A brief history of the Chinese growth model Michael Pettis' finance blog February 21, 2013 As regular readers

know I have often argued that the Chinese development model is an old one, and an tra e its roots at least as far ba k as the !Ameri an "ystem# of the 1$20s and 1$30s% &his !system# was itself based primarily on the works of the brilliant first '" "e retary of the &reasury Ale(ander )amilton *see espe ially his report to the Congress on manufa turing and his two reports on publi redit and banks+% &his development model was also impli itly part of the debate in Fran e that led to one of the most important finan ial innovations of the 1,th Century, the reation of the Cr-dit .obilier in Fran e in 1$/2% &he debate on erned one of the great e onomi 0uestions in Fran e, espe ially after the defeat of 1apoleon2 why had 3ngland, a ountry that one hundred years earlier had been poorer than Fran e, managed to surpass Fran e and all other ountries e onomi ally and te hnologi ally, even though in the pure s ien es and engineering the Fren h were at least the e0ual to the 4ritish and perhaps superior5 6ne obvious reason had to do with the finan ing of the ommer ial appli ation of new te hnology% &he Fren h banking system, dominated by rentiers and the landed aristo ra y, seemed to spe iali7e in prote ting savers, in part by mobili7ing apital and investing in gold or in government obligations% &he 3nglish banking system did this too, but it also seemed mu h more willing to finan e infrastru ture and manufa turing apa ity% In fa t more generally I have argued that the main reason !industrial revolutions# have o urred largely in 3ngland and the 'nited "tates is be ause industrial revolutions are not driven by s ientifi developments but rather by the ommer ial appli ation of s ientifi developments% For this to happen it seems that a robust finan ing system is key% 3ngland, and the '" later, benefitted from a finan ial system that seemed to do better than others in finan ing new infrastru ture and te hnologi al ventures% A well8fun tioning finan ial system, one that allo ates apital to new ventures, in other words, may have been the key differen e between 3ngland and Fran e at the end of the 1$ th Century, and for this some historians blame the brilliant but errati 9ohn :aw and his .ississippi 4ubble% &his on ern about the ineffi ient Fren h banking system led to the reation of Cr-dit .obilier, whose role was to break the onstraints of the e(isting ;oths hild8 dominated finan ial system, mobili7e the savings of the middle lasses, and allo ate these savings towards finan ial pro<e ts, su h as infrastru ture development, that would, over the longer term lead to more rapid e onomi development% I will ome ba k to this issue of the finan ial system, but the point here is that there have been many versions of this development model, and at least two ma<or e onomi theoreti ians = the >erman Friedri h :ist in the 1,thCentury and the 'krainian8Ameri an Ale(ander >ershenkron in the 20th = have formally des ribed variations on the investment8 driven growth model% .i hael )udson, one of my favorite e onomi thinkers, wrote twenty

years ago a brilliant and provo ative book *Trade, Development and Foreign Debt+, whi h tra es many aspe ts of this model to debates in 3ngland at the end of the 1$ th Century% Aside from Ale(ander )amilton, its intelle tual and politi al godfather, the main proponents of the Ameri an "ystem were figures like )enry Clay, )enry and .atthew Cary, 9ohn Calhoun, and even Abraham :in oln himself% &heir vision of e onomi poli ymaking was looked down upon as na?ve and even foolish by most Ameri an a ademi e onomists = s hooled as they were in the laisse7 faire do trines then fashionable in 3ngland = but I think it is hard for any e onomi historian not to feel relieved that neither the a ademi s nor the 9effersonian and 9a ksonian fa tions had the lout to for e !good# e onomi poli y onto '" development% Ameri a got ri h in part by doing the wrong things% .any ountries in whi h the a ademi s had real influen e at the time = Chile in the 1$@0s under the tutelage of the famous Fren h e onomist 9ean >ustave Cour elle8"eneuil, for e(ample, or .e(i o at the turn of the entury under the e(pert guidan e of 9os- A% :imantour, finan e minister under Bresident Borfirio CDa7 = never a hieved the kind of growth that the less apable student8 ountries e(perien ed% I write about some of these ases in my 1,,@ arti le for Foreign Affairs, for anyone who might be interested% &o get ba k to the main story, in another, also brilliant and provo ative, book *Americas Protectionist Take-off, 1815-191 + .i hael )udson refers to a leading member of the se ond generation of proponents of the Ameri an "ystem, a Columbia 'niversity graduate by the name of 3% Be hine "mith% Ehat is espe ially interesting about "mith in the onte(t of China is that in 1$F2 he was invited to 9apan to serve as advisor to the .ikado, be oming the first of a stream of e onomists and lawyers = most of them proponents of the Ameri an "ystem = to advise and help shape 9apanese development after the .ei<i restoration% "mith thus reates a dire t link between the Ameri an "ystem and the Chinese development model% It was of ourse the post8Ear 9apanese development model, itself based on 9apanGs e(perien e of e onomi development during and after the .ei<i restoration, that be ame the standard for poli ymakers throughout 3ast Asia and China% I think of ChinaGs growth model as merely a more mus ular version of the 9apanese or 3ast Asian growth model, whi h is itself partly based on the Ameri an e(perien e% &here were three key elements of the Ameri an "ystem% )istorian .i hael :ind, in one of his e onomi histories of the 'nited "tates, des ribed them as2 H H H infant industry tariffs internal improvements, and a sound system of national finan e

