China’s subsidies create, not destroy, value

A common narrative bandied about by the Western business press is that China’s subsidized industries destroy value because they are not profitable – from residential property to high-speed rail to electric vehicles to solar panels (the subject of the most recent The Economist meltdown).

If The Economist actually knows better and is just doing its usual anti-China sneer, then it is par for the course and we give it a pass. But if this opinion is actually held – and all indications are that it is – then we are dealing with something far more pernicious. 248 years after the publication of Adam Smith’s “The Wealth of Nations” and the West has lost the economic plot. 

To celebrate Tesla’s US$788 billion market cap in comparison to BYD’s $93 billion is to confuse incentives with outcomes. Both companies receive generous tax breaks and other government goodies. That Tesla is far more profitable than BYD while EVs have far less market penetration in the US is evidence of policy failure, not Elon Musk’s brilliance. Tesla pocketed the incentives while BYD (and competitors) delivered outcomes.

Similarly, America’s First Solar recently became the most valuable photovoltaic company as cutthroat competition in China destroyed margins. First Solar’s superior valuation in a tariff-protected market should not be grounds for celebration. 

Despite hand-wringing by The Economist, the fact that China’s photovoltaic companies are slaughtering each other by flooding the world with cheap solar panels is prima facie evidence of stunning policy success and value creation.  

To be unable to comprehend this crucial point is to never have properly understood Adam Smith. “The Wealth of Nations” was never about the pursuit of profits. 

They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species.

The entire point of enlightened self-interest was supposed to be the secondary/tertiary effects that improve outcomes for all. 

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest.

What we want from the butcher, the brewer and the baker are beef, beer and bread, not for them to be fabulously wealthy shop owners. What China wants from BYD and Jinko Solar (and the US from Tesla and First Solar) should be affordable EVs and solar panels, not trillion-dollar market-cap stocks. In fact, mega-cap valuations indicate that something has gone seriously awry. Do we really want tech billionaires or do we really want tech? 

The business press has fallen into an at best lazy understanding of value creation. At worst, neoliberal befuddlement has damaged the brains of policymakers, rendering them incapable of diagnosing economic ills.   

The much-heralded multi-trillion dollar valuations of a handful of American companies (Microsoft, Apple, Nvidia, Alphabet, Amazon and Meta) – all of which will swear up and down and all day long that they are not monopolies – are symptoms of serious economic distortion. How much of their valuation is a result of innovation and how much is due to regulatory capture and anti-trust impotence?  

It’s hard to say. China stomped on its tech monopolies and now manages to deliver similar if not superior products and services – able to make inroads into international markets (e.g. TikTok, Shein, Temu, Huawei, Xiaomi) – at always much lower prices.

The Western business press, confusing incentives with outcomes, lazily relies on stock markets to determine value creation. The market capitalization of a company is an important but entirely inadequate measure of economic value.

If you do not own shares of Microsoft, the company’s value is in the price and performance of Windows, Word, PowerPoint and Excel, which we are all forced to use. 

Non-shareholders should wonder how much cheaper and better productivity software would be if regulators actually did their jobs. Given Microsoft’s $3 trillion market cap, monopoly business model and how often Excel crashes, we can be reasonably certain that consumers are getting screwed. 

The saddest creatures in late-stage capitalism are cheerleaders who own little equity but root for mega-cap companies like sports teams. With 54% of total US market cap held by 1% of the population, it’s a given that these confused devotees far outnumber the real beneficiaries. 

Perhaps that is the end-state of the modern proletariat – to be stupefied fanboys celebrating their neoliberal serfdom. This writer thinks they would be better off worshipping Elon Musk a little less and demanding affordable cars a little more, but that’s just my opinion.

To truly comprehend what is going on, one of course needs to consult Karl Marx and “Das Kapital”, which declared that:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.

As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce.

