Is the rise of China good for America and Europe?

The 1989 purchase of the iconic Rockefeller Centre by a Mitsubishi Group company was a telling example of Japan’s growing international economic might. Unocal may not be a household name but China National Offshore Oil Company’s blocked US$18.5 billion bid for the California-based oil company is nevertheless indicative of a cash-rich China flexing its muscles on the international scene in a similar manner.

Who doesn’t know the statistics? Few were surprised by headlines announcing that ‘China is the World’s No.2 Economy’ and no-one bats an eyelid upon reading that ‘Double-digit growth continues’. GDP per capita figures tell a slightly different story. China’s output per person is six times less than that of the average American. Even GDP per capita figures do not reveal the full picture. While the fruits of China’s development have largely accelerated growth in China’s urbanised coastal regions as well as the Pearl River Delta manufacturing hub, vast expanses of central China have not developed nearly as fast. And despite the Communist ideals of the Party, China’s Gini coefficient – a measure of inequality where a score of 0 is perfect equality and a score of 100 indicates total inequality – of 47 is disturbingly high. Nonetheless, the strengthening of wage laws, curbs on property speculation and active policies which have reduced the percentage of impoverished people from 85% to 15% between 1981 and 2005 should continue to improve the lot for the Chinese masses.

As far as Europe and America are concerned, China is a one-stop manufacturing shop. For now. Owing to the abundance of factors of production – labour in particular – China has quickly adopted the role Japan once had of being the world’s workshop. Consumers in Western countries benefit tremendously as low-cost goods increase their real income. Western retailers also gain greatly, though this fact is less well publicized. When a Chinese-made shirt lands in New York – duty-paid – for less than US$5 and is then sold for US$29.95 at a Target store, it is quite clear who makes the real profit from the sale.

Yet it is true that not all the stakeholders in the American and European economies have benefited. Because its firms have outsourced a large proportion of its manufacturing to developing countries like China, the West has suffered an increase in unemployment of the worst kind – structural unemployment. Edmund Phelps, a Nobel Prize-winning economist, estimates that structural unemployment may account for almost 80% of all unemployment in America. Similar figures have been produced for European countries. This type of unemployment is hard to shake-off as there are limited numbers of new jobs that these largely low-skilled workers can take on. Lower and persistent consumer spending has proved a drag on the recoveries of Western economies from the financial crisis, especially in the Euro area where growth in the last quarter of 2010 was just 0.3%.

This structural unemployment has been caused in large part by the winding down of manufacturing operations in America and Europe. The term ‘rust belt’ is increasingly being used to describe areas not just in North-east America but also in parts of Western Europe where manufacturing has stagnated. While the American trade deficit is notoriously large, all the major European economies – with the notable exception of Germany – run gaping deficits too. As a negative trade balance lowers aggregate demand, these deficits have impeded the growth of Western economies.

However, the formerly perennial Chinese trade surplus with the rest of the world can no longer be taken for granted. With mounting international pressure to allow the yuan to appreciate, China’s trade surplus growth has been tempered; in the first quarter of 2011, China recorded a rare trade deficit of US$1.02 billion. Some say that this was a blip, but I believe that this ‘anomaly’ could foreshadow things to come.

In fact the changes started happening a while ago. When 17 workers at a Foxconn factory – a firm that makes parts for Apple’s iPhones – took their lives a year ago, a chain reaction of strikes was initiated across China, the most widely reported of which was a mass strike at a Honda transmissions factory. These strikes were signals to the Chinese government that increasingly scarce workers could no longer be paid inhumane wages and so, early this year, minimum wages across China were raised by an average of 22.8%. Research by Boston Consulting Group, a management consultancy, has predicted that Chinese wages could double within the next four or five years. Some manufacturers have tried to combat rising wages by shifting their production facilities to the poorer inland regions of China where wages are lower. However, this is only a short-term solution. The low-margin, export-driven growth China has profited from over the last decade has been made possible, in substantive part, by the external economies of scale that manufacturers benefit from. By operating in ‘production hubs’ such as the Pearl River Delta, firms achieve cost-savings due to the well-established network of ancillary firms and the pool of migrant labour that is available in the area. Such savings are unique to these ‘hubs’ and not to be found in other provinces – setting up a garments factory in Guizhou, for instance, is difficult because of poor transport links: Guizhou has only 1,983km of expressways, which ranks third-lowest in the country on a per capita basis. With an ageing population, China’s spare capacity is bound to be used up faster than it is replaced and so its competitive edge may be lost.

Looking ahead, if we accept that China’s lopsided manufacturing miracle cannot last forever where does that leave China? If China is no longer capable of dominating the low-margin manufacturing sector, then it is left with two development options. Firstly, it could try to expand the tertiary sector of its economy. However, in order for China to truly join the global services industry, it will have to overcome the language barrier. Unlike in India, for example, where the business language is English, Chinese business is conducted in Mandarin: even in the most cosmopolitan mainland Chinese city, Shanghai, multinationals often struggle to recruit English-speaking staff. Besides the language barrier, China’s currently stringent regulations and restrictions will have to be loosened in order for imports of invisibles to rise. This too will take time.