&hese three elements are at the heart, e(pli itly or impli itly, of every variation of the investment8led development model adopted by number of ountries in the last entury = in luding >ermany in the 1,30s, the '""; in the early Cold Ear period, 4ra7il during the 4ra7ilian mira le, "outh Iorea after the Iorean Ear, 9apan before 1,,0, and China today, to name <ust the most important and obvious ases% For this reason I think it makes sense to dis uss ea h of them in a little more detail% Infant industry tariffs

&he !infant industry# argument is fairly well known% I believe Ale(ander )amilton was the first person to use the phrase, and the reasoning behind his thinking was straightforward% Ameri an manufa turing ould not ompete with the far superior 4ritish, and a ording to the then8 *and now+ fashionable e onomi theories based on Adam "mith and Cavid ;i ardo, the impli ations for trade poli y were obvious% Ameri ans should spe iali7e in areas where they were e onomi ally superior to the 4ritish = agri ulture, for the most part = and e onomi poli y should onsist of onverting '" agri ulture to the produ tion of ash rops = toba o, ri e, sugar, wheat and, most importantly, otton = ma(imi7ing that produ tion and e( hanging them for heaper and superior 4ritish manufa tured items% In this way, as ;i ardo brilliantly proved, and assuming a stati distribution of omparative advantages, with ea h ountry spe iali7ing in its omparative advantage, global produ tion would be ma(imi7ed and through trade both the 4ritish and the Ameri ans would be better off% Ehile most a ademi '" e onomists and the ommodity8produ ing "outh embra ed free trade, Ale(ander )amilton and his followers, mainly in the northeast, did not *in fa t differing views over free trade as well as over slavery and state rights were at the heart of the 1orth8"outh onfli t that led eventually to the Civil Ear+% )amilton was onvin ed that it was important for the '" to develop its own manufa turing base be ause, as he e(plained in his Congressional report in 1F,1, he believed that produ tivity growth was likely to be mu h higher in manufa turing than in agri ulture or mineral e(tra tion% Contrary to Cavid ;i ardo, in other words, )amilton believed that omparative advantage was not stati and ould be for ed to hange in ways that benefitted less produ tive ountries% Ehat is more, he thought manufa turing ould employ a greater variety of people and was not sub<e t to seasonal flu tuations or flu tuations in a ess to minerals% >iven mu h higher 4ritish effi ien y and produ tivity, whi h translated into mu h lower pri es even with higher transportation osts, how ould Ameri ans ompete5 &hey ould do it the same way the 4ritish did to ompete with the superior Cut h a entury earlier% &he '" had to impose tariffs and other measures to raise the ost of foreign manufa turers suffi iently to allow their Ameri an ounterparts to undersell them in the '" market% In addition Ameri ans had to a 0uire as mu h 4ritish te hnologi al e(pertise and apa ity as possible *whi h usually happened, I should add, in the form of intelle tual property theft+% &his the '" did, and in fa t I believe every ountry that has managed the transition from underdeveloped to developed ountry status *with, perhaps, the e( eption of one or two trading entrepJts like "ingapore and )ong Iong, although even this is debatable+, in luding >ermany, 9apan, and Iorea, has done it behind high e(pli it or impli it trade tariffs and stolen intelle tual property% &he idea that ountries get ri h under onditions of free trade has very little histori al support, and it is far more likely that ri h ountries dis over the benefits of free trade only after they get ri h, while poor ountries that embra e free trade too eagerly *think of Colombia and Chile in the late 1,th entury, who were stellar students of e onomi orthodo(y+ almost never get ri h unless, like )aiti in the 1$th Century or Iuwait today, they are massive e(porters of a very valuable ommodity *sugar, in the ase of )aiti, whi h was the ri hest ountry in the world per apita during a good part of the late 1$th Century+% 4ut rather than <ust embra e prote tion I would add that there is one very important aveat%

