Insight August 31, 2010, 8:39AM EST

If Only China Were More Like Japan

China is heading toward a Japanese-style economic debacle, says columnist John Lee, who warns that the process won't be as gradual or peaceful

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Now that China has officially overtaken Japan as the world's second-largest economy, there is growing speculation by influential Chinese and U.S. economists, such as Wu Jinglian and John Makin, that China will soon endure its own "lost decade" as it suffers a Japanese-style malaise. The idea that contemporary Japan offers a glimpse of China's economic future is credible, given similarities in the two growth models. But Japan's economic decline has at least been a gradual and comfortable one for the Japanese people and government. For the Chinese Communist Party and the nation's people, following in Japan's footsteps would likely be much more traumatic.

Before there was conclusive proof that Japan was in an extended period of stagnation, some economists were warning about the dangers of over-reliance on exports and fixed investment to drive growth. Common wisdom counseled that Japan held advantages intrinsic to contemporary East Asian systems. For example, unlike the myopic policies pursued by constantly changing governments in Western systems, the dominance of Japan's Liberal Democratic Party (which ruled nearly without interruption from 1955 to 2009) allowed long-term policy thinking and implementation to occur in Tokyo. In combination with a populace of clever, responsible, hard-working people, Japan was well-placed to manage the necessary transition toward a more sustainable growth model.

Although "capitalism with Chinese characteristics" does not seek to replicate any particular model, its similarities to the Japanese approach are striking. Like Japan in the 1970s and '80s, China is nearing the end of its reliance on exports and fixed investment to drive growth—and looking to shift toward policies that can enhance domestic consumption. To achieve this, it is seemingly blessed with an authoritarian government that can concentrate on policies that need not sacrifice the country's long-term interests for short-term political expediency.

Japan built solid civil institutions

Yet, as Beijing's response to the global financial crisis reveals (bank lending jumped, from $750 billion in 2008, to $1.4 trillion in 2009), China is becoming more—rather than less—dependent on an unsustainable model to drive economic growth. Domestic consumption as a proportion of gross domestic product is actually declining. At just over 30 percent, it is the lowest of any major country in modern economic history. The figure has declined, from more than 50 percent in the 1980s, to 40 percent at the turn of this century. It was around 36 percent prior to the global downturn in 2008.

Similar models tend to lead to similar problems, as do the demographic problems in China, which will soon resemble Japan's. Worse, differences between the two political economies may bode ill for China. When the Japanese economic malaise began, the country had built solid institutions: rule of law, property rights, and a stable political system. The latter was clearly evident when the LDP lost power last year and initiated a handover without turmoil or bloodshed. Even though the Japanese development model is frequently described as a state-led approach, the private sector generally received around three quarters of the country's capital. This meant that prosperity was broadly distributed during the growth years. Even in structural decline, most Japanese are living the "good life"—and have grown rich before getting old.

In contrast, these institutions in China are relatively undeveloped, even after three decades of reform. Moreover, the Chinese model of development has taken the state's role to unprecedented levels. Even though state-controlled enterprises (SOEs) produce between one-fourth and one-third of all output, they receive over 75 percent of the country's capital. During the flood of lending from 2008 to 2009, state-controlled enterprises received over 90 percent of all capital; private industry received less than 5 percent.