China's Industrial Revolution: Past, Present, Future

November 01, 2015

In just 35 years, China transformed itself from an impoverished agrarian economy into an industrial powerhouse that produces nearly half of the world's industrial goods. How did it accomplish this in such a short time? St. Louis Fed economist Yi Wen, a native of China, discussed the country's recent transformation, as well as what it will take for China to continue its hyper growth and for it to eventually become a high-income nation. He also addressed how the U.S. can benefit from China's rise and whether poor nations can emulate its success.

Presentation (PDF)

Following his presentation, Wen was joined by fellow St. Louis Fed economists William R. Emmons and Subhayu Bandyopadhyay for a panel discussion and Q&A with the audience. Julie Stackhouse, senior vice president of the St. Louis Fed's Banking Supervision and Regulation division, moderated the discussion.


The transcript includes time markers for your reference.

Julie Stackhouse: Good evening, everyone. Welcome to the Federal Reserve Bank of St. Louis. So it is 6:30. We're right on time. We try to be very good about that and hopefully we'll be right on time at 8, which means we may end up cutting off some questions. I hope that doesn't happen. I hope each of you has a chance to ask questions that are on your mind. But let me first introduce myself. I am Julie Stackhouse. Here at the Federal Reserve Bank of St. Louis I'm a senior vice president. I run the banking supervision, the discount window, and some other stuff. I'll just kind of go on that for another day I guess but it's a great job. It's been a real privilege to be here at the Federal Reserve Bank of St. Louis for 13 years.


In fact, just this last couple weeks I've started reading Ben Bernanke's books. And I don't know if any of you have had a chance to do that, but let me tell you, he's like most, it's like accurate. It's one of the first financial crisis books I've read where I go "Uh huh, yep. That's really the way it happened." But one of the things that I've really enjoyed reading about his book is the fact that he still characterized the Federal Reserve as being this obviously fairly introverted—we tend to be fairly introverted—very nonpolitical organization. And in fact, that's our strength and maybe that's our weakness. We're not very well known to many of you, so we really are delighted when we are able to offer a program and you choose to join us, learn a little bit about the topics that are facing the financial system and that our economists are studying, but also have a chance to get to know us. So it's great. And again welcome.


Tonight we will have a presentation by one of our economists here at the Federal Reserve who we'll introduce in just a minute. But just a little bit of housekeeping. First of all, you do have microphones. After we finish the presentation we'll convene a panel and the panel will offer some perspectives on tonight's presentation, but we'll also leave lots of time for you to ask questions. When you do ask a question please remember to turn the microphone on. There's a little button in front of it. And that way we can obviously hear you so that'd be great. And we are webcasting the session so we want to be sure our listening audience is able to hear you as well. If you do need to leave the room tonight please just go up through the back and out the door. Out that end of the auditorium there are restrooms very close to that. If that is convenient for you, please feel free to do so whenever you need. With that we're going to start tonight with a few polling questions. Those that are returning have done this before but we've thrown in a wrinkle for you. When we get to one of our polling questions we are not going to have just numbers one through nine. We're going to have numbers one through 10. Now the reason that's a wrinkle is that when you look at this little gadget you say yes, but I don't see a 10. That's when you look really, really closely at the zero. Guess what? There is a 10.


And here's the deal. When we get to that "one," if you hit "one" you're getting "one" and there's no going back. So if you want No. 10 please be sure to hit the 10. But let's move on to our first question. All right, this is the one we love to ask. Is this your first time inside the Federal Reserve Bank of St. Louis? If you've been with us before for any reason you can select "one." If this is truly your inaugural visit please select "two." Oh, yeah, right. That's what I said, wasn't it? "One" is yes and "two" is no, thank you. You know that tells me right away we have a very attentive audience tonight. OK, are we all set? Let's take a look at the number up at the top. OK. So 18 percent are here for the first time. Welcome. We're glad you're here. And 82 percent have been with us before. So welcome back to that group. All right, this is the hard question that has the No. 10. "I'm employed in the following industry." And just pick the one that's closest. We know it's probably not going to be exactly right for everyone. And this is not a trick question, so OK, let's see how we're doing up in the screen. It's still going up a little bit. OK. We'll go ahead and take a look. Now that's pretty interesting. So No. 2: financial services. Does that surprise anyone? No. I got to understand this China stuff, right? And No. 9: retired. I love it. Welcome. We have this loyal following and lots in between, so that's great. We really do enjoy having the wide representation of our community here tonight. OK.


So with that it's my pleasure to introduce our speaker tonight. Yi Wen is an economist and assistant vice president in the Research division here at the Federal Reserve Bank of St. Louis. And of course he is a native of China, and he has really an interesting background. I don't know if he'll get into it in his presentation tonight but I did have a chance to talk with him before the session about some of his domestic travels and it is pretty interesting. But his research is in the field of macroeconomics with a primary focus on the business cycle and the Chinese economy. After finding many explanations on views on China's lack of economic foundation and that the current textbook economic theories often didn't explain what was going on in his country, he decided it was time to focus his research into China's economy. He is working on a book that resulted from his research. You'll see that published in the not-too-distant future, we hope. And among his other publications his work has appeared in Economic Theory, European Economic Review, the Review of Economic Dynamics, and the China Economic Review. And he has many credentials in addition to that. So will you please join me in welcoming Yi Wen.

Yi Wen: Well, good evening. Thank you very much for giving me this opportunity to talk about China. But before I start, as you can see or as you heard from Julie, I'm not Irish, so I do need to apologize for my limited English. And so I talk about the rise of China, which in my view is one of the most significant economic and geopolitical phenomena in the 21st century and perhaps also one of the most important events in human history perhaps since the Industrial Revolution. Why is that? Because China is huge and so far, despite more than 200 years after U.K. first started the Industrial Revolution, and we still have had only 10 percent of the world population, which is more than 7 billion, achieved industrialization. And if China could succeed in finishing industrialization, that's an additional 20 percent of the world population. So that's big issue. OK. So that's very important.


But because China rises so fast the entire world is unprepared, including the Chinese themselves. And so there are a lot of conflicting views floating around, talking about China's rise. Why is that happening? How to explain that. And so tonight I'm going to share with you my perspective on these issues. OK, there are so many views floating around it's like the Indian story said there's like six blind men and an elephant. So every person can only scratch a limited area of the elephant and claim that they have the complete picture. OK. So it's hard to come up with a perspective which cannot only explain China but also other nations' failure and successes and also to predict China's future.

So far there have been at least two—there are many views but I'm going to point out two—conflicting or polar views about China's rise. OK, and the first one sees China's rise as a gigantic government-engineered bubble and at the cost of its own people and the environment. So China's growth or hypergrowth is not sustainable and it will collapse because China has no democracy, no freedom of speech, no human rights, no protection of intellectual property, and low ability to innovate except copying and stealing Western technologies. And no, a host of many things which the West has possessed for centuries. And those elements have been essential for the Western civilization and the technological dominance. OK. So therefore there's no way this China rise phenomena can continue.


And on the other side, on the other polar, there's the other view which essentially sees China's rise simply as a natural or destined return to its historical position. We all know that China had been one of the richest nations in the world and one of the greatest civilizations. And therefore it's only a matter of time for China to reclaim its historical glory. China has had many great inventions in the ancient time, we all know. For example, the gun powder, the compass, the paper-making technology and printing technology, all of that were essential for the rise of the West and for Western civilization, OK? So therefore in that view, China will rise for sure. It's just a matter of time. And whenever China wakes up China will become strong, like what Napoleon once said.

But in neither view, neither of these views had strong economic analysis to back up their argument. In my view, they're either prejudice or simple extrapolations of human history. How could a nation with so many bad or adverse elements able to achieve a great ancient civilization in the past and to have several consecutive decades of hypergrowth to completely or almost completely transform from a vast impoverished agriculture land into a formidable industrial powerhouse? How could that be possible, OK, for China, have all those bad elements? On the other hand if culture and ancient civilization is the explanation, how come we do not yet see countries like Egypt, Ottoman Empire, and even Greece bursting into the world stage, at least not yet? So therefore we need a different perspective in order to have us to understand China, and that's the perspective I would like to share with you tonight. I hope that that perspective cannot only shed light on the mechanism behind China's rapid growth but also on the failures and the successes of many nations at their attempt at industrialization and so perhaps including the Industrial Revolution itself.


Again, before I start there's a standard disclaimer and I hope you take that into heart. And I'm going to divide my tonight's talk into four bullet points. First of all, I want to provide some basic facts about China's rise. Secondly, I want to provide some explanation and that's the most important part of tonight's talk. And after that I'm going to talk about what's next, OK? Then I'm going to talk about how can the U.S. respond and benefit from China's rise. Then we're going to go to Q and A, OK? So the second part is the most important part. Without that, any prediction about China or talk about the U.S.-China relationship will not be very well founded. But still giving my short limited time I will only touch upon several key issues which I detailed in my forthcoming book titled, The Making of an Economic Superpower. The subtitle is Unlocking China's Secret of Rapid Industrialization. A working paper version is available on my website. I do not mean to advertise this book, just to tell you that all the royalties from the sales of this book will go directly to Federal Reserve Bank of St. Louis Research department, not my pocket, OK? Yeah.


