The current insufficiency of total demand in China does not align with the theory of inadequate effective demand. The crux of the matter lies in the supply structure’s failure to adequately match demand. Consequently, real demand potential is difficult to be unleashed, while excess supply does not meet the true demand, rendering it ineffective supply. Thus, China is currently in a stage of “insufficient effective supply.” Only by optimizing the supply structure and promoting supply-demand matching can we enter a higher level of supply-demand dynamic equilibrium.

In December 2022, at the Central Economic Work Conference, General Secretary Xi Jinping pointed out that inadequate demand is the main hurdle of economic recovery, and we must strive to expand domestic demand. The Party Central Committee has repeatedly emphasized the critical role of effective investment. While the country vigorously implements the strategy to expand domestic demand, it is highly relevant to explore the key role and impact mechanism of effective investment.

Tackling ineffective supply

Domestic demand concerns both consumption demand and investment demand. First, consumption demand plays a foundational role in economic development. Consumption is the ultimate purpose and driving force of material production and serves as the direct expression of people’s aspirations for a better life. Income levels and supply structures jointly determine actual consumption demand. Stimulating consumption by ignoring these two factors may help to mitigate the impact of external shocks, but in the long run, it could also interfere with market equilibrium.

Second, investment demand influences economic development at multiple levels. Investment typically enters the production function through capital stock, bridging the demand side and supply side, and thus influencing the total supply and structure. It also expands household income through “production-employment” and profits.

Effective investment creates a supply that matches demand. This essential attribute determines that effective investment can smoothly complete the social reproduction cycle, obtain positive average returns, and promote employment. Therefore, whether optimizing the supply structure to better meet demand or expanding the scale of domestic demand to drive new supply, effective investment is indispensable. In contrast, the ineffective portion of investment, although counted in the current year’s GDP, generates no utility and is no different from consumption. It can be said that less effective investment coupled with more ineffective investment reduces the flow of the social reproduction cycle, resulting in more obstacles to economic development.

The changes between supply and demand further highlights the importance of effective investment. Behind the insufficient total demand lies an imbalance between supply and demand, as well as non-clearing markets. On the demand side, growth in consumption and investment demand is getting weaker, and the ratio of household consumption income continued to decline from 78.3% in 2000 to 68.6% in 2021. Private investment growth has lagged behind GDP growth for nearly four consecutive years, with investment inadequately directed toward industries with higher economic returns. Based on our calculations, from 2016 to 2021, the proportion of industries with low-efficiency, high-investment, and high-efficiency, low-investment was about 41%. On the supply side, excess capacity has persisted long-term, with the industrial capacity utilization rate remaining below 80% since 2011. This has resulted in a decrease in profitability and increased operational pressure in the real economy sector, pushing the leverage ratio from 180% to nearly 300%.

The coexistence of demand contraction and excess supply, when analyzed within the framework of economics, can be easily interpreted as “insufficient effective demand.” The core idea of this economic concept, proposed by John Maynard Keynes, is that total demand often falls short of total supply due to constraints imposed by income levels and psychological factors. Consequently, the systemic excess of supply over demand makes markets unable to clear, leading to unsold goods, reduced production, and unavoidable unemployment. At this point, economic growth depends on how much supply demand can absorb, and the most direct measures to promote growth and respond to shocks are to stimulate demand and bridge the gap through fiscal and monetary policies.

Nonetheless, the theory of inadequate effective demand no longer accurately explains the current situation of insufficient total demand in our nation. On one side, China has progressively eased income constraints on the demand side- household income levels and income distribution have improved, facilitating China’s historical achievement of establishing a moderately prosperous society in all aspects. Meanwhile, traditional demand-driven macroeconomic regulation has demonstrated limited success, and demand-side stimuli has been unable to rectify the supply-demand imbalance. As such, the present shortfall in total demand does not correspond to the theory of insufficient effective demand. The key lies in the supply structure’s inability to sufficiently match demand, resulting in the difficulty of fulfilling latent genuine demand and surplus supply actually constituting ineffective supply. Clearly, China is currently in a phase of “insufficient effective supply,” and only through the optimization of the supply structure and the promotion of supply-demand matching can we achieve a higher level of dynamic equilibrium. Effective investment is crucial for optimizing the supply structure and serves as a vital approach to tackle the issue of inadequate effective supply.

