China Rising?

So much ink has been spilled--especially over the last several years--about the rise of China that I wanted to devote a blog to the subject.

I won't bury the lead: I believe China is more likely another Japan than another United States on the rise.  My goal is not so much to tell the future--I don't know what will happen--as much as it is to cast doubt on the overwhelming consensus of China's inevitable rise to supremacy.

What consensus you might ask?  That China's economy will inevitably surpass the U.S.'s in the next 10, 20, or 30 years; that China will surpass the U.S. in technological superiority; that China will surpass the U.S. militarily; that China will surpass the U.S. in every way possible, it seems.

All of these things very well may come to pass.  But, it is not written in the stars, and the consensus view is almost entirely built on an extrapolation of current trends--a technique of forecasting which is almost never accurate.

As an interesting illustration of forecasting difficulty, I'd like exhibit #1 to be Paul Kennedy's excellent book, The Rise and Fall of the Great Powers.  Now, granted, this book came out in 1987, when Japan's ascendancy was widely accepted as given, but it's a wonderful example of how someone extremely knowledgeable in a specific field can suffer from the biases of extrapolation. 

In his book, he speaks of the 5 centers of power at the time: the U.S., the U.S.S.R., Japan, China and the European Economic Community.  He spells out how clearly Japan is surpassing or going to surpass the U.S. in computers, robotics, telecommunications, automobiles, trucks, ships, biotechnology and aerospace. 

Please understand, he was writing in 1987, when Japan Inc. was thought to be unbeatable, buying up property all over the world, technologically unstoppable.  He didn't know Japan would fall into an economic funk a mere two years later where Japan's economy wouldn't grow for the next 22 years (nor did he see the fall of the U.S.S.R. coming, and even seems to poo-poo the idea).  So much for Japan Inc. and extrapolation of the past.

But, really, how could anyone really think that Japan would surpass the U.S. in computers and software?  Or biotechnology and aerospace?  Yes, Japan has definitely done better in robotics, automobiles and ships, but to provide such a long and overwhelming list as a historian?  A bit naive, I think.

The consensus view on China reminds me in many ways of the view 20 years ago of Japan.  Don't get me wrong, Japan and China are very different stories, but people's perception seems to be similar. 

Just as China's centrally planned economy and "state capitalism" (an oxymoron if there ever was one) is seen as the wave of the future and a better way to govern, so Japan's Ministry for International Trade and Industry (MITI) and it's coordination of economic activity was seen as a huge advantage over the U.S.'s capitalism. 

Just as China's production of engineers and scientists is seen as an unstoppable force, so was Japan's.  Just as China's high research and development budget is seen as superior, so was Japan's.

Just as China's high national savings rate is seen as an advantage over the U.S.'s consumption, so was Japan's.  Just as China's superiority in aptitude tests is seen as intellectually over-powering the U.S.'s poor scores, so was Japan's.

I believe people make these extrapolations because they don't really understand the sources of growth.  They simply expect the recent past to keep going, but it almost never does.

Just as Japan's extraordinary growth came from adopting western technology and industry and having huge western markets to sell to, so does China's.  If either Japan or China had had to create these industries from scratch, as the U.K. and U.S. had done, the growth would never have materialized.  And, just as Japan's economy has demonstrated over the last 20 years, if China ever has to rely on it's own consumers and businessmen for innovation and growth, you'll see growth fall off a cliff.

Neither Japan nor China invented the Bessemer process, or assembly lines, or transistors, or binary computer logic, or almost any of the other major innovations which allowed them to grow.  They got it all from the west. 

And, this brings me back to my blog of two weeks ago, where I said that return on capital is the most important concept in finance.  You see, neither Japan nor China view return on capital as a primary concept.  Japanese businessmen are frequently on record saying that the U.S.'s focus on shareholder returns is ridiculous.  China is a communist state that sees returns on investment as a mere means to other ends.

The U.S. and U.K., at least during periods of innovation, let returns on capital as determined by individuals allocate resources, instead of some central planning bureaucracy.  The U.S. and U.K., thanks to intellectual greats like Adam Smith (a moral philosopher, not economist), recognized that human potential was unlocked when individuals were able to pursue their self-interest, as long as there was a rule of law and, specifically, protection of property rights.

Good luck finding that intellectual framework in Japan or China. 

In forecasting the future, this return on capital concept is vital to accuracy. 

If the U.S. abandons its focus on return on capital (as the U.K. has in most ways done), good-bye growth and innovation, good-bye technological and military superiority, good-bye world leadership. 

If Japan adopts a focus on return on capital at the individual level, which I believe is possible over time (perhaps in the next decade) welcome back growth and innovation. 

If China adopts a focus on return on capital at the level of the individual--an unlikely route, in my opinion--it can become a leading state.  Without that focus, growth will eventually crash and burn as it did in Japan (China is witnessing a boom in real estate, just as Japan did before its crash--coincidence?).

Forecasting China or U.S. over the next 30 years seems a bit silly without a focus on return on capital, but the consensus opinion is that it's a done deal--China will be supreme. 

I beg to differ because I don't believe large population, numbers of engineers, test scores or central planning are the lifeblood of growth, but the innovation of individuals who produce high returns on capital for their own benefit.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.