China: the iceberg ahead
Most people know that mercantilism is a failed 18-th century theory that nobody takes seriously any longer. But we can witness with our own eyes an economic paradox where a major country named China has effectively chosen this failed growth model. What's even more remarkable is that its government failed to notice that in the world of fiat currency, the 18th century variant of mercantilism must fail even more spectacularly than it failed back then under the gold standard. It is instructive to see how this model first spurs rapid growth and then causes stagnation and eventually a crisis.
So let us see. After Chairman Mao left to meet Marx, China became a capitalist economy. More capitalist in fact than USA. No food stamps. No welfare. No Social Security. No healthcare reforms. No environmental regulation. Have a 100 tons of lead powder that you want to dump into the river from which farmers take their drinking water? No problem, go ahead! You Western snobs may call it destruction of the environment, but we call it competitive advantage. So China was a free-marketer's paradise for these three decades.
There was just one thing China didn't have, and that was domestic market.
Yes, somehow the mandarins forgot to create a market. That was a most singular thing: market economy with no market. They just shipped consumer goods abroad to earn currency to purchase equipment to ship more goods abroad to earn more currency to purchase more equipment to ship still more goods abroad...
At first this strategy worked. There may be no improvement in living standards, but as long as you keep growing industrial capacity, who cares? One day this capacity will begin to work for you and that's when you will feel improvement. So one cannot blame the economic policy of Chinese government in the 80s too harshly. It caused imbalances but at least there was method in their madness.
But what happens then? At one point your industrial base starts generating more revenue than could be reinvested. Economy is like a living organism. You start with 2000 kcal a day. Then you increase it to 2500 kcal and you body grows faster. You increase it to 4000 kcal and accelerate growth just a little. You increase it to 5000 kcal and this time the effect is marginal. You consume 10000 kcal and it makes you sick. You make one more attempt, consume 15000 kcal, and in a few minutes you throw up. And so starting from 1990s China could not absorb all that export revenue. They invested 40% of their GDP, more than anyone else, and yet they still could not absorb all the export revenue.
So what did they do then? They invested the excess revenues in US Treasuries. At the time, it was not an entirely unreasonable choice. Treasuries were paying 5-6% a year. Meanwhile the yuans printed by the Central banks to purchase Treasuries streamed into the domestic economy, fueling the domestic real estate bubble. Still, anyone investing in Treasuries in the 1990s was a fool. The real profits were made in the US stock market. China was a lousy investor and missed all the action.
What would happen if China were not so beholden to mercantilism? The stream of dollars from exports would raise the exchange rate until the point where Chinese consumers could afford imports. When imports matched exports an equilibrium would be established. Chinese consumers would enjoy American cars or computers or whatever and the smarter ones would enjoy American stocks, high-yield bonds, and real estate. Since America does not have produce that many cars or computers, it is most likely that assets would be its main export product until the equilibrium were established. In short, China would have a much higher standard of living. Its consumers would be rich, and rich consumers would look interesting to the domestic producers. Over time, a viable domestic market would emerge and exports would play a secondary role to domestic production.
But the Chinese government was too stupid to let that happen. The fetish of dollar bills prevailed.
So they continued to squeeze their consumers dry in order to win more export markets. And that was a spectacular success. Marx's nightmarish vision came true. Proletarians were working for the US capitalists for a bowl of rice a day, except those proletarians spoke Mandarin. That was classical capitalist exploitation at its best, and the irony is that it was achieved by the Communist Party. The result was trillions of dollars of surplus value that could not be consumed by the workers, and if Marx was right, sooner or later it would lead to a major crisis or overproduction. When surplus value could no longer be converted into capital with any efficiency, the whole system would tumble down. But so far the music was playing...
Fast forward to 2010. What a difference 20 years make! US Treasuries pay essentially nothing, and every American agrees that after inflation, Treasuries' yield is negative. The Treasury bond market is dead. Private investors are out. The only ones still buying Treasuries are the Federal Reserve and ... yes, China. (And there is also Japan, which in this respect is an exact copy of China). Meanwhile, China is sitting on $2.5 Trillion of these Treasuries. They have now become a money-incinerating vehicle, and China is attempting to compensate for that by owning more of them.
