Sense on China's savings from Hong Kong

One of the stranger attempts to apportion blame for the international financial crisis has been the claim that China is allegedly saving too much. A brief consideration of economic fundamentals will show the economic incoherence of this view.

Consider first China’s domestic situation. China requires a high savings rate in order to finance its high level of investment. As the evidence shows that the most important determinant of the rate of economic growth is the rate of increase of investment and labour, if China were to cut its rate of investment its economy would grow less rapidly. Furthermore, China’s growth is responsible for the majority of the reduction of the number of people living in poverty in the world. Reduction of China’s rate of investment, which in turn requires a high savings rate, would therefore result in China’s economy growing less rapidly, the world economy growing less rapidly, and world poverty shrinking less rapidly - clearly nothing positive lies down that road either for China or for anyone else. On the contrary, as the Indian Prime Minister has stressed countries such as India and China require high savings rates.

Internationally what is normally argued by the ‘China is saving too much’ view is that the key issue is to reduce China’s balance of payments surplus – the latter being statistically necessarily equal to China’s surplus of domestic savings over domestic investment. A case can be certainly be made that China should utilise a higher proportion of its savings domestically. Investment in the domestic Chinese economy would almost certainly earn a better rate of return than the present situation of large scale purchases of US Treasury Bonds. It might also lead to more rapid economic growth by China. The latter however depends on other factors as well - for example, prior to the financial crisis last year China’s economy was in danger of overheating and encouraging a higher level of investment would have exacerbated this. But a high investment level is certainly a means by which China's balance of payment surplus could be reduced.

But what would be the consequence of China reducing its balance of payments surplus in the present circumstances – whatever the means chosen? China recirculates its surplus in large part through purchase of US Treasury Bonds – that is, China adds to international savings. Reduction in China’s balance of payments surplus, unless compensated for by an increase in savings elsewhere, would inevitably lead to a rise in interest rates as the international supply of savings shrank – a likely form being a very direct increase in the interest paid on US Treasury Bonds. Such a rise in interest rates, under conditions of a world economic downturn, would be highly undesirable as so far there is no indication at all of an increase in the overall US savings rate that would compensate for a decrease in international saving by China. Such an increase in international interest rates would be economically contractionary when the opposite is what is required.

More fundamentally what choice did the increase in international savings by China offer to the US - and other economies? In essence it simply meant the US economy was able to borrow money at extremely low interest rates. That finance could have been used to rebuild the productive base of the US economy - that is, it could have been invested. That such finance available at low interest rates was not invested but was instead wasted in a consumer splurge was the result of economic policies pursued by successive US government not others. Others could have used such low interest rate finance for productive purposes.

An article in China Daily on 29 May by Lau Nai-keung put the issue in rather popular and polemical style with a distinct Asian emphasis - but he actually stated the question very accurately as regards economic fundamentals (incidentally rightly linking it to the need to raise investment for environmental reasons). Lau Nai-kueng is from Hong Kong.

’The [Chinese] government has decided to make domestic consumption the engine of sustained growth. But many people tend to confuse it with personal consumption...

‘Hong Kong’s experience of the 1990s, when it saw more than six years of deflation, tells us that an economy doesn’t need excessive subprime loans to create a big enough bubble in the property market that would hurt everybody once it bursts.

‘The experience taught us that a high rate of savings should be viewed as a virtue, not as a vice. It’s the inappropriate use of savings that is to blame for the economic ills of today. The Chinese mainland’s rapid growth is attributed to massive infrastructure building financed by a high savings rate. The yield from investment into infrastructure is long-term.

'Putting more resources into education, healthcare and the environment is also investment. And such an investment has for long been overdue on the mainland...After that, we can increase the spending on social security and housing for low-income groups, which are not investment but nevertheless are very important components of social security because they enhance general welfare, social stability and harmony.

‘On completing these tasks, the government can consider a free or highly subsidized transport system. Beijing’s example of subsidized subway transport is a good example of minimizing the risk of abuse in public service. Once a smooth and efficient public transport, which is free or subsidized, is in place, owning a car would only be a status symbol. The government can then think of scrapping hire purchase for cars so that fewer vehicles are on the streets. That will not only ensure a freer flow for public transport vehicles, but also mean reduced greenhouse gas emission...

'Before the [1997] Asian financial crisis, credit cards were not very common in South Korea. But after that, credit cards were dished out on the pretext of boosting consumption, and transformed almost the entire country into a group of ruthless spenders. The savings rate of South Koreans has dropped drastically, and as a result the country is now finding it difficult to weather the global economic storm.

‘In the US, most people are... spending money they have not earned. Ironically the economic crisis has forced people to rely even more on credit cards to maintain their lifestyle... Outstanding payment for credit cards worldwide is estimated to be more than $1 trillion and rising. Like subprime loans, card payments are also packaged in different kinds of derivatives, and when bad loans pile up, as is inevitable, another wave of financial tsunami will lash the global economy.

‘We have to learn to make good use of our high savings rate, instead of encouraging the middle class to buy more houses and cars, and spend like there is no tomorrow. Most of the suggested measures does not require a lot of resources to implement and, in fact, will reduce pollution. On the contrary, they will help create quality employment and generate solid GDP growth.

‘When welfare schemes make people feel more secure, they would be more willing to spend. The social and economic infrastructure will also ensure sustained economic growth. Proper channelling of savings into investment and social spending will enhance real private consumption in the long run. Higher savings will then imply higher investment and, in turn, higher GDP and a more robust growth. Without proper savings, a high private consumption rate will lead to disaster, as has been the case in many Western countries.

‘If a high savings rate is as bad as many Western economics would like us to believe, then how come we have succeeded and they have failed to weather the economic storm?’

The last sentence would seem to hit the nail rather accurately on the head.

Comments on Paul Krugman and Alwyn Young on The Myth of Asia's Miracle - why 'quantity' may be more important than 'quality' in economics

Preparing for a panel discussion with Paul Krugman at Jiao Tong University in Shanghai led to reflection on how different the parameters of practical policy making are from those of academic economics. The questions asked and point of approach are frequently divergent

In policy making all theoretical and other arguments have to be aligned and concentrated around one settling one decisive issue - ‘what should be done’. That is, what is involved is a synthetic decision – assembling issues, and giving them their specific weights, around one point. In academic discussion exploration of distinctions and points can be pursued without settling the decisive practical question of what difference it makes to what should be done.

This particular reflection was reinforced by re-reading, to prepare the debate, Paul Krugman’s well known 1995 paper, ‘The Myth of Asia’s Miracle’. This analysis, arguments from which are still frequently used today, drew heavily on two quantitative papers by Alwyn Young on growth in the four Asian Tigers/Newly Industrialised Economies (NICs) of South Korea, Singapore, Taiwan and Hong Kong.[1]

In analysing the Asian Tiger economies Young/Krugman were attempting to deal with a theoretical/analytical issue. Was the rapid rate of growth of the South East Asian Tigers based on, or substantially contributed to, by a particularly high rate of growth of productivity – whether of labour, capital, or total factor productivity? Or to what degree was it based on quantitative growth of factors of production – i.e. accumulation of labour and capital?

It should be noted that the quantitative results of Young’s work has come under criticism - notably from Chang-Tai Hsieh. However, for the moment, leave statistical criticism aside and assume, for the sake of argument, that Young’s quantitative conclusions were correct – although, to be clear, this is done as a hypothesis and is not an acceptance of Young’s calculations per se. Then what follows?

