Tradable Prosperity

Michael Spence

17 July 2012

MILANThe global economy is experiencing a major growth challenge. Many advanced countries are attempting to revive sustainable growth in the face of a decelerating global economy. But the challenges across countries are not the same. In particular, the tradable and non-tradable parts of a range of economies differ in important ways.

In the non-tradable sector (60-70% of the economy in advanced countries), the main growth inhibitors are weak demand, as in the United States following the financial crisis, and structural and competitive impediments to productivity, as in Japan. In the tradable sector, growth depends on a country’s productivity relative to incomes and competitiveness. At the global level, there can also be a shortage of aggregate demand on the tradable side.

The Nobel laureate economist Robert Solow has shown that growth comes from three sources: the working population, capital investment, and technological progress. A growing young population helps to maintain fiscal balance and ensure intergenerational equity, but it does not by itself increase incomes. On the other hand, economic growth below the sum of growth in the working population and the labor-saving part of technological change fuels unemployment.

Developing countries, once they enter rapid-growth mode, generate growth from capital deepening via investment, in a sense making up for past underinvestment. And it is possible for advanced countries to fall behind by under-investing, particularly in the public sector, relying instead on less sustainable debt-fueled means of generating demand. So a legitimate part of a strategy to restore growth is investment.

But, as Solow noted, investment has its limits, owing to diminishing marginal returns. Often, these limits are not binding, but, once capital deepening is exhausted, technological progress, which makes inputs more productive in creating final value, is the long-run driver of growth.

The challenge is to apply these insights in a world characterized by global economic interdependence, major imbalances, and a worsening growth and employment problem. It is a world in which economies are connected directly in the tradable sector of the global economy, and indirectly through the demand and employment linkages between the tradable and non-tradable sectors of individual economies.

In the short run, the non-tradable sector is, by definition, subject to domestic-demand constraints. A shortfall in non-tradable demand inevitably limits growth on that side of the economy.

Government can, of course, bridge the gap via deficit spending (preferably focused on employment-generating investment that enhances future growth). But the advanced countries are, to varying degrees, fiscally constrained by relatively high and rising public debt, largely owing to fiscal imbalances that were hidden from view until defective growth models broke down in the crisis of 2008.

.Just how fiscally constrained these countries are remains subject to debate. Italy and Spain are clearly constrained by the absence of private capital in their respective sovereign-debt markets, with rising yields threatening their fiscal stability and reform programs. They need the eurozone core and the International Monetary Fund as temporary lenders of last resort until they restore policy credibility and regain investors’ confidence.

The US sovereign-debt market shows no similar evidence of having reached a limit yet. But bond markets do not issue many early warning signals: witness the sudden run-up of yields in Italy and Spain a year ago.

The more complex growth issues have to do with the tradable part of the global economy, where global aggregate demand – and the derived demand that lands in various places in global supply or value-added chains – is the target of competition. Total demand and its growth do matter, but so does market share. Given the growth patterns across advanced and developing countries prior to the crisis, and then the large negative shock, it is likely that there is a shortfall of tradable global aggregate demand, impeding an important component of global growth.

But, for individual economies, relative productivity versus income levels determines the share of global tradable aggregate demand that is accessible. Unlike the non-tradable side of the economy, the domestic component of global tradable demand is not an absolute constraint on growth; nor is the rate of growth of global tradable demand an absolute constraint, given the possibility of increasing share.

.Of course, not everyone can gain share at the same time. Fortunately, if countries increase productivity with the aim of boosting relative productivity and growth potential on the tradable side, this will increase incomes and accelerate the growth of global aggregate demand. It may look like a zero-sum game, but it is not.

When incomes get significantly out of line with productivity levels (as they have recently), reviving growth requires resetting the terms of trade, which can be done with exchange rates, whether managed or set by markets. In the eurozone, where countries with competitiveness problems do not have the exchange-rate adjustment mechanism, restrained income growth and productivity-boosting reforms are probably needed, as was the case in Germany between 2000 and 2006, and now in several southern European countries.

