Macroeconomic Policy and Steady Growth in China

2020 Dancing with Black Swan

Zhang Xiaojing

• Publisher: Routledge
• Year: 2021
• Print ISBN: 9781032033358
• eBook ISBN: 9781000406535
• Edition: 1
• Topic: Economics
• Subtopic: Accounting
• Index: Economics

Since the appearance of macroeconomics in the 1940s, economists have created many theoretical frameworks to explain the origin and mechanism of economic fluctuations. However, few of these have managed to gain explanatory power over reality; nor can they solve real-life problems. This book proposes a new macroeconomic paradigm that makes breakthroughs in these areas.

Based on a balance sheet approach and macro-financial linkage analysis, this book carries out a comprehensive analysis of the trends within China's macroeconomy in 2020. The author argues that the COVID-19 pandemic created a great degree of uncertainty—therefore, supply-side structural reform and improved total factor productivity have been promoted to ensure a policy of steady growth. Given the declining economic growth rate in percentage terms, China has needed to adapt to a moderate increase in the leverage ratio while applying more effective fiscal policies to achieve a dynamic balance between stable growth and risk prevention.

Scholars and students of economics and finance, especially Chinese economics, will find this book a useful reference.

Part I

Introduction

1 Dancing with the black swan: the balance between economic growth and risk in a new paradigm

Zhang Xiaojing

I A new paradigm of macroeconomic analysis

Every kind of macroeconomic analysis needs a theoretical framework, whether explicit or implicit. A good macroeconomic analysis should at least be theoretically consistent and has strong explanatory power over reality. Mediocre ones, by contrast, merely state the facts. They seem to have grasped the key points, but are fundamentally untenable because their theoretical logic is often self-contradictory. Moreover, macroeconomic analysis concerns predictions of the future. History suggests that the predictions based on theoretical models are prone to errors, some of which may be no better than a crystal ball. They may even make big mistakes by failing to predict a major crisis. Therefore, economists should be humble regarding predictions. The theory and analytical framework of macroeconomics is more focused on the analysis of correlation, structure and mechanism.

There is more than one paradigm of macroeconomic analysis. In fact, since the appearance of macroeconomics in the literatures since the 1940s, traditional Keynesianism, neo-classical economics, and neo-Keynesian economics have been in constant competition. The central task of scholars and policymakers has been to distinguish and choose between those competitive macroeconomic theories. Decades have passed since then, but there is still no consensus regarding whether neo-classical economics, neo-Keynesian economics or some other framework can correctly explain the origin and mechanism of economic fluctuations.

The current mainstream macroeconomic paradigms roughly follow the tradition of Keynesian aggregate demand analysis, and use the DSGE model as the workhorse model to discuss the origin and mechanism of economic fluctuation and provide suggestions of stabilization policies. But these paradigms all fall short regarding the focus on financial complexity, the attention on stock and structural indicators and the depiction of risk. This is the lesson that mainstream economics has drawn since the 2008 financial crisis. In view of that, this book proposes a new macroeconomic paradigm that makes breakthroughs in those areas. The main novelty of this paradigm is to use a stock perspective, such as the balance sheet approach, to reveal the macro-financial linkages, build the financial foundation of macroeconomics and provide a new analytical path regarding the balance between growth and risk. The change in paradigm contains, to some extent, a critique of mainstream macroeconomics. It also borrows ideas from “heterodox” macroeconomic approaches such as post-Keynesian economics, stock and flow methods and Modern Monetary Theory (MMT).

The authors of this book and their research team have made some useful explorations about the new paradigm of macroeconomic analysis in recent years. Specifically, our progress focuses on the following areas:

First, the research of the national balance sheet. This research was started in 2011 and produced three books in Chinese,¹ two books in English and a number of research papers. The work provides the foundation of the theoretical framework and the application of the balance sheet approach.

