A Paper Dragon

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Meltzer 3

Dr. Allan H. Meltzer is an American Economist and the Allan H. Meltzer professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. He is the author of a large number of academic papers and books on monetary policy and the Federal Resrve Bank. Dr. Meltzer’s two volume books, “A History of the Federal Reserve”, are considered the most comprehensive history of the central bank.   He is considered one of the world’s foremost experts on the development and application of monetary policy. Currently he is also President of the Mont Pelerin Society. Dr. Meltzer originated the aphorism “Capitalism without failure is like religion without sin. It doesn’t work.”

This is a monthly column written by Professor Meltzer for Defining Ideas of the Hoover Institution.

It is posted in   http://www.hoover.org/research/

China has not established the rule of law and thus there is no justice.

—Ai Weiwei: Weiwei–University presentation, 2013

Public attitudes toward China’s future have turned from celebration of its development to concern about confrontation with the United States. China’s leaders repeat their pledge to make China a global power, a serious rival to the United States.

The United States responded to the chal- lenge by offering the principal regional coun- tries other than China a multi-lateral trade agreement that commits countries to more open, competitive trading arrangements and supplements the military-political role the United States has taken since the end of World War II.

China responded both economically and militarily. It established the Asian Infrastructure Investment Bank with fifty-seven partner countries. The Bank has $100 billion to lend for infrastructure in Asia. China has the dominant role and the purpose is to bind countries economically to China. Of less importance, the renminbi is now included in the International Monetary Fund (imf) basket used to calculate the sdr or Special Drawing Right. Since the sdr has very little current importance, and the

U.S. dollar is the main international currency, China’s interest in making its currency an alter- native to the dollar is, for the present at least, unlikely to have much importance. Markets for dollars are large and liquid. Markets for China’s renminbi are not.

Militarily, China has launched an aircraft carrier, upgraded its army, and developed a landing strip on a man-made island in the South China Sea. This is a provocation be- cause several countries claim that the islands fall within their territorial waters but not in China’s. And the United States insists that freedom of navigation must not be hindered. China’s announced objective to become a major world power is central to its challenges to the United States. I believe the Chinese can succeed only if the United States falters. The reason is that China replaces the rule of law with authoritarian control of its people and economy. As the quotation from the noted artist Ai Weiwei proclaims, without the rule of law, China’s government can punish dissent without restriction. And it does.

The former Chinese leader Jiang Zemin recognized that China had to make political reforms that restricted authoritarian govern- ment. He did not make those reforms when he held power and his successors have not tried. At the local level, however, the party now permits citizens to elect village commit- tees in some places. Fujian province, on the coast opposite Taiwan, has gone the farthest toward local autonomy without opposition from the Communist Party.

Lawyers and scholars have not agreed on a succinct definition of the rule of law. The concept is so complex that statements typi- cally replace a definition with a list of features. One consistent theme is avoiding discretion-

ary decisions whether by judges, politicians, or officials. The objective is to have rules of general applicability with all parties subject to the same penalties and opportunities. “Equal justice under the law” is engraved on the U.S. Supreme Court building.

Equality under the law is, of course, an ideal. Countries differ greatly in their commitment as well as in the laws they pass. Singapore has some strict rules, but it attempts to enforce them without prejudice.

Understanding the importance of the rule of law is the foundation of democratic societies. Two propositions show its importance.

First, excepting only oil-rich states like Saudi Arabia, all rich countries have the rule of law. The rules differ. Several developed from British law but took their own paths.

Second, no country without the rule of law has become rich. A plausible reason is that the rule of law provides a degree of certainty that encourages innovation, new ideas, new prod- ucts, and new ways of achieving economic and social progress. It is not accidental that most significant innovations start in rule-of-law countries such as the United States, the United Kingdom, Germany, and Japan. In contrast to authoritarian countries, there is little or no fear of penalties for innovating. Also, corruption and cronyism are most difficult to prevent where competition is absent, as in authoritar- ian countries.

China’s president currently makes a major ef- fort to eliminate bribery and corruption. Perma- nent success is unlikely to follow. Authoritarian systems can award valuable arrangements, so the very human tendency to profit personally remains a valued right that an official can sell to a willing buyer. Officials have discretion to award those who reward them.

