Cuba's Pre-Existing Condition

It's too late for the Castros to create a market economy.

View a slide show of working in Cuba.

Last month, the Cuban government said it planned to fire 500,000 state employees, and perhaps over 1 million, saying "our state cannot and should not continue supporting... state entities with inflated payrolls, losses that damage the economy, are counterproductive, generate bad habits, and deform the workers' conduct."

Some heralded the announcement as a long-awaited sign that Havana under Gen. Raúl Castro is finally moving toward a market economy, others voiced substantial skepticism, and Marxists denounced it as a betrayal of communist orthodoxy. So, where is Cuba headed?

Most likely, nowhere fast. Far from being a hopeful indication that Raúl is serious about economic reform, the abrupt layoffs reveal a government that is simply desperate to make ends meet. And they offer yet more evidence that Cuba, one of the last countries in the world to cling to Joseph Stalin's bankrupt ideology, is not interested in joining -- or, to be charitable, does not know how to join -- the globalized, 21st-century world.

Ironically, the official announcement of the firings was made by the Cuban Workers Union -- the labor union controlled by the Communist Party. Anywhere but in repressive totalitarian regimes, the dismissal of 10 percent of all government workers would have been met with massive protests. But this is Cuba, where even though about 85 percent of the workforce of 5 million is employed by the state, there was nary a peep on the streets.

The announcement, couched in typical Orwellian doublespeak, raises more questions than it answers. "It is necessary to revitalize the socialist principle of distribution and pay to each according to the quantity and quality of their work," it read, a blundering contradictory attempt to tie the layoffs to Karl Marx's socialist maxim, "from each according to his ability, to each according to his needs." The government also said it would grant permits for those fired to seek to make a living "outside the state sector" as if it is unspeakable to talk of a private sector.

In Cuba, a state permit is required even to shine shoes -- along with 178 other private economic activities that include mostly individual service activities from baby-sitting to washing clothes. It is also unclear exactly how those selected for dismissal will be chosen; seniority, patronage, friendship, ideological purity, or some form of capitalist or socialist merit? Will race or gender play a role in these massive firings? Will the dismissals disproportionately target those who receive remittances from abroad? Perhaps more important, how are those fired supposed to find jobs? In an economy with developed private competitive markets, employees dismissed from one firm have a fighting chance of securing employment in another. But in Cuba's economic system, the government controls most economic activity. There is no private sector to absorb the unemployed. Where will they find employment?

Perhaps most bizarre is that the dismissal measure seems to assume that everyone is temperamentally suited to be an entrepreneur and make a living in fields that might be far from his or her work experience and professional training. The Cuban government is betting on the resourcefulness and entrepreneurship of the Cuban people to somehow make up for the inefficiencies of the state sector and do so without access to cash, credit, raw materials, equipment, technology or any of the inputs necessary to produce goods and services. Ironically, the most likely source for these inputs will be the Cuban diaspora, which will be eager to help its unemployed relatives and friends. Manuel Orozco, a remittances expert at the Washington-based think tank Inter-American Dialogue, underlines that, telling Reuters, "Liberalizing the economy could lead to 10 percent of Cubans receiving remittances to invest in small businesses."

This could be a motivation for the Cuban government to disproportionately target remittance-receiving workers for dismissal. Cubans will somehow make do, but in terms of actual economic development, these measures will not work; they are not designed to. Allowing Cubans to baby-sit or make paper flowers for sale to tourists are not serious economic development measures. But just in case, hoping to capitalize on any additional economic production, the government is ready to collect onerous taxes of 25 percent for social security and up to 40 percent on income depending on the economic activity (e.g., food production will be taxed at 40 percent, artisans at 30 percent, etc.).

The government is projecting a 400 percent increase in tax revenues, presumably to be collected from the fired employees turned entrepreneurs. More likely, Cubans will find ways to avoid paying taxes by relying on the black market for these economic activities. Cuban economist and dissident Oscar Espinosa Chepe writes from Havana of the impact of Cuba's economic situation on civil society: Cuban children, he tells us, grow up witnessing how their parents, obligated by circumstances, live by theft and illegality.

