Streetwise Professor

I have long questioned the validity of Chinese economic growth data. The gravamen of my criticism is that measured GDP is disproportionately driven by investment; that investment is really a cost that is intended to produce future benefits (greater output and consumption); and that the incentive system in the Chinese economy causes decision makers to incur investment costs that increase measured GDP, but that the return on these investments is low. As I’ve phrased it, this system has led to an epic, and arguably unprecedented, misallocation of capital. China’s (non-human) capital stock is too large, and misallocated across sectors, which conspire to depress returns to capital to below the level that would be achieved with a market price and profit-driven mechanism for allocating capital.

These heterodox views have been confirmed! By whom, you ask? Well, by Xi Jingping himself!

Chinese President Xi Jinping lashed out at inflated growth numbers and vowed to crack down on the pursuit of “reckless” projects that have no purpose except showing superficial results.

“Inflated growth numbers.” Check. “‘Reckless’ projects that have no purpose except showing superficial results.” Sounds like misallocations of capital caused by a perverse incentive system.

Xi used stark language to call for quality in economic gains and listed examples of wrongdoing such as unnecessarily huge industrial parks, disorderly expansion of local exhibitions and forums, inflated statistics and “fake construction kickoffs.”

Yup. A huge misallocation of capital.

“Xi said officials shouldn’t only be assessed on the basis of the GDP growth rate.” Yup, all driven by a perverse incentive system that leads decision makers rewarded on the basis of GDP-related metrics to invest large sums, the return on those investments be damned.

So Xi has recognized the manifest defects of the vaunted Chinese model, and effectively confessed that much of Chinese growth is junk. The irony of course, is that this is a system that Xi largely created, certainly deepened, and ruled with an iron fist. Meaning that his sudden shock at its consequences reminds me of Stalin’s “dizzy with success” backing off of the Soviet model he created.

But although he has diagnosed the symptoms, and the proximate cause, Xi still doesn’t grasp the underlying cause–the overly centralized nature of the CCP-dominated Chinese economy. No, it does not have Stalinesque five year plans dictating the output of Patriotic Nail Factory #10, but through its manipulation of the incentive system on multiple dimensions the CCP attempts to achieve objectives (most notably, high GDP growth and strategic industries) that it establishes.

Note Xi’s proposed corrective to the system he just admitted is fundamentally flawed:

Speaking at the work conference, Xi called for making “the assessment system more targeted and scientific, so that it works effectively like a conductor’s baton.”

An orchestra following a conductor is centrally directed. A system in which “scientists” set “targets” is not one that responds to profit and price signals, but one that responds to the incentives handed down from the CCP. Indeed, an economy with an “assessment system” other than profit and loss inherently involves massive centralization and control

And Xi’s prescription begs questions. Just what will that “assessment system” involve? What new (centrally directed) incentive metrics will replace the old ones?

Regardless of what Xi (or more likely his minions come up with to meet his command) come up with, it will inevitably result in misallocations, but different ones. Any set of centrally commanded high-powered incentives will be gamed. The games will distort production, investment, and consumption choices. Different incentives, different games, different distortions. But distortions all the same.

Transaction Cost Economics has long recognized the incompatibility of high-powered incentives and manipulable performance measures. This is why low-powered incentives are so pervasive in non-market allocation mechanisms–like inside firms. China is experiencing the effects of failing to understand this, but by advocating the replacement of old manipulable measures with new (though unspecified) manipulable measures Xi betrays a failure to grasp that the fundamental problem is with the centralized system itself, not with its implementation details.

Economic profit and loss in market transactions is a largely unmanipulable high-powered incentive system. But that is an inherently decentralized emergent system, not a centrally managed one. And such a system is completely inimical to one ruled by Party that demands obedience to its leader’s commands.

Meaning that the fact that although Xi has finally recognized the severe faults of one implementation of the CCP’s economic model, he has not–and likely cannot–acknowledge that the problem is inherent in the model itself.