Thursday, April 1, 2010

FLG's Marines Theory of Government, Development, and China

Alpheus writes:
I know I've beaten this drum before, but, well, here is it again. China's real economic advantages are, by and large, exactly the advantages America used to have, and could probably have again if we really wanted to. In the discussion of what China is doing right, Communism is just a red herring.

FLG, like Alpheus, will be repeating himself in this post.

FLG has long maintained that government is like the marines. If you need a lot of resources moved in a short period to accomplish something human beings already know how to do with little concern about efficiency, then government might just work. And in economic development, we have a Gerschenkronian model, which says, among other things, that the later you develop the more likely the state will be involved. The UK industrialized first and has historically had less government involvement in the economy than France, Germany, Russia, or Japan, all of which developed afterward.

This makes sense both theoretically and practically. The UK had organic industrial growth. Basically, although FLG oversimplifies, textile mills popped up. These aren't terribly capital intensive. Not like a steel mill, for instance. This then allowed the country to increase productivity, and create more savings and capital. The increased output of cloth created the need to carry more to market, which led to transportation developments, such as railroads.

Once railroads are developed, however, another country can simply build them. This is where the government comes in. It takes a time for individuals and small businesses to save up enough for small machinery. And then for those businesses to yield enough fruit to reinvest and pool enough capital for things like railroads. But the government can force savings and direct them toward things like huge steel mills and railroads quickly. It doesn't really matter if the government allocates capital in the most efficient way possible as long as the gains from the forced savings are big enough.

Think of it using one of my favorite economic metaphors -- digging holes. Let's say an undeveloped country is like a bunch of people digging hole with their hands. Sure, they could eventually save up, buy shovels, and then wheelbarrows and more and bigger holes will be dug. The returns from these may allow some people to invent and sell bulldozers, and eventually the country industrializes.

But since bulldozers are now invented, other countries can raise taxes, buy bulldozers, and deploy them. It doesn't really matter if the government gets the very best deal possible on the best bulldozers available, i.e. work perfectly efficiently. The country will be far more productive after the bulldozers are in place than digging with their hands.

On a more theoretical level, there are economic models of development that imply a golden rule savings rate. Nevertheless, a country can bump up their economic output through increased savings:
an increase in the saving rate shifts the function up. Saving per worker is now greater than population growth plus depreciation, so capital accumulation increases, shifting the steady state from point A to B. As can be seen on the graph, output per worker correspondingly moves from y0 to y1. Initially the economy expands faster, but eventually goes back to the steady state rate of growth which equals n.

There is now permanently higher capital and productivity per worker, but economic growth is the same as before the savings increase.

Moreover, industrialization can be wrenching economically, personally, and socially to the people currently in an agricultural economy. People generally resist making large drastic change in a short timeframe. Here, authoritarian and strong states have an advantage in development. They can forcefully push through roadblocks and inertia.

So, China's supposed advantages are only a result of their lack of development. FLG firmly believes that at some point the benefits of the authoritarian model will run out. When? Well, there's not a specific year, but FLG has an idea about when the problem arises -- when the marginal productivity of additional development is less than the inefficiency of government allocation, which is to say, somewhat tautologically, when the costs outweigh the benefits.

Okay, so states can funnel savings. Big whoop. We know that. They also can build new, shiny airports and buildings where we have older ones. But again big whoop. Airport's job is to move people. Indeed, it's not a surprise that developing countries leapfrog to new technologies, they aren't stupid. For example, why lay a bunch of cable when wireless phones exist?

There's nothing miraculous about China's development. In fact, an article by Paul Krugman that I've linked to a gazillion times explains it pretty well:
IT IS A TAUTOLOGY that economic expansion represents the sum of two sources of growth. On one side are increases in "inputs": growth in employment, in the education level of workers, and in the stock of physical capital (machines, buildings, roads, and so on). On the other side are increases in the output per unit of input; such increases may result from better management or better economic policy, but in the long run are primarily due to increases in knowledge.

China is increasing inputs. This cannot continue forever. What will eventually need to drive growth is output per unit of input, which means technological improvement. Well, technological improvement has historically come from trial and error, at which democracy and free markets are decidedly better.

Given the nature of China's economy and population, there is probably still a long way to go before the diminishing returns start to kick in. Maybe a decade or two is FLG's guess. But there are no lessons to be learned from China. We shouldn't even be looking or really even worried about it from an economic perspective.

There are two fascinating questions for FLG:
1) When, not if, exactly will China's growth slow and, more importantly, how will that affect the Chinese political system?
2) These later developing countries, like France, Germany, and Japan, have a very different financial system from the UK and US. It's more based on direct loans between banks and firms with close ties with one another. Whereas, the US and UK have bond markets for borrowing and lending money. The bank-based model is somewhat more stable, but is also less dynamic. A few years ago, people would've probably said everybody would eventually follow the UK and US into market-based systems. The recent unpleasantness in the market has probably retarded that shift, but FLG still thinks it will occur. It's just a matter of how much institutional inertia is still left over from their decisions to pursue state expedited industrialization. Nevertheless, when and if that shift will occur is fascinating to FLG.

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