China's Long Term Economic Prospects
by Paul D. Deng

China's thirty-year economic reform has been a great success.  Except for the incident in 1989 and “great inflation” in the 1990's, China's path to economic revival has been quite smooth. The Chinese economy measured by GDP just surpassed Germany and is ranked No. 3 in the world; If measured by real purchasing power, China's GDP is even larger than Japan, only second to the United States.

Economic pundits predict that if the current high growth rate is maintained, China's GDP could surpass the U.S. by 2030.  By then, China's income per capita would be a quarter as large as the U.S., assuming the ratio between these two countries' population is largely unchanged, which is about 4:1 now.

Given China's huge population, the catch-up in total GDP seems to be plausible.  And I believe China will develop into a first-world power during the process.  However, the long-term growth prospects concerning whether China can catch up with the US in living standards (a.k.a. GDP per capita) is much uncertain.

"China faces several obstacles
in its long-term economic development."

China faces several obstacles in its long-term economic development.

First, China still hasn't resolved the fundamental issue of property rights.  In the former socialist economy, assets were all owned by the state.  Economic reform has brought a lot of state-owned assets into private hands, and the influence of state in the economy has waned gradually over the years.  Still, there are many places in which property rights are not clearly defined and the government holds a grabbing hand over the economy.  One such area is agricultural land.  Who owns the land?  Who determines the use of the land?  In cases where the farmers’ lands are taken away for real estate development or for infrastructure construction, should farmers be compensated?  And who determines the amount of compensation and how it should be calculated?  

These are the questions arising from an institutional environment of unclearly defined property rights and they hinder people's incentives to work harder and dampen entrepreneurial spirit.  For example, seeing that their land can be easily taken away, farmers will not have incentives to invest in new farming technology or to improve the land's fertility.  As a result, China's agricultural output will remain stagnant and face a greater risk of food self-insufficiency.  The same analysis applies to other parts of the economy, one being contract enforcement.

Second, related to my first concern, the government's big role in the economy gives justification for its authoritarian rule.  The nature of authoritarian rule subdues democratic values, which are essential for an innovation-based economy.  The biggest advantage that the U.S. economy enjoys over all other economies is its entrepreneur-based, highly innovative economy.  Not coincidently, the U.S. government largely maintains a hands-off approach (or more so than other developed countries) toward the economy and basic democratic values, such as freedom of speech, whish is preciously protected. That's why you don't see many Bill Gates in other countries, do you?  In my view, the foundation of such an economy is freedom of speech: individuals have the freedom to express their ideas, to challenge conventional wisdom and they do so without the government getting in their way.  The free flow of ideas and knowledge is the ultimate driver of a country's long-term growth.

"The free flow of ideas and
knowledge is the ultimate driver of a
country's long-term growth."

China may easily accomplish its industrialization process, but without the free flow of ideas and without laying the foundation for an innovative economy, China may never catch up with the U.S. in living standards.

Paul D. Deng
Department of Economics
Brandeis University
www.pauldeng.com

Rising Oil and Food Prices:  Implications for the World
by Paul D. Deng

Crude oil just passed $120 a barrel this week, the highest level in history, after adjustment for inflation.  Food prices are also surging and its ripple effects are being felt worldwide:  riots broke out in countries like Pakistan, Egypt and Haiti; the IMF and World Bank issued a stern warning that rising food prices may cause hunger and famines in the least developed countries.  So what's going on?  Are we back in 70's?

There are many explanations for the current mess.  Here I want to focus on the two most popular and competing theories.  

First is the surging demand by the populous and fast growing countries: China and India.  People subscribing to this theory often cite the double digit growth rate of these two countries in the recent decade.  If you link this spectacular growth of their huge populations–China over 1.3 billion and India 1.1 billion–the math is easy.  With China and India being integrated into the world economy, more people are grabbing for limited resources, so rising prices are a natural result.  Adding to the problem is the inefficient use of energy and many other resources in the two economies.  So essentially we are seeing a large chunk of natural resources being allocated to these fast growing economies, and at the same time these resources are not being used most efficiently.  This theory is credible and makes a lot of sense.  But my problem with it is that it fails to explain why we had a sudden surge in oil and food prices since last summer.  In fact, China has been growing at an average rate of 8% since the late 70's.  The growth of China was briefly interrupted in 1989, but soon resumed its double-digit growth pattern afterwards.  India started its fast growth about 15 years later, in the mid 1990's.  However, in both cases, it is indisputable that the fast growth of both countries is not a recent phenomenon.

This leads us to the second theory for the current mess:  policies in the United States.  There are two aspects to this story.  

