John Maynard Potemkin

Keynesianism is a bubble machine

Many of the developments like this one in Ordos, China, have swathes
 of newly-created public space completely unused by anyone

By Robert Tracinski

For a while, there has been a strain of center-left American commentary that has viewed China's leaders as some kind of technocratic super-geniuses who have done a much better job of guiding their society than the loons and hacks who would actually, you know, be voted for. Call this the Tom Friedman school of thought.

In reality, China's leaders have a tendency to fall for a lot of the same economic fads that fascinate the Western center-left elites. Thus, the Chinese have been suckered into investing untold billions in high-speed rail and "green energy," endeavors that are not economically viable (even with higher population density and cheaper labor costs) and which are starting to come apart. And behind those boondoggles is one big idea China's leaders have accepted uncritically from the West: Keynesian stimulus.

Maybe this is why our center-left elites like China's rulers so much. The Chinese get to do what our elites would like to do but can't, because all those pesky voters keep getting in the way.

But it is precisely this latitude to commit fully to bad ideas that is starting to cause China big problems.

China committed to Keynesian stimulus on a much bigger scale than even the Obama administration. According to one estimate, the Chinese stimulus launched in 2008 to counteract the effect of the global recession was $586 billion in spending by the central government, plus as much as $2.7 trillion in new loans by state-controlled banks. In absolute terms, this is comparable in size to our combined fiscal and monetary stimulus, except that the Chinese actually managed to increase lending, whereas the dollars pumped into our system by the Fed never actually made it into new loans. (Which might be a blessing, when you see what happened in China.) But China's economy is about one third the size of ours, so in relative terms, this implies about three times the stimulus, as if President Obama had passed a $2 trillion stimulus bill and the Fed has pumped $8 trillion into the economy.

In short, this was precisely the kind of massive Keynesian stimulus that folks like Paul Krugman were pining for. So it is interesting to look at what it actually accomplished.

On the surface, it has been a success: China kept posting growth rates in the high single digits, while everyone else had a downturn. But now the reality behind those figures is catching up to them.

It's now pretty clear that a huge amount of that money went into a real-estate bubble and into big, empty vanity projects, including gleaming new government complexes in some of China's most impoverished areas.

And here's the big, revealing fact about how Keynesianism actually works in practice. These big "stimulus" projects were eagerly promoted partly because local officials got a cut from corrupt deals with politically connected developers. But this incentive was merely reinforced by official central government policy, in which officials were judged by the nominal GDP numbers for their region, and any economic activity, whether or not it made long-term economic sense, was promoted to pad out those numbers.

In a report on a massive new government bailout for the Railway Ministry and its high-speed rail debacle, Gordon Chang notes:

Chinese officials decreed the construction of most of the infrastructure built in the last three years because they wanted to create GDP. Now, however, they are busy thinking about how they will pay for all the "ghost cities" and train tracks to nowhere they have just built for this purpose.

Olivia Chung describes why the most notorious of the Chinese ghost cities, Kangbashi New Central District in the Inner Mongolian mining boomtown of Ordos, was built. "The new district was initiated in 2006 to drive up measurable gross domestic product (GDP) growth--a yardstick for evaluation of the performance of local officials."

China's stimulus created a vast incentive for this kind of "Potemkin village" project, on a scale Potemkin never could have dreamed of. The term "Potemkin village" is named after Russian minister Grigory Potemkin, who (according to legend) built fake settlements in the Crimea to impress Empress Catherine II with his management. Historians now think this story is apocryphal, but Potemkin's successors--ambitious bureaucrats the world over--have since compensated by making the legend true many times over. China's officials have taken this to a new level. Potemkin was supposed to have built the facades of villages. China's ministers have built entire real cities that no one lives in, just to produce statistics that would impress the emperor back in Beijing.

This is not a violation of the principles of Keynesian economics. He and his followers have endorsed much more wasteful spending: digging and re-filling holes, building pyramids, and in Paul Krugman's case, everything from real terrorist attacks to a fictional alien invasion. And what is their biggest alleged example of a successful Keynesian stimulus? World War II. Wars might be justified or necessary. But from an economic standpoint they are a violent, deadly version of digging holes and filling them back in: a huge portion of the economy is diverted to the task of building things that will get blown up. Wars represent the destruction, not the creation, of wealth.

