Fri, Aug 26, 2005 page8

• China's key problem: over-focusing

  • By Robert Shiller
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  The Chinese economy has been growing at such a breathtaking annual pace -- 9.5 percent in the year ending June -- that it is the toast of the world, an apparent inspiration for developing countries everywhere. But is China getting too much of a good thing?

  Since he became president in 2003, Hu Jintao (胡錦濤) has repeatedly warned that China's economy is overheating, and his government has recently acted accordingly, raising interest rates last October, imposing a new tax on home sales in June and revaluing the yuan last month.

  But claims that China is overheating don't seem to be based on observations of inflation. While China's consumer price index rose 5.3 percent in the year ending July last year, this was due primarily to a spike in food prices; both before and since, inflation has been negligible.

  Nor are these claims based on the Chinese stock market, which has generally followed a downward path over the past few years.

  Instead, those who argue that the Chinese economy is overheating cite the high rate of investment in plant equipment and real estate, which reached 43 percent of GDP last year. On this view, China has been investing too much, building too many factories, importing too many machines and constructing too many new homes.

  But can an emerging economy invest too much? Doesn't investment mean improving people's lives? The more factories and machines a country has, and the more it replaces older factories and machines with more up-to-date models, the more productive its labor force is. The more houses it builds, the better the private lives of its citizens.

  A number of studies show that economic growth is linked to investment in machines and factories. In 1992, Bradford DeLong of the University of California at Berkeley and Lawrence Summers, now president of Harvard University, showed in a famous paper that countries with higher investment, especially in equipment, historically have had higher economic growth. One of their examples showed that Japan's GDP per worker more than tripled relative to Argentina's GDP from 1960 to 1985, because Japan -- unlike Argentina -- invested heavily in new machinery and equipment.

  In short, the more equipment and infrastructure a country is installing, the more its people have to work with. Moreover, the more a country invests in equipment, the more it learns about the latest technology -- and it learns about it in a very effective, "hands on" way.

  It would thus appear that there is nothing wrong with China continuing to buy new equipment, build new factories and construct new roads and bridges as fast as its can. The faster the better, so that the billion or so people there who have not yet reached prosperity by world standards can get there within their lifetimes.

  And yet any government has to watch that the investment is being made effectively. In China, the widespread euphoria about the economy is reason for concern. Universal human weaknesses can result in irrational behavior during an economic boom.

  Simply put, China's problem is that its economic growth has been so spectacular that it risks firing people's imaginations a bit too intensely. At times like these, people can easily imagine that an apartment in Shanghai will be worth some enormous amount in 10 or 20 years when China is vastly more prosperous than it is today.

  And if it will be worth an enormous amount in 10 or 20 years, then it should be worth a lot today, too, since real interest rates -- used to discount future values to today's values -- are still low in China. People are excited, and they are lining up to buy.

  To be sure, their reasoning is basically correct. But when the ultimate determinants of values today become so dependent on a distant future that we cannot see clearly, we may not be able to think clearly, either.

  Since the true value of long-term assets is so hard to estimate, it is human nature to focus on the rate of increase in their observed prices, and to allow one's attention to become fixated on these assets just as their value is increasing very fast. This can lead people to make serious mistakes, paying more for long-term assets than they should, even assuming that the economy will perform spectacularly well in the future. They can overextend their finances, fall victim to promotions, invest carelessly in the wrong assets and direct production into regions and activities on the basis of momentary excitement rather than calculation of economic fundamentals.

  So, maybe the word "overheated" is misleading. It might be more accurate to say that public attention is over-focused on some recent price changes, or over-accepting of some high market values. Whatever one calls it, it is a problem.

  Fortunately, people also tend to trust their national leaders. For this reason, it is all the more important that the leaders not remain silent when a climate of speculation develops. Silence can be presumed to be tacit acceptance that rapid increases in long-term asset prices are warranted. National leaders must speak out, and they must match their words with concrete action, to help signal to the public that the speculative bubble cannot be expected to continue.

  That is what the Chinese government has begun to do. The real-estate boom appears to be cooling. If the government continues to pursue this policy, the salutary effects in terms of public trust in the country's businesses and institutions will help ensure stable and sustainable economic growth for years to come.

  Robert Shiller is professor of economics at Yale University and a director at Macro Securities Research.

  Copyright: Project Syndicate
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