So China is left with the second option: to build global brands and transition to higher-margin, more capital-intensive manufacturing. When Japan faced a similar problem in the 1960s, they allowed the labour-intensive manufacturing to shift to Taiwan and Korea, making for world leaders such as Toyota, Sony, and Panasonic in high-tech fields such as automobiles and electronic goods. According to a recent report by the Asia Society, China is on the verge of developing such world-beating brands. Notably however, this shift towards the development of sovereign brands is likely to happen more as a result of a great lunge overseas than through the slower, Japanese-style fostering of home-grown brands. The report predicts Chinese foreign direct investment to be between one and two trillion dollars in the next decade. These astronomical figures make Chinese outward investment to date - $230 billion, and on par with Denmark - look like small change. While China currently compares with New Zealand and Austria in terms of acquisitions in America, Lenovo’s $1.25 billion purchase of IBM’s Personal Computer unit and Geely’s purchase of Volvo are striking examples of Chinese firms’ growing appetite for international acquisition.

So are these Chinese investments good for America and Europe? It is very easy to suggest that the acquisitions of iconic Western brands will spell the end for Western manufacturers of capital-intensive goods. After all, what advantages do these manufacturers have over their Chinese counterparts? Out of the factors of production, the Chinese are at an advantage in terms of land, labour, and some may say capital too. The saving grace for Western manufacturers is enterprise: know-how. Chinese firms on the prowl will be able to side-step the laborious, costly process of research and development by securing Western technology and know-how through acquisitions. Parallels can and will be drawn between the current situation and how the rise of Japanese car-makers brought Detroit to its knees.

But while the 1990s did bring the fall of Detroit, it is often forgotten that, in the same period, Japanese companies like Nissan and Toyota invested over a trillion dollars in the American economy, creating 700,000 jobs in the process9.

The growth in Chinese acquisitions will not happen overnight. If one believes in free markets and in the principle that, in the long-term, firms exposed to competition will fare better than state-picked ‘winners’ mollycoddled with easy financing, then one can hope that the rapid development of Chinese firms large enough to acquire established Western corporations can only happen if there is greater economic liberalisation in China.

Liberalisation is a two-way street. Chinese brands profiting from the purchase of Western firms is only one side of the story. In December 2004, at the annual Central Economic Work Conference, the top brass of the Chinese government agreed to transition from growth led by investment and exports to a development path that relied more on domestic consumption. Higher wage costs, a strengthening yuan and a rising middle class are all factors helping China execute this rebalancing. In May, Coach, the American accessories brand, announced that it would halve its Chinese production operations, shifting the manufacturing to countries such as Vietnam and the Philippines where wages are lower. This may be an indication that, as mentioned earlier, the Chinese monopoly of low-wage manufacturing is nearing its curtain call. Perhaps more strikingly, Coach simultaneously announced plans to increase revenues from sales in China to $500 million in 2014. Over the last year alone, Coach has doubled its revenues from sales in China to US$100 million. Coach is just one of several American and European firms expanding into China to grab a chunk of what promises to soon be the largest consumer market in the world.

It is increasingly clear that economic liberalisation will lead to the interdependence of the Chinese and Western economies. The tremendous Chinese appetite for American Treasury bonds only increases the extent of this mutual dependence. Large Chinese corporations should compete with established American and European brands on the global stage, bringing benefits of lower prices and greater choice to consumers around the world. Yet it should not be assumed that it will all be plain sailing. The conflicting political philosophies of China and the West, for instance, may pose problems. The Chinese government is often lambasted for its hostile attitude to foreign firms doing business in China - a criticism underscored by Internet search giant Google’s retreat from China early last year. Indeed the Chinese establishment must recognise the merits of free competition – more efficient firms, greater choice for the consumer, and less corruption, to name a few. But the West, too, should relax its protectionist mentality. The difficulties faced by Anshan Iron & Steel’s bid to invest in a Mississippi steel mill contrast sharply with Tianjin Steel’s smooth billion-dollar investment in Texas. This nervy politicisation of issues of foreign investment is hindering bilateral trade relations. But these security concerns should die down once the West realises the fruits of mutual dependence. The acquisitiveness of Chinese firms opens originally Western firms to new markets in China and neighbouring countries just as the liberalisation of the Middle Kingdom and its citizens’ new-found wealth unlock doors for American and European firms. Though all three regions should approach intertwined growth with caution, they should realise that the global economy is not a zero-sum game.

Discussion on the Laffer Curve

The theory of the Laffer Curve was first put forward by Arthur Laffer who famously sketched the curve on a napkin during a lunch meeting with Donald Rumsfeld, Dick Cheney and a writer for the Wall Street Journal. The Laffer Curve is a theoretical representation of the relationship between government revenue and taxation. This relationship is derived from a thought experiment. First the amount of government revenue raised at the extreme tax values – 0% and 100% are considered. Proponents of the curve assume that government revenue would be zero at both these rates as 0% of anything is zero and if workers were not able to keep any of their income, then they would have no incentive to work at all. We also know that at the current level of taxation, x%, there is a non-zero value for government revenue. Hence, it is hypothesized, the function for the relationship between the two variables is parabolic (as we see in Fig. 1 below).



This is significant as it suggests that there is at least one level of taxation at which government taxation will be a maximum. In Fig. 1, this level is t%. The explanation for this relationship is that, beyond t%, people have a disincentive to work hard and be productive as they perceive that the government is taking too large a chunk of their income. Another reason is of course tax fraud and evasion.

