortgage-Backed Securities (MBS) metabolic growth 98, 101–2, 104 middle-income trap 17 military power 97, 98 mining enterprises 11 Miroudot, S. 65 mixed economies 103 Mnuchin, S. 76, 77 Modi, N. 115

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Index

Mortgage-Backed Securities (MBS) 29, 34 murky protectionism 1, 67 National Peoples’ Congress (NPC) 51 National Security State Report (2017) 72–3 Navarro, P. 86 Neuweg, I. 1 new demographic paradigm 135–6 New Development Bank 83 new economic thinking 104 new structural economics 13 Niu, M. 41 NPC see National Peoples’ Congress (NPC)

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objective evaluations 151 off-budget liabilities 44 off-budget transactions 49 Panagariya, A. 2, 17 paradigm shift in modernization 102–4 changing world order 104 historical lessons for 107–8 digital economy, opportunity and risk 106–7 new economic thinking 104 Paris accord 27 Park Chung-hee 116 persistent trade imbalance 94–6 possible factors of 99–101 personal income tax (PIT) 51 PFM see public financial management (PFM) PIT see personal income tax (PIT) ‘the plan of 100 days’ 71 policy responses 30, 34, 35, 38, 134 poll tax 57 population 2, 136–8, 147 innovation 135–8 problem in China in big/large cities 142–3, 146 college entrance exam system 141–2

low fertility rate 138–40, 147 quality and education issues 140–42, 147 rural and urban gap in education 140–41 poverty 12, 42 power and ‘Wealth of Nations’ 97–9 PPPs see public–private partnerships (PPPs) pragmatism 12 pre-school education 144–6 private versus public sector, India 115–17 privatization 8–9 productivity growth 121, 127 slowdown 2, 125–7 property rights protection 25 property tax 52–3 protectionism, US policy of 2, 104, 108, 117–18 public financial management (PFM) 47–8 public–private partnerships (PPPs) 45, 46, 49, 56 quantitative easying (QE), US 29, 33–7 Rao, N. 114 RBM stimulation package 34–5, 37–8 RCEP see Regional Cooperation for Economic Partnership (RCEP) R&D 104–5 recovery of GDP growth 36 REC scheme see Renewable Energy Certificate (REC) scheme recurrent tax on property 52, 55–6 regional benchmarking 151 Regional Cooperation for Economic Partnership (RCEP) 118 regulatory environment 133–4 renewable energy 41 Renewable Energy Certificate (REC) scheme 41

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reorientation of the US policies towards China 72–4 Revoltella, D. 2 rights protection of children 144 risk management 45–53 role of innovation 120–21 role of the state in economic growth 1 Romer, P. innovation and economic growth model 135–6 theory of endogenous growth 98 Ross, W. 77, 78 rule of law 25–6 rural education 140–41 SAT see State Administration of Taxation (SAT) saving ratio 100 scale economy 103 scale effect 136, 147 Schumpeter’s theory 137 scientific innovation 84 scope economy 103 SDR see special drawing right (SDR) SEZs see special economic zones (SEZs) Shanghai 147 fertility rates 138 shared revenues 46–7 skill constraints 130–31 slow trade growth 64, 65, 67 Smith Theorem 93–4 ‘Wealth of Nations’ 93–4 constraints to limit division of labor 101–2 persistent trade imbalance 94–6, 99–101 power and 97–9 SOEs see state-owned enterprises (SOEs) Solow’s theory of exogenous growth 98 Song, F. 1 Soviet’s Sputnik 107 Spain 44 special deals 150 special drawing right (SDR) 84

