Abstract: Whenever there is a significant decline in aggregate demand in China, two opposing ideas would emerge: one calls for measures to stimulate demand, and the other urges structural reforms to boost growth. According to the first group, the government should prioritize tackling weak demand through proactive and expansionary policies while pushing forward structural reforms. The latter, on the other hand, emphasizes implementing reforms to lay a foundation for long-term growth. The two camps differ on whether demand management and structural reform objectives can both be achieved.
In their speeches, Zhu He, Zhang Bin, and Guo Kai painted rich pictures of the current economic performance from different perspectives. They elaborated on the most important policy debates in an in-depth, objective, and comprehensive manner. Their observations, reflections, and conclusions on the current economy have enriched and deepened our understanding of the current economic issues and policy choices and facilitated us to make more robust economic decisions based on a better understanding of the economy.
Whether for individuals, enterprises, or the government, economic decisions based on a comprehensive and objective understanding of the current economic situation and future trends will undoubtedly help make the economy more resilient. Next, I would like to introduce my observations on China’s current economic performance for your reference.
Ⅰ. The aggregate balance camp favors a more positive aggregate policy
Whenever problems or difficulties, especially significant shortages of aggregate demand, occur in macroeconomic operations, two opposing thoughts arise. One argues that the current policy should focus on the early restoration of aggregate demand equilibrium and explore ways to expand aggregate demand, while the other argues that reforms should be deepened, that is, structural reforms should be implemented to alleviate short-term problems and lay a solid foundation for strong growth in the long run. This is the case in Japan, where, since the 1990s, these two perspectives have been present in every policy debate, with one calling for the restoration of aggregate balance and the other advocating structural reforms. It is also the case in China, where, since the 1990s, whenever macroeconomic difficulties have arisen, most of the arguments have fallen into these two seemingly opposing camps.
The basic idea of the camp focusing on aggregate balance can be summarized as “give back to Caesar what is Caesar’s, and to God what is God’s”, meaning the government can pursue both aggregate and structural reform objectives through different policies. Specifically, the aggregate regulation department is exclusively responsible for aggregate balance, while other relevant departments are specially responsible for structural reforms by implementing structural reform measures. In other words, different objectives are achieved through different policy instruments.
The view of emphasizing aggregate balance without opposing structural reforms and only taking the restoration of aggregate balance as the central task is convincing and tends to be agreed by macroeconomic researchers who focus on aggregates. This view is often supported by the successes and failures in the history of the United States, which are undoubtedly very persuasive. Therefore, in the current context, many researchers studying aggregates call for more positive and expansionary policies at the aggregate level.
However, from the methodological perspective and in political and economic processes, the above view is based on the fundamental assumption that aggregate and structural objectives are independent of and even mutually reinforcing each other instead of mutually exclusive. Only based on this assumption will “what is Caesar’s be given back to Caesar, and what is God’s to God”.
Ⅱ. The structural reform camp favors forcing structural reforms with economic predicaments
Structural reformists’ opinions and criticisms of the above logic are not based on technical considerations but are questioning its assumption. In other words, they believe aggregate objectives and structural issues are not independent but are, to some extent, mutually exclusive and conflicting.
In real economic conditions, the relationship between aggregate and structural objectives is often affected by the institutional context, in some of which aggregate and structural goals can be independent of each other, while in others, they conflict, resist and contradict.
In China, as the old saying goes, “Place one on the field of death, and he will fight to live”. When no economic problem emerges in aggregate, and the figures for economic growth and inflation are good, everybody, from the government to the enterprises, from the central to the local, doesn’t feel that structural reforms are urgent because, after all, everyone is having a good time. Only when the economy is in trouble, such as when the unemployment rate, price level, and economic growth rate are not satisfactory, will all the main bodies be forced to make up their minds to reform and resolutely take measures to solve the problem structurally, which will lay a solid foundation for the long-term fight for a better situation.
China’s history shows that when the economy is doing well from the perspectives of aggregate, inflation, and so on, government departments lack enough incentive and pressure to push through unpopular structural reforms. In contrast, the important structural reforms in China were introduced precisely when the economy was facing difficulties, like around 1998, when China suffered from deflation and insufficient aggregate demand. Major decisions such as WTO accession, housing reform, three-year relief for state-owned enterprises, and the overall reform of the commercial banking system were made at that time. If the economy keeps growing at a high rate, even if some scholars call for reforms, they may not get sufficient support, and the decision-making authorities may not make up their minds to open up the market.