Because Cubans cannot live by the results of their legitimate labors and work has ceased to be the principal source of one's livelihood, a survival ethic has evolved that justifies everything. One lesson to be learned from the transitions in the former Soviet bloc is that the success of reforms hinges on placing individual freedoms and empowerment front and center. In the decade following the collapse of the Soviet Union, the most successful transitioning countries were those that embraced political rights and civil liberties decisively: the Czech Republic, Estonia, Poland, Slovenia, East Germany, and Hungary. This is not where Cuba is headed with its "actualization of socialism."

The main reason is Cuba's Stalinist political order, which remains unchanged by this announcement. In a system that denies basic freedoms, society is debilitated and corrupted by a miasma of fear. For five decades, fear has been an integral part of the everyday Cuban existence. This fear must be conquered if any national project of transition is to stand a chance of success.

The Cuban penal code that is used to suppress dissent defines disobedience, disrespect, illicit association, possession of enemy propaganda and socially dangerous, and more as "crimes against socialist morality." In Cuba, the crime of "social dangerousness" permits the government to imprison people for activities they may commit in the future. Until this totalitarian document is reformed or wiped away, expect little to change.

Yet, some Cuba observers characterize Raúl Castro as a more pragmatic leader than his older brother. And though this mightbe the case in some aspects of governance, it is not a pragmatism that will lead him to embrace policy changes that may jeopardize his hold on power. More likely, this pragmatism that will induce him to formulate policies designed to perpetuate power. When Soviet leader Mikhail Gorbachev visited Cuba in 1989, Fidel Castro reportedly warned him "if you open a window [to democracy] you will lose all power." Even after his brother's passing, Raúl is unlikely to open the window.

There is another model that Cuban leaders ought to know well: Spain's rapid transformation in the 1970s from a dictatorship led by another aging tyrant, Francisco Franco, to a vibrant democracy that has posted some of the most impressive growth numbers of the last few decades. The ideal Cuban transition would look at lot like Spain's, though Cuba most likely doesn't have a strong enough civil society to pull it off.

Another, less hopeful parallel is that Cuba goes the way of the Soviet gerontocracy epitomized by Leonid Brezhnev, who was barely functional before his death in 1982. His successor Yuri Andropov, who was 68 years old, died two years later. He was, in turn, succeeded by the also elderly Konstantin Chernenko, who died a year after and was succeeded by Gorbachev. Compare this progression to Cuba: Fidel Castro is 84 years old and in poor health, Raúl is 79, and his supposed successor, José Ramón Machado Ventura, will turn 80 this month.

A new generation of Cuban leaders will eventually assume power. To be sure, they will likely favor continuity over radical change, but unlike the Castros, they might be receptive to democratic reform. These (likely military) officials will inherit not only a bankrupt economy, but also paralyzed, dysfunctional institutions, a discredited ideology, a disenchanted society, myriad social problems, and more. Cuba will be close to meeting the technical definition of a failed state, one that can no longer reproduce the conditions necessary for its own existence.

The Castros' successors will become heirs to a dangerous, unstable situation. With questionable legitimacy and a repressive apparatus in disarray, they will have to confront significant internal and external opposition. Their options will be very limited.

They can stay the totalitarian course and face the potential unfolding of uncontrollable events, culminating in a Ceausescu-like bloodbath, as happened in Romania. Or they can choose to become leaders of a democratic political opening and confront more manageable political loses. It may take the death of both Castros for this to pass, but theywill likely conclude that, for them, the safer and more prosperous life is the latter.

For now, the firings only highlight the dismal state of the Cuban economic model, perhaps best depicted by the old Soviet joke: "We pretend to work and they pretend to pay us." The regime in Havana is peddling a similar story today: They will pretend to reform, expecting the world will pretend to believe it. Let us hope nobody in Washington is buying.


The Japan Syndrome

China's teetering on the verge of its own lost decade, and a meltdown in Beijing would make Japan's economic malaise look like child's play.

This year, China overtook Japan as the world's second-largest economy, a shift in the global pecking order that surprised nobody who has been paying attention for the past 20 years.