Authoritarian regimes most often create monopolies to produce economic goods and services, sacrificing the benefits that come from competition over time. China has a mixture of state-owned enterprises and privately owned but regulated firms. The state-owned enter- prises earn much less profit by any measure. Often they are inefficient, overstaffed, and slow to adopt new ideas.

China invited foreign firms to produce in China but required them to bring their latest, best technology. Chinese firms adopted foreign technologies and methods, so they were able to compete internationally. (Now, China depends on cyber spying to learn about innovation.) Without the rule of law, China will be slow to develop independently. Authoritarian systems do not favor individual initiative. Absence of freedom of contract and secure property rights discourages innovation.

The former Soviet Union is a relevant ex- ample. Like China, it had many talented sci- entists and engineers. And it spent large sums on research, but it did not develop new tech- nologies. Its major achievement—the first suc- cessful space orbit—was principally the work of captive German scientists and engineers at the end of the Second World War.

On the Fraser Institute’s list of countries with the twenty-five largest gdps adjusted for purchasing power differences, all but the oil-rich countries have some form of the rule of law. Most of the non-oil countries in the top twenty-five have scores of 90 for property rights and in the 80s for “freedom from cor- ruption.” As the United States increased the extent of government regulation of business in recent years, its rating for rule of law de- clined. In the current Heritage ranking, the United States is in tenth place with scores of 80 for property rights and 72 for freedom from corruption. In contrast, China’s rank is eighty-ninth with scores of 20 for property rights and 35 for freedom from corruption. An alternative measure by the Cato Institute for 2012 puts the United States in twentieth place for rule of law with a score of 6.5 out of 10. China is placed at 132 (out of 152) with a score of 4.2 out of 10.

The data from both Fraser and Heritage support the two propositions about growth and rule of law or freedom. Rule of law is necessary but not sufficient for high per capita income. Although lawyers have not agreed on a succinct definition of the rule of law, secure property rights and personal freedom are on every list.

Ai Weiwei’s statement suggests how far China is from adopting a rule of law constitution. China’s government knows about the rule of law and it accepts the rule of law in international transactions, but it shows no sign that it plans to adopt and enforce general laws or a constitution that protects people and property. Doing so limits the power of an authoritarian government. To sustain a growth rate high enough to make China a world-class power, China’s ruling authorities must severely limit their power to make and change rules at their whim. The rulers are un- willing to permit greater freedom. No plans for reform open a path toward individual rights or a constitution that grants citizens enforceable rights to personal and economic freedom.

Chinese authorities act forcefully against corruption. Yet they do not recognize that corruption is inherently fostered by a power- ful state that can reward some who offer bribes and punish others. This is the very opposite of the rule of law.

Realizing China’s multi-year goal of becom- ing a wealthy and powerful nation is highly ambitious under the best of circumstances. Doing it without adopting the rule of law makes the goal impossible to attain. Unlike its Asian neighbors, China’s high growth of gdp ended long before it became a wealthy country. China will grow, but its growth will not reach the level needed to achieve China’s goal of wealth comparable to the United States or Western Europe.

For many years, commenters marveled at Chi- na’s sustained 10 percent annual rate of growth and projected it would remain unchanged into the future. A common conclusion about five years ago forecast that China’s output would surpass U.S. output by 2020. There was much discussion of China’s challenge to the United States. Some saw authoritarian direction as a better way to solve economic and social prob- lems than democratic capitalism. Forecasts of this type did not mention that it was the ag- gregate, not the per capita gdp.

That positive view of China is no longer heard. The growth rate is down to 6 or 7 per- cent per annum, and, because Chinese statisti- cal reports are not always accurate, the growth

rate may be lower than 6 percent. Wasteful production, especially of buildings that remain empty, is a long-standing Chinese problem that commentators discounted or ignored until recently.

President Xi and others boasted that China had created a new political-economic system, superior to democratic capitalism. Those boasts now have less appeal. China’s high growth rate brought substantial wealth and improved living standards for many. Like simi- lar periods of high growth in Japan and South Korea, high growth ended when the number of unskilled workers moving from agriculture to industry declined.

Current negative comments focus on the sharp drop in stock prices and devaluation of the currency. These are as overdone as the previous euphoria. China is neither a superior new model nor a government of incompetent administrators. It is a government of humans who often make errors when events move rap- idly. Many of its newly wealthy citizens show their skepticism about the future by buying expensive property on the U.S. and Canadian west coast.

