This is what
China's capital of manufacturing Shenzhen looked like in 1980, a backwater fishing village in
one of the poorest economies in the world. And this is what it looks like today. To me, this clearly demonstrates the power
of China's incredible economic miracle. A miracle
that lifted more than 800 million people out of poverty in just 40 years. However, if you turn on the news right
now, this is what you'll typically hear. The world's second largest
economy is stumbling on the alarms sounding across the globe at China's
worsening economic outlook. That's due to worsening a worsening
property slump, weak consumer spending and tumbling
credit growth. So they just stopped releasing youth
jobless data because it's so bad. Is the economy in China in danger
of a serious ongoing downward spiral? So what happened? How did China get so powerful so quickly? Why is its economy then in trouble now? And are its troubles so bad that China
is no longer expected to overtake the U.S. as the world's preeminent superpower? The standard story is that China got rich
by abandoning communism in 1978 and is now wasting its chance
to become a superpower by turning back
to authoritarian communism. But that story has always
seemed overly simplistic to me. After all, there are many countries
like, for example, Russia, that also abandoned communism
and did not get so powerful. Similarly, there are countries
that have always been more open, like, for example, India, that also didn't
get as powerful so quickly as China. Finally, if you look closer, China's
economic miracle looks an awful lot like that of Japan and other East
Asian nations like Korea and Singapore, even though China has never been as open
as these countries. So to find out the real story, I spent weeks
reading the research from renowned China experts like Professor
Michael Pettis, Wen and Dr. Yi Wen and Dr. Zongyuan Zoe Liu and I then combined
their insights with those of development economists like Nobel Prize winner
Simon Kuznets and Professor Ha Yoon Chang. And now I'm very happy to report
that I believe that I finally found the story
that connects all of the dots. The story that can explain
how China got so powerful, why it is now stagnating, and importantly, what we can expect will happen to China's
economy next. Will it overtake the USA as the reigning
global superpower or will it stagnate like Japan did after the 1980s? To answer that question,
let's get into the story right away
by answering how China escapes poverty. Okay. This story starts in 1978, when Deng Xiaoping
became the de facto leader of China. He inherited one of the poorest economies
in the world, one that has been stagnant for decades
and was even being outperformed by economies
like Sudan and Haiti. And yet, as we all know
today, China is the second largest economy in the world, leaving Sudan and Haiti
and many others in the dust when it comes to GDP per person. In between 1978 and today, China was radically transformed
from an agricultural society into the world's manufacturing hub,
with a manufacturing output today that matches that of Europe
and the United States combined. And even more impressively, the country
now dominates advanced industries, ranging from telecommunications
to electric vehicles to solar panels. So how did it do this? What is the secret sauce
that it use to achieve this miracle? To answer this complicated question,
I first tried to find out how other economic miracles,
such as those experienced by West European and North American countries
had come about throughout history. How did these economies grow rapidly to become the advanced economies
that they are today? Well, according to Nobel Prize
winning economist Simon Kuznets,
that's the type of rapid economic growth that all of these countries went through
was actually characterized by two key characteristic. The first was rapidly rising productivity
per person. In other words, these countries
were primarily able to make more stuff because people got better
at making more stuff rather than just
by having more people in your economy. The second key
characteristic Kuznets found was that these economies first shifted from being dominated by agriculture
to being dominated by industry. And then after they industrialized, they eventually became dominated
by the service industry. A process that economists typically refer to as structural transformation. And while today some countries have tried to develop it
by focusing on services right away, their growth has never actually been
as impressive as the Asian development miracles experienced by Japan, Korea,
Taiwan and Singapore. Now, according to development economists
like Cambridge Professor Ha Yoon Chang, the reason for this is that while
agriculture has been constrained by nature and services by human nature, people
in the manufacturing sector have been able to become much more productive
through automation. On top of that, manufacturing goods
can more easily be exported. So if you focus on manufacturing
as a developing nation, you can develop faster
because you can export to countries that are already rich making you richer. However, as noted by Dr. Yi Wen in his book