Haha, gotcha. That’s actually Adam Smith and “The Wealth of Nations.” That Karl Marx and Adam Smith had the same end goal seems not to be well understood. What Adam Smith got right and Karl Marx got wrong is that the profit motive can produce superior outcomes, but only when it operates paradoxically. In other words, profits need to be competed away – at least in the long term.    

The mechanics of capitalism are responsible for much of the confusion. Because the invisible hand of the market is supposed to be guided by the enlightened self-interest of participants, profits become the focus of finance and, regrettably, economics if only because so much infrastructure has been devoted to its measurement. 

With the explosion of MBA programs and undergraduate business courses, every two-bit graduate of Western universities has a working knowledge of accounting, financial statement analysis and valuation models. 

Unfortunately, all of that is at best half the story – the producer surplus part of the supply/demand chart. The consumer surplus portion of is of little interest because 1) nobody is making any money off of it and 2) there is no reliable methodology to measure it. Universities are not crawling all over each other to offer Master of Consumer Advocacy programs. 

What China has done in industry after industry is to flatten the supply curve by subsidizing hordes of producers. This spurs innovation, increases output and crushes margins. Value is not being destroyed; it’s accruing to consumers as lower prices, higher quality and/or more innovative products and services.

If you are looking for returns in the financial statements of China’s subsidized companies, you are doing it wrong. If China’s subsidized industries are generating massive profits, policymakers should be investigated for corruption. 

A recent CSIS report estimated that China spent $231 billion on EV subsidies. While that is certainly a gross overestimation (the think tank’s assumption for EV sales tax exemption is much too high), we’ll go with it. That comes out at $578 per car when spread over all ~400 million cars (both EV and ICE) on China’s roads.  

The result has been a Cambrian explosion of market entrants flooding China’s market with over 250 EV models. Unbridled competition, blistering innovation and price wars have blinged out China’s EVs with performance/features and lowered prices on all cars (both EV and ICE) by $10,000 to $40,000. Assuming average savings of $20,000 per car, Chinese consumers will pocket ~$500 billion of additional consumer surplus in 2024.

What multiple should we put on that? 10x? 15x? 20x? Yes, China’s EV industry is barely scraping a profit. So what? For a measly $231 billion in subsidies, China has created $5 to $10 trillion in value for its consumers. The combined market cap of the world’s 20 largest car companies is less than $2 trillion.   

What we have been looking at – illustrated in the supply/demand curves above – are just primary market effects. The more significant outcomes of industrial policy are externalities. And it is all about the externalities. 

To name just a few, switching to EVs weens China from oil imports, lowers particulates and CO₂ emissions, provides jobs for swarms of new STEM graduates and creates ultra-competitive companies to compete in international markets. 

Externalities from the stunning collapse of solar panel prices may be even more transformative. Previously uneconomic engineering solutions may become possible from mass desalinization to synthetic fertilizer, plastics and jet fuel to indoor urban agriculture. China could significantly lower the cost of energy for the Global South with massive geopolitical implications.

The city of Hefei in backwater Anhui province has achieved spectacular growth in recent years through shrewd investments in high-tech industries (e.g. EVs, LCD, quantum computing, AI, robotics, memory chips). In theory, the Hefei model – where local governments operate venture capital funds – can be more efficient than Silicon Valley’s version. 

While returns for traditional venture capital investments are dictated by company profits, the Hefei model is more flexible. Returns can be collected through multiple channels from taxing employment to upgrading workforces to increasing consumer surplus. The internal hurdle rate can be set lower if positive externalities are part of the incentive structure.

While Hefei has been hosting symposiums for processions of municipalities hoping some of the city’s magic rubs off, the model isn’t truly unique. It is just what the China model looks like when pushed against the technological frontier. 

While quantum computing, AI and robotics may be sexy, the formula is not much different from the macro China model. That is, a model that understands all facets of value creation – from consumers to producers to externalities – not a model fixated on and distorted by profits.