So first some basic facts about China's rise. Well, 35 years ago, China was very, very poor. OK. That's the time when President Nixon visited China, OK, and the per capita income was about one-third of sub-Sahara Africa. Africa we think is the poorest region of the world but China was even poorer than that. But only 35 years later, one generation's time, China has already become the largest manufacturing superpower, OK, or powerhouse. OK, and China supplies almost nearly half of global industrial goods including crude steel, which is about 800 percent of U.S. level and 50 percent of global capacity; and cement, which is about 60 percent of world production capacity; and vehicles, which is about a quarter of global supply; and also China has industrial patent applications which is about 150 percent of U.S. level. And China's also the world's largest producer of ships, high-speed trains, robots, tunnels, bridges, highways, chemical fibers, machine tools, computers, cell phones and many other stuff. So China currently is very much like 19th century U.S. OK, I want you to keep that perspective and that's the perspective I want to get to later.

If you look at, this is a figure about the value-added manufacturing output produced by the top five industrial powers. The blue line's the U.S. The yellow line's Japan. The green line's Germany. The brown line's Italy. And China's red. So as you can see, in the '70s China was essentially producing very tiny amount of industrial manufacturing goods and U.S. was several hundredfold of China. But starting around 1980, OK, China start to take off. And gradually accelerate and surpass all the industrial powers one by one and ultimately overtake U.S. in around 2010. OK. And if you look at a trend maybe China is going to collapse, but you could look at a trend maybe somewhere China is potentially able to produce manufacturing goods twice as large as U.S. or even more. OK, so if that is the bubble, every nation want to have that bubble and every nation should have that bubble. So therefore by looking at this picture, it's unlikely that China's rise is purely a bubble.


Now the economist Steven Cheung—perhaps you don't know him. He used to be a professor at Washington State University and spent many years at Chicago and colleague of many Nobel Prize winner in Chicago. And he's one of the important institutional economic theorists and a self-claimed Chicago School economist, OK? And he once wrote, he said that, "I can easily write a thick book in a week to criticize China." OK, China has so many problems so you just write a book. "However, the fact that China's miracle growth has been lasting for so long despite so many hostile social and political conditions is truly amazing and unprecedented. So China must have done something so profoundly right. But what is it?" Nobody knows. OK, that's the challenge.

Well, tonight I will try to provide an answer, one of the answers to that question. So of course, the longer answer can be found in my book but the shorter answer is that China, for some reason, has rediscovered the secret recipe of the original Industrial Revolution which took place in Britain more than 200 years ago. And any nation who has discovered that recipe, they can become industrialized. The French did it. Germany did it. The U.S. did it. Japan did it. OK, now since China also has found it, but what is it? So that's a one million dollar question. I will try to provide some answer, OK, hopefully. And of course another question is, if there exists a recipe lying there for 200 years how come China did not find it before, because China in the 17th, 18th century, China was even more advanced perhaps than Europe?


How come China did not start the Industrial Revolution? It was the U.K. and actually if historians' constant debate about this ... could have been India; could have been China. Remember China invented those wonderful technologies. And another question that allowed me to follow from this is that despite several decades of hypergrowth China today even though its GDP may be able to match with the U.S. in GDP terms, but its per capita income is still real low. China's still poor. Per capita income is about one-seventh of U.S. level. It's lower than country like Mexico, Turkey, or even Colombia. So therefore, next question is whether China can finish its course if China has discovered the so-called recipe. And if so, when? And what are the challenges ahead? So I'm going embed those questions into my earlier outline of the talk in this explanation part, OK, then later on talk about how can U.S. respond and benefit from China's rise.

So let's go to question No. 1: What is the secret recipe? Well, before I provide that answer, I want you to wait. Because we have to know Industrial Revolution is the single most important thing happening in human history. It changed everything. OK, in order to visualize that power here's a graph I took from economic historian Gregory Clark's book, OK, where he measured worldwide average income starting from 1000 B.C. OK, where he got the data I don't know. But most people accept that. OK. And the vertical axis essentially is the income per capita world average, OK. And he normalized 1000 B.C. as the value 1. And you can see through a thousand years entire world has been living essentially under poverty. Income fluctuate but it has not really changed much, OK.


You have under some empires, some monarchies, income is higher; sometimes it's lower, OK. It has not changed until the point 1800 and something mystically took place. OK, that's the Industrial Revolution. And since then the entire world diverged. That's called the Great Divergence by historians. And the average world income level shoot up very fast and now it's twelvefold higher than before, OK. And since that, there's no way that it will turn back. And the rest part of the world, as I said earlier, perhaps more than 90 percent population are still unindustrialized, therefore perhaps they still in poverty. So therefore ever since Great Britain has discovered this secret recipe of Industrial Revolution every nation try to emulate it, first in Europe and then in U.S. and also in Asia. But most nations have failed.

For example, I list here North and Western Europe successfully emulate the British Industrial Revolution in that about 140 years span of time. And the United States also successfully emulated Industrial Revolution in that about 120 years span of time. Then Japan also. It's the first Asian nation to successfully emulate it, to emulate the British Industrial Revolution for about 100 years. Now later you also have Asian Tigers starting much later, after World War II and but also took them less time to catch up. But again, not all the Asian Tigers have reached the level of U.S. income, not yet. For example, in Taiwan it's maybe half of the U.S. income level. And Singapore is roughly the same or even higher. And overall for them together they account for less than 10 percent of world population. So most of the nations have failed. It's not that they didn't try. They tried many times but they failed, OK. The question is why.


Economists have not come up with answers, though actually many theories floating around. One of the most popular one is called the institutional theory, OK, and it provide a broad picture or answer or theory to explain why nations fail and why nations succeed. So according to this theory, the answer, or the key, lies in political institutions. For example, if nations have inclusive institutions such as democracy then that would imply restrictions on the elite class. That would imply free market, free trade, free choice, private property rights, the rule of law, which in turn imply incentives for people to accumulate wealth, to innovate, and to grow; therefore you have prosperity, OK?

On the other hand, nations that adopt extractive institutions such as dictatorship, they would have no freedom of choice, no private property rights, no rule of law that in turn would imply no incentives for people to work hard, to accumulate capital, to innovate. That in turn would imply poverty. OK so that's the answer given by institutional theory. And one of the important institutional theorists actually lives in St. Louis. His name is Douglass North and at Washington University he received Nobel Prize for his contribution to the understanding of economic history and to institutional theory. OK. So the solution to end global poverty in all the remaining 90 percent of population is simple: democracy. Indeed, after post World War II, the United States has been leading the way to spread democracy across the globe. And one of the ideas is to end poverty, OK, because poverty not only hurts people but also generates lots of other side effects.


The question is, is it really the case? So I'm going to show you that this theory actually is difficult to square the facts. We can provide many, many counter-factual country examples to defy that theory or to show that that's inconsistent. For example, there are so many of these poor nations that have adopted democracy and liberal economic reforms yet they're still living in poverty, living in stagnation and with constant political turmoil. Those countries include Afghanistan, Egypt, Iraq, Libya, Pakistan, Thailand, Tunisia, Ukraine, and many others, OK. Or maybe time is not long enough. We should wait, right? It took the U.K. 200 years to finish Industrial Revolution. Those countries have had a democracy only maybe, I don't know, one decade, two decade or few years. Maybe time is not long enough. But those are not the only examples that are inconsistent with the theory. For example, we also have had many nations who lived through so-called extractive institutions, yet it is precisely during that period those nations grow the fastest and industrialize the fastest. For example Germany from 1850 to World War II, most of that period was under extractive institutions. And Germany was one of the industrial powers, OK. And Soviet Russia also between 1860 and World War II industrialized very fast. Most of that period was under extractive institutions, OK.


Also we have many other examples. For example, new Russia starting the 1990s after the collapse of the Soviet Union block, right? Want to transform from a socialist economy to a capitalist economy and want to continue economic growth. And they collapsed right after adopting the advice that's given by the West or by the economists. You know, "Adopt democracy and then liberalize your financial market. Privatize all your state-owned factories;" but they collapsed. And also Japan's rapid industrialization during the immediate restoration was mostly under extractive institutions, was not under true democracy. And also South Korea's economic takeoff, the most important period was during the '60s and '80s under dictatorship. We all know that. And Singapore's post-independence economic miracle. We know President Lee Kuan Yew who passed away I think last year, two years ago and had been called a dictator and essential Singapore's like a one-party and all the political party was ruled by his own family and now achieved modernization.

