China's authoritarianism is dooming its economy

We've been here several times before: a sudden and dramatic lurch in the Chinese economy that looks like it could be the Big One, the beginning of the end of China's economic miracle, perhaps even the beginning of the long-dreaded Chinese economic crash that would be globally disastrous.

Every time, China's leaders have managed to fix the problem before it became a catastrophe. The Big One never comes. There are two schools of thought on this. One says this is because China's leaders are smart, the country's economy is basically healthy, and everything will be fine. The other says that these fixes are temporary, that China's leaders are kicking the can down the road, and that China's economy is ultimately unsound.

Based on past incidents, it's a safe bet that China will pull out of this crisis as it has past crises. But, long term, I have always suspected that the pessimists were right, that China's economic model was unsustainable and doomed to collapse into recession and, possibly, the sort of resulting political turmoil the country saw in the late 1980s. One reason I believe this is that I am joined by some of the people in the best position to know: the Chinese leadership.

China's emergency

Xi Jinping and other members of the Politburo Standing Committee meet in 2012. (Feng Li/Getty)

"I want to remind those cadres who are staying on the job beyond me: My biggest worry right now is an overheating economy," Chinese Premier Zhu Rongji said in a January 2003 Cabinet meeting, his last before leaving office.

"I've already worried about this for a year now," Zhu said in comments released only years later. "I wouldn't say this publicly, but only bring it up to the top leadership, that overheating is the one thing that preoccupies my mind. Many signs seem to have emerged, and if we're not vigilant, the economic situation will be difficult to rein in."

The next premier, Wen Jiabao, warned in 2007 that China's economic model of skyrocketing export-based growth was "unstable, unbalanced, uncoordinated and ultimately unsustainable."

The Chinese government knows it can't maintain power through censorship, propaganda, and riot police alone. It needs to maintain economic growth to keep Chinese citizens happy, but it also needs to slow down that growth to keep the economy healthy in the long term.

The basic problem at the core of the Chinese economy is that it needs to be dramatically restructured to remain healthy. But Chinese leaders appear either unable or unwilling to make those changes, held back by the unusual nature of China's authoritarian, one-party political system.

China's leaders have seen the problem for a while: They've been warning one another for years that their economic model was "unsustainable." But they never fixed it, which is why we're seeing this week's latest economic lurch. The reason they never fixed it isn't that the economy was unready, or that they didn't know what to do. It's that they are incapable of doing it.

The very nature of China's authoritarian model, by basing its power on a sprawling governing elite that is heavily invested in the status quo, might now make it impossible for officials to do the things they need to do to keep the system afloat.

China's one-party rule has looked impossible for so long that we sometimes don't even see anymore how improbable its continued rule really is. China watchers, not to mention people within China itself, have been warning for decades that the system was unsustainable. But the Communist Party pulled itself out of so many dire-seeming crises that those warnings started to sound silly. But maybe they weren't. Maybe they were right.

What China has to do

(STR/AFP/Getty)

Chinese textile workers in Anhui province. (STR/AFP/Getty)

The stakes here are enormous. Since not long after the 1989 Tiananmen massacre, China's government has premised political stability on delivering consistent economic growth. No one is sure what will happen if Beijing fails on that implicit promise, but Chinese leaders certainly fear the worst. In a democracy, if people feel their government has failed them, they can vote that government out of office. But in an autocracy like China's, popular discontent can be more dangerous.

China's leaders have long planned to change the country's economic model. But they thought they would have decades to do it; as long as China remained much poorer than developed countries, the old system would hold. When Zhu and Wen issued their warnings, they saw the problem as urgent, but on a long timeline.

That timeline got much shorter after the 2008 financial crisis, which crippled Western economies as China's was growing. The gap between China and rich countries shrank, and suddenly China's economic model began looking less viable.

In recent years, China's economy has been based on exporting to wealthy, developed countries. For that export-driven system to work, China's economy needs to remain weaker than those of its buyers. One of the biggest reasons China sells so much stuff is because it can produce that stuff cheaply. But as China's growth accelerates and European and American growth slows due to financial crises, China's wages are catching up with the developed economies faster than anyone had anticipated.

If and when China gets too wealthy to continue exporting cheap products (or if the developed economies become too weak to keep buying them), it will be in big trouble. The financial crisis meant that China needed to accelerate its plan to restructure its economy.