What is true for countries on the tradable side is also true for workers, who are differentially affected by the evolution of global supply chains. The efficient integration of global supply chains has created employment opportunities in developing countries and in the higher value-added sectors of advanced countries. But it has also reduced employment options for a subset of middle-income people in the tradable sectors of advanced economies.

Many countries are struggling to adapt their growth patterns to the new challenges they face in a slowing global economy. To be effective and properly targeted, policies need to include an accurate diagnosis of growth potential and impediments in both the tradable and non-tradable parts of the economy. Focusing on one (say, the competitiveness problem in the tradable sector) to the exclusion of the other (perhaps a serious non-tradable demand shortfall or stagnant absolute productivity) will not be enough.

Michael Spence, a Nobel laureate in economics, is currently Chairman of the Commission on Growth and Development, an international body charged with charting opportunities for global economic growth. He is also Professor of Economics at NYU’s Stern School of Business, Distinguished Visiting Fellow at the Council on Foreign Relations, Senior Fellow at the Hoover Institution at Stanford University, and Academic Board Chairman of the Fung Global Institute in Hong Kong. He was previously Dean of Stanford’s School of Business and Professor of Economics at Harvard University.

July 16, 2012 7:32 pm

China: The road to nowhere

Jiaozhou Bay Bridge in Qingdao, east China©AP
Up in the air: with a span of more than 42km, the bridge at the eastern city of Qingdao is an engineering marvel – but it has yet to meet usage targets, and stands as a symbol of high investment levels some say are blighting China’s economy

For China, a country with monstrous traffic jams, the world’s longest sea bridge is a success on at least one front: it has no delays. The problem is that it also has few cars.

The bridge, which opened a year ago in the eastern port city of Qingdao, traces a wide arc across a bay, from the bustling core to farm fields far from the offices and homes it is supposed to serve. Six lanes wide and 42.5km long, enough to span the English Channel with room to spare, it raises an unsettling economic question: has China, in spectacular fashion, reached its “bridge to nowheremoment?

Click to enlarge
That the world’s second-largest economy could be wasting money on unproductive investment is a controversial claim. Many officials and investors are convinced the country needs to add significantly to its capital stockroads, airports, factories and apartment blocks – for years to come in order to catch up with more developed economies.

This sanguine view is now being put to the test. The concern is not that China has run out of good investments to make, but rather that it has already made too many bad ones, especially in the property sector, and must pay the price in the form of a sharp economic slowdown.

“It’s actually possible to get ahead of yourself and overinvest along the way. Investment has now been more than 40 per cent of gross domestic product for nine continuous years, and no other country has ever done that,” says Nick Lardy of the Peterson Institute for International Economics in Washington. “Unwinding the whole thing becomes very difficult.”

The government has been trying to do just that – to unwind the excesses of the past decade by reining in the pace of investment. The results of its efforts were seen on Friday when it announced that economic growth in the first half slowed to 7.6 per cent, the weakest since early 2009. Domestic policy was the biggest drag. Construction activity has suffered as Beijing has put the brakes on runaway property investment.

This, many analysts believe, is a good thing. For a fragile world economy, tepid Chinese growth might seem unwelcome but the alternative scenario is more frightening. If Beijing does not induce a mild downturn now, the prospect of a big collapse as bad investments pile up would loom ever larger in a few years.

“We are at a critical stage. We need to balance short-term growth and long-term growth. That is, we can’t only worry about the short-term slowdown,” says Peng Wensheng, chief economist at China International Capital Corp, an investment bank.


Yet even with such a mild dip7.6 per cent growth is, after all, faster than every other leading economypain is spreading throughout China. Construction companies have piled up losses, the stock market is swooning and many local governments, which rely on land sales for revenue, are running low on cash. Howls of objection have come from property developers and local officials.

Beijing has so far kept its nerve. Wen Jiabao, the prime minister due to step down this year, first said in 2007 that the economy was on an “un­steady, unbalanced, uncoordinated and unsustainablepath, though he then did little about it. The Rmb4tn ($627bn) stimulus programme of State media today vow that there will be no relapse. “The old way will not be repeated,” the Xinhua news agency said in an editorial in May.

