The Middle Income Transition in China and America’s Need for Structural Change

Michael Spence was the chairman of the Commission on Growth and Development (2006-2010) and is the author of The Next Convergence: The Future of Economic Growth in a Multi-Speed World, Farrar, Straus and Giroux, forthcoming, May, 2011. 

Milan—Cooperative international economic outcomes are hard to achieve, in part because they have distributional effects across countries and across subgroups within countries. Ignoring the distributional effects in favor of focusing exclusively on efficiency, balance and stability will make it difficult to converge on cooperative policies. The distributional issues are politically salient in all countries.  Economic policy makers in advanced and emerging economies need to understand and guide the structural shifts in their economies as they grow and respond to the dynamic forces domestically as well as to structural shifts in the global economy.

This capability is a crucial aspect of successful growth strategy in developing countries.

At this stage, it is a combination of art and science and has been a learned skill in high-growth emerging markets. In most developed countries, including the United States, however, finding the right balance between respecting market forces on the one hand and shifting incentives at the margin to achieve important social, structural, distributional and competitive objectives on the other have only recently started to be addressed as a serious aspect of economic policy. In fact, it has been and still is hindered by orthodoxies and polarizing rhetoric on both the left and the right.

In the case of China, the growth of the domestic market will be largely determined by the rate of growth of the middle class, and this is at the core of the growth strategy and changing growth pattern.

In the US, middle-class incomes and employment opportunities represent a structural challenge that goes beyond the crisis impacts, and the adverse trends in the income distribution or even the unemployment challenge, to the scope of the tradable sector and the range of opportunity for productive and rewarding employment for a significant fraction of the population.

Let me turn to China first. China is entering the middle-income transition, a phase of growth and development that involves major and complex shifts on the demand-and-supply side of the economy. These are well-understood in China and are part of the changing growth pattern that is embodied in the 12th five-year plan. The main challenge is implementation and overcoming internal resistance to what might be called the inevitable “destruction” part of creative destruction.

The key elements in the evolution of the Chinese economy and in policies that influence it are the following:

• The labor-intensive process manufacturing for both export and the growing domestic market have to be allowed to die off as ages rise and comparative advantage shifts.

• The whole supply side of the economy will shift up in terms of value added per person employed. That is required to support the rising incomes. It involves deepening the human capital and technology and knowledge underpinnings of the economy.

• The supply-side evolution of the economy will shift in the direction of being guided more by growing domestic demand, and growth will come from that side. The export sector will change and remain important, but its relative importance will shrink.

• To support this evolution, household incomes have to rise and their share in national income has to increase. Wage increases, which have accelerated, will help but may need an assist from government consumption through spending on essential services like education and health care and through social insurance.

• The investment efficiency of the economy needs to increase, which involves financial sector development, expanding the markets and channels of intermediation in bonds and on the equity side.

• The markets need to take a larger role in determining the direction of the economy. Investment is and will remain very high, but a portion of it occurs because the cash is available and not because of the returns. This component—investing on autopilot—needs to decline and be replaced by income flowing to the households, for consumption or for reinvestment if the returns are justified.

• An appreciating currency is one component of the structural transitions, keeping the pressure up for structural change, and that is understood in China. The issue is speed. Right now the effective real interest rate is rising much faster because of inflation and real wage increases in the export sector. It is important but until recently was over-emphasized.

What the world (especially the emerging markets) needs from China is a successful transition through this phase maintaining relatively high growth. China’s interests and the rest of the world’s are largely aligned in this, notwithstanding the rhetoric.

There are other important components of the Chinese growth and development strategy and priorities. They include energy efficiency and security, the distribution of income and access to essential services, including safety nets, environmental issues and climate change. The upcoming plan will target 7 percent growth, below historical levels, and deploy resources to achieve these other objectives. By and large these are aligned with global needs as well. However, in the short to medium run, in the areas of energy efficiency and carbon emissions, emerging market growth will dominate and global emissions will in the best case be flat.

I turn now to the US economy. Before presenting a brief description of the structural and employment challenges, it needs to be said that China’s successful implementation of its plan and the middle-income transition may help the US economy at the margin but will not fundamentally change the underlying imbalances and competitive problems.

Up until the crisis, the US economy managed to sustain relatively high (for advanced economies) growth. It did not experience a serious unemployment problem. There was a two-decade shift in the income distribution in which measured inequality rose and the middle range of the income distribution experienced modest real income growth. Post-crisis, there is a sluggish return to growth and what appears to be a persistent employment problem that I believe is still incorrectly attributed to the crisis itself. It is structural and has been sometime in the making.

The following observations are based on a detailed study of employment and value added in all sectors of the US economy in the two decades up to the crisis.

Employment growth in the US economy between 1990 and 2008 was substantial, on the order of 27.3 million jobs, off a base in 1990 of 121.9 million.