Writing in 1995 Young noted that for the period 1960-85 the four Asian Tigers constituted four out of the five countries with the fastest growth of GDP per capita in the world - the fifth, Botswana, was an economy sufficiently small that no general conclusions would be drawn from it. However, after subtracting growth due to the increase in labour input (including increased participation in the workforce, higher educational achievement etc) and the rate of additions and improvements to capital, Young concluded that the growth of total factor productivity in the Asian Tiger economies was not remarkable. Summarising his article, Young wrote that he:

‘presents estimates of “total factor productivity” in the sample economies... the ranks of Taiwan and South Korea [among economies placed in descending order of growth of total factor productivity] are now reduced to 21st and 24th, respectively. While this remains a strong performance, it is no longer dramatically differentiated from that of the rest of the world economy. Fully 81 of the 118 sample economies lie within one standard deviation… of Taiwan and South Korea. Surprisingly, economies such as Bangladesh, Uganda, Iceland and Norway are now seen to have outperformed Korea and Taiwan, whose productivity growth is only 0.5% greater than that of a renowned laggard, the United Kingdom. Singapore, where participation and investment rates have risen faster than any of the NICs, is reduced to a rank of 63rd in the world economy.’

So, therefore, Young finds the growth of productivity in the NICs was average or slightly above average and their rapid growth was not primarily due to extraordinary growth in total factor productivity but was due to large scale quantitative inputs of capital and labour. To which the appropriate answer, from the point of view of economic growth, is: ‘yes, that is quite adequate, even very encouraging. For it shows that if it is possible to combine average productivity growth with very large quantitative inputs, then the economy’s rate of growth will be far higher than the average and very rapid in absolute terms – enough to industrialise a country in a single generation (which is what the NICs achieved).’

The point is a simple arithmetic one. The effectiveness of the contribution of investment, for example, to economic growth depends on the combination of its quantity and how efficiently the economy utilises it. This blog has noted on numerous occasions that there is a fundamental logical error in judging an economy’s growth potential by economic approaches which concentrate only on the efficiency of the use of investment rather than also analysing the quantity of investment. The quantitative relation of the relative scale of investment and the relative efficiency of investment is the critical one. If, for example, economy A utilises investment 20% more efficiently from the point of view of generating growth than economy B, but nevertheless economy B invests 50% more as a proportion of GDP, then economy B will grow more rapidly than A despite the fact that economy A uses its investment more efficiently.[2]

Young/Krugman demonstrate that the rate of productivity growth of the Asian Tiger economies is not below average, but only average, as a result of which these economies quantitative advantage in growth of inputs of investment and labour ensures much more rapid growth that economies with higher rates of total factor productivity growth but much lower rates of input growth.

This is why, for example, criticisms that countries such as South Korea, during their phases of rapid growth, allegedly allocated capital inefficiently compared to more ‘liberal’ economies such as Britain or the United States entirely miss the point. An economy such as South Korea invested so much more as a proportion of GDP, almost double the rate of the US, that unless, from the point of view of growth, its' efficiency of investment was only half that of the US the South Korean economy would still have grown more rapidly than the US.

Put in properly formulated economic terms the quantitative level of macro-economic allocation of resources to investment may be more important from the point of view of economic growth than the marginal efficiency of investment. Put crudely, when it comes to investment and growth, 'quantity; may simply be more important than 'quality'. That, for example, would by itself be enough to vindicate the present very high rates of investment in India and China.

Whether it has proved in practice a more viable growth strategy to have an average rate of growth of productivity, combined with very high quantitative inputs of investment and labour, or whether it is more effective to aim at the highest rate of growth of total factor productivity, with much smaller quantitative inputs of investment and labour, may be illustrated rather graphically by showing the rank order of countries produced by Young’s calculation.

Young found that the top five countries in terms of growth of total factor productivity, after he has carried out his adjustments, were as set out in Table 1.

Table 1

09 05 21 Young TFP Growth

In short, if highest possible growth in total factor productivity is the variable that should be targeted, then Egypt, Pakistan, Congo and Malta, together with Botswana, should be taken as the most successful economies in the world – the economic models to be emulated.

If, however, the key criteria of success is increase in GDP per capita, achieved, according to Young’s calculation, by the Asian Tiger economies combining average rate of growth in total factor productivity with massive quantitative inputs of investment and labour, then in contrast Table 2 shows the world ranking of economies.

Table 2

09 05 21 Young GDP Per Capita Growth

Which economic variable is in practice decisive in determining real economic outcomes may be shown graphically by taking the case of by far the worst performing case of total factor productivity according to Young/Krugman’s account – Singapore.

Singapore, poorly performing in terms of total factor productivity, has today, in Parity Purchasing Power terms, the 5th highest GDP per capita in the world – a level 9% higher than the United States. Egypt, which is better performing in terms of growth of total factor productivity, ranks 101st in the world with a GDP per capita only 13% that of the United States. While the second ranking, from the point of view of total factor productivity growth, Pakistan ranks 130th in the world with a GDP per capital 6% that of the US.

In short, taking for arguments sake Young and Krugman's calculations as entirely correct, then the route to actual economic success, in terms of economic growth and a high living standard, lay in the average rate of increase of total factor productivity, combined with massive quantitative inputs of capital and labour, of Singapore rather than in the high total factor productivity, combined with far lower quantitative growth of inputs, of Egypt, Congo and Pakistan. Or, put in deliberately shocking terms, 'quantity' (growth of factor inputs) was much more successful in determining growth in GDP per capita than 'quality' (growth in total factor productivity)!

It is, of course, possible to have a rate of growth of total factor productivity that is so low (potentially a negative number) that even the greatest increases in quantitative inputs cannot produce viable growth – the USSR in its final period represents such a case. But the case of the Asian Tiger economies showed that provided close to average increases in total factor productivity can be achieved then quantitative increases were the decisive ones. Put formally, the evidence is that provided an average, or near to
average, rate of total factor productivity growth can be achieved then
ensuring very large quantitative inputs proved a more viable growth
strategy than aiming to maximise efficiency – i.e. total factor
productivity growth.This is simply the arithmetical outcome of multiplying the rate of growth of factor productivity by the rate of growth of inputs. The criteria which must decide the strategy chosen is therefore that which maximises the rate of growth of GDP per capita, not the abstract theoretical one of maximising rate of growth of factor productivity.

Turning to India and China this has an immediate practical consequence. It means that even if it were to be assumed, for the sake of argument, that the efficiency of their use of investment were average, or even somewhat below average, then they might well be right to concentrate on massive inputs – to take the Singapore route. That, in turn, evidently raises the question of whether investment in India and China actually is inefficient – which goes beyond the scope of the present article, but will be returned to in a future article. But it should be noted from the above that even if, for the sake of argument, it were assumed that Krugman and Young’s quantitative premises are correct then this does not constitute a valid argument, from the point of view of the key variable of maximising the rate of growth of per capita GDP, against the effectiveness of the growth model followed by either the South East Asian Tiger economies or current policies pursued by India or China.

As stated at the beginning of this article, in economics quantity in some cases may simply be more important than quality.

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This article by John Ross originally appeared on the blog Key Trends in Globalisation


[1] The argument of all three papers by young and Krugman was that the rapid growth of the NICs was based on quantitative accumulation of inputs of labour and capital and not on any productivity growth that was remarkable by international standards. The same analysis was then applied to China in Young’s 2003 paper ‘Gold into Base Metals: Productivity Growth in the People’ Republic of China during the Reform Period’.

[2] Ideally, of course, a combination of the maximum level of efficiency of investment from the point of view of economic growth and the maximum level of inputs would be achieved. However, while this is optimal in a purely abstract theoretical model in practice it may be necessary to chose between the two. An evident case of this is heavily state influenced financial systems aimed to maximise savings, as for example existed in Japan and South Korea during periods of rapid growth, versus those which are aimed to maximise the efficiency of use of savings. General discussion of this point, however, goes beyond the scope of this article.

