The Perils of False Prosperity: China, America, and a New Globalization

Let me start with a confession: China has changed my life. And like it or not, it has changed yours. My advice is to get over it and accept it. But most of all, figure out what it means. Chinas role in the global economy is key to the fate of many nations. At the same time, Chinese prosperity is equally dependent on the state of the world. It is critical that we deepen our analysis of this all-important feedback loop.
I would like to explore this phenomenon from two angles focusing first on how China responds to the lingering fragilities of a world still struggling with the aftershocks of the Great Crisis. I will then turn to the other side of the coinhow the world copes with what I believe is likely to be a stunning transformation of the Chinese economy. I will attempt to weave both aspects of this tale around the broad fabric of the globalization debatein particular, emphasizing how China and the rest of us fit into an ITenabled globalization, whose breadth and speed challenges our antiquated insights into how the world works.

April 18, 2011

Stephen S. Roach Morgan Stanley Asia

you do so at great peril. The China story is first and foremost about change. In fact, 80% of the letters in both wordsChina and change are the same. There are three characteristics of Chinas dynamism that have a critical bearing on the rest of the worldspeed, scale, and the mix of demand. All of them separate China from the pack. In terms of speed, China runs on its own development clock. Chinese time is three to four times faster than normal development time. It has accomplished in three decades what has taken most economies easily a century, or more. As recently as the early 1990s, China and India had virtually the same per capita incomes. Today, Chinas is more than 3.5 times that of India. Time and again, I have found that modern China is much quicker to hit its strategic goals than any other large economy in development history.

The real story of China is not mindless extrapolation of the aggregate figures on growth and scale. Far more important are coming shifts in the mix of the economy.
Scale has always been Chinas most visible characteristic. With a population mass of 1.3 billion people, it accounts for fully 20% of the worlds inhabitants. With scale comes clout. As China has climbed the development curve, the absolute size of its economy now stands over 19 times that of 1979 (as calculated in constant prices). As a result, its share of world GDP has risen dramaticallyfrom 4.5% in the early 1970s to around 13% at present (as measured on a purchasing power parity basis). If China stays the course and eventually punches at its population weight, it will only be a matter of time before it surpasses the United States as the largest economy in the worldmagnifying the already daunting scale effects that are playing such a major role in driving global activity.

Why China?

Few can dispute the fact that China matters a lot. Its a tale of one superlative after another. As now the second largest economy in the world, China has taken off like a rocket growing at close to 10% per annum over the past 30 years and boosting per capita incomes by more than ten-fold over this period. China has also become the worlds largest buyer of many key natural resourcesfrom copper and lead to oil and cementand is now the dominant market for most export-led economies in East Asia, Australia, Brazil, and is a major source of external demand for Canada, Germany, and the United States. James Kynge had it dead right in his award-winning book, China Shakes the World.1 For those you in the macro modeling business, if you ignore China,

Note: This paper was presented as a Jackson Institute Lecture at Yale University on April 14, 2011. 1. See James Kynge, China Shakes the World: The Rise of a Hungry Nation, Weidenfeld & Nicolson, London, 2006.

The real story of China, however, is not in the aggregate figures on growth and scale. Nor can it be uncovered by mindless extrapolation. Far more important is the mix of the economyand how that mix might change in the years ahead. The development miracle of the past 30 years has largely been a tale of the Chinese producerwith rapidly rising output directed increasingly at sourcing foreign demand. The supply side of the Chinese economy namely, fixed investment and the exports it provides to the rest of the worldwent from 35% of GDP in 1979 to nearly 80% in early 2007. Meanwhile, the demand side especially the Chinese consumerhas remained on the outside looking in, with internal private consumption falling to a record low of 35% of Chinese GDP in 2008.