What was truly surprising is that Japan was still No. 2. Like a distant uncle whose death notice reminds you he was alive, Japan is noteworthy for its furtive slinking from the world stage. It is an extraordinary disappearing act for a country whose global hegemony was seen as a fait accompli just 20 years ago. But the ur-Asian-export juggernaut has slipped into a permafunk of its own making. Japan as Number One now languishes as the 400,000th most popular book on while When China Rules the World is a bestseller.

The funny thing is that China borrowed much of its economic model from Japan: producing low-cost exports to fund investment at home while aggravating trading partners. At times, it seems like only the names have changed. Where Detroit automakers once denounced Honda and Toyota for dumping cheap, fuel-efficient sedans on American housewives, Treasury secretaries now wring their hands about the undervalued renminbi while China's trade surpluses yawn.

As pleasurable as it must be for China's leaders to have beaten Japan at its own game, the joke might soon be on them. In fact, they would do well to veer off of Japan's development path promptly. Sure, Japan's export boom funded stellar growth for four decades. But its undervalued currency eventually helped blow one of the largest bubbles in history, the bursting of which still hobbles Japan today. Japan's famously dismal demographics didn't help, but China's aren't much better. Beijing's one-child policy, introduced in 1979, has worked its way up the population pyramid such that China's supply of rural workers ages 20 to 29 will halve by 2030. Worse yet, China is much larger than Japan -- which means that the global consequences of a crash would be far greater. For the moment, Beijing is riding high, but China's sustained success depends on understanding where Japan went so badly wrong.

Some answers can be found 250 miles north of Tokyo in Kamaishi. The furnaces went out in 1988, and the birthplace of Japan's steel industry is now a sleepy fishing town. Kamaishi has drafted a number of renewal plans under the motto "City of Steel, Fish, and Tourism." Of the three, the fish are most reliable, but steel and tourism come together in an unexpected way. While the number of annual visitors is down by half since the 1990s, Kamaishi's shuttered steel mill still attracts a particular brand of tourist -- those fascinated by ghost towns. The Kamaishi Iron Works was once considered one of the finest haikyo, or modern-day ruins, in all of Japan.

But it seems even haikyo tourists are growing weary of Kamaishi -- recent blog entries complain that the site is now too decomposed, "a ruin of a ruin." Not even the receipt of Iwate prefecture's "Lively Non Flatland Area Prize" several years ago has kept people in Kamaishi, and the population continues to dwindle, from 100,000 in the 1960s to just 45,000 today. Nippon Steel, formerly the town's largest employer, has tried valiantly to help the city move on. But employment schemes such as stuffing old mills with racks of moist logs for the cultivation of shiitake mushrooms and miniature orchids have had little effect, and the company eventually abandoned its most symbolic sop to town spirit: In 2001, the once-formidable Kamaishi Nippon Steel Rugby Club was downgraded to an unaffiliated amateur club, the Kamaishi Seawaves.


The year 1985 is revered in Kamaishi as the last time the club won the national rugby championship, but the rest of Japan remembers it for the Plaza Accord, the landmark currency agreement in which the country agreed -- under substantial U.S. pressure -- to strengthen the yen. Over the next several years, the yen doubled in value against the dollar, squeezing Japanese exporters. Some factories, like Kamaishi's steel mill, closed, but for the most part, corporate Japan kept its operations intact while pleading with the government to cut interest rates and stimulate the economy. Decades of undervalued yen had pumped massive amounts of liquidity into Japan, and when this was met with low interest rates and confidence that the yen could only strengthen, the result was one of the largest asset bubbles in history. Japan has never fully recovered from the resulting bust, and its example haunts policymakers around the world. Central bankers and economists spend much of their time trying to prevent their economies from ending up like Japan's.

One argument is that the United States forced Japan to act against its own interests in accepting a stronger yen. Although it is true that the United States and other trading partners browbeat Japan, they had been doing so for years. Japan finally assented to their demands in 1985 as part of a plan to rebalance its economy. Post-World War II Japan pioneered Asia's export-driven growth model, sextupling GDP from 1950 to 1970 and pulling more people out of poverty more quickly than any country except modern China. Japan achieved this remarkable growth with a weak yen -- which supported exports and discouraged imports -- and high savings rates, which funded massive investments in infrastructure and manufacturing capacity.