There are limits to this toughness, however. Senior leaders do not want to see an abrupt downturn that leads to unemployment and, potentially, unrest. They are particularly determined this year, when a once in-a-decade leadership transition occurs, to minimise any trouble.

So in the past two months, amid signs of economic weakness, Beijing has cautiously shifted to a pro-growth position. It has cut interest rates twice, encouraged banks to lend more, especially to small businesses, and introduced subsidies to induce consumers to spend.

Analysts say this shift must be handled with the utmost delicacy. If the government stimulates too much, investment will again take off, saddle the country with yet more empty apartment blocks, deserted industrial parks and bridges to nowhere. This year’s recovery would come at the cost of serious trouble down the road.

“The worst scenario would be to ease monetary policy and at the same time to relax control measures on the property sector,” says Mr Peng. “If the easing is not carefully managed, we run the risk of making the economy more unbalanced.”

Zhuhai, which lies next to Macau in the south, is the latest city to try to force an end to the crackdown on the property sector. At the weekend, word leaked that it would relax the toughest of the government’s measures to cool the market – a ban on buying more than one home. Like other cities that tried similar tactics, Zhuhai was quickly slapped down by central authorities. It dropped its plan.

But while the leadership has surprised many with its determination to keep a lid on the property sector, there is good reason to believe it has not kicked its addiction to investment. This was reflected in comments last week by Mr Wen that could prove momentous. Expressing his concern about the slowdown, he ordered the government to focus on supporting the economy in the second half of the year. “Policies to stabilise growth include promoting consumption and diversifying exports, but currently the main task is to promote reasonable investment growth,” he said.

These words were an important signal that Beijing was ready to fire up the investment engine once more, to approve large-scale capital expenditure, especially on infrastructure, and to use state-owned banks to provide the financing. Mr Wen insisted the government would stand firm on its property controls. Short of that, though, anything of “quality and efficiency, which makes people’s lives better” would be encouraged.

The government has consistently talked about its objective of reining in investment and encouraging consumption to make growth more sustainable. In practice, though, investment grew from about 32 per cent of GDP in 1990 to about 49 per cent last year, a record high. In the 1970s, during its high-growth era, Japan barely hit 40 per cent.

“It just so happens that every time there is a need for stimulus, the most common channels are still investment oriented,” says Louis Kuijs, formerly a World Bank economist in Beijing, now based at the Fung Global Institute, a Hong-Kong-based think-tank. “These patterns have a momentum and only with very bold reform measures would we expect to see this pattern shifting substantially. We have seen some reform measures, but not truly very major ones.”

. . .

It remains clear, from one perspective, that China still needs more investment. Its capital stock per worker is just 8 per cent that of the US, giving it plenty of room to invest more, according to HSBC, the UK bank. This is obvious to anyone who has been to its sprawling cities from Shenyang in the north to Guangzhou in the south, which have clogged roads and little in the way of underground train lines.

But the rush to catch up has been unseemly. Although its capital stock should be expected to converge with that of more developed economies, this should happen over many decades, not overnight, Mr Lardy says. Nearly two-thirds of capital stock has been created since 2003. Simply put, China has built too much, too quickly.

Back in Qingdao, officials privately admit the world’s longest bridge was a mistake. The idea of a local Communist party chief, since sacked for corruption, it serves a suburban district that is also connected to the city centre by an undersea tunnel, several ferry routes and a highway that runs along the water’s edge. Though it was designed to carry 30,000 vehicles a day, an executive in a government-backed construction company says it is registering just 10,000.

More positively, some senior officials are now prepared to speak out about the issue – in public. Guo Shuqing, China’s chief securities regulator, seen as one of the most reform-minded officials, laid out the country’s problems in stark terms in a speech at a financial conference last month. “Infrastructure used to be our bottleneck, but now we are already beginning to see partial overcapacity, some roads and rail lines that are idle,” he said.

The waste has been more severe in the property sector, where construction has been speedy but shoddy, even in the richest coastal regions. Homes have to be rebuilt on average every six or seven years,” Mr Guo said.

He is not alone. An increasingly common refrain among senior policy makers this year has been the need to change the foundations of the growth model. “Reform should be implemented unswervingly or there will only be a dead end,” Mr Wen said in February.

