This is a solid piece of scholarship, in which Lardy seriously examines the challenges facing the authorities in China. After the catastrophic collapse of asset prices in OECD nations, and its negative income effect, China was still reliant on its large but potentially endangered current account balance as the primary engine of economic growth (1). Despite excellent and well-executed fiscal strategies for responding to the GFC-2008, Lardy observes that the PRC's growth strategy is imbalanced and unsustainable.
First, it is universally acknowledged that China requires massive job creation.
Second: the saving rate actually rose sharply after 2001 in response to a decline in real rates of return for household deposits. In other words, Chinese households save a lot under economic necessity, and as the negative returns on deposits rose to over 6%, the rate of income saved rose to 50% of average household income. Saving is high because there is practically no social insurance (2).
This sounds virtuous, but it is unsustainable and immiserating. Requiring persistently high rates of GDP growth in order that the bottom 80% of households can barely stay alive, is a very poor economic model. Moreover, it depends on the renminbi (yuan) remaining at a very low rate of exchange, something which could end very abruptly.
Third, and most obviously, the Chinese economy relies on very high exports. The cheap yuan means imports like electrical machinery and equipment, fuel, power generation equipment, and metal ores are more expensive per unit of Chinese production. This is good for the seven coastal provinces that produce most of the trade surplus, since they, too, enjoy advantageous terms of trade with the rest of China; but for the rest of China, the cheap yuan is yet another transfer of wealth to the rich coastal cities. This thwarts political unity and eventually is going to cripple further economic growth.
Finally, a strategy of trade surplus-driven GDP growth leads to a waste of scarce resources on producing goods for export, without compensating imports. A growing economy needs more, but in this case makes do with less; in 2007, for example, China exported 36% of its GDP and imported only 26%. This imposes a need to ration not only consumer goods, but producer goods as well.
Lardy points out that China's trade surplus is not necessary to provide jobs (p.140); the sort of industrial policy used by China means an excessive investment in capital intensive enterprises. Producing autos for export to Europe ties up a lot more capital investment per worker (or per yuan of payroll) than domestic construction, or domestic services like education (3).
Rebalancing would require allowing the yuan to rise to a realistic exchange rate (4). Increased government expenditures, including possibly a period of deficits as the PRC rebuilt its desiccated social services, would provide adequate demand while China's industrial system rebalanced. Understandably, Lardy does not insist on the Chinese authorities privatizing the state-owned enterprises (SOEs), since efforts to do this have been a flashpoint in Chinese politics since the 1980s (and--given prior experience--SOE privatization is unlikely to affect the desirability of China as an investment destination), but he does think SOEs ought to be more financially accountable to their owner (p.72).
Lardy's understanding of the dilemmas faced by the Chinese economic managers seems very advanced; he is very nuanced and serious, and this is not a polemical book. Many of the recommendations are already being implemented, but not forcefully enough.
Where the book disappoints is Lardy's expectation that rebalancing--an extremely major shift in China's industrial development policies--will be desirable to the Chinese. For millions of Chinese workers, such a shift would lead to a greater share in the national product; social injustice could be tackled; and China could be freed from the risks of a global downturn. However, the Chinese economy would accomplish all this by pulling away from cutting edge technologies. In other words, today China possess the technical capacity to achieve almost anything the West can, albeit on a very limited scale. It can explore space, but millions of its rural poor are trapped in the Middle Ages. It's very sensible to recommend that a developmentalist state invest in the medieval peasants, instead of moving ahead to create a lunar base. But this is a choice countries never make, and I think the reason is pretty easy to see.
Partly it's that technological achievement is not hydraulic: ideally, a country could develop so that every family lived in about the same level of well-being. Instead, it's impossible to diffuse industrial activity evenly. The Chinese actually have tried to do this harder than anyone else, with disastrous results. And anyway, no one wants to abandon the commanding heights of the global economy, in the hopes of reducing the Gini coefficient.
The other point is that Lardy believes "the market" will find a satisfactory equilibrium, and people who are used to managing a reforming economy know that never happens. Why, is the subject of another book.
UPDATED (12 April 2013): Readers need to be advised that this book is published by the Peter G. Peterson Institute for International Economics (IIE), a "thinktank" founded by a leading PE tycoon (and former Secretary of Commerce under President Nixon). Peterson founded the eponymous institute to promote state austerity in public policy and has recruited some fairly prominent people to lend it respectability. Many readers of this review may approve of the IIE's ideological agenda, but it needs to be known in advance.
It's not clear to me what the IIE hoped to accomplish by publishing this book, although possibly it's attempting to push a new buzzword for austerity. I have not taken away any stars because of the author's association with a propaganda vehicle because I did not detect any propaganda, but that doesn't mean it's not there.
(1) Current account balance: annual rate of increase in financial claims against foreign nationals by the citizens of a country; includes the sum of the trade surplus, net foreign aid, and net foreign factor income, i.e., income from investments abroad minus outflow of earnings from investments held by foreigners. A large current account surplus tends to increase the size of the monetary base.
China's authorities have sterilized the influx of dollars, meaning they have adopted policies that reduce the amount of new deposits the banking system generates from the new reserves. For the consequences of unsterilized foreign reserves--from the point of view of the Chinese CCP--please see Victor C Shih (2008), or my review of same.
(2) The relation between saving and social insurance is complex. China's lack of basic income security has led to a high savings rate, but France has a very high rate compared to other developed countries (17%). The USA has a very poor social insurance system and almost no net saving at all.
(3) According to Huang Yasheng (2008), China's underinvestment in education has led to a huge increase in illiteracy, as well as a disastrous decline in other services.
(4) According to the IMF, this would be RMB 4.28 per US dollar, instead of the current RMB 6.21. See 2012 World Economic Outlook Database, purchasing power parities data. For the record, currencies hardly ever have an exchange rate commensurate with their purchasing power parity. For instance, 22 Indian rupees in India buy as much as $1 US buys in the USA, but the exchange rate is INR 54 to the dollar. The Australian dollar is thought to have PPP of $0.642 US, but costs $1.041 US on international markets--a markup of 62%. Estimates of PPPs come from the World Economic Outlook Database of the IMF. Values for forex rates were as of 30 March 2013.