And also some nations even under identical institutions, you know, the same nation, with the same political institution but we still have cities with different pockets, you know, pockets with extreme poverty, pockets with extreme wealth, such as St. Louis and Chicago; and pockets with violence and pockets with obedience to rule of law, OK. For example, also in Italy under the same roof of political institutions south Italy is significantly poorer than north Italy. So therefore this institutional theory, although it sounds very, very appealing but it has lot of problems to square the facts. So we need something new, only to add something, only something different.


Also in the case of China, China's past more than three decades of rapid growth was under an authoritarian political system, OK? And if democracy is the precondition for Industrial Revolution, how come China is experiencing rapid growth? Or you may say China is not really going through Industrial Revolution. We'll see. And also what is going on in China today actually is not China's first attempt at industrialization. China has already had three attempts in the past but all failed, or more or less failed, OK? The first one started in the 1860s when China was defeated by Britain after the second Opium War. If you know a little of history you know that. OK, then the Qing dynasty monarchy finally decided to reform. Whoops, well, so backward, this tiny barbaric, you know, European people who used to live in caves when we already civilized. Now they are stronger than us so they can attack us. So they decide to reform and to industrialize. And half century later it was a gigantic failure, OK, didn't go anywhere. Because of that failure, there was a revolution. People say the monarchy institution was not good for China. And that's the reason China could not industrialize. We wanted democracy. We wanted what the U.S. has. So in 1911 there was a Xinhai Revolution which overthrew the monarchy fully adopted by mimicking the U.S. institution. OK, parliamentary system while, yes, European style, but democracy and inclusive institutions, even Communist Party was allowed to play a role in the government. So the Communist leader Chairman Mao, actually he was a high official during the Republic era of China because the institution was very inclusive, open to all the competing parties. And yet 40 years later, China failed to industrialize. That's why Japan was so easy to invade China and completely overwhelm China's military force.


And because China remained in poverty after almost 100 years of two attempts, failed attempts, at industrialization, the Communism took power, said, "It's my turn. You have all done things wrong. Capitalism is not the way to go because capitalism generated all the poverty in China, inequality. A few people or the elite class get rich. But the majority people still live in poverty." So the Communists say that's not the way to go. We have to do something else in order to industrialize China. So Communism took power around 1949. But again 30 years later China still remained very poor. So that's the year of 1978, after the death of Mao, and Deng Xiaoping took power. So why did China fail in previous three attempts at industrialization? Well, is it the lack of free market? During Communism yes, there was no free market. But not true during the late Qing dynasty and during the Republic of China. Private property rights during the Qing dynasty was even better than it was in Europe, OK. Historians have consent on that. And during the Republic of China was full-fledged private-property rights, OK. And so it's not the lack of free market per se or private property rights. But it was the lack of democracy under Communism, yes, but not during the era of the Republic of China. And it's also not lack of natural resources. Even though China is very poor in terms of natural endowment, but that's not the reason. There are many nations successfully industrialized without very much natural resources, such as Singapore, Hong Kong, Taiwan, and Japan, OK. So, but on the other hand, many other nations are very rich in natural resources. They could not industrialize, such as Middle East countries or even Latin American countries. OK, so natural resources seems not to be the necessary condition.


So what has China done differently this time, the fourth attempt at industrialization? Well, before I give you a synthesized theory, let me just describe some basic facts. OK, based on that we can throw some theory. First of all, the first attempt China did it in a very humble, gradualist, experimental approach, because China or the Chinese leader thought we could no longer afford not to succeed this time. OK, we have to succeed and we have failed three times before. So they want to approach gradually and they wisely refused all the lectures and theories from the West, unlike Russia. Russia accepted a bunch of MIT, Harvard economists, you know, the hyper economists, and to guide them, to tell them how to reform. And Russia collapsed. And China said "No, don't come here. OK, we'll manipulate it our own way." So first important feature for that, for China's fourth attempt, is to maintain political stability. I'm not going to judge whether that's morally right or wrong. I'm just describing the fact, OK? So maintain political stability at all costs. I have to emphasize that, all costs. OK, if any nation want to come to China to do regime change, no way, OK. So that's essentially at all cost. And so no more revolutions. So they said, "It's enough. We have had enough revolutions so now they lost two industrializations. So this time we're going to take the existing political institutions as given. We want to maintain political stability."

And also this time what they have done differently is to focus on the grassroots. They took a bottom-up reform starting in agriculture where the majority of the population lives. OK, when China started reform in 1978, 80 percent of the populations was peasants, poor peasants.


They are not even called farmers. They're peasants. And Qing dynasty's China's government and Republic China's government did not pay attention to the grassroots, did not pay attention to the peasants. They ignore them. And they started industrial revolution, industrialization, in the cities. Of course you have several or few merchants get very rich. But the majority of the nation remained in poverty. So this time they focus on the grassroots, they took a bottom-up approach starting in agriculture, not in the financial sector unlike what Russia has done. Start to set up a stock market and a lot of financial securities floating around and sell the equities, all the state-owned factories. But turns out that's a wrong approach, OK. You'll start building by starting from the roof rather than from the foundation. And also promote rural industries despite their primitive technologies. They need to start with more than industries. Invite Boeing or Ford company come to Beijing to set up factories. Those things may be done but they're not the focus.


The focus is in the rural area starting with rural factories, even though they are tiny, two, three, four, 10, 20 people. And it was very primitive technology. Technology is so primitive they were like 18th century England, OK. And use manufactured goods instead of only natural resources to exchange for machineries. And enormous amount of government support in infrastructure buildup. And also because when China started reform – 1978 – Communism has already spent 30 years to build up those heavy industries. Russia, what Russia did is to privatize all of them overnight. But China did not because they were still, even though they were highly inefficient, they were still the backbones of the economy. They took a dual-track approach, gradually privatizing and the market forced to grow to overtake them. Even today China still remains 20 percent of manufacturing produced by state-owned factories, OK. Before it was 100 percent. OK, they took a very gradual approach and they move up the industrial ladder from light to heavy industries, gradually from labor- to capital-intensive production, gradually from manufacturing to financial capitalism.

China's only started to do financial capitalism today even after three decades or more than three decades of rapid growth. And they encounter problem. You know last month there's talk the market start to tumble. So they're still learning, OK, how to do financial capitalism. But China has been able to grow so rapidly for three decades without, essentially without a stock market. So what's essential, so essential about stock market? Well, maybe essential for the future, not essential for the past. But at least so far they have not really had a well-functioning stock market. OK, think about that. Is that something unusual or something with some truth in that?


Whereas when the IMF and the World Bank go to develop relations, try to lecture them how to develop, the first thing they tell them to do is set up a stock market. That may not be necessary. And a stock market invites foreign speculators. They're the ones driven by capitalist spirit, you know, self-interest guided. And also they move gradually from a high-saving state to a consumeristic welfare state. OK, it's not there yet but they're moving toward that direction. So now I want to start to get into more the theoretical aspect after describing what China has done. I want to claim that actually, China's fourth attempt turns out mimic almost exactly what has happened in history for all those successful industrializations in terms of going through several key states, not in every aspect. I mean U.K. was always different from China. Institutions were different, cultures were different. But there are some very important mechanisms or key steps hidden in terms economies that are very much the same. So that's where I want to generate.

So if you look at all the successful industrializations, almost all of them, they have gone through several important stages, starting from primitive agriculture. OK, first stage after the Dark Age, especially after the Renaissance, or after Columbus's global voyage, Europe starting from Italy went through several centuries of process of market creation. I call it a fermentation of the market, so like when you ferment the sourdough bread. OK, it's a gradual process. OK, I call that, historians call that proto-industrialization. And that appeared, was features the mushrooming of rural industries with the purpose of long-distance trade. OK, so the industrialization did not start from the commercial cities even though in 16th century Europe, 17th century Europe, they all have quite a lot of commercial cities like London. OK, but industrialization did not start from there. So, from the poor rural areas, but however, with the goal of long-distance trade. Then around about late 18th century some things start to dramatically change, OK. Industrial Revolution took place first in U.K. I call that first Industrial Revolution. But later on I'm going to talk about second and maybe third and fourth.


The fundamental feature of that first Industrial Revolution is labor-intensive mass production for mass market. Of course in the U.K. we all know it's the textile industry. And interestingly, later on all the European nations who have successfully emulated U.K. also started with textiles: France, Germany, Netherlands, even U.S. Said, well, of course at that time there was nothing else. We still do not know automobile yet. No, even Japan, when Japan started its industrial revolution the first phase also started with textile. Even today's China. OK, China in the first 20 years of rapid growth focused heavily on textiles. And by 1995, China became the world No. 1 textile producer and exporter. So again you repeat the earlier stage of development. Why's that? Of course, I have some theory to come up but let's see if I have time to go through.

