Solow, Krugman, and China

Perspiration vs. inspiration?

The work of Nobel laureates Robert Solow and Paul Krugman offers great insight into China’s increasingly difficult economic problems. From my perspective, that problem hinges on Chinese productivity — the Holy Grail for any economy, capitalist or market-based socialist. For China’s rapidly aging population, productivity now takes on even greater importance.  As China’s working age population declines — it peaked in 2015 and UN demographers see it falling by another 220 million by 2049 —  the only way it can sustain solid output growth is to extract more value-added from each worker through faster productivity growth.

For China, that will be hard to do. It now draws more support from low-productivity state-owned enterprises and has put increasingly intense regulatory pressure on the high-productivity private economy, especially Internet platform companies. Against that backdrop, the possibility of a quickening in overall productivity growth looks remote.

The hows and whys of productivity have long been subject of contentious debate in the economics profession.  Academics have drawn attention to several prominent sources of productivity growth — technology, investment in human capital, research and development, and inter-industry shifts in the mix of national output. The late Robert Solow, the inventor of modern growth theory, put it best, framing productivity is as a “residual” proxy for technological progress after accounting for the physical contributions to output made by labor and capital.

Paul Krugman, in a celebrated 1994 Foreign Affairs article, brought the Solow growth-accounting framework to life in thinking about economic development. The vaunted performance of the fast-growing East Asian Tigers, Krugman argued, reflected the perspiration of  “catch-up” growth achieved by building new capacity and bringing workers from low-productivity rural areas to higher-productivity cities. In a prescient warning of the Asian Financial Crisis of 1997-98, Krugman stressed that these economies ultimately failed to follow through on the genius of inspiration imbedded in the Solow productivity residual — call it a lack of imagination.

The Chinese leadership is suffering from an increasingly worrisome imagination deficit. Their deeply entrenched countercyclical policy mindset — decades of proactive fiscal and prudent monetary policy — is at odds with mounting deflationary risks, exacerbated by the lethal interplay between a rapidly aging population and serious productivity problems. At the same time, the government is stifling innovation through a barrage of regulations, attempting to draw inspiration from ideology. Without a more imaginative approach to economic stewardship, China could remain stuck, unable to muster the courage that its reformers drew on so successfully in the past.

I have been to China three times in the past three months.  I have discussed my growing concerns with a wide range of senior officials, business leaders, academics , students (both Chinese and former Yale grads), and friends. In stitching their views together, and after re-reading Solow and Krugman, my concerns have only deepened.