desperately clinging to the lifeline of political support. This is obviously a deeply troubling issue for the worlds most powerful economy. Safety nets, of course, are critical in anchoring the moral fabric of any society. Thats especially the case in the United States, where memories have been seared by the experience of 25% unemployment in the depths of the Great Depression. But there is a fine line between the safety set and a sense of entitlement. If an ever-expanding safety net becomes a permanent feature of the environment, it can have the unintended consequences of impeding the creative destruction that is necessary to purge a system of its excesses. Thats what happened in Japan as its corporate zombies prevented the painful but necessary adjustments in its post-bubble economy. And thats what could happen in the United States if Americas zombie consumers play a comparable role in hobbling the deleveraging and balance-sheet repair that is now so sorely needed in a post-crisis US economy. Even so, there is good reason to expect ongoing consolidation from the American consumer. Personal consumption still stands at 70% of real GDP in the United Statesdown just one percentage point from its pre-crisis peak of 71% but fully four percentage points above longer-term average of 66% that prevailed in the final quarter of the 20th century. Lacking in post-bubble support from income and wealth and still facing the imperatives of major balance-sheet repair, there is a distinct likelihood of a mean reversion of the consumption share back to 66%. If that turns out to be the case, the American consumer has completed only about 20% of the coming retrenchment.

The Next China will see a producer economy increasingly giving way to a consumer society.
That was then. Now it is time to prepare for a major role reversal. The producer economy will increasingly need to give way to a consumer society. This could well be Chinas most daunting transitionwith profound and lasting impacts on the rest of Asia. This transition is equally daunting for the rest of us. Just when the world is figuring out how to cope with a strong China, it will now need to come to grips with The Next China.

Post-Crisis Pitfalls

The story starts where the Great Crisis of 2008-09 left off. History tells us that post-crisis damage is lasting.2 In part, thats because pre-crisis booms distort balance sheets and infect the real side of debt- and asset-dependent economies. When the boom goes bust, the excesses then get unwound. And that takes time. Balance sheet repair becomes essential, as does a reversal of excess spending in the real economy. Crises, of course, also wreak havoc on banks and other financial intermediarieswith lingering impacts on the lending capacity of post-crisis economies. Thats pretty much what has happened in Japan over the past 20 years and what now appears to be unfolding in the United States and Europe. In Japan, zombie companies were the epicenter of a protracted post-crisis shakeout.3 In the United States, there may well be a new generation of zombie consumers. In this case, the zombies would be those afflicted by acute labor market distress, underwater mortgages, excessive debt, and subpar saving yet sustained by the requisite life-support measures of extended unemployment benefits that have now been augmented by home foreclosure containment programs, other forms of debt forgiveness, and extraordinary monetary and fiscal accommodation. Bruised and battered by crisis, recession, and its aftermath, Americas zombie consumers are

Aftershocks from the Great Crisis of 2008-09 are likely to be lastingimparting stiff headwinds to external demand for export-led economies like China.
While the stories are different elsewhere in the developed world, the outcomes are comparablemajor headwinds to aggregate demand in both Europe and Japan. In Europe, its mainly the combination of the restrictive implications of fiscal consolidation as an outgrowth of the sovereign debt crisis together with the ongoing pressures on a weakened bank-centric system of credit intermediation. In Japan, its the risk of two lost decades turning into a thirdas structural productivity impediments are exacerbated by the demography of a now shrinking population and an evermounting overhang of sovereign debt that now exceeds 200% of Japanese GDP. In all three economiesJapan, the United States, and Europeseverely impaired financial systems have exacerbated their crises and extended the postcrisis adjustments.

2. See Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009. 3. See Ricardo J. Caballero, Takeo Hoshi, and Anil K. Kashyap, Zombie Lending and Depressed Restructuring in Japan, NBER Working Paper 12129, April 2006.

In short, Japans lost decades could well be the template for what now awaits other major developed economies. This is obviously a tough prognosis for an interconnected, or globalized, world. Despite the hopes and dreams of the decoupling in a so-called two-track world, post-crisis sluggishness of end-market demand in major developed economies puts enormous pressure on the external demand underpinnings of export-led developing economies. Thats especially the case for China and Asias other developing economies, where the combined export share of GDP rose from 35% in the late 1990s to 45% in mid-2007. In todays post-crisis climate, that leaves export-led Developing Asia with two optionsan acceptance of slower growth or a rebalancing toward internal demand. No economy in the region will be able to duck these choices.

as the worlds largest exporter. The critical question that China must now address is whether it can stay the course of export-led growth in a post-crisis world.

