Aug 28, 2021 09:40 AM

Weekend Long Read: Talking Out the Implications of China’s Great Demographic Reversal

“The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival” by Charles Goodhart and Manoj Pradhan.
“The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival” by Charles Goodhart and Manoj Pradhan.

Editor’s note: A new book by two economists on how demographic trends impact the world economy was recently translated into Chinese by two central government financial officials. “The Great Demographic Reversal: Ageing Societies, Waning Inequality and an Inflation Revival,” published in 2020, was written by Charles Goodhart, a professor at the London School of Economics, and Manoj Pradhan, founder of Talking Heads Macro. It focuses on demographics and China’s participation in the global economy. The translators are Liao Min, vice minister of China’s Ministry of Finance, and Miao Yanliang, chief economist of the State Administration of Foreign Exchange. The following is a conversation that the authors and translators had with one another in April, which sheds light on details of the book, and provides a glimpse into how Chinese officials view some of the key economic challenges facing China.

Start of the book

Liao Min: First of all, I would say that both of us really like your book. The first question I would ask you is for what reason that both of you wrote this book. Because the mainstream thinking before this pandemic held that we were still in the process of a slow economic recovery — the interest rates would continue to decline, and everything would be the same for even the next five to 10 or, maybe 20 years.

Longread02_Liao Min

Liao Min, vice minister of China’s Ministry of Finance.

Charles Goodhart: Work on the book goes back quite a long time. We started it when we were both working together at Morgan Stanley in London.

Manoj Pradhan: The argument that was going around at that time was that interest rates would remain in place for a very long time. At that time, the 10-year and 20-year yields were mostly negative in the advanced economies. Both Charles and I were very uncomfortable with the notion that things would never change again, because they always do. Our argument was that markets, when they’re looking correctly at the cyclical movement — what they’re ignoring is that long term structural factors, which are part of the production function, are ready for a change.

It was a relatively easy point to say that the introduction of China and everyone else had helped inflation come down in the global economy, because at that point we had seen it for 30 years. At that point in time, I think the argument we made was, if demography is going to reverse, why would these trends remain in place?

That’s how the discussion started, and then it went on into how would we deal with debt? What about the example of Japan and all these related issues? By the time we got to the stage of submitting the paper to the Bank of International Settlement (BIS), we had already published a Morgan Stanley paper on demography and another paper on debt. It was a matter of bringing them together.

Goodhart: One of the chapters of which we are most proud is chapter four on the effects of the neurodegenerative diseases, and how this is going to make the aging society both more expensive for governments and more difficult to deal with, even more than we had thought before. This was partly as a result of personal experience. Both Manoj and myself, for family reasons, have had close contact with the problem of dementia. And I think that one of the points that we are proud of is such interdisciplinary connections, we have tried to connect our macroeconomic analysis to demography, and also to certain medical implications of aging.

Longread03_Charles Goodhart

Charles Goodhart, professor at the London School of Economics.

Liao: Professor, that’s the chapter I like most. As you said, it’s research across different lines of business. It’s a very strong and interesting argument, and allows us to think deeply about the situation. When I read chapter four, I think what has happened in China recently is another very good example. And your book makes us think how we can meet the challenges of the aging population swiftly. Because it is changing very fast.

From the one-child policy, we can now have more than two children. Unfortunately, the problems caused by the aging population, the medical, the health care… all such issues are happening in big cities in China. I would say that chapter is one of the best in this book. Of course, the main conclusion of the big reversal in the book is very strong.

Inflation after the pandemic

Liao: I would also like to talk a little bit about the chapter on China, on what’s happened recently, particularly after the pandemic. It seems to us in the financial market, the indicators tell us the inflation pressure actually is increasing. Some believe the age of inflation has arrived. But some people said this is a transitory phenomenon caused by the pandemic.

Without this pandemic, I think your conclusion in this book is still going to hold, but it won’t be proved so quickly. The pandemic proved your point. What’s your view about what’s happened recently, especially in the financial market and in the major economies, like in the US, particularly about interest rates and inflation.

Goodhart: The answer is that nobody really knows what’s going to happen in the next year or two, because we’ve never been in a situation like this, where we’ve had a very considerable degree of lockdown. Now we are coming out from that.