But once you almost finish the first industrial revolution with mass production of labor intensive goods for mass market that generates demand for transportation. The cargoes, you know, you need to maintain constant supply of cotton, the raw import of raw materials. And to distribute throughout the entire world you need better transportation, and that provides the stimulus. OK, and I call the industrial trinity because that's energy, plus locomotive power plus infrastructure, infrastructure including transportation infrastructure and communications.


OK, of course as time changes the content or the form of the trinity may change from coal to oil, for example, from telegraph to telephone, for example. But the essence of that element is the same. So the U.K. experience of that industrial trinity boom. Then that also triggered the second Industrial Revolution, which features the mass production of the means of mass production. The industrial trinity essentially is a means, not a final goal of consumption, right? And with that you have second. But once you finish second industrial revolution, that means the economy closes the loop. Now you can finally be self-sustained and maintain self-sustainable growth. And that's the point that where ultimately there's so-called a food security issue get it resolved because you can finally mechanize the production of agriculture. Then human survival is no longer dependent on weather. OK, so only nations that finish industrialization that they are no longer subject to, highly to natural disasters like developing poor countries do, OK. Then after finishing second industrial revolution, nations move into a new phase, sometimes what we call postindustrial revolution or what we call welfare state, which essentially features service economy and a social safety net, democracy, human rights, end of death penalty, bunch of other issues start to emerge even though human beings have had the idea of democracy, human rights, maybe once in B.C. or during the Greek time, during the ancient China time. But those ideas are not implementable because of the lack of economic foundation.


So only after nations finish their industrial revolution then the foundation's there for those ideas to be implementable. OK, and that was precisely why it is only those Western nations who have industrialized have stable democracy. And the other poor nations, they adopt democracy before starting or finishing industrial revolutions, their democracies are not stable; they come and go.

So again, let me quickly go through the patterns of industrialization, for example, U.K. was the first country to start industrial revolution, and U.K. spent at least 250 years to go through their first phase of the Industrial Revolution, which I call proto-industrialization, OK? And starting from around the middle of the 18th century to 1830, U.K. kick-start first Industrial Revolution and almost finished it. Then U.K. went through this industrial trinity boom, mass amount of production of engines and coal mining and railroads. And U.K. also kick-started second Industrial Revolution around 1850 to finish that around 1920. So all that period, that U.K. was the only dominating industrial power in the world.

By 1928, long after U.K. has finished first Industrial Revolution and also finished second Industrial Revolution, U.K. adopted universal suffrage. OK, now look at U.S. Before 1820, even before United States became a unified nation, U.S. has already started, had already started proto-industrialization. OK, and during that time, lots of tiny small firms and the long-distance trade were set up in the rural areas, not in the commercial cities, not in Boston, not in Philadelphia, OK? And around 1820 to 1860, you know, around the year of the Civil War, U.S. finished first Industrial Revolution.


And slightly later, when there was overlap, U.S. also experienced boom in industrial trinity. Example: the so-called railroad mania, right? U.S. has had that. And around 1870 to 1940, U.S. entered second industrial revolution. Start to engage in mass production of the means of mass production. And lots of inventions start to develop. Before that, the U.K. laugh at U.S. —"You are so poor, you mimic us. You steal all the technology from me," — but once the U.S. entered second industrial revolution, then U.S. start becoming the dominating power of the world, passed U.K.

And after the U.S. finished second industrial revolution, around 1940s, that's when the U.S. started full mechanization of our culture. Around 1920, U.S. agriculture was still very backward. About 50 percent population live in rural area. But once it reached 1940 that picture start to change. Then after World War II, U.S. fully entered welfare state. And we start to see lots of social civil movements around. And civil rights movement in the '60s, universal suffrage in the U.S. come quite late compared to other European countries. So do not lecture developing country, where are they? Well, the model of democracy, the U.S., come late. OK, 1965, and Violence Against Women Act signed in law in 1994 and same-sex marriage legalized in 2015.


Maybe a hundred years from now they're going to say, "How come the U.S. was so uncivilized in the 2015s? They did not allow gay marriage." But now we're considered we're very liberal; we're moving forward; we're moving ahead of many nations.

OK, so civilizations, economies develop in stages. If you jump forward, skip some stages, you have disorder, it won't be stable. So look at Japan. Similar pattern, OK. Before the so-called Meiji Restoration period when finally the Japanese door was kicked open by U.S. Navy, Japan had several hundred years of political stability, and commercial prosperity was mimicking like Song dynasty China around 900 to 1100. OK, but Japan was lucky to have that period right during the Western industrialization period so they can right connect to industrialization. So from around 1870 to 1890, Japan opened up its economy to the Western trade and started full-fledged proto-industrialization. Again, Japan did not jump into setting up modern industries. From 1890 to about 1920, Japan witnessed their first industrial revolution by relying on very extensive labor intensive low value-added technology: textiles, silk. OK, sell those goods to the West in exchange for machineries. So only later on Japan started to have a boom in industrial trinity. They had the finesse and gradually learned the technology along with the help of Westerners to build their infrastructure system.


Then they kick-start a second industrial revolution between 1920 and '41. Did not finish. Interrupted by Second World War because Japan became so ambitious and wanted to overtake the entire world because once the economy's so developed your appetite will develop. You want more raw materials. And they want to grab all the nations. You want to become a colonizer and so they could engage into Second World War. And the war stopped from 1945, Japan continued its second industrial revolution and finished around '70 or '80s. And that's also the period Japan entered a peaceful period of welfare state building, of course with tremendous amount of U.S. help.

Now you look at China. Well, China has only had slightly more than three decades of economic growth, but China actually went through the first three phases very rapidly. OK, why China's able to finish those phases so rapidly instead of take 100 or 200 years? I'm going to come back to that issue later. So you look at China state of economic structure. Around the first 10 years after they become reformed China went through this so-called proto-industrialization stage. OK, in that stage, in that period China's village firms increased by twelvefold just within 10 years. And they continued to increase later on, doubling every three years. OK, and that's a tremendous amount of economic force. But that's very invisible by the Westerners because using very primitive technology, producing very primitive goods. And village industries' gross output increased by thirteen- or fourteenfold. And starting around the 14 percent of GDP to about half of GDP also comes from rural industries.


Rural industries are very primitive in China. Economists call that a village township industries. On the surface look very different. Many economists I think made a mistake by thinking China's township village industry as something unique to China. Why is that unique? Because there's a township industry, they're not really private. They're collectively owned by farmers. They inherited this property land ownership from communism. Deng Xiaoping did not privatize land when he started economic reform. Yet despite the lack of private property, which we think essential for economic growth, China economy grew very fast, OK. But actually, even if the ownership is very different from U.K. but the format is the same, is a rural industry, OK, and aiming at long-distance trade. The village peasant workers increase to a big number, which is about 100 million just after 10 years of reform. A hundred million, that's a big labor force, but they all reside in the rural area; they didn't move to the city. OK, this city urban migrate did not happen yet. That come later. Whereas Latin America tried policy to push the farmers to go to cities. But where do they stay? Where can they find a job? So that tells us something why this proto-industrialization is important, has to happen in the rural area. And the farmers' average income also increased tremendously, about twelvefold, and the China had short economy as all the other communist nations and the social planning, right? Shortage economy. So not enough food, not enough coats, and everything was put on a quota. OK, but China ended that after just first 10 years of rural industrial growth.


Now China entered the second phase, which is 1988 to 1990, is roughly speaking. OK, that's called the first industrial revolution and that features mass production of low value-added labor intensive goods across the entire nation, both rural and urban. And China entered, remember, WTO around the end of that period. Before China entered WTO because the negotiating was so hard most people predicted that China was going to be hurt by joining WTO because China conceded so much. The U.S. food is going to flood China. But actually after, as soon as China joined WTO it's the other way around. Chinese goods start to flood U.S. because China was very well prepared and people did not notice. Even Chinese themselves perhaps did not notice. And so China became in that period as a sign of the flagship industry, which is textile, China become No. 1. Just like U.K. did in the early 19th century, U.S. did in the middle of 19th century, Japan did in the early 20th century, China did in the late 20th century. You go through that in stages. And by that time, village firm workers reached even higher, about one-third of China's entire rural labor force. Still they did not move to the cities. Maybe you say, "Oh, government has policy not allow them to move." But they were free to move to find jobs even though they do not have the benefits by leaving cities. And most of them stayed in the rural area to do their job. So that's the second phase.


Then since around the end of 1990s, China entered the phase of industrial trinity boom so you to see mass build of highways and railroads and also the housing bubble start to follow, housing boom, because once you are satisfied with food, once you are satisfied with clothing, you want shelter. So the shelter boom starts to come. And China starts to engage in mass production of energy, such as coal, and intermediate goods, such as steel and cement and a bunch of other things. And it is after that period China also, China for example the infrastructure was built so fast with the tremendous amount of savings accumulated from earlier era. China did not rely on international loans unlike many, many Latin American countries. It relied on its own saving. Even today China's national saving rate is still 50 percent of GDP. What's the U.S. level? Ten percent, maybe 15. But it's fine for the U.S. developed already. But if for undeveloped countries, developing country you only have 10 percent of saving rate that's a problem.