The Making of an Economic Superpower Unlocking China's
Secret of Rapid Industrialization, the Path to Prosperity does not end there. You see, in line with Kuznet’s
observation. Even today, all rich countries
then transition further from a manufacturing economy
to a service oriented economy. Now, I realize that this second transition
might seem counterintuitive, so we'll dive deeper into that in detail
in the second part of this video. But first, knowing that
that most economic miracles came about by becoming a manufacturing power,
I think we can already answer a question about how China dragged itself
out of poverty by stating that it did so by making its people more productive,
by becoming a manufacturing powerhouse, which of course doesn't really say
much as it then raises the question how did China become
a manufacturing powerhouse? Which gets us to the standard story
that China became a manufacturing powerhouse by abandoning
communism and embracing globalization. And share
this story makes a lot of sense at first. After all, while under communism,
China only made limited progress in manufacturing. And it was only after Deng
Xiaoping opened up China to market forces
and the outside world slowly via special economic zones
that China's economic miracle kicked off. So it makes sense that this is often
where the standard story stops. Economic growth was simply a matter
of opening up to the world. But while I agree that it is a crucial
first step, I never felt satisfied
with that simple explanation alone. After all, if escaping
poverty was as simple as doing nothing, you'd surely have
a lot more wealthy countries. More importantly,
this simplistic narrative is not in line with historical evidence
of substantial government intervention in East Asian states
like Japan, Singapore and Korea. Heck, even if you dive into the history
of the economic development of the United States,
you'll discover that the first U.S. Secretary of Treasury, Alexander Hamilton, never believed the British Free market
economists of the time, as he wrote that in countries
where there is great private wealth, much may be affected by the voluntary
contribution of patriotic individuals. But in a community is situated like that of the United States,
the public purse must supply the deficiency
of private resources in what can be so useful as in prompting
and improving the efforts of industry. Which means, in simpler terms, that in a poor developing nation
which the US was at the time, the government must actively
stimulate industrial development. So what did the government
of successfully developing nations did to transform their economies
and stimulate industry? Well, according to Professor
Michael Pettis from Peking University, the Chinese government indeed roughly
followed the same development model as America, Japan and the East Asian Tiger
economies did before it. A model that he classifies
as the investment driven growth model. To illustrate how this model works, let's
have a look at the story of Shenzhen, which in the 1980s
was just a fishing village whose only advantages were that it had low
labor costs and was situated next to the bustling
metropolis of Hong Kong. In May 1980, it became the first special economic zone
created by Deng Xiaoping. This meant that,
unlike in the rest of China, foreign businesses could now set up shop
here, and the Chinese made it extra attractive by promising them lax labor regulations and tax breaks. So as you might have noticed,
that part is actually still in line
with the traditional opening up story. However, there were then three key problems holding Shenzhen back
from truly becoming an attractive destination for foreign firms
and domestic entrepreneurs alike. To really understand this,
I think it is helpful to think about it from a perspective
of a Chinese entrepreneur that, for example,
wanted to start a car company in Shenzhen. First of all, well, it is great
that you can have cheap workers there for your factory. You can clearly see that
this small fishing village does not currently have the infrastructure
needed for your massive factories. Most obviously there are not enough houses
for all of your workers. There is not enough electricity. And yeah, clearly these ascended roads cannot facilitate the hundreds of trucks
that will help you bring the goods
to the harbor of Hong Kong. And even if all of this infrastructure
was already here, you'd run into a second problem,
which is about where you will find the money to build a big factory in dirt
poor China. Finally, you realize that
even if you are able to get the money, you will still not be able to compete
with the big Japanese and German carmakers, which have specialized
knowledge and big existing factories. Luckily for our entrepreneur, though,
China implemented a version of the investment led growth model,
which was built around three pillars that aimed to solve these three problems with clever government interventions. Now, the first key pillar
of this growth model is that the economy was reshaped to facilitate investment
in infrastructure. Not only was the local government
instructed to build the necessary infrastructure such as electricity, water and roads
