Bullish On Chinese Companies, Bearish On China...
China has been growing on extractive institutions. This has made her the second largest economy, but it won't make her the largest.
Why do countries differ in wealth?
Why is the United States a wealthy country and Mexico is not? Why did the Industrial Revolution happen in the United Kingdom and not Spain?
The answer to these questions is the exact reason why you shouldn’t expect the Chinese economy to develop like the US economy and even pass the US one day.
Though it seems simple and everybody could come up with many reasons why countries differ in wealth, none of them provides a conclusive explanation.
Geography doesn't explain the difference between Mexico and California.
Climate doesn’t explain the difference between Singapore and China.
Religion doesn’t explain the difference between Slovakia and France.
This fence proves that:
Left side of the fence is Nogales, Arizona and the right is Nogales, Sonora.
They share the same geography and climate and mostly the same religion and culture. People on the left side have relatives on the right side and vice versa. Yet, GDP per capita on the left side is $70,000 and on the right it is $13,000.
This is an example provided by Daron Acemoglu and James Robinson in their book “Why Nations Fail?” that explains the political origins of wealth disparity between the countries. They won the Nobel Prize in Economics last year for this work.
Their book is a masterpiece. If you haven’t read it already, I strongly recommend you to read it.
The thought they advance in this book perfectly explains why China won’t maintain its superior economic growth in the long term. We have started to see it stagnate.
Acemoglu & Robinson basically say that there has to be two things for sustainable economic development:
Duly centralized state.
Inclusive political and economic institutions.
Without these two, any economic growth, however strong, is unsustainable in the long term.
Where does China fall in this picture? Well, let’s discuss.
What the hell is inclusive institutions? 🏦
Acemoglu and Robinson talk about two main types of political and economic institutions: Extractive and inclusive.
Extractive economic institutions are those where private property isn’t protected and tools of production belong to the privileged class that extract wealth from the work of others.
Extractive political institutions are those that concentrate power at the hand of a person or class at the expense of others.
Naturally inclusive institutions are the exact opposite.
Inclusive economic institutions are those that promote active economic activity such as innovation and entrepreneurship by protecting personal property.
Inclusive political institutions are those that spread power over the masses.
Political or economic institutions of any type may precede another and whatever kind of institution comes first, it tends to create the same type of institutions in the future.
If extractive economic institutions are in place, they lead to extractive political institutions because economically weak masses cannot reclaim power. If extractive political institutions are in place, they lead to extractive economic institutions because the ruling class doesn’t want an economically empowered society that could threaten its rule.
That creates a vicious cycle.
In the same way inclusive economic institutions lead to inclusive political institutions because economically powerful masses can force the privileged class to share the power. Inclusive political institutions lead to inclusive economic institutions because people work hard and innovate if they know they could keep the fruits of their labor.
That creates a virtuous cycle.
Therefore, the basic theory is that even if some level of economic growth is achieved under extractive institutions, it won’t be sustainable because incentives are not there.
People cannot be forced to think creatively if they know that they won’t be allowed to have benefits of their inventions.
And without innovation and technological disruption, long-term economic growth is no more than a dream.
How Does Economic Development Take Place? 🤔
It’s amazingly simple.
People create wealth by creating products that we use. When we devise new methods to create the existing products better and faster, we develop further. The efficiency we gained allows us to think and design new products that didn’t exist before.
But, how could some societies do that consistently over long periods of time?
Acemoglu and Robinson say that there are two things that allow such development:
Sufficiently centralized state.
Inclusive economic and political institutions.
It’s actually very intuitive. Centralized state needed to ensure order and security so resources could be allocated to more valuable activities.
Shipbuilding for instance is a more valuable activity than farming. However, if people in the society fear for their security and lives, they won’t allocate time to shipbuilding. They will move to a secure location in the countryside and do farming for subsistence.
If a centralized government guarantees their security and order, then some of these people can leave farming and think about shipbuilding. This is the first pillar.
Centralized government allows profitable reallocation of resources.
However, centralized government is not the same as inclusive economic and political institutions.
