Tuesday, 30 November 2010

Why did China’s stimulus package succeed and those in the US fail?

By John Ross

The difference between China and the US’s economic performance during the last three years is stark.Taking the latest available data, that for 3rd quarter 2010, US GDP was still 0.1% below its level of three years earlier. It was also 0.8% below its peak - achieved in the 4th quarter of 2007.

China's GDP, in contrast, had grown by 30.3% over the three-year period to the 3rd quarter 2010. In constant price terms China added over one trillion dollars to GDP during a period when the US economy contracted.

Turning to the pattern of development of GDP, the explanation of the different performance of China and the US is clear - as will be shown in Figures 1-4 below.

Such difference in performance of the US and China's economies, and the differing results of their policies for dealing with the international financial crisis, are clearly of great practical, and therefore theoretical, economic importance.

US investment decline

Taking first the US, the driving force of the Great Recession is clearly the decline in US fixed investment – as has previously been noted. Figure 1 shows that, in constant price 2005 dollar terms, by 3rd quarter 2010 US GDP was $103bn below its peak level in 4th quarter 2007. However, most components of US GDP were already above that level - net exports were up $46bn, private inventories up $103bn, and government expenditure up $131bn. Personal consumption had declined but only by a marginal $8bn.

In contrast, US private fixed investment had fallen by $409bn - divided approximately evenly between a $209bn decline in non-residential investment and a $202bn fall in residential investment. In short, the fall in fixed investment accounted for the entire decline in US GDP. Indeed, the fall in US fixed investment was four times the total drop in US GDP – the increase in other components of US GDP being insufficient to offset the fixed investment decline.

Figure 1

10 11 16 Components of GDP

Figure 2 shows the corresponding changes in current dollar terms. Here, as inflation is occurring, almost all components of US GDP have increased in nominal prices since the 4th quarter of 2007. US GDP increased by $439bn, private inventories by $118bn, the net trade balance improved by $134bn, government expenditure increased by $281bn, and personal consumption by $388bn. However, US fixed investment fell by $482bn, divided into a decline of $236bn in residential investment and $246bn in non-residential investment.

Figure 2

10 11 16 Components of GDP

Therefore, however measured, the dominance of the US Great Recession by the severe decline in fixed investment is evident. As previously analysed, this US pattern is not specific but typical of almost all major developed economies.The investment rise in China

Turning to China, unfortunately data for the changes in the components of GDP in constant price terms is not available. However the pattern in the data available for changes in current prices terms is so clear, and occurred during a period of low inflation, that it leaves no doubt either as to the processes taking place nor to the contrast with the US.

Figure 3 shows the changes in the components of China’s GDP during the critical year 2009 following the open eruption of the financial crisis with Lehman Brothers' collapse in September 2008. Figure 4 shows the changes during the overall period 2007-2009.

The trend in components of GDP in China is evidently the mirror image of the US. Instead of a fall in fixed investment, Chinea's stimulus programme not only ensured there was no decline in this component of GDP but propelled a major increase in it.

Taking the narrow period of 2009 alone, to minimise the statistical effects of price changes, China’s GDP rose by 3.0 trillion yuan. China's net trade surplus declined by 0.9 trillion and inventories fell by 0.2 trillion. Government consumption rose by 0.3 trillion, household consumption by 1.1 trillion, and fixed investment by 2.9 trillion. The increase in fixed investment was equivalent to 95% of the increase in GDP and the increase in household consumption equivalent to 35% - these two increases being offset by the net decline in other GDP components.

Figure 3

10 11 16 Change in Components of GDP 2008-2009

Taking the period 2007-2009 as a whole, as shown in Figure 4, China’s GDP rose by 7.9 trillion yuan. Net trade worsened by 0.8 trillion. Inventories rose by 0.1 trillion, government consumption by 0.8 trillion, household consumption by 2.6 trillion, and fixed investment by 5.3 trillion – i.e. the increase in fixed investment was equivalent to 67% of the increase in GDP and the increase in household consumption to 33%.

Figure 4

10 11 16 Components of GDP 2007-2009

Therefore. if the Great Recession in the US was caused by a precipitate fall in fixed investment, China’s avoidance of recession, and its rapid economic growth, was driven by the rise in fixed investment. Given this contrast, the reason for the difference in performance between the US and Chinese economies during the financial crisis is evident.

There is, of course, nothing mysterious regarding why China’s fixed investment increased rapidly. It was driven by a stimulus programme of both direct state investment and use of state owned banks to rapidly expand company financing.

Why the US did not follow China’s example

The two entirely different economic outcomes in the US and China, after more than two years of the most severe financial and economic crisis in eighty years, self-evidently have major implications for both economic practice and theory.

In terms of practice, why did the US not follow China’s route, which was the most successful in any major economy, in dealing with the Great Recession? If the core of the Great Recession, not simply in the US but internationally, is a decline in fixed investment why did the US not carry out, as did China, a programme aimed against the crux of the downturn – i.e. a programme aimed at reversing the fixed investment fall?

The answer lies in both ideology and economic structure. The prevailing ideology in the US is that state intervention is bad, therefore a large scale programme of state investment should not be implemented even when private investment was falling precipitately.

