Deciphering the Chinese Economic Miracle

 The article, "Deciphering the Chinese Economic Miracle: The Resolution of an Age-Old Economists’ Debate — and its Central Role in Rapid Economic Development" by Kun Duan, Plamen Ivanov, and Richard Werner, published in Review of Political Economy in 2023, analyzes China’s rapid economic growth through the lens of its banking system reforms. It argues that China’s economic success stems from a unique synthesis of the Currency School’s emphasis on public control of money creation and the Banking School’s advocacy for decentralized credit allocation, implemented through a decentralized public banking system. Below is a detailed breakdown of the article’s key sections and arguments, tailored to your request for deciphering its content.

Abstract

The article posits that China’s economic rise is driven by its banking sector reforms, which integrated Currency School (centralized public money supply) and Banking School (decentralized money creation) principles. This created a "social democracy with Chinese characteristics," leveraging public banks to fuel economic development through "quantitative public bank easing." The authors provide historical and theoretical evidence to explain how this approach supported China’s rapid growth, offering policy lessons for other economies.

Key Points:

• China’s growth is attributed to decentralized public banks that channel credit to the real economy.
• The synthesis of Currency and Banking School ideas resolved a long-standing economic debate.
• Policy implications include the benefits of public banking and credit guidance for economic development.

1. Introduction

The introduction outlines China’s transformation from an agrarian economy to a global industrial power within four decades, driven by Deng Xiaoping’s market liberalization policies starting in 1978. Key achievements include:

• Economic Growth: China’s GDP (PPP-adjusted) became the world’s largest by 2014, with a 1,759% increase in real per capita income from 1980 to 2015 ($714 to $13,277).
• Poverty Reduction: Over 850 million people were lifted out of extreme poverty (from 88% in 1981 to 0.7% in 2015), though 373 million remain below the middle-income poverty line ($5.50/day).
• Strategic Initiatives: Policies like Made in China 2025 and the Belt and Road Initiative aim to transition China to an innovation-led economy.
• Challenges: Rising income and wealth inequality pose risks to the Chinese Communist Party’s (CCP) vision of a "harmonious society."

The authors challenge the Washington Consensus, which attributes economic success to market-based institutions and private property rights, arguing that China’s "weak institutions" (non-democratic system, weak legal framework) defy this model. Instead, they focus on the banking sector’s role, which has been overlooked in mainstream analyses despite its centrality in East Asian growth models (e.g., Japan, Korea, Taiwan).

Figure 1: A chart comparing annual GDP growth rates of China, Germany, USA, France, and UK (sourced from World Bank data) illustrates China’s consistently higher growth, peaking at double-digit rates during its reform period.

2. The Currency — Banking School Debate: A Brief Review of the Economic Theory

This section reviews the historical debate between the Currency School and Banking School, which shapes the article’s theoretical framework.

2.1. Contemporary Theories

• Neoclassical Models: These often ignore the role of banks, assuming money is neutral and financial intermediaries exist only due to market frictions. They struggle to explain why banks are "special."
• Post-Keynesian and Empirical Views: These recognize banks’ ability to create money endogenously (Moore 1988; Werner 2005). Keynes (1937) noted banks’ critical role in economic activity, a view echoed by Marshall and Rochon (2019), who advocate public banking as a precise policy tool.

2.2. Currency School

• Core Idea: Money creation is a public privilege that should be centralized to avoid private banks’ excessive profits and speculative lending. Proposals include:
  • David Ricardo (1824): Suggested a nationalized Bank of England with exclusive money-issuing powers, reducing other banks to intermediaries.
  • Chicago Plan (1930s): Advocated "full reserve banking" to end bank runs, reduce failures, simplify monetary systems, and stabilize economic cycles (Fisher 1935).
  • Modern Proposals (e.g., Positive Money): Central banks should control money creation, adjusting money supply based on inflation/employment targets (Dyson et al. 2016).
• Criticism: Critics (e.g., Goodhart and Jensen 2015) question how central authorities would determine optimal money supply levels.

Table 2: Summarizes Currency School proposals across centuries, highlighting their focus on centralizing money creation.

2.3. Banking School

• Core Idea: An elastic, decentralized money supply by private banks supports economic growth. Banks create money through lending, which is critical for real economy activity.
• Historical Context: Post-1844 Bank Charter Act, British banks circumvented restrictions by creating "accounting money" (Werner 2005). Over 90% of money in advanced economies is now created by private banks.
• Criticism of Currency School: Full reserve banking is pro-cyclical, potentially destabilizing economies (Goodhart 2017). It may also fail to curb private banks’ financial engineering (e.g., cryptocurrencies).
• Common Ground: Both schools agree on the need to direct lending to the real economy to avoid asset bubbles and economic instability (Werner 1997).

Table 1: Maps how China’s banking system integrates Currency (public control) and Banking School (decentralized credit creation) principles.

