Michael Spence

Chairman, Commission on Growth and Development

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by Michael Spence

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Michael Spence is currently Chairman of the Commission on Growth and Development, a Nobel laureate in economics.
May 22, 2012
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China and the United States are in the grip of major structural changes that both dread will end the Halcyon era when China produced low-cost goods and the US bought them. In particular, many fear that if these changes lead to direct competition between the two countries, only one side can win.

That fear is understandable, but the premise is mistaken. Both sides can and should gain from forging a new relationship that reflects evolving structural realities: China’s growth and size relative to the US; rapid technological change, which automates processes and displaces jobs; and the evolution of global supply chains, driven by developing countries’ rising incomes. But first they must acknowledge that the old pattern of mutually beneficial interdependence really has run its course, and that a new model is needed. 
 
The old model served both sides well for three decades. China’s growth was driven by labor-intensive exports made more competitive by transfers of technology and knowledge from the US and other Western countries. This, coupled with massive Chinese public and private investment (enabled by high – and recently excessive – savings), underpinned rising incomes for millions of Chinese.
 
The US consumer, meanwhile, benefited greatly from declining relative prices of manufactured goods in the tradable side of the economy. Accordingly, US employment shifted to higher-value-added activities, in turn supporting higher incomes in America, too.
 
Multinational companies operated increasingly efficient and complex global supply chains, which could be reconfigured as the shifting pattern of comparative advantage dictated. Global supply chains ran largely from east to west, reflecting the composition and location of demand in the tradable part of the global economy. 
 
But all of this is starting to change. The benefits are shifting from cost to growth. Supply chains are now running in both directions, and are being combined in novel ways. Chinese demand is not only growing, but, as incomes rise, its composition is shifting to more sophisticated goods and services.
 
Thus, China’s role is changing: once the West’s low-cost supplier, it is now becoming a major customer for Western products. This represents a major opportunity for advanced economies to rebalance their growth and employment, provided that they are positioned to compete for the appropriate parts of evolving supply chains.
 
Rising Chinese incomes also imply structural change for China, as continued growth presupposes a shift to higher-value activities. Technology and knowledge will still be important, but China must begin generating new technologies, in addition to absorbing Western tools and skills.
 
In order to meet the challenges of structural change, the goal for US policy should be to expand the scope of its tradable sector, with a focus on employment. Reorienting US policy toward external demand across a broader array of sectors, in turn, requires attention to two critical areas: education and investment.
 
High-quality education and more effective skills development are crucial to generating new employment opportunities for the middle class, while investment can rectify America’s disconnection – particularly that of its medium-size businesses – from global supply chains. The trading companies and infrastructure that smaller, more open economies have created in order to connect to global markets are underdeveloped in the US.
 
To be sure, success in these areas will not come overnight. But nor is the status quo a permanent condition; it can be improved with investment and supportive policy. Moreover, the US would benefit in the short term from relatively simple measures, such as removing barriers to inward foreign direct investment, particularly from China. On the Chinese side, policy prescriptions are not the issue. The importance of evolving a different growth pattern is already understood, and has been enshrined in China’s 12th Five-Year Plan. Its successful implementation will require strengthening incentives to innovate, deepening the technology base, investing more in human capital, developing the financial sector, and applying competition policy equally to domestic, foreign, and state-owned enterprises.
 
Given the requirements on both sides, how to ensure a productive and mutually beneficial relationship between the US and China is a relatively straightforward matter. China still needs access to advanced-country markets and technology, but the emphasis is shifting to homegrown knowledge, skills, and innovation. The US, still an innovation powerhouse, can help, but requires access to the growing Chinese market and a level playing field once there. The same is true of financial-sector development. 
 
In the US, a determined effort to restore fiscal balance and establish a sustainable growth pattern – that is, one not based on excessive domestic consumption – is crucial to long-term economic health. Such rebalancing implies sustained reduction of the current-account deficit by expanding exports, rather than merely curtailing imports. Chinese demand will help, all the more so as its economy grows in size and sophistication. So expanding linkages with China now is an investment in the future with a rising return, rather than a quick fix.  
 
A lower US current-account deficit will also benefit China, whose $3.2 trillion in foreign-exchange reserves – held mostly in dollar-denominated assets – is becoming a large and risky investment. Progress towards external balance in the US would allow a slow reduction in China’s reserves, alleviating its asset-management headache.
 
A deeper understanding of each other’s shifting structural challenges would facilitate both sides’ ability to identify areas of mutually beneficial cooperation. But the core of the relationship is simple: China needs US innovation to grow, and the US needs Chinese markets to grow. If both countries are to benefit from such symbiosis, there is no alternative to collaboration, substantial investment, and reforms on both sides of the Pacific.
 
 
Michael Spence is currently Chairman of the Commission on Growth and Development, a Nobel laureate in economics.
 
This article was first published in EJ Insight.
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