Animal Spirits with Chinese Characteristics

The Chinese economy is a large and still-expanding part of an increasingly global system. What happens in the “Middle Kingdom” now affects us all. A booming China creates opportunities and jobs all over the world. A bust would be felt from Silicon Valley to sub-Saharan Africa.

An analysis of investment cycles must begin with the underlying economic system that gives rise to them. In China, the system is essentially socialist. The main players are state-owned enterprises and local governments; the rules of the game are primarily a consequence of public ownership. This chapter focuses on these “Chinese characteristics,” describing the nature and extent of the state’s role in investment.

One might think that China would be immune to booms and busts. Under capitalism, the investment cycle appears to be primarily the result of mistakes by the private sector. In a country where the economy is dominated by the state, these should be relatively unimportant. Why should investment still be cyclical? This chapter begins by examining this question from a theoretical point of view, then traces the Maoist-era roots of today’s investment cycle.

China’s transition to today’s “socialist market” economy is generally considered to have started in 1978. In December of that year, the third plenum of the Chinese Communist Party’s eleventh Central Committee declared economic development rather than class struggle to be the “basic line.” This set in motion a new policy of “reform and opening.”

Chinese investment booms since 1978 have invariably been led by local governments—governments at the provincial, municipality, county, township, and village levels—rather than by the central government. They may invest either directly, for example, in public works or through the enterprises they control. They may also act indirectly—by offering incentives to enterprises outside their jurisdictions or to the private sector.

The Chinese banks have always been enthusiastic participants in investment booms. They are the most important source of external financing for the construction of infrastructure, industrial capacity expansion, and speculation in real estate and financial assets. Without their active involvement China’s boom—bust cycle would be considerably less extreme.

Smoothing investment fluctuations is a priority for central banks around the world. The People’s Bank of China (PBoC) is no exception. Its approach to macro-management is fundamentally different from that of its Western counterparts, however. The state’s dominant role in investment decision making and China’s inflexible foreign exchange rate regime make it difficult for the PBoC to use interest rate policy effectively. It must instead rely on more unconventional strategies to mitigate booms and busts.

Bankruptcy plays an important role in free market economies. It is one of the processes of “creative destruction,” to use the term that Schumpeter made famous. Shifts in consumption patterns as well as increasing efficiencies in production processes tend to discipline risk-takers betting on past economic trends. In the more extreme cases, bankruptcy becomes a significant enforcer of the mechanisms of the free market.

Beijing plans to engineer a long-term transition to a more efficient “mode of growth.” Unlike the countercyclical policies described in the previous two chapters, this transition would allow for a permanent reduction in investment volatility. There would be less wasted investment during booms and less need for central government-led busts. Investment would not only become more productive but also account for a smaller share of final demand.

Chinese investment cycles result from a collective action problem facing the Party and its members. On the one hand, overinvestment is undesirable for the Party as a whole because it is economically destabilizing. Individual decision makers, on the other hand, do not take the macroeconomic effects of their actions into account. For local officials, the optimal level of investment may be practically unlimited, particularly when the objective is to advance their own careers or to provide a vehicle for corruption.