3. Banking Reforms in China and the Synthesis

This section details how China’s banking reforms synthesized Currency and Banking School ideas to drive economic growth.

3.1. The Structural Transformation of the Chinese Banking System

• Pre-Reform (1950s–1978): China operated a Soviet-style monobank system under the People’s Bank of China (PBoC), which served both commercial and policy roles.
• Post-1978 Reforms:
  • 1980s: Deng Xiaoping decentralized the banking system, adopting the Prussian subsidiarity principle (decentralized decision-making). Four state-owned policy banks (PBs) were established: Agricultural Bank of China (ABC), China Construction Bank (CCB), Bank of China (BOC), and Industrial & Commercial Bank of China (ICBC).
  • 1990s: Three additional PBs were created (China Development Bank, Import and Export Bank, Agricultural Development Bank). The original four PBs were transformed into competitive state-owned commercial banks (SOCBs), with non-performing loans (NPLs) cleaned up via asset management companies (Turner et al. 2012).
  • Expansion: Over 100 city commercial banks and 1,000+ rural commercial banks were established to support private entrepreneurs and state-owned enterprises (SOEs).
• Four-Pillar System: China’s banking system now comprises SOCBs, joint-stock commercial banks (JSCBs), city commercial banks (CCBs), and rural commercial banks (RCBs). The state retains majority ownership (60–90% in SOCBs), with the CCP appointing senior management.

Figure 2: Illustrates the growth of China’s banking system (1960–2016), showing the rise in bank numbers and assets (sourced from Zhu 2018).

Table 3: Outlines the institutional and functional characteristics of China’s banking system, emphasizing public ownership and decentralization.

3.2. Window Guidance

• Definition: Window guidance is a central bank tool to direct bank credit toward productive sectors (e.g., SMEs, industry) and away from speculative uses (e.g., real estate, financial assets). It was adopted from Japan’s model (Werner 2002a).
• Implementation in China: The PBoC uses window guidance to steer SOCBs and other banks, ensuring credit supports economic growth. It resembles Japan’s credit guidance but is enhanced by public bank ownership.
• Effectiveness: Window guidance avoids consumer price inflation, asset bubbles, and banking crises by prioritizing productive investment (Werner 1997, 2005). It contrasts with Western advice to liberalize banking and rely on interest rate policies (Goodfriend and Prasad 2006).
• Criticism: Neoclassical economists and institutions like the World Bank oppose credit guidance, favoring market-driven allocation. However, the authors argue it is effective in real-world conditions, as evidenced by China’s growth.

Table 4: Compares window guidance with interest rate policies, highlighting its precision in directing credit.

3.3. Post-Keynesian Economic Theory on Public Banks and Credit Policy

• Deng’s Vision: Deng Xiaoping recognized banks as the core of a modern economy, advocating a "credit economy" where banks fuel SMEs and innovation (Lin 2004). He rejected neoclassical loanable funds theory, aligning with Post-Keynesian views on banks’ money creation role (Keynes 1937; Rochon 2001).
• Public Banks: China’s public-dominated banking system leverages credit creation to achieve full employment and growth, unlike Western systems where private banks prioritize profits over real economy lending.
• Synthesis: China’s system combines Currency School’s public control of money creation (via state-owned banks) with Banking School’s decentralized credit allocation (via thousands of local banks). This allows the PBoC to guide credit aggregates while loan officers handle detailed allocation, ensuring efficient resource distribution.

4. Conclusions and Policy Implications

The article concludes that China’s economic miracle results from its decentralized, public-dominated banking system, which integrates Currency and Banking School principles through "quantitative public bank easing." Key findings and policy implications include:

1. Rejection of Centralized Money Creation: The Currency School’s proposal to centralize money creation (e.g., Ricardo’s plan, Soviet-style systems) is inefficient, as seen in historical failures. China’s decentralized banking system is more effective.
2. Lessons for the UK: Creating small, public, and community banks could boost SME lending and address low productivity (Mkhaiber and Werner 2021).
3. Reassessing European Banking: The European Central Bank’s push for banking consolidation reduces SME lending. New public banks could revive growth, as in China.
4. China’s Future: To avoid the middle-income trap, China should expand public bank easing for productive investment, supporting initiatives like Made in China 2025 and the Belt and Road Initiative.
5. Global Relevance: Developing and transition economies can adopt China’s model of decentralized public banking and window guidance to stimulate growth and employment.

Key Contributions

• Theoretical Synthesis: The article resolves the Currency-Banking School debate by showing how China combines public control (Currency School) with decentralized credit creation (Banking School).
• Empirical Evidence: China’s banking reforms, particularly window guidance and public bank dominance, explain its rapid growth and poverty reduction.
• Policy Relevance: The model offers actionable insights for other nations, challenging the Washington Consensus’s emphasis on privatization and deregulation.