China needs to shift its economic emphasis from selling exports — at times driven by state-run industrial enterprises — to selling to domestic Chinese consumers. This means moving wealth from the state and state-run companies to Chinese households, which would then drive China's continued growth.

That was always going to require some trade-offs. An urban middle class that's wealthy enough to drive sufficient domestic consumption is also going to be too wealthy to work cheap factory jobs. And this is also going to require a Chinese currency that is too strong, relative to those of wealthy importers like the US and Japan, for China to keep pumping out cheap exports. It was going to hurt export industries and state-run enterprises, which means hurting the elite.

China's solution to this was not ideal. It did increase domestic spending, and exports have dropped, but rather than pumping that money into the middle class and businesses to serve it, too much of that money has gone into massive and at times wasteful infrastructure spending. And that gets to the ways that China's political model is coming to stand in opposition to its economic model.

Why China might not be able to pull it off: elite opposition

Downtown Beijing. (WANG ZHAO/AFP/Getty)

There are several ways in which China's political system makes it very hard for it to confront its economic challenges. One of them is something that I sometimes shorthand as China's steel problem.

A few years ago, China announced that the country would cut steel production. I asked a journalist who covers Chinese industry if this was good news. After all, China was producing and exporting way too much steel, flooding global markets and dropping prices — not to mention keeping China's economy on the export-led model it needs to drop. So this must be a good step, right?

He responded that it probably would be if not for the fact that China had been announcing this policy for years, and for years Chinese steel production had been rising. Beijing, he said, could make all the declarations it likes, but there are a lot of high- and mid-level officials, not to mention the powerful state-run industries, that might not see it as in their interest to go along. Often, they don't, sometimes rewriting policy as it happens.

China's steel production did finally dip a bit in the first quarter of this year, the first production drop in 20 years, after US and EU producers called for tariffs to punish Chinese overproduction. This goes to show how hard it is for China to make any sort of economic pivot; it wasn't until steel producers faced the threat of tariffs that they finally obeyed the order to drop production.

A major problem of the Chinese system, which can look efficient and monolithic from the outside, is that local officials, mid-level officials, and senior officials sometimes have divergent incentives — and they often have enough political autonomy to go on their own way. Beijing might ban forced abortions, for example, but the practice still happens in places where the local official thinks he or she knows better.

This gets to the larger problem with China's needed economic transition to a consumer economy: The leadership can't pull it off unless the larger Chinese system wants to make it happen. And the system gives every indication of not wanting it to happen, for the simple reason that it would be bad for the people who dominate that system.

China's growth has created some very powerful industries and interests in the country. The firms that made a lot of money became politically connected, and vice versa. State-run industries and rich elites hold an awful lot of power in China, to the extent that the line between officialdom and the business elite is blurred at best. All of them benefit generally from the status quo, and specifically from the current system that prioritizes state-run enterprises, export industries, and certain domestic industries such as housing and construction that are not healthy outlets for growth.

These people are going to want to resist change, even change that's good for China overall. That's true of efforts to shift to a consumption-driven economy, which would be bad for their business and political interests. And it's true of redistributive policies to build up the middle class, which would hurt their interests.

In 2011, the Eurasia Group issued a lengthy report on China's current five-year plan, warning that this opposition could be enough to stop China from making the necessary changes to its economy.

The group's prediction was severe: "China's leadership will fail to introduce the bold reforms necessary to meaningfully redistribute wealth from corporations and government to households. For instance, big state-owned firms will fiercely resist contributing large chunks of their dividends to government social security funds."

But the same tendency to intervene in the economy, particularly in China's financial system, could well set up a battle over capital allocation and investment decisions, in which powerful stakeholders will resist any attempt to transfer wealth to new constituencies. And China's leaders are unlikely to deal with these powerful "losing" interest groups holistically. Nor is a strongman or tightly knit group of leaders likely to be able to overcome them. Ultimately, then, China's political environment will defeat many elements of the FYP [five-year plan]. Without significant changes to governance structures--and to the role the state plays in capital allocation--China's economic landscape will not change as fundamentally as the FYP's designers (and many foreigners) hope.

The report warns that the Chinese Communist Party could endanger the very stability of Chinese politics if it fails to implement the needed reforms. "China's rebalancing agenda is not merely about economics but, ultimately, the political viability of the Chinese system," the report conclude. "That income and development gap is unsustainable both economically and politically."