to the port of neighboring Hong Kong, it was also given the incentive to do so by tying its revenue
to the value of the land in the district. However, given
that China was one of the world's poorest countries,
they then still ran into a problem. How to pay for this
initial infrastructure? Well, this is where the second key
pillar of the investment driven growth model comes in. You see, to pay for infrastructure
as well as for the factories themselves and the required equipment from abroad,
You basically need two types of money, local money and foreign money,
which is basically U.S. dollars. Now, local money is, in theory, infinitely available
since the central bank can just print it. However,
given that this could be inflationary, most countries have outsourced
the business of money creation to private banks who create money as debt. This means that banks can create debt
that is hopefully used to make factories that produce stuff
and therefore will not be inflationary and will not increase debt to GDP
because it increases GDP. However, to make sure that this is indeed
what the debt money is used for, China used the same trick
as Japan did by forcing banks to create credit only for sectors
that it thought were productive, such as in China's
case, housing and manufacturing. On top of that, China's
central bank and state banks purposefully kept interest rates low,
encouraging investment by entrepreneurs. Second, now let's talk about foreign money
to ensure that the right type of foreign money
would flow in China, restricted speculative money flows and incur
it direct investment in factories. And while foreigners
needed to share some power and technology with the locals when they wanted
to build a factory in China, this was still very attractive for them given
that there was such good infrastructure and that wages were kept purposefully low. You see, thanks to the registration system
that is known in China as the hukou system,
if you work in a city like Shenzhen but you are not originally from that city,
then yes, you can live and work in that city,
but you don't have access to crucial social services
such as education and health care. Now, as noticed by people
like Professor Pettis, a crucial side effect of this system is that it
entices workers to accept lower pay and crappier jobs as the system
makes them much more vulnerable. And on the flip side,
this means that entrepreneurs like our friends can more easily
exploit these workers. Of course,
this is terrible for ordinary workers, but in line with China's investment
driven growth model, it helped keep wages and workers
rights low and therefore China an attractive destination
for foreign investment in factories. So now fast forward a couple of years
and Shenzhen had the money and infrastructure to attract enough firms
to become a major manufacturing hub. However, the problem
was for an advanced industry like ours that the knowledge gap
just appeared too big. And while China did
develop a local industry, it wasn't able to compete
with the Japanese and the Germans on the international market
for decades to come. However, as you might have heard,
China has recently overtaken both Japan and Germany to become
the biggest car exporter in the world. Which brings us to the third
and final pillar of the investment led growth model,
and that is infant industry protection. Okay. The basic idea
is that in very advanced industries, there are many barriers
that prevent companies from entering them. So, for example,
our car entrepreneur in Shenzhen might have access to cheap workers,
good infrastructure, loans and knowhow, but he still could not compete
with Western carmakers because they had far too much knowledge. So to upgrade the Chinese economy. The Chinese aimed to protect their young
sectors from international competition while letting them compete
amongst themselves and therefore have the time to learn. So how did they protect their industries? Well, the most obvious way
was to use import tariffs. So, for example,
if a European manufacturer wants to export to China in the 1980s,
it could expect to pay 50% to the Chinese state
for the privilege. But as Chinese industries
matured, the country lowered tariff rates. And indeed, because China isn't super rich
yet, Chinese tariffs are still generally higher
than those in advanced economies. For example, today our Chinese car
entrepreneur friend who's gotten really rich still only pays roughly 10% to export
a Chinese made car to Europe. While his competition in Europe
would pay between 15 to 25% to export a car to China. However, before you get mad at China,
I have to say that this is normal in our current trading system where advanced economies,
except the developing countries have higher tariffs precisely
so that they can develop. But there are more ways that China help
their domestic infant industries. For example, if we stick with our friend
in the car industry, he got a running start
because China required that all foreign carmakers
that wanted to sell cars in China did so in a joint venture
with a local entrepreneur, something that was very profitable