An important difference between China and its neighbors is that Chinese growth slowed when large parts of China remained poor and backward. While many residents of coastal cit- ies enjoy a greatly increased living standard, large numbers of Chinese continue lives not very different from the past. A measure of China’s relative position is that per capita gdp is only 22 percent of the U.S. level. And the United States no longer has the world’s high- est per capita gdp. The difference between the two countries is an indication of how much China must grow to reach developed country status. Of course, it does not have to close the entire gap.

Economic growth occurs when population or labor force and productivity grow. China’s future population growth rate is negative. For thirty-five years, until recently, government policy restricted births and forced abortions. The low birthrate of the past implies that population will age and decline. Forecasts predict that the current 1.4 billion population will decline to 500 million by the end of the twenty-first century. The forecast calls for a decline of little more than 1 percent per annum. The forecast may, of course, prove wide of the mark, but the direction is clear. Declining population will reduce economic growth. To keep population stable, popula- tion must grow at a rate just above 2 percent a year. Currently, Japan shows the effect of slow population growth on gdp growth.

That leaves productivity growth as a possible source of high economic growth sufficient to become a wealthy nation. There are good rea- sons for skepticism that China can restore past productivity growth.

As a possible example of growth over the next seventy or eighty years in the United States and China, I assume China’s annual productivity growth is twice as fast as in the United States, say 4 percent versus the Unit- ed States’s 2 percent. Allowing for declining population, China’s gdp rises annually by 3 percent. In about 2090, China’s per capita gdp would be only one third of U.S. gdp.

The comparison is one example of many. The maintained 2 percent U.S. growth rate may be too high. Also, China’s higher growth is unlikely to be sustained over seventy years. The main point is that whatever numbers one chooses, China starts from a low level and is unlikely to realize its leaders’ ambitions to become the world’s leading power.

The years of China’s high productivity growth saw a massive movement of workers from ru- ral farms to manufacturing centers. Workers brought few skills other than the ability to work hard and willingness to do so. This large pool of unskilled labor is no longer available for several reasons.

First, as worker skills increased, productivity and wages rose. Much of the textile industry moved out of China to Vietnam, Bangladesh, and other low-wage countries.

Second, Chinese agriculture is very inef- ficient. Farms are small, land cannot be pur- chased, and much of the work is done by hand labor. Communist ideology prevents farmers from reaching efficient scale. Currently 35 per- cent of the labor force remains in agriculture. It produces only 10 percent of China’s gdp. In

the United States, 1 percent of the labor force is in agriculture. It produces one percent of the much larger U.S. gdp. China reports that urban income is three times rural income on average. A principal reason is low agricultural productivity. I have never received a good ex- planation of the failure of Chinese farmers to develop agricultural cooperatives that enabled them to own farm equipment collectively as in the United States during the era of small farms. Third, China retains restrictions on worker movement from farm to city. These restrictions slow China’s current and future growth and retard agricultural productivity.

China will continue to grow. Its current effort to increase the share of private consump- tion from 34 percent of gdp is a way of raising consumption standards in the interior of the county to benefit a large part of its popula- tion. This policy is likely to contribute to real growth of output. But it will be slow.

Another opportunity for growth calls for China to increase the technical skills of its workforce. Currently, China exports comput- ers, hand-held telephones, and other technical products. China produces the packaging and provides the marketing. Most of the techni- cal parts are imported from Japan, South Ko- rea, and Taiwan. As the Chinese labor force acquires the necessary skills, the growth rate will benefit.

China’s problems are now discussed active- ly. Many refer to the large number of empty buildings as a waste of capital spending, where earlier these problems were ignored. Some critics join China’s officials in seeing one of China’s main problems as the transition from an export-oriented economy to domestic con- sumption. Others see the major problem as the need to convert state-owned enterprises into privately owned or directed firms. This recog- nizes that the private sector is more productive and much more profitable than the state sec- tor. Still, others point to extensive water and air pollution, sizable income inequality, and widespread corruption, in order to criticize the emphasis on economic growth as excessive.

If China’s leadership could close the state- owned enterprises or sell them to investors and make them compete, China would take a
step toward higher growth. The state-owned enterprises absorb a large share of the credit issued by state-owned banks. They receive favorable treatment. They waste capital and earn much lower returns than companies in the private sector. They produce much of the air pollution that burdens China’s cities. They are protected politically and the government seems unable to reform them.

