How do we know that China is overinvesting? - By Michael Pettis

Of course the question of whether or not China is misallocating capital can be endlessly debated because it is very hard to prove except in retrospect. I would argue that there are several reasons why we should believe that capital has been wasted on a large scale for many years. The first reason is simply historical precedents, something which unfortunately rarely enters into most economic analysis. No country in history that has had anywhere near the growth in investment as China has not had a serious problem in subsequent years, in which debt rose to crisis levels and growth ground to a stop.

The fact that China is so poor is often proposed as an argument as to why this cannot also be the case for China, but of course this is a nonsensical argument. Poorer countries with lower levels of worker productivity are less able, not more able, to absorb very high levels of investment. This may seem counterintuitive at first, but only if you believe that there is a single optimal level of investment for every country regardless of its specific conditions. If the purpose of investment is to save labor and labor cost, then it should be clear that the lower the level of worker productivity and the cheaper and more abundant the amount of labor, the less investment in capital stock is justified.

This is why when so many analysts compare the per capita capital stock of China with that of the US or Japan, and then announce that this proves China has a long ways to go before it runs out of investment opportunities, I am always surprised, and even a little skeptical about their economic backgrounds. This comparison simply does not make sense.

If it did, overinvestment crises would be largely limited to rich countries, not poor countries – something that is certainly not confirmed by history. Anyway I find bizarre the idea that the best comparison for China, one of the poorest countries in the world even if you accept the validity of GDP numbers and ignore the very low GDP share of household income, is the US or Japan, two of the richest and most technologically advanced countries in the world.

But I think there are more formal reasons to believe that China is misallocating capital.