During that lockdown, a number of developments have occurred. People have increased their savings really very sharply, in part because they haven’t been able to spend. It has been forced savings. Nobody knows how much, and how far. Once normality returns, people will use their savings. The money supply has also gone up very sharply in most countries. In some countries like Japan and the U.S.A., it has been going up far faster than virtually ever before. We believe that means that there will be a bit of a blip in inflation in the year after normality returns.

The mainstream view is that everything will come back to much lower inflation, about 2% per annum, without any additional effort by the authorities. But we feel that the inflationary expectations will have shifted owing to the expansionary policies that have been adopted, particularly in the U.S., but also in other parts of the world, which will continue. And that labor will already be beginning to be in shorter supply; in the U.S. for example, the unemployment benefits are now so high that people are not prepared to accept low paying jobs, e.g. in services. They’d rather remain unemployed. In the U.K., a lot of the low paying jobs and services were done by immigrants, largely from Eastern Europe. A very large number of them have gone home. So for a variety of different reasons, we think that wages will start rising. And minimum wage rates have been rising quite sharply in many countries in the world. So we think that the recovery in the bargaining power of labor, in the strength of labor’s position, because the supply is going to be smaller relative to the demand, will have been brought forward, and that inflation will continue to be higher than most central banks now think.

Pradhan: If you look at the financial market side, I think markets were very reluctant to think about this last year — this is a globally synchronized story.

Longread04_Manoj Pradhan

Manoj Pradhan, founder of Talking Heads Macro.

During the great financial crisis, it was the opposite — an extremely asynchronized expansion: First, the U.S. and the U.K. had massive housing debt crisis. A few years after that, China’s slowdown began. About a year after that, Europe went into a crisis, then you had the “fragile five” countries (South Africa, Brazil, Turkey, India and Indonesia) in emerging markets. So even if you had 10 years of an expansion on paper, where global growth looks steady, every two or three years, there was a big shock. We never really got into a situation where we thought every economy is expending sustainably.

This time around, what we are looking at is the most synchronized expansion we will ever see in our lives. Every economy is growing. China and north Asia started in February 2020, and every advanced economy and even emerging market economy revived in June. After that, there have been some hiccups, some lockdowns again, but output has never gone back down to the level of February 2020. When everyone is growing at the same time, the chances of positive spillovers are significantly higher. If some economies have a problem at home, they can benefit from external demand.

The Federal Reserve continues its accommodation. Fiscal policies are being used heavily in the advanced economies and even in China. Most people who do analysis of countries are only used to looking at their own particular country and end up ignoring, or paying too little attention, to global effects. As we said in the book, most have paid lip service to the effect that China has had on the world. And similarly, I think they’re ignoring the effect of this massive global expansion that we’re seeing, even if one country is weak, when you put 150 of them together, it’s a very strong impact.

Liao: Some people will argue the arrival of inflation is not because of the long-term structural factors like the demographic change; it’s because of, as you said, a lot of synchronized money supply in a lot of major economies. How can you argue against this opinion?

China today still provides relatively cheap labor to the global market, particularly during this pandemic. The exports from China to the outside world increase substantially. That means these kinds of dynamics are still there. And then the inflation rate is actually rising faster than the demographic change. Some people would argue maybe that actually proves your argument is not so accurate — the inflation rate is the result of policy. It’s not because of the structural change. So how would you respond to that?

Goodhart: I think there’s a lot of truth in what you say.

Indeed, when we were writing this book in 2019, before we had any idea about Covid, we really did not know when the turnaround in these underlying demographic trends would have their main effect. And we didn’t really know to within plus or minus five years. We were fairly confident that unless there was a huge medical breakthrough or other major factors, the world would become more inflationary by 2030. But we weren’t at all confident when the turning point would be. What I think we’re arguing now is that these recent policy measures and the resulting synchronized upsurge are going to bring about an increase in inflation, and that once increased inflation takes hold, because of the underlying trends in demography, and in globalization, that turning point will come rather quicker than we previously appreciated.

Now, one of the things that we don’t know, is how far globalization is going to slow down, and maybe even reverse. We don’t know, in particular, how far the economic struggle between China and the U.S. will go, whether it will crimp China’s world exports, or not.