Second, the research of macro leverage ratio. The macro leverage ratio, defined as the proportion of debt to GDP, is an important indicator of macroeconomics risk. The analysis of this ratio can contribute to the discussion about the balance of growth and risk.²

Third, the research of the financial cycle. The rise of the financial cycle theory means that the impact of finance, including credit and real estate, on the economy is exceeding that of the business cycle.³ Macroeconomics without the consideration of the financial cycle is like Hamlet without the prince.

Fourth, the research of financial stability in a balance sheet perspective. This line of research is largely outside of the mainstream. We used the balance sheet approach (especially the national wealth approach) to redefine financial risk and financial stability using the relation between the real economy and the financial sector.⁴

Fifth, the restructuring of the macroeconomic policy framework.⁵ Since the 2008 financial crisis, economists and policymakers have entered a “brave new world” where problems far outnumber solutions. The new macroeconomic policy framework has yet to emerge, and there is a long way toward consensus. We propose a new direction of restructuring macroeconomic policy framework based on those international discussions and the unique characteristics of Chinese macroeconomic regulation.

Sixth, the research of MMT. This heterodox theory, which originated about two decades ago, has risen in prominence today. One of the main reasons lies in the difficulties in policy responses of rich economics since the 2008 financial crisis. MMT has some inherent theoretical inconsistencies, but it can help us in realizing the essence of currency, improving the macroeconomic paradigms and dealing with real-world economic problems. Also, the “non-mainstream” methods of MMT are also very informative.⁶

Those research perspectives to be sprawling in multiple directions, but they are roughly centered on two themes: macro-financial linkage and the balance sheet approaches. Therefore, these seemingly fragmented research programs can form a complete picture, which is our new paradigm of macroeconomic analysis. The following sections will discuss those two themes respectively.

1 Macro-financial linkages

Macro-financial linkages have become a focus of both the academia and policymakers since the 2008 financial crisis. The IMF pays especially strong attention to this. Macro-financial linkages, or the relations between the financial sector and macroeconomic growth, is the analytical framework of the Global Financial Stability Report (GFSR), one of the IMF’s two flagship reports (the other is World Economic Outlook). It focuses on how the financial sector spreads and amplifies economic shocks. Before the financial crisis, policymakers and scholars have been ignoring macro-financial linkages. However, we can find such financial vulnerabilities in many crises, such as high leverage or maturity mismatch. GFSR has proposed an indicator of financial risk: GaR (Growth at Risk). GaR depicts the risk of an economic downturn using the lower quantile of GDP growth under given financial conditions.⁷ Empirical results show that a loose financial condition indicator can significantly lower the risk of economic downturn at the margin, but this effect is not sustainable and decreases in the medium term. This result puts an emphasis on the intertemporal substitution effect: loose financial regulations can boost economic growth and reduce fluctuations in the short term, but fluctuations in the medium term increases due to the accumulation of endogenous vulnerabilities.⁸ This is consistent with our recent research findings that accumulating debt can significantly boost economic growth but only in the short term (the effect is no longer significant after only a two-term lag), and that debt accumulation, as measured by the leverage ratio, has a negative effect on future growth. This reveals the complexity of debt-driven economic growth.⁹ The risk in financial stability is often measured by the probability of a banking crisis, but it has not been depicted rigorously in terms of macroeconomic policymakers. GaR, on the other hand, measures the systemic financial risk from a growth risk perspective, and therefore can bring financial stability risk into a broader macroeconomic model.