Even though extractive institutions remain in place, centralized governments ignite a wave of economic growth simply because of more profitable reallocation of resources. Before centralization, all people were farmers; after centralization some of them were assigned to shipbuilding. Given that shipbuilding is a more valuable activity, economic output increases, simply because a country of farmer slaves will be a smaller economy than a country of shipbuilder slaves.
Yet, the next wave of growth, that comes with technological disruption, doesn’t happen under extractive institutions because people don’t have incentives to devise easier ways to build ships or to design better ships.
Next wave comes only when people know they can keep the fruits of their innovations. You need inclusive economic institutions for this. And it doesn’t stop there. Then, the new economically developing class will want a word in politics to ensure that their interests will remain protected. If that doesn’t happen, innovation won’t be continuous.
Here, this chart shows economic development of the European economy in waves:
First wave of growth stems from reallocation of resources under strong but extractive political institutions, the next wave requires inclusive institutions.
History shows us that growth among extractive institutions does not last long.
Can it happen one day? I don’t think so. History is full of examples.
Growth Under Extractive Institutions 📈
This was perhaps the most widely used Economics 101 textbook between 1950-2000.
Its writer Paul Samuelson was indeed one of the greatest economists of the last century but one of his core beliefs was off the target, way off the target.
At the time the world was astonished by the growth of the Soviet Union. Everyone knew the regime was cruel and nobody in the West wanted to live under it. However, they were also convinced that the growth under a different regime was possible. How couldn’t they?
The Soviets put the first man in Space.
They sent the first probe to the moon.
Economy was growing at 12% against the US’ 6.0%.
In fascination, Samuelson made an ominous prediction in 1961 Edition of the book:
Soviet GDP per capita would pass that of the US probably by 1997.
-Samuelson’s Economics, 1961 Edition
What happened then?
Economic growth in the Soviet Union plummeted to 5.5% in the 1970s while the US, a much bigger economy, was still growing 4.5% annually.
What did Samuelson do?
Instead of thinking something could be wrong with the model, he revised his prediction and said Soviet GDP per capita would pass that of the US by 2021.
We all know what came later…
As you see, the Soviet economy grew very fast between 1945-165 and then it started to slow down which was followed by a collapse.
Even in 2015, after adjusting it for Purchasing Price Parity (PPP), US GDP per capita was nearly two times that of Russia. An average US citizen had twice the purchasing power of a Russian citizen.
But why did this happen?
Why did the Soviet Union grow so fast and then slowed down?
Well, Acemoglu-Robinson framework explains this perfectly:
The Soviet Union established a strong centralized government and reallocated resources from agriculture to industry.
Reallocation of resources to a higher value economic activity created a growth boom.
For that growth to be sustainable, it should have been accommodated by innovation and creative destruction.
People didn’t have incentives to innovate because they knew the system was rigged and the government wouldn’t allow them to keep the benefits.
Without creative destruction, growth started to wane.
The Soviets achieved the first step: A strong centralized government allocated resources to a higher value economic activities and growth boomed.
They failed at the second step: They couldn’t turn extractive institutions to inclusive institutions to fuel innovation, entrepreneurship and creative destruction.
This is not the only example.
There is one another, probably even more indicative than the Soviet Union example: South Korea & North Korea.
These two countries were divided by a line after a civil war. On each side of this line, geography, climate, language, culture, religion was the same. Yet, their levels of economic development today are way different.
The country was officially divided into two in 1948. While China supported communists remained in force in the Northern part, the Southern part was re-established by the support of the United States.
There was little difference between the first rulers of the two countries except their ideology. Kim Il Sung was a communist dictator while Park Chung Hee put South Korea firmly on the road to cohesive-capitalist development.
As you see, North Korea also grew rapidly until the mid-1980s. This was due to the more efficient reallocation of resources. However, as we saw in the Soviet Union case, it started to stagnate after 1985 and ultimately started to shrink. On the other hand, South Korea implemented widespread democratic reforms and growth accelerated after1980.
Look at every comparable case and you will see the same result. If you aren’t seeing the same result, it could be because the country is still enjoying the growth that comes with more efficient allocation of resources. Every extractive order is doomed to stagnate once there is nothing to be gained from reallocation of resources and destructive innovation is needed.