His words have been followed by an array of reforms in the past few months, part of a multi-pronged attempt to steer China away from its over-reliance on investment.

Cheap capital has been a leading cause of excessive investment, and the central bank has started to correct this by increasing the influence of market forces on interest rates and the exchange rate. At the same time, seeking to direct financing to more productive uses, regulators have ordered banks to lend more to smaller businesses and less to state-owned enterprises. There has also been progress in changing the fiscal system to make local governments less dependent on land sales and hence less gung ho about new investment projects.

. . .

That the reforms are being pushed through just months before Xi Jinping is expected to be installed as president is a strong indication that the next generation of leaders backs the changes.

Yet they are so far best characterised as a series of small steps, not a thoroughgoing overhaul. Both the current leaders and their successors are wary of doing anything too radicalunless it is absolutely certain that the system is broken, why fix it?

People are betting on the incoming leadership taking up the reform challenge. But that’s far from guaranteed. As an economy matures, it becomes harder to reform,” says Ben Simpfendorfer, founder of Silk Road Associates, a Hong Kong-based consultancy.

One adviser to the cabinet says there has been significant progress on at least one front. Five years ago, it was hard to persuade officials that overinvestment was a concern. “Now they all agree. Implementing the necessary reforms is a different issue, though,” says the adviser, speaking on condition of anonymity.

As the economy slows and Mr Wen talks more about the need for investment than structural reform, China is at risk of once again going down the same old road – the one he called a dead end just a few months ago.

The temptation to keep the economy racing along in the short term, heedless of longer-term pitfalls, is hard to resist.

Financial system: A boom driven by distortions

Severe distortions in China’s financial system are seen by many analysts as the biggest single factor behind the country’s runaway investment boom.

Large corporations and state-backed entities are able to borrow money from banks at artificially cheap levels, fuelling reckless spending decisions. Meanwhile smaller businesses – the lifeblood of the economy, generating about 80 per cent of jobs – are seen as risky borrowers since they lack government backing and so have little access to the state-run financial system.

Money flows to the state-owned enterprises in the end and they can use this to get into real estate or to provide financing for others, so asset bubbles get more and more serious,” says Zhang Jun of Shanghai’s Fudan University.

The government has ordered state-owned companies to stop investing in real estate if it is not one of their core businesses in a bid to halt a development that officials feared was driving up property prices and increasing balance sheet risks. But many companies ignored this edict and continued to pile into property until the market soured last year. For example, COFCO, the country’s top grain trader, is also one of its biggest shopping mall developers.

“Our major concern is making a profit, not quitting the housing market,” an unnamed official at a state-owned firm was quoted as saying by China Business News, a local paper.

Ordinary people subsidise such largesse by stuffing their savings into bank accounts with exceptionally low interest rates. Deposit rates in real terms have averaged 1.5 per cent since 2004, despite the economy growing 10 per cent a year.

Chinese people have few other choices for their money. The country’s stock market is riddled with insider trading and rotten corporate governance; it is extremely difficult for individuals to invest abroad; and the mutual fund and insurance industries remain under-developed.

Outside of banks, savers have one other viable investment option: property. A study by China’s Southwest University of Finance and Economics recently found that city dwellers owned on average 1.2 homes.

With many in the middle class struggling to get a foot on the property ladder, the implication is that wealthier citizens often own multiple homes and do not mind allowing them to sit empty in the expectation that they will appreciate.

“It’s very common for officials with power and with money to have four or five homes,” Zhang Zulin, the mayor of Kunming, a southwestern city, said in a speech last month.

Copyright The Financial Times Limited 2012.




Updated July 16, 2012, 7:34 p.m. ET

The Incredible Bain Jobs Machine

In a competitive economy, $5,000 computers become $500 tablets. Consumers get to spend the difference elsewhere in the economy.


Since 1986, Staples has opened 2,000 stores, eliminating the jobs of distributors and brokers who charged nasty markups for paper and office supplies. But it enabled hundreds of thousands of small (and not so small) businesses to stock themselves cheaply and conveniently and expand their operations.

