Who Killed the Chinese Economy?

DAN KURTZ-PHELAN

There is no doubt that China’s economy is struggling. After Xi Jinping ended zero-COVID a year ago, most economists expected growth to surge—but that never really happened, and deeper problems became apparent. What are the exact causes of China’s stagnation? That’s a question of intense debate. The economists Zoe Liu, Michael Pettis, and Adam Posen each have their own answer. My colleague Justin Vogt spoke with them at a November 14 discussion co-hosted by the Peterson Institute. China’s future and the future of America’s policy toward China hinge on which of their answers is the right one.

JUSTIN VOGT

Good morning to everybody. Thanks for joining us. This is a dual event: it’s a Foreign Affairs event launch for our November/December issue, but we’re doing this in partnership with our friends at the Peterson Institute for International Economics as well. I like to think about what we’re going to do this morning as sort of like a game of Clue, a Foreign Affairs edition of Clue—the board game Clue—with the mystery that we’re trying to solve being, who killed the Chinese economy? And we’re going to get a couple of different guesses at that. Was it zero COVID in the 2020s with the excessive state interventions? Maybe it was Chinese leader Xi Jinping in the 2010s with the civil-military fusion strategy. Or maybe it was the CCP in the aughts with an outmoded growth model. 

We’re going to get variations on those guesses today from our terrific panel of guests: Adam Posen, Zoe Liu, and Michael Pettis. Take my word for it when I tell you that these are three of the very best experts on China and on the Chinese economy. I’m going to start with Adam because actually this entire sort of question was brought to the fore by this tremendous piece that Adam wrote for the magazine a couple of months ago called “The End of China’s Economic Miracle.” That’s what sort of started this debate. And the piece that is in this issue of the magazine is what’s called a response package, where we asked some people to respond to Adam’s argument and to critique it, and then for Adam to respond to them. So in some ways, this is like a live-action version of that response package. 

Adam, let me start with you. Can you explain for me and for all of us the idea that you put forward in your original article, which was that what China is struggling with is something that you refer to as “economic long COVID.” Can you explain what that is, the sources of it, and the ramifications for the Chinese economy?

ADAM POSEN

So in my view, the stunning fact about China’s economic slowdown is how little bounce China got after reopening in zero COVID. And most economies, including Japan, including other neighbors in Asia, but all high income economies, saw some degree of big consumer rebound right after they reopened. In China, that rebound barely existed and then fizzled out. And so when I look at that, what I find more deeply is that you see a huge shift in Chinese household behavior. They stopped buying durable goods, autos, expensive things. Small businesses, which are essentially owned by households, do the same thing. They start putting more and more money into bank accounts, into cash, like liquid substances or forms of assets. And in general, savings go up, but importantly, they’re moving towards liquidity. And I interpret this as a reaction to the zero COVID policy, which made China’s Communist Party and Xi’s more aggressive interventions in the face of the average Chinese person.

For decades, there was what I called a “no politics, no problem” compact in China. This, to me, was a big part of the actual Chinese miracle: that from Deng until Xi takes power in 2013, if you weren’t a democracy protester, if you weren’t an oppressed Muslim minority or some other ethnic minority, basically you could go about your commercial life. You might have to pay a bribe, you might not always get the contract you wanted, but basically you were left alone as long as you did no politics. Starting with Xi’s consolidating power in 2015, but especially with their zero COVID crackdown, average Chinese suddenly were subjected to “your company is closed, you can’t go to your job, you’ve lost your business.” And it’s arbitrary by a given party member in a given city making up their mind. And this resonates in a way with the people that putting an Alibaba executive in jail or putting an anti-corruption campaign does not, cause that’s just abstract leaders.

And so when we have this, this breaks the compact, and it’s very hard for an autocrat, which is what Xi and the Communist Party are, to reestablish credibility. They can say, “Oh gee, we did it just because of COVID and look at all the millions of lives we saved.” It’s still not credible that they’re going to go back, especially since there’s a laundry list of ways in which Xi and the party have been more and more intrusive in recent years. And the two key points to go with that: this behavior, this long COVID, economic long COVID, meaning the non-responsive consumers to incentives because they’re hoarding liquidity, they’re trying not to get expropriated, they’re basically scared. 