.any ountries have prote ted their infant industries, and often for many de ades, and yet very few have made the transition to developed ountry status% 'nderstanding why prote tion !works# in some ases and not in others might have very important impli ations for China% I wonGt pretend to have answered this 0uestion fully but I suspe t the differen e between the ountries that saw su h rapid produ tivity growth behind infant industry prote tion that they were eventually able to ompete on their own, and those that didnGt, may have had to do with the stru ture of domesti ompetition% "pe ifi ally, it is not enough to prote t industry from foreign ompetition% &here must be a spur to domesti innovation, and this spur is probably ompetition that leads to advan es in produ tivity and management organi7ation% I would argue, for e(ample, that ountries that prote ted domesti industry but allowed their domesti markets to be aptured and dominated by national hampions were never likely to develop in the way the 'nited "tates in the 1,th Century% I would also argue that ompanies that re eive substantial subsidies from the state also fail to develop in the ne essary way be ause rather than for e management to improve e onomi effi ien y as a way of over oming their domesti rivals, these ountries en ourage managers to ompete by trying to gain greater a ess to those subsidies% Ehy innovate when it is far more profitable to demand greater subsidies, espe ially when subsidi7ed ompanies an easily put innovative ompanies out of business5 :ast April, for e(ample, I wrote about plans by Euhan Iron K "teel, ChinaGs fourth8largest steel produ er, to invest LM%F billion in the pork produ tion industry% &he ompanyGs management argued that they ould ompete with traditional agro8businesses not be ause steel makers were somehow more effi ient than farmers, but rather be ause their si7e and lout made it easier for them to get heap apital and to get government approvals% &hey were able to invest in an industry they knew little about, in other words, be ause they knew they ould e(tra t e onomi rent% &his learly is not a good use of prote tion% &he lessons for China, if I am right, are that China should forego the idea of nurturing national hampions and should instead en ourage brutal domesti ompetition% 4ei<ing should also eliminate subsidies to produ tion, the most important being heap and unlimited redit, be ause senior managers of Chinese ompanies rationally spend more time on in reasing a ess to these subsidies than on innovation, a sub<e t on whi h, in spite of the almost absurd hype of re ent years, China fares very, very poorly% &here is nothing wrong with prote ting domesti industry, but the point is to reate an in entive stru ture that for es in reasing effi ien y behind barriers of prote tion% &he diffi ulty, of ourse, is that trade barriers and other forms of subsidy and prote tion an be ome highly addi tive, and the benefi iaries, espe ially if they are national hampions, an be ome politi ally very powerful% In that ase they are likely to work a tively both to maintain prote tion and to limit effi ien y8enhan ing domesti ompetition% It was Friedri h 3ngels, not often seen as a hampion of apitalist ompetition, writing to 3dward 4ernstein in 1$$1, who said that !the worst of prote tion is that when you on e have got it you annot easily get rid of it%# Internal improvements