An unfortunate side effect of export- and investment-driven growth is that it strangles the consumer. But that's kind of the point: The entire exercise depends on suppressing consumers as their cheap labor fuels exports. In Japan's case, the same undervalued yen that supported exports sapped consumers' purchasing power while yields on their savings were kept artificially low to fund cheap loans to corporations and government. And the shrunken share of economic spoils that did end up in the hands of consumers had no outlet but the heavily protected domestic market with its hopelessly inefficient and shockingly overpriced goods and services. When American humorist Dave Barry traveled to Japan in 1991, he was stunned to find department stores selling $75 melons.

The result was a horribly lopsided economy. Consumption generally accounts for around 65 percent of GDP in most modern market economies, while investment in fixed assets such as infrastructure and manufacturing capacity makes up 15 percent. In 1970, Japan's figures were 48 percent and 40 percent, respectively. In plain English, the Japanese were consuming relatively little while investing heavily in steel plants and skyscrapers, which didn't leave much for fish or tourism. Belatedly, Tokyo realized that a balanced economy must also have consumption and that coating the country with factories and infrastructure wouldn't do the trick. Japan tried to rebalance slowly through the 1970s and early 1980s: The yen was allowed to strengthen a bit each year, and consumption ticked up to 54 percent of GDP, while investment shrank to 28 percent by 1985.


Having accomplished this much, Japan's leaders thought in 1985 that it was finally safe to strengthen the yen. As one high-ranking Japanese central banker explained privately several years later, "We intended first to boost both the stock and property markets. Supported by this safety net -- rising markets -- export-oriented industries were supposed to reshape themselves so they could adapt to a domestically led economy. This wealth effect would in turn touch off personal consumption." With the benefit of hindsight, we know this was a bad idea. The strong yen touched of a wicked asset bubble that quite literally blew Japan's economy to pieces, and many in China think this was the United States' aim. Xu Qiyuan, a researcher at the Chinese Academy of Social Sciences, summarizes the popular Chinese view. "It is a conspiracy theory.… A lot of Chinese people think that the United States forced Japan to appreciate in order to make the economy collapse and that it is trying to do the same thing to China," he told Reuters.

In fact, Japan's stronger currency would not have led to economic collapse if the domestic economy had been able to take the baton from exports. In the event, export-oriented industries did not adapt to a domestically led economy because the domestic economy was not fit to lead. Conceived as a tranquil oasis for the Japanese to enjoy their exporters' hard-fought gains in peace, domestic Japan frowned on competition. Former Japanese Vice Finance Minister Eisuke Sakakibara termed this the "dual economy," in which world-class exporters existed alongside domestic companies that were "very tightly regulated with a lot of subsidies from the government, which makes them extremely uncompetitive." As a result, productivity in Japan's service sector lagged manufacturing badly. Having nowhere better to go, the Bank of Japan's loose money found its way into stocks and real estate instead of funding innovation.

Japanese companies large and small punted in stock and property markets, generating huge paper profits that masked their inefficient domestic businesses. The Nikkei nearly quadrupled from 1985 to 1990, and land values in many areas did the same, leaving ample opportunity for companies to pad profits with stock and real estate investments. But when the bust came five years later, domestic companies were as inefficient as ever, only now also stuffed with debt and bad investments. And they had company.

Failed exporters didn't go out of business; they joined the ranks of the domestic undead and sold their uncompetitive products at home. For example, Japanese cell phones were once the world's best, but now they are badly outmoded and can barely be found outside Japan. Overpaying for lousy cell phones is one thing, but domestic support for subpar products has even extended to pharmaceuticals. Japanese doctors prescribe hundreds of useless drugs that flopped overseas. Just one example is Ono Pharmaceutical's Kinedak, which failed to receive approval in the United States as it had no discernable impact on humans, but still sells $160 million per year in Japan. The zombie coddling was epidemic. The steel industry is one of hundreds of other examples. Kamaishi's 1988 closure was the exception, and it took Japan 20 years to cut its steel capacity in half, bringing supply and demand into balance.


