FOR those just tuning in...

Lots of people worry that China's investment-led growth is unsustainable, leaving China vulnerable to an investment bust. But a recent paper by Yin Zhang of Goldman Sachs and Michael Buchanan argues that China's investment is not as excessive as it looks. Almost 40% of it, indeed, can be thought of as "quasi-consumption". In a previous post, I threatened to explore what they meant by "quasi-consumption". Here I make good on that threat.

The exploration will require a brief dip into national accounting definitions. What a snooze, you might think. But be aware that for some people, such definitions are intellectual bloodsport. Witness, for example, the scrap on Scott Sumner's blog, between a commenter called "Saturos" (who offers a useful elaboration of established accounting definitions) and an antagonist called "Major Freedom" (who claims to have invented better ones of his own).* 

So, what do the Goldman economists mean by quasi-consumption? A recent Free Exchange column summarises their argument as follows:

...Michael Buchanan and Yin Zhang of Goldman Sachs say that some Chinese investment is best seen as “quasi-consumption”. In this category they place things like earthquake-proof schools and more comfortable metro lines. Instead of adding to the economy’s productive capacity, these assets provide a flow of services (such as reassurance to parents and relaxed travel) directly to consumers. In this respect they are more akin to consumer durables, like washing machines or cars, than to iron-ore mines or steel plants.

That passage jumbles together two or three distinct ideas. It is a bit sloppy and confusing. In trying to make sense of a confusing passage, it is usually an advantage to have written it. But not always. So let's turn instead to the original paper. The Goldman economists write:

Not all investment is the same. Some investment only serves a purpose if it raises near-term productive capacity—for example, building a new factory or adding new machines is likely to increase potential capacity once it is completed, but is unlikely to directly create enjoyment for households.

In contrast, having clean and safe schools and hospitals creates a direct positive benefit for households...“quasi-consumption of health and education services”.

It is harder to make such broad generalizations about transportation investments—building a freight railway that alleviates an acute bottleneck (say for coal shipments) may provide a substantial immediate boost to productive capacity, whereas building a more comfortable metro line may be more like “quasi-consumption”.

Scott Sumner (who has not had the chance to read the original paper) finds this sort of perspective "odd" (although he should also find it familiar). For Mr Sumner, investment is a simple concept: 

Investment is the construction of capital goods.  Period, end of story. Capital goods are highly durable assets, such as subways, airports, apartment buildings, hospitals, schools, etc.  Factories are also capital goods, although they tend to be less durable (at least in America) than the other items that I listed.

That's largely right, of course. Durability is key. If a good is used in production, but not used up in production, then it is usually counted as a capital good. A blast furnace, for example, helps produce a useful service: smelting. The typical furnace also remains standing even after a year of blasting. Furnace-making, therefore, counts as investment. By contrast, a cheap blowtorch that is worn out after 11 months does not qualify as a capital good. Once you've counted 11 months' worth of welding, you've counted the blowtorch's entire contribution to GDP. There's no need to count the blowtorch as well.

(For the record, the Goldman economists understand these accounting definitions perfectly well. As they write, "The point here is not that the spending on schools, hospitals, some transportation infrastructure and property has been mis-recorded in the national accounts—the spending creates durable assets and hence is rightly recorded as investment.")

But durability is not quite all there is to it. A car, for example, provides a useful service. It also lasts more than a year. If a firm adds a car to its fleet of vehicles, it counts as investment. But if a household buys a car, it counts as consumption. Why? The short answer is the obvious one: it was bought by a household not a firm. The deeper reason is that the GDP statistics do not generally count services produced within the household. They don't count trips taken in the family car or meals prepared on the family stove, and so on. These activities are said to be beyond the "perimeter" or "frontier" of what counts as production**. Since national accountants do not count the consumer services the car provides, they count the car itself as consumption. "By convention, all goods and services apart from dwellings are considered to have been entirely consumed once they have been acquired by households," write François Lequiller and Derek Blades in their guide to the national accounts.

