Let us now turn to China, and the comparison to the US.

China does not publish figures for measured saving but it is relatively easy to calculate them indirectly. Savings, by an accounting identity, are equal to gross fixed capital formation, plus inventories, plus the current account of the balance of payments. As figures for all these are published savings can be calculated indirectly. Carrying out this exercise for other countries which do publish measured savings figures shows that there is always, as would be expected, some difference between calculated and measured savings figures but it is not great and therefore, provided the difference being looked at is not very small in magnitude, there will be no ambiguity as to the results.

Slide 20 therefore shows calculated savings for China compared to saving in the US – which is directly measured. The outcome is clear. Under the impact of the financial crisis China has now overtaken the US in absolute terms, not simply relative ones, as the greatest source of finance for investment, that is savings, in the world.

Therefore if the first paradox was that the world’s number one capitalist economy is not currently producing any capital, the second paradox is that the world’s number one communist country is currently producing more capital than anyone else – or to be more strictly correct, because there is an issue as to whether this should be categorized as ‘capital’ in the strict sense, China is currently producing more funds for investment than any other country. This is a simple arithmetical result of the fact that while China’s economy is approximately one third of the size of the US, at official exchange rates, the collapse of US savings under the impact of the financial crisis means that the US savings rate is now less than one third that of China.

Slide 20

GDP growth in China and the US

Turning from finance available for investment to predictions for GDP growth Slide 21 shows a mechanical extrapolation of current growth rates for China and the US. This historical data are the calculations made by Angus Maddision and the projections forward are of average growth rates of the last five years. As may be seen on that basis the total size of China’s GDP overtakes that of the US in 2018. Goldman Sachs assumes in its forecasts that China’s economy slows, but it still projects China’s economy as becoming larger than that of the US by 2026.

Slide 21

Of course in GDP per capita it will take China much longer to catch up with the US. If China had the same GDP per capita as the US its economy would be four times the size of that of the United States. On a mechanical projection, which I would never advocate, Slide 22 shows that the GDP per capita of China would catch up with the US after 2050. The GDP per capita trends for Japan and the former USSR have been put on this chart for comparison.

Slide 22

The fundamental determinants of economic growth

We will now turn for a moment from the immediate economic situation to much more structural trends.

I think it is useful to place current economic developments against very long term trends, and what, therefore, is the most fundamental driving forces of a long term economic process, as this gives a sense of perspective. It also shows that current developments can be explained very logically in terms of economics. At the end I will return to more current developments.

To return right to fundamentals shows the opening sentence of the classic founding work of economics – Adam Smith’s The Wealth of Nations. Smith states: ‘The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity and judgement with which it is any where directed, or applied, seems to have been the effects of the division of labour.’ This analysis of Smith, that the driving force of the greatest power of the development of production is the division of labour, or socialised production to use another terminology, remains entirely valid as will be seen - whether considered on the longest time frame or in terms of modern econometric analysis of economic growth.

To start with the very longest time scale Slide 23 shows the situation of the original three great centres of world production – China, India and the Roman Empire (with its nucleus in Europe). Since then, of course, one new great centre of production has been added - the extension of Europe into North America in the United States.

Slide 23

Slide 24 also shows that until 1870 China remained the world’s largest economy. Furthermore the unified character of the Chinese state, under the emperors, prevented it being directly colonised in the way that India was by the British. After 1870, of course, China was overtaken by a whole series of states in Western Europe (and then by the US).

Slide 24

In passing, however, we may note that although China was the world’s largest economy, followed by India and Western Europe, none of these three centres for much of the last two thousand years had the world’s highest GDP per capita – that is the highest level of productivity. That was for much of history enjoyed by the Islamic world - with its centres in Iran and Iraq (Slide 25).

The Islamic world - we may say the role of Islam if we want to give an economic interpretation - was that it constituted the trading connection between the three great productive economic centres of China, India and Europe. This decisive role of Islam, its role as the centre of the international division of labour, may therefore be seen as a vindication on the grandest historical scale of Smith’s analysis - as it created the world’s greatest productivity of labour.

Slide 25

The historical place of Russia within the development of the world economy

If you’ll excuse me making an amateur observation on Russia where did it fit within this long term development of the world economy? I’ll probably say something stupid as regards some features but there are plenty of people in the room who can correct me. The specific situation of Russia was that it was geographically between two very powerful forces – first to its East, where it was confronted by China and the Mongols, as well as later Japan, and also to its West in the countries of Western Europe. Russia therefore had to have tremendously powerful military forces in order to defend itself. Russia will inevitably be crushed between what is to its East and to its West unless it is a very powerful state. That is my fundamental understanding of the position of Russia. I will make some observations on the implications of this later.

The development of productivity in the modern economy

If we now turn from very long term economic growth to the more modern era, after the creation of capitalism, we also may note the order of succession of the dominant economic powers – first Venice, then Holland, then Britain and finally the US. This, in terms of development of GDP per capita, of productivity, is shown in Slide 26.

Slide 26

This chronological order – Venice, Holland, Britain, the US – has a clear logic. Each state consolidated a larger political area constituting a division of labour. The basis of Venice’s power was its trade with the Muslim East, Holland constituted the first capitalist world empire, Britain overtook Holland to create an even larger empire, The US then overtook Britain by creating the first continental scale capitalist economy – it could create an even greater division of labour within its borders than in the entire British empire. All this, of course, also corresponds to the logic first identified by Adam Smith.