Less investment convergence

China’s social investment has long displayed a converging trend, with investments concentrating in a limited number of industries. As mentioned, China’s economy is experiencing “effective supply deficiency,” and the primary aspects of the supply-demand balance contradiction have gradually shifted. Investment, which serves as a bridge connecting supply and demand, has evolved from stimulating growth in the early stages to impeding economic development during the transition of supply-demand balance.

Following the reform and opening up, due to income levels being insufficient to fully absorb increased productivity, China has supported several key pillar industries and advantageous industries through government investment and state-owned capital operations, which resulted in increasingly converging investments. Initial investment flows were primarily directed towards agriculture, forestry, animal husbandry, fisheries, energy, and transportation sectors. Having entered the 21st century, investments started to converge in manufacturing and real estate. Industry convergence created significant scale effects and spurred related sectors.

However, as reform and opening up continued, and as the Chinese economy began to express the features of a major economy, the potential demand for a high-quality life emerged as a new expectation. Meanwhile, excess capacity struggled to adapt and match, leaving supply efficiency to be enhanced. Nonetheless, due to factors such as policy inertia or imperfect market mechanisms, the converging industries of the past continue to attract a substantial amount of social investment, resulting in weakened macro investment efficiency. On one hand, supply in converging industries surpasses demand, leading to the buildup of ineffective supply. On the other hand, the shortcomings of an incomplete industrial system under the convergence model gradually surface, with new business models capable of matching demand lacking resource support, thereby restraining the existing supply system.

Empirical evidence indicates that since the 21st century, China’s investment convergence has displayed a notable upward trend, peaking between 2010 and 2015, which coincides with the economic growth’s downward trajectory. Moreover, the degree of investment convergence in China began to decline in 2012, underscoring the timeliness and effectiveness of supply-side structural reforms. Nevertheless, the current level of investment convergence remains relatively high compared to the early 21st century. Both logical deductions and empirical analyses concur that the converging social investment model’s contribution to China’s economy has turned from positive to negative. Therefore, reducing investment convergence is crucial for expanding effective investment. In a large economy like China’s, especially amidst the increasing anti-globalization forces, this issue deserve more attention.

Expanding domestic demand

Expanding domestic demand relies on effective investment, and the need to diminish investment convergence and enhance effective investment’s pivotal role is consistent on both theoretical and practical levels.

First, as the primary aspects of the supply-demand balance contradiction shift, China should adjust its economic management and macroeconomic regulation approaches accordingly. While Keynesian demand management policies used to work during periods of insufficient effective demand, their underlying assumptions have fundamentally changed. China should focus on its actual national conditions, integrate the fundamental characteristics and requirements of Chinese modernization, and explore and deepen the theoretical framework of socialism with Chinese characteristics.

Specifically, the precision, flexibility, and effectiveness of macroeconomic regulation should be improved, concentrating on structural rather than aggregate-level adjustments. Timely and appropriate use of guidance-oriented industrial support policies can help avert a new round of social investment convergence.

Second, we need to fully utilize the market’s decisive role in resource allocation while enhancing the government’s functions. In terms of the market, an orderly and standardized bankruptcy liquidation mechanism should be established to streamline the elimination of inferior performers. This will ensure that market entities genuinely bear risks and losses, encouraging effective investments to displace ineffective ones and effective supply to replace ineffective supply. Regarding the government, it should strengthen its social functions in areas like public services and maintaining market order. State-owned capital investments can gradually focus on infrastructure with natural monopoly characteristics, while vigorously supporting strategic emerging industries to create a conducive environment. Additionally, through the improvement of various laws and regulations, market barriers should be broken down to form a synergistic development force between the market and government, promoting the free flow of all production factors.

Third, innovation is the primary driving force, and it is the key to narrowing the supply-demand gap. New supply that meets demand stems from innovation, and reducing investment convergence relies on the generation of new business models through innovation. Innovation depends on a country’s long-term accumulation of knowledge, talent, and capital. That is why fostering an innovative environment is more efficient than increasing factor input directionally. This necessitates greater policy support in areas such as education, employment, and social security. It is also important to build an inclusive policy support system, and better engage market entities in innovation and entrepreneurship. These measures will ultimately help provide a favorable environment for market entities to innovate independently.

He Jingtong and Zhao Zimu are from the School of Economics at Nankai University.