The macro-financial linkage approach also pays strong attention to the Financial Cycle. The debate about the economic cycle has a long history. And the financial cycle, or economic cycles that take finance into consideration, has gathered attention since the Great Depression of the 1930s, but has waned since the rise of the Real Business-Cycle theory (RBC) in the 1970s. More recently, it has risen in prominence again after the 2008 financial crisis. In the wake of the crisis, people seem to have suddenly “remembered” the Japanese bubble of the 1980s, the Asian financial crisis of the late 1990s, the dotcom bubble and its burst in 2000, which all bear some relations to the financial cycle theory. Research papers with “financial cycle” as a key word have mushroomed in the recent literature, a lot of which come from international organizations such as the Bank for International Settlements (BIS) and the IMF. Those organizations’ focus on this issue highlights the newfound importance of financial cycles on the real-world economy. The patterns of financial cycles have only strengthened since the liberalization and globalization of finance in the 1980s. Economic cycles (or business cycles) loomed large before, but the impact of financial cycles has grown to outweigh business cycles. Moreover, financial cycles have a global impact. The global financial markets are even more closely related with larger spillover effects, creating a “resonance” of global financial markets. Economic cycles are usually measured by output indicators, while financial cycles are measured by credit and asset prices, especially real estate prices. Drehmann et al. has found that a typical economic cycle spans around one to eight years, but a financial cycle spans for more than 16 years.¹⁰ And the amplitude of financial cycles is significantly larger than that of economic cycles. Financial cycles lead to the deterioration of resource mismatch. Its cyclical change is not a direct reflection of changes in the real economy. However, despite the relative independence of the financial cycle, the fluctuations in finance can lead to similarly huge fluctuations in resource allocation, and in turn deliver a negative shock to the real economy. During booms, credit usually expands and the leverage ratio increases, which is a direct consequence of loosening financial constraints. This loosening, coupled with widespread optimism, allocates a lot of resources (including capital and labor) to the sectors that are ostensibly prosperous but in fact inefficient, which leads to resource misallocation and drags down productivity growth. This misallocation is temporarily masked by seemingly strong economic growth. But when boom turns to bust, asset price and cash flow go down. Debt becomes the dominant variable of the economy. Meanwhile, economic entities cut down their expenditures in order to repair their balance sheets. Resource misallocation in financial booms is even more difficult to reverse, because the over-concentration of capital in the boom sectors will impede subsequent recovery.¹¹ The research of financial cycles has deepened our understanding of the macro-financial linkage analysis.

Another front in the macro-financial linkage approach is macro-financial network analysis. The European Central Bank (ECB) has made pioneering research in this field.¹² The research of macro-financial networks aims to combine the analytical methods of financial networks and balance sheets in order to comprehensively analyze systemic risks in both sectors. Theoretically speaking, there are three factors that determine the financial risk in a sector: the risk of the sector itself, its linkages to other sectors and the risk in those related sectors. Jean-Claude Trichet, a former President of the ECB, defines financial risk as a risk that “develops inside the financial system and causes extensive shocks to the financial system and the real economy”.¹³ The Financial Stability Board believes that systemically important financial institutions have “a large scale, great complexity and extensive linkage, therefore the shocks they face will cause significant damage to the wider financial system and economic activity”.¹⁴ Those ideas all put an emphasis on both the risk of the institutions themselves and their outside linkages. The analysis of inter-sector linkages needs a macro-financial network that depicts the extensive linkages among different sectors. Castrén and Kavonius,¹⁵ according to the national balance sheets, divide the economy into households, non-financial businesses, banks, insurance, other financial institutions, government and foreign sectors. They used balance sheet data to build a model depicting intra-sector and inter-sector risks.¹⁶ From a macroprudential perspective, the risk of “too connected to fail” is at least as important as the risk of “too big to fail”.

The macro-financial linkage analysis promoted by the IMF, the financial cycle analysis by the BIS and the macro-financial network analysis by the ECB all aim to improve the analysis of the amplifying effect of finance on the economy in an attempt to build a “finance foundation” of macroeconomics.

2 The balance sheet approach

The balance sheet approach (BSA) provides an...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Tables
• List of Contributors
• Preface
• PART I: Introduction
• PART II: Stabilizing growth
• PART III: Stabilizing leverage
• PART IV: Stabilization policy
• Afterword
• References
• Index