First is the fast depreciation of US dollar and second is Bush's energy policy of converting corn for ethanol.  The US dollar started to depreciate in 2002.  But since last August, the depreciation has sped up because of large interest rate cuts from the Federal Reserve in combating the meltdown in both the housing and financial sectors.  The fast depreciation of the dollar has had a huge impact on world commodity prices.  

"The fast depreciation
of the dollar has had a huge impact on
world commodity prices."

This is because the US dollar is the world dominant currency and almost all commodities are invoiced in US dollars.  If the US dollar goes down, the commodity prices will go up.

Secondly, Bush's Energy Policy Act in 2005 played a big role in our mess today.  Bush's policy basically gave a go-order to convert corn to ethanol, the alternative energy that's supposed to ease our pain from the soaring energy price.  In reality, what we got is the classic example of poorly designed policy with unintended consequences.  Corn itself is food.  Imagine what will happen to corn prices when you pull out a large chunk of the supply from the world market.  You may ask, why have prices of all food gone up, not just the price of corn?  This is because when farmers in the U.S. and in other countries see huge opportunities in growing corn, they will substitute corn for other crops, as growing corn is more profitable.  More troubling is that corn is widely used for many other purposes, such as feeding cattle.  As a result, meat prices also went up.  In short, converting food for energy use is just stupid!  Shall I remind you that there are still 1 billion people living under $2 per day? No wonder a series of hunger-caused riots broke out in the poorest countries recently.

Regarding food consumption, there is a huge difference in developing countries versus developed countries.  In developed countries, food consumption accounts for less than 5% of disposable income; in developing countries, the share of food consumption is much higher.  In China, it accounts for 1/3 of the income.  The share will be even higher for countries that are poorer than China.  Due to short food supplies, some developing countries have recently resorted to the extreme measure of limiting food exports and keeping food at home.  For example, India recently banned exports of several agricultural produces.  Similar measures have been adopted in other developing countries, too.  As a result, supermarkets such as Costco and Sam's club in the US were reported yesterday to limit how many bags of rice customers can purchase.  This is unbelievable!

So what to expect?  My guess is that we will probably be entering another era of global inflation.  Unlike central bankers in the developed countries, governments in developing countries have less experience in fighting inflation, and some even prefer higher inflation as long as growth is fast.  This is a dangerous policy mistake and should be best avoided.

Paul D. Deng
Department of Economics
Brandeis University
www.pauldeng.com

Banking East and Banking West:  Two Markets Trade Places
by Paul D. Deng

If you were to ask me to compare the banking systems in China and the US five years ago, I would give you a strange look.  The banks in these two countries are quite different.  In fact, they are so different that any comparison five years ago would be worthless.  So what makes a comparison worthwhile now?

American banks are in trouble.  The whole financial system is experiencing a meltdown and the outlook is grim.  The system previously thought so advanced now looks so fragile. The fifth largest investment bank, Bear Stearns, just collapsed last week.  So people might want to ask what went wrong in today's modern sophisticated American banks.

"So people might want to ask
what went wrong in today's modern
sophisticated American banks."

At the same time, Chinese banks seem to be doing fairly well.  Since last year, news has often popped up that Chinese banks invested in beleaguered American banks.  The question is, how could these weak Chinese banks, long troubled by non-performing loans, be able to salvage much richer and savvier American counterparts?  The answer is two fold.

First, Chinese banks have not suddenly becoming solid and strong, and American banks haven't suddenly lost their heads.  In my opinion, Chinese banks still have a long way to go to become real, independent commercial banks.

What actually happened is this.  The Chinese government began transferring billions of dollars earned from international trade toward bailing out individual state banks, one at a time.  Thanks to over-consumption by American consumers and over-saving by Chinese individuals, the foreign exchange reserves of the Chinese Central Bank surpassed $1.5 trillion last year.  This is a huge amount of money, more than 10% of the US GDP, or about 50% of China's GDP.  The bailout of these state banks cleared all bad loans brought about by lending to inefficient state-owned enterprises.  And it also gave the banks a fresh start.  Afterwards, with a bit of good luck and timing – the Chinese stock market has been soaring over the last several years – these banks became publicly traded one by one, accumulating big piles of cash.  Yes, they suddenly looked much stronger.

But these bailouts were just a small part of the $1.5 trillion.  The rest, or a majority of it, was invested by the Chinese Central Bank into US Treasury bills, or bonds.  With this huge inflow of cash, plus cash from the Japanese and from Saudi oil money, interest rates in the US were pushed down.  This also helped to push down mortgage rates, credit card APR's, and interest paid by corporations when they needed financing.  American consumers felt so groovy and happy that they spent even more.  More houses were sold, more mortgage equities were withdrawn, and corporations, flushed with cash, did more mergers and acquisitions, took more risks, and finally tricked more consumers with shaky credit into buying ever more expensive houses.  "House prices are never gonna fall," young homeowners were told.

