Balkinization: David Schleicher’s Lessons for Modern China

David Schleicher’s Lessons for Modern China

Guest Blogger

For the Balkinization symposium on David Schleicher, In a Bad State: Responding to State and Local Budget Crises (Oxford University Press, 2023).

Rick Hills

In A Bad State is both straight-up narrative history and politico-legal policy advice. That combination invites the question of whether the lessons of the former are generalizable enough to justify the latter. This is not to say that the narrative could not stand alone without the advice. A giant portion of United States’ history has been spent sorting out the bad debts of profligate state and cities: No one before Schleicher has provided a comprehensive, clear, and lively account of how the U.S. Supreme Court, Presidents, and political parties have fretted about how to deal with these fiscal hangovers.

But do these stories have any lessons to offer to anyone outside the peculiar and perhaps unique circumstances of the United States? At the end of the book, Schleicher offers sober, middle-aged, somewhat disillusioning advice that there are no easy answers. An inevitable trilemma of moral hazard, macroeconomic stagnation, or infrastructure disinvestment undermines confident prescriptions for hard budget constraints or Keynesian revenue sharing. Balance, resilience, prudence — these maxims sound like the sort of deflating kind of advice a marriage counselor gives to a long-suffering and burnt-out couple who are better off together but just cannot re-kindle the True Romance of Big Theory.
Does such advice apply to any other society or just to our particular bickering, over-spending federal marriage? Perhaps because I have just returned from a seven-year part-time job teaching in Shanghai, it seems worthwhile to ask whether Xi Jinping should read Schleicher’s book for advice on how to fix China’s municipal debt problem. In what follows, I will argue that Schleicher’s book provides a surprisingly accurate diagnosis and cure for what ails China today.

1. The Chinese debt debacle

Since before covid, veteran China watchers like journalist Dinny McMahon have warned about Chinese subnational governments’ drowning in debt? The expense of covid only exacerbated the debt crisis by burdening local governments with massive lockdown bills. It is not easy to figure out the exact extent of Chinese cities’ indebtedness, because local officials conceal debt by attributing it to non-governmental finance vehicles the bonds of which are secured by governmental assets — primarily land. In 2023, however, Goldman Sachs estimated that Chinese subnational debt amounted to $23 trillion. That’s roughly the size of the entire United States’ GDP or 284% of China’s entire GDP. By contrast, the combined federal, state, and local debt of the United States amounts to roughly $28.8 trillion ($3.2 trillion of which is state and local debt) or roughly 136% of GDP.

Despite this massive debt burden, Chinese cities keep piling debt on for dubious infrastructure projects — railroads to nowhere, eco-parks and other tourist attractions that no one wants to visit, and thousands of “ghost” apartment buildings.

Why cannot Chinese local governments pull out of their addiction to debt? Schleicher’s trilemma suggests three reasons: (1) An out-of-balance emphasis on avoiding macroeconomic stagnation above all else, (2) lack of close monitoring of local investment decisions, and (3) the absence of resilient precautions like promotion of citizen mobility to the most productive places.

Consider, first, the Chinese government’s obsession with macroeconomic stability. As Schleicher notes, subnational spending can be an important counter-cyclical strategy for avoiding recession. The central government started using this strategy back in 2008, instructing local officials, known as “cadres” or “ganbu” ( 干部 ) in Communist jargon to spend freely. Promoting cadres primarily on the basis of their success in boosting local GDP, the central government gave mayors and party secretaries plentiful incentives to juice wages and expenditures with debt-financed construction projects.

Second, the Chinese government did not install prudent monitoring mechanisms, as Schleicher recommended. State-owned banks dumped cash on unproductive firms, and local cadres dumped money on dubious projects. Some of this investment took the form of off-the-books financing through in-kind subsidies in land. Because urban land is owned by “the State,” local governments in need of revenue “requisitioned” rural land, officially controlled by villages, to urban use, dispossessing farmers and leasing the land on 40-70 year terms to developers for lump-sum payments. Because any sort of construction generates short-term spikes in GDP on the basis of which a cadre could earn promotion, local cadres did not focus on the quality of the projects they were financing. China sprouted vast crops of airports where no one wanted to fly, theme parks that few visited, and ghost cities of empty apartment buildings in so-called “third-tier” cities where no one wants to live.

Finally, China lacked the mechanisms for resilience urged by Schleicher. In particular, Schleicher notes that citizen mobility allows people to move from unproductive to productive jurisdictions, a form of mitigation of bad investments through migration to good ones. Citizen mobility is, in fact, high in China: Hundreds of millions of rural residents left their villages to work in cities between 1990 and 2020. But the central government placed big obstacles in their way. The central government limits the quantity of land that can be devoted to residential purposes in an effort to keep a lid on the population of the fastest growing and most productive cities. Local governments also lack sufficient mechanisms or incentives to recover revenue from rural migrants: They have no authority to levy a property tax nor are they promoted on the basis of rising land values, so neither their local revenues nor their careers are advanced by attracting more migrants.