Japan's commitment to social harmony, or wa, prevented a proper housecleaning post-bubble. In 1990, on the eve of a global boom in finance and information technology, a little creative destruction could have set Japan on a new and more sustainable path. The timing would have been fortuitous because Japan's bad demographics turned morose when the working-age population peaked in 1995. Less labor calls for more productivity, but Japan's demographic deadline did not catalyze tough reforms. Instead, policymakers dithered while massive overcapacity depressed profits and inhibited innovation.

Dithering was par for the course in a system designed to maintain the status quo. Although technically a democracy, the extent of Japan's central planning has at times matched China's. Japan has been centrally planned since it was ruled by Gen. Douglas MacArthur, eventually morphing into an informal alliance between bureaucrats, business leaders, and elected officials known as the "iron triangle." Difficult reforms were not in the triumvirate's best interest. Bankruptcies and unemployment are never palatable, but they are intolerable for a ruling class whose legitimacy depends on engineering social harmony.

The bubble's burst knocked Japan down, but torpor in the name of wa has kept it from getting back up. From one of the fastest-growing economies in the world, Japanese GDP has grown at less than 1 percent per year since 1991, and GDP today is lower than it was in 1997. Exports, though, barely missed a beat after the Plaza Accord: Despite the stronger yen, net exports actually increased in 1986 and are a bigger part of the economy today than they were in 1985. But without a functioning domestic economy, Japan cannot prosper, so it doesn't. Persistent overcapacity restrains private investment and consumption is the last thing on most consumers' minds, so Japan runs on exports and government spending. After 20 years of almost continuous fiscal stimulus, Japan has little to show other than mounting government debt, now nearly 200 percent of GDP.

No sooner had Japan's go at global hegemony faded from memory than a new export juggernaut appeared. Like Japan, China funds its export and infrastructure investment with the private savings born of suppressed consumption, and it does so to an even greater effect. China's economic growth has shattered all records, and so have its imbalances.

China is far more dependent on exports and investment than Japan ever was, and the numbers are still moving in the wrong direction. Investment accounts for half of China's economy while consumption is only 36 percent of GDP -- the lowest in the world, drastically lower than even other emerging economies such as India and Brazil. But as the Japan example illustrates, low consumption leads to high savings, and China's thrifty citizens, coupled with booming net exports, have bestowed upon the country the world's largest current account surplus, triple that of Japan's in 1985.

Much has been made of China's trade surpluses, and it is easy to get lost in the numbers. At times like these it is important to remember just how large China is -- and that in terms of global economic impact, it is only getting started. With GDP per capita only one-tenth that of the United States, China is already the second-largest economy in the world. Chinese infrastructure spending moves global commodity markets, and many basic materials set record prices over the last few years thanks to China's nation-building efforts. With steel capacity per capita only half of Japan's 1974 peak, China can already produce more steel than the United States, Europe, Japan, and Russia combined. In addition to its investment boom, persistent Chinese net exports and current account surpluses also generate significant global financial imbalances. In 1988, Japan's foreign exchange reserves stood at 5 percent of Japanese GDP and 0.7 percent of global GDP, whereas China's are now half of Chinese GDP and a full 5 percent of global GDP. Reserves of this magnitude have the potential to destabilize the Chinese and global economies.


Bulging foreign exchange reserves don't only irritate trading partners; they also stoke inflation pressures at home. Inflation is dangerous in a still-poor country where much of the population cannot tolerate higher prices for basic essentials, but it is a natural consequence of an undervalued currency. When Chinese exporters give their dollars to the Chinese central bank (PBOC), the renminbi they receive in exchange increase the domestic money supply and cause inflation. Official inflation statistics are rising, but they only tell part of the story. Massive liquidity in the system has caused a number of mini-bubbles such as garlic's hundredfold price increase over the last two years.