One of the things that we have noted is that the effect of Covid itself has led on many countries to a concern that really crucial industries, in particular pharmaceutical industries making vaccines, should be available within their own country. I think that the example of the crisis itself has meant that there will be pressures in many countries, in the euro area, in the U.S. as well, to ensure that certain industries are on shore. To take one particular example, I think there is a concern in the U.S. about the fact that China has a very large proportion of the available rare earths in the world. There will be a very considered and systematic attempt in the U.S. to discover and exploit rare earths in areas outside of China. That again is just one example. We do think that politics, for whatever reasons, is moving in a direction that is going to reduce globalization, which will, therefore, restrain the continued upward trend in China’s exports as a proportion of world exports.

Measuring China’s impact

Pradhan: China’s impact on the world is measured in ways that heavily understate its true impact.

For example, the Federal Reserve and investment bankers look at China’s impact on import prices. They look at the share of Chinese imports and its current account. Or they look at how China’s imported goods have affected inflation. But that is not enough. Because in other ways, China has been huge dampener on inflation.

I think the problem is that we are talking about technological transformation. If you think about China, China has undergone the biggest technological transformation on the entire planet. Because in 1979, when China started opening up, it had no capital stock at all. The good news is that when you have nothing in capital stock, everything that comes into the economy is new. If you take the subway in New York or London right now, they are very difficult to maintain, because they were built more than 100 years ago. What happens in China is that when you build a new railroad system, it’s brand new.

So you take the latest technology and it’s much easier to innovate on that. Now you add to that a very cheap source of labor relative to world standards and one that has knowledge embedded in it for centuries. So it is China’s technological transformation, combined with cheap and skilled labor, that has affected advanced economies by putting pressure on other industries.

As Charles says, the problem with wages is that the threat of offshore to China is what kept wages low. But we cannot measure that in an economic system. If we are right, then most of that pressure is in the past, and that means our story of the future is still valid.

And the exports you mentioned, they are part of the Covid economy. We are consuming primarily manufactured goods, deliveries and takeaways. North Asia is the place on the planet to go to for all these things, which is why exports have been so strong. When the world normalizes a little bit more, that export growth will slow down. In fact, China itself does not want to be an export-dependent economy. It wants to be a domestically sustained economy, so I think the emphasis will move away from that.

The second point I will make is drawing from Charles’ experience. He was talking about his experience when he was with the Bank of England. After the 1980s, when the initial fight with inflation was won, central banks didn’t really have to aggressively fight inflation year after year to bring it down. It just kept falling almost by itself.

One of the proofs that our thesis is working will be if inflation starts becoming harder and harder to fight, reversing the story of the last 30 to 35 years.

Finally, and very simply, central banks will find it increasingly hard to fight inflation for two reasons. First, because inflation will be the result of the structural and global forces of demography. Second, governments will not approve of rising interest rates because it hampers growth and gets in the way of the government’s reelection chances.

Liao: I fully agree. Because now a lot of other economic reasons also play a role on the global stage — technology, competition, geographic and political pressure — we are moving into uncharted water for globalization.

According to your argument in the book, at least, this is a very strong explanation for the past 30 or 40 years. As you said China is moving onto the global stage and brings with it a huge amount of cheap labor — a clearly deflationary scenario.

I’m quite confident this kind of factor is going to play its role in the future. It may not give a 100% explanation for the future, but when we think about what will happen next, we need to bear in mind the importance of demographics. And also, very importantly, as I said at the very beginning, not only in the developed country like the US and Europe and Japan, but also in China, we faced huge demographic pressure.

We spend a lot of time thinking about how to make sure we are not going to face big problems caused by the aging population, because that’s a huge impact upon our productivity and economic growth. Therefore, I would say, this is a very strong book. We need to learn more from Professor Goodhart. He is always riding the wave.

Impact of labor

Miao Yanliang: I must admit that when Mr. Liao asked me to translate the book with him, I had some disagreements with the views expressed in it. I’m a mainstream economist who believes in low interest rates and low inflation. But the more I read it, the more I find myself becoming convinced. So before I become a full convert, I have a few questions.

Number one, the book puts population front and center of the argument, in explaining two very important macro-economic variables – inflation and real rate. Traditionally, as we learn in textbooks, there’re three things that comprise production: technology, capital, and labor. And labor in most cases is just a footnote, for instance in a typical Solow model. The equilibrium for GDP growth, for per capital labor, for per capita capital, doesn’t change with labor growth. In the equilibrium, labor has no role. What’s driving the business cycle? What’s driving potential growth? It’s all about technology and capital. These are the two factors that people rightfully focus on. So the question is why population and why now?