The essence of modern Chinas economic strength comes from its unwavering commitment to growthtogether with the credible wherewithal to deliver on that commitment.
This, in fact, has been the subject of intense debate inside of China for several years. Chinese Premier Wen Jiabao put it best in the pre-crisis days of early 2007 when he first spoke of the Paradox of the Four Unsa Chinese economy that appeared strong on the surface but beneath the surface was increasingly, unstable, unbalanced, uncoordinated, and ultimately unsustainable.4 The Premier packed a lot into that diagnosis. He raised a broad range of concerns from income disparities and fragmented governance to excess energy consumption and environmental degradation. But he repeatedly underscored his concerns over Chinas unbalanced macro structure. Nor was this idle conjecture. It was a fact-based critiquetoo much supply, too little demand; too export-led and too little support from internal private consumption. Needless to say, in this post-crisis climate, the Premiers concerns take on even greater meaning. The aftershocks in crisis-battered economies such as the United States, Europe, and Japan point to a major shortfall of external demand growth for Chinese products. As a consequence, there is a new urgency for China to rebalance its macro structure.

Just as Japans corporate zombies were the epicenter of its lost decade of the 1990s, America has a new generation of zombie consumers who could play a similar role in restraining the US recovery in the years ahead.

China in Transition

China is an important case in point. Its economic power did not arise in a vacuum. Export-led prowess has put China in a league of its own. But that means China can hardly afford to ignore weak post-crisis growth in its major external markets. And so it faces its own set of critical choices at this very moment in time. But first, a brief digression. The essence of modern Chinas economic strength comes from its unwavering commitment to growth. I remember all too well when I first started fixating on China. It was in the depths of the Asian financial crisis in the late 1990s. Back then there was a strong consensus that China would be the next to fall. I begged to differ. After repeated trips to China in late 1997 and early 1998, it quickly became evident to me that Chinadeeply scarred by an economy that was in shambles just 20 years earlier in the aftermath of the Cultural Revolutionwould stop at nothing to maintain social stability and keep the growth miracle alive. Significantly, China had the credible wherewithal to deliver on this commitmenta vast reservoir of domestic saving and policies that supported state-owned enterprise reforms, massive rural-urban migration, and population control. And the rest is now history. The first phase of Chinas development strategy has been defined by the classic export-led model of economic development. There can be little dispute over its success. Real GDP growth averaged close to 10% per year over the past three decades and per capita incomes have risen by tenfold over this period. In 2010, China surpassed Germany
4. See Stephen S. Roach, The Next Asia, John Wiley and Sons, 2009.

In a weak post-crisis external demand climate, China needs to turn to the internal demand of its 1.3 billion consumers.
Moreover, there is an even deeper analytical point that lies at the heart of the Four Uns. The manufacturing-led dynamic that has driven Chinas 30-year export- and investmentled miracle is in danger of hitting the proverbial wall. The main reason is the time-honored formula for manufacturing productivity enhancementcapital-labor substitution. Thats right, by substituting machines for workers the modern Chinese economy has morphed into a recipe for labor-saving growth. The numbers certainly bear that out: Since the year 2000, China has led Asia in terms of average annual GDP growth (10%), but has been the laggard in the region in terms of net employment growth (+0.5%). For a nation with daunting labor-absorption imperatives, labor-saving growth presents China with a major conundrum. Since it generates too few jobs per unit of GDP,


China needs more units of GDP to hit its employment and social stability objectives. In a nutshell, thats why China now requires such rapid output growth. Meanwhile, despite all the talk about scientific development, China is a very inefficient user of energy and other natural resources. Given the hyper-growth requirements of labor absorption, that leads to an increasingly resource-intensive mode of economic growth. And with coal accounting for fully 70% of Chinas energy consumption, resource-intensive growth also spells environmental degradation and pollution.

