Paul Krugman’s Unpleasant Peasant Arithmetic

China’s economy is not as scary as the Nobel prizewinner thinks.

TO GO WITH STORY China-economy-forex,FOCUS BY KELLY OLSEN This picture taken on August 17, 2012 shows a Chinese bank staff member counting stacks of 100-yuan notes at a bank in Huaibei, east China's Anhui province. China's currency is facing strong downward pressure this year as the country's once surging growth rates slow amid a stalling global economy and signs of capital flight after years of inflows. CHINA OUT AFP PHOTO (Photo credit should read AFP/AFP/GettyImages)

China’s vast $10-trillion economy is a source of angst, as well as awe, for many prominent foreign economists. Larry Summers of Harvard believes its miraculous “Asiaphoric” growth may soon regress to a mediocre rate. Kenneth Rogoff, his sometime quadmate, believes China is a big economic risk for the year. Nouriel Roubini argues that China’s growth model, characterized by high saving and investment, is unsustainable — and the authorities know it.

But how does China look to the most prominent economist of them all — the one with a Nobel Prize, a regular opinion column in the New York Times, and a photo-portrait hanging in the economics department of one of Beijing’s most prestigious universities? As it happens, Paul Krugman was in Hong Kong recently to answer that very question.

Read the headline coverage of his visit in China’s official press and you will discover that Krugman “believes in [the] future of China,” which is fortunate, because both the country and the future are real. Watch him yourself, however, and the emphasis is a little different.

“China is a very scary prospect,” he says, which might suffer “a very nasty recession — maybe worse — along the way.”

Krugman’s thesis, outlined in Hong Kong and in a 2013 column, is stark: “China is running out of peasants, basically.” During its economic miracle, tens of millions of people moved from backward farms to more productive factories. This ready supply of workers kept returns on capital high, underpinning China’s extraordinary rates of investment (which peaked at 48.3 percent of GDP in 2011, according to the National Bureau of Statistics [NBS]). During this era, it made sense for businessmen to multiply their assembly lines, and for city officials to raise their skylines, in step with the massing ranks of rural-to-urban workers.

That growth model, however, is finished, Krugman argues. China’s working-age population (aged 16-59) is now falling, according to the NBS. This new scarcity of labor will depress the returns to investment, necessitating a less frantic pace of capital accumulation: the investment rate must fall by about 20 percent of GDP, according to Krugman.

Since capital spending is such a vital source of demand in China, so the argument goes, a 20-point drop will plunge the economy into a “nasty slump” — unless consumption (the big alternative source of demand) can rise as fast as investment falls. That’s what is at stake when economists talk blandly about “rebalancing” China’s economy.

There are, then, two parts to Krugman’s pessimistic thesis. The first is that China’s demographic limits require a sharp drop in its investment rate. The second is that other kinds of spending will not fill the hole in demand that gentler investment leaves behind. In what remains of this column, I’ll quibble with the first claim. (In a future one, I may pick some nits with the second.)

Quibble 1: Urban employment is still growing strongly in China.

China’s working-age population is now falling, as Krugman notes. But employment, especially urban employment, is not. China’s cities added 13.2 million jobs last year, according to the Ministry of Human Resources and Social Security, the highest number this century. An alternative measure by the NBS showed a smaller gain. But it was still over 10 million. Of course, 10 million now represents a smaller percentage increase in China’s urban workforce than it did in the past, when that workforce was smaller. But the decline is gradual, not sudden.

Quibble 2: China’s countryside — and its colleges — will yield many more workers for the rest of this decade.

China has not run out of “peasants,” as Krugman indelicately describes them. About 45 percent of the population (almost 619 million people) still live in rural areas, according to the official figure. Indeed, a new report by the World Bank, using satellite imagery and an alternative definition of urban areas, suggests the number could be substantially higher. (The World Bank satellites counted roughly 175 million more countryfolk in 2010 — the latest year for which statistics are available — than China’s official statisticians.)

Further reassurance can be found in recent number-crunching by Qu Hongbin, Julia Wang, and Jing Li of HSBC. They foresee “minimal” pressure on the supply of non-farm labor, which will grow by 14 million a year on average for the remainder of this decade, by their estimates. This partly reflects the leveling off of China’s college boom, which is allowing graduations to catch up with the increase in matriculations. The three economists also make the (admittedly controversial) claim that 60 million new people will abandon rural life by 2020 if urban pay is sufficiently attractive.

