Economic Growth Outlook for China and the U.S.

In How Economies Grow we explored the three phases of economic development.  To recap: in the first phase of economic growth (what experts call a “catch-up” phase) labor flows from agriculture into industry. 

In the second phase (still a “catch-up”) labor flows from agriculture and industry into services.  In the third phase, the economy is “caught up” (defined by most economists as per capita GDP about half the U.S.’) and growth is almost wholly dependent on technological innovation – on inventing new ways to be more productive.

Doing that – inventing the technologies that drive productivity increases (and economic growth) in advanced economies – is fairly hard work.  The inventers doing this work need all the help they can get from policymakers.  Indeed, policies (what we call “prerequisites for growth”) make the difference between 2.4 percent annual productivity growth (U.S. 1995-2005) and 1.4 percent growth (Euro area 1995-2005). 

A 1% difference in productivity growth rates may not sound like a lot, but it matters significantly to a country’s per capita income over time.  Imagine, for example, another country with the same per capita GDP as the U.S. in 2005.  All else equal, if that country realizes productivity growth of 1.4% per year and the U.S. realizes productivity growth of 2.4% per year, by 2050 per capita GDP in the U.S. will be 56% higher than in the other country.

In Prerequisites for Growth we explored the general kinds of policies that facilitate technological innovation: policies and institutions that promote competition; unfettered markets; efficient tax policy; free trade; enforcement of private property rights and contracts; efficient enforcement of the rule of law; regulations that correct inefficiencies; market flexibility; high-quality infrastructure; government support for education; and government investment in R&D.

Given, then, our understanding of how economies grow and the kinds of policies that are necessary to fuel growth at the advanced stage of economic development, we ask: What is the economic growth outlook for China and the U.S.?  Here, we explore the answers to that question.

Economic growth outlook for the United States 

There are reasons to be concerned about America’s future as an economic growth leader among the developed economies.  Those causes for concern include:

  • Market intrusion.  In some cases, policymakers “pick winners” – giving subsidies to industries like agriculture and auto manufacturers.  In 2009, for example, the U.S. Congress passed a $787 billion stimulus bill that included a “buy American” provision requiring projects funded by the stimulus to use only U.S.-made goods.[1]
  • Fiscal imprudence. The U.S. faces record-high deficits.  Nobel Laureate Ed Prescott has well demonstrated that, seeing high deficits today, people assume tax increases tomorrow – which leads to less capital investment (and less technological innovation) today.[2]
  • Declining primary education. U.S. primary education continues to fall behind.  That means fewer U.S. students are prepared for college – or even relatively lower-skilled jobs in increasingly innovative industries.  So even while institutions of higher education in the U.S. are still among the best in the world, American students may not be prepared for that education.  Consider that in 2000 the number of foreign students studying the physical sciences and engineering in U.S. graduate schools for the first time surpassed the number of U.S. students.  For many, that is a sign that America’s educational system is no longer preparing the next wave of American technological innovators (rather, preparing foreign students to go back to their home countries and innovate).[3]

Yet America’s market intrusion, fiscal imprudence, and declining basic education have long been causes for concern – even as the U.S. economy has grown robustly.  Robert Samuelson suggests, then, that there must be some sort of “magic” formula – some quintessentially American intangible that keeps the economy growing even when indicators say it shouldn’t be.[4]  If there is such a formula, ingredients surely include:

  • A relatively flexible market. The U.S. leads other developed economies in labor productivity.  There is evidence that the U.S. has faster rates of labor productivity growth than other developed economies because of the relative flexibility of its labor market.  As economics professor Art Blakemore writes, “Resisting the forces of creative destruction apparently comes with a cost – lower productivity growth, and hence, lower standards of living.”[5]
  • Strong higher education. A far higher proportion of U.S. workers have college degrees in the U.S. compared to other developed economies.  Economists Robert Barro and Jong-Wha Lee report that average years of schooling in 2000 was 12.1 in the U.S., 11.6 in Canada, 10.9 in Australia, 10.2 in Germany, 9.6 in Japan, 9.4 in the UK, 7.9 in France, and 7.2 in Italy.[6]
  • Research & Development. The U.S. continues to invest more in R&D (see chart below).  The number of patents granted in the U.S. has also risen rapidly in the last two decades.

US R&D Expenditures by Source of Funds, 1953-2008

(Click the figure to enlarge it.)