&he se ond element of the Ameri an "ystem was internal improvement, whi h today we would probably all infrastru ture spending% Broponents of the Ameri an "ystem demanded that the national and state governments design, finan e and onstru t anals, bridges, ports, railroads, toll roads, and a wide variety of ommuni ation and transportation fa ilities that would allow businesses to operate more effi iently and profitably% In some ases these pro<e ts were paid for dire tly *tolls, for e(ample+ and in other ases they were paid for ta( revenues generated by higher levels of e onomi a tivity% It is easy to make a ase for state involvement in infrastru ture investment% &he osts of infrastru ture an be very high, while even if the benefits are mu h higher they are likely to be diffused throughout the e onomy, making it hard for any individual ompany to <ustify absorbing the osts of investment% In this ase the state should fund infrastru ture investment and pay for it through the higher ta(es generated by greater e onomi a tivity% For me the interesting 0uestion, espe ially in the Chinese onte(t, is not whether the state should build infrastru ture but rather how mu h it should build% In fa t this is one of the greatest sour es of onfusion in the whole China debate% .ost China bulls impli itly assume that infrastru ture spending is always good and the optimal amount of infrastru ture is more or less the same for every ountry, whi h is what allows them to ompare ChinaGs per apita apital sto k with that of the '" and 9apan and on lude that China still has a huge amount of investing to do be ause its apital sto k per apita is so mu h lower% 4ut this is ompletely wrong, and even nonsensi al% Infrastru ture investment is like any other investment in that it is only e onomi ally <ustified if the total e onomi value reated by the investment e( eeds the total e onomi ost asso iated with that investment If a ountry spends more on infrastru ture than the resulting in rease in produ tivity, more infrastru ture makes it poorer, not ri her% In China we have problems with both sides of the e0uation% First, we donGt know what the true e onomi ost of investment in China might be% In order to al ulate the true ost we need to add not <ust the dire t osts but also all the impli it and e(pli it subsidies, most of whi h are hidden or hard to al ulate% &he most important of these subsidies tends to be the interest rate subsidy, and this an be substantial% If interest rates in China are set artifi ially low by / per entage points, for e(ample, whi h is a reasonable estimate, an investment of L100 million re eives an additional subsidy of L/ million for every year that the loan funding the investment is outstanding = and loans are almost never repaid in China% 6ver ten to twenty years of outstanding debt this an add 308M0N to the initial ost of the investment% &his means that the re ogni7ed ost of an infrastru ture pro<e t is mu h lower than the true e onomi ost, with the differen e being buried in e(pli it and impli it subsidies% 4ut the bigger problem is in the value reated by the investment% Ee an think of the value of infrastru ture primarily as a fun tion of the value of labor saved% In ountries with very low levels of produ tivity, ea h hour of labor saved is less valuable than ea h hour saved in ountries with high levels of produ tivity% For this reason less produ tive ountries should have mu h lower apital sto k per apita than more produ tive ountries% &his should be obvious, but it seems that often it isnGt% Ehen analysts point to high 0uality

