One problem is that if you rely on direct funding from the government, what tends to get funded are large infrastructure projects which then take on a life of their own. The big problem with Keyesian stimulus is not so much starting big projects, but shutting them down once you have gotten out of trouble. Once you have a large political group that is making money from an infrastructure project, it becomes difficult to shut down. This is less of a problem with health and education, but it can be a big problem with things like roads.

Something that the government has to do is get credit to small and medium enterprises, and at that point the banks play a crucial role since only the banks have the staff to figure out who to lend to. The problem with lending to small and medium enterprises is that it’s something new for the big state banks, and they are likely to do it badly at the beginning. A small increase in NPL’s is not necessarily a bad thing, if it actually does encourage small and medium enterprise formation.

One important point is that when I say that the Chinese economy should be focused on investment and not consumption, I *don’t* support state subsidized capital to heavy industry. What I do support is investment in small and medium businesses. Getting credit to a dim-sum stand is in some ways much, much harder than getting credit to a steel factory.

Flora: have to say I share your concern on China’s longer-term growth outlook. the “expensive bet” on a quick recovery in global trade and economy trade will likely prove miscalculated,

I don’t think that the Chinese government is betting on a recovery in global trade and economy. It needs to create enough demand so that you have reasonable economic performance in China *regardless* of what happens in the rest of the world. It really doesn’t have a choice in the matter. If the government doesn’t get the Chinese economy growing in the next year or so, then the people on the streets will take matters into their own hands.

Flora: The Govt should focus more on helping the private sector in the rational way instead of blindly throwing money into public sector investment mainly initiated by local govts…

It’s not either/or. The problem is getting money into small and medium enterprises is very tough to do. One big problem is that large enterprises are too big to fail, so no one minds loaning them money. Small and medium enterprises can fail, so people are reluctant to lend to them in tough times. Another big problem is corruption. It’s much harder to make sure that money to small and medium enterprises gets to the right people than it is to monitor money to big enterprises.

Flora: a permanent derating of china’s GDP to below 5% beyond this cycle is not totally out of the question just like what happened to Japan after early 1970s.

I don’t think this is likely. Japan’s GDP started to hit limits after it had already reached levels of industrialization that China will not see for decades. Remember that by the 1920’s, Japan was already an industrialized nation with a far more productive economy than China has now.

Chinese GDP growth is not magical. It’s that the country is so underinvested that anything will help. The first freeway that you put in a county will generate huge amounts of economic growth as well the first factory. It doesn’t matter if the freeway or factory are incredibly inefficient. It is less inefficient than what was there before. If you have a poor enough country, then even industrialization through a broken inefficient system will create growth. Look at Russia from 1930 to 1960. Part of the problem with these discussions is that people are so fixiated about Japan and Russia in 1990, that the don’t look at the lessons of Japan and Russia in 1935.

Brian, Paul Krugman was particularly nasty about some of the misunderstandings that arise from savings = investment identity.

BCG, I think I agree. William Buiter discusses some of the reasons why here.

Mr. Yu, very interesting point about the lending. I will cite it in my next blog entry.