for all parties involved at first, but is now causing some headaches
in European boardrooms. As our entrepreneurial friend
started his own car company after having learned all the tricks of the trade
from his previous European partner. Crucially, though,
China did not fall into the trap that many African nations fell into,
and that is protecting your infant industries
from all competition. You see, if China had done that,
our friend may have just gotten lazy and this company would never have been
able to compete globally. So to prevent that outcome, China let its infant industry firms
compete ruthlessly amongst themselves. And as a consequence,
the Chinese firms learned quickly. And so just like America and Japan
before it, China was able
to complete its transformation from agricultural economy
to manufacturing powerhouse, thanks to indeed opening up its economy,
while at the same time the government pursued the investment
led growth model with its three key pillars
of investing in infrastructure, setting up an effective financial system
and employing infant industry protection. And so you'd expect China
to just be continuing to catch up to America and Japan. However, now we have all of this bad news
about that's due to worsening and worsening property slump, weak consumer
spending and tumbling credit growth. So just stop releasing youth jobless data
because it's so bad. Is the economy in China in danger
of a serious ongoing downward spiral? Which raises the question,
if this was such a good model, then why did China's growth model stop
working? Well, that is something we will get into
after talking about online data. You see, well, China's government
wields overwhelming control elsewhere. It's big tech. And knowing you inside out gathering data about you
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China's growth model stopped working, because let's face it,
the news anchors actually have a point. China's economic growth has been rather
disappointing the last few years, halting its progress
towards superpower status. Many investors on Wall Street,
for example, had expected economic growth
to come roaring back after COVID. But just as people like Michael Batters
had been predicting all along, China's miracle growth did not come back
as China's investment led economic growth model had actually already stopped
working around 2007. When China's premier at the time,
Wen Jiabao, already said that its rapid
economic growth had become unstable, unbalanced,
uncoordinated and unsustainable. And the reason was that China's
economic growth relies too much on investment and exports,
and therefore the solution should be that rather
than boosting investment further, China should have switched
to boost domestic consumption, which means that China's a leader
at the time seemingly intended to follow the development economics of Simon Kuznets
by boosting consumer growth, which should then lead
to a bigger service sector. Now, to understand
why that switch is actually needed, I think it is important to keep in mind
that as an economy becomes dominated by services, this does not mean
that manufacturing output decreases. For example, as you can see here,
while manufacturing output grew faster in China,
it still grew in the United States. Similarly, as China transitioned
from an agricultural economy to a manufacturing based economy,
its food production still kept rising. So one way of looking at economic growth
is more that it's sort of a tower
where each layer builds on the next. You have to have enough food first
before you build a manufacturing industry, and you need to have
a manufacturing industry before you build a thriving service sector
on top of it. Because the thing with agriculture
as well as manufacturing is, the better you get at it, the fewer people
you need to make food products. So if you just stick
to these two activities exclusively, you are going to end up
with a lot of unemployed people for then who will buy
all of these products. Well, in advanced economies, the people
buying food and manufactured stuff are mostly those people that work
in the service industry like me, for example, in the United Kingdom, while
services account for 78% of the economy. The service sector actually employed 95% of all workers. So today, China's investment driven model
with its suppression of worker incomes and easy credit
for factories and construction builders is actually holding China's economy back because it means that ordinary people
simply do not have enough money to buy. All the stuff
that Chinese producers make was more if ordinary people have more money. This means that they have a way
to signal to firms what they need next and therefore what firms
should be investing in next. Something that is sorely needed given the extreme state of malinvestment
or bad investments. In China, for example,
some now estimate that enough housing has been built in China
to accommodate 3 billion people. However,
there are only 1.4 billion people in China and its population
is set to shrink in the future. But crazy news like this now
hopefully starts making more sense to you, given that you now know
that China has actually not changed its growth model