There are certain historical precedents for the curve. For instance, in 1924, Secretary of the Treasury Andrew Mellon noted that ‘73% of nothing is nothing’. Acting on his belief that governments experience diminishing and indeed negative returns on marginal tax increases, Mellon pushed for tax decreases for all tax brackets and it is this pressure that resulted in the eventual reduction of the highest income tax bracket from 73% to 24%. Income tax receipts rose from US$719 million in 1921 to over $1 billion in 1929. This average 4.2% increase over an 8-year period, supporters say, is evidence for the existence of the Laffer Curve

However, I would argue that this evidence is misleading. This annualized 4.2% increase was achieved during the ‘Roaring Twenties’ when the economy was in an expansionary phase. From Fig.2 we see that, during the same time period (1921-1929), the American GDP rose from approximately US$560 bn to US$820 bn which amounts to a 4.9% annual increase. As national income should equal national output (and hence the rise in one should equal the rise in the other), we see that the ‘increase’ in tax receipts was less than expected given that incomes should rise at the same rate as output. Therefore, I feel that the evidence from the 1920s is hardly evidence for the Laffer Curve. Some may say that the marginal difference between the growth of tax receipts and incomes (0.7 percentage points), in light of the much larger cuts in the tax rate, suggests that there is a Lafferite correlation. However, one must not forget that America has a progressive tax rate – as people get richer (as they did during the twenties on a mass scale), they will pay a larger proportion of their income as tax and so tax receipts will naturally rise by a greater percentage than incomes. I feel that this, at least in part, explains the relatively small differential of 0.5 percentage points.



Another oft-cited example of the principle of the Laffer Curve in practice is that of Ireland. While between 1984 and 2000 the Irish government slashed income tax for the top bracket by about 20 percentage points and cut corporations tax by over 30 percentage points, GDP growth was robust at an annualised rate of 10.8%. However, one must remember that the Laffer Curve describes the relationship between tax rates and government revenue not GDP. Indeed, over the same period, tax receipts as a percentage of GDP fell from 40.3% to 33.8% according to the OECD. Of course, this fall in percentage revenue is in spite of an undoubted rise in nominal tax receipts. Similar conclusions that decreasing high tax rates will increase nominal tax receipts but decrease tax receipts as a percentage of income can be drawn from a few other historical examples such as Russia in the early 2000s.

Whether these examples constitute a defense or criticism of the Laffer Curve depends on what interpretation of the Curve’s y-axis you take. If the ‘Government Revenue’ label shown in Fig.1 is said to actually be ‘Government Revenue as a Percentage of GDP’ then the examples cited above seem to weaken the argument for the Laffer Curve. Either that or the evidence could be construed to suggest that the tax cuts in the examples above were made when the initial tax rate was sub-optimal. An alternative conclusion could be that, though the initial rates of tax were above the optimal point (‘t’ in Fig.1), the cuts were so drastic that government revenue peaked and fell back down again – went ‘over the hill’, so to speak.

On the other hand, the label ‘Government Revenue’ could be interpreted as revenue in absolute real terms. Under this interpretation, it would seem that the curve does exist as the tax receipts have risen in all the above cases. However, should this rise in receipts not be attributed to the rise in GDP rather than the tax cuts? Some would counter by saying that it is the tax cuts themselves which have caused GDP to rise by allowing consumer spending and corporate investment to rise. This is a fair point. However, I would argue that there are several reasons why the effect of tax cuts on GDP should not be lauded so much. Firstly, tax cuts are an example of expansionary fiscal policy. Such policies are overwhelmingly used when economies are in recessions or bottoming out – in output ‘troughs’. According to the well-established theory of the business cycle, troughs are naturally followed by recoveries – growths in output, hence it is arguable whether it is the tax cuts which have really spurred GDP (and nominal tax receipts) or simply the business cycle in motion. Secondly, when in economic contractions, governments use a host of different measures to try and arrest the decline in output, namely, increases in government spending, increases in the money supply, decreases in the interest rate, decreases in the reserve ratios of banks and decreases in taxation. In the context of these other measures and their proven effectiveness, it is hard to argue that tax cuts alone have caused the rise of nominal tax receipts. Thirdly, there are reasons unique to each individual case that may substantially account for the increases in revenue. Take the example of Ireland – one compelling reason why its GDP rose so dramatically is that, while the country had previously been dependent on the UK economy, the growth of the EU’s single market meant that the Irish economy had new opportunities to grow. Also, in the time period mentioned, Ireland had substantial help from the EU’s Structural Fund which allowed its economy to grow at a faster rate. In the case of Russia, rising receipts could be attributed to a decrease in corruption – introducing a flat tax rate increased ease of collection and reduced bribery and the siphoning off of money.

Therefore, we see that whichever interpretation of the y-axis one takes, it is hard to argue that the empirical evidence suggests that the Laffer Curve exists – that decreases in taxation beyond a certain tax rate ‘pay for themselves’. Indeed the diagram below, taken from a Wall Street Journal article published in 2007, seems to suggest that there is a slight positive correlation between corporations tax and percentage of GDP accounted for by corporations tax receipts. (Please ignore the ‘Laffer Curve’ shown in the diagram – clearly the author feels that a best-fit line should be a roof over the data set rather than a line indicative of the true trend).