This occurred well before the breakdown of the real estate market. The real estate market is on top of that, it doesn’t help, but it occurred and is independent of that. And in fact, the behavior of moving into savings and out of durable goods is not necessarily what the real estate market crash would do. And the other point is, this goes with a turn against the private sector, not just the big fancy platform companies, but against the private sector more generally in China, which is marked and is different than the previous 30 years in China. So to me, we have economic long COVID in China. The ability to stimulate the economy is very limited, even though they keep trying, and therefore there’s pressure for capital, people, talent and money to exit. And that’s the direction I think policy needs to think about. 

JUSTIN VOGT

And so the sort of metaphor here that you’re making with economic long COVID is that it’s not the virus itself that has caused these lingering symptoms, but the kind of overactive immune response on the part of the state that has stuck with us. 

ADAM POSEN

Thank you for bringing it out. Yes, that is what I wanted to convey.

JUSTIN VOGT

Sure. Good, good. Zoe, you wrote about this. Obviously, you took up Adam’s article and you wrote a really interesting critique of it. If I understand your critique correctly, some of what Adam has written you sort of agree with, but the emphasis is slightly different. I’d love to hear your kind of basic take on the story that Adam tells about this, and where your view of it differs.

ZOE LIU

Really, I understand this situation as President Xi Jinping, he did not assemble China’s economic time bomb, but I do think he should be blamed for having shortened the fuse. And if I can explain this a little bit more, this is how I view the Chinese economic problems. 

I view it as having the problem of “four Ds,” including debt, demographics, demand, and decoupling. I think Professor Pettis can explain this in terms of the structural problems way much better than I do, especially in terms of debt, demand, and demographics, and all that. What I think President Xi Jinping’s share of the responsibility here is really with regard to how his policies accelerated the trajectory of decoupling. And a lot of these four Ds that I talked about—debt, demand, demographics and decoupling—a lot of these problems have long been evident, as Professor Pettis noticed, and he’s written widely about this. And President Xi Jinping and his predecessor, they were aware of these problems, but they really didn’t do enough to mitigate these long-standing issues.

So, therefore, I think it is unfair to blame Xi Jinping entirely for creating all these problems or for the lack of economic recovery post-COVID. And that’s why I think he didn’t assemble the time bomb. However, really his responsibility is in terms of the last decoupling. So this is where I think I agree with Dr. Posen in terms of the policy missteps that he did have been highly consequential. But I would differ with Dr. Posen in terms of the role of the decoupling or for that matter, identifying COVID-19 as a critical juncture. I would argue that actually the critical juncture happened several years before zero COVID, COVID-19 as well as zero COVID. Because if you remember back in 2013, President Xi Jinping already put out his own personal explanation, his own explanation to what does he mean, what he thinks deepening reform and opening up means.

And in writing and in his speech, he’s specifically talking about, for him, reform and opening up really is about the emphasis of the city sector, the leadership of the party in economics and finance. And in a way he has been quite honest. And then, why this matters for decoupling and why this relates to COVID, I would say that the net effect of zero COVID was actually to make President Xi Jinping overconfident that his asserting foreign policy could be persuasive. And many of us probably still remember the initial shock of COVID. The Chinese government response was relatively successful in terms of controlling the virus, the spread of the virus compared with the rest of the world. And in a way, the Chinese government’s response actually is very much reflective of their governance philosophy. In Chinese, crisis is the same term—crisis and opportunity is wéijī, and wéi is very much Sun Tzu kind of thinking; in chaos there is great opportunity.

And this is also where I think President Xi Jinping’s draconian zero COVID policies actually created a dent not just for himself, but exacerbated, exacerbated not created, the previous demographic debt and demand problem. Before COVID or before 2019, when we think about the Chinese economy, it looks like a Monet. It’s like an impressionist painting. It looks beautiful from afar, but it looks like a jumbled mess up close. But after COVID, the problem still exists, but it’s now like a Jackson Pollock, in the sense that it looks like a jumbled mess from afar and a jumbled mess up close. So from that perspective, I really don’t think President Xi Jinping should be blamed for the lack of recovery or for assembling the time bomb, but he actually did shorten the fuse.

