By John Ross
Introduction
China since 1978, on the basis of the socialist market economy introduced by Deng Xiaoping and Chen Yun, has enjoyed the most rapid sustained growth of any major economy in history. The significance of this is not the numbers, or its effect in terms of steel and concrete, but its accompaniment by the most rapid increase in real incomes of any major economy, and by far the most massive rapid reduction of poverty in human history.
The importance of China’s economy is therefore twofold. The first is the material scale of China’s economic achievement. The second is the conclusions that can be drawn for other countries—the “universalizable”, or not, character of China’s economic system
No country can mechanically copy another’s economic system. As China insists, its economy has unique “Chinese characteristics” and there is no “Chinese model”. But the elements of which this economic system is composed are universal. As analysed below China has solved in practice problems which can be stated in terms of general macro-economic theory. For that reason these elements, in quite different forms and combinations, are of major importance for economic policy elsewhere.
China and macro-economic theory
China’s “reform and opening up” process under Deng Xiaoping and Chen Yun was, of course, developed in a Marxist economic framework. Most people in the West are, however, unaware of, or disagree with, Marxist economic categories. Therefore, to make the essential points more easily comprehensible to such an audience, this article will put them in the more familiar terms, of Western economics – those of Keynes. The proviso that needs to be made, however, is that this is the actual Keynes of The General Theory of Employment Interest and Money and not the vulgarised version that appears in economics textbooks.
To take one example, budget deficits do play the central role in China’s stimulus packages – for example during 2009’s maximum anti-crisis measures against the International Financial Crisis China’ s budget deficit was only 3% of GDP, and its core was the use of state investment to regulate the macroeconomy. The core of Keynes General Theory itself, as opposed to vulgarisations, however itself also centres on the factors determining investment. It is therefore through this optic that both Keynes’s and Chinese economic strategy can be best understood by those familiar with a “Western”, as opposed to Marxist economic framework.
The rising proportion of the economy devoted to investment
Already in the founding work of classical economics, The Wealth of Nations, Adam Smith analysed that a necessary consequence of the increasing division of labour was that the proportion of the economy devoted to investment rose with economic development: As is relatively well known Marx followed Smith in concluding that the percentage of investment rose as an economy developed – describing this process as a “rising organic composition of capital”. Keynes also held that the proportion of the economy devoted to investment rose with economic development.[1]
A necessary consequence of an increase in the proportion of the economy devoted to investment is that the impact of any decline in investment will have increasingly serious consequences as an economy became more developed. Keynes analysed: “the richer the community, the wider will tend to be the gap between its actual and its potential production… For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.”[2]
In the mid-20th century attempts were made to factually dispute the conclusion of classical economics that the proportion of the economy devoted to investment rose with economic development – Milton Friedman devoted an entire book, A Theory of the Consumption Function, to attempting to refute Keynes regarding this. However, the findings of modern econometrics are conclusive.[3] Factually, as classical economics, and Keynes analysed, the clear historical trend is for the proportion of the economy devoted to investment to rise.
To illustrate this, Figure 1 shows the proportion of the economy devoted to fixed investment of the leading economies of successive periods of rising economic growth over the more than 250-year period for which meaningful statistics can be found.
Figure 1
The potential destabilising consequences of the rising proportion of investment
A reason Friedman attempted, unsuccessfully, to refute Keynes over the rising proportion of the economy devoted to investment was that such a trend had the conclusion that any disturbance to the investment mechanism has increasingly destabilising consequences. Friedman noted of Keynes analysis: “the central analytical proposition of the [theoretical] structure is the denial that the long-run equilibrium position of a free enterprise economy is necessarily at full employment.”[4]
It is evident that there is a parallelism between the analysis of Keynes and that of Marx regarding the role of profit and investment. Marx analysed that, in the absence of offsetting factors, a rise of the proportion of the economy devoted to investment would lead to a falling rate of profit. This is a necessary consequence of a situation whereby the capital stock rises relative to the profits level. In short, the increasing division of labour, through its consequence in raising the proportion of the economy devoted to investment, the process analysed by Adam Smith, created a tendency of a declining rate of profit which Marx analysed as a “barrier to the development of the productive forces.”[5]
Keynes also approached economic fluctuations via the profit rate: “The trade cycle is best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital.”[6] However, Keynes specific development was to approach the potentially destabilising consequences of the rising proportion of the economy devoted to investment via the angle of effective demand.