A shift to labor-intensive services is a key aspect of the coming transitionenabling China to target lower growth and temper its resource- and pollution-intensive development pattern.
Services, in one sense, are the antidote to labor-saving manufacturing-led growth. They offer the alternative of labor-intensive growthprecisely what todays unbalanced and unsustainable Chinese economy needs. The newly enacted 12th Five-Year Plan places a heavy emphasis on services as a pivotal aspect of Chinas structural transformation.5 That has the potential to be a huge plus for lagging labor incomes, which currently limit overall personal income to a mere 42% of Chinese GDPliterally half the share of the US. Moreover, to the extent that the China also provides greater support to the funding of its social safety net, an increasingly larger portion of the resulting increase in labor incomes would then show up in the form of discretionary consumer spending rather than as a continued surge of fear-driven precautionary saving.6 There is an important added bonus to an increasingly services-led Chinese growth pattern. By raising the labor content of a unit of incremental GDP, China would eventually be able to target a lower growth ratepossibly somewhere in the 6-7% range. The reason: In China, growth in services generates about 35% more jobs per unit of GDP than does an average unit of manufacturing and construction GDP.7 Consequently, an increasingly servicesbased growth model would make it possible for China to hit its employment and social stability targets with considerably less GDP growth. That, in turn, would provide significant relief for Chinas resource- and pollution-intensive growth equationunderscoring yet another important windfall of macro rebalancing and a key means of resolving the Paradox of the Four Uns. History speaks to a major pitfall on the road to economic developmentthe dreaded middle-income trap. Research

suggests that rapidly growing emerging economies are often stymied when their per capita incomes hit the $17,000 thresholds (as measured in US dollars at constant 2005 international prices).8 China is probably only about three or four years away from reaching this key income level. If it stays the course with its current growth model and fails to address the imperatives of the Four Uns, a middle-income trap could become a very real possibility. Conversely, if China embraces the services-led pro-consumption strategy of the 12th Five-Year Plan, such a trap can be avoided. Yes, these are all daunting challenges. But as was the case in the late 1990s, I remain impressed by Chinas deep and credible commitment to growthand to the rebalancing that will now be required to achieve that outcome.

The Mirrors of Globalization

Chinas transition is an important segue to the final point I want to touch onthe globalization debate. China is undoubtedly the greatest beneficiary of the modern era of globalization. Since its economic takeoff in the early 1980s, Chinas share of world trade has increased by eight-fold. According to IMF calculations, that is 50% faster than the average gains of Asias newly industrialized economies (Korea, Taiwan, Hong Kong, and Singapore), about three times the gains of the major ASEAN economies (Indonesia, Thailand, the Philippines, and Malaysia), and more than five times the gains of Japan during comparable phases of their respective development trajectories.9

China has been the greatest beneficiary of the current wave of globalization. The risks of a backlash against globalization are serious.
Globalization assures us that nothing happens in isolation. It underscores the obvious but important point that Chinas transition will have equally important implications for the rest of the world. Unlike Japan, with a chronically low import share of its GDP, China is an open economy. Its import-to-GDP ratio has fluctuated in the 25% to 30% range since 2000. That means as the worlds largest mass of consumers starts to play a more active role in driving economic growth, Chinas major trading partners have the potential to reap enormous benefitsespecially its East Asian suppliers such as Japan, Korea, and Taiwan. Over the past dozen years, China has replaced the United States or Europe as the major export destination for each of these export-led economies. To be sure, the current mix of Chinese imports reflects a heavy concentration of foreign-made components and

5. See Premier Wen Jiabao, Report on the Work of the Government, Delivered at the Fourth Session of the Eleventh National Peoples Congress, March 5, 2011 and Stephen S. Roach, Chinas 12th Five-Year Plan: Strategy vs. Tactics, delivered at the 12th annual China Development Forum, Beijing, March 21, 2011. 6. See Marcos Chamon, Kai Liu, and Eswar Prasad, Income Uncertainty and Household Savings in China, IMF Working Paper, November 2010. 7. See Qing Wang, Steven Zhang, and Ernest Ho, The China Files: Chinese Economy through 2020, Morgan Stanley Blue Paper, November 8, 2010. 8. See Barry Eichengreen, Donghyun Park, Kwanho Shin, When Fast Growing Economies Slow Down: International Evidence and Implications for China, NBER Working paper No. 16919, March 2011. 9. See International Monetary Fund, World Economic Outlook, Chapter 3, Asia Rising: Patterns of Economic Development and Growth, September 2006.