I think in the book you argue that a great reversal of demography is actually two things, not just demographics, but also a reversal of globalization. These two forces have come together in China. Now, the two forces seem to be in reverse. And, if I think about this, you also mentioned capital: China’s capital increase and technological progress. But if I look at now, China’s dependency ratio really shifted 10 years ago – 2010 was the turning point. What makes you think the turning point is now? I’m still questioning why we put population center and front, which traditional macro textbook never did.

Longread05_Miao Yanliang

Miao Yanliang, chief economist of the State Administration of Foreign Exchange.

Goodhart: I think that the textbooks were wrong to ignore shifts in the supply of labor.

The supply of labor in the world has been changing really quite dramatically over the last 30 years. It is now going to change again.

You ask why the turning point is now? It’s because these trends have very slow-moving effects on wages. It takes a long time. One of the other factors has been the decline in women’s fertility, the birth rate, interacting with the availability of consumer durables, such as refrigerators and washing machines. This means that those of working age population, half of them, almost all the women until the 1950s, worked at home and didn’t add to GDP. Now, female participation in the workplace, the proportion of women joining the workforce, has increased dramatically over the last four or five decades.

If you combine China’s economic surge, globalization generally, and the increase in the proportion of women working outside the home, I think it has been a tremendously important underlying factor. One of the problems is that these trends have occurred so slowly and smoothly, that if you’re only looking two years ahead — and most macro-economic forecasts only looks two years ahead — you can ignore it because it’s roughly equivalent to a fixed factor. But if you’re looking 10 years ahead, you can’t ignore it. Now, because of the momentum involved in these underlying global changes, it’s always going to take a long time before the turning point leads to a significant change in the underlying relationship between capital and labor.

The Covid crisis has been a major crisis, leading to major policy changes throughout. And that is going to bring about an acceleration of the effect of these longer-term underlying changes.

Pradhan: One of the key differences between emerging and advanced economies is that labor is cheap in emerging markets and capital is cheap in the advanced economies on a relative basis. How do emerging markets accumulate capital? They accumulate capital by distorting the price of capital. And it typically happens in surges.

In China, for example, the impossible trinity was broken by stopping capital flows, that allowed monetary policy to have independence, and control the exchange rate too. This kind of a surge is particularly potent when demography is improving in the background.

The second point I would make is if you read our China chapter, you will see that the first line asks whether China led to globalization or if globalization led to the emergence of China. We honestly don’t know the answer. But one of the reasons that labor has not attracted the amount of attention that it should have over the last 30 years or so, is that you’ve had a real confluence or mix of the two. People can’t tell whether we should call it a China labor shock, or a globalization shock. They’ve both meant more or less the same thing.

And finally, there’s a global change in aging. The Scandinavians are aging, America is aging. Europe is aging very rapidly. North Asia is aging, and Eastern Europe is aging. There’s almost no part of the global economy where there is a demographic dividend. And as Charles says, the textbooks will change.

Miao: If you think about the long-term issues, the demographic factor does have a more important role, and then it appears in the economic model. Just now you mentioned aging globally. One of the main arguments in the book about rising inflation is that the dependency ratio will increase because of aging – in the book it says too many mouths will be chasing too little food. As economists, we know that too much money will be chasing too few goods. We never thought about inflation this way. Then it seems very intuitive. The way you said working is deflationary because you must produce more than you consume. It’s very intuitive. However, in textbooks or in models, nobody thinks this way.

Technology vs. demographic changes

Miao: But I want to present a counter argument, using the case of agriculture. Less and less people work in agriculture. Yet, we have no problem in ensuring food supply for over 7 billion people and there is simply no inflation there. In a way, it shows that technology plays a major role in reducing the amount of labor needed to produce something. If you believe the population is driving inflation, aren’t you implicitly saying technology is not changing fast enough, or even that it is taking a backseat? Otherwise, you cannot reconcile this with what has happened in agriculture, right?

Goodhart: Yes, I agree. We are not, and have not attempted to be, experts in what is likely to happen in technology. It is possible that technology could advance hugely, raising productivity enormously. Much of the problems that we see could go away.