infrastru ture in China whose 0uality e( eeds omparable infrastru ture in ri h ountries, this is not ne essarily a good thing% It might <ust be an e(ample of the amount of waste you an a hieve when spending is heavily subsidi7ed, when there are strong politi al *or pe uniary+ in entives for e(panding investment, and when there is limited transparen y and a ountability% 6ther things matter too% If a ountry has low levels of so ial apital = if it is hard to set up a business, if less effi ient businesses with government onne tions an su essfully ompete with more effi ient businesses without government onne tions, if the legal and politi al stru ture reates problems in orporate governan e *the !agen y# problem, espe ially+, if the legal framework is weak, if property rights are not respe ted, if intelle tual property an easily be lost = then mu h infrastru ture spending is likely to be wasted% In fa t it turns that it may be far more effi ient to fo us on improving, say, the legal framework than to build more airports, even though *and perhaps be ause+ building airports generates more growth *and wealth for the politi ally onne ted+ today% Eeak so ial apital be omes a onstraint on the ability to e(tra t value from infrastru ture, and this onstraint is very high in poor ountries with weak institutional frameworks, Journey to the West &his issue of how mu h investment is enough is a very important topi that deserves mu h more dis ussion, but I think there is a very good e(ample of why we need to be worried about how useful additional infrastru ture investment in China might be% &his shows up most learly in ChinaGs push to reate development in the western part of the ountry% 6ften when I 0uestion the e onomi value of ChinaGs push to the western, poorer parts of the ountry *by the way e onomi value is not the same as so ial or politi al value, the latter of whi h may nonetheless <ustify pro<e ts that are not e onomi ally viable+ I am almost always treated with the story of the Ameri an Eest% In the 1,th Century, as everyone knows, the '" went west, and most e onomists agree that this made e onomi sense for the ountry and was an important part of the pro ess that led it to be oming the wealthiest and most produ tive ountry in history% 4ut we must be very areful about drawing lessons from the Ameri an e(perien e% &he '" is not the only ountry in history that !went Eest#% "everal other ountries did so too, but for some reason we ignore their e(perien es altogether when we dis uss China% 4ra7il, for e(ample, went west and north in the 1,/0s and 1,@0s as it e(panded from the ri h southern oastal areas into the Ama7on and the Caribbean% &he "oviet 'nion did something similar after the "e ond Eorld Ear as it went east into "iberia% .ost e onomists today agree that the 4ra7ilian and "oviet e(perien es were e onomi ally unsu essful and left those ountries burdened with su h enormous debts that they were at least partly to blame for 4ra7ilGs debt risis in the 1,$0s and the ollapse of the "oviet e onomy in the 1,F0s% It turns out, in other words, that there are both su essful and unsu essful pre edents for ChinaGs going west% Ehat are the differen es and how do they apply to China5 Again, I anGt say that I an fully understand or e(plain them, but one ma<or differen e leaps out% In the '" it was private individuals, seeking profitable opportunities, that led the move into the Ameri an Eest, and government investment followed% In 4ra7il and the "oviet 'nion, however, there was little

in entive for private individuals to lead the pro ess% It was the government that led, and private businesses followed only be ause government spending reated great opportunities for profit% 6n e government spending stopped, so did business% .y very preliminary on lusion is that large8s ale government ambitions allied to strong politi al motivation and funded by heap and easy a ess to redit an lead very easily to the wrong kinds of investment programs% &he '" e(perien es of government investment in the 1,th Century, in other words, may be a very poor pre edent for understanding ChinaGs urrent poli y of in reasing investment spending, espe ially in the poor western part of the ountry% 4ra7il and the "oviet 'nion may be mu h better pre edents% At the very least these gloomier e(perien es should not be ignored when we think of ChinaGs poli ies% !>oing Eest# isnGt always a great idea from an e onomi point of view and has led to at least as many, and probably more, bad out omes as good out omes% It is not lear why these lessons annot possibly be applied to China% A sound system of national finance &he third pillar of the Ameri an "ystem was the reation of an appropriate finan ial system% 4ut what does that mean5 It is hard to des ribe the Ameri an finan ial system in the 1,th Century as stable and well8fun tioning% In fa t the Ameri an banking system was haoti , prone to rises, mismanaged, and often fraudulent, and yet the '" grew very rapidly during that time% ChinaGs banking system, on the other hand, is far more stable = in fa t the favorite li h- of Chinese bankers is that while the system may not be effi ient, it is very stable% Ehat makes the Chinese banking system stable, of ourse, is that it is widely believed that the government stands fully behind the banks% It makes no differen e, in other words, how weak the redit allo ation de ision is, be ause by ontrolling redit and the deposit rate, and by limiting alternatives for Chinese savers, the government guarantees both the li0uidity and solven y of the banking system% As long as government redibility is inta t, the banking system is unlikely to fail% In that sense you an easily make the ase the Chinese banks today are sounder than Ameri an banks in the 1,th entury% &his might bode well for the future of the finan ial system in the short term, but in the long term it is not lear to me that monetary soundness and finan ial stability are ne essarily orrelated with more rapid growth% I say this be ause I have seen no eviden e that ountries with sound and onservative finan ial systems grow faster than ountries with looser and riskier finan ial systems *although they do seem to have fewer finan ial rises+% In fa t I have more than on e made referen e to 4elgian bank historian ;aymond de ;ooverGs provo ative and profound omment that !perhaps one ould say that re kless banking, while ausing many losses to reditors, speeded up the e onomi development of the 'nited "tates, while sound banking may have retarded the e onomi development of Canada%# Canada was blessed *or ursed, a ording to de ;oover+ in the 1,thCentury with being part of the 4ritain, and so inheriting 3nglandGs mu h better managed finan ial system% !;e kless# banking is hard to define, and ertainly it is easy to make the ase the Chinese