However even if this ideology had been dispensed with, there are no structures in the US capable of delivering a large programme of state led investment. State fixed investment in the US is only 3.5% of GDP – too small a base from which to reverse the consequences of the scale of decline in private fixed investment which occurred.

It is therefore clear why Hu Jintao stated that China’s high performance in the financial crisis was due to the superiority of its economic structure. China, following the commencement of its economic reform in 1978, abandoned the administered economy of the type created in the USSR. However, while the Chinese state no longer administers the economy, it has sufficient levers to control the overall macro-economic investment level. Overall investment can therefore be decelerated to slow down an overheating economy, as in 2007, or increased to stimulate investment to counter economic downturn - as in 2008. China's government policy is set not via administrative regulation but by controlling the overall macro-economic investment level.

The purely private character of investment decisions in the US economy, in contrast, left it with no serious defences to confront the crisis in 2008 driven by a downturn in private investment. The US economy was therefore hampered, compared to China, by both ideology and economic structure. Whereas China was able to undertake direct state stimulation of investment, the US was forced to rely on indirect methods, budget deficits and quantitative easing, which proved ineffective in comparison. China’s economic structure therefore showed a superiority during this crisis not only to the administered economy of the USSR, which it had already demonstrated during the previous thirty years of economic reform, but to the purely private market economy of the US.

Economic theory

In addition to the practical policy issues, considerable light is evidently cast on fundamental economic theory by analysing the dynamic of the Great Recession, China’s successful stimulus package, and the failure of the policy response in the US. Such testing and clarification of economic theory would be expected from the most severe economic crisis for eighty years.

In particular, as shown above, events made clear that it was trends in fixed investment that shaped developments. This corresponds to analyses put forward not only in Keynes’s General Theory but elsewhere, but which are not central in neo-classical economic theory.

It is thefore such theories and analyses centring on the determinants of investment as the critical variable in the economy which have been confirmed by the events since the beginning of the international financial crisis.

The test of economic analysis

Finally, the test of any theoretical position must be how fact it explains and predicts the facts of the unfolding economic process. The analysis set out in this blog over the last two years has consistently analysed developments in the US and Chinese economics in terms of the trends in fixed investment - the theoretical reasons for this framework have also been set out. This angle of approach has been confirmed in both the case of the US and that of China - as shown in the data above. Failure to analyse the core of the situation via China’s ability to raise fixed investment, and the US’s inability to do so, or even primarily concentrating on trends in consumption, in contrast led to analysis which was proved erroneous by developments both in China and the US.

Michael Pettis of Beijing University, for example, stated at the outset of the financial crisis that: ''I continue to stand by my comment… that the US would be the first major economy out of the crisis and China one of the last.' In reality, as author of this blog argued, the exact opposite would occur: ‘China will be the first major economy out of the crisis and it will emerge from it before the US.’ The facts clearly confirm that China was the first economy out of the crisis, that it emerged from it before the US, and the analysis that the US would be the first major economy out of the crisis and China one of the last was in error.

Stephen Roach, then Chairman of Morgan Stanley Asia, similarly focussing on consumption rather than trends in investment, argued in his book The Next Asia that it was impossible for China to achieve its 8% growth target for 2009 and that he was ceasing to be an optimist on China’s economy. This analysis was clearly not confirmed by events – China not only met but surpassed its 8% growth target and China and a number of other Asian economies have been able to far outperform developed ones.

Other writers with a different analysis to this blog were evidently confirmed in their prediction that China’s stimulus package would be a success – Jim O'Neill, of Goldman Sachs being a well known example. O’Neill, as with Stephen Roach, however saw the core of the crisis in the US as being deleveraging of the US consumer sector and therefore focused on a perspective of decline

of the US consumer which has not in fact occured - as shown above. Such an analysis, therefore, did not concentrate on the key factor in the US recession, which lay in the fixed investment fall.

The differences in analysis which explain the different prognoses that have been tested over the last two years clearly have continuing different practical conclusions. If the core of the problems in the US economy continues to be in fixed investment then it is unlikely purely indirect measures to influence this, such as a new round of quantitative easing (QE2) and the budget deficit, will be as effective as China's direct intervention to maintain investment. Not only has China's economy outperformed the US in the last three years but it will continue to do so - not only due to rapid growth in China but to slow growth in the US.

Only if the US were to turn to a programme of direct state intervention to boost to new investment, as urged by Richard Duncan and others, would there be likely to be a short term revival and increase in investment qualitatively equivalent to that which appeared in China's stimulus package. However the strengthening of political trends such as the 'Tea Party', and the consolidation of right wing Republican control of the House of Representatives, make any such programme unlikely. The US economy will therefore continue to be hobbled, in comparison to China, by anti-statist ideology. The US economy will therefore continue to be strongly outperformed by China's and the success of China's stimulus package will stand in contrast to the failure of the measures which have been utilised to attempt to kick start the US economy.

Analysis of the success of China's stimulus package, and the comparative failure of those in the US, will therefore continue to be of central importance in both practical economic policy making and discussion of economic theory.

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This article orginally appeared on the blog Key Trends in Globalisation.


1. Attempts to point to issues in China such as asset bubbles in property prices and inflationary pressures in food prices simplly do not quantitatively compare to the fundamental fact – the stagnation of US GDP and the thirty per cent increase in China’s GDP over a three year period.

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