TCS Daily

From Communism to Keynesianism

By Christopher Lingle - September 11, 2006 12:00 AM

While it seems that China has escaped from the economic disasters of the bad old days of communism, it is succumbing to the theories and policies of warmed-over Keynesianism. Beijing is giving up class struggle and central planning to apply discredited tools designed to manage aggregate demand.

Whereas central planning kept China's economy on the brink of collapse, Keynesian-style policies could, well, bring China's economy to the brink of collapse.

Beijing has become addicted to fiscal spending aimed to boost current economic growth. This has caused growing fiscal deficits and ballooning public-sector debt that will weaken China's long-term economic prospects. Economic growth bought with increased government spending is unsustainable and creates distortions that cause imbalances in the overall production structure.

In addition, more spending by corrupt cadres will bring low-quality growth -- low due to the inefficiency and corruption associated with government spending. In all events, this vigorous pump priming has been ineffective in reversing the deflationary trends in the Chinese economy.

With massive amount of fixed-asset spending on capital expenditures by the government and state-owned enterprises, the central government accounts for more than two-thirds of investment in the country. In the recent past, such spending outpaced GDP growth by a factor of three.

Even so, Beijing has continued its policy of fiscal stimulus and growing budget deficits. Ignoring the question over the accuracy of official GDP figures, China has an annual public-sector deficit that is well over 3 percent of GDP.

Then there are problems on the revenue side that will mean Beijing will face increasing strains on its finances. After substantial gains over recent years, central government finances have begun to deteriorate.

Beijing's large and growing deficits are adding to existing public-sector debt. When contingent liabilities that include recapitalizing the banks and fulfilling pension obligations are added to existing government debt and total bad debts held by SOEs, the total could be as much as 70 percent of GDP.

China's leaders are embarking on a dangerous gamble. They are undertaking a typical political ploy of inflicting long-term costs to capture short-term gains that will prove to be illusory. Public-sector deficit spending imposes a burden on future generations of taxpayers that will be required to pay for today's follies.

Beijing's tendency for spending beyond its means reflects a range of new pressures, including the hopes of smoothing the political transitions in the Communist Party leadership expected later this year. Public spending is also motivated by an attempt to break a nagging deflationary cycle and avoid further slowdowns in growth. At the same time, officials intend to provide high-cost social welfare programs, but need also to address obligations arising from reform of the banking sector.

In all events, economic theory suggests that these policies might work if the problems at hand are cyclical and temporary in nature. Even casual observation reveals that China's economy is suffering from long-term and structural problems that require radical and massive restructuring. Clearly Beijing has made a misdiagnosis and is attempting to apply an incorrect antidote.

How effective is deficit spending in reviving economic growth? A recent test case of applying Keynesian-style cyclical cures to resolve structural problems can be seen in Japan. Since the end of its "bubble economy", most of Japan's additional public-sector expenditures were financed by deficits.

With government spending during the 1990s exceeding 800 trillion yen, it was five times greater than fiscal expenditures in the US during its restructuring in the 1980s. Despite massive expenditures combined with expansionary credit policies and a zero-interest rate, Japan's average economic growth in the 1990s was about 1.1 per cent.

Tokyo's outstanding debt rose from 56 percent of GDP at the beginning of the 1990s to about around 130 percent. Many credit-rating agencies put the figure at a much higher level.

This bad news in Japan is the outcome of a government too stubborn or afraid to implement the necessary policies to force radical restructuring of the economy. By following this same path of timidity and lack of resolve, Chinese leaders are likely to follow a course that will cause their economy to falter in the medium to long term.

Some similarities exist in the necessary restructuring for these two economies. In both Japan and China, small and medium sized enterprises are starved of capital while industrial behemoths are kept alive. Rising incomes and lower unemployment rates for both countries await policy changes so a new entrepreneurial class can provide the basis of future growth.

Despite high levels of personal savings in both countries, the allocation of these funds is grotesquely inefficient. Both Japan and China suffer from a lack of a well-functioning domestic capital market. In both countries, most borrowing goes through the banking system.

An obvious problem with bank-lending is the vulnerability to political pressures. Indeed, the politicization of decisions on capital formation is at the core of the serious financial sector problems in China and Japan. Both countries need domestic stock and bond markets that are wider and deeper. Since capital markets require greater transparency and accountability, massive failures are less likely.

Restructuring in China and Japan needs to be aimed at more than merely cutting costs. Cost reductions can only resolve temporary difficulties. Proper restructuring requires a dynamic perspective that involves deep reform of management practices and government involvement in the economy.

Beijing and Tokyo should force changes in their respective corporate and political cultures to encourage real entrepreneurial initiatives in the private sector to resolve their economic woes.

Christopher LINGLE is Senior Fellow at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala.


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