The Potemkin village aspect of Keynesian stimulus is built into the basis of the theory. Keynes believed that the economy was driven by the emotional vitality of "animal spirits." (The competing theory was that capitalists act on economic expectations shaped by price signals, particularly the price of credit, i.e., interest rates.) In Keynes's view, businessmen build and take risks in a kind of emotional frenzy, and the way to whip them up into such a frenzy is to create the illusion that a lot of economic activity is occurring around them and a lot of money is being made, so they will want to get in on it. So the whole essence of Keynesian stimulus is to create an illusion. It's a democratic version of Potemkin's subterfuge. Its purpose is not to fool the monarch but to fool the markets.

Contemporary Keynesians have a more sophisticated fallback. The purpose of stimulus is to get money flowing through the economic system, which will give consumers real cash to spend and give businesses the sense that there is a vibrant market for their products. But it is all still the creation of an elaborate illusion. All of the stimulus cash is flowing into projects that are unproductive and unsustainable, setting the economy up for an inevitable contraction.

Here's a better version of the Potemkin analogy. In a brilliant RealClearMarkets column, Jeffrey Snider described the Fed's monetary stimulus as a variation on the "pump and dump" stock fraud. The scam is that the con-man "pumps" the price of a thinly traded stock, usually by buying shares in order to produce a short-term uptick in the stock price. He then points to his own activity as proof that this is a "hot stock," hyping others into bidding the price up farther. At that point, he dumps his own shares at the artificially elevated price, pockets the proceeds, and leaves the suckers to take their losses when the stock price reverts to normal.

Ben Bernanke's version is to print money and use it to buy financial assets and pump up their prices. Then use this artificial manipulation of asset prices to hype the market into believing that this is a genuine, self-sustaining economic recovery, causing them to make investments and bid asset prices up farther, at which point the Fed can safely dump its purchases back onto the market.

Fiscal stimulus attempt to create the same kind of illusion. The idea is to generate a lot of apparent activity by building empty cities and bridges to nowhere and hope that everyone will see this and think the economy is still growing wildly, so they will keep speculating in expectation of all the big profits they will make from the boom. And so you end up building a lot of empty skyscrapers or empty solar panel factories.

Then what happens? China's central government is now trying to clamp down on credit to keep inflation under control and to prevent the real estate bubble from getting even bigger. This sudden and total denial of credit from official, state-owned banks has sent everyone scrambling to "unofficial," black-market lenders. This, in turn, leads to the phenomenon Olivia Chung calls "borrow-and-die," in which developers and factory owners take out loans to keep their doors open, but at interest rates so ruinous that they actually accelerate the process of collapse.

Recent debates about whether the "stimulus" has succeeded in the United States have missed the whole point of Keynesian stimulus. It's not about how many jobs were "created or saved" by government spending and subsidies, even if such a thing could actually be measured. The point of stimulus is that this government spending is supposed to "prime the pump" for a self-sustaining take-off of private economic activity, a renewal of the "animal spirits." But what China is showing us is that Keynesian stimulus spent on Potemkin projects doesn't end up jump-starting private economic activity. Instead, it sucks credit away from private activity into unsustainable "bubbles," leading to an inevitable credit bust that kills off private activity.

Maybe the legendary thrift and industry of the Chinese people will allow them to absorb all of the ghost cities and the "borrow-and-die" factories and avoid a big downturn. Maybe this time really will be different. But the point is that the "stimulus" of 2008 is going to turn into a big blow to the economy in 2011 and 2012.

We have already seen this at work here in America. "Green jobs" are a leading example, and Solyndra is the leading symbol: half a billion dollars spent to "stimulate" the economy by building a giant new solar panel factory so it can stand empty. Keynesianism is a bubble machine Lawrence Welk would have been proud of. It now looks like this is about to be demonstrated on a truly epic scale in China.