The components of effective demand
Effective demand composed both consumption and investment, with the latter tending to rise relative to the former during economic development: “when aggregate real income is increased aggregate consumption is increased but not by as much as income… Thus to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level… It follows, therefore, that given what we shall call the community’s propensity to consume, the equilibrium level of employment, i.e. the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment.”[7]
Keynes noted no automatic mechanism ensured that the necessary volume of investment would occur: “the effective demand associated with full employment is a special case, only realised when the propensity to consume and the inducement to invest stand in a particular relationship to one another… It can only exist when, by accident or design, current investment provides an amount of demand just equal to the excess of the aggregate supply price of the output resulting from full employment over what the community will choose to spend on consumption when it is fully employed.’[8] Put bluntly: “An act of individual saving means – so to speak – a decision not to have dinner today. But it does not necessitate a decision to have dinner or buy a pair of boots a week hence or a year hence.”[9] Or in more sophisticated terminology: “The error lies in proceeding to the … inference that, when an individual saves, he will increase aggregate investment by an equal amount.”[10]
A shortfall of investment would be amplified by the well known economic “multiplier” into much stronger cyclical fluctuations: “It is… to the general principle of the multiplier to which we have to look for an explanation of how fluctuations in the amount of investment, which are a comparatively small proportion of the national income, are capable of generating fluctuations in aggregate employment and income so much greater in amplitude than themselves.”[11] The outcome of the fluctuations in investment, combined with consumption, in turn determined employment: “The propensity to consume and the rate of new investment determine between them the volume of employment.”[12]
The role of the interest rate
In turn: “the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest.”[13] The reason for this was that the marginal efficiency of capital was “equal to the rate of discount which would make the present value of the series of annuities given by returns expected from the capital-asset during its lift just equal to its supply price.”[14]Consequently “the inducement to invest depends partly on the investment-demand schedule and partly on the rate of interest.”[15]
From this analysis Keynes derived key policy conclusions.
Budget deficits
One, which is well known, is the use budget deficits confronted with recession – the vulgarisation of Keynes lies in reducing Keynes theories to support for budget deficits, not in the fact that he supported deficit spending. Keynes analysed budget deficits in general terms of what he termed “loan expenditure”: “’loan expenditure’ is a convenient expression for the net borrowing of public authorities on all accounts, whether on capital account or to meet a budgetary deficit. The one form of loan expenditure operates by increasing investment and the other by increasing the propensity to consume.”[16]
Therefore, in one of his most famous passages: “If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again… with the help of repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”[17]
Such a general view of deficit spending, did not, of course mean that Keynes was indifferent to what deficits should actually be spent on, and his contempt for double standards regarding when budget deficits were justifiable was scathing: “Pyramid-building, earthquakes, even wars may serve to increase wealth, if… our statesmen… stands in the way of anything better. It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly ‘wasteful’ forms of loan expenditure rather than for partly wasteful forms, which because they are not wholly wasteful, tend to be judged on strict ‘business’ principles. For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest…wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable.”[18]
Interest rates
While Keynes supported budget deficits, nevertheless the fundamental cause of recession lay in more fundamental factors affecting investment, which in turn were affected by the rate of interest: “we shall show that the succession of boom and slump can be described and analysed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.”[19]
As investment was affected by interest rates, therefore, a crucial issue in raising investment was a sufficiently low rate of interest. This problem, in turn, tended to become more acute because of the rising proportion of the economy devoted to investment: “Not only is the marginal propensity to consume weaker in a wealthy community, but owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate; which brings us to the theory of the rate of interest and to the reasons why it does not automatically fall to the appropriate levels.”[20]
The aim of low interest rates was to relaunch investment by ensuring that the return on investment was above the rate of interest plus whatever was the required premium to overcome liquidity preference. But as Keynes openly acknowledged, such low term interest rates destroy the ability to live from income from interest – which is why, in his famous phrase, Keynes foresaw “euthanasia of the rentier.”[21] He concluded: “I see… the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work.”[22]
“A somewhat comprehensive socialisation of investment”
Despite support for low interest rates Keynes, however, did not consider it likely that these would be sufficient by themselves to overcome the effects of an investment decline. It would therefore be necessary for the state to play a greater role in investment: “Only experience… can show how far management of the rate of interest is capable of continuously stimulating the appropriate volume of investment… I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest… I expect to see the State… taking an ever greater responsibility for directly organising investment.”[23]
This led Keynes to support a “somewhat comprehensive socialisation of investment’: “It seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.”[24]
Keynes noted that this “somewhat comprehensive socialisation of investment” did not mean the elimination of the private sector, but should mean socialised investment operating together with a private sector: “This need not exclude all manner of compromises and devices by which public authority will co-operate with private initiative… the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society… apart from the necessity of central controls to bring about an adjustment between the propensity to consume and the inducement to invest there is no more need to socialise economic life than there was before…. The central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.” [25]
Keynes held this was necessary because: “It is certain that the world will not much longer tolerate the unemployment which, apart from brief periods of excitement, is associated – and, in my opinion, inevitably associated – with present capitalistic individualism.”[26]
Summing up
It is now possible to clearly see the structure of Keynes argument. The rising proportion of the economy devoted to investment meant any downturn in investment would have increasingly destabilising consequences. This could be dealt with to some degree through budget deficits, but given that the key element was investment, and investment was determined by the interaction between profit and the interest rate, a policy of low interest rates was necessary. This would lead to the “euthanasia of the rentier” – for which likely read state ownership of banks. However, it was unlikely interest rates would be sufficient by themselves and therefore the state would need to step in with “a somewhat comprehensive socialisation of investment” which would however work alongside the private sector.