Virtually all (97.7 percent) of the net incremental employment stems from the non-tradable sector. This occurred despite dramatic labor-saving technology in information processing that ran across all sectors of the economy.

The leading employment sectors are government and health care in that order, both on the non-tradable side. Together these two sectors generated over 10 million additional jobs over the period, accounting for almost 40 percent of the increment. Health care added 6.3 million jobs off a base of 10 million. Government added 4.1 million off a base of 18.4 million.

Given the pressure on the government budget, continued gains in government employment seem unlikely. Equally, health care absorbs a sufficiently large fraction of GDP (on the order of 16 percent) that expansion in that sector is at least questionable. An aging population may require more health services, but the government’s ability to finance the expansion is in doubt.

Other non-tradable services that generated employment gains—for example, retailing—have been driven by debt-financed consumption. After the financial crisis, the prospects for job growth in these sectors are duller.

The tradable sector experienced job growth in high-end services, including management and consulting services, computer systems design, finance, and insurance. These increases were roughly matched by declines in employment in most areas of manufacturing.

The loss of employment occurred in the manufacturing sectors. These involve complex multistage supply chains. The employment decline was largely the result of the out-migration of lower valued-added (VA) functions to global supply chains. But as the emerging markets grow, they compete for more sophisticated functions. That does not mean that the US will lose all the parts of the manufacturing VA chains in which it has developed a comparative advantage—just that there is more potential competition on the horizon.

Manufacturing sectors that suffered a loss of employment nevertheless experienced rising value added. Therefore value added per job rose, in some cases dramatically. High-income jobs remained in the tradable sector.

For the tradable sector as a whole, value added per person employed rose substantially, with an increase of 44 percent from 1990 to 2008, far above the increase of 21 percent in the economy as a whole. The tradable sector is gravitating toward higher value-added components of global supply chains. These consist, in broad terms, of high-end services; some are embedded in manufacturing industries and some, like finance and insurance, exist in pure service industries.

Given the prospect of slowing employment growth in non-tradables and rising competitive pressure on tradables, there will be major employment problems in the near future.  Even if the non-tradable sector is able to continue to absorb the growth in the labor force, there will be downward pressure on wages and salaries and hence consequences for income distribution. The reason is that the growth in value added per person and hence average income was quite low (less than 0.7 percent per year).

The post-crisis shortfall in domestic demand is causing stubbornly high unemployment, even as the economy begins to recover some of its growth momentum. In principle, foreign demand, especially from the high-growth emerging economies, could make up some of the difference. Although the US trade deficit fell to $375 billion in 2009, from $702 billion in 2007, the adjustment came entirely from a sharp decline in imports, from $2.35 trillion to $1.95 trillion, whereas exports actually fell slightly, from $1.65 trillion to $1.57 trillion.  In other words, the adjustment came from a fall in imports, not a rise in exports.

To create jobs, contain inequality, and reduce the US (probably unsustainable) current-account deficit, the scope of the export sector will need to expand. That will mean restoring and creating US competitiveness in an expanded set of activities via heightened investment in human capital, technology, and hard and soft infrastructure. The challenge is how to do it in the most effective way.

One overall consequence of these domestic and global trends is that in advanced countries, a substantial fraction of the population is starting to worry that the opportunity set (at least on the employment front) for their children and grandchildren may fall short of what the current and preceding generations experienced in the post-war period. That is new and threatens the social contract, or what would be called social cohesion here in Europe.

Though detailed studies of other major economies are not available, it is clear that the evolution of structure and income distribution is not the same across advanced countries. Germany is notably different from the US in structure and in the institutions for making collective choices about economic direction and tradeoffs. Its tradable sector and export patterns are also structurally different. There appears to have been a deliberate choice to retain jobs, focus on competitiveness and accept relatively low wage growth.

Let me conclude.

I believe that finding domestic solutions to these issues, ones that do not do too much damage to the openness of the global system, is a crucial underpinning of the G-20 process. There aren’t easy answers and in truth we do not now know how to do this, nor do we know what tradeoffs are involved. This view seems entirely consistent with former International Monetary Fund chief economist Raghuram Rajan’s insight as summarized by NPQ editor Nathan Gardels:

“Rather than, for example, focusing on currency exchange rates or indicators of surplus or deficits, the G-20 countries should engage in domestically defined paths of reform that lead toward convergence, which take into account the political and cultural realities of each nation state. This is the way to reconcile the local and the global.”

My only amendment would be to expand the phrase to “rapidly evolving structural, political and cultural realities.” Addressing the structural and distributional issues seems an important part of finding politically and economically feasible paths of reform that lead toward convergence on cooperative outcomes and paths.

This summary is based on an analysis of the structure of the US economy. The Evolving Structure of the American Economy and the Employment Challenge, Michael Spence and Sandile Hlatshwayo, Council on Foreign Relations, working paper, March, 2011.