Growth engine fires up

The lack of effective demand calls for the implementation of expansionary fiscal and monetary policy to stimulate the Chinese economy

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Some have argued that because of factors such as its aging population, relatively high per capita income and the scale of its economy, the slowdown of China's GDP growth rate from about 10 percent to 5 percent is inevitable. But long-term variables that affect the economy incrementally and cumulatively should not be used to explain short-term economic changes. For example, although China has an aging society, the challenge that the Chinese authorities are currently facing is youth unemployment rather than labor shortage. Furthermore, even if the demographic aging affects the economic growth rate in a particular year, there is a long causal chain from the explanatory variable to the outcome variable. You cannot say that because China is aging, it must be satisfied with an economic growth rate of 5 percent. To jump to conclusions by skipping over many steps in the causal chain is a non sequitur.

China's indicative economic growth target should be set by trial and error based on recent experience, rather than by relying on estimates of its potential growth rate. The so-called potential economic growth rate refers to the maximum sustainable long-term growth rate an economy can achieve when it fully utilizes all its available resources, such as labor, capital and technology, without triggering high and accelerating inflation. There are three standard methods to estimate potential output: aggregate approaches, production function approaches and dynamic stochastic general equilibrium models. All methods used to calculate the potential growth rate are imperfect in one way or another and can be used only as references when making decisions.

So, what exactly is China's potential economic growth rate? It is difficult to provide a definitive answer. Nevertheless, we should still be able to roughly gauge whether the economy is operating above or below the potential rate. If the previous year saw low economic growth (or high unemployment) coupled with low inflation, the government should not hesitate to adopt more expansionary fiscal and monetary policies to stimulate the economy. Conversely, the opposite conditions would warrant a more contractionary policy stance.

The fact that China's GDP growth rate has declined from 10.3 percent in 2010 to 5 percent in 2024 and its consumer price index (CPI) growth rate has remained below 3 percent since 2012 makes it evident that the Chinese macroeconomy is currently challenged by insufficient effective demand rather than mere overcapacity that basically is a sectorial problem. Hence, the implementation of expansionary fiscal and monetary policy to stimulate the economy for a higher growth rate is entirely warranted.

China's government debt-to-GDP ratio is much lower than most industrialized economies and the People's Bank of China's benchmark interest rates are well above zero, all of which show that China still has substantial policy space for implementing expansionary fiscal and monetary policy. Traditionally, the Chinese government has been very cautious about running a budget deficit, prioritizing economic stability and sustainable growth. It worries the inflationary consequences of a loose fiscal policy. However, recent experience shows that the fiscal authorities' focus should be on fiscal sustainability rather than on fiscal balances. China is a high savings country. The yield of China's 10-year bonds is about 1.6 percent, which suggests that Chinese households are very keen on holding more government bonds as a store of value. As long as the domestic demand for government bonds is strong, China doesn't need to worry too much about its fiscal sustainability. On the contrary, a more expansionary fiscal policy could accelerate GDP growth. This higher growth rate would, in turn, lead to a lower government debt-to-GDP ratio over time, ultimately making China's fiscal position more sustainable. A similar argument applies to the analysis of China's monetary policy.

Others have argued that deepening China's structural reforms is more critical than combating deflationary pressures for achieving higher long-term growth. They contend that an economic slowdown creates more space for implementing such reforms. Consequently, proponents of this view feel no urgency to employ expansionary fiscal and monetary policies.

However, this argument is flawed because the pursuit of expansionary policy and structural reform are not mutually exclusive. In fact, they are mutually reinforcing. For instance, boosting consumer demand effectively requires a dual approach: It necessitates both macroeconomic tools, such as the distribution of consumption vouchers and tax cuts, and deep-rooted structural reforms, such as strengthening the social security system, which is crucial for reducing precautionary savings and encouraging household spending.

Conversely, a favorable macroeconomic climate, sustained by supportive policies, facilitates the process of structural reform. For example, workers made redundant in declining industries will find it significantly easier to transition to new jobs in a growing economy with robust aggregate demand. This makes reforms socially and politically more manageable.

In the late 1990s and early 2000s, when China's growth rate was low due to the impact of the Asian Financial Crisis, it was beset by the severe non-performing loan problem, making the retrenchment and restructuring of its banking system an urgent priority. Some urged the government to refrain from implementing expansionary fiscal policy, warning that it would exacerbate the non-performing loan problem. However, the government proceeded with its stimulus plans. The resulting high economic growth rate led to a crucial outcome: the leverage ratio of banks decreased. Growth expanded the denominator (GDP and bank assets) faster than the numerator (bad debts), improving the health of bank balance sheets. This improvement made the subsequent restructuring of the banks significantly easier to execute.

The 4-trillion-yuan ($561.3 billion) stimulus package, launched in November 2008, has been widely debated. Many economists attribute the subsequent sustained decline in China's economic growth, the drop in total factor productivity and various financial irregularities to this plan.

In my view, a more objective assessment would be that, despite its side effects, the overall direction of the stimulus package was correct. The issue was not that the government introduced the stimulus, but that it exited the stimulus too rapidly after achieving a V-shaped economic rebound.

The government was fully aware of the potential negative impacts of expansionary fiscal and monetary policies and intended to exit these policies as quickly as possible from the outset. This intention was followed through — the fiscal deficit-to-GDP ratio was reduced to about 2 percent in 2011 from about 3 percent in 2009. New loans dropped to 7.5 trillion yuan in 2011 from 9.6 trillion yuan in 2009. The growth rate of infrastructure investment declined sharply from 44.3 percent in 2009 to just 5.9 percent in 2011. The hasty exit was bound to cause a slowdown in China's growth rate and create various financial irregularities, especially the local government debt problem.