special economic zones (SEZs) 9, 45, 47 stability 9 State Administration of Taxation (SAT) 45–6, 55 state-owned enterprises (SOEs) 10, 11, 37, 38, 116, 122, 150 Stern, N. 1 Stigler, G. 93 stimulations negative aspects of 36–8 positive effect of 35–6 structural recession 82 structural reforms 39, 54 subjective evaluations 151, 153 see also objective evaluations sub-prime lending crisis 33, 34 Summers, L. 107 supply curve 93 sustainable growth 40–42, 54–5 recent developments and preconditions 45–8 sustainable investment 43–5 sustainable urban transition strategy 46, 50 Svejnar, J. 1 tariff policy 70, 74–5, 78, 88 tax policies, US 22 tax reforms 47–8, 54 technological innovations 6 technology 18, 23, 97 competition 101 development 25 innovation 6, 84, 137, 138 life cycle of 104–6 13th Five Year Plan (2016–2020) 42 Timmer M.P. 66 Toffler A. 107 too-big-to-fail 33, 36 total factor productivity growth 121 trade 117–18 agreements 18, 60, 61, 64 deficits 94–6, 100–101 elasticity 63–4, 67 global geography of 61–3 US–China see US–China trade

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Index

trade growth 1, 60, 67 drivers for 65–6 and GDP growth 63–5 trade policy 60, 66 US 72–4 trade tensions 2 US and China 67 trade war 69, 70, 93, 109 Trump, Donald 93, 99, 106 traditional interest rate policy 34 transition 8–10, 12–13 Trump, Donald 2, 22, 69, 70, 76–8, 101, 109, 122 China–US trade and economic policies towards China 70–72 and economic relations 70–72 election campaign in 2016 86, 87 hard-line policy towards China 86–7 mid-term elections in 2018 87 policy preferences of key members of 85–6 politics of 121 tariff policy 70, 74–5, 78 tax reform plan 74 trade war 93, 99, 106 two-child policy 138–9 2017 Trade Policy Agenda and 2016 Annual Report 71 UK GDP ratio 99 poll tax 57 property tax 52–3 trade deficits 95, 99 under-investment 127 unemployment 123 United Progressive Alliance (UPA) government 114–16 United States (US) bailout of financial institutions 33–5, 37 economic policy 22–3 economy 30–31 endogenous crisis 31–2

161

financial crisis 31–3 GDP growth 32, 35 GDP ratio 99 housing price in 31 income inequality 82 investment in common goods 26–7 leadership challenges 107–8 long-term interest rate 36–7 negative aspects of bailout 36–7 policies towards China, reorientation 72–4 policy interventions 33–5 protectionism policy 2, 104, 108, 117–18 quantitative easying (QE) 29, 33–7 recent changes in 121 rule of law 25–6 secular slowing down of economic growth 79–80 sub-prime lending crisis 33 tariff policy 88 trade deficits 95, 99 United States Trade Representative (USTR) 71, 74, 75, 78, 89 UPA government see United Progressive Alliance (UPA) government urban density 142 Urban Development Investment Corporations (UDICs) 45, 48 urban education 140–41 US–China competition and cooperation 1 US–China economic disputes 74–5 US–China relationship 24, 27 US–China trade 70–72 consultation on disputed issues 76–7 on trade issues, joint statement 77, 78 disputes and conflicts 74–5, 78–9, 88 and economic relationship 72–4 imbalance 88 policy 72–4

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US–China trade war 69, 70, 93, 99, 106, 109, 118 US policy shift 2, 83–5 Chinese economic system, characteristics of 83 Chinese policies and 83–5 comparative competitiveness 81 influence of short-term political factors 86–7 policy preferences of members of Trump administration 85–7 slowing down of economic growth 79–80 structural recession 82 USTR see United States Trade Representative (USTR) Vajpayee, A.B. 114 VAT 46, 50–51, 55

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Washington Consensus 8 weak currency 23 weak demand 126 weak investment 126

‘Wealth of Nations’, Adam Smith 93–4 constraints to limit division of labor 101–2 persistent trade imbalance 94–6 power and 97–9 Wei, Shang-Jin 65 Wei, Zhi 65 Western Development Strategy 44, 45 Western education model 141 World Trade Organization (WTO) 60–61, 73, 75 GDP growth 65–6 trade elasticity 63–4 Xiao, K. 41, 47 Xie, Chunping 1 Xi Jinping 2, 11, 71, 75, 77, 122 Yuan, X. 49 Zhang, X. 49 zombie companies 38 ZTE Corporation 75