Why China might not be able to pull it off: financial control

Chinese stock investors gather at a terminal in Fuyang. (STR/AFP/Getty)

If what China wants is a healthy, consumer-driven economy that will keep the country prosperous and stable, then one thing it really needs to get there is freer financial institutions. This is a big part of how you direct money to serve domestic consumption, building up things like local businesses. And, indeed, Chinese leader Xi Jinping has talked a lot about making this a priority.

But it turns out that China's leaders didn't really mean it. As we learned this week, much as they might have seen the long-term benefits of freer markets, they are unwilling to bear the short-term costs — and they want to keep control of banks to keep diverting money to those entrenched state-run industries and elite interests. The 2011 Eurasia Group report predicted exactly this:

The senior political leadership is not receptive to reforms that would weaken the Chinese Communist Party's power over the financial system and thus jeopardize its ability to bankroll massive industrial policy spending on powerful constituencies, which constitutes another major 12th FYP priority. Given this discord, Beijing is unlikely to articulate or pursue a convincing plan for remedying the financial sector's most glaring inefficiencies over the next five years.

That goes a long way to explain why the Chinese government responded to this week's stock crash with such drastic interventions.

"The economic hopes invested in Xi [Jinping] and [Premier Li Keqiang] stemmed from their pledge in late 2013 to let market forces play a 'decisive role' in allocating resources," the Economist's Simon Rabinovitch wrote. "The actions of the past ten days have made abundantly clear that it is still the other way around: the Chinese government wants a decisive role in markets."

The reasoning here, as the Eurasia Group's report explained, is almost certainly about politics. Keeping firm control of China's financial sector is in the short-term interests of the state-run industries and elites who are so powerful in China. But it is against the long-term interests of China's economic health, making it harder to grow the middle class and domestic consumption.

Instead, China found short-term fixes that have made it worse

Chenggong, one of a number of Chinese "ghost towns" of vast housing developments that sit largely empty. (ChinaFotoPress/ChinaFotoPress via Getty)

In China, everything the government does comes down, at some point, to maintaining stability and Communist Party rule. The leadership believes, with reason, that it needs to keep economic growth high: Rising urbanization and wages means that the cost-of-living is going up all the time, and growth has to keep pace with that to maintain the rising standard of living. And maintaining the standard of living is, at this point, a core premise of Communist Party rule and thus of the country's stability.

The smart way to deal with this problem would have been to liberalize the financial sector, allowing for more investment in new businesses that serve domestic consumers, and to redistribute more wealth to the middle classes so that they'll go out and spend it. But for the reasons discussed above, China couldn't do that. Xi Jinping did try to address this larger problem with a massive anti-corruption campaign and crackdown on misbehaving officials. This was meant, among other things, to get the elite in line for the necessary reforms. Xi, like other Chinese leaders before him, did see the problem and did try to address it, but the system has been just too big and resistant to change.

China's stopgap to keep the economy moving was to funnel huge amounts of money into things like massive state-run infrastructure projects — the famous empty airports and hotel complexes. This did indeed help maintain economic growth. But a lot of that spending was just waste, and the "growth" was unsustainable.

At the same time, this encouraged Chinese consumers to pour their money into unwise investments like real estate or, more recently, the stock market. Because Beijing kept dumping money into these projects, it looked like they would grow forever. And the absence of a liberalized financial sector meant that consumers had few other places to put their money. So consumers helped drive what has been a set of bubbles across the Chinese economy.

Everyone is focused right now on the enormous bubble in the Chinese stock market — driven in part by regular Chinese investors who followed the terrible logic of bubbles by dumping money into investments that looked like they would grow forever. But maybe a more instructive example is the enormous real estate bubble. In 2011, 13 percent of Chinese GDP came from real estate investment. Urban housing stock constituted 41 percent of Chinese household wealth.

The result of this is that China watchers have been just sort of waiting for China's real estate to implode, and hoping that it wouldn't be totally catastrophic when it did. The same goes for the Chinese stock market, which has been in an obvious — and obviously dangerous — bubble for some time. That bubble currently appears to be, to at least some extent, popping.

The fact that the current downturn was entirely foreseeable and yet not prevented speaks to the larger danger looming over China. Its ever-worsening failure to make the necessary economic transition is just as obvious, and the consequences just as foreseeable. China's leaders are really smart people who can see all of this coming. The fact that they haven't taken the necessary steps to avert either this little disaster or what could be the potentially much larger disaster of a failed transition tells you something pretty scary: It might just not be in their power.

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