JUSTIN VOGT

I like this. We’ve moved from a sort of medical metaphor to an artistic one. Just in defense of Jackson Pollock, tastes may differ. Some people like those jumbled messes. And that’s interesting though, because I’m also thinking about what you said about the overconfidence, that it’s good to remind ourselves that in the early phases of the pandemic, there was reason for the Chinese government and for the CCP to believe that what they had done was sort of correct and they were doing so much better. That’s an interesting thing that I think we tend to forget in our presentism. 

Speaking of presentism, I think Michael, your contribution here and your critique, if I understand it again correctly and you can explain this more thoroughly, is that you see the roots of some of the problems that China is now facing far earlier than both Adam and Zoe and sort of not only see them there, but believe that they were sort of foreseeable and even foreseen. Can you explain exactly what you mean by that? And whereas Adam’s talked about the turning point being, or maybe not the turning point, but the point of no return being 2020. Zoe has talked a little bit about 2015 and 2013 with Xi’s arrival on the scene. I think you seem to put this turning point closer to around 2006. And I’m curious about what are the factors, what was happening then that sort of cast the die in your point of view?

MICHAEL PETTIS

Sure. Well, thanks very much, Justin, and thanks Adam and Zoe. The other famous Adam, Adam Tooze, refers to me as the structuralist, and I think that’s accurate. I think it’s a much more structural argument as to what happened with China. Basically, the Chinese growth model, this sort of the high savings, high investment model, is not particularly Chinese. Many countries have followed it, and it always seems to follow a pretty similar path. 

You have a period of very rapid healthy growth, followed by a period of very rapid, unhealthy growth driven by a surge in debt, and then a difficult adjustment. And one of my favorite economists, Albert Hirschman, talked about this way, way back in the 1970s. And what he argued is that this is what happens to a successful development model. A successful development model by definition makes itself obsolete because it resolves the problems it was designed to address.

And then you need to shift the model, and if you don’t shift the model, you end up developing a different set of imbalances. And he also noted that almost no one shifts the model. And the reason, he argued, is because a successful development model creates a series of institutions that disproportionately benefit certain constituencies that become very powerful and it’s very hard to shift the model because of the blocking efforts by those constituencies. Well, he died before the whole China story, but he could have been talking about China. 

And so what I would argue is that this high investment model made a lot of sense in the 1980s and 1990s when China was possibly the most underinvested economy in the world, but with the fastest growth rate of investment, they closed the gap pretty quickly between what they had and what they could productively absorb. Now at that point, you’re supposed to shift to a different model, but no one ever does—not Brazil in the 1970s, not Japan in the 1980s, not the Soviet Union in the 1960s. And that’s when you end up with very high investment rates that are no longer productive. So when that happens, you start to see debt grow faster than GDP. So this is a pretty old story. 

I would argue that most people would say the problem began in 2009, 2010. I think it started earlier than that, but it doesn’t matter. At some point, we started to see this unsustainable acceleration of debt in order to maintain high growth rates. And here’s where another economist that I cite a lot, János Kornai, is very important. Kornai argued that in these types of economies, you have a shift from the hard budget constrained part of the economy to the soft budget as long as you want high growth rates, because a hard budget constraint part of the economy—for example, the private sector won’t systematically engage in non-productive behavior. If they do, they go bankrupt. So if you want to maintain higher growth rates than the real economy can deliver, then you have to increasingly shift activity to the soft budget constraint, which in China was largely local governments in the property sector. 

And so as a result, the problems in China predate Xi Jinping. In fact, back in 2012, remember when Xi Jinping became a party secretary, we all agreed this was a good thing because he was a pragmatist and a market guy. And back then, I argued that if you looked at the historical precedents, what was very likely to happen was the recentralization of economic decision-making because the conflict over adjustment would be so difficult that without a recentralization of power, they would probably fail to do it. 

So I would argue that all of this was already baked into the pie before COVID. Now, I agree with Adam and Zoe that COVID mattered and I think it mattered because it accelerated what was already a pretty bad process—not just in China, but in the United States, Europe, and the rest of the world. So we saw the debt pick up even more rapidly, and more importantly, during that period, we saw the household share of GDP drop, and what was particularly bad, we saw income inequality increase, which put even more downward pressure on consumption. So I would argue that that’s the basic problem, and if I could summarize it in a snappy phrase, I would say it’s not that the recentralization of the economy caused the slowdown; I would say it was the slowdown that caused the recentralization of the economy.