But equally, there are people, Bob Gordon for example, who have argued that all the low hanging fruits and the easiest technological advances with the most direct and most obvious economic effects have already been undertaken. And there’s a huge debate among those dealing with technology as to whether technology will slow down or speed up. We don’t claim to have any particular expertise on this. Our thesis is not an entirely optimistic one, but there are certain aspects that could be advantageous, greater equality within countries, for example.

And there are certain reasons why our thesis could be wrong. For example, it would be wonderful if medical science came up with a cure for the neurodegenerative diseases. It would mean there would be far fewer people having to look after the old; old age would be much more pleasant and much less of a burden for the state. It is possible that medicine could deal with some of the problems. I think what we’re trying to say is that there are good, coherent reasons for believing that life may become more difficult with slower growth.

Pradhan: First, our main thesis is that actually we need technology. You mentioned agriculture. The same thing has happened in manufacturing.

China’s share of global exports has increased tremendously, but that did not create a decline in growth. What it did was to shift the composition of growth. The U.S. has become more consumption oriented. China was very investment oriented.

Those trends are changing again. Now China wants more consumption. The U.S. will have to deliver more investment if it wants to keep growth steady, and that will mean more technology adoption.

Second, there are some people in every sector who find technology is good for them, and gives them better salaries. Then there are others who find that technology is bad for them, because it replaces their jobs. The services sector, especially the task of looking after the elderly in a direct or indirect way, is different because this is something that robots and automation are less suited to. Every person is different even if the task is the same, and those with neurodegenerative diseases may not be able to perform the same task the same way every time. We need people.

However, if immigration is not really an option because of politics, then we need to divert those people from other parts of the economy. So we need technology to destroy other jobs that are repetitive in other parts of the economy. The services sector is thus a little less open to the kind of agricultural transformation you talked about, because it’s not a repetitive set of tasks. It’s not something that is seasonal, it’s not something that can be programmed.

Japan had one hotel that was fully robotized. It opened about three years ago, and in the last three years, 50% of the robots have been fired and replaced by humans, because they cannot change their programming to be flexible enough. Now that could also change, but will it happen quickly enough? People talk about driverless cars as if every car is going to be driverless in the next five years. It will probably take much longer than that. And by that time, we’ll have many more older people, and the equation will look very different.


Residents line up to collect their unemployment compensation in Huaian, East China’s Jiangsu province, in December 2020. Photo: VCG

Miao: If I understand you correctly, basically you are saying that with this demographic shift, there is going to be a huge demand for labor, even if technology can help on manufacturing or agriculture front, it cannot really help as it previously did on the services front, especially age-related services.

Pradhan: That’s exactly right.

Liao: When I read this book, one impression I got is — globalization or the global economy is a complicated system, so the capital, technology, labor — every factor is going to play its role. But how can you identify one factor according to your logic? That’s what the book actually tells to me, to think about this big issue in the long run, but in a very simple way and with a very clear logic.

Of course, you can’t say that one factor is going to replace all the factors or other factors. We don’t have this kind of ambition, and it’s actually far away from the reality. But I would say, this book provides a very strong argument. And we must remember that the factors actually play a very important role in the long run, and have always been underestimated by economists.

Aging, savings and real interest rate

Miao: I do have one more question which I think the mainstream economists put a lot of thinking into it, but they reach different conclusions from yours. It’s the impact of population aging on savings and demand of funds.

For the impact on savings, you said that when you have aging, there are lower savings. But recently, more and more people are doubting that, saying aging might actually increase savings.

If you look at Europe, because life expectancy has increased a lot, so a person has much longer time to live from the day of retirement than before. People have to save a lot more and the savings ratio is actually on the rise.

Even if we take a step back and say, indeed, less people are working, so savings ratio may come down, and with it the savings come down. Then you have to look at demand side as well. On demand side, in the book, you argue that because people are less willing to move, so the demand for housing will be there. I found this one particularly perplexing in the sense that in normal cases, people in the U.S., when they have kids, they live in a single-family house. After retirement you move to a two-bedroom apartment. And then maybe later on, you may even move to a care center. So with aging, the housing demand and the investment demand comes down.