So yes, you can see the number. China's build of highways very fast and today also China builds speed trains. And about 28 provinces out of 30 or if you include those municipal cities, and that's 34, covered by high-speed trains. And that's the largest high-speed network in the world now, exceeding Europe. So now how come China can't achieve that? So many people like Chicago School economists—some of them are my friends. I don't want to offend them. Say it's marketism, it's they're trying to fill marketism. I have told you long time ago since Adam Smith. Let the market take over. Let the invisible hand take over and you're going to achieve prosperity.


Yes, the one of the very important, distinct feature of Deng Xiaoping's reform is to allow market forces to play an important role but that's not all, OK, so that's why I said yes and no. Yes, for obvious reasons the market impose economic incentives to compete, and competition we know is very important, not only for human beings but also for animal species. And impose discipline on management and technology adoption. If you adopt the wrong technology you are going to fail. If you adopt the right technology you are going to succeed. So that create a Darwinian creative destruction forces to eliminate losers. During the communism and socialism era, no firm is allowed to fail. Basically the government protects every firm no matter how inefficient you are. But once they introduce market forces, if you don't do well, you fail. So that's what a market does.

But on the other hand, the answer is "no" for some overlooked reasons, which we do not emphasize enough even though they are very important, OK? First of all it is extremely costly for those independent, anarchic, uneducated peasants to cooperate for organizations. How can they trust each other? How can they up their saving together? Where are they going to make sales? Where does the raw material come from? So it's very costly for them to do that. And because it's very costly to create market in the first place. According to Adam Smith, he said the invisible hand is the key to generate prosperity, but did he assume that the market or the material exists? No. You go to poor countries, you saw people but there was no market. OK, you have group of isolated peasants put together to mass produce something where are you going to sell? You're going to carry the bag across the mountain to knock on the doors? And also where does the raw material supply come from? You have to constantly maintain the flow from raw materials into finer goods and to sell it. So you need a master distribution system in order to make mass production profitable. So it's very costly to create a market. One of the important aspects of market, of course, is infrastructure, but it's more than that. And also what is overlooked is that it's even more costly perhaps to create market regulations, market regulatory institutions, to regulate market forces, to prevent cheating and fraud.


You know, market forces by themselves are not necessarily productive. They can be very destructive. We just learned that from the recent financial crisis. You need government to set up regulations. They rule the game so as to allow the productive side of the market to flourish and to let the destructive part of the market to be controlled. So therefore those elements are very important.

Now the next question is how to create well-regulated big markets. Without big markets, we cannot have mass production. Without mass production, the goods will not be cheap enough for everybody to afford that we know that we cannot have prosperity. We just have poverty, OK? Well, the early European powers relied on mercantilist state of government and powerful merchants to create monopolistic global markets. Took them hundreds, hundreds of years. Of course, also through colonialism, imperialism, and slave trade, those were very important elements for those merchants to get rich. And those are the ones to help create the market. Of course, backed by government, their navy ships. And those merchants, they had the government permission to use military force to knock open any poor nation's doors to the trade. That's what Britain did to China and even by sending opium to China in exchange for teas and silk. So in the case of U.K., generations of British monarchies and merchants including, for example, the British East India Company helped create for England the world's largest, deepest, thickest textile markets, cotton supply chains. South U.S. was one of the major cotton supply for U.K. and the trading networks. That kick started the first Industrial Revolution. That's why it was U.K., not Netherlands, even though Netherlands was even more prosperous, even richer than U.K. but Netherlands failed to grasp monopolies of the global textile market, so they failed. And the U.K. managed to do that under...backed by U.K. government and the monarchies.


So today developing nations may no longer have the privilege and the time, several centuries of gradual market fermentation, to nurture a big, powerful cast of merchants and rely on them to create the markets. So therefore government has to pay a bigger role today than it has took before. And if you look at China's... the three phases of industrialization, even in the very beginning the proto-industrialization or the village firms, government officials create a very pivotal, important role, to have them set up firms, have them to distribute the good, to make the sales, to provide the supply of raw materials, OK, because there was no big class of merchants. During the communism there were some; they were all killed.


Adam Smith actually already realized this importance of the size of market. He said we all know that division of labor, which is important for productivity, is limited by the extent of the market. And so I say to this in my book that the free market is not free. It is a fundamental public good that is extremely costly to create. The ongoing industrial revolution in China has been driven not by technology adoption per se but instead by continuous market creation led by a capable government, mercantilist government. And the famous English manufacturer—I don't know, if you read history you know him—Matthew Boulton, he wrote to his business partner James Watt, who invented a steam engine, and said that, "It is not worth my while to manufacture your engine just for three counties. But it will be very well worth my while to make it for the entire world." But where does the world market come from? It was created by British monarchies and their merchants. Otherwise you have the steam engine technology. So what? You cannot make money. Actually steam engine technology has been there from a long, long time ago but the economy did not use it because it's not profitable until mass market is created.

So, therefore, now come back to the questions I posed earlier. What is the secret recipe of industrial revolution? Why did China not find it before? Now I can give you the summary. So I create a new stage theory in my book. So firstly we need to create a market. A modern industrial market takes several key stages to create. Development is a sequential process of market creation. No matter how late a nation starts its development it must repeat earlier stage to succeed. You cannot just skip it, jump forward directly from agricultural, primitive method of production to modern automobile assembly line.


If you do that it is not sustainable. Just like learning mathematics, human race has through thousands of years discovered the laws of mathematics but starting from numbers to arithmetic to algebra to calculus, etc. So despite we already know calculus very well from mathematician. But for today's children to learn mathematics you still have to repeat those earlier stages, exactly like the entire human race has traveled except at a rapid, more faster pace. You have to repeat it. So that's my metaphor for this new stage theory.

In contrast, most modern development economic theories try to teach developing countries or the nations they want to do that themselves, too. OK, it's not like taking lessons from other economies. They want to do it themselves; they want to leap forward. OK, they want to leap forward. And to start industrial revolution by building advanced capital-intensive industries, by setting up modern financial systems, by erecting more than political institutions because that's what U.S. has today, therefore they think if we want to grow to the level U.S. we should do that also. But that's the roof of the building, not the foundation. They missed the chance to see how the American built their foundation in the 19th century. They are born too late. But those are written in history and we have to read it.

I pose several wise theories I read. That's people's argument why should we repeat earlier backward stages. We should just jump directly forward but that's going to be a big mistake. So I said such a top-down approach violates the historical sequence of the Industrial Revolution, therefore create problems.


So now with the basic picture I give to you about China's rapid growth and the so-called industrial revolution secret recipe, the natural question is what's next because China has not finished yet. OK, China's still in the middle of finishing that industrial revolution. China especially is in the middle finishing second industrial revolution, has already finished proto-industrialization and first industrial revolution. It's in the middle of the second one. So this is roughly the government plan and also roughly my estimate. OK, if China stay on the course, then China is able to eliminate poverty by 2020. OK, China has already eliminated 720 million poverty and 70 million still remain. And by 2025 to 2030, China should be able to finish, or perhaps even earlier, finish its second industrial revolution. So when I look at China I do not pay attention to the stock market, those daily fluctuations. I look at the deeper economic forces. And if you look at the newspaper in China, every day they report the innovation. And there is key sectors which belong to heavy industry. Every day you have news. So you can see this underlying trend was just like 19th century U.S. and early 20th century U.S. China was moving very rapidly and so by looking at the stock market and the change rate is the fundamental mistake. That's not going to help you to understand China. You have to look at the underlying fundamental force. And China want to build up mature financial capitalism. One aspect of that is internationalization of China's currency, OK? And maybe around 2017 to 2020 China will be able to achieve that.


So five years from now if suddenly China's RMB currency becomes one of the major global reserve currency don't be surprised. China is moving toward that rapidly. And became one of the chief capital net exporters. China has already achieved that too. This year China already become net capital export instead of just capital importers. And China now is carry money, huge sum of money investing everywhere: in Africa, in North America, in Middle East. China has that demand, has that capacity.

China build new global transportation system because China's population is four times the U.S. So China's potential of the size of the nation you really want to reach the U.S. income level per capita is four times the U.S. They need much larger market to support that giant relation. And therefore the current global infrastructure system is not enough for China. So China want to build a larger one. Was like the U.K. in the 19th century. U.K. was building railroad everywhere. But China's not doing that through colonialism or imperialism. China's doing that based on mutually beneficial trade, and that's the major difference. And by 2050 China become full-fledged welfare state and a high-income country. That's the goal set up by the government plan and I think the probability to achieve that is high. But it doesn't necessarily mean the per capita income is exactly the U.S. level. But even if China could achieve per capita income level of South Korea or Japan, China's total GDP would be three times large as the U.S. How can you imagine that? I mean within the U.S. has been the largest economy in the world. How can you have another nation be twice or three times bigger than the U.S.? Well, that's China's potential if China can create a large enough market to support that kind of scale of production.