JUSTIN VOGT

That’s interesting. You have the causal arrows reversed in a sense from where Adam does. You see the same factors, but you see them affecting each other in a different sequence almost. 

ADAM POSEN

Can I add—

JUSTIN VOGT

Yeah, please jump in.

ADAM POSEN

Yeah. And I just want to affirm Dr. Liu and Professor Pettis’ characterizations, these are very different points of view. As you just said, Justin, causality runs the other way. I would make two points. I think first, the heavy duty structurals version, which Michael argues for, is too dismissive of the agency of both the party and the average Chinese household. If you look at the period, even including the period Michael talks about, there’s enormous growth in private sector employment, in returns on private sector assets, and in private sector investment, as my colleague Nick Lardy documented in Markets Over Mao. And then, starting in 2015 and accelerating, Xi turns it around. But then again, the households don’t react until we have the zero COVID in the way that I identify. 

And so to me, while the structuralist problems are there, it both exaggerates the determinism coming out of the structural problems and also, frankly, their magnitude. All economies slow down, all economies accumulate over time. There was nothing inevitable that you couldn’t have put more money in the private sector and gotten higher returns than you did the last several years. Anyway, just to say, I think Michael and Zoe are being perfectly fair contrasting views, but just that would be my point of difference. I don’t think their model fits the developments that I saw.

JUSTIN VOGT

Right. Let me ask you to clarify one thing though, and that will probably generate a response either from Zoe or Michael. You say this wasn’t inevitable. And I guess what I’m curious, then, is that it’s really sort of a political question, and I’m wondering if it wasn’t enough, why were the choices made that you see as having led to this point where there was agency? You talked about the household spending patterns. What about on the policy question? What was the particular policy choice and why do you think that was the choice that the CCP opted for instead of the other choices that presumably you think might have if not averted the current situation at least pushed it further off into the future?

ADAM POSEN

I’m not a good enough Chinese expert. I’m a macroeconomist; to do that, I would have—I think there are two clear contributing factors. One is that not to over-personalize this, but in an autocratic system, the views of the leader do matter. And Xi’s views, clearly from the time he took office, but particularly from 2015 forward, where the market had gone too far, the party had gotten soft, the people had gotten soft, and you had to deal with it. A second factor is you can argue how much instead of what something none of the three of us have mentioned yet: the external environment. How much—although Zoe makes reference to the remilitarization needs, to be fair—so how much this is a reaction to perceived threats or external ambitions and that pushes you in this direction.

But I think it’s ultimately mostly about control. And that’s why, again, I tried to speak of the long COVID. It’s the immune resistant response as you kindly invoked. It’s not because the Communist Party ever was not in control. It was that the Communist Party’s self-control broke down, that unlike Deng and his successors, Xi broke this “no politics, no problem” compact. I don’t know if it’s inevitable, but it’s very hard for an autocratic system, a party, to resist that temptation for decades. It’s amazing to me how long China did.

JUSTIN VOGT

Right, that’s one of the things that comes through in your piece originally. It’s sort of like, the image that I had in my mind—and I almost put this in the edit and I decided it wasn’t okay for Foreign Affairs, but I’ll do it now though—is that image of the old Road Runner cartoons where Wile E. Coyote goes over the edge of the road and is sort of running on air until suddenly he realizes and drops. That’s kind of the image that I got from your analysis of recent Chinese economic history.

Zoe, I want to go back to Michael in a second, but Zoe, Adam mentioned something that I did want to bring in because one thing that your essay talks about is this question of Xi’s kind of broader foreign policy and its effect on some of this, sort of the re-embrace of nationalism, what you described as this civil-military fusion and its effect on the Chinese economy. Can you pick up where Adam left off there and kind of talk a little bit about that context in which this happened, because that’s also on our minds now I think with the APEC summit happening this week and with a meeting between Biden and Xi, and I’m sure that some of our attendees are going to want to hear a little bit about that. So it’d be interesting to hear your take on that.

ZOE LIU

I do think President Xi Jinping’s elevation of the civil-military fusion strategy to the level of national strategy.

JUSTIN VOGT

Can you just explain what that is quickly, what you mean by that?