Paul Krugman at Jiao Tong University Shanghai - by John Ross

Paul Krugman, 2008 Nobel Economics Prize Winner, chiefly for contributions to ‘New Trade Theory’, and well known New York Times columnist and blogger, under the rubric ‘Conscience of a Liberal,’ was in Shanghai last week delivering a speech on the present international financial crisis at Jiao Tong University. The event attracted wide media coverage in addition to over 1,000 people in the immediate audience. For those able to read Chinese a full account, including on specific issues to deal with the China, can be found here. As I was on the panel with Krugman discussing his talk afterwards it was an excellent opportunity to clarify issues with someone who is now one of the most influential economic voices in the US.

Krugman’s sincerity, good intentions, and factual knowledge were beyond dispute. He bluntly contrasted the new situation for rational discussion under the Obama administrations, in comparison to George W. Bush's, as the ‘difference between light and darkness’. Krugman’s overall economic perspective, with a major exception discussed below, was rather realistic - the format of a nearly one hour talk, followed by two hours of panel discussion and audience questions, giving considerably greater opportunity for detailed clarification than newspaper columns.

Krugman outlined his view that ‘probably’ the world economy would escape a 1930s type depression – noting that the fact he had to use the word ‘probably’ showed how serious the situation was. What he however considered possible, and feared, was a prolonged economic stagnation, or anaemic recovery, similar to the 1990s ‘lost decade’ in Japan. In such a perspective there would not be a 1929 type collapse in production but only a weak and protracted US recovery – i.e. a prolonged period of US economic stagnation. According to the latest survey by the Wall Street Journal such a perspective has now become the dominant view among US economists of diverse theoretical outlooks.

Krugman’s own argumentation for such a perspective was Keynesian – he restated Keynes was his ’god’. The present blog, in contrast, would not agree with such a line of reasoning - and would stress supply side factors rather than those rooted in demand stressed by Keynes. The reasons for this are that additions to effective demand are ineffectual rather than raising output, or merely produce inflation, if the appropriate conditions for increasing production do not exist on the supply side of the economy. This is not merely the case under the well known condition that spare capacity does not exist in the economy, in which case evidently increased demand cannot translate into increased output, but, in a private sector dominated economy, under conditions in which profitable increases in output cannot be undertaken. Nevertheless, analysing the supply side, then provided rational economic policies are adopted a 1929 style collapse, if not a significant period of relative economic stagnation in the US and Europe, should be avoidable.

The reason for this lies in the different state of the world economy today compared to 1929. In 1929 the US was not only the world’s largest economy but also its most dynamic. When the US financial system imploded in that year there was therefore no backstop to prevent the whole world economy being dragged downwards.

Today the world’s most rapidly growing economies are in Asia not in the US. India has the second most rapidly expanding economy in the world and is coming through the international financial crisis with a slow down in the rate of growth in GDP but no contraction of the type seen in the US and Europe. China’s savings, i.e. its finance available for investment, are as large as those of the US in absolute terms. Some other South East Asian states are continuing to grow – although a number, such as Singapore and Hong Kong, have suffered severely from the financial crisis. In short there is today an economic and financial backstop to the US, unlike in 1929.

These economically more dynamic Asian states are not large enough by themselves to propel strong overall world economic growth. China, India and the economies of the other South East Asian states taken together are still somewhat smaller than the US economy. But they are large enough, provided rational economic policies are pursued elsewhere, to prevent an international 1929 type collapse. Relative stagnation in the US and Europe, accompanied by growth in major parts of Asia, is therefore a realistic perspective for the world economy - even if the present author would arrive at that conclusion via a rather different perspective than Paul Krugman - Krugman did not outline his specific perspective for Asia. The proviso, however, is provided ‘rational’ policies are pursued and this is where the differences with Krugman developed in the debate.

Relative economic stagnation in the US and Europe, accompanied by still relatively strong economic growth in China and India, necessarily means a further shift in the economic relation of forces in favour of the latter two countries. From the point of view of the world economy and its recovery, or of increasing the standard of living of the two and a half billion people in these countries, of course, this is no problem. But it is for those who approach the financial crisis not via the angle of what is good for the world economy but from that of how to maintain the dominance of the US in the world. It is this which produces the danger of policies being pursued that are not economically rational.

The underlying problem in the world economy at present is that at its current rate of investment in GDP the US cannot compete, at anything like its present exchange rate, with the rising Asian economies. This is the cause of the well known US balance of payments deficit. US consumption has therefore been kept higher than its production via a massive borrowing from abroad that is ultimately unsustainable. The only way stabilisation can be achieved is therefore through a reduction in US consumption. This, in turn, can only take place through means that are either extremely painful for the US population in terms of reduced living standards (a reduction in the share of household consumption in GDP) or by means which probably involve reductions in US military spending (that is if a reduction in government consumption is not to take place in the fields of health and education). In short, to adapt the old phrase, the US can afford butter or guns but it can no longer afford both.

The attempts by the Obama administration to avoid this choice between butter and guns, that is to maintain both the high level of household consumption in US GDP, together with spending on health and education, while simultaneously refusing to cut the military budget has only been achieved through a radical reduction in US investment. But such a strategy is not viable in anything other than the short run as it undermines further the competivity of the US economy – the original cause of the crisis. The inescapable choice between butter and guns therefore still lies ahead for the US.

Paul Krugman, when questioned, however would not accept the importance of the low US investment rate. He also argued that in any case he could see no policy which could reverse this. He also stated the further decline in US investment was only due to the fall in residential investment under the impact of the sub-prime mortgage crisis.

First these statements are factually incorrect. While the decline in US investment certainly started in the residential sector, under the impact of the sub-prime mortgage crisis, the largest fall in US investment since the financial crisis started in September 2008 has been in non-residential investment. Between the third quarter of 2008 and the first quarter of 2009 US residential investment fell by 0.6% of GDP but non-residential investment fell by 1.6% of GDP i.e since the beginning of the international financial crisis 72% of the decline in the proportion of US GDP devoted to investment has been caused by a decline in non-residential investment and only 28% is due to a decline in residential investment.

These trends are shown in Figure 1, which graphs the decline in the components of US GDP as a percentage of total GDP since the third quarter of 2008, and in Figure 2 – which shows the decline in residential and non-residential US investment as a percentage of GDP over the same period. These trends make it clear that since the financial crisis broke out it is the decline in non-residential US investment, not in residential investment, that has been the driving force of the economic downturn.

Figure 1

09 05 18 Since 3Q 2008

Figure 2

09 05 18 GDFCF % change since 3Q 2008

Second, however, a decline in residential investment is by itself destabilising. It both reduces overall demand in the US economy and will be a contributory factor to macro-economic destabilisation created by future house price bubbles – such bubbles are due not only to excessive demand, due to excessively lax monetary policy, but to shortages in supply due to lack of investment in housing stock. This is clear from the experience of countries such as the UK, where house price bubbles have been worsened by shortage of supply, particularly in specific areas of the country such as London.

Third, contrary to Paul Krugman’s reply, it is evident that there are policies which could raise US investment. Shortage in US savings, accompanied by a balance of payments deficit, is simply another way of saying that the US is consuming more than it produces. Increased investment, financed from within the US, requires that the share of consumption in US GDP must be cut. As noted above that can either be done by reducing living standards, that is reducing household consumption, which presumably Paul Krugman would not want, or by reducing government consumption. Releasing resources in these ways would stimulate investment both via indirect means, ending the excessive calls on available resources leading to a reduction in interest rates, or via direct ones, the government for example increasing tax breaks for investment, or both. Therefore it is simply not true that there are no policies which would increase US investment.