It's the same story elsewhere. Apple employs just 47,000 people, and Google under 25,000. Like Staples, they have destroyed many old jobs, like making paper maps and pink "While You Were Out" notepads. But by lowering the cost of doing business they've enabled innumerable entrepreneurs to start new businesses and employ hundreds of thousands, even millions, of workers world-wideall while capital gets redeployed more effectively.

This process happens during every business cycle and always, always creates jobs. Yet is ignored by policy mavens.

It is now four years after the wheels fell off our financial system. The government has tried every gimmick to revive the economy: fiscal stimulus, monetary easing, loan write-downs, foreclosure modificationsall duds. It seems like no one remembers how an economy creates jobs anymore. The right answer, in fact the only answer, for jobs and better living standards, is productivity.

Economists define productivity as output per worker hour. But ramping up the output of trolleys or 8-track tapes won't increase living standards. It is not just technical efficiency that matters, it is also effectiveness—that is, producing what the economy really needs and consumers will pay for.

And so, in a broader sense, productivity is really about doing the right things the right way. Using modern construction equipment, we could build a pyramid on the National Mall in Washington with amazing efficiency, but it would not be effective.

So how does productivity result in more employment?

Three ways. First, some new technology comes along that allows something never before possible. Cash from an ATM, stock trading from an airplane's aisle seat, ads next to Google search results.

The inventor or entrepreneur who uses the invention benefits from sales and wealth and hires people to produce the good or service. We don't hear about this. Instead we hear about the layoffs of bank tellers, stockbrokers and media salesmen. So productivity becomes the boogeyman for job losses. And many economic cranks would prefer that we just hire back the tellers and toll collectors.

This is a big mistake because new, cheaper technology becomes a platform for others to create or expand businesses that never before made economic sense. Adobe software killed typesetters, but allowed millions cheaply to get into the publishing business.

Millions of individuals and micro-size businesses now reach a national, not just local, retail market thanks to eBay. Amazon allows thousands upon thousands of new vendors to thrive and hire.

Consider Uber, a 20-month-old start-up, whose smartphone app knows where you are and with a simple click arranges a private car pickup to take you where you want. It doesn't exist without iPhones or Androids. Taxi and limousine dispatchers lose. Customers win. We'll all be surprised by new tablet applications being dreamed up in garages and basements everywhere.

The third way productivity results in more employment is by attracting capital to satisfy new consumer demands. In a competitive economy, productivitydoing more with lessalways lowers the cost of products or services: $5,000 computers become $500 tablets.

Consumers get to spend the difference elsewhere in the economy, and entrepreneurs will be happy to sell them what they want or create new things they never heard of, but will want. And those with capital will be eager to fund these entrepreneurs. Win, win.

The mechanism to decide the most effective use for this capital is profits. The stock market bundles profits and is the divining rod of productivity, allocating capital in cycle after cycle toward the economy's most productive companies and best-compensated jobs. And it does so better than any elite economist or politician picking pork-barrel projects and relabeling them as "investments."

The productive use of capital is not an automatic process, of course. It is all about constant experimentation. And it is never permanent: Railroads were once tremendously productive, so were steamships and even Kodachrome. It takes work, year in and year outupdate, test, tweak, kill off.

Staples is under fire from Amazon and other productive online retailers. Its stock has halved since its 2010 peak and is almost at a 10-year low. So be it.

With all the iPads and Facebook and cloud-computing growth, why is unemployment still 8.2% and job creation stalled? My theory is that productivity is always happening but swims upstream against those that fight it. Unions, regulations and a bizarre tax code that locks in the status quo.

In good times, no one notices. But in slow-growth economies, especially in the last 10 years, regulations and hiring rules and employer mandates and environmental anchors have had a cumulative dampening effect on productivity.

How can government do the right thing to help productivity and the employment it fosters? Get out of the way. Every government-mandated low-flow toilet, phosphorous-free dishwasher detergent, CFL light bulb, and carbon-emission regulation is another obstacle on the way to a productive, job-creating economy that produces things consumers really want.

Mr. Kessler, a former hedge-fund manager, is the author most recently of "Eat People" (Portfolio, 2011).

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