China has formally overtaken Japan as the world's second largest economy. Yet, for all the recent excited commentary, there's less cause for baijiu toasts in Beijing than they might think. That's because China's economic growth has followed what's sometimes called "the Japanese model." In Japan and other Asian countries, this model has proved extraordinarily successful in the short term in generating eye-popping rates of growth -- but it always eventually runs into the same fatal constraints: massive overinvestment and misallocated capital. And then a period of painful economic adjustment. In short: Beijing, beware.
Japan's "lost decade" of the 1990s -- from which it still has not emerged -- followed a period of high growth, at the heart of which were massive subsidies for manufacturing and investment. The Japanese model channels wealth away from the household sector to subsidize growth by restraining wages, undervaluing the currency, and, most powerfully, forcing down the cost of capital. In every prior case, once the train gets rolling, it has been very difficult to correct course. That's because too much of the economy depends on hidden subsidies to survive.
Nor is Japan the only country to rise quickly and then suffer in this fashion. Brazil, which experienced "miracle" growth years during the 1960s and 1970s, had its own lost decade in the 1980s, for similar reasons. Beijing would do well to heed these tales of caution.