The booming and rosy US economy went on and on, until last summer, when a normal financing deal on Wall Street got blocked and everything began to unravel.

The second part of the answer has something to do with the sophistication of American banks.  Yes, they are so sophisticated and complicated that unless you are a street professional, you won't recognize any of these acronyms:  CDO, ABS, MBS, CDS and SIV. Do any of them sound familiar to you?  One of the biggest problems is that American financial institutions are highly leveraged.  They also rely heavily on new financial products and innovations, meaning few investors really understand the underlying risks involved.  High leveraging says a typical bank on Wall Street may borrow 20 times or even 30 times from its own capital to engage in a risk taking investment.  If the bank earns money, everybody is happy.  If not, the bank will quickly go bust.  And this was how Bear Stearns collapsed.  The table below shows you the leverage ratio of US financial institutions.

Paul D. Deng
Department of Economics
Brandeis University
www.pauldeng.com

India and China:  Contrasting Models of Economic Success
by Paul D. Deng

People often like to compare China and India.  Once upon a time, they were both the greatest civilizations in the world.  Both countries have a very large population; both now are growing at a dazzling rate. The chief difference is their political system:  China is non-democratic; India is the largest democratic country in the world.

To be fair to India, China initiated her reform much earlier than India, at the end of the 70's.  India didn't start major reforms until the early 90's. That arguably contributed a big part to the income gap you see between these two countries.  Also, a lot of people tend to neglect the fact that, like China, after independence, India adopted a similar Soviet style economic structure to manage its economy.  So the result of India's pre-reform slow growth was due to its economic system rather than its political system.  Any comparison ought to take the above facts into account.

The major weaknesses India is facing, as I see it, are the following: First, it has a very poor infrastructure, which impedes investment, both domestic and foreign; Second, the old bureaucracy still remains; however, it is gradually improving; Third, the unique Caste system hampers India's real democratic progress (read this article, if you want to know more.)

Many people argue that India's political system is superior to China's, saying it's just a matter of time before India will surpass China.  I both agree and disagree with such a view.  Here is why.

On the one hand, I herald individual freedom.  Fundamentally, I think China's long term development can not be achieved without political freedom.  In this regard, India is indeed much more promising.

On the other hand, I want to point out that democracy is not a one-stage shot:  it involves many stages of development.  Full-fledged democracy, like you'd whiteness in some Western countries, requires economic prosperity as its precondition.  Because of this, I tend to think that India's democracy is at the lower end of the democratic spectrum, especially when you consider its caste system.  It's still democracy, but the people in India enjoy much less freedom than rich democracies do, both economic and political.  Meanwhile, China certainly does not have a democratic system, but I do see some real democratic progress going on as a result of the rising economic power of its people.  Any conclusion based on democracy or non-democracy is not as clear cut to me.

Aside from these differences, it's my wish that both countries achieve great economic prosperity and political progress in the coming decades.  Then the world we are living in now will become a much better place. 

Paul D. Deng
Department of Economics
Brandeis University
www.pauldeng.com

Capitalism Without Democracy:  Does it Work?
by Paul D. Deng

Asia East:  Do you think China can be run like a company?  It appears China is accepting capitalism now, but is not moving toward democracy or free elections.  I've often heard people say you can run a country like you run a business.  Does that really work?

In theory, if the development goal of a country and all her people are the same, namely to achieve efficiency, then you can run a country like a company. But in reality, that's impossible and unsustainable.

People have different values:  some prefer economic freedom, some prefer political freedom, some prefer both but disagree on which one should go first. This diversity also shows up in people's value judgement on relative importance of equality and efficiency. The old Soviet and China ignored the diversity of values and were looking to rally people behind their grandiose communist goals and tried to "scientifically" manage the economy, and manage people's minds. They all failed miserably.

I don't think China today is being run like a company. Maybe it's Chinese leaders' wishful thinking, but what happened certainly shows otherwise.  It's more like a federalist style in its earliest shape. What I see is an evolutionary rising of democratic values as a result of rising economic power. This process may take a long time. At the same time, old communists try to stay in control, but their influence is quickly fading. Just look at how many people in China really care about what their leaders have to say these days, especially those socialist rhetorics. Inside the communist party itself, people's value are also evolving. Didn't they admit small business men into the party a few years ago?  Maybe they will allow free elections some day.

Finally, on capitalism and democracy. In the Western world, they always go hand in hand, so one often questions what China's economy really is. I think capitalism lays the foundation for demoracy, i.e., no democracy exists in non-capitalist world, at least so far. But capitalism can exist in a non-democratic world. As Milton Friedman famously phrased, "Economic freedom is the necessary condition of political freedom but not the sufficient condition."

Paul D. Deng
Department of Economics
Brandeis University
www.pauldeng.com