You started to see where it goes?
Let’s Talk About China… 🇨🇳
If you are dealing with economics and finance one of the recurring themes you always come across is the ignorance of the people and recurrence of history…
Mark Twain puts it best:
“This time is different” are the most dangerous four words in finance and economics.
Unfortunately, very smart people today are falling into the same traps again, like Samuelson did with the Soviet economy.
In 1990, economists in the IMF estimated that China would overtake the US as the world’s largest economy by 2015-2017:
Well, that never happened.
In 2017, Geoff Colvin from Fortune magazine published a new study in his corner that predicted Chinese economic supremacy by 2030…
Well, we are 5 years away from 2030 but it has now become clear that the Chinese economy is not overtaking that of the US in 5 years.
Just as Samuelson did, these forecasters also keep postponing this great shift. They all are missing the same thing: Chinese growth isn’t accommodated by the creative destruction.
After Deng Xiaoping reforms, we have seen a massive reallocation of resources in the Chinese economy.
They have built a massive manufacturing hub on cheap labor.
Used the proceeds to build their heavy industry and technology.
Yet, this development hasn’t been supported by innovation and creative destruction.
Today, Chinese companies look all powerful and capable. But which of these technologies was first developed by the Chinese?
They are making chips using ASML devices.
They are making cars that the US has made first.
They are developing AI models after the US companies have done so.
Once we have the technology, they are super fast to capitalize on it and maybe perfect it but they aren’t good at developing them.
Why? Simple.
They have achieved the first phase of economic growth by reallocating resources. But the second phase requires inclusive institutions that create a fruitful environment for entrepreneurs and independent thinkers.
China lacks that.
You can forcefully reallocate resources but you can’t force your way into innovation. Mind doesn’t work creatively under pressure and the brilliant minds in China are under pressure from their government.
How can a young entrepreneur feel energized after he sees what the government did to Jack Ma? He can’t.
This is why Chinese economic growth, regardless of how spectacular it is, won’t be continuous. The US, on the other hand, will keep reaping the benefits of its open and inclusive institutions, entrepreneurial environment and creative destruction.
🏁Conclusion
What China has done so far shouldn’t be underestimated.
The 1970s Agrarian society has become one of the most vibrant economic and industrial hubs in the world. Given its huge population, it’s likely that the country still has some juice to squeeze by reallocating its massive resources to industry and technology, allowing it to maintain its current growth rate for some more time.
Beyond that, however, is a rocky path.
It has to transform its institutions in an inclusive way to remove the barriers before innovation and creative destruction.
Can it do that? I don’t think so. Not under Xi Jinping.
However, given that there is no strong candidate for the post Jinping era, they may have a window to do this.
Can they do it? Of course.
Will they do it? History is filled with more negative examples than positive.
Does this mean Chinese companies will underperform? Not at all.
There is only a little connection between this macro issue and how a Chinese company like Pinduoduo can perform over the short and medium term.
They can produce the best cars, they can make really good AI models and sell to the world through e-commerce.
But.. When it comes to venturing into next frontiers, they are disadvantaged. Massively disadvantaged.
This is why I am bullish on strong Chinese companies like Pinduoduo, Alibaba, BYD; but I am bearish on China in the long term.
"Geography doesn't explain the difference between Mexico and California."
I'm not sure about that. Productivity is affected by weather (more aircon for a factory), by the distance to the coast (higher costs to ship goods), whether the terrain is flat or mountainous.
And we can look at the governments of countries, but then, how much of that is affected by the activities that happen there?
Wow, Oguz, what a brilliant distillation of the long history of economic development in our world. Your inclusion of just a few thinkers and country examples is spot on.
I’ve also been pondering the vagaries of development ever since the few years in the 1970s when I was managing a small chicken hatchery in Mobutu’s Congo.
The one thing that I haven’t quite come to terms with is the place of Shumpeter’s “creative destruction”which you seem to see as an unmitigated good thing in the process of development. How can we have broad participation and entrepreneurial innovation when everything gets bigger and most power is concentrated in fewer individuals?
A great essay and an an amazing distillation of the process of economic development down into the subject of investment in China!!