Mar 06 2008

Walking the fine line between good growth and bad growth in China / Asia-Pacific / China – China to focus on curbing inflation

Growth – the ultimate macroeconomic policy goal. Growth leads to improvements in material well-being; by definition it means more output per person. Growth also enriches society in other ways: more tax revenue for governments means more to spend on public goods like education, health care, and infrastructure, which all contribute to development of human capital, standard of living, and productivity. But is there such a thing as too much of a good thing? When it comes to growth in China, that may be the case.

According to Chinese premier Wen Jiabao:

“The primary task for macro­economic regulation this year is to prevent fast economic growth from becoming overheated growth…”

So, fast growth is good, but overheated growth is bad?

I once had a Jeep Wrangler that when I drove it across the country, anytime it hit 70 mph it started to overheat… is that the kind of overheating China’s economy is experiencing? Well, kind of, yes.

The reason my Jeep would overheat was that the pistons in the engine had to move so rapidly to keep the engine going at enough RPMs that the friction created overwhelmed the engine’s ability to properly cool itself. In China, the pistons can be compared to the manufacturing industry and agricultural sectors, which last year were stretched to their limits to meet not only rising demand from foreigners for China’s output, but record levels of domestic demand as well.

For the first time last year, China’s domestic consumption made up a larger component of the country’s GDP than investment. Returning to our metaphor, the engine was forced to work harder than usual, but I hadn’t spent enough to maintain the engine, so it was not properly lubed and tuned for the stress of long-distance travel. Maintenance on an engine is important, otherwise it will wear out and overheat while driving at high speeds over long distances. Likewise, investment in new capital is vital for an economy to keep from overheating as it grows at high rates over long periods of time.

Rising consumption and exports, without a corresponding increase in investment, means capital depreciates too quickly to meet Chinese and the world’s demand for output. In terms of our macroeconomic model, AD shifts out more rapidly than AS, causing inflation:

“the premier said the political priority was to tame consumer price inflation, which hit an 11-year high of 7.1 per cent in January.”

Rising consumption and net exports puts upward pressure on prices in China. To worsen matters, food prices have experienced record increases in the last year, making the matter especially hard for China’s urban poor, separated from the farmland and its produce as they are.

Investment, while an expenditure itself, tends not to contribute to inflation (as might be thought, since it shifts AD outward), but mitigate it, due to the supply-side effect attributable to the increase in capital and productivity that it creates. To combat rising food prices in China, Mr. Wen plans to encourage investment in the agricultural sector through targeted government intervention:

The government would expand agricultural commodity production, strictly control industrial grain use, establish an early-warning system to monitor supply and demand, and strengthen “market oversight” and “price inspections”, he said.

Subsidies for the poor would be increased and provincial governors and mayors held directly responsible for ensuring basic food supplies, said Mr Wen.

Overall China’s picture is looking rather rosy, it would appear. While 7.1% inflation is certainly something to fear, it seems to be manageable in the context of a global slowdown in income growth, and the corresponding decrease in demand for Chinese exports that implies. Combined with a strengthening RMB, China can look forward to a slower rate of growth in 2008, (“a now routine annual ‘target’ of 8 percent expansion in [GDP]”). The trick for the government is to foster investment and productivity growth in the agricultural sector to keep food prices down in the face of growing demand for meat products among China’s middle class.

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

3 responses so far

3 Responses to “Walking the fine line between good growth and bad growth in China”

  1. kxc.024on 08 Mar 2008 at 1:28 pm

    Unfortunately, growth and inflation often go hand in hand. In the case of China, inflation seems to be an increasingly serious problem. Especially now that many businesses are coming into China for investment (although not as much as China would like), a lot of rural people have abandoned their villages and fields for a higher paying job. Problem now is that agriculture is the main source of rising price levels, due to demand-pull inflation. Therefore, their measure of expanding the agricultural section through subsidies is a great idea. Hopefully, this will help lower the price level or at least the rate of inflation for the people.

    On the other hand, while inflation is a serious problem, it is less of a problem in China than in other countries, such as the USA. I think this is due to the fact that there is a huge emerging middle class in China and it is only recently that they've begun to have a significantly larger amount of income to spend, so an increase in the price level is not as bad.

  2. James Tsaoon 09 Mar 2008 at 11:26 pm

    Great Comparison with the Jeep. Inflation would be detrimental to China's economy especially because China is exporting such a significant amount of its goods. I can see if the government fosters investment and productivity growth in the agricultural sector, AS can rise and keep in pace with the rise in AD to keep food prices low. Yet, if the government spending/regulation is inefficient the end result might be that AD rises by a greater proportion than AS since government spending and investment is part of AD. Personally, I don't think government spending would help the crisis all that much because the agricultural sector in China is so big and diverse. Unlike the industrial sector, the agricultural sector is more spread out and therefore harder to invest upon. Even if productivity was somehow increased, it is hard to make sure that the excess supply is of good quality.

  3. Chan Min Parkon 15 Mar 2008 at 11:47 pm

    As consumption and net exports continuously increase, demand continuously shifts outwards and there will be tremendous inflation. Your engine overheats and in the beginning it may seem as if its okay but if you leave it like that and it keeps overheating, its going to cause a big problem. Therefore it is important to see the line between good growth and bad overheated growth. Investment and better capital could increase the performance of the engine. Increasing consumpton and net exports can help growth but at the same time productivity and investment needs to increase to keep the inflation level in control.