Abstract: In this article, the author shares two main points. One is that there are differences and great uncertainties in the theoretical concept and empirical estimations of the potential growth rate. Therefore, we should not pay too much attention to one indicator; instead we should look at the system of indicators. The other is about the logic to discussing macroeconomic policies, such as whether the policy should focus on maintaining the economic growth at 6% in 2020. In general, the logic should be deciding first "whether such a target is worthy of the efforts" and then "how to do it". But the author stresses that the question of "how to do it" determines or affects "whether such a target is worthy of the efforts," as different approaches to maintaining growth requires comparison of costs and benefits.
Potential growth rate: Theoretical definitions are often different.
Potential growth rate is a theoretical definition which cannot be observed. Overall, academia, policy departments in central bank and market participants often cite the following three definitions in research and policy discussion. First, potential growth rate is the growth rate when resources are effectively allocated. But this tends to be thought of as the lower-than-potential actual growth, which leads to misunderstanding that the potential growth rate is the fastest possible growth, that is, the best state of growth assuming resources have been effectively allocated. This definition is meaningful for the study of China's economic system reform and how to increase the role of market allocation of resources, but not meaningful for us to discuss the economic growth in 2020, which may lead to misunderstandings, because it takes time for a structural reform that focuses on removing the obstacles for the improvement of the efficiency of resource allocation to achieve results. Second, the potential growth rate is one when supply and demand are balanced at macro level, and when there is neither inflationary nor deflationary pressures. This is a common concept when we discuss macroeconomic policy, especially monetary policy. For example, the Taylor rule links short-term interest rate with inflation expectation and output gap (that is, the deviation of actual output from potential output). But the occurrence of the 2008 financial crisis challenges this concept, leading to questions like "Does price stability indicate economic stability?" and "How did the financial crisis occur and lead to large fluctuations in the economy?" Third, the potential growth rate is a sustainable growth rate, instead of a short-term growth at the expense of long-term one. This involves balance between short-term and long-term goals, and aggregate demand management and supply-side structural reform. Accumulation of financial risks may cause unsustainable growth even with price stability, and social problems as a result of the polarization between rich and the poor people and environmental pollution may also endanger sustainable growth. Therefore, environmental protection, prevention and resolution of financial risks as well as targeted poverty alleviation are conducive to promoting sustainable growth, that is, potential growth rate. While the above three definitions seem to be different, emphasizing different aspects and having different implications in different contexts, they are in fact unified if they are considered under classical economics. If resources are believed to be allocated by the market, and effectively, there would neither be sustained imbalance between supply and demand, nor sustained inflation or deflation, according to Say's law (supply creates demand); similarly, the growth brought about by the effective allocation of resources in the market would also be sustainable. The key is whether it is truly the market that is allocating resources, and in an effective way. This involves two schools of economics. What I want to emphasize is that when we discuss whether the market is allocating resources effectively, and whether government intervention is needed, we need to find out what is the main factor behind market failure?
There are many possible reasons for this, including industrial policy. However, based on the past experience and research literature, the biggest factor that causes market failure is how we look at finance and whether finance can effectively allocate resources.
The procyclicality of finance could damage sustainable growth. Classical economics believes that the market effectively allocates resources, supplies creates demands, while the currency is neutral and the financial market is efficient. Economic fluctuations could reflect real economic factors, such as external shocks including population, technological progress, and natural disasters. Most of the literature uses population to explain the Great Depression of 1930 and the Great Recession after the 2008 crisis (the "secular stagnation theory"). Keynesianism believes that the market sometimes fails. The main reason for the failure is that the currency is non-neutral, that finance is unstable, and that it may bring asset bubbles (irrational bubbles). The procyclicality of finance drives Juglar-cycle fluctuations of the economy. After the Great Depression in the 1930s, Keynes published The General Theory of Employment, Interest, and Money. From Keynes's theory, the post-crisis recession can be explained from the perspective of the financial cycle. The views of the two major schools are completely opposite, but there seems to be a reconciliation in the past 40 years. The New Keynesianism appeared in the 1980s. The theory believes that the market is generally efficient, and that finance effectively converts savings into investment. However, because of the stickiness, price could not adjust promptly for supply or demand shocks, leading to fluctuations in the real economy including employment. Counter-cyclical operation of monetary policy can flatten economic fluctuations, which is a model that the Central Banks have generally recognized in the past 40 years. Although New Keynesianism also covers the word "Keynesian", their spirits diverged. Basically, it believes that finance is effective, and price stickiness entails cyclical fluctuations. The global financial crisis greatly challenged New Keynesianism's policy principles and frames. Returning to the original thought of Keynes, people reflect on the role of finance, and the procyclicality of finance attracted the attention. This is how I would like to understand the potential growth rate. The biggest problem is related to finance, so the topic I share today is "potential growth rate and deleveraging."
