Streetwise Professor

There’s a lot of ooh-ing and aah-ing and cheering over China’s recently announced (Keynesian) stimulus. All of this cheering has things exactly backwards. The stimulus won’t return China to its growth path and may not even stave off a downward spiral.

Yes, many of the cheerleaders think this is just the thing required to make China grow again. This is a category error.

Keynes and Keynesian economics are about the business cycle (the “trade cycle” in the terminology of Keynes’ time). Keynes has diddly squat to say about economic growth, and Keynesian stimulus won’t generate real long-term growth: indeed, it arguably is anti-growth (for reasons I will discuss below).

I’ve mentioned before that I took Bob Lucas’ (undergraduate!) growth course in 1981. Lucas had of course gained prominence in macroeconomics for his analyses (Keynes-debunking analyses in fact) of business cycles. The growth class marked a pivot in his research: the reason he taught the class was to provide an impetus to read up on and understand the growth literature and to structure his thinking about it. As he told the class, and as he said publicly later, when you grasp the real importance of growth–long term increases in per capita economic output–all other issues, including cycles around trend, pale in comparison

Using Keynesian logic to draw conclusions about growth qua growth is profoundly ignorant. Like I say, a category error: mistaking an epiphenomenon for the real important phenomenon.

What China has done–in a nutshell, changing reserve requirements and the like to encourage shaky banks to lend to shaky corporates and injecting state capital into the shaky banks–is a signal–a clear signal–that Xi and his economic mandarins realize that the system is on the brink of collapse. This is a daisy chain bailout (government to banks to corporates and local governments) to stave off such a collapse by moving risk onto the government’s balance sheet. And its not as if the government’s balance sheet is so amazeballs.

Massive bailouts are a sign of massive problems. So the alleged massiveness being applauded should be a sobering warning instead.

The perceived necessity for this intervention reflects a recognition that China’s growth model has failed. I would argue (and have argued for over a decade) that it was fundamentally flawed from the start. The investment/infrastructure driven model generated growth in an income accounting sense (I adds to measured GDP, so growing I leads to growing measured GDP). But a vast proportion of this investment that looked great on national income accounts was malinvestment–a huge misallocation of capital.

That capital is now, in effect, being marked to market, with the effects being recorded on bank and local government finances. Austrian business cycle theorists (including Hayek) or even Minsky have a lot more insights to provide about this than Keynes. Government interventions of various sorts (including financial repression and other measures that distorted the price of capital) led to this misallocation.

As Herb Stein said, something that can’t go on forever will stop. Massive capital misallocations cannot go on forever–the marking to market eventually comes. So the “growth” model built on these misallocations has stopped.

I said earlier that the intervention may actually be anti-growth. Here’s why. To the extent that it is an effort to extend and pretend–and it certainly looks that way–it is extending a failed model and pretending that it will actually fix it. But the failed model is inimical to real, sustainable growth. So extending it and pretending that it isn’t a failure is anti-growth. To achieve real growth the system needs purging of bad investments and a reset based on totally different–and market-based–principles.

To reprise my old analogy, more stimulants didn’t make Michael Jackson healthier. They just kept him going. But they couldn’t keep him going forever, so he stopped. Living.

I am deeply skeptical that a committed communist such as Xi or the army of ideological true believers he has put in virtually all leadership positions is capable of making the fundamental changes necessary to achieve growth. They are too invested in, and believe too fervently in, the state directed development model, and are too inveterately hostile to a privately directed one, to pivot from the one to the other. So they will continue to try to patch the leaks in the boat that got them here. That will buy some time, but only some.

Meaning that eventually, the Chinese economy will wind up on the bottom–just like its new sub that sank at the dock.