Yasheng Huang of MIT writes on WSJ: China’s economic growth has largely been driven by government-heavy-handed investments. Chinese economy lacks a real consumption base. So in hindsight, the “decoupling” theme now sounds almost ludicrous.

I see the key to solve the problem is to shift investment/consumption decision-making from government to individuals. But in order to nurture a good investment/consumption environment for individual investors, it requires establishing a social security system and an affordable healthcare system. Without them, individuals will still resort to precautionary savings and deposit their their money into the banks. And of course, since all large banks are controlled by the state, government thus replaces individuals in their decision making. So in this sense, privatization of state banks and simultaneous introducing foreign competition into the financial system will also help.

Remember the hype about “decoupling”? Not so long ago, Western analysts — in particular investment-bank economists — were peddling the idea that China had become a powerful economic center of its own, able not only to drive its own growth independent of the United States but also to power the global economy forward.

To the extent that these Wall Street economists are still employed, few would make that argument now. The economic numbers emerging out of China are sobering. Exports, still the backbone of the economy, are contracting for the first time in seven years, according to the latest data. They’re being driven down by slackening demand overseas. Even worse is the sharp decline of imports, a sure sign of falling domestic demand. These two developments taken together signal monumental economic challenges ahead. Clearly China is not bucking global trends.

So how did all the decoupling theorists get it so wrong? This isn’t an idle question. The decoupling theory itself was the product of faulty economic analyses that persist today, even as the decoupling theory falls out of favor. Debunking these claims carries important policy implications.

The fundamental problem, and a mortal bias of economists, is a fixation with simple measurements — especially GDP data. Ask a professional economist how many provinces China has and you are likely to draw a blank stare. But ask him what the GDP growth of China has been and he’ll quickly be able to tell you that China has grown at a double-digit rate for 30 years and that at this rate China will overtake the U.S. by 2035 (or some other date). GDP-centrism is endemic, and often comes at the expense of deeper analysis. Just look at the enthusiasm with which economists and analysts greeted Goldman Sachs’s famed “BRIC” report forecasting dramatic booms in Brazil, Russia, India and China — a report based on little more than fifth-grade mathematics.

This obsession with China’s impressive GDP growth often ignores discussion of what’s causing that growth and whether it’s self-sustained. This is where the decoupling enthusiasts stumbled, and where policy makers can still go seriously wrong. Consider, for example, data about the very slow growth of household incomes in China. This is particularly apparent in rural households. For the past 20 years or so, rural household income has grown at a rate half that of GDP growth. The slow household income growth, combined with rapid GDP growth, means that China has created a huge production capacity but it has done so at the expense of its own consumption base. This fact alone should have disproved the decoupling hypothesis. All the new “excess” production had to go somewhere, i.e., to the U.S. What’s more, the persistence of this gap suggests that over time, China’s growth has become more, not less, a derivative of America’s consumption appetite.

This raises the important policy question of why and how Chinese growth systematically undermined its own consumption potential. To answer this, one has get a grip on how China’s rapid GDP growth happened in the first place. Part of that growth is a result of economic liberalization, but the market-driven part is small and has been diminishing. Fixed asset investment, heavily controlled by the government, has risen to nearly 45% today, from a level of 30-35% during the 1980s. Much of the GDP growth since the mid-1990s has been a result of government-organized massive investment drives — in infrastructure, urban construction and urbanization. This government-heavy growth has done the most damage to China’s consumption potential, pushing the country further to a dependency on the markets of the rich nations.

Let me illustrate this point by an example. The following proposition will sound familiar to many foreign investors who have done business with Chinese local officials eager to get their investment capital: “Do you want 10 acres of densely populated land for your new factory? No problem. We will clear the land for you in three weeks.” Many foreign investors marvel at the “business friendly” attitude of local governments in China, especially in sharp contrast to the seeming incompetence of the Indian government to get things done.

But this “business friendliness” is the heart of the problem: The Chinese households often reap almost no financial benefits from the conversion of their residential land into industrial or commercial development. The Chinese government, thanks to its formal ownership of all land assets, can relocate households on a scale unthinkable in a market economy, often with compensation far below the fair market value of the land. This is why factory owners incur far lower costs in setting up operations in China as compared with other countries, and also is why thousands of skyscrapers can mushroom seemingly out of nowhere overnight in Chinese cities.

But China is not exempt from a basic economic principle: A cost to one person is an income to another. The fact that factory owners and developers in China incur lower costs means that the income to some other economic participant is low. Those who derive low income in China happen to be the majority of the population, especially the rural Chinese who have little political power to protect themselves. Thus one sure mechanism of private wealth creation — urbanization achieved when small landholders sell out to developers at market prices — is almost completely missing in China despite the fact that the country is urbanizing at a dizzying rate on the surface.

All this is significant beyond the esoteric confines of the decoupling debate. To truly rebalance the Chinese economy requires the Chinese government to focus on income growth of the Chinese people rather than being fixated with GDP growth. One straightforward way to do this is to adopt market pricing of land by permitting and encouraging competition when acquiring land from Chinese peasants as a part of its current stimulus package. In the past two years, the Chinese leadership has done a good job reducing the expenditures — such as taxes, education and health fees — of the Chinese peasants. It is time now to raise their income.

