- The Washington Times - Sunday, August 10, 2008

ANALYSIS/OPINION:

COMMENTARY:

After 30 years of economic liberalization and rapid growth, China is now the world’s third-largest trading nation and fourth-largest economy. In a new study for the Carnegie Endowment for International Peace, Albert Keidel, a former U.S. Treasury official, predicts that by 2035 China will be the world’s largest economy and by 2050 grow to twice the size of the U.S. economy.

In “China’s Economic Rise: Fact and Fiction,” Mr. Keidel dispels myths about China’s rise and presents a strong case for continued growth. He also makes a persuasive case for a policy of engagement and downplays the need for a sharp appreciation of the yuan.

Mr. Keidel concludes, “Beijing now seems likely to overcome potential stumbling blocks such as economic instability, pollution, inequality, corruption, and a slow pace of political reform” to become the world’s largest economy. I generally agree with his analysis, but with several caveats.

First, it’s very difficult to predict the path of an economy over the long term, as many unforeseen problems can arise - including policy reversals or natural disasters. Just look at Argentina, which was one of the world’s richest countries in the early 20th century, but by the end of that century was one of the least economically free countries and no longer wealthy. What mainly will determine the path of China’s development is whether Beijing follows policies that support, rather than destroy, economic freedom.

Second, I think Mr. Keidel places too much faith in China’s current system of market socialism and its repressed capital markets, arguing that “China’s financial system, rather than a liability, is on the whole a source of confidence in optimistic growth scenarios.” That positive assessment neglects the problem of “forced saving” and accepts the dubious idea that planners somehow know better than free-market participants how best to allocate capital.

China has generated high savings rates and allocated substantial funds toward infrastructure investment, but investment decisions are often politicized and personal freedom violated in the process of “development.” Moreover, as the late British economist Peter Bauer liked to note, “It is more meaningful to say that capital is created in the process of development, rather than that development is a function of capital.”

China could conserve scarce capital by attracting foreign funds to finance infrastructure, as the U.S. did during its early development. A move toward free capital markets would help China close the gap between domestic saving and investment, and thus help normalize the balance of payments.

It is not in China’s interest, as a capital-poor nation, to be a net capital exporter - accumulating $1.8 trillion of foreign exchange reserves, with a large portion invested in U.S. government debt, including now questionable Fannie Mae and Freddie Mac securities.

China’s capital markets cannot be world-class until financial repression is ended and capital freedom - along with widespread private property rights and the rule of law - instituted. Interest rate and capital controls, a pegged exchange rate, lack of private investment alternatives, interference with the free flow of information, poor accounting practices, and a still sizeable government presence in allocating investment funds (with consequent corruption) mean that China has a long way to go before it matches the transparency and efficiency of Hong Kong.

On a brighter note, much has been done to reform the banking system since 2000, and to create a market-based exchange rate regime since July 2005. Likewise, Beijing is gradually liberalizing capital controls and interest rates. Thus, financial repression could disappear in 10-20 years, and Shanghai could become the world’s leading financial center.

Third, Mr. Keidel’s forecasts depend on benign assumptions about inflation in both the U.S. and China. But those assumptions are suspect in a world of government fiat monies and discretionary central banks, with politicians still believing that a little inflation is the price for growth.

In truth, even mild inflation of 2 percent to 3 percent per year can erode the value of money in a relatively short time - and inflation is now accelerating in both the U.S. and China. More important, most economists now recognize that there is no long-run tradeoff between inflation and unemployment - a little more inflation does not lead to a permanent lowering of the rate of unemployment. In fact, there appears to be a positive relation between inflation and unemployment, as the stagflation of the 1970s demonstrated. Inflation also leads to a loss of economic freedom when price controls are imposed and credit is rationed.

Inflation is not due to increases in the relative prices of energy and food, but to excessive growth of domestic money and credit relative to real output. In China’s case, inflation is driven, in part, by an undervalued yuan, which the People’s Bank of China pegs by printing domestic currency to buy up dollars and other foreign currencies stemming from China’s large current account surplus and from capital inflows. Domestic demand for credit, especially by state-owned enterprises, to spur investment puts further pressure on the PBC. Many economists now predict that China’s inflation rate will exceed the official target of 4.8 percent for 2008 by at least 2 percentage points.

One of China’s biggest challenges is to tame inflation while letting markets set energy prices at levels reflecting global demand and supply. Controlling inflation, however, requires a more independent monetary policy and a faster nominal appreciation of the yuan - both of which may be politically difficult.

A slowdown in the U.S., if prolonged, and further turmoil in U.S. financial markets, would dampen demand for Chinese goods and slow China’s growth. In turn, China needs to work off excess capacity and slow the growth of money and credit to achieve price stability and enhance prospects for long-run development.

Finally, the path of China’s development will depend as much on politics as on economic reasoning. I agree with Mr. Keidel on the importance of U.S.-China engagement as a crucial factor in preserving and fostering world economic harmony and development. A move toward protectionism would be a disaster for all concerned and lower the wealth of nations - perhaps much more so for China than Mr. Keidel assumes.

If reformers let markets grow - and accept the notion of “spontaneous order” - eventually market liberalism would replace market socialism. The Chinese people would then experience real development, in the sense of a wider range of choices.

Increasing individual choice, however, requires political reform, which would endanger the Chinese Communist Party’s monopoly on power. How that dilemma is resolved will be an important determinant of China’s future. My hope is that the goal of “peaceful development” will prevail, and that by 2035, China will not only be the world’s largest economy but also among the freest.

James A. Dorn is a China specialist at the Cato Institute in Washington, D.C., and editor of the Cato Journal.

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