Giving exporters four renminbi per dollar instead of six would be the quickest fix, but China prefers "sterilization" instead of currency appreciation. In sterilization, the central bank issues bonds to soak up the extra renminbi. The catch is that China's dollar reserves earn dollar interest rates, so if the PBOC pays a higher rate on its own bonds, it pays out more interest than it earns. To keep from hemorrhaging money, the PBOC must keep China's interest rates close to U.S. rates. But U.S. rates are far too low for China, particularly with food prices rising and assets looking bubbly. The government has tried targeted policies such as price controls on certain foodstuffs and restricted lending to asset speculators, but the inflationary pressures are so great that this piecemeal policy resembles a game of whack-a-mole.

China's adoption of the Japanese growth model in the 1990s was widely praised for deregulating and opening up China. This new economic model took shape under the leadership of President Jiang Zemin and Premier Zhu Rongji. Engineers by training, both had been mayors of Shanghai and were seasoned technocrats by the time they rose to national power in 1989 and 1991, respectively. During their tenure, China's GDP soared thanks to what Massachusetts Institute of Technology economist Yasheng Huang calls "a growth strategy centered on large-scale infrastructural and urban investment projects."

Although there is no doubt that this new growth strategy created tens of millions of jobs and a glistening national infrastructure, the attendant imbalances have created problems. Huang notes that by suppressing personal consumption and small-scale entrepreneurial activity in favor of state-owned enterprises and select multinationals, China's 1990s growth did not sufficiently benefit its citizens. "The story of the 1990s is one of substantial urban biases, huge investments in state-allied businesses, courting FDI [foreign direct investment] by restricting indigenous capitalists, and subsidizing the cosmetically impressive urban boom by taxing the poorest segments of the population."

China's current leadership, under President Hu Jintao and Premier Wen Jiabao, has indicated an intention to change course. In fact, many interpret Hu's guiding principle of a "harmonious society," first introduced at the 2005 National People's Congress, as speaking directly to a rebalancing away from export and investment and toward consumption. In a recent report, David Cui, co-head of Hong Kong/China research at Merrill Lynch, contends that Hu aims "to achieve more balanced and sustainable growth that relies more on internally generated drivers." Beijing had started to try to cool the real estate and stock markets as part of this shift from investment to consumption, but the global financial crisis forced it to bin that effort. Instead, the Chinese government spent lavishly on shovel-ready infrastructure projects to support the Chinese and global economies. But this spending funded a number of white elephants: boondoggle infrastructure projects, empty malls, empty cities, and hopelessly uncompetitive industrial capacity hiding under the skirts of local governments.


With the global economy now out of free fall, China's leaders have issued a comprehensive slate of reforms to foster consumption and curb excessive capital investment. Using the full suite of policy tools available to a command economy, the government has removed tax incentives for some exports and added new ones for research and development while directing banks to curb lending and utilities to raise power prices for certain heavy industries. At the same time, new pension schemes, health-care coverage, and even a budding tolerance for collective bargaining with underpaid workers are intended to boost consumption. Although the Chinese authorities have long frowned on labor unrest, they have looked the other way at a recent spate of strikes and demands for higher wages. In fact, in some cases, local authorities have done the collective bargaining for their citizens by mandating higher minimum wages. Higher wages are easy political sells, but several initiatives even centrally plan creative destruction.

One of the more ambitious initiatives appeared on the website of China's Ministry of Industry and Information Technology one Sunday afternoon this August. The ministry lists 2,087 steel, cement, and other factories that must be closed by Sept. 30 of this year. But haikyo tourists might not want to book their trips now: China's version of repurposing does not generally mean shipping in moist logs and converting the facilities into miniature orchid nurseries as Nippon Steel did in Kamaishi; Chinese authorities have been known to dynamite inefficient factories to be absolutely certain they are closed for good -- not simply fired back up again by conspiring local authorities and businesses once the heavies return to Beijing.

But plant closures are easier announced than done, particularly in the face of increasingly vocal and sometimes violent workers. In summer 2009, the sale of a steel mill owned by the provincial government in Henan province was halted after workers protested. The government preferred to return the $26 million deposit paid by the erstwhile acquirer than risk repeating an incident three weeks earlier where rioting workers beat to death an executive who announced the restructuring of a steel mill in Jilin province. Here, Beijing would be wise to swallow this pill in one gulp, rather than allowing the bitter medicine to slowly trickle down, paralyzing the entire economy as it did in Japan.

