Free exchange: A reasonable supply TO BECOME rich, poor countries must enlarge their productive powers, mobilising workers, absorbing new technology and accumulating capital. They must expand what economists call the "supply side" of the economy, which determines how much a country can produce, and therefore how much it can earn and spend. The other side of the economy - demand - can also intrude on the story. In the course of development, poor countries often struggle to keep spending in check. They are prone to inflation and trade deficits, which must be financed by foreign borrowing. Sometimes these excesses result in a financial crisis that leaves demand in the dumps and supply in disarray. Simply put, successful development entails expanding supply as quickly as possible without allowing demand to grow even faster. China's policymakers fret a great deal about the supply side of their country's economy. They worry about accommodating the flow of rural migrants to the cities, amassing the physical infrastructure appropriate to their ambitions, and upgrading the country's technology. Such concerns fill their five-year plans and 60-point plenary resolutions. Critics of China's growth model, in contrast, tend to focus on the demand side. This is not because China's spending is too strong. On the contrary, China's domestic demand has fallen short of supply in 22 out of the last 23 years, and inflation last year averaged under 3%. China's critics worry instead about the composition of China's demand. Household consumption accounts for too small a share and investment looms too large. If this imbalance is not corrected, they argue, China may eventually suffer from an investment bust, causing a sharp slowdown in spending - perhaps even a contraction. Among the most prominent critics of China's economy is Michael Pettis of the Guanghua School of Management at Peking University. Investment, he points out, accounts for a dizzying 48% of China's spending (see chart 1). Investment plays a dual role in development, adding both to demand and, when projects reach fruition, to supply. But China's high rates of investment are nothing to celebrate, Mr Pettis argues in a recent book. They are both excessive and misdirected. As a consequence China is misallocating capital on a grand scale. Much of the investment is financed by bank loans and other kinds of debt. In principle, it should create useful assets that have a higher economic value than the liabilities incurred to finance them. But if the investment is misconceived, the debts will prove difficult to repay. Perhaps four or five years from now, Mr Pettis believes, China will reach the limits of its "debt capacity" and suffer a sharp slowdown in capital expenditure. Consumption will not be able to compensate for this drop-off in investment, Mr Pettis argues. Household spending accounts for only about 35% of China's demand. Thus even if it were to grow by about 10% a year, it would contribute only 3.5 percentage points to China's growth. This simple arithmetic once prompted Mr Pettis to predict that China's "average growth in this decade will barely break 3%." He was even prepared to bet on it, entering into a lighthearted wager with our Free exchange blog. In his book, he says it will not exceed 3-4% for the decade after 2012-13, a subtle shift in position. Losing interest Consumption is suppressed by a variety of mechanisms that deprive households of income and transfer it to corporate borrowers. The most powerful, in Mr Pettis's opinion, is the cap the government places on the interest earned by household deposits in banks. One might think that low interest rates would encourage consumption by reducing the reward for saving. But the evidence suggests that Chinese households save to meet certain goals, such as making a down-payment on a home. If saving yields little, they simply do more of it. Mr Pettis thinks of this "financial repression" as an invisible tax on household saving, which might amount to as much as 8% of GDP. In a thought experiment, Mr Pettis imagines China's government taxing half of household income to build bridges to nowhere. This, he rightly points out, would be unfair to households and a colossal waste of resources. But it would not lead to unsustainable debts, as he claims, since the bridges are financed with taxes, not by debt. China's investment binge can endure because the saving that China taxes exceeds the investment it subsidises. Many of China's companies are heavily in debt. But as a country, China consistently spends less than it earns, generating a current-account surplus and adding to its foreign assets. China is, then, living within its means. And those means are now considerable. It produces over $8 trillion-worth of goods and services, without undue strain on its capacity. There is little question that capital does not always go to the most deserving investment, and that the lives of China's citizens would be more comfortable if consumption played a bigger part in the economy. But China's capital stock still seems more productive than Thailand's or South Korea's (see chart 2). And even if investment is stripped from the figures and countries are ranked solely by the remaining components of GDP (namely consumption and net exports), China is still the world's second-biggest economy. Whatever its flaws, the development of China's supply side is undoubtedly impressive. It boasts an industrious, mobile workforce, ingenious entrepreneurs eager to absorb new tricks and serviceable, even occasionally lavish, infrastructure. The demand side of its economy, if China's critics are to be believed, is more precarious. But it is hard to think of a developing economy that has been held back for long by a shortage of demand. Economist.com/blogs/freeexchange