What is true, however, is that such policies would require a change in the shape of the US economy. However that is precisely what is required - as it is the present unsustainable excess of US consumption over US production that led to the financial crisis. Maintenance of the present structure of the US economy merely means that the crisis will reappear even if the most immediate wounds are bandaged up through the financial stabilisation packages.

In short, the error of Paul Krugman’s perspective was that it underestimates the reshaping of the US economy that is required. This error is in line with the present policies of the Obama administration which, as discussed on previous posts on this blog, are also essentially maintaining the existing pre-crisis structure of the US economy. Whether or not the immediate US government packages stabilise financial markets, which remains to be decided, the fact that the underlying distortions of the US economy have not been resolved means that in the medium term, and possibly in the short term, various symptoms of the crisis will reappear.

The discussion with Paul Krugman in Shanghai was therefore enlightening not only from the point of view of its discussion of China but from the point of view of analysis of the US economy. It revealed Paul Krugman, together with the Obama administration, underestimates the scale of transformation which is required in the US economy.This misunderstanding by the Obama administration will doubtless have significant consequences in the months to come. Altogether a clarificatory event.

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This article originally appeared on the blog Key Trends in Globalisation

Trade and the worsening in the structure of US GDP under the impact of the financial crisis

A prime reason for the severe contraction in world trade accompanying the international financial crisis is shown in Figures 1 and 2 below.

Figure 1 shows the rapid shrinking of the US balance of trade deficit since July 2008. In that period the monthly US trade deficit has declined from $62.5 billion to $27.6 billion – a fall of 56%. On an annualised basis this is equivalent to a fall from a deficit of $750 billion a year to $330 billion. Such a movement, equivalent to a shift of $420 billion a year, necessarily sends deep shock waves through the international trade system.

Figure 1

09 05 16 Trade Balance

Figure 2 shows the means by which this reduction in the deficit has been achieved.

US exports and imports have both fallen, but the contraction in US imports has been far greater than the fall in exports. Since July 2008 US exports have fallen by 26.2% but imports have declined by 34.3%. Considering only visible trade, US visible exports have declined by 32.1% but visible imports have fallen by 38.4%. As was pointed out on this blog, and as is now widely reported, such falls in trade are more rapid than in 1929-30. 

Figure 2

09 05 16 E I % Change since maximum

The consequences of such trade shifts for the US balance of payments, and therefore the internal structure of the US economy, are equally clear.

Overall figures for the US balance of payments are not yet released but the US trade position dominates its current account balance.[1] The US trade deficit was reduced from 5.0% of GDP to 2.4% between July 2008 and March 2009. There is no shift in other components of the US balance of payments that could compensate for this, and when the overall US balance of payments is published it may be safely assumed that its deficit will be shown to have also shrunk in approximately the same proportion as the trade deficit.

Such a decline necessarily reflects the shifts taking place in the internal structure of US GDP. By an accounting identity a balance of payments deficit is exactly equal to the shortfall of domestic savings compared to domestic investment. As it has been noted on a previous post on this blog that the total US savings rate is not rising in any significant fashion this means that the entire improvement in the US balance of payments situation is due to a decline in US investment.

This trend is confirmed by examining the changes in the individual components of US GDP since the first quarter of 2006 – this date being the one after which US investment started to decline as a proportion of GDP. These are illustrated in Figure 3.

Between the first quarter of 2006 and the first quarter of 2009 US household consumption rose by 1.1% of GDP and government consumption rose by 1.2% of GDP. In absolute terms US household consumption rose from 69.6% of GDP to 70.7% of GDP and government consumption rose from 15.8% of GDP to 17.0%. That is the share of overall consumption in US GDP has risen by 2.3% since the first quarter of 2006.

In the same period formation of inventories fell from plus 0.4% of US GDP to minus 1.0% of GDP. The really major decline was in gross fixed capital formation. which fell from 20.0% of US GDP to 15.7% - a decline of 4.3% of GDP. In terms of comparisons to annual rates, US fixed investment in the first quarter of 2009 was at its lowest share of the the economy since the aftermath of World War II in 1946. 

Figure 3

09 05 15 Change in % of GDP since 1Q 2006

If a shorter time period is taken, since the beginning of the fall of overall US GDP in the third quarter of 2008, the same pattern appears. US household consumption has risen by 0.2% of GDP, government consumption has remained static, inventories have fallen by 0.6% of GDP, and fixed investment has fallen by 2.1% of GDP.That is

These figures make clear that the reduction in the US trade deficit has not been achieved through a
reduction in the share of consumption in GDP (i.e. a rise in savings)
but via a fall in US investment.Therefore rather than the financial crisis, and the various government financial packages, moving the US economy away from consumption and towards investment, the result which s required, they have so far increased the proportion of consumption in US GDP – the opposite of what is required. 

Such a trend has major short term and long term economic consequences.

First, unless the US can increase its rate of borrowing from abroad, that is balance of payments deficit widens again, any increase in the rate of US investment can only come at the expense of a reduction in US consumption. The key decisions as to whether such a reduction will occur through a fall in US consumer expenditure (with the ensuing political discontent) or through a reduction in government expenditure (defence, health, education) remains to be taken. So far all that has occurred, with the various financial packages, is that the existing pattern of unaffordable consumption in the US economy has been maintained - which has been financed by slashing investment. This is a formula for further strategic US economic decline.

Second, without an increase in investment it is hard to achieve US economic growth. Indeed at present all potential sources of demand in the US appear severely constrained. While household consumption is maintaining its share of US GDP it is nevertheless falling in absolute terms as unemployment increases and real wages decline for those in work. Government consumption cannot increase significantly, as the Presidential administration has made clear, due to the already existing scale of the budget deficit and the strain put on borrowing in the Treasury Bond market to finance this. Exports cannot increase due to the decline in world trade. US investment is not only not increasing but is falling as it takes the strain of the rebalancing between savings and investment caused by the decline in the US balance of payments deficit. With all potential sources of increased demand blocked the US faces an anaemic recovery even if the decline in GDP is halted.

Third, the underlying cause of both the problems in the US economy and the international financial crisis, is that the extremely low level of investment and savings by the US makes it unable to compete with other more dynamic economies – as seen in the US balance of payments deficit. A decline in the share of investment in GDP will make the US even less able to compete – meaning that the US will be able to contain its balance of payment deficit only by maintaining the economy in a state of low growth or recession.

In short, so far the various US financial stabilisation packages have prevented a collapse in the interbank lending market and halted the rapid decline in share prices – although they have not yet halted the decline in housing prices. They, however, have not solved the problem of excessive and unaffordable US consumption. On the contrary the structure of US GDP has so far deteriorated further.

The conclusion is that financial melt-down has so far been avoided but the underlying illness has not been cured. Therefore the symptoms of the underlying problems are likely to work through to the surface again. The only issue not yet known is in what form the symptoms will reappear.


[1] The overall difference between the US balance of payments and its balance of trade deficits in the twelve month period to the last quarter of 2008 was 0.03% of GDP. The largest difference in any single quarter in the last ten years was 0.8% of GDP. These numbers are far too small to affect the trend of the huge shift in the US trade and balance of payments since July 2008.

The failure of the US savings rate to rise shows the tough decisions in the financial crisis still lie ahead

It is widely recognised that the low level of savings in the US is one of the prime causes of the present international financial crisis. Figure 1 shows the way in which the US savings rate, which was already low in terms of international comparisons, began to fall sharply from the beginning of the 1980s onwards. The date of this shift is significant as it indicates that it was policies inaugurated by the Reagan administration which commenced the undermining of the macro-economic position of the US.

Figure 1

09 05 17 US Savings

Given that the inadequate level of US savings is a major cause of the international financial crisis knowing whether it is increasing is therefore of major significance from the point of view of understanding whether the causes of this crisis are being overcome.