In the past decade and more, China witnessed problems such as a prolonged economic downturn and a periodic shortage of aggregate demand, to which China responded with relatively more aggregate policies than structural ones. In the long run, China’s debt problem became increasingly serious, leverage rose, the economic operation seemed less efficient, and the new economic growth points became less significant. At this juncture, the structural reform camp tended to believe that the government should take the opportunity to force the relevant departments and economic entities, with the relatively difficult economic situation, to make up their minds on structural reforms, which may open up new horizons in a few years.
It can be held that both the aggregate balance and the structural reform camps are logical. The core difference between the two theories lies in how they look at the relationship between aggregate and structural objectives, i.e., whether they are politically and economically independent, mutually reinforcing, or mutually exclusive, determined by the institutional and cultural contexts.
For instance, structural reforms and aggregate targets in the U.S. can be independent, with the Federal Reserve only responsible for aggregate targets, with Congress, state governments, and the executive branch responsible for structural reforms. In contrast, China’s economic system operates on a different logic, and Japan may not be the same as China. Every major reform in China’s history was forced by economic predicaments, such as the shift to economic construction as the center after the reform and opening up and the introduction of the household contract responsibility system with remuneration linked to output in the rural area, both due to the severe economic difficulties.
Therefore, some scholars don’t think the current economy is difficult enough to rush to balance the aggregate. Instead, they believe China should hurry to forge consensus and promote structural reforms. This view is not fully based on technical analyses but on a realistic observation of the political and economic process, under which international experience may not be applicable.
Ⅲ. The economic slowdown is a “symptom”, and the “l(fā)esions” should be found
Solving economic problems is like treating patients because it is necessary to solve the symptoms and find the lesions. For patients with severe fever, it is often essential to first reduce the fever, then identify the lesion and treat it with the right medicine. High fever is only a symptom, and the lesions can be various. Therefore, a doctor needs to find the lesions and prescribe the right medicine.
Similarly, low price growth and economic growth are economic “symptoms”. Aggregate demand expansion, lower interest rates, and other policies targeting these “symptoms”, like fever reduction measures, may be necessary but not enough. Only by studying the lesions in depth can we solve the problem. Every time the economy faces insufficient aggregate demand, the “symptoms” are similar, but the “l(fā)esions” may vary. Since the beginning of the second quarter, the economy has highlighted the relative weakness of aggregate demand, but the research and analysis of the lesions still need to be further deepened and refined.
Some important facts are worth focusing on considering the current insufficient aggregate demand.
First, the unemployment rate for China’s population aged 16 to 24 has hit a record high and is likely to continue to rise in July, while the unemployment rate for those aged 25 to 59 hit a record low in June. People aged 25 to 59 far outnumber those aged 16 to 24. As the unemployment rate of such a large group of laborers hit a record low, the unemployment rate of the young population is merely a “symptom”. It cannot be explained with a simple “insufficient aggregate demand”, so it is important to find the right “l(fā)esions”.
Second, the current unemployment rates in China’s 31 major cities are significantly higher than the national average. Since the beginning of data records and before the pandemic, the unemployment rates in China’s 31 large cities had been outnumbered by the national average because the national average takes into account data from many small and medium-sized cities. However, today’s unemployment rates in the 31 major cities are significantly higher than the national average.
Based on the available data, it is reasonable to infer that the labor markets beyond China’s 31 major cities have recovered to the pre-pandemic level. With the unemployment rate 2019 as a benchmark, the unemployment rate in small and medium-sized cities may already be lower than the pre-pandemic level. In contrast, unemployment rates in the 31 large cities are significantly higher than before the pandemic. I am afraid that such a large structural divergence cannot be explained solely by a lack of aggregate demand. If so, it is doubtful whether the conclusion based on the lack of aggregate demand is robust enough.
Third, the current growth in the number of rural migrant workers in China is significantly high relative to the current aggregate demand. Based on historical data and the current economic growth rate, we can infer a reasonable number of rural migrant workers, from which the current number may have exceeded two standard deviations away, not like a random perturbation. Even though the data for this extrapolation is incomplete, the data on labor force on-the-job time is also illustrative. According to the survey, compared to before the pandemic, the labor force of all types worked significantly longer in a week, which cannot be explained by a lack of aggregate demand because a deficiency in aggregate demand should imply a deficiency in the demand for labor.
