Prof. Edward C. Prescott On China

Edward C. Prescott, the Economics Chair at the W.P. Carey School of Business at Arizona State University, knows a thing or two about macroeconomics. In addition to his work at ASU, Prof. Prescott is a senior monetary advisor at the Minneapolis Federal Reserve Bank and was awarded the Nobel Prize in economic sciences in 2004. According to the ASU website, Professor Prescott has altered the course of macroeconomic thinking over the past three decades with his research that spans such areas as business cycles, economic development and general equilibrium theory and finance.

Given Prof. Prescott’s background, I was looking forward to hearing what he had to say about China at the Global Auto Forum 2010 that was held recently in Chengdu. Professor Prescott did not disappoint with his analysis of where China is and where the country is headed. His main conclusions:

• In 2020, China’s auto production may total as much as 50 million vehicles and will continue to grow, peaking at 75 million vehicles in 2030, before stabilizing at 60 million vehicles per year.

• China will become increasingly suburbanized.

• China will become more integrated with the most advanced industrial countries, and in time will become one of the most advanced industrial economies in the world.

• China will create new technologies and will spawn many multinationals with operations abroad in the years ahead.

As support for his conclusions, Prof. Prescott points to the period before 1800 when living standards varied little across countries and over time. After 1800, however, living standards began to increase, first in the West, as stagnant economies transitioned to the industrial revolution and to a period of modern economic growth where living standards double every 35 years. As an economy enters this phase of development, its people get richer because output per person increases due to productivity gains. After losing ground against other countries for nearly two centuries, China entered its period of modern economic growth in 1978 and is now rapidly catching up to the rest of the world.

As countries grow rich, the number of vehicles per person rises. Assuming that vehicles last 20 years and that China’s population grows to 1.5 billion people, China’s annual vehicle demand will grow to 75 million in 2030, when China has the same number of vehicles per person (800 per 1000 people) as other advanced economies like the United States. Currently, China has less than 100 vehicles per 1000 people, far below even relatively undeveloped economies like Mexico, Hungary, Poland and the Czech Republic.

With more cars will come more superstores, which are more efficient than mom-and-pop stores, and which further increase output and income. (In fact, foreign companies like Carrefour, Wal-Mart and Tesco are expanding rapidly in China, and China is creating its own universe of retailing giants, bringing more order to China’s fragmented distribution system.)With more two-earner households and two car families, and a desire for space and access to recreation, Prof. Prescott believes it inevitable that Chinese will increasingly choose to live in the suburbs, and not in the center cities where they work.

As China becomes more integrated, it will become richer, and this is good for the Chinese and good for the rest of the world. In his view, a set of countries is economically integrated if:

• its members do not impose tariffs and restrict imports from other members;

• its members have a considerable degree of economic sovereignty from the collective entity;

• member countries set their own tax rates; and

• property rights of foreign companies are protected.

As an example, Prof. Prescott cited Germany, France, Italy, Netherlands, Belgium, and Luxemburg—the original EU countries — whose productivity was one-half that of the United States for the 50 years prior to World War II. Productivity in these countries, however, went from 40 percent to 100 percent that of the United States in the 35 years following the signing of the Treaty of Rome in 1957.

Finally, he discussed how open borders, integration and the threat of foreign competition increases efficiency in an economy. Rather than protecting inefficient industries, he believes that countries should open their industries to foreign competition in order to improve efficiency.

As an example, Prof. Prescott points to what happened in Northern Minnesota on the Iron Range in the 1980s. In 1982, then President Reagan permitted competition from new Brazilian mines. As a result, productivity at the Minnesota mines doubled with no new investment because work rules changed and the employment of skilled workers was cut in half. As if to address today’s inevitable question of “jobs,” Prof. Prescott said that the laid off workers went to the Twin Cities and quickly found higher-paying employment.

Prof. Prescott’s recommendations for China are two-fold:

• Have a level playing field with intense competition.

• Do not subsidize inefficient producers.

If it does, Prof. Prescott believes that China will produce more technology capital and have more multinationals with operations abroad in the years ahead. In his view, the biggest danger is that China becomes centralized and closed, as it did in 1400, when it was the richest country in the world.

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