From tuition ban to Evergrande collapse, is China tripping over its chase for 'common prosperity'?

Since the last quarter of 2021, signs of a sharply decelerating Chinese economy have begun to emerge. This slowdown goes well beyond the property, private education, and internet platform companies that were the targets of intense regulatory action in the last 12 months.

In the first year of the pandemic, China's success in suppressing the spread of Covid-19 provided the impetus for a strong rebound at the start of 2021. The Chinese economy grew by 18.3 per cent on an annualised basis in the first quarter of 2021. In the last quarter of 2021, GDP growth is expected to slow to below 4 per cent.

This slowdown is likely to persist in the months ahead, as the Chinese authorities show no signs of letting up on a strict zero-Covid policy that has led to periodic lockdowns of Chinese cities, and depressed consumer and business sentiments.

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China's regulators are also likely to continue with their crackdowns in a range of industries, many of which have been key sources of innovation (and profit) in the last decade.

Chinese policymakers may argue that the current slowdown is a necessary but temporary correction, especially in the overleveraged (and inflated) housing sector and the under-regulated consumer internet industry.

This slowdown may even be justified by pressing policy goals: to curb excessive borrowing and speculation in real estate; concerns that China's internet giants hoard and exploit personal data without regard for privacy; worries about financial stability with big tech's entry into consumer finance; the network externalities and monopoly power that China's tech titans enjoy; and the wasteful arms races in education that private tuition causes.

Underlying these industry-specific concerns is the grand vision of "common prosperity" - President Xi Jinping's signature campaign to reduce inequality in China. Consequently, the debt limits on property developers and the crackdown on tech companies are framed in terms of ensuring affordable housing and preventing the "disorderly expansion of capital".

These concerns have their echoes in developed countries that also struggle to constrain the market power of big tech, the negative spillovers that large financial institutions can cause, and the pernicious effects of income and wealth inequality. One can hardly criticise the Chinese state for having the autonomy and political wherewithal to take on capitalist enterprises before they become too powerful, too entrenched, or too big to fail.

But these (legitimate) policy goals are received, filtered, interpreted, and implemented by a Chinese state machinery that is, increasingly, ideologically quiescent. In this environment, the risks of policy overreach, rigidity and maladaptation are considerable.

Indeed, a number of potentially serious policymaking errors have already appeared, undermining a Chinese state that was - until a few years ago - quite adept in learning from mistakes.

The first error is that policy intents are being conflated with outcomes. This violates one of the main truisms in policymaking: that just because one's policy intents or goals are valid does not mean that his policy instruments are correct. Policies are, and ought to be, judged by their outcomes, not by their intents or goals - no matter how noble or virtuous these are. After all, the road to hell often starts with good intentions.

It is highly questionable whether the policy instruments that the Chinese state has deployed to curb excesses in the property, internet and private education industries are appropriate.

Economists have a preference for targeted interventions that address specific market failures or problems, and minimise collateral damage to the rest of the economy. By contrast, the interventions that have been applied this past year have often been blunt - relying too much on bans and administrative diktats that are costly to enforce and likely to produce unintended consequences, rather than on market-friendly, incentive-compatible interventions.

The most obvious example of this conflation of good intent with good outcomes has been the outright ban on for-profit tuition. But the efforts to deflate the housing bubble are also flawed for the same reason. There is no denying that there is huge excess capacity in housing, and that many of China's leading property developers are overleveraged.

But the underlying cause of this was that local governments, starved of other sources of financing, have become overly reliant on revenue from land sales. This is a long-standing, structural problem that requires a structural solution - such as larger fiscal transfers from the central government or efforts to diversify the sources of local government financing.

Instead the authorities opted for what must have seemed, at the time, a quick fix: the imposition of "three red lines" that set tight limits on how much leverage property developers can take, and curbs on mortgage lending by banks.

The outcomes have been a much deeper credit crunch in real estate than policymakers had anticipated, pushing developers such as Evergrande into default and creating risks of systemic financial contagion. None of these outcomes were the intended consequence of the three red lines; they are nonetheless evidence of poor policymaking.

The credit crunch in real estate may have been a price worth paying if it had led to an easing of credit conditions in the more productive parts of the economy. That is not happening. Even though China's planners want banks to lend more to favoured sectors such as agriculture, green technologies, semiconductors, and artificial intelligence, banks are less willing to do so in an environment where consumer and investor sentiments have turned negative.

The second policymaking error that has crept in this past year stems from the misguided belief that to increase equality, one needs to sacrifice efficiency. This error is most obvious in the official common prosperity narrative. There is little doubt that inequality represents a critical policy concern that merits government action.

The sensible approach, as elegantly demonstrated by the economists Kenneth Arrow and Gerard Debreu 70 years ago, would be to let markets operate freely to promote efficiency and growth, while relying on taxes and transfers (i.e., redistribution) to bring about the desired level of equality. There is no need to sacrifice economic efficiency for social equity. Indeed, the former is often a precondition for the latter.

The common prosperity campaign is increasingly seen to justify anything that takes China's new tycoons (whether they are in tech, property, or private education) down a peg or two (or in this case, by a few billion dollars).

But a moment's introspection should tell us that reducing the wealth of China's tycoons does nothing to promote common prosperity. Unlike income or wealth taxes that can be used to finance social transfers, the destruction of market values of China's largest private enterprises is a deadweight loss: nobody benefits from it.

Instead of promoting common prosperity, the regulatory crackdown on internet platforms increasingly resembles a moral crusade that is more likely to lead to common poverty, as innovations that could have increased financial inclusion by lower-income Chinese households are snuffed out by overzealous, ideologically-driven regulators.

A third policymaking error is a growing tendency to view the economy as a mechanical system that can be precisely engineered to fit planners' utopian visions. This is reflected, for instance, in the Chinese state's preference for upstream technology firms (especially those engaged in research and development) over consumer-facing ones that "simply" adopt or use existing technologies.

China's economic policymakers should remind themselves that Russia - whether during Tsarist or Communist times - was not short of scientific breakthroughs and cutting-edge technologies in a wide array of fields. What it lacked were the political institutions and commercial enterprises that promoted the widespread deployment (and adoption) of these technologies.

The distinction between desirable upstream technologies and less desirable downstream ones is also an unhelpful one. In a complex, interconnected economy, the latter may well enable the former, confounding the planner's linear prediction that technology breakthroughs drive business applications.

For example, Amazon and Alibaba both started as e-commerce platforms (a downstream industry) before they developed capabilities in cloud computing, which in turn made possible advances in big data and predictive analytics (upstream technologies).

Furthermore, Chinese industrial policy is also now driven more by non-market, "strategic" considerations (such as achieving technological self-reliance) as well as by the party's ideological objectives.

While an activist, interventionist state has always been a feature of state capitalism in China, this was previously tempered by the primacy of economic growth. What has changed in recent years is that the growth objective may now be subordinate to political goals - such as enforcing ideological discipline and fealty to the party, or pursuing common prosperity.

The problem with the growing political intrusiveness of the Chinese state is that as the economy becomes more complex, planners ought to rely more on decentralised market signals and on market actors responding and adapting to their own circumstances. This is much less likely to happen when firms have to comply with, or are subjected to, political decrees and diktats from above.

This article originally appeared on the South China Morning Post (SCMP).

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