In contrast, Western countries maintained their expansionary fiscal and monetary policies for a significantly longer duration. For instance, when the subprime crisis erupted in 2007, the United States fiscal deficit-to-GDP ratio stood at 1.1 percent. It increased to 3.1 percent in 2008 and surged to 9.8 percent in 2009. The US maintained an annual average deficit-to-GDP ratio of 4.8 percent from 2009 to 2019. The average rate was 6.9 percent for the period from 2009 to 2021.

Following the implementation of quantitative easing in 2008, the Federal Reserve's balance sheet expanded from less than $1 trillion to $4.5 trillion in 2014.

The Fed lowered its target for the federal funds rate to 0.25 percent in 2008 and maintained this near-zero interest rate policy until the end of 2015. It reinstated the Zero Interest Rate Policy in March 2020, which remained in effect until March 2022.

It is worth mentioning that the Franklin Roosevelt administration's New Deal, adopted in 1933, spurred a significant rebound. However, fearing fiscal imbalances and inflation, the government implemented fiscal austerity in 1937. This policy shift triggered a renewed recession, and the US economy did not achieve a full recovery until the wartime economy emerged in 1941. This historical episode underscores the crucial importance of correct policy timing.

While no country should become addicted to fiscal and monetary stimulus, such policies should not be exited before confidence is fully restored and demand becomes self-sustaining. Certainly, this is easier said than done; it is a matter of experience and the art of statecraft.

Inflation is not "always and everywhere a monetary phenomenon". Chinese economic policymakers and economists were once almost uniformly disciples of Milton Friedman, a US economist and Nobel laureate, firmly believing that "inflation is always and everywhere a monetary phenomenon". They held that the inflation rate was highly correlated with the growth rate of money supply, and that any apparent divergence was merely due to a lag of the former behind the latter.

However, broad money supply growth in 2009 was 27.7 percent, while the growth rates of GDP and CPI were 8.7 percent and minus 0.7 percent, respectively. The sharp increase in the money supply after the global financial crisis, coupled with a sharp decline in the inflation rate, is difficult to explain merely by a time lag.

The crucial point is that the external shock of the global financial crisis led to a collapse in effective demand, which directly caused the CPI to fall. In this instance, the change in the inflation rate was caused by an imbalance between supply and demand in the real economy, rather than by changes in the money supply. Hence, policy should be aimed at stimulating aggregate demand rather than focusing only on price stability.

Since the outbreak of the global financial crisis, developed countries worldwide have implemented unconventional ultra-loose monetary policies. Although the effects of these ultra-loose monetary policies have varied across these countries, they have not caused inflation in any of them. On the contrary, how to raise the inflation rate has become a major headache for their central banks since late 2021. The implementation of monetary policy over the past decade has forced economists to rethink the nature of money. However, it is also worth mentioning that eventually, ultra-loose monetary policy will trigger inflation, if monetary authorities fail to exit in a timely fashion. Again, the right timing is crucial.

Many economists argue that China's "investment-driven" growth paradigm or strategy has reached its limits and that the country should shift to a "consumption-driven" approach. This argument is misguided. In fact, there is no such a thing as a "consumption-driven" growth paradigm or strategy.

Across all economic theories — from classical economics to Marxist political economy to modern growth theory — none propose the existence of a "consumption-driven" growth paradigm. Economic growth, or its potential, depends on the accumulation of physical capital, increases in effective labor supply and technological progress. In a macroeconomic production function, there isn't an independent variable that is called consumption. Consumption contributes to economic growth only to the extent that it enhances human capital. For example, hiking improves health and thus increases effective labor supply.

The experience of China's reform and opening-up also demonstrates that without a high investment rate supported by a high savings rate, it would have been impossible for China to transform itself from the world's 11th-largest economy into the second-largest economy with a robust manufacturing sector and a comprehensive supply chain in over 40 years.

The role of consumption becomes relevant only in the context of demand management: Boosting consumption, along with investment and net exports, can help close output gaps and align actual growth with potential. But consumption does not raise potential growth itself.

When the economy faces deflationary pressure, macro policies should aim to stimulate both consumption and investment, at times with greater emphasis on consumption. This may raise the consumption rate — the share of consumption in GDP — relative to the investment rate. However, the key metric is not the consumption rate but the absolute level of consumption. In many developing countries, consumption levels remain low even with high consumption rates due to low investment and constrained economic growth. In such cases, elevating investment is essential to expand productive capacity and raise future consumption possibilities.

The trade-off between investment and consumption fundamentally represents a choice between present consumption and higher consumption in the future. This trade-off should be determined through public deliberation and collective decision-making.

The communiqué released by the Conference of the Political Bureau of the Communist Party of China Central Committee on Sept 26, 2024, emphasized the need to strengthen the force of countercyclical adjustments by fiscal and monetary policies, ensure necessary fiscal expenditures, and effectively issue and utilize ultra-long-term special government bonds as well as special bonds for local governments to enhance the leading role of government investment. It also calls for reducing the reserve requirement ratio and implementing interest rate cuts with sufficient intensity.

To ensure the effective implementation of these policies, it is essential to draw on past experiences and lessons to clarify misconceptions in macroeconomic management. There is more work to be done.

The author is an academic member of the Chinese Academy of Social Sciences. The author contributed this article to China Watch, a think tank powered by China Daily.

The views do not necessarily reflect those of China Daily.

Contact the editor at editor@chinawatch.cn.