Jon, my former virtual landlord sent me a link to this article by Robert Fogel, suggesting that it was “time for another one of your ‘whistling past the graveyard / you can’t trust the numbers’ posts”. And he’s quite right.

As with just about every other “forward looking” report on China, Fogel focuses on current trends which cannot continue in a straight line:

In 2040, the Chinese economy will reach $123 trillion, or nearly three times the economic output of the entire globe in 2000. China’s per capita income will hit $85,000, more than double the forecast for the European Union, and also much higher than that of India and Japan. In other words, the average Chinese megacity dweller will be living twice as well as the average Frenchman when China goes from a poor country in 2000 to a superrich country in 2040. Although it will not have overtaken the United States in per capita wealth, according to my forecasts, China’s share of global GDP — 40 percent — will dwarf that of the United States (14 percent) and the European Union (5 percent) 30 years from now. This is what economic hegemony will look like.

Maybe. Or maybe the demographics that this ultra-expansionist scenario depends on won’t play out the way Fogel thinks. There’s also the problem of depending (in any meaningful way) on official government statistics:

Most accounts of China’s economic ascent offer little but vague or threatening generalities, and they usually grossly underestimate the extent of the rise — and how fast it’s coming. (For instance, a recent study by the Carnegie Endowment for International Peace predicts that by 2050, China’s economy will be just 20 percent larger than that of the United States.) Such accounts fail to fully credit the forces at work behind China’s recent success or understand how those trends will shape the future. Even China’s own economic data in some ways actually underestimate economic outputs.

[. . .]

though it’s a common refrain that Chinese data are flawed or deliberately inflated in key ways, Chinese statisticians may well be underestimating economic progress. This is especially true in the service sector because small firms often don’t report their numbers to the government and officials often fail to adequately account for improvements in the quality of output. In the United States as well as China, official estimates of GDP badly underestimate national growth if they do not take into account improvements in services such as education and health care. (Most great advances in these areas aren’t fully counted in GDP because the values of these sectors are measured by inputs instead of by output. An hour of a doctor’s time is considered no more valuable today than an hour of a doctor’s time was before the age of antibiotics and modern surgery.) Other countries have a similar national accounting problem, but the rapid growth of China’s service sector makes the underestimation more pronounced.

Well, then, at least Fogel accepts the notion that the official data may not be accurate. That’s better than a lot of commentators, although he’s still looking at it as if the official numbers were some sort of “baseline”. They’re not (although he does make a very good point that GDP numbers don’t capture improvements in quality . . . but that’s true for all economies, not just China’s). They’re even more pure fiction than the Climate Research Unit’s imaginary data.

It’s not even a deliberate lie: it’s a natural artifact of the current Chinese economic model. China’s economy is much more free now than it was ten years ago, but it’s not a free market economy yet. The central planners still attempt to control the “levers” of the economy — and they have some pretty crude ways of doing that. During the modernization of the industrial sector, probably the biggest driving force was the Peoples’ Liberation Army (PLA). They needed huge quantities of equipment, and the government didn’t want to buy everything from former Soviet and Warsaw Pact inventories (for one thing, the quality was generally poor and the technology was at least a generation behind the West).

This meant that the PLA needed — and got — much more say in what was produced and where it was produced. In other centrally planned economies, the state handled this sort of industrial policy. In China, the PLA got directly involved. A Soviet arms factory might have a military liason office with a general, several staff officers, and some GRU/KGB/NKVD oversight. The Chinese equivalent would have the general directly in charge of the factory, running it like a division of the army.

In this way, the PLA stopped being just the customer/end user. They cut out the middleman and absorbed the entire supply chain. The PLA became a significant economic player in the Chinese industrial economy . . . and this is still true today. The generals aren’t formally in charge, but they own the companies that do military production.

So what? So let’s look at how a civilian corporation’s incentives differ from one owned directly by the army. In a civilian corporation, the CEO runs the business with an eye to generating the largest profit possible while staying (for the most part) within the law. A CEO who deviates from this to ride a favourite hobby horse will eventually face the wrath of the stockholders who want that maximized profit. There are natural limits on how much freedom to invest in uneconomic activity any CEO will be given. Sensible stockholders don’t try to micromanage the firm, but do raise questions if too much of the company’s efforts are devoted to things clearly not related to the company’s long term benefit. Company accounts can be rigged, for a time, to show misleading results, but eventually (Enron, Worldcom, etc.) the truth will out.