Through this discussion, we have seen that the evidence in favour of the Laffer Curve is not particularly strong; this is despite a perfectly sound seeming logical progression (the thought experiment) to arrive at the Curve. I would argue that the reason why the theory doesn’t stand up well in practice is that the premise that two points are known for cetain (government revenue at 0% and 100%) is flawed. While it is undeniable that a 0% tax rate will lead to no revenue, whether a tax rate 100% would lead to zero receipts is less obvious. Wouldn’t people still go to work knowing that, though they will not be able to retain any of their income, they will get it all back in the form of government provided services (free housing, education, food, entertainment etc.)? Lastly, it is clear that coming up with a Laffer Curve and an ‘optimal tax’ rate for any given economy is impossible. It is resoundingly impossible because data from a single country would have to be taken over a time period of years during which time the mythical Laffer Curve itself would be constantly changing as a result of changes in income, culture and attitudes towards government intervention. ‘Freezing time’ by using data points from several countries for a given year (as in Fig.3) is similarly pointless as the very nature of the Laffer Curve is that it is idiosyncratic – unique for each different country. To put it simply, there never will be a ‘ceteris paribus’ situation in the real world.

The Hong Kong Budget 2011 and what it means for Inflation

When Hong Kong Financial Secretary John Tsang presented the 2011-2012 Budget on Wednesday, he announced that fighting inflation and inflation expectations was the Government’s main target.

However, a look at the ‘Combat Inflation’ section of the budget raises more questions than answers. The first point mentioned is that the government will waive property rates up to HK$1500 per tenement per quarter at a cost of HK$9.9 billion. The Budget then states that HK$4.7 billion will be spent in subsidies to every residential electricity account and that two months rent will be paid to public housing tenants at a cost of HK$1.9 billion. These endeavours are counter-intuitive as each measure will actually free up money that individuals would otherwise have spent on rates, electricity and rents. This money, instead of ending up in government coffers, will now be released into the market, inevitably contributing to demand-pull inflation. Indeed, the effect of this spending on aggregate demand will be greater than the amount of spending itself as the people who benefit from these waivers/raised benefit ceilings/lump sums are generally those with a high marginal propensity to consume. In other words, this spending by the government will have an amplified effect on inflation.

This said, the Budget does include significant supply-side policies that are bound to reduce underlying inflation in the long-run. Government capital works expenditure will be a record HK$58 billion this year – a figure that will rise to over HK$60 billion in the next few years, Tsang promises. Spending on education and health care will increase by 6% and 9% respectively, reflecting a total expenditure in these two areas of HK$94.4 billion this year. While, in the long-term, this spending will increase aggregate supply and reduce inflation, in the short-term this will only exacerbate inflation as aggregate demand will receive a boost. We always knew the government would have to bite the bullet someday and engage in supply-side policies to counter the largely cost-push inflation (apart from in the real estate market) but perhaps this year, given the high inflation, wasn’t the opportune time to do it.

Despite these unprecedented spending increases, the government plans to unveil HK$5 billion to HK$10 billion worth of HKD denominated ‘iBonds’ within the next six months. Investors will be paid an inflation-linked coupon twice every year. Superficially this appears promising as one would assume that the iBonds will reduce the money supply and increase savings. However, the advent of the iBonds is unlikely to increase savings as most of the money invested in the iBonds would otherwise have been saved somewhere else. Moreover, the relatively small scale of the bond issuance (less than 0.5% of total bank deposits in Hong Kong) will most likely mean that the iBonds don’t dent inflation.

Many people, myself included, have lambasted the Budget, however one cannot help but feel sorry for Mr. Tsang. Hong Kong’s dependence on foreign production for virtually everything means that most of the inflation that the city is experiencing is imported. Sadly, Mr. Tsang can do little about tensions in the Middle East, droughts in Russia and Argentina, or floods in Canada and Pakistan. In fact, the only thing that Hong Kong can do to control imported inflation is to raise the value of its currency which would mean dropping its peg to the weakening dollar.

Mr. Tsang’s approval ratings fell through the floor shortly after he announced the Budget as politicians and the people complained that the Budget would not lower inflation. They were right, in the short-term at least. However, these people also moaned about the fact that Mr. Tsang did not include any tax rebates in the 2011-2012 Budget. These two complaints are contradictory – lowering taxes will do nothing but increase inflation, especially if the rebates are for low-income earners who save little and tend to start strong multiplier effects. Indeed, if Mr. Tsang has to be lauded for one thing it is for preserving the HK$71.3 billion budget surplus. Spending away this surplus as politicians have suggested would only have increased inflation and I believe that the Financial Secretary is wise for holding out with his Keynesian counter-cyclical strategy and holding on to the surplus in expectation for what he calls ‘the perfect storm’ that may loom ahead.

Deep Vaze

Dropping the Deficit

On 16th October 2010, the Obama administration announced that America's budget deficit was at its highest level ever at a staggering $1.42 trillion - over three times higher than the previous record set at the end of the last fiscal year. By the end of the decade, the deficit is predicted to have soared to around $10 trillion. Almost all other countries in the OECD are running budget deficits. In fact, the total deficit for OECD countries went from -1.2% of total OECD GDP in 2007 to -7.9% in 2009.

To understand why this is unsustainable one must first understand that a government funds a deficit by selling bonds - promissory notes to pay the bearer back later. The amount of bonds sold makes up the difference between the governments receipts and expenditure (in other words, its deficit). As the deficit widens, governments will keep on selling these bonds. Clearly, this cannot carry on to infinity - at some point people will stop buying bonds because they will think that bonds are too risky.