The result is that Chinese cadres keep running the same playbook — promote local growth through investment in infrastructure — but with less cash, as real estate prices start to collapse in all but the most productive cities.

2. Lessons for China from the United States’ Gilded Age?

In A Bad State, in short, seems to diagnose China’s debt woes pretty well for a book that does not venture outside of United States history. The accuracy of diagnosis might be the result of the resemblance between China’s current state of affairs and the debt crises of Gilded Age America described that Schleicher describes so well. As Yuen Yuen Ang notes in China’s Gilded Age, China’s boom-and-bust economy today looks a lot like postbellum America before the Depression of 1893, when “American state governments were fiscally independent and eager to promote development, both to win elections and to get rich.”

In A Bad State provides one more parallel: Both Gilded Age America and contemporary China suffered from a massive municipal debt crisis. A huge portion of the U.S. Supreme Court’s docket was taken up by states’ and municipalities’ trying to evade repayment of their bondholders. Those creditors lent money to starry-eyed boosters who wanted to transform their hamlet into the next Chicago with a railroad spur. Like Chinese cadres, the local politicians who promoted this boosterism were sometimes corrupted by investment promoters, sometimes simply suckers, and sometimes merely politicians with a short time horizon. The result was a mad scramble for investment followed by defaults as the United States was glutted by rail lines and hit by depressions and panics, including a mammoth depression in 1893.

The United States climbed out of the 1893 Depression despite the trilemma described by In A Bad State. Will China do the same? Predictions about China are always hazardous. There are reasons, however, for cautious pessimism: Parallels between the United States and China may diverge, because institutions promoting balance, resilience, and prudence in Nineteenth Century United States are missing in the People’s Republic of China.

Consider, first, how two independent tiers of federal and state courts simultaneously promoted infrastructure investment and monitoring of local officials. Federal courts took on the role of forcing local governments to re-pay bondholders for debts already incurred, thereby saving the market for municipal bonds necessary for financing useful infrastructure. This role not only required federal courts to crack down on municipal officials’ creative ways of evading repayment but also to overrule state courts that regularly protested against the federal judiciary’s usurping the state judges’ job of construing state laws and municipal powers. But state courts played an important role as well, in narrowly construing local governments’ power to insure indebtedness in the first place with doctrines like Dillon’s Rule. Such state doctrines required extremely specific statutory authorization for local investments, thereby enlisting the state legislatures and state courts in monitoring local officials’ investments.

Both the federal and state doctrines were judicial inventions with little justification in previous doctrine or specific statutory language. The justification for these innovations was not law but policy: Failure to pay bondholders would dry up investment in infrastructure, while failure to restrict local investments would invite civic boosters to plunge into future doomed ventures. The willingness of each judicial system to impose these limits, however, depended on their independence from each other. State judges, often elected by angers taxpayers, tended to resist repayment of bondholders, while federal judges, detached from the nitty-gritty of state politics, played little role in restraining future bond issues.

China lacks such independent checking institutions. The Communist Party’s central leadership —increasingly, Xi Jinping — calls the shots, and local cadres scramble to outdo each other in demonstrating their commitment to whatever the central government announces. Right now, the Party’s leaders want to bolster falling real estate prices, so local officials have little incentive to limit their indebtedness. As a result, there is little independent monitoring of local investment decisions.

Consider, next, how Chinese Communist Party’s ideological commitment to centralization prevents accurate monitoring of local cadres. Shitong Qiao and I have suggested that freeing up land markets and promoting citizen mobility would enable the central leadership to use land values as a proxy for local cadres’ performance. If Chinese homebuyers were freer to choose among competing jurisdictions when buying real estate, then the central government could use those choices as a basis for assessing which local governments were doing the best job in attracting homebuyers. Local governments that invested in useless white elephants would lose buyers; local governments that gave homebuyers what they wanted would gain buyers. The resulting slumps and rises in local land values could be a signal for central officials of comparative performance of competing cadres. In effect, Chinese homebuyers would vote with their feet for or against local officials without threatening the central leadership with protests or ballots.

In practice, however, the Chinese Communist Party’s Leninist ideology discourages such delegation of decision-making power to private decision-makers. Xi Jinping remains determined to pick winners among Chinese cities, capping growth in China’s most productive areas and thereby forcing the population into less productive cities. In particular, the Communist Party has steadfastly refused to give rural households a right to alienate their farming rights, preferring that local governments expropriate and use the gains from converting rural to urban land. This is in stark contrast with nineteenth century United States, where farmers retained the gains in real estate values from expanding cities while the central government had little power to control rural migration into the cities with the best wages. Those farmers became active monitors of their local officials’ investment decisions, because the value of their land was at risk.

In short, an ideology that celebrates central control stymies accurate monitoring of local cadres’ performance in today’s China. The result is an imbalanced trilemma, where macroeconomic stimulus always trumps monitoring local cadres. Schleicher could have warned Xi Jinping that such an imbalanced model of local debt is a recipe for moral hazard.

Rick Hills is the William T. Comfort III Professor of Law at NYU Law School. You can reach him by e-mail at roderick.hills@nyu.edu.

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