But the book argues exactly the opposite. Because this is how you derive the conclusion that the real rate will go up. I think it’s important that we have to address these concerns, even if you agree that savings come down, but many people believe that savings actually go up. And even if savings come down, demand can come down even faster, which will still give you a lower real rate instead of a higher real rate.

Goodhart: Different countries with varying cultures would differ.

Perhaps my experience in the U.K. may have been a bit particular, but the tendency is for old people to want to stay in the same house, even when their children have left, because moving is painful, and really quite difficult, up to the end, when one probably has got to go off to a care home. But with the increase in life expectancy, the period of time in which the allocation of room space is very strongly misallocated will be extended, because the old will be living in a house which was probably initially large enough for their children to live in as well. They’ll go on living there when their children have left for quite a long time. A considerable misallocation of floor space is likely to occur.

There’s another consideration as well, one of the points that we make in the book, which I think demography experts have taken on board, but economists have not. It is that the age of marriage and having a first child is trending up very sharply.

In the past, people would marry in their early 20s, and have their children usually by the time they were 30, who probably would have left home by the time that they were 50. They would then have 15 years unencumbered, their most productive years, to save. Now the age of marriage is going up, the age of having the first child is rising. A lot of people don’t finish having their family until they’re in the 40s now; that means that the number of years when you can stay without having responsibility for children and so on is declining. And the years in which you have least other family responsibilities are now roughly from 18 to 30. When you’re a 25-year old, you rarely appreciate the fact that you’re likely to live to 85 or more, that you will have 17 or 18 years of retirement. You ought to start saving for your retirement then. The only thing you think about when you are young is actually to get a house which leads to quite a lot of saving. There is quite a lot of saving for housing, but that effectively is it. The young will not be saving sufficiently, because it’s very hard when you’re 20 years old to envisage what life is going to be like when you get into your retirement age. The subjective discount rate is actually quite high.


Senior citizens hang out at a park in 2016 in Qingdao, East China’s Shandong province. Photo: VCG

Pradhan: In our book, we are very clear that we have higher conviction on rising inflation than we have about a shift upward in the equilibrium real interest rate. Because, as you say, the problem is that savings and investment are both moving in the same direction, and so you’re making a call on which one is moving by more. If savings are falling by more than investment, real interest rates will rise. If investment is falling by more, then real interest rate will fall. So it’s difficult to have as much conviction.

The path of inflation is much clearer. Let’s say we go with the conventional thesis. Let’s say the equilibrium real interest rate remains flat. The conventional wisdom is we are in a disinflationary environment, so real interest rates are going to rise because of falling inflation. We are saying the opposite. Even if the equilibrium real interest rate remains flat, the rising inflation is going to push real interest rates lower.

On top of that, we’re saying that there is a tendency for the equilibrium real interest rate to even rise by itself, which means you get slightly higher real interest rates, along with higher inflation, which means nominal yields could really rise by a lot. That’s the critical part.

Having made that point, I’ll add that housing is a very complex problem. The elderlies don’t like to leave their homes as they grow old. But many ageing families also want to be close to medical facilities and that tends to pull them toward urban areas — just look at the empty towns and villages in Italy. Finally, if the elderlies stay in their homes, then younger families in urban areas will need new housing to move into. Overall, it seems to us that the demand for housing is going to remain quite solid, while savings continue to fall. The result should be upward pressure on real interest rates.

Liao: In terms of what’s happened in China recently, as you said, a lot of people want to move into big cities, but also a lot of people in the big cities want to move outside the cities into the rural areas to have a larger house. This will have some impact on the demand for houses.

Pradhan: That echoes with some of the trends in advanced economies. There are a lot of people who are looking for a second home. Overall, however, housing remains a very complex problem. I think Charles is generally right. My father does not want to leave his room. No matter how beautiful the rest of the world is, he wants to stay where he is. It’s a complex story. We don’t pretend to have all parts of it accounted for.

Globalization and what changed China’s focus on consumption

Liao: I want to discuss a specific case about China from the book.

First of all, I like your historical analysis of the China story. You mentioned the three acts actually shaping the global economy and also the Chinese economy. That’s very impressive. But one thing I want to ask you, because the Chinese story hasn’t ended, we will continue to develop and to try to embrace globalization. But given such volatility in the outside world, do you have any specific suggestions for the Chinese government based on the conclusion of your book?