banking has been re kless, espe ially in re ent years, but it is a very different type of re klessness% 6n e again I annot say with omplete onfiden e how ChinaGs version of its development model differs meaningfully with the Ameri an "ystem on the sub<e t of banking, but I would suggest there are at least two very important differen es% First, the Ameri an finan ial system then *and now+ has been very good at providing money to risky new ventures% It provides apital on the basis not only of asset value but, more importantly, on future growth e(pe tations, and risk8taking has been a tively rewarded In China it isnGt lear that this is the ase at all% Chinese banks favor large, well8 onne ted, and often ineffi ient giants at the e(pense of risk8takers% "e ond, although both systems were prone to bad lending, the Ameri an banking system tended to orre t very 0ui kly = in the form of a risis = and bad loans were written down and li0uidated almost immediately% &his was ertainly painful in the sort term = espe ially if you were a depositor in the affe ted bank = but by writing down loans and li0uidating assets three important ob<e tives were a hieved% Finan ial distress osts were 0ui kly eliminated *writing down debt does that in ways I wonGt get into be ause they are well8known and mu h dis ussed in orporate finan e theory+, apital allo ation was driven by profitability, not by impli it guarantees, and assets were returned to e onomi usefulness 0ui kly% A lassi e(ample of the last of these ob<e tives may be the response to the railway bubble of the 1$@0s% Curing and after the 1$F3 risis, a number of railroads went bankrupt, in luding ma<or lines like the 'nion Ba ifi and the 1orthern Ba ifi , the latter of whi h even brought down 9ay Cooke K Company, the leading finan ier of the '" government during the Civil Ear% After the risis some ma<or railway bonds traded as low as 1/820N of their original fa e value, and so they were pur hased and reorgani7ed at huge dis ounts% &he new buyers were onse0uently able to ut freight and passenger osts dramati ally, in some ases by over /0N, while still earning more than enough to over the osts of buying the railroads, and this led to a ollapse in transportation osts in the '"% :i0uidation, in other words, provides an important e onomi value to the e onomy% It allows assets to be re8pri ed, whi h reates a boost to the e onomy and prevents those assets from a ting as a deadweight loss% If the railroads hadnGt been li0uidated, in other words, any redu tion in osts was likely to be minimal and the railroads would have been far less useful to the development of the '" e onomy% Comparing development models &his issue of the newsletter is long, and I plan to write about this a lot more in the future, but for now I think it makes sense to summari7e some of the important points about the Ameri an "ystem and other similar growth models, like the Chinese version% 1% Infant industry prote tion has worked to promote long8term development under ertain onditions and has not worked under other onditions% I would argue that the key differen e is that in the former ase there were powerful for es that drove managerial and te hnologi al innovation and rapid growth in effi ien y% In the '" ase this seems to have been brutal domesti ompetition% If China wants to benefit

from its own prote tion of infant industry, it is important that there be similar domesti drivers of innovation and effi ien y% 1ote that a ess to heap apital annot be su h a driver, even though it is one of the main sour es of Chinese ompetitiveness% A ess to heap apital is <ust another way to prote t infant industries from foreign ompetition% 2% 3very ountry that has be ome sustainably ri h has had signifi ant government

investment in infrastru ture, but not every ountry that has had signifi ant government investment in infrastru ture has be ome sustainably ri h%6n the ontrary there are many ases of ountries with e(traordinarily high levels of infrastru ture investment that have grown for a period and then faltered% I would argue that the differen e is almost ertainly the e(tent of apital misallo ation% In some ountries it has been mu h easier for poli ymakers to drive apital e(penditures, and in those ountries it seems to have been relatively easy to waste investment% If this is the ase in China, as I believe it is, the key issue for China is to rein in its spending and develop an alternative and better way to allo ate apital% &he point is that there is a natural limit to infrastru ture spending, and this limit is often imposed by institutional distortions in the market e onomy% Ehen this natural limit is rea hed, more investment in infrastru ture an be wealth destroying, not wealth enhan ing, in whi h ase it is far better to ut ba k on investment and to fo us on redu ing the institutional onstraints to more produ tive use of apital, su h as weak orporate governan e and a weak legal framework% &he pa e of infrastru ture investment annot e( eed the pa e of institutional reform for very long without itself be oming a problem% 3% Any e onomy looking to a hieve sustainable long8term growth must have a !good#

