Will China’s New “Supply-Side” Reforms Help China? - Part 2

What are Beijing’s “supply-side” policies?

What are these reforms? Here is how the People’s Daily describes them, in an article that calls them the “top priority” of this month’s annual Central Economic Work Conference:

The supply-side reform will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system. Public service is set to be improved and new demand created to spur growth.

The country’s top leaders are likely to introduce all-round “supply-side reform” at the annual Central Economic Work Conference, which began on Friday in Beijing. “All signs are pointing in the same direction, that supply-side reform will command center stage next year,” according to a policy review of the conference by China Minsheng Bank, one of the largest non-State banks.

The article goes on to give a little more detail further along, of which perhaps the most important and encouraging comment, at least in my opinion, is the suggestion that the GDP growth target will be de-emphasized:

A Web commentary by People’s Daily called the supply-side reform “a profound change”. It will be led by a series of policies to improve public service, environmental protection, quality of production and further opening-up to the global economic system, it said.

In the most immediate move, the commentary said, the government will have to reduce housing inventories, and one way is to subsidize rural migrant workers so they can settle down in the cities where they work. It should also shed excessive industrial capacity, especially in industries with low technology and poor market prospects, it said.

A third thing to do is to deepen reform of the financial system, so as to build a nationwide system of financial service, taxation and multiple layers of insurance, the commentary added. Wang Yiming, vice-president of the State Council Development Research Center, said reform will definitely be the priority at the meeting.

GDP growth will be assigned secondary importance, economists said. Some suggested that next year’s GDP growth target should be lowered from “around 7 percent” this year to between 6.5 and 6.8 percent. GDP growth in the first three quarters reached 6.9 percent year-on-year, down from the 7.3 percent last year. The growth target won’t be published until the National People’s Congress in March.

In its December 22 primer, Xinhua explained what Beijing might mean by supply-side reforms:

Supply-side economics holds that the best way to stimulate economic growth is to lower barriers to production, particularly through tax cuts. The wealth-owners, rather than spending on direct “demand” purchases, will then be more enticed to invest in things that increase supply, such as new businesses, innovative goods and services.

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. …Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.

The return of Say’s Law

My understanding of the proposed reforms is that they are only partially described by use of the phrase “supply-side”, whose overuse is already causing some off us the same confusion felt by Inigo Montoya, the vengeful swordsman from The Princess Bride: “You keep using that word. I do not think it means what you think it means.”

The phrase itself was first used in 1976 by Herbert Stein, of the University of Virginia, to discuss a body of policies that had evolved in opposition to demand-side policies, often mistakenly attributed to Keynes, that could not explain or address the stagflation of the 1970s. These policies later became more widely known as “Reagonomics”, the heart of which is usually assumed to be tax cuts as part of a strategy to reduce government involvement in the economy on the grounds that government involvement creates incentives that systematically distort economic behavior and reduce productivity.

The heart of supply-side economics is Say’s Law, sometimes summarized as “supply creates its own demand”, based on the work of Jean-Baptiste Say, a French economist who lived from 1767 to 1832 and whose main work is A Treatise on Political Economy. In that book Say claimed that “a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.” Because the full value of any commodity produced is dispersed into the economy in the form of production costs, wages, and profits, insufficient demand for goods can never be a fundamental condition of any free market because the payments involved in creating the supply of goods and services also create purchasing power which will either be used for consumption or will be saved and directed to investment, creating demand that is equal to the value of those goods.

This doesn’t mean that Say and his followers deny that there can be supply and demand mismatches, of course, but that they happen only for two reasons. First, as long as perfect information is impossible, the economy will be subject to bad information, poor judgment or exogenous shocks that can cause these mismatches. These tend to be fairly small in effect and are always temporary. Second, and far more powerfully, institutional distortions can force agents into systematic misalignments of supply and demand (mainly by changing incentives for political reasons) that can get very deep and can persist for very long periods. The main source of these distortions, according to supply-siders, is the government. In that case the best way to increase productivity permanently is to remove the source of these distortions.

According to Say and his followers, policymakers should never worry about inadequate demand as the source of depressions. They should only worry about policy distortions that cause the market to create the wrong mix of goods and services. In what is perhaps the most quoted of all of Say’s passages, he says:

The encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.

But we have to be careful about how we interpret that last clause. At first glance Say and the supply-siders seem to suggest that the whole rebalancing thesis is wrong for China, and that there is no reason to worry about the low consumption share of GDP. If this were true, however we would immediately have to dismiss supply-siders because it only takes a little arithmetic to show that China’s soaring debt burden is a direct consequence of its demand imbalance, and to dismiss the consequences implies both that the country’s debt capacity must be infinite and that there will never be uncertainty about the allocation of debt-servicing costs, neither of which can possibly be true.