A freighter leaves the Haikou Port Container Terminal in South China’s Hainan province in May 2021. Photo: VCG

Pradhan: If you asked me this question five years back, the situation was very different. Because five years ago, I think the conventional wisdom within China seemed to be still that China can get back to growth rates of 8% and 9%. And that was a very dangerous line of thinking. Because that meant that policymakers would keep trying to revive the old model of growth and keep trying to do things that were going to make matters even worse in the future. But that has changed.

Since 2015-2016, I think there’s been a dramatic change in the outlook for the Chinese government and policymakers. They understand fully well that the old model of growth needs to be discarded. Steel capacity has been destroyed and state-owned enterprises (SOEs) are not seen to be the key drivers of future growth. The search for a new model of growth is still ongoing. In fact, my personal view is that the trade war between China and the U.S. has actually been pretty good for China. Because even when the trade war was launched, China was very complacent about its model of growth. There is a chart in the chapter in our book on China which suggests that China looked like it was going down the path of Japan as it tried to become more consumption-oriented.

In Japan, it happened because investment was just stifled after the excess investment in previous decades. So Japan became consumption-oriented in a mathematical, passive way — in the sense that consumption became a larger share of GDP, but consumption growth remained very low. That was the danger that I think China was facing.

However, the trade war has changed things, and I think it has had an unexpected benefit for China because it has been forced to consider other models of growth, not just rely on consumption (which I think would have ended badly in disappointment).

For example, the shock to the semiconductor outlook has changed so much that both the U.S. and China want to be relatively self-dependent. That’s not necessarily a bad thing, because China has been forced to look at the future in a more inward looking way and allocate a smaller quantity of capital towards projects that will protect future growth. I think the biggest challenge is how to get away from the problems of the past — the debt that remains on the books from the SOEs and banks. If that debt can’t be written down or converted into equity, then you can’t lend to other people. If you do write it down, however, you have to recapitalize banks. No one wants to recognize the problem, because it means everyone’s balance sheet looks weaker.

For the future, the key bit of focus I would recommend in addition to social housing, is to have a long and careful look at the (senior) care system. Governments all over the world have paid too little attention to the future needs of the elderly. The more you incentivize the growth of workers to look after the elderly or systems that will look after the elderly, the less your pressures will be in the future. That’s something that needs to be given much more importance in policy circles, particularly in China.

Liao: That’s important to the world, too, not just China. And no society, in my view, has done things up to speed with how you cope with a world of severe aging. I think it just hasn’t been thought about anywhere in sufficient depth.


A senior citizen walks with her dog in Japan. Photo: VCG

Goodhart: Yes, that’s a very good point. I fully agree that the aging population issue hasn’t been paid enough attention to. And our societies are not prepared for that kind of change. As I said at the very beginning, the Chinese government now pays quite a lot of attention to this, but I think it’s very difficult to turn around because this is a long-term problem. If you want to develop the social care system, the social security system, the health care system industry, it is not so easy. You have to spend a lot of time and a lot of effort on that.

Liao: The book already gives us a kind of alarming view in this regard. I would say when this book gets published in China, a lot of people will pay attention to it because China has 1.4 billion people, and democratic change issues are always the No. 1 issue. The only problem is, we have actually neglected this problem for quite a long time. We enjoyed the population dividend for quite a long time. But that has changed and we need to pay back.

China’s debt issue

Liao: There is one issue I want to discuss with the two of you.

In your book, there’s a discussion about the Chinese leverage ratio and debt issue. You said because both sides of the leverage are on the same balance sheet, the debt issue is not a big issue in China— all the liabilities and assets are owned by the government. Things should be fine.

I would say, as Manoj just said, the debt issue is a problem. Because a lot of people in China argue that yes we have this huge debt, but we also have a huge accumulation of assets. However, the assets cannot generate profit or cash flow in the future, it’s going to hurt you badly because you owe a lot of money to other people. Your assets just cannot generate the sufficient profit to let you pay back the debt. Therefore, this is something China needs to pay quite a bit of attention to.

Pradhan: You are 100% right. There’s nothing at all wrong with your reasoning. But what we are pointing out in there is a policy choice. The policy choice is that if you choose to take care of debt by writing it one side off against the other, the price that you pay is that you cannot then accumulate future credit.

