Xu Gao says China must not delay stimulus to its economy

The Chief Economist of Bank of China International urges Beijing to emerge from Friedrich Hayek’s shadow and listen to John Maynard Keynes.

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Sep 18, 2024

Resistance to economic stimulus runs deep in China, often likened to drinking poison to quench thirst. Xu Gao, Chief Economist at Bank of China International Co. Ltd. and adjunct professor at the National School of Development (NSD) at Peking University, traces this sentiment, somewhat surprisingly, back to Friedrich Hayek.

Hayek, author of The Road to Serfdom and The Fatal Conceit: The Errors of Socialism, remains so influential that, according to Xu, even the economic policies of socialist, Communist Party-led China continue to be shaped by his theories. Xu argues that both expansionary stimulus and contractionary regulations are mere tools, and it’s time for China to emerge from Hayek’s shadow and take bold steps to stimulate its faltering economy.

What follows is Part III of Xu’s 10,000-character essay urging Beijing to take decisive action. Parts I and II have already been featured in The East is Read, our sister newsletter. Xu has graciously approved our translation for publication.

VI. Stimulating the Economy Is Not "Drinking Poisonous Liquor to Quench Thirst"

After thoroughly evaluating the logic behind stimulus measures, it is important to refute a common misconception that likens stimulus measures to "poisonous liquor" and suggests that stimulating the economy is akin to "drinking poisonous liquor to quench thirst." The underlying assumption is that while stimulus measures may provide short-term relief, they inevitably result in severe long-term consequences. However, the discussion in section IV of this essay on the sustainability of stimulus measures demonstrates the bias in this view. This misunderstanding will now be analyzed and refuted from a historical perspective.

Opposition to stimulus measures has long existed in the history of economics. Friedrich Hayek, the 1974 Nobel Prize laureate in Economics, wrote in Lecture 3, "The Working of the Price Mechanism in the Course of the Credit Cycle," in his Prices and Production and Other Works (2nd ed., 1935):

"If the proportion between the demand for consumers' goods and the demand for producers' goods as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed. And, even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances and new crises. The only way permanently to "mobilize" all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure...we may perhaps prevent a crisis by checking expansion in time, but that we can do nothing to get out of it before its natural end, once it has come."

Hayek believed that while stimulus measures might prevent an economic crisis in the short term, they would hinder the market's natural adjustment mechanisms, thereby sowing the seeds for new crises. As a result, the appropriate government response to an economic crisis was to do nothing and allow the market to recover through a process of self-correction and healing.

Undoubtedly, Hayek represented the kind of "Candides" in John Maynard Keynes' eyes—someone who believed that the market would naturally return to an efficient state. Any interference in this self-correcting process, such as stimulus measures, would only delay the economy's recovery and sow the seeds for new crises.

As early as 1923, Keynes offered a sharp rebuttal in his A Tract on Monetary Reform:

"But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."

Keynes' "long run" critique rejects the idealized belief held by economists like Smith, Ricardo, and Hayek—that the economy will eventually return to its most efficient state through the market's self-correcting mechanisms. However, the "short run" before markets return to efficiency, no matter how much turbulence and hardship it involves, is a process that cannot be intervened in and must simply be endured.

However, both in theory and practice, the assumption that markets will naturally return to an efficient state has been proven wrong. Even in the developed Western countries where modern economics originated, few still hold an absolute belief in market efficiency. The prevailing view among economists today is that markets can deviate from efficiency for extended periods. When such deviations occur, macro policies must respond—stimulus is needed when demand is insufficient, and regulation is necessary when demand is excessive. In this sense, most now agree that Keynes was right: much of life is spent in the "short run," where markets deviate from efficiency. This requires active intervention, rather than relying on the idealized "long run" as a guide for action.

In China, the idealized "long run" scenario envisioned by Hayek is neither the reality nor the pursuit of the market economy with Chinese characteristics. The functioning of the Chinese market differs from the efficient state assumed by Western economics, partly due to institutional constraints that still impede China's market operations and limit the role of the market, but more importantly, because the market economy with Chinese characteristics represents an organic integration of an "efficient market with Chinese characteristics" and a "well-functioning government." This "efficient market with Chinese characteristics" is fundamentally different from the idealized efficient market model proposed by Western economics.

