China and The One - Two Punch

In the sport of boxing, a one - two punch is a combination of two blows, normally a left followed by a right cross, which could be devastating to the opponent. Well, economic theory has delivered a solid one - two punch to China, throwing it off the economic trajectory the world has become accustomed to for the past 30 years. How China defends itself from these blows, and remember in boxing the one - two punch is usually the initial attack to throw the opponent off guard, will determine not only China's economic and political future, but also global growth for decades to come.

The first of these blows is what is known as convergence theory. With a mixture of various economic tools and forward thinking leadership, a country that was lagging in economic development can move into a cycle of unbelievable growth, possibly for years, as it catches up to the more economically advanced nations. Factories that did not exist are built, as are new cities, highways, communications systems, high-speed railroads etc. all feeding on each other and stimulating the economy to achieve very high levels of growth. At one point it even begins to look like a perpetual motion machine that never stops with the investment of growth reinforcing additional growth, you build a power plant which then gives you cheap electricity to build a manufacturing plant and so on and so on.

But at one point convergence occurs. As an example, how many steels mills do you need to build after a certain point? Naturally at that point, the exaggerated growth level based on catch up investments slows and the economy returns to average global growth patterns.

The second punch is what economists call "The Lewis Turning Point." It was named after the Nobel Prize winning Saint Lucian economist Arthur Lewis. In 1954 Lewis published his theory, Economic Development with Unlimited Supply Of Labour".

In it Lewis discussed how a capitalist sector could develop by taking labor from the non-capitalist subsistence sector. At the beginning stages of development, there would be an "unlimited" supply of labor available, which would mean the capitalist sector could expand without an increase in wages. The high returns from these initial factories could then be invested in other more advanced factories again using the supply of cheap labor. The process, like convergence, almost becomes self-sustaining, leading to rapidly increasing wealth within the country.
But then comes what is now known as the Lewis Turning Point. That is the point when the low hanging fruit, the excess labor in the economy is used up by the growth and wages rise and the country's products become less competitive worldwide.
Most seasoned boxers know how to defend against opening fakes that put them off balance but the Chinese government appears to have never wanted to see these punches coming. Convergence theory has been proven to be more than a theory and perpetual motion machines only exist in science fiction. But as Hyman Minsky, the American economist, taught, during positive economic times people and institutions become complacent, basically ignore history and - by definition - the seeds of the next economic crisis are sown.

What has been remarkable in China since Deng' time, is that its leadership has been excellent in general, in terms of macro-economic issues, willing to take huge structural risk whether initially liberating the economy, joining the WTO and now even talking about having the Renminbi float by 2020. But none of those gambles truly threatened the legitimacy of the government. This time it is different; to prepare a defense against the blows could challenge the legitimacy of the system.

The Chinese government's political legitimacy for the last 30 years has been based not on communist theory, but on substantial economic growth and the guarantee of increased standard of living of its citizens from year to year. It is almost as though there was a new unwritten form of the 18th century social contract created after Mao's death between the Chinese communist party and the people. A Confucian interpretation of the Rights of Man, which says ignore western style democratic practices (which truly never existed in the long history of China), forgo some level of personal freedom, and the government will markedly increase the standard of living for the nation as a whole, insuring life, possibly the pursuit of happiness, but not liberty.

This is a radically new concept in political culture; power in a country is no longer solely derived from the king, the dictator, the elites, the party or even the direct electoral consent of the governed, but from the economic well being of the governed. In authoritarian nations like China, where there is no electoral system for the citizens to vent their frustrations with the government, the economic well being of the people has become the de facto vote of the people. And once this economic right / contract has been directly or indirectly transferred to the people it is almost impossible for the government to renege. In many respects this a modern, broadly economic update to the historic Chinese concept of the Mandate of Heaven where if the emperor does not rule wisely he or she will loose heaven's mandate and be overthrown.

One of the main problems with this system of "economic" legitimacy is that by being dependent on economic growth, it rests on the premise that global markets will be constant and economic growth in a semi capitalist system can be controlled and always managed upward. Essentially the legitimacy of the government, and not the party in power, is based on the vicissitudes of markets. This is a difficult plank to walk if there ever was one.

How the Chinese leadership reacts when they can no longer live up to the mandate of growth is still to be seen. The challenge facing the government is massive. How do you re-engineer a gigantic and slowing economy from being investment led to become a more balanced consumer-driven economy, without causing some disruption and pain, which then threatens the legitimacy that the government is based on? How long can the Chinese government continue to allow inefficient state owned companies, many hardly producing anything anymore, that were built up during the race to convergence, to continue to operate, and accumulate massive debt just to prevent unemployment. Surely there is a better use for both the capital and human investment. And how do you control the perception of the population that the mandate of heaven is still enjoyed by the government when the annual growth rate could fall from 7% to 4%. In a developed economy like America, a 4% growth rate would be an unbelievable boom. For the Chinese however, who have become accustomed to a 7% plus growth rate, the fall to 4% could be perceived as a severe recession, a recession that would directly challenge the mandate of growth.