This boundary--this line between production and non-production in the national accounts--is clearly drawn. But it is a little arbitrary. Suppose, for example, a household buys and occupies a home. The house is obviously a durable asset, but the service it provides (shelter) is produced within the household. You might therefore think that the national accountants would treat owner-occupied homes in the same way they treat household cars. But in this case, they make an exception. The statisticians "impute" an implicit rent, based on what similar homes fetch on the rental market. This imputation allows the GDP statistics to capture the consumer services a home provides. They are brought within the perimeter of production, so to speak. And the home itself can then be classified as a capital good not a consumer durable.

In principle, the national accountants could handle cars in the same way. They could "impute" the market value of car trips, based on car rental rates, just as they now infer the implicit rent paid by homeowners. The car trips could then be counted as consumption. The car itself could be counted as investment. (And the wear and tear on the car over the course of a year could be counted as depreciation, or "consumption of capital", in measures of net domestic product.)

So Mr Sumner is not quite right. Durability is not the only thing that counts. Distance from the perimeter of production can also come into it. Investment, we might say, is the construction of durable assets. Comma. The purchase of some durable goods (cars, washing machines, and so on) can count as consumption, not investment, if those goods are sufficiently close to the consumer--if the services they provide are enjoyed directly by households, rather than being embodied in another good, mediated by a market transaction, or otherwise well captured in the GDP statistics. There is a bit of "give" in how statisticians think about these things.

The Goldman economists do not put it quite this way themselves, but their thought experiment does emphasise that the services provided by housing and social infrastructure fall very near, if not beyond, the GDP-perimeter, just like the trips provided by a household car. The shelter provided by dwellings, the transport provided by a metro, and the education provided by a school are all services enjoyed directly by individual members of a household. If this flow of services is not adequately captured in the consumer spending figures***, then it might be interesting to count the durable asset itself as consumption instead. In effect, this conceptual manoeuvre allows the Goldman economists to treat homes and metros in the same way the national accounts now treat cars:

The durable assets created by the property and social infrastructure spending are not fully used up in one year, and so in that sense accounting for it all in one year... is not a purist approach to assessing the consumption patterns over time (we should discount the future flows of services). However...[the same] is true of purchases of other consumer durables like washing machines, cars, air conditioners etc too...

This idea of the GDP-perimeter also helps shed light on the slightly baffling use of the term "productive capacity" in the passages above. According to those excerpts, building a new metro line, a hospital or a school does not add to society's "productive capacity", at least in the near term. This is an odd thing to say (as "Saturos" points out on Mr Sumner's blog). Surely, a comfortable metro does add to productive capacity. At the very least, it adds to society's capacity to produce comfortable subway rides. So what exactly is meant by "productive capacity" if a metro does not add to it?

Intuitively, the Goldman economists seem to mean something close to corporate capacity: the capacity to produce commercial goods and services. Or, to put it another way, the capacity to produce goods and services the value of which is well captured by the GDP statistics. That excludes services that are close to the perimeter of production, services that are produced within the household or purchased at a token price, like a comfortable subway ride.

According to the Goldman paper, a lot of the durable assets that China is building so frenetically provide these close-to-the-consumer services. So, does that make Chinese investment crazy? Or just quasi?



*  Their controversy begins with the fatal words, "I’m going to save everyone a lot of controversy"...

Saturos now wishes he'd fought on longer. But in flaming, it's not the winning, but the not taking part that counts.

** In their guide to the national accounts, François Lequiller and Derek Blades call it the "production frontier". I prefer perimeter, because it is less easily confused with a production possibility frontier. In the System of National Accounts, it is called the production "boundary".

*** China's statisticians do impute owner-occupier rents. Things like subway fees (a single ride on the Beijing metro costs two yuan) should also appear in the household consumption figures. The value of government-provided services is also captured by the cost of producing them, including the cost of capital, which is proxied by the consumption of fixed capital (eg, wear and tear). So the services provided by housing and social infrastructure are not entirely missing from the consumption figures. But subway fees reflect only a fraction of the value of the service provided. Owner-occupied rents may not be very well measured either. And it is widely recognised that consumption of fixed capital understates the value of the services provided by government capital. (See Box 4 in the Lequiller/Blades guide above.)

Update: This footnote was updated to mention an additional way in which the value of infrastructure services is already measured in the GDP statistics. The updates are in italics.