But however, it's not easy. So I want to mention about the challenges ahead for China. On the one hand, China has been growing very fast, but the same like for the European countries for the U.S. has gone through which we may have forgotten. Lots of problems emerged during industrialization. In the case of China, China contains all those centuries of problems together into one single generation. You can imagine how big that problem is. OK, those problems include, are not limited to rampant corruption and organized crime. U.S. corruption in the 19th century was very high. You can buy, pay, I don't know, couple hundred dollars, to become a congressman or to buy a congressman. And unprecedented pollution was very, very severe and China now is determined to tackle that problem because that's not only a problem in China but also is a problem of the world. But fortunately China's government is determined to tackle that and has talked to the President Xiaoping has visit U.S. talked to President Obama and the two nations want to join hands to be the leader to tackle that issue. That's important.

And rising divorce rate and suicide rate. Before most of the marriage, just like India perhaps or other developing nations, was parents arranged. You know, no divorce, very few. Today people are free to fall in love but also free to separate and divorce rate becomes very high. But once you have this high divorce rate the problem becomes, who's going to take care of the children? In the U.S. we have a well-built social so-called safety net or rule of law, regulation system to enforce the parents to take over the children.


Even doesn't matter how many times you get married. But developing nation when you first met those problems it takes time to form those social institutions, OK, causes lots of problems. And the widespread business fraud and scandals and the market full of lemons and low-quality goods. This was not unique to China. Look at 19th century U.S. when U.S. was catch up with U.K. Not only U.S. steal technology from the U.K., also produced a lot of fake goods. The same happened to Japan in the early 20th century. I'm not saying this is excusable. But this is natural stages for backward nation to catch up and we have market for those that mean it encourage people to pursue their self-interest. But when they pursue their self-interest the easy way to make money is to cheat so not through hard working. OK, you have to set up institutions to prevent them to cheat but that's not easy. We'll come back.

And also pervasive asset bubbles. Housing bubble is one of them. Stock market bubble is another. U.S. during the 19th century had experienced and missed 50 times a financial crisis. And once U.S. moved to the 20th century the Great Depression you still remember. So all those things could happen and China condensed that into 35 years. But yet China has not experienced a single very dramatic financial crisis yet. And so that means the government has been and is managing the economy reasonably well. The rising income inequality is a big issue in China because not everybody is able to get rich at the same pace, same rate, and it cause discrimination. And frequent industrial accident also happen. OK, and a bunch of others I will not go through. You can read. So lots of challenges ahead, but however, I am optimistic because the fundamental driving force of industrialization is what I told you earlier. There's a force in action and those problems became like growing pains, OK, growing pains.


Now last question: How can U.S. benefit from China's rise? That's big issue and I don't have much time to go through but let me just mention a few. First of all China's rise help to provide very cheap consumer goods to the entire world and to the U.S. OK, so that means the U.S., even the poorest cohort of the population can afford a lot of basic consumer goods and also their children can afford those goods. And also China in return is a big market for the U.S. When China's rapid industrializing you need machineries to produce this labor intensive goods so you can import machines from U.S. And now China has environment problem and the green technology that can also come from U.S. OK, so big market. Remember China's market is even bigger than Europe. Not yet, OK. We will become bigger than Europe. So U.S. trade with China for example has been increased by fiftyfold. That's a big number. And Boeing just this huge demand from China, for example, more than 6,000 airplanes will be ordered from Boeing. That's going to maintain their employment almost forever. Which nation can afford more than 6,000 airplanes in the next 10 to 20 years? China. And only China. Next maybe India. So we'll see. And also China is a great opportunity for financial investment. The U.S. now has a very well established financial system and money can flow to everywhere. And China is still in that building stage so it provides a huge market for the U.S. investment. Actually one of my colleagues here is a—I don't want to reveal his name because I don't think that conflict with his interest working at the bank but he was buy China stocks and making lots of money and he's very good at investing at that. I'm not good at that. I don't buy any stocks.


And also, you know, the U.S. has come through second Industrial Revolution in the late 19th century and finished it in the early 20th century. So most of the infrastructure built in U.S. is very old. When I came to the U.S. to study in the '80s, it's like this was heaven. China was so backwards, so poor. But nowadays I travel back to China as if I'm going from Third World country to First World country. So U.S. infrastructure definitely need upgrade. You know, ports, roads, bridges, rails, subways, host of other kind of infrastructures. Estimated investment needed to upgrade U.S. infrastructure by 2020 is about 3.6 trillion. That's a lot of money. So how can the U.S. finance it? By estimate we put all the resources together the gap is still about 1.6 trillion. Who can finance that? Maybe China. China has lots of savings and monies. OK, reason that China set up Asian Infrastructure Investment Bank precisely to channel money to build infrastructure in Asia and also in other parts of the world. And unfortunately, the U.S. decided not to join that, and I think that the U.S. should have joined that so U.S. can channel fund to build, to upgrade U.S. infrastructure for the 21st century.


Let me just mention a few more points, then I'm done. Let me read off from the slides. So ever since the 15th century, the spirit of capitalism, according to my description "has been shake hands and do business." That's the essence. Of course, in the old times backed up by navy ships. But that's the essence. Regardless of ideology, regardless of religion, regardless of culture, and regardless national boundaries, that's how capitalism, regardless all those evil elements in the past, has created modern civilization human race has ever seen. OK, so you move to any industrial nation you see civilization. OK, whereas you go to backward nations of course, people still kind, the laws of bad forces and you don't want to live there. And for at least half century after World War II the U.S., United States, has been the leading nation, pursued one of the history's most successful nation building's win-win strategy. And we do business; I win, you win. It's not a zero-sum game unlike what Russia did before. And that strategy has nurtured the rebuilding of Europe and Japan and of the development of many other poor countries and bound them together economically.

And today seems that China is carrying the U.S. banner forward. China is investing everywhere, doing business everywhere without asking about their political system, without asking about their religion, without asking about their culture. And the U.S. criticizes that, say "You don't have any standard." China say, "I don't need a standard. Doing business mutually beneficial, that's the only standard." OK, so China's pushing that strategy and that's a win-win strategy. So now, but how much each individual nation can benefit from China's rise depends entirely on that nation's own world view and development strategies. So China did not design a solid policy in response to British industrialization. So China failed three times, missed the train. So now China's rise provides a good opportunity for many poor nations to industrialize, but it's up to them how to grab this opportunity. OK, so that's the end of my talk. Thank you very much.


Julie Stackhouse: This is where we're going to introduce some unplanned optionality in the session tonight. We are really at the top of our hour and I know many of you have plans yet tonight. So what we're going to do is take like a 30-second stand up and stretch break and if you're saying, "It's 8:00, I really want to leave," please do. We absolutely respect your time. But if you have some questions that you want to have answered before you leave tonight we'll go just a little but longer for those of you who really want the questions. So we'll let you pick what works best for you. In the meantime I'll ask our two panelists to come up while you're taking that 30-second stretch break.

OK, stretch break is over. This is where I can see some conflicted views, which is "Uh, I probably need to maybe go back. I really don't want to miss the questions," and so we appreciate that. We want to make it that hard for you. Initially I thought maybe I'd just seek the views of our two additional panelists here tonight, both who are economic researchers here at the Federal Reserve Bank of St. Louis. But in the interest of making sure we cover your questions, let's just see if there are any questions in the audience right now. So way in the back row.


Man: Professor, thank you for your enlightening thoughts. Can you give us some insight as to shadow banking concept of the demographics. I mean with the one-child policy that came in 1971, we're getting very close to the cliff where those people are starting to retire at age 60, not 65. There's no safety net, and who's going to support the demographic imbalance where there are more people retiring than people working? Who's going to pay for the living of from 60 to say, 85? And help us through that concept. And then finally give us some thoughts on total debt to GNP when you include the 31 provinces. The numbers you hear are relatively high, 2.8, 2.9. When you include the provinces, total province debt where the tremendous expansion has been outside the cities going west.

Yi Wen: Well, I try to answer a little bit. I also have two colleagues. They are expert in finance. Perhaps they can also try to answer a question. OK, I group them into two. One's about banking system, finance, credit system problem. Another one's about demography. About the banking system, yeah, China indeed, in the past decade has accumulated a lot of debt, OK? It's not all bad thing, because as the economy develop you need to develop a financial system. A financial system implies credit. OK, you generate lots of credit. And actually, according to standard the developing country China still does not have enough credit or debt.