If China can tough through these reforms and consolidate inefficient capacity, it will have accomplished much, but to really transition to a domestically led economy, Beijing will need to nurture a competitive service sector. And that's a much bigger ask. There is not yet consensus for such a move as many within China are still wedded to the 1990s growth model. Mei Xinyu, a researcher at the Chinese Academy of International Trade under the Ministry of Commerce, recently wrote that "the manufacturing industry can provide enough jobs to Chinese people and also widely distribute the benefits of economic growth." In fact, the service sector is better at both. The International Monetary Fund (IMF) recently found that the benefits of growth are not distributed equitably to workers in manufacturing-oriented economies; wages tend not to keep pace with productivity gains in countries like China and Japan where productivity in services lags manufacturing badly.

Not that an IMF report makes a lick of difference -- but when wages start lagging and the masses start realizing that their efforts are not being rewarded, then Beijing will have to take action. Yet it will likely have a hard time making such a shift. Dynamic service sectors are not generally compatible with central planning because service economies are naturally discombobulated. Technocrats can calculate where a new bridge or airport will have the greatest positive impact and then build that bridge or airport -- but it is much harder to dictate from on high the creation of the next Facebook or to manifest a thriving small business sector.


In both China and Japan, finance, media, and other key service sectors are seen as too sensitive for free competition, so players with government ties are protected by onerous regulatory barriers to entry. It is not a coincidence that Japan has the lowest service-sector productivity in the G-7 and one of the lowest in the OECD. For their part, China's heavily protected and state-owned banks not only seek to limit their own competitors, but, through their lending practices, also hamper competition in other sectors by giving lower rates to favored, often state-owned, companies. A recent study by Li Cui of the Hong Kong Monetary Authority found that small businesses in China have less access to credit and pay much higher rates than larger companies. A recent article in the IMF's Finance and Development magazine concludes that opening up China's banking market to foreign competition could have sweeping positive effects throughout the economy.

While none of these reforms is easy, China's ticking demographic clock makes them urgent. China's one-child policy produced a large demographic dividend in the 1980s and 1990s as those of working age had fewer dependants to support. Starting in 2015, however, China will suffer the inverse -- a growing number of aged relying on a shrinking pool of young workers. "China has always been a demographic early achiever," quips a recent U.N. population report.

When China's working-age population peaks in 2015, it will be 20 years after Japan's crested the wave, but it will do so at a much lower level of prosperity than was Japan's at that time. The harsh reality is this: Japan got rich before it grew old, and China will grow old before it gets rich.

Urbanization can offset the peak in the working-age population, but half of China's rural population is over 65 as many younger farmers already moved to the cities for manufacturing jobs. In fact, the number of 20-to-29-year-olds, an important source of cheap labor, has already begun to shrink and will halve by 2030. This is not necessarily a bad thing: An aging society can allow for an economic rebalancing. Quality of employment will soon trump quantity while an older and more prosperous population demands improved health care, financial planning, and other services. If China were not aging so quickly, it could probably grow its way out of trouble and put off rebalancing for a while yet. But the trifecta of an undervalued renminbi, overinvestment, and an aging population looming just over the horizon means that authorities had better figure it out, and fast.

History has given China this moment to do what Japan could not. The Japanese did not seriously attempt to rebalance until their economy was well-developed, ossified, and allergic to change. So when the jig was up on their longstanding economic model, rather than rebalance, Japan unraveled. In this sense, the global financial crisis was serendipitous for China. By reminding China's leadership that relying on exports means depending on unreliable foreigners, the crisis put the pain of rebalancing in perspective. It is not out of altruism that we have seen renminbi appreciation accompanying Chinese wage hikes and other rebalancing measures. A slight loosening of controls over media and finance could be in the offing. Deregulating the service sector might be a frightening political proposition, but perhaps less so than not having one when the exports dry up.

Like a (very) large Kamaishi, China risks having nothing to turn to when the industrial boom runs its course. But history need not repeat itself, and China's leaders seem determined to steer the country onto a more sustainable path. All that remains is for them to do it.

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