In the paragraphs following the discussion on debt, we say that the price of this strategy is that consumer led growth cannot be credit driven. Because, as you digest capital losses from past capital misallocation, you can’t then have enough new capital to create new credit growth. If the choice becomes that you want fresh credit growth, then you cannot continue with the present strategy.

The present strategy in China seems to say “I am happy with lower growth.” China simply wants to digest the debt in a way that does not create more problems. If the strategy is to create new assets and generate growth at a rapid pace, then clearly something needs to change. But as long as this stronger growth strategy is not the priority, and China is willing to accept a lower level of growth in return for controlling debt, then I think we are at a sustainable equilibrium.

China’s labor market

Liao: Another issue is —as you said — in both Japan and China, the labor market is incapable of acting as shock absorber.


A woman labors in a garment factory in Huaibei, East China’s Anhui province. Photo: VCG

In Japan, this is because of the longstanding cultural elements. In China, it’s because of social stability reasons – China doesn’t want to lay off workers. Actually, my personal view is slightly different. Over the past 30 or 40 years, China has had huge success. But along the way, actually, we laid off huge numbers of SOE workers in the 1980s or early 90s. A lot of people lost their jobs. SOEs, commercial SOEs, and also the commercial banks and major SOE banks laid off a lot of people.

What I’m trying to say is, we did not lay off people at the same pace as a western country, like what’s happened during this pandemic. In an advanced economy, like the U.S. or in Europe, they just laid off the pilots, laid off the workers in different industries because of impact of the pandemic. But in China, they continue to stay with the company or with the enterprise, instead of being laid off.

In terms of the market economy analysis, suggestion or conclusion, I would say maybe we need to be a little bit more careful. Because you already said at the very beginning about China, the three acts, the reforms in China are the most important experiences we have. That’s the secret of the Chinese success story. If people who read this book think about the labor market, their impression will maybe weaken your argument at the very beginning.

Today, in terms of the private sector, the role played by them in employment, in productivity, in taxes, in every aspect — they play a much more important role than SOEs. Before 1979, 100% was the planned economy, but now we have changed a lot — that’s the same logic in this book in the first part about China.

Pradhan: This one is a very easy one to reconcile. We would have enjoyed much more of these conversations when we wrote the book. It is clear that the role of the private sector in China has increased tremendously. Most of the employment comes from there. In fact, if you look at China’s policy during the pandemic, it has to be more fiscal, not monetary, because monetary policy is very good at funding large banks, local governments and big enterprises, but 70% of employment in China comes from small and medium enterprises which are private, and fiscal injections were the only ones that could make their way to such institutions.

The comparison between China and Japan is relevant, because most of the misallocation has been done by China’s SOEs. The private sector has not misallocated so much. The private sector doesn’t have as aggressive a need to make layoffs. The misallocation from the 80s and the 90s was cleared using the experiment of asset management companies. That approach was given a much smaller role this time. The idea was not to take a shock approach to banks and shock the banks’ balance sheets via the creation of ‘good’ and ‘bad’ assets, but to absorb capital allocation from the past in two ways: through some asset management companies and through debt-for-equity swaps. On the physical side, much of the excess capacity (for example, in the steel sector) was just shut down. That’s not something you can do with labor. But because the excesses were with the SOEs, there was a flexible approach to dealing with excess labor, as it was slowly allowed to move into cities and into private enterprises.

Your comments help make the story consistent. It’s really good.

Liao: It’s a very interesting discussion and very thoughtful. Demographic change is a big challenge, and a quite sensitive one. We will do it gradually and need to come up with a kind of a policy that can give people incentives — make all these people happy to work a little longer.

For instance, one policy choice would be let (workers) get a sort of retirement package. But at the same time, they can earn some extra money when they work for society. Some people suggest we can just give them a kind of exemption to the income tax, let them work a little longer and make some contribution to society. In terms of the health care system, that’s the big challenge — particularly during this pandemic, when all hospitals have been tested heavily.

I do hope Chinese readers of your book can come up with some new ideas, help us to deal with the demographic problems and debt problems, or reform and opening up. Thank you so much.

Charles Goodhart is a professor at the London School of Economics; Manoj Pradhan is a founder of Talking Heads Macro; Liao Min is vice minister of China’s Ministry of Finance; and Miao Yanliang is chief economist at the State Administration of Foreign Exchange.

Contact editor Michael Bellart (

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