  • Enforcement of the rule of law.  This includes protection of private property and an independent court system that is free of corruption.  In the World Bank’s World Governance Indicator rankings, the U.S. consistently ranks among the top nations with respect to the rule of law.
  • High-quality regulatory practices.  The U.S. is generally good at making policies that emphasize market incentives while curbing excess bureaucracy, removing price distortions (such as monopoly pricing) and increasing transparency so participants in the market can make informed decisions.

Economic growth outlook for China

Over the short- or medium-term, China will continue to grow at around 9% (trend over last decade).  But once it has realized all of the productivity gains (and corresponding economic growth) to be had from transitioning rural agricultural laborers into manufacturing, and eventually into lower-end services – once it can no longer rely exclusively on low-cost labor – China will have to find a new game.  Can it?  There are reasons to be skeptical:

  • China so far seems unwilling still to let go the reins of state control.  Despite the fact that they are clearly a violation of the World Trade Organization Agreement on Government Procurement (GPA), China has maintained “indigenous innovation” policies (formally since 2006) that require government procurement to favor products that include Chinese intellectual property.  This is the tipping point: China can choose to open up more to multinational corporations (MNCs) and continue to grow and learn from them, or it can close off, impose strict regulations that drive MNCs away, and the opportunity to “follow the leader” in technological innovation will evaporate.[7]

    It’s a balancing act, though: China wants to make policies that favor domestic firms (just like the U.S. does), but not drive out the MNCs that domestic firms learn from (which is a normal, and efficient, part of the economic growth process).  Though China has not yet done so, one of the cornerstones of the agreement made between President Hu and President Obama in January 2011 (and reinforced in May by Treasury Secretary Geithner and Vice Premier Wang) is that China will remove its domestic content mandates from government procurement policies.
  • Heavy subsidies for “key” industries – including automotive, chemical, construction, electronic information, equipment manufacturing, iron and steel, non-ferrous metals, science and technology, aviation, coal, defense, electric power and grid, oil and petrochemicals, shipping, and telecommunications.[8]  But we know that governments – even China’s – are notoriously bad at “picking winners” and attempting to do so makes markets less efficient, which inhibits technological innovation.
  • A persistent maintenance of the renminbi at an artificially low peg to the U.S. dollar.  The value of the renminbi (RMB) has been a thorn in the side of policymakers in the U.S. and elsewhere.  Between 2005 and 2008 China allowed the RMB to appreciate by about 21% relative to the dollar, but halted that appreciation in July 2008 when the economic crisis hit.  In June 2010 China once again resumed its appreciation of the RMB (though it maintains the de facto peg to the dollar).  Since last June, the renminbi has appreciated by about 5% against the dollar.

All of that said, many of the (justifiable) criticisms directed at China concern the very behaviors China is leveraging to catch up economically.  Once the country joins the league of developed economies, it won’t be able to get away with those behaviors – again, it will have to find a new game.  Most analysts believe that it will.

In fact, China’s most recent (12th) Five-Year Plan outlines a number of reform targets that – if implemented – will help China continue its transition from Phase 1 and 2 to Phase 3 of economic growth.  Those reform targets include:

1. Economic targets

  • GDP to grow by 7 percent annually on average;
  • More than 45 million jobs to be created in urban areas;
  • Urban registered unemployment to be kept no higher than 5 percent;
  • Prices to be kept generally stable.

2. Economic restructuring

  • Rise in domestic consumption;
  • Breakthrough in emerging strategic industries;
  • Service sector value-added output to account for 47 percent of GDP, up 4 percentage points;
  • Urbanization rate to reach 51.5 percent, up 4 percentage points.

3. Innovation

  • Expenditure on research and development to account for 2.2 percent GDP;
  • Every 10,000 people to have 3.3 patents.

4. Environment and clean energy

  • Non-fossil fuel to account for 11.4 percent of primary energy consumption;
  • Water consumption per unit of value-added industrial output to be cut by 30 percent;
  • Energy consumption per unit of GDP to be cut by 16 percent;
  • Carbon dioxide emission per unit of GDP to be cut by 17 percent;
  • Forest coverage rate to rise to 21.66 percent and forest stock to increase by 600 million cubic meters.

5. Agriculture

  • Annual grain production capacity to be no less than 540 million tons;
  • Farmland reserves to be no less than 1.818 billion mu.