A more sophisticated reading, however, would recognize that China’s demand imbalance could never have existed except for very powerful political incentives that created in the past two decades deep institutional distortions. In that case the point of supply side reforms would be to eliminate these distortions so that the imbalances can reverse, and it seems to me that the only possible disagreement among supply-siders must be whether the purpose of reforms is to eliminate institutional distortions as quickly as possible or whether Beijing should take active steps to speed up wealth transfers to the household sector. Which side you support depends, clearly, on how urgent you believe it is to begin to deleverage the Chinese economy and how quickly rebalancing can occur as you eliminate distortions.

The main tenets of China’s supply-side reforms

It is pretty easy to see why this economic theory might appeal to Beijing. China produces far more than it is able to consume or demand domestically, but even with one of the highest current account surpluses in history and with explosive credit expansion to generate demand, inventories are rising and growth rates dropping sharply. Reforms during the past three years have done too little to resolve the problem, and whether China can rely on these reforms depends on how much longer Beijing can afford to allow excessive credit expansion before China runs into debt capacity limits, and on whether Beijing is strong enough to overcome domestic political opposition and speed up the pace of the rebalancing.

Is this new set of supply-side reforms the solution? At least some of the policies that are being bandied about are actually contradictory or mutually exclusive, and clearly there is not nearly enough certainty about what exactly the reforms entail nor, just as importantly, whether they can be implemented, but already analysts have been wrestling with the implications, trying to clarify the reform proposals, and providing their initial evaluations. According to last month’s Economist:

Those who first pushed supply-side reform onto China’s political agenda want a clean break with the credit-driven past. Jia Kang, an outspoken researcher in the finance ministry who co-founded the new supply-side academy, defines the term in opposition to the short-term demand management that has often characterised China’s economic policy—the boosting of consumption and investment with the help of cheap money and dollops of government spending.

Whatever the supply-side reforms imply about earlier reform proposals, I do not think we can easily declare yet either that the new policies will be successful as predicted or that they won’t – with one exception: I am very confident in saying that unless implicit wealth transfers to the household sector rise to 2-3% of GDP annually, which I recognize will be politically very difficult to manage, there is almost no chance that growth over the rest of this decade can remain at 7% or even at 6% or 5%.

Because we are still in the very early stages of this new set of policies, it is hard to discuss them except in very abstract terms, and already so much ink has been spilled describing them that contradictions and confusions have emerged. An article in China Daily seems to set the stage at least as well as any other:

China used to rely on three major forces to drive economic growth – investment, exports and consumption, which are classified as the demand side. As the effectiveness of boosting growth in the demand side wanes, the government has started to reform the supply side, or the supply and effective use of production factors, including funds, resources, skilled workers, equipment and technologies. The reform aims to accelerate economic growth by freeing up productivity and raising supply-side competitiveness. Measures will include cutting excess industrial capacity, reducing housing inventories and cutting production costs with policy support.

The focus on freeing up productivity and raising competitiveness is of course no different than the promises made by the earlier set of reforms, but supply-side doctrine proposes that rather than raising productivity by improving the distribution of demand and letting producers respond, Beijing will take steps to boost production efficiencies, confident that more efficient and profitable producers will trickle down into stronger consumption. Credit Suisse, in its December 21 report, specifies more concretely how Beijing plans to raise productivity:

The central committee of China’s communist party held the annual Economic Working Conference between 18 and 21 December. The conference listed five major tasks for 2016: (1) Reduce over-capacity. (2) De-stocking. (3) De-leveraging. (4) Lower corporate costs. (5) Improve weak links in the economy.

The meeting pointed out that supply-side policy should be given more attention in order to stabilize growth. The conference highlighted that promoting the supply-side structural reform is an innovation to help China to adapt to, as well as to lead, the new norm of the economy. In the coming years starting from 2016, China will promote the supply-side structural reforms on top of appropriate expansion of aggregate demand. China will maintain macro policy stability in order to create a stable macro environment for structural reform. China will enhance the strength of active fiscal policy through tax cuts and the periodic increase of the budget deficit. Steady monetary policy should be adapted with flexibility. China will maintain adequate liquidity and appropriate growth of total social financing. China will increase the degree of direct financing, lower funding costs and further develop the exchange rate mechanism.

An primer in Xinhua proposes, similarly, the following policies that are consistent with Credit Suisse’s understanding:

Cutting housing inventories, tackling debt overhang, eliminating superfluous industrial capacity, cutting business costs, streamlining bureaucracy, urbanization and abandoning the one-child policy are all examples of supply-side reforms. Viewed as a whole, these measures can also be considered “structural” reform. By cutting capacity, nurturing new industries and improving the mobility of the populace, vitality and productivity should increase.