Media publicity has, therefore, recently been given to the fact that US household savings have started to rise significantly – increasing from 0.6% of household income for the whole of 2007 to 4.2% of household income in the first quarter of 2009. This, it is suggested, indicates the required and desirable increase in the US savings rate is already occurring.

Unfortunately such reports are based on elementary economic misunderstanding. A country’s total savings, that is the finance available for investment, are not equivalent to household savings. Nor, in the case of the US, are household savings even the largest part of total savings. A country's total savings are the sum of household, corporate and government savings (or dis-saving).

To allow estimation of the most recent trends in the US savings rate Figure 1 therefore shows two different ways of calculating this. The first is direct measurement. The second is calculation from macro-economic variables.[1] As would be expected in practice the two measures do not absolutely coincide but the discrepancy is small and the overall trend is the same. Given that there is a significant delay in the publication of measured US savings rates, due to practical difficulties in compiling these, the data in Figure 1 shows that it is reasonable to use calculation of the US savings rate from macro-economic variables to estimate changes in this. This has the advantage that macro-economic data is available for a more recent period.

As may be seen from Figure 1 there has been no increase in the share of total savings in US GDP. The increase in household savings is merely being offset by the increase in the government budget deficit and by the decline in corporate earnings under the impact of the financial crisis.

This data shows clearly that no improvement in the structural position of US savings has taken place. So far a cooling bandage has been applied to the patient, that is the US financial system, through bank bailouts and other means but the savings figures indicate clearly that the underlying disease is still there. All the tough decisions on how to resolve the crisis lie ahead.


[1] By a national accounting identity, domestic investment (gross fixed capital formation plus formation of inventories) is equal to domestic savings plus the current account of the balance of payments.

China’s investment surge aids its own and the world economy - by John Ross

The publication of data for April paints a graphic picture of the present interplay of forces within China’s economy. They also show, so far, the broad correctness of the policies undertaken by China’s government in meeting the international financial crisis and, simultaneously, illuminate the very serious errors of writers such as Martin Wolf, chief economics commentator of the Financial Times, who advocated an entirely different course.

Externally China’s economy continues to be struck with great force by the current collapse in world trade produced by the international financial crisis. China’s April exports were down 22.6% compared to a year earlier. This is a lesser fall than for most countries but necessarily applies severe contractionary pressure to China’s economy.

Internally the Chinese government’s stimulus programme has led to a 30.5% rise in investment in fixed assets in the first four months of 2009 – an increase from the 28.6% year on year increase in the first quarter. Simultaneously China's retail sales in the year to April grew by 14.8%.

The result of the contradictory impact of the negative pressure from the decline in export, and the positive one from internal economic expansion, was the 7.3% year on year increase in industrial output to April. This is relatively low by China’s recent standards but stellar by those of almost all other countries which are suffering major declines in industrial production.

As China’s investment is rising more rapidly than consumption the share of investment in China’s GDP is necessarily rising. While precise quantitative data on the composition of GDP will not be available for some time nevertheless it is possible to judge orders of magnitude.

If it is assumed that China’s overall consumption rises at the same rate as retail sales (which is probably on the high side but no alternative objective measure is available at present),and that retail sales and investment continue to rise for the rest of the year at the same rate as in the first four months, while it is simultaneously assumed the balance of payments surplus declines by 30%, then this implies fixed investment would rise from 43% of China’s GDP in 2007 to approximately 46% in 2009. Evidently there are a considerable number of assumptions in such an estimate regarding trends in the rest of the year but it gives a rough yardstick.

Calculations done by Jing Ulrich, chairwoman of China equities at JP Morgan in Beijing, give a slightly lower estimate - that at present rates of growth investment will account for 45% of China’s GDP this year. Whatever the exact final outcome, therefore, it is clear that the share of investment in China’s GDP is rising.

In the present circumstances this has necessary consequences for China’s balance of payments surplus – given that such a surplus is necessarily equal to the surplus of domestic savings over domestic investment.

It is wholly unlikely that China's total savings level is rising at present given that the state budget is projected to move from balance to a 3% deficit this year, and company profits, the main source of China’s high savings level, are falling as a proportion of GDP under the impact of the financial crisis. China this year will at best have the same savings level as last year, or more probably its savings rate will decline somewhat.

As China’s savings rate is static or falling, and investment is rising, this implies a fall in China’s balance of payments surplus during 2009. China’s broader balance of payments figures will not be available for some time but balance of trade figures are available to April - and the trade balance dominates China’s overall balance of payments position.

The trade figures indicate that China’s monthly trade surplus fell from a peak of $40.1 billion in December to $13.1 billion in April. This figure, however, does not take into account seasonal fluctuations and a comparison with April last year shows a smaller reduction from $16.7 billion to $13.1 billion. The trend in the balance of payments surplus at present, however, is downwards. China’s balance of payments surplus, in short, is likely to fall as domestic investment rises.

This development may be sharply contrasted to the course advocated by Martin Wolf, and others, that China should close the gap between its savings and investment levels primarily by cutting its savings level rather than increasing its investment rate. As has been frequently pointed out on this blog there is a clear factual, as well as theoretical, positive correlation between a high rate of investment and a high rate of growth. China’s economy would slow if it were to reduce its investment rate – something which is not merely undesirable from the point of view of China but, particularly given the present international financial circumstances, is also highly undesirable from the point of view of the world economy. The present course of the Chinese government, which is increasing China’s investment rate, is therefore far preferable to the course advocated by Wolf not only from the point of view of China but from the point of view of the world economy.

Regarding China’s balance of payments surplus itself, while China requires a high rate of investment for a high rate of economic growth there is no reason to be found in economic theory, nor is there any evidence to suggest, that a high balance of payments surplus is any sense a precondition for rapid economic growth. Indeed, as a balance of payment surplus necessarily means that resources are not being productively invested in China, but are being invested in US Treasury bonds, it would be preferable, and secure a higher rate of return, for China to productively use a larger proportion of its assets within China – or put in other terms, the preferable way for China to use its high savings rate would be to increase its domestic investment rate from its previous level.

The argument that has appeared in sections of the foreign language media that China should not increase investment because this will increase ‘overcapacity’ is entirely fallacious theoretically. A high level of investment does not consist in creating more production capacity of the same type at the same levels of technology, efficiency, or productivity – the proposal that China should create more low value added production capacity is evidently false. The issue is high investment to upgrade China’s economy technologically and in terms of productivity and efficiency. Moreover, factually, China is at the beginning of this upgrading of its investment capacity. Capital stock per US worker or per West European worker is very much higher than per Chinese employee. To overcome this lag requires that the investment stock per Chinese worker rise more rapidly than in the US or Europe for a prolonged period.

In addition to direct investment in the workplace the efficiency of any economy, its level of productivity, does not rely only on extra machinery but on the efficiency of a country’s entire productive system including transport, communications, education etc. China has many decades of rapid investment to go through not only in machinery but in infrastructure before its level of capital stock, and therefore overall economic efficiency, even remotely approaches that of the US or Europe. This is merely another way of stating that, in order to achieve the technological and productivity level of the US and Europe, China must go through many decades in which its rate of growth of investment must exceed that of the US and Europe.

Nor, contrary to what is sometimes argued, is a high rate of investment contrary to the environmental needs of China – the exact opposite is true. Environmentally protective policies, for example low carbon emission power generation, is likely to be more expensive than environmentally damaging technology in the short term - although not necessarily in the longer one. To maintain a high level of economic growth in an environmentally protective fashion will therefore require a higher level of investment in China to maintain the same rate of growth – although such investment, of course, will not be in the same technologies as at present.

Increasing its level of investment, therefore, means the technological and productivity upgrading of China – both in terms of immediate productive capacity and the other indirect forms of investment supporting it, and not a merely quantitative expansion of existing technological and productivity levels. In short the argument that extra investment is wrong because it will create ‘overcapacity’ is entirely economically fallacious.

