Wednesday, May 20, 2009

Is it time for the death of Chinese growth model?

Michael Pettis argues that the fiscal stimulus enacted in the Asian economies, particularly China which is providing a “steroid-fuelled” growth, will potentially boost growth in the short term but their growth model is not sustainable.

One of the consequences of the Asian development model has been that production outgrew consumption for decades. When a country produces more than it consumes, it must run a trade surplus to export its excess capacity. The Asian model consequently required high and rising trade surpluses that allowed Asian producers to produce far in excess of what Asian consumers could afford to absorb.

But there cannot be trade surpluses without trade deficits elsewhere. A fundamental requirement for the Asian model was that foreigners were able to run the requisite trade deficits. In practice, only the US economy and financial system were large and flexible enough to play this role. The Asian model, in other words, implicitly involved a massive bet on the willingness and ability of the US to continue to run large and rising trade deficits.

The assumption that implicitly underlay the Asian development model – that US households had an infinite ability to borrow and spend – has been shown to be false. This spells the end of this model as an engine of growth. The sooner Asian policymakers accept this and force through the necessary economic and political changes, the less painful the transition will be. Unfortunately this does not seem to be happening.

Many Asian nations are using fiscal stimulus to prop up export-based sectors. Is exports-based growth model still the answer to higher GDP per capita in developing and emerging nations? As the main buyers (US and the EU) are cutting back consumption expenditure and the governments ‘required’ to maintain fiscal balance down the road (deficits can’t go forever), will the exports-based growth obsessed nations find customers to buy their goods and services? Also, will domestic demand in the developing countries be strong enough to prop up GDP growth rate? Is the exports-based growth model still relevant for the low income countries? And, is the model nearing death for emerging nations? Interesting questions that need answers!

Here is Szirmai arguing that the manufacturing sector still matters for growth and catch up in the developing countries.

Manufacturing sector and growth

According to Szirmai, the manufacturing sector still matters for growth and catch up in the developing countries because of the following reasons:

  • First, there is an empirical correlation between the degree of industrialisation and per capita income in developing countries.
  • Second, productivity is higher in the manufacturing sector than in the agricultural sector.
  • Third, a further aspect of the structural change bonus argument focuses on the dynamics of sectors. Manufacturing is assumed to be more dynamic than other sectors. A transfer of productive resources to more dynamic sectors contributes to growth.
  • Fourth, the transfer of resources from manufacturing to services provides a structural change burden in the form of Baumol’s disease.
  • Fifth, compared to agriculture, the argument runs that the manufacturing sector offers special opportunities for capital accumulation.Capital accumulation can be more easily realised in spatially concentrated manufacturing than in spatially dispersed agriculture. This is one of the reasons why the emergence of manufacturing has been so important in growth and development.
  • Six, the manufacturing sector offers special opportunities for economies of scale, which are less available in agriculture or services.
  • Seven, the manufacturing sector offers special opportunities for both embodied and disembodied technological progress.
  • Eight, linkage and spillover effects are stronger for manufacturing than for agriculture or mining. Linkage effects refer to the direct backward and forward linkages between different sectors.
  • Finally, as per capita incomes rise, the share of agricultural expenditure in total expenditure declines and the share of expenditure on manufactured goods increases (Engel’s law).

That said, he argues that the role of manufacturing sector on growth is weakening, especially in the industrialized nations. The strongest contributions are found in the period 1950-1973, when there were special opportunities for absorption of mass production techniques by developing countries. In the advanced economies, the role of services has become much more important.

Financial crisis and the academic economics

Here is a critical assessment of the stuff we learn in econ in light of the financial crisis.

The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clear a systemic failure of the economics profession. Over the past three decades, economists have largely developed and come to rely on models that disregard key factors—including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context—that drive outcomes in asset and other markets. It is obvious, even to the casual observer that these models fail to account for the actual evolution of the real-world economy. Moreover, the current academic agenda has largely crowded out research on the inherent causes of financial crises. There has also been little exploration of early indicators of system crisis and potential ways to prevent this malady from developing. In fact, if one browses through the academic macroeconomics and finance literature, “systemic crisis” appears like an otherworldly event that is absent from economic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory. That, to us, is a systemic failure of the economics profession.

This failure has deep methodological roots. The often heard definition of economics—that it is concerned with the ‘allocation of scarce resources’—is short-sighted and misleading. It reduces economics to the study of optimal decisions in well-specified choice problems. Such research generally loses track of the inherent dynamics of economic systems and the instability that accompanies its complex dynamics. Without an adequate understanding of these processes, one is likely to miss the major factors that influence the economic sphere of our societies.3 The inadequate definition of economics often leads researchers to disregard questions about the coordination of actors and the possibility of coordination failures. Indeed, analysis of these issues would require a different type of mathematics than that which is generally used now by many prominent economic models.

We believe that economics has been trapped in a sub-optimal equilibrium in which much of its research efforts are not directed towards the most prevalent needs of society. Paradoxically self-reinforcing feedback effects within the profession may have led to the dominance of a paradigm that has no solid methodological basis and whose empirical performance is, to say the least, modest.

They argue that economists have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. And, this time they failed to do just that. They argue that there was some sort of “academic moral hazard”. Also, Rodrik argues that the failure has to do more with ideology-wrapped economists than economics itself. See this one about economics crisis under heterogeneity as well.