Governments today must take whole-hearted measures to drop this deficit sooner rather than later so that the situation outlined above when no one is willing to fund the deficit never happens. That said, this fiscal restructuring must be made in a smart way which mitigates the effects on economic growth.

Fiscal restructuring cannot solely involve reductions in government expenditure as the poor (who gain the greatest from government expenditure) will be hit the hardest. Balancing the budget cannot only consist of tax hikes either. This is because of the sheer scale of OEDC countries' deficits. If taxes rose higher and higher, eventually the fabled Laffer Curve would kick in and the government would actually experience negative marginal revenue. Therefore, dropping the deficit must take into account both tax raises and spending cuts.

Tax increases do not necessarily have to cripple weak recovery that is underway. In fact, aggregate demand could actually increase if tax hikes for the upper decile in an economy are countered by slight tax reliefs for the poorer people. This is because the rich 'leak' more money out of the economy than the poor do - mainly in the form of imports. Hence taking money away from the rich and giving it to the poor would help stimulate growth through the formation of a positive multiplier effect.

Governments should strive to achieve higher tax revenues and greater economic efficiency simultaneously. This can be done through the imposition of carbon taxes and higher taxes on harmful goods like cigarettes and alcohol. Taxing these demerit goods would reduce externalities in the economy (and hence increase efficiency) while increasing government tax receipts at the same time.

Keynesian economists believe in counter-cyclical expenditure where the government borrows and spends during recessions and pays back its debts during times of growth. By that model and given the fragile state of the global recovery, Keynesians are in support of huge increases in government spending (in many countries through bouts of quantitative easing) in order to make up for a shortfall in aggregate demand due to reduced consumption. However good this may sound in theory, this model isn't practical as, unfortunately, political cycles and economic cycles don't coincide. Governments don't usually repay their debts right before elections as such moves are not popular. Also, such huge rounds of Keynesian government spending crowd out consumers and therefore may have the opposite effect than that intended.

I believe that it is important when restructuring government spending to try and incentivize people to work. Minimum wages and other welfare benefits should not be so high that it doesn't make sense for people to work at all. Reducing spending in a way that encourages people to work should also go some way to helping increase tax revenues for the government. Cutting back government training and re-training schemes and instead giving firms some financial reliefs if they train their own workers can also improve the efficiency with which the quality of labour is increased.

This said, certain areas of government expenditure should be preserved. Education and healthcare systems are fundamental to the long-term health of the economy and so I don't think they should suffer from spending cuts. Of course, education and healthcare account for a sizable proportion of government expenditure - hence the effectiveness of spending cuts as a means of dropping the deficit is reduced.

With the baby boomers retiring over the next decade, governments are set to face the double-whammy of lower tax receipts and higher welfare payments. As The Economist notes (16th October 2010 edition) the 'median advanced country will be spending 27% of GDP on age-related items' by 2050. The only solution to this dawning predicament is to raise the retirement ages and cut the benefits. Such upward movements in retirement ages make sense - life expectancy has increased in all countries and by as much as 10 years in Europe. However, governments who try to raise retirement ages will inevitably come up against fierce resistance - evidence of which we are seeing in the form of violent protests in France. This is a measure that is easier said than done.

Another measure governments could take is to unpeg its spending from inflation rates. In other words, spending should be decided in nominal sums rather than real sums. While this may seem a little bit sneaky, it does mean that when times are bad and there is inflation, public finances will actually benefit (as real expenditure will reduce), enabling the government to spend money to boost the economy. An automatic reduction in real spending during times of inflation will also help reduce demand-pull inflation. Similar 'unpegging' has been successful in the fiscal restructuring of several countries including in Sweden.

Whatever governments around the world do to reduce their deficits, they must do quickly and decisively in order to instill the public with confidence in their measures. The above are my views on what paths they could take. I would be interested to know your opinions - please leave a comment below.

Why Developing Countries Cannot Achieve Growth and Greater Equality of Income Simultaneously

I came about this ‘proof’ while investigating the following problem: Imagine that there are four people in a country. Three of these people earn $1 and one person earns $2. Hence, the total income in the economy is $5. As a result of economic growth, an extra unit of income enters the economy and now the situation is that two people earn $1 and two people earn $2. The question is whether the second situation is more of less equal than the first.

In order to solve this problem, we must first decide how we will measure equality. The Gini coefficient – derived from the Lorenz Curve – is a commonly used and widely accepted measure of inequality and so I will use it as my inequality measuring tool.

As mentioned, the Gini coefficient (GC) is derived from the Lorenz Curve. The Lorenz Curve is the curve that tracks how the cumulative percentage of national income (y-axis) changes as you ‘accumulate’ the total population (from poorest to richest). On the below diagram, the GC can be calculated as the proportion of area a/area a+b. Clearly, the higher the ratio, the more unequal the country is as the Lorenz Curve is further from the line of perfect equality.

Now that the definitions are out of the way, let’s get down to the problem. If we plot the Lorenz curve for scenario 1 and 2 (scenario 1 is three people $1, one person $2; scenario 2 is 2 people $1, 2 people $2) we find that the GC for scenario 1 is 0.15 and the GC for scenario 2 is 0.166. In other words, the second scenario is more unequal than the first. At first this can seem counter-intuitive as total income in the economy has increased and all the extra earnings went to someone who was formerly ‘poor’. The implications of this are that in a country where more than half the people are ‘poor’, any increase in output (which is the same as an increase in income as national income = national output) up until the point where half the people are poor and half are rich will inevitably lead to rising inequality.

