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BAUMOL'S COST DISEASE

China is invoking a great American economist to warn against lagging productivity

US and China flags fly on a lamppost.
Reuters/Brian Snyder
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  • Mary Hui
By Mary Hui

Reporter

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Though Chinese leaders like to paint the US as a rotting empire in terminal decline, they nevertheless seem to like drawing from the American intellectual canon to make the case for top-level national economic strategies.

At the World Internet Conference last month, Chinese vice premier Liu He—who has led trade negotiations with the US since the advent of the trade war—made a keynote speech on the state of China‘s digital economy. While extolling how industrialization and digital technology have supercharged China’s economic rise, Liu also sounded a word of warning, according to a summary in Xinhua: China needs to beware of and “overcome Baumol’s disease” (link in Chinese).

More fully referred to as Baumol’s cost disease, it is an idea developed by the famous 20th-century American economist William Baumol. The concept, which Baumol began developing in the 1960s, explains why the cost of services like schooling and haircuts rise faster than cost of goods like pencils and T-shirts.

The reason for this, Baumol argued, is because of different rates of productivity growth in different sectors. For instance, playing a symphony takes an orchestra the same amount of time today as it did in 1960. The same can probably be said for teaching a college algebra course, or giving someone a haircut. Productivity in those service jobs, then, has not grown much. By contrast, it’s much cheaper to produce a computer today than five decades ago. This rising worker productivity allows producers to both cut prices and raise wages. This in turn pushes wages up across the economy, but at a faster rate than productivity growth in labor-intensive service jobs like concert violinist or college math instructor. So concert violinists become higher paid relative to their productivity, and the extra costs are passed on to consumers in the form of higher prices.

Why is China worried about Baumol’s cost disease?

Though Liu only made a passing mention of Baumol’s cost disease, an economist at Tsinghua University, Jiao Xiaojuan, has since written a longer essay (link in Chinese) explaining the significance of the affliction as it relates to China.

Liu’s invocation of Baumol’s cost disease, Jiao wrote, is “profound and significant…[involving] the question of whether China can continue to maintain stable growth after entering the era of service economy.” She warned that China’s service sector as a whole remains a low labor productivity industry, and “as the proportion of the service industry continues to rise, China’s economy will have a longer period of sustained downward movement.”

China Daily, the state news outlet, also recently dedicated a piece to Baumol’s cost disease. “With the service industry accounting for an increasing proportion of the national economy, people are becoming acquainted with Baumol’s Cost Disease,” the article noted. “…That means if the productivity of the service industry does not progress, the expansion of its share in the national economy, which is a goal of the government’s restructuring policies, will dampen the overall economic growth rate.”

China and the “real economy”

It could be that China’s worry is misplaced.

“I think the government’s view on Baumol disease stems from two misperceptions,” said Victor Shih, an expert on China’s political economy and a professor at University of California San Diego. Officials seem to think that ”because internet platforms are not making real things, they are not productive,” but in fact the platforms have improved the efficiency of buying and selling, logistics, finance, and the like. “To me, that is a market outcome and not a disease,” he said.

But assuming that China’s economists and policymakers have correctly diagnosed the disease, how should the country go about curing it? Both Jiao and China Daily see a solution in digital technology that can raise the productivity of labor-intensive services.

“The crux is to raise productivity in services and narrow the productivity gap between the service industry and manufacturing,” China Daily noted. “This requires the large-scale application of artificial intelligence and other new technologies in the service industry.”

Jiao, of Tsinghua, gave the example of digital technology drastically improving productivity in the cultural services sector: smartphones and fast internet connections mean cultural consumption can happen anywhere; search engines improve users’ access to cultural content; algorithms can figure out what kind of cultural material consumers want.

This focus on the digital economy as a key driver of sustainable and high-quality economic growth is reflected in national-level strategies and policies.

In a speech (link in Chinese) before the Politburo last month, Chinese leader Xi Jinping described the importance of the digital economy in soaring rhetoric, describing it as “a key force in restructuring global factor resources, reshaping the global economic structure and changing the global competitive landscape”—the implication being that China should take a leading role in that restructuring.

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