supplies that are assembled and then re-exported. But as Chinese aggregate demand shifts away from products directed at external markets toward those aimed at its internal markets, China could become a new and important source of growth for consumer-product export businesses around the world. This would also be true of the United Stateswith China its third largest and most rapidly growing export market. It could also be the case for Germanywhere China has just replaced the United States as its largest non-European export destination. Despite the opportunities of a pro-consumer transformation of the Chinese economy, the rest of the world is not exactly thrilled over this possibility. At work are fears on the dark side of the globalization debateespecially, pressures bearing down on hard-pressed workers in the developed world. These fears are understandable in one important sense: In the developed world, workers are being squeezed as never beforefeeling the unrelenting pressures of subpar job growth, high unemployment, and relatively stagnant real wages.

financial analysts, medical technicians, and a broad array of professional service providers from distant platforms in India, China, Eastern and Central Europe, and Latin America. In the past, our two-sector models told us to relaxrich countries that lost manufacturing jobs to low wage developing countries could shelter their hard-pressed workers in sacrosanct non-tradable services. That doesnt work any more. In the new globalization, the lines of distinction have become blurred between tradables and what used to be known as non-tradables. Courtesy of the explosion of the Internet, the cross-border connectivity of globalization has spread with hyper-speed from manufacturing to servicesfrom blue-collar factory workers to white-collar knowledge workers. And barring a Luddite backlash, this trend has only just begun to expose high-wage knowledge workers in the developed world to the increasingly intense pressures of IT-enabled international competition.10 As a result, white-collar shockand the political backlash it evokeshas become a very real threat in this new era of globalization. Nor do our economic theories and models shed meaningful insight on how the world copes with this new globalization. In fact, none other than Paul Samuelsonone of the high priests of modern economicsconceded near the end of his life that under certain assumptions, Ricardian models of comparative advantage could break down.11 Ironically, those conditions hit the nail right on the headnamely, a disruptive technology (the Internet) and a rapidly rising low-wage, low-productivity pool of labor (China). When Samuelson folded them into his mathematical rendition of David Ricardo, he found that a rich developed country could well face a permanent loss in real per capita income from international trade. And just like that, the theory of globalizationif there ever was onegot turned inside out.

At work is a new strain of white-collar shock stemming from an IT-enabled globalization that puts unprecedented pressure on knowledge workers in the developed world.
This is where economic theory breaks down, in my view. The apologists of globalization circle their wagons around David Ricardo, the theory of comparative advantage, and trade liberalizationarguing that answer to the angst of labor rests in policies and dispute mechanisms that insure a level playing field in the cross-border exchange of tradable goods. This underscores one of the great shortcomings of modern economics: What looks good in theory is often irrelevant in practice. The current globalization is far removed from the classic two-country, two-good Ricardian models. Nor does it bear much resemblance to the first era of globalization in the early 20th century. At work today is a powerful and increasingly disruptive IT-enabled globalization. Not only does it entail the everexpanding exchange of tradable goods produced by bluecollar workers but it now also involves a rapidly growing cross-border exchange of knowledge-based activities generated by white-collar workers. And in this latter case there is far more at work than just the offshoring of low-value added functions such as data processing and call centers. In the Internet era, the mid- to upper-end of the services-based value chain has quickly come into play. Thats right, with the click of a mouse, counties like the United States have ready access to the knowledge-based output of software programmers, actuaries, consultants,

Full Circle

Globalization is long on questions and short on answers. While it speaks to the increasing cross-border linkages between sovereign economies, globalization doesnt offer much hope for the harmonization of political value propositions. Thats especially the case in the zero-sum paradigm of global competition, where battles for market share often loom decisive in the political economy of growth. The globalization debate ultimately boils down to the key question as to whether there is an inherent conflict between national and global aspirations for prosperity. A vulnerable post-crisis world cant afford wrong answers. At risk is nothing short of a destabilizing political backlash against globalization that could fan the flames of protectionism. Thats especially the case in the United States. With the post-crisis labor market remaining in acute distress, Washington is reluctant to look in the mirror

10. See Alan S. Blinder and Alan B. Krueger, Alternative Measures of Offshorability: A Survey Approach, Princeton University CEPS Working Paper No. 190, August 2009. 11. See Paul A. Samuelson, Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization, Journal of Economic Perspectives, Summer 2004.

