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The U.S. and China Race to the Middle

Nov 09 , 2011

As the world economy continues its increasingly tenuous recovery it would be tempting to stick with the dominant narrative – Asia’s inevitable rise and the accelerating decline of the West. The U.S. labor and housing markets remain stunted. Greece is near default threatening the rest of Europe with a cascade of inter-related financial failures that may rival Lehman’s collapse. Yet the Shanghai and Hong Kong stock markets have been spiraling downwards not upwards at the news (down 19% and 22% respectively from their April, 2011 highs). There has been no flight to safety half a world away from Manhattan or Frankfurt.

If anything, the economic futures of China and the U.S. are becoming more and more alike as time goes on.  Both countries are now struggling, albeit from different starting points, with a race to sustaining the real engine of economic growth, the middle class.

In the U.S. consumers drove global economic expansion for over half a century. With nearly 70% of its economy focused on consumption fortunes were created domestically and abroad as countries exporting into the U.S. boom.

That middle class is now under its greatest threat since before the Great Depression as wealth continues to accumulate at the top and the rest struggle or drop to the bottom. Poverty rates in the U.S. have risen to 15%, its highest level in over fifty years. The one-income household of the 1950’s that gave way to the two-income family by the 1970’s wasn’t enough to keep the consumption engine going. Credit card debt and loans against rising home values filled in the gap. That well has been tapped dry.

China on the other hand has become the world’s largest consumer of flat screen TV’s and soon computers and automobiles. Chinese tourists are making or breaking the fortunes of top vacation destinations. There appears to be no way but up for spenders among the 1.2 billion. Yet contrary to casual observations of high-priced shopping malls and luxury cars along Beijing and Shanghai avenues, these signs of material well-being are still the province of the few and have little to do with a robust middle class driving growth. High income earners alone are not economically strong enough to keep expansion humming along or dramatically shift the fortunes of the “other 800 million” barely getting by.

While China’s economic gains have been impressive, government planners realize that without a vibrant middle class growth rates will falter. Investment and exports cannot continue to dominate the domestic landscape where consumption only accounts for 35% of the economy.

The problem for both, coming from such disparate starting points is the hollowing out of that very middle, which provides political stability and sustained economic opportunity.

Income inequality rates in the U.S. and China are becoming more similar and while projections for a Chinese middle class rivaling that of the U.S. by 2025, 2030, or 2050 continue (push out far enough and anything can be predicted), the foundations for that growth are actually weak and getting weaker. China’s own leadership makes this case to its public on a regular basis and is featured in their 12th Five Year Plan.

How does China make the transition, especially considering the continued dominance of the state in major parts of the economy? If history is any guide those sectors will remain uncompetitive and a drain on the system taking up an inordinate amount of bank lending because they lack the incentives and pressures to innovate.

In addition to this negative influence of the state sector, China wants to rise up the value-added ladder by producing high-tech products, both domestically and for export. The innovative ecosystem that promotes new discoveries and brings them from lab to market are, however largely absent.

Coercing foreign companies to bring their technology, which often ends up in competing domestic companies’ hands, creates an obvious disincentive. A weak legal infrastructure to protect intellectual property slows down the creation of higher wage jobs. Limited access to financing for small and medium sized enterprises further stunts growth. Without the necessary social investments China’s middle class will remain weak and vulnerable.

The U.S., in the past at least, has made expert use of education, access to capital, and law to create one of the most innovative societies in history. The forces of a free market alone, however appear increasingly insufficient as income inequality rises. Controlling health care costs which are an increasing form of compensation rather than wages, tax policy, and incentives for retraining need to be addressed.

The challenge for both the U.S. and China remains, charting a middle course between too much state control which causes imbalances, and too little which creates an increasingly bipolar economy of extremely high booms and destabilizing crashes. Personal consumption by the top 1% cannot drive economic growth in either country.

Success in the twenty-first century will ultimately be defined not by having the largest economy, but by creating and sustaining a robust middle class. Despite the many disagreements in U.S.-China economic relations, that shared goal at least should become the basis of more productive talks and cooperative relations in the future.

Brian P. Klein, an international economist, writer and consultant is a former U.S. diplomat with service in China and was a 2008-2009 Council on Foreign Relations International Affairs Fellow. He is currently at work on his first book.

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