since Wen Jiabao speech in 2007. This can also explain why we now see these ridiculous things,
such as gigantic mountains of electric vehicles or ridesharing bikes
that nobody has bought. And it can also explain why China's trade
surplus has just kept going up. It's not just that
Chinese products are so good. It is also that Chinese
people are still too poor to buy everything that the country produces. It can even explain China's
massive housing bubble. You see, the investment
led growth model kept interest rates low. And combine that with the fact
that local governments had to make sure that the land values
kept going up to keep paying for all of that new infrastructure
that they kept building and building. And you see that
they actually had a really big incentive to encourage the housing bubble
as rising housing prices meant that people would keep on buying more housing units
even though they wouldn't live in them. And while the scale of overproduction
in China is really exceptional, I don't think
we've seen anything like this before. The situation itself is not unique. If you look at the history of investment
led growth models, you'll see that
many of these rapid development miracles ended in a bubble,
followed by crisis or by stagnation. For example, after a rapidly
growing in the 19th century, America's economy crashed after its
stock market bubble popped in the 1930s. Similarly, Japan's rapid economic growth
in the sixties and seventies was followed by a massive housing bubble
and stock market bubble in the 1980s, which then popped and led to three decades
of stagnation starting in the 1990s. So is China's economy
heading towards a similar fate, and will that look like a U.S. style depression? Or will it look like a Japan style
stagnation? In other words, what's next for China? Will China be able to make the switch
to a modern economy and reach superpower status as it transitions
to a sustainable growth model that fosters a thriving service sector alongside agriculture and manufacturing? Or will the country keep pushing
and pushing the investment led growth model until it breaks? Well. In my research,
I've basically found three scenarios. First, I found some economists
which have pointed out that in theory there's actually still a lot of reason
for optimism for China's economy. After all, China's population is only at
20% of the wealth of the United States. And so there's still just a lot of room
for growth. What's more,
unlike Japan's government in the 1990s, China's government does actually recognize
that it needs to boost consumption and that its current
growth is unsustainable. However, according to Professor Pettis, this optimistic scenario
is unlikely because of politics. You see, while
switching to a more sustainable growth model is the best option for the Chinese
people, it will mean that the owners of heavy industry and the construction
industry give up many of their privileges. And in China, these crucial sectors
are largely controlled by the members
of the Chinese Communist Party and, as recently said
by a Chinese economist, Dr. Yang Zoe Liu, on the Odd Lots
podcast, The Chinese Communist Party has always been at the center
of a capital allocation. And by empowering the household,
or for that matter, the private sector, it basically dilute
or potentially remove their relevancy. In other words, it is not likely that
the Chinese Communist Party is willing to actually give the power to households
that is needed to develop a service sector and thereby lose
some of its relative power in the economy. And this is why I think that it's likely
that the investment led growth model will not be radically reformed
and therefore the unsustainable growth China has now will continue
until it stops naturally either in the form of an economic collapse
as it did in the United States, or in the form of several lost decades
as it did in Japan. And given that China's financial system
is state controlled and therefore it cannot collapse, as the banks
did in the United States, most economists I follow now believe that this stagnation
scenario is the most likely, which means that the Chinese economy
will have a difficult time catching up to the United States
in the next few decades. In other words, China got out of poverty
thanks to investment led growth. But now, by clinging on to that model
for too long, its growth has become unsustainable
and therefore it will likely not reach superpower status
for the foreseeable future. But yeah, that's my take. Do you think the Chinese leadership
will switch growth models or do you think they are too invested
in the current growth model that produces so much stuff
that people don't need? Let me know in the comments below
if you like, This style of video which uses the insights of experts
to tell a story that goes deeper than the standard narrative. Then consider supporting my work
by becoming a patron or member. Finally,
if you want to know more about why I don't think that the Chinese collapse
scenario is likely. Check out this video over here. Or alternatively,
if you want a positive story about China, check out this video
over here about its car exporting miracle.