But tracing this argument has now actually arrived at a “Chinese” economic structure – although approaching it via a Keynesian and not a Marxist framework. China’s policy of “Zhuada Fangxiao” (“grasp the large, let go the small”), that is maintaining large firms in the state sector and releasing small ones to the non-state/private sector, coupled with abandonment of quantitative planning, means that China”s economy is not being regulated via administrative means but by general macro-economic control of investment – as Keynes advocated.
Implications
What is the overall significance of this? China’s policy was arrived at via Marxist and not a Keynesian framework. It was derived from Marx’s analysis of the increasing, but incomplete, socialisation of labour during the primary stage of socialism. It noted that Marx had advocated that capital should be wrested “by degree” from the bourgeoisie—“by degree.[27]” being not the “all at once and 100%” of the post-1929 Soviet model. The structure of China’s socialist market economy, with its leading role of large scale industry in the state sector, but non-statisation of smaller scale production, and in particular agriculture, with the “household responsibility system”, was derived from Marx with non evidence of significant influence from Keynes.
But one of Deng Xiaoping’s most famous statements is of course “cats theory” – “it doesn’t matter whether a cat is black or white provided it catches mice”. But “cats theory” can also be applied to economics itself – your can describe something in either Marxist or Western economic terms but it can lead to the same economic structure and policies. “Zhuada Fangxiao” is a conclusion that may be arrived at from either a Marxist or a Keynesian framework.
But while one might be indifferent to the colour of theoretical cats evidently it is not possible to be indifferent as regards policy measures to be taken – precise measures in terms of economic structure, interest rates, investment etc are required. There is a radical difference in what is being carried out in practice between the US and Europe on one side and China on the other as regards the potential policy measures which have been outlined.
In the US and Europe budget deficits have been utilised to some degree—although they are coming under increasing attack. Low central bank interest rates have been pursued and some forms of quantitative easing, that is driving down long term interest rates through central bank purchases of debt, have been used. But no serious programmes of state investment have been launched – let alone Keynes’s “somewhat comprehensive socialisation of investment”.
In China, in contrast, budget deficits have been combined with lower interest rates, a state owned banking system (“euthanasia of the rentier”) and a huge state investment programme. While the West’s economic recovery programme following the international financial crisis has been timid, China has pursued full blooded policies of the type recognisable from Keynes The General Theory as well as its own “socialism with Chinese characteristics.” Why this contrast and why has China”s stimulus package been so much more successful than that in the West?
Because in the West, of course, it is held that the colour of the cat matters very much indeed. Only the private sector coloured cat is good, the state sector coloured cat is bad. Therefore, even if the private sector cat isn’t catching insufficient mice, that is the economy is in recession or stagnation, the state sector cat must not be used to catch the mice. In China however both cats have been let lose – with the result that far more mice are caught.
The post-international financial crisis recession in all the Western economies was driven by a decline in investment – in most countries the decline in fixed investment accounts for the large majority of the decline in GDP. Keynes’s calls for not only budget deficits and low interest rates but also for the state to set about “organising investment” are evidently required. But this is blocked because the state coloured cat is forbidden to catch mice.