Purely abstractly, from a financial point of view, the highest possible utilisation of China’s savings for a still higher investment within China itself is desirable – which of course, as a by-product, would eliminate the balance of payments surplus. However such abstract financial considerations are subordinate to more practical constraints.

First, in the medium and long run the population of China will gain most from a high rate of economic growth, which requires a high level of investment. That is, the gain in sustainable consumption, both individual and social, which flows from a high growth rate and high investment level exceeds that which would be gained from increasing the share of consumption in GDP. Nevertheless such medium and short term gains must be balanced against short term consumption – with the key criteria being the welfare of the population and therefore its support for the economic system which has brought such success.

Second the rate of investment must be used to upgrade environmentally protective technologies and to replace, not expand, environmentally damaging ones.

Third handling very large investment programmes is not merely a question of allocation of finance but involves material organisation of the economy. As the author is aware of not only from theory but from experience of dealing with large infrastructure projects in London it is considerably easier to make allocations of finance than it is to ensure the efficient delivery of very large scale investment programmes. Whether China possesses the capacity to achieve the latter on any specified scale is a concrete issue that only those in the centre of the relevant economic decisions making have the information to take. Furthermore social, as well as strategic economic growth decisions, must be taken into account.

From an overall financial point of view under the conditions that prevailed in the first half of 2008 prior to the financial crisis, when the Chinese economy faced over- heating and rising inflation, it would, of course, have been dangerous and irresponsible to increase investment further. But now China’s economy is faced not with overheating but an international economic downturn and a potential, if not yet extremely serious, threat of domestic deflation rather than inflation – China’s consumer price index fell by 1.5% in the year to April and its producer price index fell by 6.6% in the same period. Under those circumstances an increase in the rate of investment does not pose the threat of overheating.

China’s investment surge is therefore not only good for its own economy but good for the world economy. Those, such as Martin Wolf, who proposed an alternative course that China should reduce its savings and investment rates were dangerously wrong.

Investment, Savings and Growth - International Experience Relevant to Some Current Economic Issues Facing China

The following study on the international relation of investment, savings and economic growth is based on a paper produced by the author, John Ross, for Antai College of Economics and Management, Jiao Tong University Shanghai. It originally appeared on the blog China in the International Financial Crisis.

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This is the first of two papers devoted to the evidence on the relation between investment, savings and growth with particular regard to present economic issues facing China in relation to the international financial crisis. The two papers, although interrelated, are produced separately for the following reasons.

The first paper is an historical and comparative examination of the factual relation between investment rates and economic growth rates. The economic evidence it produces is clear. A very high rate of investment is required for rapid economic growth of the 8% a year level China requires. It is a high level of investment, not a high level of consumption, which is indispensable for rapid economic growth rates – there are no examples of countries with low rates of investment and very high economic growth. Those who argue that China, to maintain its level of economic growth, must increase its consumption level and reduce its rate of investment must produce evidence to justify that claim – and will be unable to do so.

However, from an underlying strategic economic issue such as the above, it is not possible in a one to one mechanical way to derive immediate policy conclusions – something the present author is acutely aware of from both theoretical considerations and practical experience. In order to judge a specific immediate policy it is necessary to have not only an overall framework but also detailed knowledge of concrete economic circumstances. The issues dealt with here affect economic strategy and other concrete factors must be taken into account in framing short term economic policy responses.

Investment and savings

In relation to the international financial crisis significant discussion has taken place regarding the US and China’s savings rate. However, from the point of view of China’s economic growth rate, the issue with the most direct effect is China’s rate of investment. The savings’ rate’s effect on growth is indirect.

This distinction may be easily illustrated by noting that while savings are necessarily required to finance investment it is both theoretically and practically possible, for example, for a country to have a high savings rate but to have relatively low or moderate investment and economic growth rates – Saudi Arabia and Libya are examples. In such cases a high savings rate is not used to maintain a high rate of domestic investment, with an associated high rate of economic growth, but instead foreign assets or exchange reserves are accumulated.

It is therefore investment which directly affects the rate of national economic growth. For that reason, regarding the potential for strategic economic growth, analysis should commence with the investment rate.

Confusion of domestic demand and domestic consumption

This strategic issue relates to a further, more immediate, economic question. In sections of the media stimulation of ‘domestic demand’ is sometimes treated as though it were the same issue as the stimulation of ‘domestic consumption’. This is self-evidently theoretically false. Domestic demand consists of two components, investment and consumption. Stimulation of domestic investment is just as much stimulation of domestic demand as is stimulation of domestic consumption.

The consequences of different allocations of GDP resources to investment and consumption are, however, extremely different from the point of view of China’s economic growth. As will be seen in detail below a very high level of fixed investment in GDP is a precondition for a high economic growth rate in any country - including China. Lowering the proportion of China’s investment in GDP, that is raising the proportion of consumption in GDP, will lead to a much slower rate of growth of China’s GDP. From this more immediate angle also the first key macro-economic issue that should be examined is the investment rate.

This paper, therefore, examines the relation of the rate of investment and the rate of economic growth both from a fundamental historical perspective and from the point of view of the recent international experience of high growth rate economies.

The tendency of the proportion of the economy devoted to fixed investment to rise

Considering first the investment rate from a long term historical perspective, one of the most factually well established historical trends of economics is that the proportion of the economy devoted to fixed investment historically rises with time - and that this rise is correlated with increasingly rapid rates of economic growth.

This process can be clearly measured over a three hundred year period, and can also be seen to operate dramatically in the period since World War II. All major economies that have grown rapidly have a high level of fixed investment. There are no examples of major economies which have grown rapidly with a low rate of investment.

These facts have evident conclusions for the discussion of the model of economic growth and for China’s investment level.

After considering this from the point of view of a long timescale, setting out the factual data, it will be examined from the point of view of the experience of high growth economies since World War II.

The historical trend of the proportion of investment in GDP

Figure 1 shows the percentage of fixed investment (gross fixed capital formation) in GDP for a series of major countries over the longest periods of time for which data is available.[1]

Figure 1

The pattern is evidently clear and striking. By far the strongest trend is for the proportion of GDP devoted to fixed investment (gross domestic fixed capital formation) to rise with time. This in turn, as will be shown, is associated with progressively rising rates of economic growth.

The historical correlation of increasing proportions of GDP devoted to investment with rising rates of GDP growth

Considering this historical trend in more detail, and analysing countries in the chronological order in which a new peak in the proportion of GDP devoted to gross fixed domestic capital formation appeared, the following is the historical pattern.

- Commencing with the period immediately antedating the industrial revolution, the proportion of GDP devoted to fixed investment in England and Wales, at the end of the 17th century, was 5-7 per cent. [2] This rose slightly, although current estimates are that it did not rise greatly, during the 19th century - peaking at over ten percent of UK GDP prior to World War I.

This level of investment was sufficient to launch the first industrialisation of any country but at a rate of growth which, while unprecedented at the time, was extremely slow by contemporary international standards - about two per cent a year.

- Turning to the latter part of the 19th century, the proportion of US GDP devoted to fixed investment had risen to considerably exceed that for the UK – reaching a level of 18-20 per cent of GDP by the last decades of the century.

A sharp fall in the proportion of the US economy devoted to fixed investment commenced in the late 19th century, and was particularly pronounced during the period between World War I and World War II – being associated with the great depression of the inter-war period. After World War II the US resumed its pattern of 18-20 per cent of GDP being devoted to gross fixed capital formation. This generated an average growth rate of 3.5 per cent a year. With such a growth rate an economy doubles in size every 20 years and quadruples in size every 40 years. It was on the basis of this historical level of investment, and growth rate, that the US overtook Britain to become the world’s greatest economic power.