If we take this problem a step further and say that, as a result of further growth, the scenario changes to the following: three people earning $2 and only one person earning $1. In this case, our intuition is right – the third scenario is more equal than the second. Indeed the GC for this situation is 0.11 which is even lower than scenario 1. Clearly scenario 3 is the best out of all three as average income is the higher and there is the least income inequality.

What these three scenarios show us (and the same effects can be seen using different numbers) is that, with no government intervention to redistribute income, if a country with more than half the population poor (most developing nations) grows, there will be an inevitable rise in inequality up until the point where half the population are poor and half are rich. Beyond this point, inequality reduces more rapidly than it rose in the first place.

This example suggests several things. Firstly, as most developing countries have a GC that they would hate to increase, having a completely free economy with no progressive tax structure is harmful as it will lead to further inequality and further social tensions. Also, the fact that equality improves after the 50:50 mark leads me to believe that developing countries should be less alarmed when they see a rising GC as the above scenarios suggest that this will fall if the poor are continually being elevated to the ranks of the ‘well off’. Finally, this example suggests that in a country where the GC is high to begin with (perhaps greater than 0.6), and government tax policies are non-existent or ineffective (maybe in a lawless or incredibly corrupt state), it may actually, in the interests of social harmony, be unwise for that country to pursue growth!

Note: A natural reaction to the situation that I have presented is to say that it is unrealistic for all of the ‘extra’ $1 of income to have gone to a formerly ‘poor’ guy. In real life a large chunk of this extra $1 goes to the ‘rich’ person who already had $2. This is very true. However, the fact that inequality initially increases even in this rosy, best-case situation is helpful in proving my point that, in real-life (which is far worse that this best-case situation) inequality will definitely rise at first.

Note on the Note: Some of you may question my calling the situation ‘best-case’ in the paragraph above. Surely the best-case situation is that the extra $1 is split evenly between the ‘poor’ people – doing this will certainly reduce the Gini coefficient. While this is correct, it is grossly unrealistic. To understand why this is true, it is important first to bear in mind that each individual in my scenarios would represent tens (or even hundreds) of millions of people in an actual economy. It is impossible for government policies to simultaneously benefit these teeming masses and to the same degree. Therefore, it would be too unrealistic to split the extra income evenly between the poor.

On Rare Earths and Clean Energy in China

In June of this year, China announced restrictions on the exports of rare earths from the country. China introduced quotas and taxes of up to 25% on the exports of rare earths – a group of 17 chemically similar metallic elements which are used in a range of industries including in the production of electric car batteries, solar panels and wind turbines. While the country cited environmental concerns as the reasoning behind the restrictions, these export barriers also help keep the prices of rare earths in China low as there is a constant oversupply. On the other hand, foreign producers who require rare earths will face increasing costs as supply is constricted – after all, China has 97% of the world’s rare earths. The imposition of rare earth export restrictions is one way in which China is seeking to extend its domination in the international clean-energy market.

The oversupply caused by the export restrictions will only be exacerbated by news earlier this week (9/9/10) that the state is planning to consolidate the country’s currently fragmented rare earth industry – a structural change that will involve the industry being led by several big firms. The government plans to reduce the number of firms in the industry from 90 to 20 by 2015 through a series of mergers and acquisitions. Presumably, the move will allow the industry to benefit from greater economies of scale, resulting is lower costs which ultimately aid clean-energy industries. On the graph below, this consolidation represents a movement along the ATC curve to a greater level of output, resulting in lower average costs.

On top of creating an oversupply of rare earths, the Chinese government is also taking steps to increase the external economies of scale that the industry gains from. One example of this is the government’s announcement of a new, high-speed railway route linking Nanchang, the capital of inland Jiangxi province, with the industrial coastal regions. The new route will cut down travel distances for the transportation of resources by 200km and will cut costs by US$4.20 per tonne. Hence, this railway, due to be completed in 2013, will be a boon especially for the manufacturers of wind turbines and electric car batteries, as Jiangxi province’s potential for the exploitation of rare earths is 16 times the national average.

While this article has focussed on rare earths, rock-bottom interest rates, bargain deals for land and government intervention of US$1 billion every day to artificially keep the value of the yuan low have all contributed to the remarkable rise in competitiveness of Chinese producers of clean energy and ‘green’ goods. China’s efforts have certainly made clean energy more affordable – over the past two years, solar panel prices have halved and wind turbine prices have dropped by a quarter, largely due to the massive economies of scale (both internal and external) experienced by the sector. The graph below shows the rapid increase in scale of wind turbine manufacturers in China – indeed, China is set to make about half of the world’s wind turbines and half of the world’s solar panels this year.

While some may laud China for embracing cleaner fuels and weaning its manufacturers off dirty fuels, this protectionism clearly violates World Trade Organisation rules. While I am in favour of government subsidies in ‘green’ sectors of the economy, it is unfair for China to support firms which export clean energy – doing so cripples foreign producers who are unable to benefit from such large government subsidies, cheap labour etc.

In order to prevent the world from becoming over-dependent on China for alternate energy as oil and gas reserves are depleted, China should increase its relatively meagre subsidies for the domestic consumption of clean energy and withdraw the export restrictions on rare earths. Doing so would allow its clean energy industry to continue to flourish on the back of rising domestic demand, as well as permit other countries to develop their alternate energy sectors.

