China economy prediction, Version 2.0

Well, a few posts ago (which, sadly, was more than a few weeks ago), I rounded up some predictions about the future of China's economy. My guess, as I said, was as good as anyone's. Last night, though, I was watching a PBS documentary about China's future, and today while I was taking a long walk I thought about the problem a little further, and I thought I'd post my thoughts.

Background (skip if you know the Solow model)
What do economic models tell us about growth? The best-known and most widely accepted model of growth is the Solow model. It basically says that countries grow by saving their money and using those savings to buy "capital" (which includes machines, vehicles, buildings, well-trained employees, computers, software, etc.). "Capital" then allows people to make more stuff, some of which they save, and the cycle continues. At first, how fast economies grow depends on how much they save, which affects how fast they accumulate capital. But eventually, building up more and more capital hits some diminishing returns; you get so much capital that it starts wearing out as fast as you can replace it. At that point, the economy hits a "steady state"; after that, it doesn't matter how much a country saves. In the steady state, the only way to grow is through "productivity increases" - figuring out how to make better capital (e.g. faster computers), or to make more efficient use of the capital you have.

From everything we've seen in the last century or two, this model works pretty well for industrial countries. During the "capital buildup" phase, countries tend to grow 6-10% a year; think Europe and Japan after WW2, Korea and Taiwan in the 80s/90s, etc. But at some point, every country's growth drops to around 2-4% - about the same rate the United States usually grows. Countries that save more tend to grow faster at first, but hit that drop sooner.

In the Solow model, growth gradually falls to the "steady-state" level of 2-3%. But in real life, countries appear to be able to "keep the party going" for a while - through property bubbles, or govt. investment, or whatever, they manage to keep that 6-10% growth going for a while after it would naturally slow down. But then all that happens is that instead of coasting to a slower speed, those countries hit a wall, and have to cope with a depression while they work out their inefficiencies (think Japan in the 90s).

There's no reason to think this won't happen with China. China is growing even faster than Europe and Japan did, but that's just because it saves more. At a certain income level, that dog won't hunt no more.

China
Just looking at countries in Europe and East Asia, we see that most countries lose their "super-fast growth" when the reach a level of per-capita income about 3/4 of the U.S. level. Right now, that's about where Japan, Europe, and Taiwan are, and South Korea is getting there. So let's do some back-of-the-envelope calculations and figure out where that leaves China.

U.S. per capita GDP right now is about $44,000. China's is $8000. That means the Average Chinese Person makes 2/11 times as much as the Average American. China's economy is growing at about 10.5% per year. Subtract Chinese population growth (0.5%) and U.S. productivity growth (2%), and we find that China is catching up with us at a rate of about 8% a year.

Now let's assume that China keeps catching up with us at 8% a year until it no longer can - in other words, let's assume China's government or big businesses "keep the party going" instead of letting it slow down gradually. In that case, the ratio of China's average income to America's will double about every 8.75 years.

If it doubles twice, that'll be a ratio of 8/11 - a little more than 3/4, or about the same level as Japan and Europe. So, by this calculation, that should happen in 17.5 years - i.e., in 2025. So around 2025, China should "hit a wall" and stop growing...unless it turns out to just be much better at economic growth than any country we've ever seen before, for reasons we've never seen before.

But there's a few reasons why China's growth might slow sooner. There's global resource constraints - there's only so much oil, copper, etc. in the ground. There's environmental constraints - China is running out of clean water, it's incredibly polluted, and it's severely threatened by global warming. There's political constraints - China's party-based patronage system is well-known, and corruption often leads to inefficiency. And there's population constraints - thanks to the "one child policy," China is a rapidly aging society, which means it will soon have to support legions of retirees. Any or all of these factors could kick in in the next 18 years, which could cause China to "stall out" at a lower level of income than Japan or Europe did. An example of this happening is Korea, whose growth has slowed dramatically before they even reached half of U.S. income levels.

So, let's assume some factors cause China to slow down or stall out a bit early - let's say at 2/3 of U.S. GDP. That would have China continuing its current growth explosion until around 2020.

So all the people who are predicting China keeping up its mad growth pace until 2040 are either pulling your leg, or they know something you don't. My bet is that they're pulling your leg. China will stop its mega-growth in 2020, not 2040.

But of course, if you think for a minute, that's still going to be huge. China is so big that, even at 2/3 of U.S. income levels, it'll have an economy 3 times the size of ours - that is, about as big as the U.S., the EU, India, and Japan combined. Thus, in 2020, it is difficult to predict that China will not be the richest and most powerful country on the face of the planet, by a large margin. The 21st century may or may not be the Chinese Century, but the 2010s will be the Chinese Decade.

After that, it's anybody's guess. Usually, after countries "stall out" and fall to 2-4% growth, they stop getting so much wide-eyed press. Usually that restructuring is a painful process that involves a long period of slow growth - Japan and Europe in the 90s, America in the 70s. When that happens to China, political unrest could divide the country or topple the government...or environmental problems could cause mass chaos and unrest...or the government could try to take back control of the economy...who knows. But if China rides out that crisis, it'll still be by far the world's biggest economy, and will stay that way for decades, until India catches up. That is nothing to scoff at.

On the contrary, we must start preparing for a world with China as No. 1. It'll be here next decade.