China is reverting to the mean, predictably so

A photo of one of China's ghost cities, from the Daily Mail.

Lately, China's economics growth figures have disappointed to the downside. To many observers, this wasn't a surprise. A reversion to the mean was bound to happen, as described by Lant Pritchett and Lawrence Summers in Asiaphoria Meet Regerssion to the Mean:

However, predicting future levels of output by the extrapolating the current growth rate into even the near, much less the distant, future is on very weak scientific footing. The single most robust and striking fact about cross-national growth rates is regression to the mean. There is very little persistence in country growth rates over time and hence current growth has very little predictive power for future growth. Hence, while it might be the case that China continues for another two decades at 9 percent per capita growth, given the regression to the mean present in the cross-national data this would be a 3 standard error anomaly. - (this and following emphasis mine)

So it is not at all surprising that China failed to achieve its 7,5% target rate of growth. Indeed GDP growth in China has been falling for several years. It is surprising that China managed to keep such a high rate of growth for so long*.

China has had growth rates of over 6 ppa for 33 years starting in 1977 and this data set ends in 2010. - (that's 37 years if the figures were updated to include 2010-14)

But rare is this so-called super-rapid growth?

First, episodes of super-rapid (>6 ppa) growth tend to be extremely short-lived. The method of dating growth episodes doesn’t allow an episode of less than 8 years. The median duration of a super-rapid growth episode is 9 years, only one year longer than its possible minimum. There are essentially only two countries with episodes even approaching China’s current duration. Taiwan had a growth episode from 1962 to 1994 of 6.77 ppa (decelerating to 3.48 from 1992 to 2010). Korea had an acceleration in 1962 to 1982 followed by an acceleration in 1982 until 1991 when growth decelerated to 4.48 ppa so a total of 29 years of super-rapid growth (followed by rapid growth).  So China already holds the distinction of being the only country, quite possibly in the history of mankind but certainly in the data, to have sustained an episode of super-rapid growth for more than 32 years.

Reversion to the mean, by definition, means that the longer something deviates from the mean, the higher the probability of it reverting back to the mean. Betting against China hasn't been a profitable bet for the last 30 years*, but it might change. How far down might a reversion to the mean take China's GDP growth? Based on historical figures, the authors offer this:

Third, the typical (median) end of an episode of super-rapid growth is near complete regression to the mean. The median growth of the episode that follows an episode of super-rapid growth is 2.1 ppa. So the “unconditional” expectation (or central tendency) of what will happen following an episode of rapid growth is a reversion to not just somewhat slower growth but massive deceleration of 4.65 points (more than twice the cross-national standard deviation).  A deceleration of that magnitude takes growth in India from 6.29 to 1.64 and in China from 8.63 to 3.98.   

A slowdown in overall growth is bound to affect some sectors more than others. Investment (think housing, infrastructure and manufacturing capacity) in particular will take a beating. Investment as a share of the economy has reached 50% and most of it was financed with debt. The overall debt-to-GDP ratio went from 153% in 2008 to 243% in 2014 (see this and this). Debt has grown faster than debt servicing capacity and this is bound to end up in tears for investors, as it already has for investors in some of China's ghost cities. Empty apartment buildings, nearly empty high-speed trains and shopping centers only mean one thing - no revenue, thus nothing to service debts with. China's banking system is intoxicated with bad debt and up to a point it was manageable by simply refinancing the old loans. Every speculative bubble finds its limit and looks like China has met its limit at the 240% debt-to-GDP mark. 

Without substantial growth in I, G or NX, the growth has to come from somewhere else. More on that in my next post.

*There is evidence that China has been manipulating inflation, income and spending statistics, see this and this. But even if we assume a quarter or even half of the GDP growth is fake, the China's growth is still unprecedented. Some have pointed to the quality of leadership in China, or the extensive industrialization (China was a rural economy before the 70s), or the size of China which allowed them maintain a high rate of growth by pumping money into less-developed regions as wealthier regions slowed down, or the quality and efficiency improvements of their manufacturing. A plethora of explanations have been offered, but the persistence of super-rapid growth remains a mystery.

Jevons paradox

Photo from Pixabay (CC licence)

Economics is sometimes defined as the study of how society allocates scarce resources. Technological improvement is the means by which resources are put to better uses to produce more goods at cheaper prices. Theoretically, improving the efficiency of a resource-consuming activity would lead to a decrease in the amount of that resource being used. Or so you would think. In practice, the theory is of very little help as it only explains first round effects.

In 1865, the English economist William Stanley Jevons observed that technological improvements that increased the efficiency of coal-use led to the increased consumption of coal in a wide range of industries. He argued that, contrary to common intuition, technological progress could not be relied upon to reduce fuel consumption. - all excerpts from Wikipedia

The very first steam engines were used to pump water out of mines, thus allowing the miners to deeper and access more coal. An improvement that would increase the engine's output would allow the miners to go even deeper or to build a smaller, less costly, engine. This improvement in efficiency would be of great advantage to the owners of the mine who would now have a cost advantage. It would mean more output and/or lower prices for coal, compared to their competitors, of course. The engine itself would consume less coal per ton of water displaced, which, as put forward by the theory, should decrease the use of coal (as far as production remained roughly the same). Alas, it is only at that particular mine that we might witness an decrease in the use of coal.

It is not long before second round effects start having an impact. Businesses that couldn't afford a steam engine when it was first introduced might now want to take a second look. Low-lying areas that had more water to pump out but also distant mines where coal mining would be profitable were it not for the high transport costs can both benefit from a cheaper and more efficient steam engine. As a result, more steam engines are built necessitating the use of more coal to keep them running. Further improvements in size, output and weight would herald the rise of the factory and the steam locomotive. All of this is to say that an improvement in efficiency will drive down the relative cost of using that technology, which will increase the demand for that technology. 

The Jevons paradox will trump all efforts at efficiency and conservation. A cheap, fuel efficient car will have a larger impact on overall fuel usage (and pollution) than a big, gas-guzzling SUV simply because it is more affordable and several times more units will be sold. The Tata Nano is a great example - its initial $1'600 price brought tens of thousand of new drivers on the road, drivers that used very little if any fuel before the car was introduced. It is virtually impossible to escape the paradox. Recent improvement in LED technology have made screens so cheap and energy efficient that they even show up at fast food restaurants in place of printed menus. Instead of reducing energy use, as was once thought, improvements in LED affordability and efficiency are now having the opposite effect. The same goes for household appliances, electronics, basically anything you can think of.

The Jevons paradox has been used to argue that energy conservation may be futile, as increased efficiency may increase fuel use. Nevertheless, increased efficiency can improve material living standards.

And that is the whole point. Improvements that drive down costs make technology more affordable and life less miserable. The reduction in cost and improvement in efficiency of the washing machine and other household appliances has given women more choices and liberties than the feminist movement. The right to vote isn't worth much if the woman still has to cook, do laundry and clean the house without the opportunity to educate herself and realize her potential in the labor market. With all that being said, is there anything that can be done to conserve resources? 

As the Jevons paradox applies only to technological improvements that increase fuel efficiency, policies that impose conservation standards and increase costs do not display the paradox.

The obvious conclusion is that efficiency improvement are not enough to fight global warming. Jevons paradox is the reason why all the cheer for better LEDs and similar technological improvements will result in naught. Intergovernmental agreements, conservation standards and entirely new technologies are necessary. And if fighting global warming seems silly to you, consider that all fossil fuels still pollute the environment (China is a prime example), whether you accept people's role in global warming or not.