But on the other hand given China's stage of development, maybe the debt is way too high, OK, could be. China's total government debt corresponded to U.S. state government federal debt actually is not very high, 40 percent of GDP. Most of the debt are either private debt or local government debt. They are, in the case for local government debt, they are all secured or collateralized. OK, so in that case that's safer. And also today the Chinese government is engendering some kind of securitization of those government debt so pushed them to the market. And then the market decide, you know, the correct debt level and the price for the debt. And so also most of the Chinese debt are domestic held. It's not international held. So that's, you can compare to Japan. Even though Japan's government 200 percent compared to this, twice as high as the U.S. Also then, Europe faces slightly I will say more, less risk when it's held by domestic. But still, as I mentioned earlier China has not finished financial capitalism and it's still learning, just starting to learn how to build financial capitalism. And China's tackling that problem. And later on my colleagues can help me with more about that.

With respect to the one-child policy, is a lot of conflicting views. China, I think two days ago, just had adopted a new policy, relaxed the constraint, the restriction from one child to two children. And many international news medias was to welcome that change. Now there are several questions. No. 1, was the one-child policy necessary? Today, it seems the one-child policy is no longer binding so that means even if you relax it, no more people don't want to have a second child because of the cost of raising children is already so high.


And that's the stage most industrialized nations have gone through. OK, Japan, Europe. But China seems to come a little bit early because of this one-child policy. But if China did not have this policy, starting from '78 when the reforms started, China had about a one billion population at that time. If you look at U.K. and the U.S. or many other industrial nations, population growth was the fattest during the first Industrial Revolution, when people's income started to rise and, you know, they can afford having more children and also medical technology started to improve. And if you follow the U.S. population growth or the U.K. during their first Industrial Revolution, then today China's would be somewhere around two billion without one-child policy. That's precisely why the Chinese government decided to adopt that policy, thinking that China's very poor and a limited amount of arable land could not support that big population, even though China's countryside is the same as the U.S. but the arable land was only one-quarter of the U.S. and China has four times larger population. So seems that a policy somehow is necessary in that regard. But on the other hand, the side effect that has caused population to age too early.

OK, so China has to find a way to overcome that. And when you are in the process of industrialization, especially in the first, second phase, you rely on cheap labor to produce labor-intensive goods. If that labor's not there you cannot hope to finish that process. But fortunately, China has already finished that stage. China's in the state of second industrial revolution, so therefore China should be able to find a way to address that problem. That means China has to upgrade its technology faster than it normally would be.


OK, for example China now is the largest nation in terms of importing robots and not just producing robots. Once you can have robots to substitute for this cheap labor, that cheap labor's no longer needed, OK, so that the issue of hindering the China's growth, that issue can be resolved. But however, there's another issue, as you also hinted. You're going to have two kids supporting four very old parents. And China's life expectancy has been increasing very fast because of industrialization. China's average life expectancy has already reached the mature industrialized national level. It's about 78 years old. And how are you going to support that? That requires social safety net and requires lots of government help. But fortunately China has a very capable and a strong government which can mobilize lots of resources. And hopefully they can find a way to solve that issue even though the age issue come a little bit too early in China.

Julie Stackhouse: Let's get one more perspective. Bill, I saw you taking notes. Did you have something to add?


William R. Emmons: I'll do the financial and you can talk about the demographics. I'm Bill Emmons, an economist at the St. Louis Fed. Let me comment on the financial system in the shadow banking. I think compared to the United States I would characterize the Chinese system overall maybe as somewhat less efficient in allocating capital. On the other hand, it's probably more stable, that is less subject to panics and collapses compared to the U.S., not least because the core of the financial system in China is government owned. All of the major banks are state owned so they are not really subject to collapse in the same way that our financial institutions were. It's, I think, quite likely that there would be government support if there are severe problems whether it's at the local level or at the state-owned banks. There is a precedent. The large Chinese banks some years ago had the bad assets cleaned off, put into bad banks, and run off over time. And as Yi pointed out there's much less international connection. The financial system in China is not as integrated with other countries as our system was or in Europe. And maybe the final point is the macroeconomic context that China is a very, very high saving country, has very large international reserves, and so it is almost impossible to imagine that China could run into a classic emerging markets financial crisis in which a loss of confidence of foreign investors undermines their financial system because they are the banker to the world. They're the surplus country, so they're not dependent on foreign investors to the same way that a typical, you'd think of emerging markets, financial crisis. So less efficient, I think, but on the other hand much more stable probably, immune to a kind of a financial panic.


Julie Stackhouse: I don't think I've ever heard you say the glass is half full before. That's really a positive statement for this guy. OK, what about the one-child policy?

Subhayu Bandyopadhyay: It's great that you passed the demographic question to me because this is something that I'm very interested in. Actually today I noticed New York Times article by Amartya Sen, who's a Nobel economist, who was discussing actually, the fact that maybe the one-child policy's effect on bringing down China's population or birth rate is a little overstated. Women's education increases and opportunity of women actually led to some voluntary declines in Chinese. So in other words, at this point Sen is arguing that maybe the empowerment and enrichment of China's women has been a major factor in bringing down their birth rates. Having said that, in terms of the stats, I was looking at the stats. When you think of India and other very populous economy, just to give you a sense of the numbers, China is around like 1.35 billion. India is around 1.25 billion, so India's almost catching up, very, very, very large. I noticed that China's labor force is around 800 million. India's is around 500 million, so China clearly has a much larger labor force. But at the same time I notice that China's age distribution is very different from India's. China, one of the things that happened in China is that you have a very large—I forget the exact numbers but zero to 24-year-old population in China is much less as a present age in the population compared to India. So for example India is much younger in terms of the population distribution. Now, in terms of a number, India's median age is 27. China's median age is 37. And I was discussing I don't know exactly what American's median age is but probably America, Europe will be the 40s.


So you can see that something that Yi has already talked about, China is getting close to the very developed nations' median ages. Now in terms of the implication into the future is that exactly what Yi said. You know, taken in very simple terms you are a young couple. That's where I think where your two and four came from. You're a young couple, then you are supporting your, one of the spouses is supporting their parents; the other is supporting the other parents. So basically one kid supporting two parents. In terms of the macroeconomics suddenly you have the graying of the people. Replacement population would be two parents producing two children. Now have two parents producing one child. So what, halving of the labor force? If you suddenly halve the labor force, does the GNP halve? And then if the GNP halves you have less money, less resources to support the old, right? So that could be a serious issue.

On the other hand there could be arguments made that if China did not go through this kind of policy it would have been congested, there'd be too many people, overpopulation. It would not have the freedom to grow as productively as it is doing today. So one way to think about it is, first of all China's taking steps to increase the population growth rate, for instance getting rid of the one-child policy.


Second is that perhaps Chinese technology is going to evolve at a rate that indeed people are able to provide, you know, for two parents because one child is as productive as two children would have been without the one-child regime. So future is uncertain. There are adjustments to be made. But I see a lot of reason for optimism.

Julie Stackhouse: Yes, way over on the left hand side.

Man: Thank you. This was a delightful talk. I've got five quick questions.

Julie Stackhouse: How about one?

Man: They all kind of fit together, but one of the things we've dealt with is textile industry thrived during the religious wars [inaudible]... Two, how would America, the United States' hubris not create warring conditions? We have an expanded Security Council. We have [the] World Bank. We haven't, only Pope Francis seems to like the UN compared to the United States. Third, does debt bring down civilization? Would Article 20 say that about certain maps of civilization with our debt and Europe's debt so severe? Fourth, when are learned people going to challenge the Vatican in its concept of contraception? And five, the fear I have of China is the elitist government, if that model prevails in the world, that's frightening to free democracy. That's it.

Julie Stackhouse: OK, wow. Well, I don't know if we can go through all those questions but maybe we can just tackle a little bit the Chinese government's style. Do you have any thoughts on that, Yi?


Yi Wen: Yeah, I think the way China's government manages their economy is indeed on one hand kind of unfitting to today's world style. But I want to make two points, OK, on that. No. 1, is that you look at the European industrial powers since the Renaissance, since the 15th, 16th, 17th, 18th, 19th century, look at U.S. or Japan. They all more or less went through a period, as I mentioned earlier, of a strong government. Even if U.K. had the so-called Glorious Revolution, which gives the parliament the monarchy, government took all the power. But that does not mean the combined government has really the power. Very powerful British government and that's precisely why this level of state of capacity. But U.K., the first nation to start Industrial Revolution, not other nations. OK, for example, the Flanders and the Belgian, they had equally flourishing proto-industries but they failed industrialization because they did not have a strong government to guide them to create a market for them. And U.S. government has been very powerful in history, even today. So on one hand, in the U.S. we see lots of freedom, very high degree of freedom. On the other hand what we do not pay attention to is that the freedom is insured by a huge amount or high degree of government regulation. U.S. is most highly regulated nation in the world. And the government, look at our police force is semi-militarized. You go to China, police may have no gun. How can they control 1.3 billion population? And so you have in order to ensure that you have freedom you must have the capacity, what people call state capacity, to ensure you can reduce or mitigate those evil forces. And so during the development stages, you need to have a strong government. Otherwise, mafias are going to run the show. Look at what happened in Libya and in Afghanistan. OK, although many government they were originally the mafia. But having one mafia is better than having multiple mafias.


