Why Capital Is Fleeing China: The Crushing Costs of Systemic Corruption

September 4, 2015

What China will be left with a poisoned land stripped of talent and capital.

Corruption isn't just bribes and influence-peddling: it's protecting the privileges of the few at the expense of the many. Rampant pollution is corruption writ large: the profits of the polluters are being protected at the expense of the millions being poisoned.

This is why capital and talent are fleeing China: systemic corruption has poisoned the nation and raised the cost of doing business. External costs such as environmental damage must be paid eventually, one way or the other.

Either the cost is paid in rising chronic illnesses, shorter lifespans and declining productivity, or profits and tax revenues must be siphoned off to clean up the damage and the sources of environmental degradation.

In large-scale industrial economies such as China and the U.S., that cost is measured not in billions of dollars but in hundreds of billions of dollars over a long period of time.

I have often noted that one key reason why the U.S. economy stagnated in the 1970s was the enormous external costs of runaway industrialization were finally paid in reduced profits and higher taxes.

China's manufacturing base simply isn't profitable enough to pay for the remedial clean-up and pollution controls needed to make China livable. That means labor and all the other sectors will have to pay the costs via higher taxes.

Pollution and environmental damage is driving away human capital, i.e. talent. This loss of talent is difficult to quantify, but it's not just foreigners who have worked in China for years who are pulling up stakes to escape pollution and repression--talented young Chinese are finding jobs elsewhere for the same reasons.

The game-changer is automation, i.e. robots and software eating the world. To understand the impact on China, let's start with unit labor costs, i.e. the cost of labor needed to produce each unit of output.

If it takes one worker an hour to assemble 10 light fixtures, the unit labor cost of each fixture is 1/10th of an hour's total compensation costs, i.e. wages and overhead. (Total compensation costs include all overhead such as vacation, healthcare, pensions, social security taxes on labor paid by the employer, etc.)

If an automated machine can produce 1,000 of the same units in an hour, and the only labor is the machine's one operator, the the unit labor cost of each fixture is 1/1,000th of an hour's total compensation costs.

When labor's contribution to production costs drop to near-zero, there's no labor arbitrage left to make China a low-cost producer. Frequent contributor Mark G. explains:

"Doing business in China has its own set of local costs. In the past, these costs were outweighed by the greater profit potential of dirt-cheap Chinese labor. But once unit labor costs fall to near-zero as factories are automated, the remaining cost inputs for any manufacturer become a proportionally much larger part of the price.

Environmental regulatory arbitrage is the sole exception. But even this advantage must fade as the Chinese consumer middle class acquires influence. Very few Chinese of any class will have a direct profit stake in automated factories. Any pollution emitted by automated factories becomes a direct cost and a form of tax that those living nearby must bear. Therefore I anticipate that even this current advantage of effectively no environmental regulation will soon dwindle as Chinese tolerance for pollution fades."

Environmental clean-up costs have been avoided due to corruption. Filters are taken off at night, when the smoke is less visible. If local residents complain too loudly, local squads of goons attack them.

The Chinese state exists to enforce the privileges enjoyed by the few at the expense of the many. Paying pollution-remediation costs slash profits--indeed, in many cases, these external costs completely wipe out profits.

Dissenters and anyone daring to question the corruption must be suppressed by whatever means are available, and the central and local governments in China have been liberally deploying every tool of repression.

This systemic repression is the direct consequence and cost of corruption. So by all means, poison the nation and its non-privileged citizens to benefit the few at the top of the heap, and arrest, beat up or silence critics and dissenters.

What China will be left with a poisoned land stripped of talent and capital. That's the ultimate cost of systemic corruption.

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