When praising the Chinese government's advantages of "the ability to mobilize resources to accomplish major initiatives," it is crucial to acknowledge that this advantage is rooted in the government's strong guiding role in the market and the market's dependence on the government. If the market were as self-sufficient and optimal as assumed in Western economics, any government intervention would only cause deviation from an ideal state, and the concept of a "well-functioning government" would not exist. The efficient market imagined by Hayek is neither the reality in China nor the objective of the market economy with Chinese characteristics.

Thus, applying Hayek's market fundamentalism to liken stimulus measures to "poisonous liquor" and opposing them is inconsistent with China's economic reality and the development path of the market economy with Chinese characteristics. In China's macroeconomic practice, stimulus measures are not merely compensations for market inefficiencies or even market failures but are an integral part of the country's effective market system. These policies should be employed according to the changes in the economic situation, without being restricted by misleading ideas like "drinking poisonous liquor to quench thirst."

VII. Stimulate When Needed

From the analysis above, it is clear that the evaluation of stimulus measures must be considered within a specific context, and the same measure can produce vastly different outcomes depending on different macro environments. Therefore, whether to implement stimulus depends on the macro environment; avoiding stimulus when needed is as misguided as applying it when unnecessary.

The sustainability of stimulus measures also hinges on the macro environment, with the true constraint being the economy's supply capacity. As long as supply constraints remain loose (i.e. when demand is insufficient and excess supply capacity exists), stimulus can continue to promote positive economic growth and secure the necessary resources for implementation, ensuring sustainability. Therefore, stimulus measures should be guided by inflation and the balance of payments, which indicate whether supply constraints have tightened. When inflation is below target and there is a balance of payments surplus, demand should be stimulated. Conversely, when inflation exceeds the target and there is a balance of payments deficit, stimulus measures should be withdrawn.

When determining the necessity of stimulus measures, decisions must be based on actual economic conditions, not influenced by misleading notions like "drinking poisonous liquor to quench thirst." Using language detached from reality to label stimulus measures as either good or bad does not promote the high-quality development of China's economy. In practice, both expansionary stimulus and contractionary regulatory policies are technical tools for managing the macroeconomy, each suited to specific economic conditions. These tools should not be arbitrarily rejected or left unused. Moreover, treating these technical measures as conflicting with China's long-term policy goals only imposes unnecessary self-constraints, making it harder for the government to manage the economy effectively.

In September 2014, amid increasing downward pressure on the economy, market expectations for an interest rate cut were high. However, some voices opposed the rate cut, viewing the market expectations for a rate cut as reflective of a lack of confidence in reforms. On September 17, 2014, People's Daily published an article titled People's Daily's Financial Commentary: Interest Rate Cuts Are Not in Conflict with Reform, which rebutted the mistaken notion that technical decisions like interest rate cuts conflict with broader policy directions such as reforms. The article argued:

"There is no inherent connection between the market's expectation for an interest rate cut and its confidence in reforms. The Chinese economy entering the 'new normal' [medium growth] aligns with the laws of economic development, and it is widely accepted that flexible monetary policies should be employed at different stages. Whether to cut interest rates or reserve requirements ratios should depend on the actual economic conditions. In the future, targeted interest rate or reserve requirement ratio cuts may still occur without altering the overall direction of monetary policy... Economic policy interpretation should not be politicized. As economic conditions change, policies must be adjusted in a timely and appropriate manner. Decisions on interest rate hikes or cuts are situational and should not be tied to broader policy directions, as this could limit policy options, and missing the right window for action could lead to regret."

Ten years on, the views expressed in People's Daily's commentary still stand. China's path toward building a market economy with Chinese characteristics and pursuing high-quality development remains steadfast. Stimulus, as a tool for government macroeconomic regulation, does not conflict with the general direction of China's economic development. It simply requires timely and appropriate use in response to changes in the economic situation. Given the current significant pressure from shrinking demand in China, stimulus measures should be employed when needed.

At the Fifth Plenary Session of the 19th Central Committee of the Communist Party of China (CPC), held in October 2020, the Central Committee explicitly called for "promoting a better integration of an efficient market and a well-functioning government."