Far too often, governments and commentators focus on total GDP (gross domestic product) when seeking ways to raise living standards. What they should instead be looking at is the growth of income per head. They should measure this in real terms, adjusted for inflation, so you can see what people can actually buy.
Unless a country is stuffed with abundant natural resources requiring no labour to exploit them, income per head is determined by productivity – how much is produced by one unit of input, usually of labour, capital or both. Labour productivity (output per worker) is important because it provides a basis for wages. Higher productivity ultimately means higher wages.
And as Adam Smith pointed out in 1776, capital productivity (output per unit of fixed investment, such as a lathe or a robot) is also important. Adding a new machine can enable a worker to produce more widgets (increasing productivity of labour), but if the machine is hi-tech, such as a computer-numerically-controlled machine tool, it may produce many more widgets than the machine it replaced.
Nowadays, economists combine measures of labour and capital productivity and call the result “total factor productivity” (TFP). Once an economy is using labour as efficiently as possible, for example if it has succeeded in moving all its surplus farm labour to work in urban industry, the only way incomes can rise is by a sustained increase in TFP.
China’s economic reforms started with the abolition of collective farming and the leasing of land to individual farm families. After farmers had met their quotas for grain to be delivered to the state at fixed prices, the rest of the harvest was theirs to sell off at the market price.
Since 80% of China’s population in the 1970s lived in rural areas, this reform had an immense impact. The incentives provided by the revival of family farming increased output and efficiency overnight; crop yields shot up in the early 1980s, sharply boosting rural incomes. New housing was visible all over the countryside, along with new consumer durables. Whereas the communes found work for everyone, families soon found that not all their members needed to work to produce maximum output. What was to be done with those who were effectively made redundant?
The answer soon came in the 1980s and the 1990s with the rise of coastal industry, initially in Guangdong province adjoining Hong Kong. Hong Kong capitalists shifted their textile and clothing, plastic toy, electronics and other factories into China. Other foreign investors joined them. And China’s own manufacturers had their hands full supplying increased demand for consumer goods.
To keep wages low, labour was recruited from China’s villages. Some of these were migrant workers who travelled to the coastal cities in search of employment, as has happened on a smaller scale for many decades. Others signed up for jobs promoted during job fairs in the villages.
Economists have seen the movement of rural labour to low-wage, labour-intensive, low-technology employment on China’s coast as a vindication of West Indian economist W. Arthur Lewis’ theory of “unlimited supplies of labour”, in which surplus rural labour is used to develop industry. As this labour is earning practically nothing in the village, even a low wage provides an incentive for townward migration.
This process is now coming to an end. Since the mid-2000s, many migrant workers have returned to their villages. (Usually by not going back to their factory jobs after their home leave during Chinese New Year.)
To retain them, and attract more workers from the countryside, employers have had to increase wages. Provinces have raised the minimum wage to encourage workers to stay put. Militancy has increased, both in the form of unofficial strikes and pressure on the official trade union movement to become more active in support of worker demands. As a result, industrial wages have more than doubled since 2007.
Companies have therefore had to seek to increase TFP, since they cannot continue to add cheap labour. This process is supported by the shift up the technology ladder by China’s export manufacturing which has taken place in recent years. This has been supported by government policy as well as by market forces.
In the opening years of this century, TFP grew rapidly, enabling GDP growth to maintain an average of around 10% a year. But after 2007 productivity growth collapsed to just a couple of per cent a year. The main reason appears to have been the stimulus programme. By allowing massive credit creation in 2008-2009, the authorities ensured that GDP would continue to grow by over 9% a year in real terms, then slow to rates still above 7%.
But this was achieved at the cost of a reduction in efficiency improvements, as the extra borrowing was wasted on unnecessary investments and property speculation. State-owned enterprises, in particular, have used “stimulus” easy money to pile up machinery that sits unused, greatly reducing TFP.
Policies to promote sustained productivity growth need to be long-term; they have to operate on the structure of the economy, not merely on the current phase of the business cycle. While there is a need to enact reforms to free up markets and reduce government intervention in them, there is an accompanying need to beef up regulation and invest in human capital.
While the government needs to keep an eye on the general level of interest rates, just as it tracks other economic variables like consumer prices and the rate of unemployment, it has no business fixing interest rates at unrealistic levels or in allocating lending to its friends in the state-owned enterprises. Interest rates should be liberalised so that a realistic cost of capital can be taken into account by companies planning investment projects. This, not government blue-pencilling of projects, is the best way to curb over-investment.
China’s leaders also need to lay the human foundation for the “technical upgrading” they never cease to advocate. Although it now has some of the best universities in Asia and has a good vocational education system, China still spends less government money on education as a proportion of GDP than its competitors. It needs to do more, especially in basic education in rural areas. The advance to universal high-quality healthcare also needs to be accelerated; a healthy workforce is more productive.