6. Livelihood

  • Population to be no larger than 1.39 billion;
  • Life span per person to increase by one year;
  • Pension schemes to cover all rural residents and 357 million urban residents;
  • Construction and Renovation of 36 million apartments for low-income families;
  • Minimum wage standard to increase by no less than 13 percent on average each year.

7. Social management

  • Improved public service for both urban and rural residents;
  • Improved democracy and legal system;
  • Better social management system for greater social harmony;
  • More than 10 percent of all residents will be registered as community volunteers.

8. Reform

  • Encourage qualified enterprises to get listed in stock markets;
  • In-depth reform in monopoly industries for easier market entry and more competition;
  • Improved government efficiency and credibility.

Ed Prescott is optimistic, too.  He has said that “If current trends continue, and I predict they will, China will produce more technology capital and have more of its firms with operations abroad.  It will become more integrated with the advanced industrial countries and in time become one.”  Here’s why:

  • Openness to private enterprise (foreign and domestic). While China still subsidizes state-owned enterprises and places limits on foreign investment, foreign-owned enterprises are already a far larger part of China’s economy than state-owned enterprises are (see Chinese Exports by Enterprise Type chart).  But according to He Weiwen (director at the China Institute for Open Economy), China re-strengthened its emphasis on state-owned enterprises when the 2007-2009 recession hit; it must now relinquish some control back to the private sector.[9]
  • Improving education.  While China’s levels of educational attainment are still far lower than in developed economies (as a percentage of total labor force, or as measured by average years of schooling), education levels – in both quantity and quality terms – have risen dramatically in China in the last decades.  The country is clearly working hard to develop its own stock of high-quality human capital.
  • Rapidly – and dramatically – improving infrastructure.  Today, China’s distribution and transportation network outside of the urban areas is relatively underdeveloped.  According to Global Sources CEO Merle Hinrichs, “Today, China typically relies on local markets – they don’t have an infrastructure for national distribution.”[10]  Yet China is rapidly developing its infrastructure ­– even where there is not yet demand.  According to Caterpillar CEO Jim Owens, "In 10 years China will have better infrastructure than the U.S.”
  • Freer markets.  According to the U.S. Trade Representative’s 2008 report, “China has taken many impressive steps over the last seven years to reform its economy, while making progress in implementing a set of sweeping WTO accession commitments that required it to reduce tariff rates, eliminate nontariff barriers, provide national treatment and improved market access for goods and services imported from the United States and other WTO members, protect intellectual property rights, and improve transparency.”[11]
  • Financial reform. China is also looking to internal financial reform to boost its consumption by: creating more financial vehicles for investment – to transform savings deposits into effective investments; and decreasing the share of government holdings on national income.[12]

China has managed to astound the world with its incredible 30-year growth miracle.  In place of traditional hútòngs we find stunning skyscrapers.  In place of rickshaws we find BMWs and Fords.  We should not underestimate the power of China’s state-planned economy to lead itself into the club of developed economies – even if that means China must let go the reins of central planning.

This article is part of Issues in Depth: What is the Future of China's Economy? America's?  Click here to explore this issue in depth – to read more articles similar to this one, see relevant data charts and graphs, and hear from the experts.

[1] Of course, the U.S. has long bailed out failing industries, subsidized others, and protected still others – even at the same time that it has remained an economic growth leader.

[2] Edward Prescott, “Why Do Americans Work So Much More than Europeans?” Federal Reserve Bank of Minneapolis Quarterly Review Vol. 28, No. 1, July 2004, pp. 2–13.

[3] For more detail, see The U.S. Is Declining.

[4] Robert Samuelson, “U.S. Shouldn't Fear Rise of China, India,” The Business Times, 26 May 2005.

[6] Robert J. Barro and Jong-Wha Lee (2003): "International Comparisons of Educational Attainment" Journal of Monetary Economics 32(3), 363-394.

[7] “The question is whether China wants to be increasingly integrated into the global system or increasingly isolated.” See Michael Barbalas, Amcham-China president, “U.S. companies find China less welcoming,” Financial Times.  Also see Financial TimesEuropean business wary of China regulation” for a discussion of multinational corporations’ perspectives on China’s indigenous innovation and other rules. 

[8] James McGregor, Time to rethink U.S.-China trade relations, The Washington Post, 19 May 2010.

[10] ibid.

[11] United States Trade Representative, “2008 Report to Congress on China’s WTO Compliance,” Dec 2008, p. 3.

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