Modern econometric findings on economic growth

To turn from history to modern detailed statistical analysis Slide 27 shows the findings on the sources of growth in the US economy. These are made by Professor Dale Jorgenson who is the most outstanding figure in modern growth and productivity econometrics – the official system of calculation of national accounts in the US and OECD has been altered to take account of his findings.

Slide 27

As it is very fundamental I will explain the table in Slide 27 in detail. The final column, which shows the most rapid growth of all, is what is technically referred to in economics as ‘intermediate inputs’ – that is the input of one industry into another industry. As each industry has both inputs and outputs if these are added up for the whole economy they total zero. What this column is measuring, therefore, is the way in which the economy is becoming subdivided in its development – that is how the division of labour is progressing. The result shows the number 115% – which means that the growth of intermediate inputs/division of labour is growing at 115% of the rate of growth of the economy. In other words the economy is becoming more and more subject to division of labour, and therefore also increasingly interconnected. Econometrics finds that this is the single most rapid rate of increase in the economy - the largest source of growth of production. Within the US economy it is a statistical finding which confirms the process of increasing division of labour identified by Adam Smith as the decisive factor in economic growth and productivity development.

What this number shows is that the conclusion which Adam Smith arrived at from observations and individual examples is confirmed by modern econometrics - increasing division of labour, socialised labour if you wish, remains the most powerful force of production.

This reality, incidentally, is why ‘import substitution' strategies, the building of self-contained economies, won’t work. Because by cutting an economy from the widest possible division of labour, that is the international one, it cuts an economy off from the most powerful force of production. That is why patriotism, and the building of a powerful national political state, must be strictly distinguished from the idea of a self-enclosed economy – because a self-enclosed economy will be weak and therefore produce a weak state.

One of the great concepts of Deng Xiaoping was that to re-create a great powerful Chinese state, which has been successfully achieved, China had to have an internationally oriented economy. This strategic understanding of Deng Xiaoping was therefore much superior to that of the leaders of the former USSR.

Fixed investment as the second most important source of economic growth

Returning to Slide 27 it may be seen that the next largest source of US growth, after the division of labour, is increase in fixed investment - physical capital. Whichever period is taken around half, or slightly more than half, of US growth is due to the accumulation of physical capital.

Here, once more, it is useful to make a comparison to the policies of the former USSR. As is well known the USSR, from the time of the first Five Year Plan onwards, aimed at a very high level of investment in GDP. But this was envisaged within an almost self-contained economy – the USSR was a non-market case of ‘import substitution’ in the way that Argentina for most of the 20^th century, for example, was a classic case of market based import substitution (and Argentina also underwent relative economic decline as a result).

The leaders of the USSR mistook the second most powerful force of development of production (fixed investment/physical capital) for the first – the extension of the division of labour which is today necessarily international in scope.

China based itself on the international expansion of the division of labour, and also within that developed an extremely high level of investment. China’s strategy was successful while that of the former USSR was not. There are, of course, other factors in this comparison but this one is absolutely fundamental.

The goal of China’s policy was not international. The aim was to create a great Chinese state. But a powerful national state had to have an internationally oriented economy – recall the official description of the economic process in China is the ‘Reform and Opening up Process.’ Deng Xiaoping understood that a national aim required an international economic orientation. That bedrock understanding, and ability to see the distinction, was, and remains, a key cornerstone of Deng Xiaoping’s historic genius both as an economic policy maker and as a national political leader.

The third most powerful factor in the development of production

The third most powerful factor in the development of the US economy, as shown in Slide 27, was historically the increase in labour inputs - which accounted for around one third of the increase of GDP after the effect of the increase in the division of labour is netted out. Recently, however, in the US this increase in labour inputs has tended to be replaced by technology – which is why the US has experienced ‘jobless growth’. As can be seen in Slide 27, in the most recent period of US economic expansion analysed ‘total factor productivity’, which is generally considered to be dominated by technology, although it actually contains other elements as well, overtakes labour inputs as the third most important source of economic growth.

Summary of the sources of economic growth

To summarise, the most important input into US growth remains increasing division of labour, the increase in fixed capital is the next most important, accounting for about 50% of growth after the division of labour, but technology has now become the third most important factor, and increase in labour inputs the fourth.

In order to show that this process in the US is not exceptional, but reflects the general process of economic development, Slide 28 shows factors accounting for growth in the G7 economies as a whole. Unfortunately data for ‘intermediate inputs’, which is the increasing division of labour, is not available for the combined economies of the G7. But the ranking between capital investment, labour and technology is clear and the same as the US. In Slide 29 I have consolidated this into inputs of capital and labour in one column and the contribution of technology in the other.

Slide 28

Slide 29

As may be seen from Slide 28 the contribution of investment to economic growth in the G7 is essentially the same as that for the US – it accounts for 50-60% of growth after the effect of increasing division of labour is netted out. Technology and labour each account for about 25% of growth. The development of investment in the G7, as in the US, is therefore the most important factor in economic growth after the division of labour. Labour and technology each represents only about half the contribution of the increase in investment.

This fact, that after increase in the division of labour the level of investment is the most important factor in economic growth is crucial for understanding both historical and contemporary developments.

(next part)