Quibble 3. China has run out of “surplus” labor. But it did so years ago.

Pay is key. Even if China has not run out of rural labor altogether, it may have run out of surplus labor, as economists define it. Drawing on the theories of Sir Arthur Lewis, Krugman argues that China’s farms were once heavily over-manned. Workers could move to modern factory jobs without their contribution being missed in the farms they left behind. Now, however, this surplus labor has been exhausted. Because so many of their peers have already migrated, the rural laborers who remain have increasing scarcity value. That has pushed up agricultural wages. To attract further migration, factory wages must rise also. China has reached what is called the Lewis turning point.

The logic is powerful. But Krugman’s timing is off. China surely passed the Lewis turning point years, if not decades, ago. Some scholars think China exhausted its surplus labor in the early 2000s. Others wonder if the Lewis Turning Point even exists, pointing out that Chinese wages, urban and rural, have been rising since the early 1990s.

Quibble 4. China’s growth largely depends on getting more out of workers in industry and services, not getting more of them out of agriculture.

If we agree that the Lewis turning point now lies one or two decades in the past, Beijing has no reason to fear it in the future. Its growth model has long since moved on. Contrary to popular belief, most of China’s progress over the past decade has stemmed from getting more out of workers within industry and services, not from moving more of them out of agriculture. In a typical year from 2004 to 2013, China reaped 2.3 percentage points of growth from shifting workers between agriculture, industry and services, according to my calculations. But improving the productivity of workers within these sectors accounted for 7.3 points.

Quibble 5. China’s growth depends on capital-deepening, not capital-widening.

How has China managed to raise the productivity of workers so dramatically? Partly through its widely ridiculed, much-lamented capital spending. Krugman argues that China’s heavy past investment was worthwhile only because the urban workforce expanded in step. Each dollop of extra capital was matched by an extra batch of workers, a process sometimes called capital-widening, because it spreads an even layer of capital across a widening base of workers.

China’s investment, however, mostly represents capital-deepening — not widening. Beijing’s net investment has more than kept pace with the urban workforce, leaving each worker with a growing amount of equipment, accommodation, and infrastructure at his or her disposal. If China had one dollop of capital per urban worker in 1992, it could boast 4.6 dollops 20 years later, based on capital-stock estimates by Wu Guopei, Wang Weibin, and Zhang Xining of the People’s Bank of China (whose preferred unit of measurement, I should stress, is not dollops but rather 100 million yuan at constant 1952 prices).

If Krugman’s thesis were right, China’s capital stock could not have outpaced its urban workforce by so much and for so long without careening into rapidly diminishing returns, an investment bust, and a nasty recession. Returns have diminished, inevitably, as China’s economy has matured. But they are not low. And investment has not plummeted in response.

Quibble 6: China has great scope for further capital spending.

There is a simple reason for this: China is still a developing economy. It still has enormous scope for useful investment, even if it often conspires to invest wastefully instead. Its GDP is now vast, but GDP per person is still modest. Investment represents an enormous fraction of China’s annual output. But it is not enormous relative to the size of its workforce.

One final number will, I hope, make China seem a less scary prospect. By my calculations, its annual investment per worker was still less than half of America’s in 2013, if the two countries’ spending is compared at purchasing-power parity (and less than 30 percent if compared at the market exchange rate). And China’s accumulated stock of capital per worker is an even smaller fraction of America’s, insofar as such comparisons are possible. Which is to say: there’s still a lot of room for growth.

That rosy official headline after Krugman’s visit was not entirely wrong. He does believe that China will eventually inherit the future, thanks to the sheer size of its population and its proven potential for catch-up growth. In the meantime, however, he worries that it could all go horribly wrong. But if it does, it will not be for a lack of investment opportunities. Or a lack of peasants.

Disclaimer: This article does not represent investment advice or any kind of professional counsel, nor does it represent an offer to buy or sell securities or investment services. The opinions, which are subject to change, are those of the author not BNY Mellon Investment Management.


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