To put it another way, the US and Europe insist on participating in the race while hopping on only one leg – the private sector. China is using two legs, so little wonder it is running much faster than the West.
To turn from metaphors to economic measures, a large scale expansion of the transport system, the creation from nothing of the world’s largest high speed rail system, or the stated aided development of renewable anergy, or a large scale state house building programme, of the type being followed in China as part of anti-crisis measures not only delivers goods that are valuable in themselves but boosts the economy through its macro-economic effect in boosting investment. But in the West such state investment is blocked as it creates competition for the private sector. As the top aim in the West is not to revive the economy, but to protect the private sector, therefore such large-scale investment must be undertaken.
It is therefore an irony. Keynes explicitly put forward his theories to save capitalism. But the structure of capitalism has made it impossible to implement Keynes policies even when confronted with the most severe recession since the Great Depression. The anti-crisis measures of China’s “socialist market economy” are far closer to those Keynes foresaw that any capitalist economy. Whereas in the US, for example, fixed investment fell by almost thirty percent during the financial crisis in China urban fixed investment rose by over thirty percent. Consequently, there is nothing mysterious whatever about the relative success of the two economies in emerging from the international financial crisis – China’s economy having grown by seventeen percent in two years and the US remaining below its previous level of GDP.
Deng Xiaoping famously said his death was “going to meet Marx”. But Deng also has the possibility of an interesting talk with John Maynard Keynes.
And Keynes would be very interested to discuss with Deng’s two cats – who appear to have read the General Theory more closely and accurately than any administration in the West.
Note: This is a slightly expanded version of an article originally written in 2010, and published in Soundings, in the context of the international financial crisis. Material simply relating to detailed events around the International Financial Crisis has been removed.
Bibliography
Barro, R. J., & Sala-i-Martin, X. (2004). Economic Growth (Kindle Edition). Cambridge, Massachusetts, US: MIT Press.
Friedman, M. (1957). A Theory of the Consumption Function. Princeton: Princeton University Press.
Keynes, J. M. (1936). The General Theory of Employment, Interest and Money (Macmillan 1983 ed.). London: Macmillan.
Marx, K. (1981). Capital Volume 3. Harmondsworth: Penguin.
Marx, K., & Engels, F. (1848). Manifesto of the Communist Party. In K. Marx, & F. Engels, Collected Works Vol.6 (1976 ed., pp. 476-519). Moscow: Progress Publishers.
[1] The explanation Keynes offered was, however, different to that of Smith and Marx—who explained it due to increasing division of labour. Keynes ascribed it to the consequences of rising savings levels accompanying increasing wealth. As the percentage of income consumed fell with increasing wealth the proportion devoted to saving necessarily rose proportionately. As Keynes stated in the General Theory: “men are disposed… to increase their consumption as their income increases, but not by as much as the increase in their income… a higher absolute level of income will tend, as a rule, to widen the gap between income and consumption.”Keynes, J. M. (1936). The General Theory of Employment, Interest and Money (Macmillan 1983 ed.).p96-97 London: Macmillan. All page references are to this edition.
[2] (Keynes, 1936, p. 31)
[3] As even neo-classical economists now admit – see (Barro & Sala-i-Martin, 2004, p. 40)
[4] (Friedman, 1957, p. 237)
[5] (Marx, 1981, p. 350)
[6] (Keynes, 1936, p. 313)
[7] (Keynes, 1936, p. 27)
[8] (Keynes, 1936, p. 28)
[9] (Keynes, 1936, p. 210)
[10] (Keynes, 1936, p. 83)
[11] (Keynes, 1936, p. 122)
[12] (Keynes, 1936, p. 30)
[13] (Keynes, 1936, p. 27)
[14] (Keynes, 1936, p. 135)
[15] (Keynes, 1936, p. 137)
[16] (Keynes, 1936, p. 128)
[17] (Keynes, 1936, p. 130)
[18] (Keynes, 1936, p. 129)
[19] (Keynes, 1936, p. 144)
[20] (Keynes, 1936, p. 31)
[21] (Keynes, 1936, p. 376)
[22] (Keynes, 1936, p. 376)
[23] (Keynes, 1936, p. 164)
[24] (Keynes, 1936, p. 378)
[25] (Keynes, 1936, p. 378)
[26] (Keynes, 1936, p. 381)
[27] (Marx & Engels, Manifesto of the Communist Party, 1848, p. 504)
The above article was originally published here on John Ross’ Substack.