Julie Stackhouse: OK, let's see if we have another question that we can get in here way in the back in the middle.

Man: Thanks a lot. This is great. I really appreciate the timeline especially. I don't know if this is best for Yi or Bill, but can you maybe talk a little bit about the timing of the relaxation of capital controls that's expected, especially like when will citizens be able to invest in stuff other than A shares?

Bill Emmons: Well we have, one of my colleagues has done some work on this who could tell you exactly the timing, but I think Yi pointed out that this is a fairly carefully planned, staged liberalization. And so I think, what did you say? Within the next five years—

Yi Wen: Yeah, I think this is actually the current government goal, right? Look at government's pushing very hard RMB internationalization, pushing RMB to join the SDR by the IMF and but in order for RMB to be international currency or one of the major reserve currency you must have had a RMB convertible. Otherwise it's not possible. So government is having set of steps, of programs to push for that. And ultimately the capital control will be lifted. But before you lift the capital control to welcome the tsunami you better build a lot of irrigation system, right? Although unlike the during the Asian financial crisis those poor nations did not have that system, so the tsunami come and go and you get ruined. So this is there for you want to start the economic development with financial system. That's why it's a problem. You should go step by step. I think China is moving to that direction.


Julie Stackhouse: We can take two more questions. Yes, back there.

Male: Yes, you mentioned that you expect the RMB to be the world reserve currency in the next two to five years. Are you expecting a decline in the U.S. dollar, and also is China currently accumulating gold to back the RMB?

Yi Wen: Well, I think two to five years, that's the pace China's setting up. OK, making RMB first of all as a major trading currency. Then they can become reserve currency. But in order for RMB to replace U.S. dollar as the major or No. 1, that's going to take long, long time. OK, when I say major one it's maybe top four. U.S., euro, RMB, and the British pound. China now has already passed, I think, Japanese yen to be the rank and force. So expect to pass British pound.

Man: So you expect a decline in the U.S. dollar.

Yi Wen: Well, it's not entirely zero-sum game although there's a zero-sum aspect to that. I mean, U.S. dollar has been dominating the world global trade for many, many years. But once China's currency gets accepted as one of the reserve countries, of course U.S. dollar's share is going to shrink but not to the degree to make U.S. dollar No. 2. I think the U.S. dollar will still be No. 1 for many, many years.


Bill Emmons: I think probably economic fundamentals will be the main determinant of currency values, not so much reserve currency status.

Man: You mention the gold question. Then about gold backing the RMB?

Yi Wen: You know, since I'm not an expert in finance, I do heard that China has been accumulating gold. And also China has been allocating the IMF to have some new form of global currency rather than having just some nation's individual currency as the world currency. Let's have something everybody agreed upon. But takes time for that institution to form.

Bill: Just on the gold, I think no central bank today would really seriously consider a gold-backed currency, but to the extent that gold can serve as a reserve asset, it could play a role, as could any foreign exchange, any other currency.


Julie Stackhouse: And if you have any more questions afterwards we'd be happy to take them. Right up here in front.

Man: I was just wondering, you know, China's had several dynasties. And does the communist government worry more about an economic downturn than other capitalist countries? And secondly, how does the average Chinese feel about the communist government?

Yi Wen: I guess I'm the one.

Julie Stackhouse: Guess that's yours.

Yi Wen: Well, actually you know whenever I travel to China I talk to people. Also I teach courses in China, talk to students. I talk to my parents. So basically for example, you talk to taxi drivers. I think they're the best cover of the population to give you their free opinions, right? And I think on one hand, the taxi drivers or what do they think other people are thinking? They do not enjoy many aspects of what the Chinese government is currently managing the economy. OK, because as I mentioned earlier, rampant corruption. But on the other hand, they also understand that China—I think if you ask them literally. Whenever you travel to China just ask the taxi drivers. They think it's too early for China to adopt democracy, because they have seen what has happened in other nations when they adopt democracy too early. So I mentioned that in my paper democracy must have the economic foundation. It does not mean once you get rich automatically have democracy. But without that foundation, democracy cannot function. So I say that unless...democracy cannot function without industrialization. And industrialization is impossible without a strong state. So that's essentially my view.


So of course the Chinese people, they want to see government to have more reforms so that a government gradually become more like a servant, like a social planner. And the government also is realizing that they're changing their role. That's why President Xi Jinping is changing his government: We need to transform, change our role from a social planner to become a servant, to serve the economy, serve the poor people, serve the middle class instead of being the emperor, decide...making decisions for everybody. And so basically, ordinary Chinese people on one hand dislike many local governments. They like the central government. If we have a vote I think the people have done this, international organizations done this survey. Chinese government received the highest positive rate among all the nations, even higher than U.S. in terms of people's like their central government. But a lot of local government officials, they were engaging lots of wrongdoings and that requires establishment of institution to track them down. And so that's why currently why China is trying to really build the legal system more or less like the West has to handle those issues. I don't know if I fully answered your question.


Julie Stackhouse: And we'll take questions after if we do. I know we're really, really late on time, so if you do have a question that wasn't answered feel free to pop on down before you leave tonight. Before we go real quick, Subhayu, we haven't heard a lot from you tonight. If there's one thing you want to leave the audience with that you think is important, what should it be?

Subhayu Bandyopadhyay: Well, when I was hearing Yi's presentation, you know, we talk a lot about American exceptionalism. And one thing that I was thinking is kind of the British exceptionalism and starting it all. And so what was it? You mentioned Japan was very stable over the centuries and so were other places. In fact, when you think about India I know India's history reasonably well. India was a very, very rich country. And then, you know, there were empires from the time of Buddha, 600 B.C. and all. And they're like, well India probably was preeminent, and I saw your graph when you were doing the early parts. India has the largest share of the world GDP. Now but it fell. The empires rose, empires declined, you know. And so what is unique about today's capitalism that we seem to think that this is going to be stable, irreversible rise? So that's one, sort of in a larger landscape, that's one thing. And in terms of the ...but I'm tempted to think it is. I mean there is something that is durable in today's, in the free market capitalism that we have today, with boundaries of course.


But then when I think about the British Industrial Revolution, you know, I cannot think of Elizabethan England opportunities that were... so it is not democracy. It was a monarchy at the time and I think it was a very good time for England. And I think what from your presentation seemed the rural development was very important. It happened in England under a monarchy, at least started under a monarchy. In China, however, it happened in a very different environmental milieu, one where England had already shown the way, U.S. had already shown the way. So I'm trying to get at this endogenous development of rural productivity manufacturing where maybe that would be something that could be useful for poorer nations in Africa and all to emulate.

The other thing is that, in terms of going forward, I think something that Yi probably didn't get time to expound a lot is that today's world is fundamentally different from the ancient India or ancient China I just mentioned. It's very integrated. And I think that probably also had a major role in the spread of the British Industrial Revolution. Britain was not—Japan was pretty isolated. Very stable, but very isolated. England from the 1600s, they were like English traders going to India. Actually, I remember seeing pictures of English traders from the Elizabethan times going in a very servile way to the Indian emperors. And then 150 years later, they were ruling India.


So it's a very, it's an evolving thing. But one thing that must have played a big role is England's ability to reach out to the entire world, so globalization. But China already has that. India today has that. And this is, I myself, an international economics person, I feel very strongly that today's possibilities can be sort of really, you know, the economic opportunities come from globalization and openness. India's a great example of that. China too. So China lets Nixon and all, you know China opens up to some degree. India in the ‘90s, India was pretty industrialized through very socialistic Russia-type efforts. But India really started taking off in the ‘90s when India liberalized in a big way and started doing a managed load of exchange rates. I remember it was my grad student days. Exchange rates in two steps went from like 18 Indian rupees to a dollar to maybe 22 next day. Next day it was like 26 or something. And that was the beginning of the turnaround, and India started running, sort of managed to get a lot of inflows. Its balance of payments improved.

So to bring it all together, I think I see a lot of optimism in terms of India, China, U.S., other nations, of course, sort of in this going forward in this global economy. But we have hard problems to solve in other spheres.


Julie Stackhouse: So great strategy in China. All about execution and of course that's untested at this point or being tested perhaps in the days ahead. Bill, anything on your part?

Bill Emmons: I'd say the rise of China is a good thing for the United States and for the world as a whole.

Julie Stackhouse: That leaves us with a very clear picture, doesn't it? So I have never seen this guy so optimistic. I'm going to worry a little bit about that tonight. Well, thank you all for joining us. If you did have a question you didn't get answered and want to visit with one of these individuals feel free to do so. And again, thanks for being with us tonight.

This popular lecture series addresses key issues and provides the opportunity to ask questions of Fed experts. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.

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