Therefore, while there is nothing wrong with pursuing aggregate stimulus policies based solely on aggregate data analysis, the policy response may be inappropriate if the “l(fā)esions” are not analyzed in depth. Similarly, without further reflection on the current political and economic process, the policy response will also be problematic.
In all, as we look closely into China’s aggregate and structural problems and study in depth a large amount of data from macro to micro, it is not hard to find that the structural characteristics and “symptoms” of China’s current shortage in aggregate demand are unprecedented, which means that the “l(fā)esions” behind are never seen before, and thus the response policy should be unprecedented.
Q&A
Bloomberg: Currently, there are heated discussions about liquidity trap, so I wonder whether the current monetary policy is still effective and, if so, how effective it is.
Gao Shanwen: Structurally, China lacks the basis to enter a liquidity trap. Under the current structure and at this interest rate level, in general, monetary policy can still function normally. The following two facts can support this view.
First, China's currency multiplier is in the normal range. Around 2010, China's currency multiplier was about 5; today's currency multiplier is about 9, and the currency multiplier has been rising for more than a decade. Internationally, before Japan entered the bubble economy, the money multiplier was between 10 and 15. Before the outbreak of the financial tsunami in the U.S. and Europe, when the banking system was functioning normally, the money multiplier was also in this range. So far, China's currency multiplier has always maintained an upward trend; from the absolute level, from the normal conditions of the currency multiplier level is still a certain gap that may rise further. Therefore, from the perspective of the currency multiplier, it is too early to say that China is in a liquidity trap.
Second, the risk premium of our loan interest rate over treasury bond interest rate has been declining for more than a decade. Nominally, China loosened the control of interest rates ten years ago or even earlier. The marketization of loan interest rates and the free-floating of deposit interest rates are supported by law; interest rates in the interbank treasury market have been fully liberalized over the last 15 years. In this process, a basic problem worth paying attention to is that over the past decade, the decline of the loan-weighted interest rate has been significantly larger than the decline of the long-term treasury bond interest rate.
From the perspective of banks, the premium of loan interest rate over treasury bond interest rate represents the liquidity risk and default risk of loans. Why has the risk premium narrowed by hundreds of basis points over the past decade? The theoretical explanation is that there has been a significant improvement in the liquidity of loans or a significant reduction in the risk of default on loans. Still, these two explanations are difficult to accept because the economy is in a downward range and corporate profits are falling, the economic basis for the reduction in loan default risk and the improvement in loan liquidity does not exist.
I think the decline in China's loan-to-bond risk premium over the past decade or so represents a shift from a highly regulated, relatively fragmented commercial banking system to one with highly interconnected and highly market-oriented interest rates. It may be at the end of that process. In this process, the bank's pricing system needs constant adaptation and adjustment, which reflects the pressure in the process of market-oriented reform, rather than the precursor of entering a liquidity trap.
Therefore, from the aggregate point of view, China's monetary policy is still in a normal state, and can still play a normal role in supporting the economy. It is too early to talk about the liquidity trap.
Caijing: On the premise that the Federal Reserve keeps a high-interest rate policy, once the PBC adopts a low interest rate policy, it will further increase the interest rate differential between China and the U.S., and form a big impact on the RMB exchange rate. How will the central bank choose between stabilizing the economy and stabilizing the exchange rate?
Gao Shanwen: China's financial reform over the past decade may not have been successful in some areas, but it has made significant progress in at least one area. It may even be said that the fundamental result-china's exchange rate formation mechanism has achieved a high degree of marketization. At present, the RMB is floating freely against the U.S. dollar and other currencies to a large extent, and the free-floating of the exchange rate opens up a rare operating space for domestic monetary policy autonomy.
In this case, monetary policy is relatively independent, and there is no need to overthink exchange rate movements. In fact, as for the fluctuation of the exchange rate of the RMB against the U.S. dollar, the media are no longer keen to discuss it, the market has paid little attention to it, and the exchange demand of the masses is not urgent, it shows that public opinion and the market have fully accepted the free-floating of the RMB.
This is the keynote speech made by the author at the Seminar on CF40 Macroeconomic Policy Report (Q2 2023) themed “Navigating Weak Demand and Low Inflation: Lessons from the US, Japan and Europe” on July 24, 2023. The transcript has been edited for length and clarity. It is translated by CF40 and has not been subject to the review of the author himself. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations.