Japan and the Velocity of Money

On 27^th August 2010, the Japanese government released data which showed that the core consumer price index, a weighted basket of goods which excludes volatile food prices, had fallen by 1.1% in July from a year earlier – the 17^th straight month of decline. This decade-long trend of falling consumer prices has happened despite the government’s efforts to prevent the deflationary spiral.

In the wake of the recent results, the Bank of Japan (BOJ) is mulling over whether to return to quantitative easing (which involves flooding markets with extra cash under a liquidity target) – a policy which had little effect in tackling deflation in the early 2000s before it was terminated in March 2006. Simply pumping cash into the economy didn’t work then and won’t work now as consumers look to defer purchases in expectation of lower prices in the future. Rock-bottom interest rates of 0.1% (the benchmark rate) have been equally unsuccessful in shaking off deflation. Clearly increasing the money supply has failed.

The quantity theory of money states that:

M*V = P*Q

where M is the money supply, V is the velocity of money, P is the price level, and Q is an index of the real value of final expenditures. Of these terms, three are fairly self-explanatory though the definition of the ‘velocity of money’ may need some clarification. The velocity of money is the average frequency with which a unit of money is spent in a specific period of time – the number of times a unit of money changes hands in, say, a year. The question for the Japanese government is how to increase the value of P.

As increasing M (money supply) has failed to cause inflation, by this equation, the government is left with two other options – to decrease Q or to increase V. It is quickly obvious why reducing Q to cause inflation is a bad idea. Given that P*Q can be defined as the nominal value of output, reducing Q would reduce output. While this may lead to higher prices in the short run as the supply curve shifts inwards, in the (slightly) longer run, lower output would mean lay-offs which, in turn, would cause the demand curve to shift inwards as well – causing the price level to fall once more.

Because decreasing Q is out of the question, Japan’s only remaining option is to increase the velocity of money (also known as the velocity of circulation). In order to increase the velocity of circulation in an economy, there must be a strong multiplier effect – in other words, there must be as little leakage as possible from the flow of money within the country. One of the most significant ways in which money is leaked out of a country is through imports. It follows that Japan must try and reduce imports. An extremely strong yen, which hit 15-year highs this week, is therefore ominous for the Japanese government as it reduces the competitiveness of exporters and makes imports more affordable, helping to keep overall prices low. It is extremely important that Japan reduces the value of the yen in order to channel consumers’ money away from imports and towards domestically produced goods – spurring a multiplier effect.

Decreasing the value of the yen should, according to the quantity theory of money, help increase the velocity of money and hence, cause healthy inflation. However, in the long term, a structural change involving the reduction of inequality may be needed to keep imports in check. Inequality in Japan is higher than in India (Source: Gini coefficients, CIA World Factbook 2010), meaning that there are plenty of rich Japanese who probably love imported goods. Taking some money away from the upper echelons and diverting it to the poor (who would save little and spend on domestically produced goods) may be the best way to go in the long run.

Deep Vaze

28/8/2010

Levi’s new brand Denizen a Warning to Foreign Firms

On August 18^th, jeans-maker Levi Strauss & Co. announced the launch of a new line of jeans called Denizen. The Denizen jeans range will initially be sold in China, South Korea and Singapore and is Levi’s attempt to corner the jeans market for 18-29 year-olds in Asia. Denizen jeans will be priced at US$40-60 – half the price of Levi’s jeans currently sold in China.

While this news may excite college students in Shanghai, it is also a vivid example of the income disparity in China. Levi’s latest move reflects the difficulty they faced selling their original jeans in China which were too pricy to qualify as inexpensive casual wear yet too cheap to be a luxury good. In other words, even a global jeans giant like Levi’s was unable to derive profit from the ‘middle-ground’ segment of the Chinese consumer market – the segment which is rich enough to want to wear better jeans than bargain, local-made brands yet who can’t afford top-end jeans. The reason for Levi’s failure to do so is simple – the ‘middle ground’ segment doesn’t exist.

The Chinese Gini coefficient (a commonly used measure of income inequality) reached 0.47 in May 2010 (Source: China Daily, 12/5/2010), surpassing the global warning level of 0.4 (a Gini coefficient of 0 indicates perfect equality and a value of 1 indicates perfect inequality). Li Shi, a professor on income distribution and poverty studies with the Beijing Normal University, said the top 10% of Chinese earners had incomes 23 times that of the poorest 10% in 2007. In 1998, the top 10% earned only 7.3 times what the bottom 10% did. Clearly, China is made up of those who are very rich and those who are very poor – there is no (significant) middle ground.

This glaring and worsening disparity in China doesn’t bode well for foreign firms looking to set up in the Middle Kingdom. To make it worthwhile, these firms will have to adapt their mid-price-range products so that they are either targeting the low end of the market (as Levi’s have done) or the exorbitantly expensive end. However, such modifications would entail significant investments. What’s more, many firms simply won’t be able to adapt – after all, the brand image of Diesel can’t change into something equivalent to Gucci overnight. These troubles may put off many foreign firms who aren’t large enough to afford such an adaptation. Evidently, if China wants to boost domestic consumerism, inequality is an issue they must deal with.