finan ial system that allo ates apital effi iently and rewards the orre t level of risk8taking% It is hard to determine what the hara teristi s of a !good# finan ial system are, but we shouldnGt be too 0ui k to assume that this has to do with stability% EhatGs more, while obviously the apital allo ation pro ess is vitally important, I would also suggest that the li0uidation of bad loans is <ust as important% 4ad loans, as 9apan showed us in the past two de ades, an be ome a serious impediment to growth in part be ause finan ial

distress distorts management in entives in the way widely understood and des ribed in orporate finan e theory and in part be ause they retard the pro ess by whi h bad investment is absorbed by the e onomy% M% 6ne thing I have not dis ussed above is the role of wages% &he Ameri an "ystem was

developed in opposition to the then8dominant e onomi theories of Adam "mith and Cavid ;i ardo, in part be ause lassi 4ritish e onomi theory seemed to imply that redu tions in wages were positive for e onomi growth by making manufa turing more ompetitive in the international markets% A main fo us of the Ameri an "ystem, however, was to e(plain what poli ies the 'nited "tates, with its mu h higher wages than in 3urope at the time, had to engineer to generate rapid growth "ustaining high wages, in fa t, be ame one of the key aspe ts of the Ameri an "ystem% &he 9apanese version of this development model, as well as many of the various versions implemented in other ountries throughout the 20th Century, shared its view of wages not with the Ameri an "ystem but rather with lassi 4ritish e onomi theory% ;ather than take steps to for e up wages and keep them high = thereby both driving produ tivity growth and reating a large domesti onsumption market for Ameri an produ ers = many of the later versions of the Ameri an "ystem sought to repress growth in household in ome relative to total produ tion as a way of improving international ompetitiveness% &his is perhaps the main reason why the 'nited "ates, unlike many other ountries that have implemented similar development strategies in the 20th Century, tended to run large urrent a ount defi its for mu h of the 1,th Century &his different fo us on whether high wages are to be en ouraged or dis ouraged is, I believe = although very little dis ussed in the theoreti al literature as far as I know = nonetheless perhaps the most important differen e between the Ameri an development model and its many des endants in the 20th and 21st enturies% I would even argue, although I annot prove it, that one onse0uen e of this differen e is that growth in demand tends to be more sustainable when it is balan ed between growth in both onsumption and investment%

In analy7ing ChinaGs growth in the past three de ades we seem to forget that there have been many growth !mira les# in the past two hundred years% "ome have been sustainable and have led to developed ountry status but many, if not most, were ultimately unsustainable% 1early all of the various versions have had some similar hara teristi s = most obviously infant industry prote tion, state8led investment in infrastru ture, and a finan ial system that disproportionately favored produ ers at the e(pense of savers = but the way these hara teristi s played out were very different, in large part be ause the institutional stru ture of the e onomy and the finan ial se tor reated a very different set of in entives% I would argue that in understanding ChinaGs growth and its sustainability we need to have a lear understanding of why these hara teristi s worked in some ases and not in others% .ost e onomists who fo us on China seem to know little about e onomi history, and when they do, their knowledge tends to be limited to a very superfi ial understanding of '" e onomi history% 4ut there are many pre edents for what is happening in China and not all suggest that further Chinese growth is inevitable% 6n the ontrary, the histori al pre edents should worry us% In most ases they suggest that China has a very diffi ult ad<ustment ahead of it and the losest parallels to its de ades of mira le growth suggest unfavorable out omes% 'nderstanding why the growth model has su eeded in some few ases and failed in most will help us enormously in understanding ChinaGs prospe ts%