ZOE LIU

This so-called strategy did not start from Xi Jinping. The whole civil-military fusion started during Hu Jintao’s era. The idea is to empower or basically mobilize China, the whole of the society, whole of a nation element, blurring the nature of military and the private sector and the civilian sector in terms of technological advancement and technological self-sufficiency. So President Xi Jinping really elevated that into the level of national strategy and combining that with Made in China 2050. 

So a lot of these really triggered, alerted Western politicians, and in particular here U.S. policymakers in Washington, D.C. And in response, U.S. policy makers accelerated a lot of the preexisting mechanisms, such as export control, such as investment screening. And now we are in an era of outbound investment screening. If President Xi Jinping did not accelerate a lot of these policies to such a higher level, I do not think it would trigger such a response from the United States.

And as a consequence, what used to benefit China’s economic rise—on the one hand, international confidence in the Chinese economy as well as policy predictability, and then on the other hand, China’s easy access and cheaper, lower cost to advanced technologies in the investor market—those things are no longer there. And I would agree with Dr. Posen in that President Xi Jinping, a lot of his policy misstep did matter, but I would say that it matters before COVID and more specifically, he removed the predictability and the lack of political drama that used to benefit the Chinese economy.

JUSTIN VOGT

Michael, both you and Adam tell this story that to my lay person’s mind, it brings to mind this expression that at least when I was a college student I learned, which was the middle income trap, that there was this kind of problem where, as you put it, a system was developed to solve a certain set of problems, and then once it solved those problems, it became obsolete and you had to switch. Is that essentially what you’re describing? Is that another name for what you’re describing or is that different from what you’re talking about? 

And regardless of what the answer is there, I guess my question for you is if China missed its opportunity or the opportunity it had some time in the aughts to shift growth models, do you only get one chance as a regime type or is this a kind of thing that you can try again, you can keep adapting? What’s your view of that?

MICHAEL PETTIS

Well, to address the middle-income trap, it’s not a phrase that I really like because it seems to me that we often trot it out to mean we don’t know, so it must be the middle-income trap. But I would call it an investment trap because it affected all countries that had very, very high investment growth models. Japan, which is certainly not a middle-income country, it’s quite a rich country, also went through this trap. Poorer countries like Brazil in the 1960s and 70s and so on. 

There were about a dozen, two dozen countries that went through this growth model. And what’s really striking is how they all follow the same pattern. You have very rapid, healthy growth followed by very rapid, unhealthy growth, followed by a very difficult adjustment. And the adjustment can range. I talk about the American-style adjustment, which Brazil followed too, which is a rebalancing in the form of a crisis.

So the United States in the 1930s, you’ll remember GDP contracted by 35 percent, household income contracted by half of that—brutally painful, but it rebalanced and it was quite quick. In Japan, what we saw is that GDP growth went from roughly four, five percent to around half a percent. Consumption growth dropped by a lot less. I don’t have the per capita numbers, but the per capita numbers look like they dropped from around three percent to two percent. So it wasn’t as brutal an adjustment, but it took a very long period of time. 

And what’s really striking about this—and Daron Acemoglu and James Robinson do a series of very interesting papers on this—what’s really striking is how politically disruptive it’s always been except for two types of political systems. They argue highly competitive political systems, which seems to mean robust democracies, and then highly non-competitive, which basically seems to mean a highly centralized autocracy.

By the way, an example of the latter was China in the 1980s, a series of reforms ferociously opposed by the party, but with a highly centralized leadership, they were able to implement the reforms anyway. So I think that’s a really important part of it. We always see that, and that’s why I argued that if you were going to advise back in 2012, you would’ve said either become a democracy or recentralize power. That’s part of the process. 

Now, I realize my answer is getting a little bit long, but I wanted to talk a little bit about the rise and fall of the private sector. What really seems to drive the private sector in China has been a combination of domestic consumption and exports. And so domestic consumption bottomed out around 2010, 2011 with household consumption at a truly surreal 34 percent of GDP. And after that, we started to see a partial recovery of consumption and the private sector benefited from that. But that more or less stopped a couple of years before COVID, and during COVID, we saw again the consumption share of GDP go down, and that’s much more important than exports. And so I would argue that what’s really driving the expansion and contraction of the private sector has really been the distribution of income to the household sector. I think that’s what’s really been key.

JUSTIN VOGT

I want to thank all three of you, I want to thank our friends at the Peterson Institute, and I want to thank everybody who attended this morning. Best of luck to you and thanks again.