Note: Having said this, some people may argue that Western firms won’t actually have to adapt their product range that much. After all, America’s Gini coefficient was 0.45 in 2007, up from 0.41 in 1997 (CIA World Factbook). Even the UK’s Gini coefficient is quite high at 0.34. The key reason why China can’t be compared with the likes of the US and the UK is that the poorest people in the latter two countries are much richer than the poorest in China. According to the IMF, the US’ GDP per capita at purchasing power parity (PPP) was $46,381 (in International dollars) compared with China’s which was Intl. $6,567, about seven times less. Clearly, while countries in the West may have inequality comparable to China’s, they are still much richer. Therefore, Western firms will have a tough time adapting to the polarised Chinese market and hence, China must tackle its inequality problem by pulling millions out of poverty.

The Neo Neo-Colonialists

Neo-colonialism is the term given to the involvement and dominance of modern capitalist businesses in nations which used to be colonies. Typically these were large corporations from the developed world taking advantage of resources and labour in the developing world. This, however, isn’t the trend which we are seeing today. What we are seeing is China’s largest firms becoming the first neo neo-colonialists – a developing nation’s firms dominating the economic affairs of other developing economies.

I’ve written before on how rising inflation in China caused by the increasing prices of factors of production (namely labour) represent the nation’s approach to the steep end of their long-run aggregate supply curve (see below) where any increase in output will result in a significant rise in the price level (see article: ‘China’s inevitable inflation’). Indeed, the reason for China’s foreign scramble for resources is obvious enough. China’s third-largest steel maker Wuhan Iron & Steel Group is in talks with ArcelorMittal, the world’s largest steelmaker, to develop overseas mining projects which would make Wuhan Steel less dependant on expensive imports of iron-ore. This is the latest in a string of moves taken by Wuhan Steel to achieve iron-ore self-sufficiency in ‘three to five years’ (Deng Qilin, chairman of Wuhan Steel). Wuhan Steel has acquired stakes in iron-ore mining firms from Brazil to Venezuela.

Wuhan Steel isn’t the only large Chinese firm with a voracious appetite for foreign firms. PricewaterhouseCoopers (PwC) said in a recent report that Chinese outbound merger and acquisition deals for the first six months of 2010 are at record highs, up by more than 50% over the same period last year. The report also said that the main targets of mainland firms were industries involved with natural resources – a trend that supports the view that the mainlanders are aggressively trying to shift their LRAS curve outwards to curb inflation.

The rate of growth of Chinese interests abroad is only quickening. In 2000, China-Africa trade surpassed $10 billion, this year it is likely to cross the $110 billion mark. The Chinese government is a vocal supporter of this neo neo-colonialism – on August 16^th 2010, the Ministry of Commerce launched the China-Africa Research Centre which will (among other things) ‘help Chinese firms planning ventures in Africa with consultancy services’ (Fu Ziying, vice-minister of commerce).

The rest of the world should be at least a little concerned at this growing trend. With China snapping up foreign resources at breakneck speed, other countries’ firms may be cut off and face decreasing competitiveness due to the higher costs of imports of raw materials. This could have serious unemployment repercussions outside of China and could stunt the growth of other developing nations by giving China an absolute advantage in manufacturing. The only upside is that we’ll continue to be able to buy cheap goods from China. In light of these implications, perhaps the West shouldn’t be so aggressive in urging China to raise the value of the yuan – an action which would certainly expedite China’s rise as the first neo neo-colonialist.

Genomics

Genomics is a fledgling industry – its barely four years old. It is also an industry with a lot of potential. By analysing customers’ genes, those in the field can predict (with increasing accuracy) the likelihood that the customer will suffer from a disease in the future. Clearly such ability has the power to change the medical world – people will be more informed as to what medication to take (as they will know the side-effects they are likely to get from various different treatments), and high-risk customers will be able to mitigate their health risks by taking preventative medicine and adopting healthier habits.

Though currently only those with plenty of cash are capable of sequencing their entire genome, prices are falling fast. A decade ago whole-genome sequencing cost a billion dollars (Source: The Economist). In 2007, genome-sequencing firm Knome charged $350,000 to sequence a genome; today, they charge $40,000 and by 2015, that figure may well be down to $1000.

Franklin D. Roosevelt said that with great power comes great responsibility. The same is true with genomics – governments have the responsibility to regulate the industry so that consumers aren’t taken advantage of in this particularly technical field. Indeed, a report by America’s Government Accountability Office (GAO), a watchdog, found that much of the information given to consumers who had their genes analysed was ‘misleading and of little or no practical use to consumers’. Some firms currently claim to be able to know what sports kids will be good at from their genes alone – a claim that the GAO called ‘complete garbage’.

Because consumers are so vulnerable to false information in this industry, the regulation of tests for things like the probability of contracting an illness and the probability of suffering side effects from drugs is highly likely. More frivolous tests like ancestry checks look set to be left unregulated. This is wise as the whole point of this new technology is to make consumers better informed, not to give doctors another chance to swindle money from their patients. I would go as far as to suggest that consumers should be prohibited from getting medication or receiving treatment from the same institution that sequenced their genome. That way, the firm that actually sequences the genome doesn’t benefit from the sales of drugs and treatments that take place as a result of the genome analysis. Because of this, the sequencing firm will have no incentive to give wrong or misleading information to the consumer. Through regulation and the industry structure I’ve outlined above, the true potential of genome sequencing can be harnessed.