China's Flirtation with Keynesian Economics

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China's economy has made enormous progress since modernization began in 1978 under the direction of Deng Xiaoping. However, while no one expects the transition from communism toward market-based economies to be painless, the full truth is much more brutal in that China's economic future may be rather bleak.

After nearly 50 years of experimenting with a failed economic system, China is now flirting with another widely repudiated theory, Keynesian economics. The recent National Peoples' Congress announced plans for a substantially larger budget deficit aimed at stimulating domestic spending to avert an economic slowdown. This attempt to re-inflate China's domestic economy combines numerous interest rate cuts (at least seven since May 1996) and massive public spending on infrastructure that began during 1998.

Attempts to boost overall domestic spending through credit expansion and pump priming are hallmarks of Keynesian policies. It is worth noting that where applied elsewhere in the post-World War II era, these policies eventually contributed to rising misery indexes (unemployment rates plus inflation rates) and rising public-sector debt, and brought "stagflation" into the economic lexicon. In short, although there were some illusory or, at best, temporary benefits, deficit spending and loose monetary policy tended to make matters worse.

Apart from the dubious record of deficit spending, we might inquire whether China's economic illness has been properly diagnosed. While there are warning signs of a dangerous deflationary spiral, the proposed remedies are off base. China's problem with deflation cannot be resolved through Keynesian "reflationary" policies, as they only act as countercyclical measures at best.

China's current price instability is a symptom of other fundamental problems in its domestic economy. To some degree, trying to play in the global economy on its own terms has exposed these faults. But the basic problem is that China faces a glut of manufacturing inventories and insufficient domestic spending. There has been a decline in retail prices since the first quarter of 1999. This is not surprising since China's industrial capacity is estimated to be almost double current demand.

Domestic demand is suffering since workers in state-owned enterprises who have kept their jobs are saving more in light of planned downsizing that must eventually lead to cutting 50 million jobs or more. Although always high, China's marginal saving rate has climbed substantially over the past year to a remarkable 68 percent.

Declining Exports

Meanwhile, export growth is dwindling. In particular, China has lost ground in some crucial product groups like steel and shipbuilding. Devaluation of the Korean won and Japanese yen has eroded China's comparative advantage in pricing. There are also various signs that foreigners are viewing their presence in China much more critically. In a Japan's Export-Import Bank survey, manufacturing firms with three or more overseas affiliates identified China as the worst on the basis of foreign direct investment performance. Unsurprisingly, statistics offered by China show that investment by Japanese companies declined by 15 percent in 1998, while their total investment declined by 27 percent.

There may be no escape from continued declines in economic growth. Declining exports and incoming foreign investment combined with collapsing domestic consumption is a recipe for a deep downturn. …