At the same time, consumers are still working for their daily bowl of rice. The yuans printed in exchange for these dollars only succeeded in causing inflation, and inflation never benefits consumers without access to credit. Chinese consumers don't have access to credit and besides, their culture is still feudal. It promotes saving and hoarding, and staying out of debt. So consumers only saw skyrocketing real estate prices to the tune of 27x annual income and thus they became poorer. Even a house is now out of reach.
The only real asset they have is $2.5 trillion worth of Treasuries, and that asset they own collectively via the Government.
Now look at this situation carefully. This $2.5 Trillion represents the country's lifetime savings, the only fruit of 20 years of slave labor. What happens when it's devalued by inflation in America?
Let's put it in perspective. That's 50% of China's GDP. It's the same thing for China as a $7 Trillion investment for America. To get the idea about the scale of the future crisis, imagine that American households invested $7 Trillion in Zimbabwean bonds. And now President Mugabe is printing quadrillions of Zimbabwe dollars, and your bonds are 5, 10, and 30-year bonds that lock in 2.5%, 3%, or 4% nominal rate of return. And imagine that American households wake up one morning and realize that they own pieces of paper that say "bond". What would happen then?
The answer is, a complete and total destruction of all economic activity. This hypothetical situation is worse than the housing crisis and dotcom crisis combined. Great Depression is the only possible outcome.
Of course, USA is not Zimbabwe. The Treasury debt will not be devalued in one month or year. The Chinese Central bank's investment won't be wiped out overnight. But it will slowly bleed to death over a decade or two. The Great Depression in China will be felt as a very strong headwind slowing down its economy, and it will continue year after year after year.
How will China look in the eyes of outsiders? A huge country, desperately poor, whose government saved money for decades but somehow still ended up broke. The people survive on a bowl of rice a day. The export industry is thriving, but except for factory owners, no one else feels any wealth effect. The yuans printed by the government in the past decades are no longer backed by dollar reserves - these reserves had been lost in the dollar inflation of 2010s. The industrial capacity is astounding. It could make the country rich overnight. But this capacity is not working for the domestic market because consumers cannot buy what they produce. The pig-headed government is still shocked by the loss of dollar reserves. It doesn't understand how it could happen. But it believes in mercantilism. Consume less, produce more, ship it all to America and hold trillion dollars' worth of rapidly devaluing Treasury bonds - that's the way to make China rich. The government devalues yuan by half, suppresses real wages, tries to attract investors with 0% corporate tax rates, offers export subsidies - and still gets nowhere. Western markets are already saturated with Chinese goods and cannot absorb more. And the multinationals are only interested in countries with rich consumers. They readily invest in France, Australia, Israel, Canada, UK, but are no longer interested in a country of beggars and paupers with large and stagnant export industry. Investment tops out and then gradually drops off. Everybody feels the economy had run into a concrete wall. Analysts wonder aloud how long the Communist Party can keep its monopoly on power...
What can still prevent this scenario? One possibility is US inflation, including CPI and asset inflation, must remain under 4%. In other words, the dollar must remain a good store of value, as gold did in the Middle Ages. This has never been true so far, and it's even less likely to be true in the future. The other possibility is Chinese government getting out of Mercantilist mindset, revaluing the yuan, and turning its attention to the domestic consumer. Again, we see no evidence of that happening. The last remarks by Wen Jiabao prove that the idea of consumption-driven economics has never dwelled in his head.
To conclude, I see only two scenarios in which China can avoid the ultimate Great Depression, one fantastic and the other realistic. The fantastic scenario is Wen Jiabao or his future successor reading a good Western economics textbook, preferably by Keynes. The realistic scenario is that aliens from the Andromeda nebula come to China in a flying saucer and share their latest technology with the locals so Chinese exports could remain competitive at the exchange rate demanded by Tim Geithner.
But I think that most likely their economy will just collapse under the weight of bad loans to the US government.