- In the period following World War II Germany achieved a level of fixed investment exceeding 25 per cent of GDP – peaking at 26.6 per cent in 1964. This period 1951-64 was that of the post-war German ‘economic miracle’ with average growth of 6.8 per cent a year - with such a growth rate an economy doubles in size every 11 years and quadruples in 22 years.

- Starting at the beginning of the 1960s Japan achieved a level of gross domestic fixed capital formation of more than 30 per cent of GDP. This reached a peak in the early 1970s, at 35 per cent of GDP, before later sharply falling. During the period of a high and rising rate of investment in GDP the average annual rate of growth of the Japanese economy was 8.6 per cent.

- From the 1970s onwards, South Korea similarly achieved a level of fixed investment of 30 per cent of GDP. During the 1980s this rose above 35 per cent of GDP. The other East Asian ‘Tiger’ economies – Singapore, Hong Kong and Taiwan – showed a similar pattern. South Korea’s economy confirmed the relation between fixed investment and economic growth illustrated by Japan by growing in this period by an average 8.3 per cent a year.

Such growth rates in Asia showed that something unprecedented in human history was now possible – that it was possible to industrialise an economy, and achieve a ‘first world’ level of development, in a single generation.

- From the early 1990s onwards China achieved sustained rates of fixed investment of 35 per cent of GDP with, from the beginning of the 21st century, this rising to more than 40 per cent of GDP – a level never before witnessed in human history. The result was average 9.8 per cent a year economic growth over a sustained period – also the most rapid sustained economic growth ever seen in human history.

- To complete the chronological picture, the proportion of GDP devoted to fixed investment for two countries recently undergoing rapid economic growth, India and Vietnam, is shown. The proportion of Indian GDP devoted to fixed investment has not reached the Chinese level but has become high – reaching 33.7% of GDP in 2007 and 37.6% of GDP by the second quarter of 2008. On this basis, in the last five years, India has achieved an average growth rate of 8.8 per cent a year.

In Vietnam the proportion of GDP devoted to fixed investment rose from 13 per cent in 1990 to 25 per cent in 1995 and then to 37 per cent in 2007. Economic growth has accelerated rapidly, rising to an average of 7.9 per cent a year in the five years up to 2007.

Considering these trends, such a high level of investment is a necessary condition for rapid economic growth. No substantial country without comparable high levels of fixed investment has achieved such rapid rates of growth on a sustained basis. But while such a high level of investment is a necessary condition for rapid economic growth it is not a sufficient condition. Other elements which must accompany a very high rate of investment in GDP to produce rapid economic growth are considered below.

Recent experience of countries with high rates of economic growth

Turning to analysing post-World War II examples of sustained high economic growth, only 21 countries have achieved 8% growth a year sustained over a 20 year period since World War II. Leaving aside two extremely small states, Botswana (population 1.6 million) and Swaziland (population 1.1 million), which have economies dominated by individual projects, these countries that have undergone at least an 8% growth rate over a twenty year period fall into only two categories.

The first are eight Asian economies which have experienced prolonged periods of rapid growth - China, Japan, Singapore, South Korea, North Korea, Taiwan, Thailand, and Hong Kong. These form the primary focus of this study as their economies are not dominated by direct and indirect effects of the single commodity oil.

The second group are oil producers, or states adjacent to oil producers, in which rapid economic growth has been due to the direct and indirect effects of producing this commodity.[3] Growth rates based on oil are evidently not available to countries that do not have oil reserves and therefore do not form a generalisable model of development or are not immediately adjacent to countries which are large oil producers – for this reason the growth pattern of economies dominated by oil production are not considered in detail here.

Investment levels in the high growth Asian economies

To illustrate the decisive role played by high investment rates in sustaining high growth rates the percentage of Gross Fixed Capital Formation (fixed investment) in GDP for six of the eight high growth Asian economies is shown in Figure 2 - comparable IMF data for North Korea and Taiwan is not available. India has been added to this comparison due to the size of its economy and its recent rapid growth.

The evident feature of these economies countries is that all have had, during their periods of rapid growth, very high percentages of Gross Domestic Fixed Capital Formation in GDP. Taking the peak years for each country, Gross Domestic Fixed Capital Formation reached 35.6% of GDP in Hong Kong, 36.4% of GDP in Japan, 39.1% of GDP in South Korea, 41.6% of GDP in Thailand, 42.7% of GDP in China and 47.4% of GDP in Singapore.

Figure 2

It may be seen that no cases at all of rapid sustained economic growth without such a high rate of investment are to be found in such high growth economies. It is therefore evident that the economic evidence demonstrates that a high percentage of gross domestic fixed capital formation is a precondition for rapid economic growth. It is a high proportion of investment in GDP, not a high proportion of consumption, that forms the precondition for rapid economic growth.

Furthermore detailed examination makes clear that in those countries in which investment declined as a proportion of GDP – Japan, Hong Kong, South Korea and Singapore – this led to a marked decline in economic growth. On the contrary in those economies in which investment rose as a percentage of GDP, China and India, economic growth accelerated. The correlation between a high rate of growth and a high rate of investment is therefore evident.

In the data below the annual rate of growth is stated as the average over a five year period - in order to smooth out purely short term fluctuations in business cycles.


Measured in PPP terms Japan is Asia’s second largest economy. Japan’s rate of Gross Domestic Fixed Capital Formation peaked at 36.4% of GDP in 1973 but then fell to 23.3% of GDP by 2007.

Over the same period of time Japan’s annual rate of GDP declined from the 8.4% per cent rate in 1973 to only 2.1% (see Figures 3 and 4).

Figure 3

Figure 4

South Korea

South Korea is the Asia’s 4th largest economy - after China, Japan and India. South Korea’s level of Gross Domestic Fixed Capital Formation in GDP peaked at 39.1% in 1991, although the 1996 level of 37.5% was only marginally lower.

Thereafter South Korea’s level of Gross Fixed Capital Formation declined sharply to 28.8% of GDP in 2007. South Korea’s annual rate of GDP growth fell in parallel from 9.4% in 1991, and 7.3% in 1996, to 4.4% in 2007 (see Figures 5 and 6).

Figure 5

Figure 6


Thailand’s percentage of Gross Domestic Fixed Capital Formation peaked at 41.6% of GDP in 1990 and 41.1% of GDP in 1995. It then fell to 26.8% of GDP in 2007.

Thailand’s annual rate of GDP growth over the same period fell from 10.9% in 1991, and 8.6% in 1995, to 5.6% in 2007 (see Figures 7 and 8).

Figure 7

Figure 8


Singapore saw one of the most sustained high levels of investment in GDP in any country in world history with more than 30% of GDP devoted to fixed investment for 30 years from 1970-2000. Singapore’s Gross Domestic Fixed Capital Formation peaked at 47.4% of GDP in 1984, remained at 38.7% of GDP in 1997 and fell to 24.9% of GDP in 2007.

Singapore’s annual rate of GDP growth over the same period fell from 8.5% a year in 1984, and 9.7% a year in 1997, to 7.1% a year in 2007 (see Figures 9 and 10).

Figure 9

Figure 10

Hong Kong

The percentage of Hong Kong’s GDP devoted to Gross Domestic Fixed Capital Formation, amid significant fluctuations, fell from 35.6% in 1964 to 35.6% and to 20.3% in 2007.

Hong Kong’s annual average growth rate fell from 10.5% in 1964 to 6.4% in 2007 (see Figures 11 and 12).

Figure 11

Figure 12

China and India

India and China show a clear contrast to Japan, South Korea, Singapore and Hong Kong.

