How countries set themselves up for failure
When someone goes bankrupt and takes to the streets, our first gut reaction is that some unforeseen accident has just happened. Wow, who could have thought it's happen to (---------Dick Fuld, Bernie Madoff, Ken Lay, ............... - select your favorite). A back swan has swum by. But upon a second thought we almost always see how the victim has in fact cooperated with the theory of probability to bring about his own demise. We usually see not one, but a whole string of mistakes culminating in this tragic output. Any such single mistake would be a small deal. What's more, we usually see in retrospect that even a series of mistakes would not be fatal. The man in question could have made two, three, five, seven, or even ten mistakes in a row, and still survived the consequences. But then he makes his final, eleventh mistake, and that settles the outcome. The ultimate irony is that while he was making these mistakes, he must have imagined that he was acting in his own best interests. It must have been with the sense of victory, triumph, and cheerful exuberance that Dick Fuld increased his leverage from 5x to 10x, then to 12x. then to 15x, then to 20x, and finally to 30x, and each increase made him think that he'd just climbed one more step up the ladder. Which he was, only to fall down from a greater height.
Countries are also like that. They happily accumulate the ingredients of their future downfall, and their leaders claim credit for that achievement, until the stuff finally hits the fan. The history of the French Revolution shows clearly how skillfully, cleverly, and determinedly Loius XVI was setting up that final position on the political chessboard from which he was checkmated. History is full of such examples, and the list is still growing.
Here's today's likely candidate to join the list: China. We can see the same familiar pattern of accumulating toxic stuff that will ultimately cause the crash. But the process of preparation for that final jump from the 30th floor does not look bearish at the first glance. We see a growing economy, growing exports, growing stock valuations, growing foreign reserves, growing purchases of commodity futures. It seems like a never-ending party. Except that all this growth is just setting the stage for the crash. The 2 trillion of currency reserves have just grown to 2.4 trillion. More than half of GDP has thus been invested in junk by the China government! It will have to be written off. The nearly-fatal financial crisis in the US broke out when US banks learned they'd have to write off bad loans totaling some 15% of US GDP. Can you imagine the magnitude of the crisis when China has to write off 50% of its GDP? This crisis will be devastating, and it will be aggravated by other factors:
-No reserve currency status of the yuan.
-No way to raise cash in the financial markets.
-A broken export model with little domestic consumption to pick the slack.
-A lot of forward contracts obliging the government to buy $10 oil for $60 dollars a barrel for the next 10-20 years.
-A pile of worthless gold purchased in 2009 for $1000 an ounce.
-An incredible number of steel-producing factories that were built to produce steel in order to build still more steel-producing factories in order to produce even more steel, and the final demand for that steel was supposed to come from the coal mines and the highway construction and commodity speculators, and all that projected demand has suddenly dried up.
-Investment, which used to be responsible for a whole third of China GDP, drying up to less than 10% because all these rosy growth projections failed to materialize.
-Thousands of factories already built struggling with overcapacity and lack of orders and hundreds of empty highways leading to ghost towns in the middle of nowhere that destroy any incentive to invest more money in China's economy.
-Merchantilist ideology that stifles any constructive debate on ways to climb out of that hole and an ideologically bankrupt government that can't offer any solution except to tighten the belts, give away goods essentially for free and buy even more US bonds.
When the collapse comes, we'll see in retrospect that the seeds of the crisis have been sown in the feel-good 2000-2009 when the growth seemed unstoppable and the Chinese government looked so incredibly smart.