Cultural economics of China and the effective demand growth model

I had a friend who worked as a teacher in China. She made about $600 per month there 10 years ago. She said there was one question that the Chinese would ask her, even Chinese that she met for the first time. People would ask her name, where she was from, what her job was… and then they would ask her … How much money she made.

As an American, that is a very uncomfortable question, but the Chinese were very straightforward and unabashed with the question. They felt it was a normal acceptable question to ask. The problem was that she made 3 times what her Chinese co-workers were making. As they found out what she was making, animosity grew. They were socially respectful enough at work but she could feel a tension about wages.

Think of the massive number of workers in China who think at least once a day about higher wages and more time off. Yet their loyalty to their companies is institutionalized. Many companies control where their workers live, the rents they pay, the hours they work and so on. I have heard it said from Chinese businessmen that workers perform better with strong authoritarian control.

There is a great desire for the Chinese to make more money in their work. Even the future success of China’s re-balancing depends upon higher wages. But how much would wages have to rise in order for the re-balancing to succeed?

I bring in the growth model of the effective demand research…

This model shows the optimal path of labor and capital utilization as the real GDP in an economy grows or declines as the case may be. The green line shows effective labor share equal to capacity utilization. The green line is the optimal path. The blue line shows the optimal capacity utilization for any given level of real GDP. Here is the equation of the blue line…

cu* = optimal capacity utilization… Y = real GDP… els = effective labor share… a = business cycle amplitude constant in terms of a base year’s dollars.

The optimal level of labor share is found where the blue line and the green line cross.

The red line is the effective demand limit based on a natural unemployment of 7%. The red line has the equation…

cu = els/(1-u)

cu = capacity utilization… els = effective labor share… u = natural rate of unemployment

The orange line is actual data from the US, 1967 to 2012. You can see how the economy stays below the red line as real GDP changes through the business cycles.

When real GDP is low (dark blue line), labor share is optimally low to allow for investment, as is the case in China. But China’s real GDP is growing at over 7%. So the line is shifting up. As the line shifts up, real GDP increases, and labor share must increase in order to maintain optimum utilization of labor and capital.

Now the question… what happens if labor share does not grow as real GDP increases?

This graphs shows an effective labor share of 58%, yet real GDP has grown far beyond that as seen by the blue line shifting upward. The yellow dot shows where the economy must remain, since the yellow dot cannot go above the red line. Capacity utilization is thus constrained to around 64% by effective demand. The only way to increase capacity utilization is to increase labor share.

The difference between the blue line of optimal utilization of capital and the yellow dot is the dead-weight loss to society. Now as real GDP increases in China without a corresponding increase in labor share, the dead-weight loss will grow and grow and grow. Eventually the dead-weight loss can be so great that growth is inhibited, in spite of ever-accelerating growth in investment spending.

The dead-weight loss is based on low labor costs in the face of rising output. The result is more profit to those who own capital. There are incentives to increase profits through investment, and not production for domestic demand. To continue on this path of high investment is not optimal in order for an economy to mature.

I am explaining the situation is China through the eyes of the effective demand research.

My back of the envelope calculation says that as China’s real GDP grows at 8% per year, their labor share would have to rise on average at 2.3% per year. For example, if effective labor share is 60% this year, next year it should be 61.4%. That is a big increase, but then so is an increase of 7% for real GDP.

There are many cases through history where a country is growing and then they reach a barrier and the growth stops. In many cases, the barrier comes from a labor share that never rose enough. Such is the case with many export-led economies. China is in a race with the above curve so as not to face a huge dead-weight loss from insufficient effective demand. If labor share does not rise enough in China, there will be repercussions felt around the world.

My view is that China will simply not be able to raise labor share enough due to their cultural values. They have strong institutions to keep workers under a strict control. They also have a reputation for being stingy with their money. We see their dismal offer of $100,000 for the Philippines after that terrible storm. That is like the cost of 5 cars. It is what is called a “character-defining moment”.

As Michael Pettis explains, they must have enough social capital in order to absorb all that capital investment. Social capital refers to the institutions of business and society, as well as the purchasing power of society. When social capital is well-developed, capital investment is absorbed. He puts forth an argument with the implication that expansionary monetary policy designed to bolster investment will ultimately be ineffective when social capital is weak.

“What Beijing must do, in this case, is to ignore GDP growth rates and focus on household income growth rates, which anyway are what should really matter. Rather than continue to increase investment in manufacturing capacity, infrastructure, and real estate, Beijing should find ways to curtail investment growth sharply and to allocate what capital is invested to small and medium enterprises, to service industries, and to the agricultural sector, all of which are sectors whose growth at the expense of the current beneficiaries of high investment growth (SOEs, local and municipal governments, national champions, etc.) are likely to imply improvement in China’s social capital. Doing this will also require significant changes in the legal, social, financial and political institutions that constrain China’s ability to absorb capital efficiently.”

My view is that China is so determined to be an economic rival of the US, that they will keep increasing investment until their economy is as productive as the US. They will base this growth on the comparative advantage of low wages and low labor share. As a culture, it will be extremely difficult to switch from a mind-set of increasing productive capacity, to one of increasing purchasing power of the workers.

Related articles:

Lambert, Edward. When labor share does not rise in the growth model. Effective demand blog, 4/6/2013.

Lambert, Edward. Building the growth model of effective demand. Effective demand blog, 4/6/2013.

Pettis, Michael. Rebalancing and long term growth. Michael Pettis’ Chinese financial markets blog. 9/3/2013