Potential growth rate: There is a lot of uncertainty in empirical estimates. How to estimate the potential growth rate? There are roughly two approaches. The first is through production function, which mainly considers variables such as labor, capital stock, and total factor productivity (TFP). In recent years, most of the studies on the potential growth rate of China's economy indicated the downward trend, while the degree is uncertain. Is it 6%, 5%, or 4%? Looking back at the historical forecasts of China's potential economic growth rate, it seems that they were not forward-looking enough. In my book Fading-away Dividends in 2013, I predicted that the growth rate of the China’s economy during the 13th Five-Year would drop to about 6%, in which the most important consideration is population. The second is through macro-model: aggregate demand, aggregate supply and monetary policy reaction function. Aggregate supply is a macro concept (different from the production factors in the first approach). It is the relationship between inflation and output gap, and also the Phillips curve. Based on the estimated relationship between aggregate demand and supply, the monetary policy reaction function, the actual inflation rate and growth rate, we can extrapolate the potential growth rate by balancing fluctuations.
But there are three problems with this method. First, given that output gap and inflation are both determined by the macroeconomic situations, do changes in aggregate supplies drive changes in aggregate demands in the first place, or is it the other way around? Second, actual implications behind the model that uses mere technical variables are not fully revealed. Third, this model cannot explain the financial crisis. Based on these logics, we need to build an indicator system to estimate the sustainable growth rate. Besides GDP growth, indicators that directly reflect people’s livelihood and innovation inputs like employment, health care, education and national R&D inputs as well as financial indicators might as well be taken into account. We should consider the proper balances between demands and supplies, economic cycle and structure and real economies and finance.
In the macro-financial context, we need to combine countercyclical adjustments with structural reforms and policy adjustments to understand how tight credit policies, loose monetary policies and loose fiscal policies could help sustain economic growth. In response to the cyclical downward pressure on the economy, we should ease monetary policies to promote credit expansion and ease fiscal policies to stabilize short-term economic growth. In response to the downward financial cycle, we should ease monetary policies and fiscal policies while tightening credit policies. Credit crunch, whether a result of regulatory controls or market response to the cyclical downward pressure, will be a long-term trend that goes beyond short-term economic fluctuations. The underlying cause for problems arresting credit supplies like shortage in bank capitals and concentrated exposures of credit risks is the previous over-expansion of credits. Artificial intervention would only trigger greater future risks and delay resolution of the problems.
When we ease the monetary policies in the second half of the financial cycle, the central bank could reduce the price of base money and the risk-free rate while supporting fiscal easing by expanding its balance sheet. It can hold more risk assets like low-interest rate policy re-loans or support fiscal expansion with its profits.
In response to structural adjustment, we should tighten credit policies while easing fiscal policies. Our past economic growth has been way too dependent on credit expansion. As a result, the macro leverage ratio (non-governmental debt to GDP ratio) is too high, there is the risk of asset bubbles, and the over-expansions of finance and real-estates squeeze the profits of real economies, which all render resource allocation less efficient and lower the sustainable growth rate. While the non-governmental sector presses ahead with the deleveraging drive, fiscal expansion is not only a counter-cyclical adjustment, but also the carrier and embodiment of the economic structural adjustments.
In conclusion, macro policy-making is a trade-off between costs and benefits. There is no such thing as a perfect macroeconomic policy. We must think about how to ensure a certain level of growth before wondering whether we should do it or not. Given the high leverage ratio of the non-governmental sector and high housing prices, it will harm future economic growth if we still rely on massive credit expansion. It was proposed on the Central Economic Working Conference that the macro leverage ratio must be kept stable in 2020. It means to strike a balance between stabilizing cyclical economic growth and adjusting the financial cycle. In a mid-term perspective, I do not think deleveraging has come to an end, as the economy has an endogenous motive of deleveraging because of the mounting deficiencies in the past. Under this circumstance, reducing financing costs with loose monetary policies and increasing government expenditures with loose fiscal policies will help prevent against a dramatic credit crunch and achieve an orderly deleveraging.