and accept any responsibility for this wrenching problem. Instead, it is all too quick to blame others for failures made at homeespecially China with its large trade imbalance and so-called manipulated currency. Before you accuse me of fear mongering, keep in mind that the US House of Representatives actually passed an antiChina currency bill by a lopsided 4 to 1 bipartisan margin in September 2010. If ever enactedand hopefully that will never be the casesuch legislation would impose stiff sanctions on all Chinese products sold in the United States. And China would most assuredly retaliate either with reciprocal tariffs on US exports to Chinaagain, our third largest and most rapidly growing export marketor with reduced purchases of US Treasuries, or both. Suddenly, the two largest economies in the world would find themselves on a very slippery slope, painfully reminiscent of a path traveled during the 1930s.

an important twist for any saving-short economy. To keep economic growth funded on a cash flow basis, it must borrow surplus saving from abroadand run massive current-account and trade deficits in order to attract the foreign capital.

However, Americas unprecedented saving shortfall has led to a multi-lateral trade imbalance that cannot be resolved through bilateral actions against any one trading partner.
That is one of the more divisive points where China enters the US growth debate. Yes, America runs its largest trade imbalance with China. Truth be known, however, it is only one of 90 bilateral trade deficits that the United States runs with the rest of the world. With apologies to Al Gore, the inconvenient truth is that saving-short America has a multi-lateral trade imbalance that cannot be solved by bilateral actions such as those contemplated by the US House of Representatives last September. Consider the following scenario: Lets say that Washington closes down trade with China and yet fails to address the national saving problemunfortunately, a very real possibility for a dysfunctional political system that appears utterly incapable of dealing with open-ended federal budget deficits. Consistent with that scenario, the Chinese piece of the multilateral trade deficit would just go somewhere else. That somewhere most likely would be a higher-cost producerin effect, putting a tax on hard-pressed middle class US workers. What happens then? Do we pick off Americas other trading partners one by one? At the heart of this dilemma is the dichotomy between a true and a false prosperity. In a true prosperity, an economy lives within its meansas those means are largely delineated by current production and by the labor income associated with that production. Conversely, in a false prosperity, an economy lives beyond its meansand relies on the surplus saving and suppressed consumption of others to fund its newfound windfalls. Unfortunately, we in the United States have lost sight of true prosperity and have become hooked on the temptations of a false prosperity.

American workers and Washington politicians increasingly blame China for the distress bearing down on labor.
I am not saying that the US-China trade relationship shouldnt be an active point of focus and negotiation on the political agendas of both nations. What I am sayingor at least about to sayis that the United States needs to do a much better job in getting its act together on its own domestic economy. That should be a major challenge to the current generation of Americas economists, politicians, and policymakers. At the core of this challenge is the need for a deep dive into the very concept of national prosperity. Americas core value proposition is wrapped around the aspirations of a consumer society. However, when labor income generation comes under pressure, as it has in recent decades, we dont ask why. Instead, we blame others for our problems. But then we do something equally reckless: We deploy newfangled tools of financial engineering to uncover alternative sources of consumer purchasing powernamely, those that arise from the interplay between open-ended asset appreciation and credit bubbles. And we are delighted to use these tools as a means to fund current consumption. Of course, our trading partners like China are equally delighted to sell into our bubble-supported markets. In a globalized world, we all share our collective madness. Yet it doesnt stop there. As we in America become convinced that this is the new way the world works, our mindset shifts. The income-based economy that was long conditioned to live within its means morphs into an asset-based economy that has discovered the Holy Grail of a new source of prosperity. Saving the old-fashioned way out of income becomes pass in an era of asset-and credit fueled saving. However, there is

At the heart of this dilemma is the dichotomy between a true and a false prosperityand the global imbalances it has spawned.
That takes me full circle back to globalizationand to the global imbalances it has spawned. Trust methey are not sustainable. Chinas pro-consumption 12th Five-Year Plan speaks to one surplus saver who has figured this out.

The budget fiasco in Washington suggests that the worlds biggest deficit saver has not figured this out. Denial is no longer an option. The Great Crisis of 2008-09 was but a warning shot of what lies ahead if we dont face up to the challenges and the pitfalls of the quest for prosperity in a new globalization.

Stephen S. Roach, a member of the faculty of Yale University, is Non-Executive Chairman of Morgan Stanley Asia and author of The Next Asia.

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