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The ‘middle income trap’: Washington’s new consensus about China October 2, 2012

Posted by Geoff in Politics, Policy and Political Science.

The idea that China is at risk of getting caught in a ‘middle-income trap’ has become conventional wisdom in London, New York, and Washington. The middle-income trap occurs when labor costs become too high for a catch-up development strategy based on low cost, low value-added production using ‘off-the-shelf’ technologies. Instead, the experts argue that China needs to shift to a more innovation-oriented strategy in order to move up the global value chain, where barriers to entry created by technological sophistication and high productivity result in higher profits for companies and less sensitivity to changes in labor costs. 

When that’s as far as it goes, the middle-income trap argument seems fairly valid. Japan experienced the same phenomenon with the rise of the ‘Asian tigers’ in the 1980s, and South Korea and Taiwan experienced it when China was integrated into the global economy in the 1990s and 2000s. New potential low cost production platforms are popping up all over the developing world, consciously seeking to emulate China’s export processing zones, thereby chipping away at their competitive advantage. While Chinese producers have been able to increase productivity because of increasing returns to agglomeration and learning-by-doing, other regions are hot on their tails.

However, when one digs deeper into the discussion of the middle-income trap, it becomes clear that commentators in the Western business press are using it to re-affirm their faith in the superiority of Anglo-American free market capitalism. The policies that they suggest lead to innovation include financial liberalization, privatization of state-owned firms, deregulation, strengthening of intellectual property rights, and complete openness to external trade. Unfortunately, China’s corrupt rent-seeking elites will block the transition to an Anglo-Saxo…errr…open-access order. Sure, China has done well for itself, but clearly their problem is that they’re not enough like us. 

There are a couple of big problems with this narrative. First of all, the core capitalist countries write the rules of international trade and investment flows to protect their technological advantages. When the United States tries to limit technology transfer through the inclusion of intellectual property rights and investment protections in global and bilateral trade agreements, we are being the ‘rent-seeking’ elites discouraging the uptake of new technologies in the developing world. I almost hit the roof the other day when I heard a report on NPR about American businessmen who are disgruntled that the Chinese government is no longer bending over backwards to attract their investment, forcing them to source inputs in-country and transfer technology. Why, it’s almost like it’s their country or something! The hypocrisy is mind-bending: we criticize them for not trying to move up the value chain even while we’re ‘kicking away the ladder’. 

Secondly, it’s not as though the free market, as it behaves in real-life America and Britain, always encourages innovation. The corporate governance structure, based on the principle of shareholder value, creates extremely short-termist incentives that push companies to focus on cutting labor costs to maximize quarterly earnings rather than investing in uncertain, long-gestation new technologies. Don’t just take my word for it: read John Kay’s analysis of how market incentives in the pharmaceutical sector encourage more investment in marketing, rather than risky new drugs that might actually cure a disease or something. Innovation in the American economy often means finding new ways to invent profits out of thin air, shift costs off balance-sheet, and avoid taxation with accounting tricks. There’s no reason to believe that China cannot fashion some sort of coordinated or controlled form of capitalist organization that could compete with their free market counterparts.

If I were Chinese, I would be pretty well pissed off about Americans and Brits having the audacity to criticize my economic model so shortly after the implosion of their own systems. While they do have to worry about the middle-income trap, the Chinese government’s massive investments in higher education and infrastructure insure that the groundwork for moving up the global value chain is there. Chinese investments in solar panels illustrate that the government is finding ways to foment innovation using coordinated solutions. The last thing they need right now is a dose of free market shock therapy. 




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