U.S. officials traveled to China this week in an effort to end the bitter trade war between the two countries. The main obstacle to a settlement is natural rivalry: The United States is trying to protect its position as the most important superpower, and China is serving notice that it covets that status for itself.
What further complicates matters is a clash of economic systems. China practices state capitalism; the government owns many large firms and decides which industries will receive subsidies, protected markets and favorable loans. In the United States, private markets and firms mostly determine which companies grow or shrink.
The result is a stalemate. Many Chinese policies and practices (rules that coerce the transfer of new technologies or business plans to Chinese businesses, or that discriminate against foreign companies) make perfect sense in the context of state capitalism. But to Americans and other private investors, they violate the norms of open competition and fairness.
This makes negotiations exceedingly difficult. For China to abandon its policies would mean, in effect, scrapping its whole economic model. Politically, this would be hard to swallow. Similarly, for the United States to condone China’s state capitalism would legitimize a system that puts U.S., foreign and private investors at a permanent disadvantage.
The contradictions are inescapable. If an agreement is possible, it may skirt the central differences between the two countries and concentrate on limited Chinese pledges to buy more U.S. imports.
Interestingly, the conflict is of recent origin. In a new book — “The State Strikes Back: The End of Economic Reform in China?” — economist Nicholas Lardy of the Peterson Institute for International Economics argues that, until a few years ago, China seemed to be moving gradually toward a system of private enterprise.
In 1978, when Deng Xiaoping launched China’s present economic reform, state-owned firms dominated the economy. Now, according to Lardy’s estimates, private firms account for roughly 70 percent of the country’s output (gross domestic product).
The reversal came after Xi Jinping assumed leadership of the Communist Party in 2012 and, later, the presidency. He changed course, favoring state-owned firms, as Lardy shows by citing loans to businesses.
In 2013, 57 percent of loans went to private firms and 35 percent to state-controlled firms. By 2016, there had been a stunning reversal; state firms received 83 percent of loans, compared with 11 percent for private firms. Much of this lending came from state-owned banks.
This relates to a larger issue: the ferocious debate, mostly among economists, over China’s future economic growth rate. In the decade leading up to the 2007-09 Great Recession, GDP growth averaged 10 percent annually. Since then, it has dropped to a 6 percent to 7 percent range, and some economists predict it will ultimately fall to a 2 percent to 4 percent range.
Many theories have been advanced to explain this shift. After years of fast growth, it’s said, China has exploited most existing technologies. It will now act more like a “normal” economy. Or: China has too much debt, limiting expansion. Or: China’s population is rapidly aging, hampering labor force growth.
Lardy dissents. He attributes the slowdown mainly to two factors: a declining trade surplus and the misguided decision to favor state-owned firms, which he regards as monstrously inefficient. He reports that the profitability of private-sector firms is more than double that of state-controlled companies.
“The real [explanation] of the underperformance of state firms vis-à-vis their private counterparts [is] insufficient profit-maximizing behavior, including corruption, on the part of the senior management of state firms and a large misallocation of capital [investment funds] by Chinese financial institutions, especially banks.”
The irony is inescapable. If Lardy is right — and his conclusion will likely be challenged — the decision to favor state capitalism will weaken China’s future economic growth. But growth may not be the main reason that Xi has acted as he has.
Even Lardy concedes that economic reform “must force into bankruptcy more long-lived zombie firms, mostly state-owned, that now survive by borrowing ever increasing amounts from state-owned banks.”
It is a specter that cannot please Xi, who may fear that “social unrest, unemployment, [and] financial instability” will weaken the Communist Party’s grip on power, as Lardy notes. The main motive for protecting state firms may be political, more than economic. And that’s why it may be so hard to change.
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