THE BLOG
08/28/2015 10:32 am ET Updated Dec 06, 2017

China's Market Crash Means Chinese Supergrowth Could Have Only 5 More Years to Run

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Ever since I became an adult in 1980, I have been a stopped clock with respect to the Chinese economy. I have said -- always -- that at most, Chinese supergrowth likely has five more years to run.

Then there will come a crash -- in asset values and expectations, if not in production and employment. After the crash, China will revert to the standard pattern of an emerging market economy without successful institutions that duplicate or somehow mimic those of the North Atlantic. Its productivity rate will be little more than the 2 percent per year of emerging markets as a whole; catch-up and convergence to the North Atlantic growth-path norm will be slow if at all; and political risks that cause war, revolution or merely economic stagnation rather than unexpected booms will become the most likely surprises.

I was wrong for 25 years straight -- and the jury is still out on the period since 2005. Thus, I'm very hesitant to count out China and its supergrowth miracle. But now "a" crash -- even if, perhaps, not "the" crash I was predicting -- is at hand.

There seems to be no secret Chinese institutional or developmental sauce.

The ongoing collapse of the Shanghai stock market is another retelling of an old story. As Charles Kindleberger said, "displacement" creates opportunities for profit. A boom gets under way, fed by ample and expanding credit. When the urge to speculate is present -- as it almost always is -- prices rise, and positive-feedback kicks in, in which people buy because they have or others have made money. In Kindleberger's words, "There is nothing so disturbing to one's well-being and judgment as to see a friend get rich."

The end is what Adam Smith called "overtrading." And then, Kindleberger explained:

At some stage, a few insiders decide to take their profits and sell out.... Prices begin to level off. There may then ensue an uneasy period.... Speculators realize, gradually or suddenly... it is time to withdraw.... The rush is on. Prices decline. Bankruptcies increase. Liquidation sometimes is orderly but may degenerate into panic.... The word for this state... is revulsion.... Overtrading, revulsion, discredit -- all these terms have a musty, old-fashion flavor ... but they do convey a graphic picture.... The panic feeds on itself ... (1) prices fall so low that people are again tempted ... (2) trade is cut off ... or (3) a lender of last resort succeeds in convincing the market that money will be made available in sufficient volume to meet the demand for cash. Confidence may be restored even [by] the mere knowledge that one can get money ...

The rapid rise in the Shanghai market from November 2014 to June 2015 counts as such a displacement, boom and euphoria culminating in overtrading. And we now -- just as in 2000 with the U.S. NASDAQ -- have the revulsion and the discredit.

A great deal of China supergrowth always seemed to me to be just catch-up to the norm one would expect, given East Asian societal-organizational capabilities. China had been far depressed below that norm by the misgovernment of the Qing, the civil wars of the first half of the twentieth century, the Japanese conquest and the manifold disasters of rule by the paranoid Mao Zedong. Take convergence to that East Asian societal-capability norm, the wisdom of Deng Xiaoping and then Jiang Zemin in applying the standard Hamiltonian gaining-manufacturing-technological-capability-through-light-manufacturing-exports development strategy (albeit on a world-historical scale) and a modicum of good luck, and China seemed understandable. There thus seemed to me to be no secret Chinese institutional or developmental sauce.

Given that, I focused on how China lacked the good-and-honest government, the societal trust and the societal openness factors that appear to have made for full convergence to the U.S. frontier in countries such as Japan. One of the few historical patterns to repeat itself with regularity over the past three centuries has been that, wherever governments are unable to make the allocation of property and contract rights stick, industrialization never reaches North Atlantic levels of productivity.

China will -- unfortunately -- likely become another corrupt middle-income country in the middle-income relative development trap.

Sometimes the benefits of entrepreneurship are skimmed off by roving thieves. Sometimes economic growth stalls. Sometimes profits are skimmed by local notables, who abuse what ought to be the state's powers for their own ends. China -- in spite of all its societal and cultural advantages -- had failed to make its allocation of property rights stick in any meaningful sense through the rule of law. Businesses could flourish only when they found party protectors, and powerful networks of durable groups of party protectors at that.

Another headwind for China in the future is that, as the very sharp young whippersnapper Noah Smith points out, the Hamiltonian manufactures-export strategy is played out, not just for poorer countries wishing to emulate China but for China in the future. Historically, the Hamiltonian strategy of moving farmers to factories and setting them to work using imported manufacturing technology is the only reliably successful development strategy because manufacturing technology is the only one that can be reliably imported. You buy the machines to make the products, you buy the blueprints for the products to be made and, with a few engineering coaches hired from abroad -- and you are in business.

But that requires that people outside your country buy your low-priced manufactures. And the world has reached a point at which demand for manufactured goods is no longer highly elastic. Already James Fallows reports on Chinese entrepreneurs lamenting how the real profits flow to the owners of scarce natural resources or the owners of brands and of design and engineering resources, leaving those who actually make the manufactured goods with only crumbs.

Greece or Chile thus seemed to me to be China's most likely future, and it always seemed to me it would take quite a while to get there.

Yet, so far, contrary to my expectations for more than a generation, China has hitherto kept growing and growing rapidly, even without anything a North Atlantic economic historian would see as the rule of law. It has had its own system of what we might call industrial neofeudalism. Instead of the king's judges enforcing property and contract rights, Chinese entrepreneurs have protection via their fealty to connection groups within the party that others do not wish to cross.

It is, in a strange way, almost like the libertarian fantasy in which you hire your own personal police department in a competitive market come to life. Such a system should not work: Party connection groups should find themselves unable to referee their disputes. The evanescence of their positions should lead them into the same shortsighted rent-extraction logic that we have seen played out over and over again in Eastern Europe, sub-Saharan Africa, Southeast Asia, South Asia and Latin America. Somehow, in China, eppur si muove.

Now I do believe that after this stock market crash, China is likely to have another five, maybe ten, years of very healthy growth. The party can redistribute income from the rich to the middle and the poor and from the coasts to the interior. Mammoth demand from an enriched urban middle class and peasantry can provide business for all of China's factories that otherwise would be selling into an export market with lower-than-expected demand elasticity. The interior can be brought up to the manufacturing productivity standards of the coast.

After it ebbs, China's success at grasping the future depends not on economic growth but on political reform.

But that, I think, is the last trick the Chinese government can play to keep anything like Chinese supergrowth going. And after it is played, China will -- unfortunately -- likely become another corrupt middle-income country in the middle-income relative development trap.

I have been wrong about the duration of China's growth miracle for all of my adult life. But I am confirmed in my forecast when I read the thoughts of very sharp China perma-bull Stephen Roach:

There are many moving parts in China's daunting transition.... While progress on economic rebalancing is encouraging, China has put far more on its plate: simultaneous plans to modernize the financial system, reform the currency, and address excesses in equity, debt, and property markets... [plus] an aggressive anti-corruption campaign, a more muscular foreign policy, and a nationalistic revival couched in terms of the "China Dream."... The economic-reform strategy [could be] stymied by the lack of political will in a one-party state.... History is littered with more failures than successes in pushing beyond the per capita income threshold that China has attained. The last thing China needs is to try to balance too much on the head of a pin. Its leaders need to simplify and clarify an agenda...

Therefore I once again say: China's supergrowth likely has five more years to run. And, after it ebbs, China's success at grasping the future depends not on economic growth but on political reform. It depends on the establishment of the rule of law and an open society rather than the rule of the CCP and a closed party elite. Only after successful political transition might economic growth and convergence resume.

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