It took over 20 years for John Maynard Keynes’s “General Theory” to be translated into Chinese. That was still a bit too soon for some of its readers. Published in 1957, around the time of Mao Zedong’s “anti-rightist” campaign, Keynes’s theory was denounced as “anti-science and anti-people”. He was accused of the unforgivable sin of seeking to “defend capitalism”.
Over five decades later, things are different. The present leadership of the Chinese Communist Party, Hu Jintao and Wen Jiabao, have embraced Keynesian prescriptions with great determination. In response to the financial crisis of 2008 they approved an audacious stimulus package, unbalancing the government’s books and spurring the country’s banks to lend. That helped defend their peculiar brand of capitalism from a crushing slowdown.
Something similar may be required in 2012 if America’s stagnation and Europe’s debt crisis once again threaten the global economy. But the new leadership of Xi Jinping and Li Keqiang (expected to take over towards the end of the year) is unlikely to embrace Keynes as wholeheartedly as their predecessors. Indeed, they may find themselves slave to the scribblings of a different dead economist, Keynes’s intellectual foe, Friedrich Hayek.
Whereas Keynes worried about inadequate investment—too little entrepreneurial spending to keep everyone gainfully employed—Hayek worried about bad investment. If credit were too easy, he argued, entrepreneurs would embark on overambitious projects that take too long to reach fruition and make insupportable claims on society’s resources.
It is not hard to find overambitious projects in China: think of the country’s “ghost cities”, such as Ordos in Inner Mongolia, which is being built by government fiat long before people are ready to live in it. But although China invests at a formidable pace, it also saves at a prodigious rate. In such a thrifty economy, interest rates should be low, credit should be readily available and investment should be high.
Yet in 2009 and 2010 things went too far. Spurred on by the government, China’s banks increased their lending by almost 9.6 trillion yuan ($1.5 trillion) in 2009. That is roughly twice the size of the Indian banking system, as Bank Credit Analyst, a research company, has pointed out. In other words, China’s lenders added two Indias to their loanbooks in the space of a year.
Much of this lending flowed to some 10,000 investment companies sponsored by local governments, which cannot borrow directly in their own name. These companies set about building roads, bridges, irrigation works and some housing schemes of dubious merit. These loans added about 5 trillion yuan to the debt of local governments, which now amount to 10 trillion-14 trillion yuan or 25-36% of GDP (see chart).
China’s authorities now admit what was always obvious: many of these projects will fail to raise enough revenue to repay their creditors. Defaults have already surfaced in Yunnan province and elsewhere. Some of these projects will be abandoned halfway. They are what Hayek would call “malinvestments”, investments in capacity that no one is willing to pay for or wait for.
Hayek’s students dubbed their Austrian-born professor “Mr Fluctooations” because of his preoccupation with the ups and downs of the business cycle, which he described in heavily accented English. He believed that boom-time malinvestments were responsible for the subsequent bust, much as binge-drinking is responsible for the next morning’s hangover.
This sequence seems intuitive, but it is in fact something of a puzzle. In a caustic critique of the “hangover” theory of recessions, Paul Krugman, who won the Nobel prize for economics 34 years after Hayek, complained that “nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present.” If an economy has squandered capital on misguided ventures, leaving its people worse off than they thought, why should so many of them stand idle? Surely people should work more, not less, in response to such bad news.
Hayekians argue that after bad investments are exposed, it takes time for economies to reorganise themselves. Loan losses may undermine confidence in the banks that incur them, hampering their ability to finance fresh investments. And when workers are laid off, it may take a while for them to find new employers or acquire the skills that alternative jobs demand.
Hayek believed that governments can do little to ease the pain of economic restructuring. Even if he is right, which is hotly disputed, politicians refuse to believe him. China’s policymakers will prove no exception. The central government will step in, helping the banks and their borrowers to shoulder their debt burdens.
How it intervenes is still an open question. It may use public revenues to complete some infrastructure projects, rather than allowing bridges to fall short of the opposite bank or roads to stop short of towns. It may force banks to write off other loans, recapitalising any lenders that cannot withstand the losses. These bail-outs may take place in the open, or they may happen behind closed doors, through regulatory indulgence and implicit subsidies.
One Chinese scholar recently argued that Hayek was better known in China than in the West. But China’s policymakers, just like their Western counterparts, will find Hayek’s diagnosis of fluctooations more compelling than his prescription.