Other problems facing China are inadequate pension and health care systems for the de- mands of an aging population. Satisfying these demands draws resources from investment to consumption, slowing economic growth but adding to social welfare. China is unlikely to have the resources to invest heavily to raise productivity while servicing an aging popu- lation and reducing air and water pollution. Important as many of these problems are, they are not the main obstacles to achieving the leadership’s goal of making China a great power. No country, ever, has been able to make the necessary adjustment and achieve a high living standard without adopting a strong rule of law embedded in some constitutional system. China’s administrators, therefore, face a major choice. They must restrict their authority by adopting a rule-of-law constitu- tion. That does not mean they must become as open and free as Hong Kong. Singapore has a strong rule-of-law tradition but also strong restrictions on personal behavior. Property rights, limited special privilege, allowing the market instead of the administration to allo- cate credit, uniform enforcement of laws, open competition to improve products and services, and freedom of speech—unlike laws under authoritarian rulers—encourage innovation and fair dealing.

For China to grow from its current level of per-capita gdp to a level four or five times higher, it must adopt the rule of law. That is not an overnight change. It must remain in effect, as part of a constitution, long enough to be believed. Most likely it has to survive a crisis that challenges the authoritarian state to intervene to protect its friends. Estimates by mit Professor Daron Acemoglu suggest that a country gains as much as a 20 percent increase in per capita gdp over thirty years by shifting from autocracy to democratic government.

Some Chinese officials recognize that a con- stitution that protects the rule of law is essen- tial for China’s development. At the Fourth Plenary Session of the Communist Party, an officially appointed group proposed adopting a constitution that supported the rule of law. They wrote that this major change is a prereq- uisite if China is to achieve its development goal—becoming a major world power. No response followed.

Neither the 2015 report of the International Finance Forum, where current and past of- ficials discuss current reforms and propose additional changes nor the discussion and proposal of President Xi mention the rule of law or constitutional change. The rule of law is not likely to be proposed.

Current Chinese leadership has undertaken a massive program against corruption. High officials, previously immune from prosecution, have been arrested. The program is popular and costly.

It cannot succeed permanently. Once the program ends, corruption will be lower for a time. Without enforcement of the rule of law, it will return.

Instead of seeking a possible cooperative rela- tion with the United States and its Asian allies, China’s leadership has chosen confrontation. Examples are the development of island military bases in the South China Sea that push China’s border far beyond the international limit and into areas claimed by several of its neighbors. In the East China Sea, China confronts Japan over an island. On the non-military side, China offers its neighbors “One Belt, One Round” to lead these countries to China for trade and commerce. And to tighten the linkage, China opened the Asian Infrastructure Investment Bank to develop ties binding its neighbors to China. The aiib has $100 billion to lend and fifty-seven member countries. China is the Bank’s manager. The United States and Japan are not members. The Bank is an alternative to the United Nations Asian Development Bank, which China sees as controlled by Japan and the United States.

In all of these activities China views itself as an ancient civilization that was held down by the West and has now risen to a position that demands respect and admiration. The United States responded with the Trans-Pacific Part- nership inviting countries into a trade agree- ment centered around the United States. The agreement, if ratified, will exclude China.

The former Soviet Union managed to con- front the United States for decades despite its lack of freedom and economic growth. Most Soviet citizens remained impoverished dur- ing the Cold War. That did not prevent the challenge.

China is unlikely to come close to closing the gap in per-capita income with the United States, Japan, or Western Europe. That does not prevent an authoritarian state from using its

resources to strengthen its military, as China has done and seems determined to continue doing. But, as the Soviet Union eventually learned, confrontation with the United States can be very costly. If the United States decides to increase military spending by one percentage point of per capita gdp, China must shift 5 or 6 percent of its current per capita gdp to match the United States. That reflects the difference in the incomes of the two countries. It takes a determined president and a Congress that seeks stability and acts to sustain it.

Our response must continue to show that rule-of-law countries offer the greatest opportu- nity for individuals to raise living standards and enjoy opportunities and freedom. This contrasts with China’s authoritarian system that denies freedom of speech and uses force and the threat of force, as seen in Tiananmen Square.


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