A Chinese firm that’s owned by the army? Profit may be nice, but the “CEO” reports to a different master: the guys with the guns. The company accounts will show exactly what the guys with the guns want them to show . . . and the oversight and auditing committee members carry submachine guns. You’re told that your target is 10% growth? Don’t you think that the reported result will be at least 10%? Because your life may depend on the reported results being acceptable.

If the PLA had scaled back their involvement in the economy as the economy liberalized, this might only be a problem in old fashioned “heavy” industries. There’s not much evidence that this happened, however. The PLA’s portfolio may not include all sectors of the economy (even the PLA must have limits), but the official stats can’t indicate what portion of reported growth is from freer parts of the economy and what portion is from the 47th PLA industrial army.

Then there’s the other factor that will hobble China’s reported growth, demographics:

It’s the same story with the relative decline of a Europe plagued by falling fertility as its era of global economic clout finally ends. Here, too, the trajectory will be more sudden and stark than most reporting suggests. Europe’s low birthrate and its muted consumerism mean its contribution to global GDP will tumble to a quarter of its current share within 30 years. At that point, the economy of the 15 earliest EU countries combined will be an eighth the size of China’s.

Europe does indeed have a falling birthrate: most population growth in Europe these days is from immigration and the vastly higher birth rate of recent immigrants. Set aside the immigrants and the immigrant birth rate and most EU countries are well below replacement rate — they’ve stopped growing and started shrinking in population. Is it any wonder that Europe’s predicted share of the world GDP is poised to shrink as well?

China has a different demographic problem, and one that has the potential to cause disruptions far beyond their own borders: the aftermath of the famous “one child” policy. China has a vast disproportion of males, because Chinese parents opted to keep boy babies and abort girl babies. This may be another case where we can’t depend on the official numbers, but even if you do think they’re close to accurate, it doesn’t paint a pretty picture:

To say that China’s one-child family policy has been a disaster is an understatement. A report released earlier this month by the nation’s top think tank — the Communist Government’s Chinese Academy of Social Sciences (CASS) — says that the policy has created a huge gender imbalance with significant implications for future social stability.

Indeed, according to the report, 24 million men reaching marriageable age by 2020 will never marry because of the sex imbalance. Think of it in these terms: what if the entire population of New York City or of Australia was never able to marry. Imagine the social implications in a city or nation that large where no one can marry. Imagine if that city or country is comprised solely of 24 million men; men with no homes to return to at night; men without the responsibilities of a family to keep them engaged in productive pursuits.

Military adventurism may be in the near future for China’s neighbourhood. It’s one of the traditional ways to control and direct the excess of young males away from domestic social disruption. Fogel still prefers the rosy glow of the positive scenario, however:

Of course, China faces its own demographic nightmares, and skeptics point to many obstacles that could derail the Chinese bullet train over the next 30 years: rising income inequality, potential social unrest, territorial disputes, fuel scarcity, water shortages, environmental pollution, and a still-rickety banking system. Although the critics have a point, these concerns are no secret to China’s leaders; in recent years, Beijing has proven quite adept in tackling problems it has set out to address. Moreover, history seems to be moving in the right direction for China. The most tumultuous local dispute, over Taiwan’s sovereignty, now appears to be headed toward a resolution. And at home, the government’s increasing sensitivity to public opinion, combined with improving living standards, has resulted in a level of popular confidence in the government that, in my opinion, makes major political instability unlikely.

I’m not too sure that the Taiwan situation is even close to a peaceful resolution, but that’s a different topic altogether.

Anyway, speaking of hobby horses, I guess this topic counts as one of mine:

• August, 2004 – Rant: “The Chinese Economy”
• October, 2004 – More Economic Voodoo — or is that Feng Shui?
• April, 2007 – The Chinese economy
• May 2008 – Those untrustworthy Chinese economic numbers
• January, 2009 – China’s economic situation
• May, 2009 – Official Chinese statistics
• November, 2009 – Contrarian investment strategy: short Chinese stocks