China is one of the few countries in the world endowed with the land mass, the energetic and talented population, and the entrepreneurship to become a true global economic powerhouse. But that potential has been squandered by a misguided development strategy that privileges production at the expense of consumption and uses political power to suppress costs rather than relying on market mechanisms to boost income. In the midst of a global recession, China, along with its 1.3 billion people, is paying a dear price for that mistake now.

Mr. Huang is a professor of international management at the MIT Sloan School of Management and the author of “Capitalism with Chinese Characteristics” (Cambridge University Press, 2008).

The Journal has a report on how to use exchange rate (by depreciating) to get out of deflation. Barry Eichengreen and Ben Bernanke both hold such view. But as pointed out in this article on Economist Magazine: not all countries have the luxury to implement such policy, especially those who borrowed heavily and in foreign currency. So currency depreciation is not the panacea and it can’t be blindly appled everywhere.

The dollar’s sharp turn weaker into the end of the year is threatening to reshuffle winners and losers in global trade amid the toughest economic conditions in decades.

For countries like Japan and Germany, it is a source of anxiety, since a stronger currency makes exports less competitive as global demand shrinks. For the U.S., it is a more welcome development and might also help counteract declining prices. In some emerging markets, a weaker dollar is a relief for companies that must pay debts denominated in dollars.

Still, in today’s environment, few countries want to be the last one standing with a strong currency. Some economists worry that countries could actively seek to weaken their currencies in an effort to gain an advantage over their trading partners, setting off a round of devaluations that ultimately damage world trade.

Until recently, the dollar was one of the most robust currencies around, surging against everything except the Japanese yen. But in recent weeks — and particularly after the Federal Reserve slashed a key interest-rate target to near zero — the dollar has abruptly changed course.

On Friday, the dollar slipped against the euro, with one euro buying $1.406 late in New York. The dollar has weakened about 10% versus the euro and 8% against the yen since the start of November.

That is good news for U.S. exporters, but it is raising concerns in places like Japan and Germany, which are both gripped by recession.

In Japan, officials are so concerned by the strengthening yen that they have sent signals they might intervene to stop it. Earlier this month, Honda Motor Co.’s president warned that the pumped-up yen could cause the “hollowing out of Japanese industry.”

“Both countries are very dependent on exports, with very little domestic growth,” says Adam Posen, an economist at the Peterson Institute for International Economics. “Bad news is coming, and the dollar going down is additional bad news for them.”

Of course, there are upsides to a having a stronger currency in some corners of the globe. The dollar’s turn lower has brought a modicum of relief in emerging markets, where currencies have been battered in recent months. That is easing the burden on companies with debts to pay in foreign currencies.

For the U.S. in particular, a weaker currency could be a welcome help on another front — avoiding a cycle of declining prices.

“There is a pretty compelling argument both in theory and in history that if your problem is deflation, then pushing down the exchange rate is an effective way of addressing that problem,” says Barry Eichengreen, an economist at the University of California, Berkeley.

Mr. Eichengreen notes that, during the Great Depression, it was difficult to use a weaker currency to export more because of protectionist policies in place around the globe. However, it was a useful way to change people’s expectations about prices, since imports become more expensive. When the U.S. devalued the dollar in 1933, he said, the prices of some commodities, which had been spiraling lower, suddenly began to go up.

One fan of this line of thinking: Federal Reserve Chairman Ben Bernanke. In a 2002 speech, Mr. Bernanke noted that the devaluation of the dollar and the rapid increase in the money supply in 1933 and 1934 “ended the U.S. deflation remarkably quickly.” He described the episode as an illustration of what can be achieved “even when the nominal interest rate is at or near zero.”

That, of course, describes where the Fed’s key interest-rate target sits today. The fact that the Fed has been willing to embrace unconventional and aggressive lending measures carries an implicit message, says David Gilmore of Foreign Exchange Analytics, a Connecticut research firm, namely that “a weaker dollar in an orderly way is certainly a desired outcome.” He adds that the Treasury Department has avoided its usual mantra in recent months in which it reiterates its support for a strong dollar. The current problem, he says, is that “every country on the planet needs a weak currency right now, and not everybody can have one.”

In late November, China briefly pushed its currency, the yuan, sharply lower against the dollar, raising fears that it could be seeking a competitive leg-up. Since then, the yuan has recovered those losses. In Vietnam, where the local currency, the dong, is pegged to the dollar, the central bank devalued the currency on Wednesday for the second time this year. The move will help facilitate exports and control the trade deficit, the central bank said in a statement.

In the late 1990s, a number of emerging markets from Asia to Russia faced financial crises and were forced to devalue their currencies. Eventually, that helped spur economic recoveries by touching off export booms at a time of buoyant demand elsewhere. Today, though, the whole world is reeling, making it difficult for a country to export its way out of trouble.

“The world can’t depreciate [its currency] against Mars and export to the rest of the solar system,” says Simon Johnson, a former IMF chief economist.

It explains why new books (especially textbooks) these days are sold at exorbitant expensive prices and how the Internet has changed book selling. (source: NYT)

For over 20 years, Japanese stock market went nowhere but down.