Whereas in Japan, South Korea, Singapore and Hong Kong there was a decline in the proportion of the economy devoted to investment and a decline in the rate of economic growth, both India and China India have systematically increased the share of investment in their GDP and have seen an acceleration of their growth rates. Because this pattern in India and China is so strikingly different to Japan, South Korea, Singapore and Hong Kong it is worth looking at in some detail.

India’s Gross Domestic fixed Capital Formation increased from 17.9% of GDP in 1977 to 22.7% of GDP in 2000 and to 33.9% of GDP in 2007. By the third quarter of 2008, before the onset of the international financial crisis, India’s Gross Domestic Capital Formation reached 37.6% of GDP. Over the same period India’s annual GDP growth rate accelerated from 4.5% in 1977 to 6.0% in 2000 and to 8.8% in 2007.

Unlike those who advocate a reduction in investment and savings rates, Manmohan Singh, who is not only India Prime Minister but an excellently trained economist, has constantly stressed the need to raise India’s savings and investment rates and has made this a foundation of his economic policy – with considerable success, as has been seen, in terms of sustaining high growth rates.

Manmohan Singh considered China’s high savings and investment rates as the foundation of superior economic performance. For example in 2003 when asked, ‘is it legitimate to compare India and Chinese economies?,’ he replied: ‘There is nothing wrong in the comparison. It is good to try and achieve the growth rate of China. But we must remember that the Chinese savings rate is 42 per cent of the Gross Domestic Product, whereas savings in India is hovering at 24 per cent.’

Before he became Prime Minister in May 2004 Singh set out clearly the investment rate without which India’s target growth rate could not be achieved: ‘at a Delhi seminar, Dr Manmohan Singh spoke out regarding the targeted eight per cent growth rate in the Tenth Plan... he opined that an eight per cent growth rate would require a 30 per cent ratio of savings to income and a substantial rise in the tax-GDP ratio.’

Therefore in 2006, after assuming office, Prime Minister Singh noted with satisfaction the increase in India’s savings rate and set the goal of increasing it further together with a concomitant rise in the the investment rate: ‘Our statisticians now tell me that our savings rate has shot up in the last couple of years to about 27 to 28 percent of our GDP… we are a country where the proportion of young people to total population is increasing. All demographers tell me that if we can find productive jobs for this young labour force, that itself should bring about a significant increase in India's savings rate in the next five to ten years. If our savings rate goes up, let us say, in the next ten years, by 5 percent of GDP, we would have generated the resources for investment in the management of this new urban infrastructure that we need in order to make a success of our attempt at modernization and growth.’

By 2007 Prime Minister Singh therefore welcomed the further increase in India’s savings and investment rates. According to India’s premier financial paper, the Economic Times: ‘The investment and saving rate is as high as 35 percent of national economic output, Singh said at a meeting of his Congress party in this southern Indian city, the hub of a 50-billion-dollar IT industry at the vanguard of the country's economic resurgence.’

Similarly, India’s finance minister, P Chidambaram , called in February 2007 for a further increase in India’s savings and investment rates: ‘India’s savings and investment rate as percentage of GDP have gone up by 2 per cent each. But to sustain the revised growth rate of 9 per cent in the 11th Plan, he [ P Chidambaram] said: “Both savings and investment as proportion of GDP must be raised further.”

By February 2008 Prime Minister Singh noted the continued advance of the savings rate and the new high reached in India’s investment rate: ‘Highlighting the strong fundamentals of the economy, Dr. Singh said that the savings rate in the country has touched almost 35 per cent of Gross Domestic Product (GDP) and the investment rate is at an all time peak of over 36 per cent of the GDP.’

The orientation of India to very high savings and investment rates, and the relation of this to rapid economic growth, is therefore clear (see Figures 13 and 14)

Considering China its fixed investment increased from 27.8% of GDP in 1978 to 34.3% of GDP in 2000 and to 42.7 % of GDP in 2007 42.7%. In the same period China’s rate of GDP growth accelerated from 4.9% in 1978 to 8.6% in 2000 and to 10.8% in 2007.

Figure 13

Figure 14


The conclusion from economic evidence is therefore clear.

A high percentage of fixed investment in GDP is an indispensible precondition for a rapid rate of growth – there are no examples of countries with rapid rates of GDP growth and low proportions of the GDP devoted to fixed investment. It is a high level of investment in GDP, not a high rate of consumption, that is necessary for rapid GDP growth.

In those countries in which the rate of investment in GDP fell – Japan, South Korea, Singpore and Hong Kong – the rate of economic growth also fell substantially. In those countries – India and China – in which the percentage of GDP devoted to investment rose the rate of economic growth also increased.

In short all evidence establishes clearly that it is the high rate of investment which is decisive for rapid GDP growth.

This overwhelming factual evidence, of course, supports what is evident from a theoretical point of view. Consumption, by definition, does not add to productivity potential or production capacity and therefore increasing the rate of consumption does not raise GDP growth. If China lowers its proportion of the economy devoted to investment its economic growth rate will also fall - as is confirmed by the international experience noted above.

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The paper draws on earlier material which appeared in 'Why Asia will continue to grow more rapidly than the US and Europe - a historical perspective' on the blog Key Trends in Globalisation.


[1] The figure for England for 1688 is that in Angus Maddison, The World Economy, OECD Paris 2006 p395. UK figures after 1688 and up to 1947 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p74. Figures from 1948 are calculated from International Monetary Fund, International Financial Statistics (August 2008) Minor adjustments have been made to chain the earlier statistics to be consistent with the IMF data – in no case does this make any significant difference to the pattern shown. The data for fixed investment for the earlier period used by The Economist One Hundred Years of Economic Statistics are based on calculations in C H Feinstein and Pollard Studies in Capital Formation in the United Kingdon 1750-1820, Oxford University Press, Oxford 1988. Other commentators have suggested that Feinstein and Pollard's figures are somewhat too high - see for example. N F R Crafts British Economic Growth during the Industrial Revolution, Clarendon, Oxford 1986 p73. None of these revisions and differences however is of sufficient magnitude to alter the fundamental pattern shown here.
US figures prior to 1948 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p74. Figures from 1948 are calculated from International Monetary Fund, International Financial Statistics (August 2008) Data for the earlier period give only private fixed capital formation whereas that after 1948 is for total fixed capital formation – i.e. including government fixed capital formation. There are no reliable estimates of government fixed capital formation in the earlier period and therefore data for the earlier period have been adjusted upward by the difference between the two in 1948 – which is slightly over two per cent of GDP. This has the effect of revising upwards slightly the percentage of GDP allocated to fixed investment in the earlier period but the difference is too small to affect the overall pattern.
Figures for Germany prior to 1960 are calculated from One Hundred Years of Economic Statistics, The Economist, London 1989 p202. Figures from 1960 are calculated from International Monetary Fund, International Financial Statistics(August 2008). There is however no significant statistical difference between the two.
Figures for Japan, South Korea, China, India and Vietnam calculated from International Monetary Fund, International Financial Statistics.

[2] Phyllis Deane and W A Cole in British Economic Growth 1688-1959, Cambridge University Press, Cambridge 1980 p2 being closer to the lower figure while further studies have tended to revise the figure upwards slightly. The higher estimates for the earlier period have been taken here so as to avoid any suggestion of exaggerating the degree to which the proportion of GDP devoted to Gross Domestic Fixed Capital Formation has risen. The precise figure used here is that calculated by Maddison in Angus Maddison, The World Economy, OECD Paris 2006 p395. The higher figure, as can be seen, makes no difference to the overall trend.

[3] These countries are Iran, Iraq, Equatorial Guinea, Kuwait, Israel, Jordan, Oman, Qatar, Saudi Arabia, Libya, Gabon, Equatorial Guinea, and the United Arab Emirates.