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If you dump me, I will float and you will drown, said the Scorpion to the Frog

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October 08, 2008 – Comments (0)

Americans like to think that they're driving the Chinese growth. Hence, the logic goes, it's a positive-sum game, what's good for America is good for China, and the Chinese have the responsibility to make sure that we succeed. To that end, they should be supporting our dollar, subsidizing our mortgage rates, and shipping to us a ton of their already cheap goods essentially for free. True, we pay them with dollars coming off from our printing press, and all our expence is the price of paper and ink, and we know it, and they know it, and we know that they know, but they should still keep the music playing because, the logic goes, where else will they find consumers willing to consume so many consumer goods?

This logic is wrong for many reasons. Let's start with the simplest. A man who is willing and able to consume lots of consumer goods is not a consumer. It's being able to pay that makes him a consumer. The seller can make a poor man a consumer by lending him money. That can be a good strategy provided the loan is collateralized or the man offers some other guarantee that the loan will be paid back.  But what if the man can pay back his loan only by taking a second loan from the same seller, which he then can pay back only by taking a third loan, and so on? Well, I have news for you. The meaning of it all is that the man gets his consumer goods for free while the seller postpones the realization of his loss by putting worthless receivables on his balance sheet and pretending that they are valuable assets. What happens ultimately is that, burdened with his illusory earnings and real losses, the seller is no longer able to provide financing. At which point the seller says, "sorry, no more loans for you, and now please pay me back what you owe". The buyer replies, "f...you". The seller opens his books, takes a charge-off against receivables and reports a sudden, staggering loss. The buyer walks away, the seller closes shop and walks up to the bankruptcy court. This is how such business models usually end, barring some sudden improvement in the consumer's fortunes.

What does that tell us about the Chinese export-driven economic model? The US public debt is now going up to 11 trillion, in addition to the 50 trillion internal debt. Ask any illeterate Chinese farmer if such a debt can be paid back without debt forgiveness or refinancing from the lender, and you can guess his reply. In other words, the Chinese export-driven economic model has always been a bubble because the Chinese never had a consumer who was able to pay for these exports in the first place.

But if Chinese factories don't really have a consumer who can buy their products, if they are essentially giving their products away for free, then why not give them away to their own citizens? They are craving for consumer goods just as much, they are just as poor and unable to pay, and they can also make empty promises, borrow and refinance until the music finally stops. A Chinese debt bubble by itself is no better or worse than an American debt bubble, but there is one crucial difference: while the former bubble robs Chinese producers just as badly, it also raises the standard of living of the Chinese people. Whereas the latter bubble subsidizes American consumers but does little for Chinese consumers.

To be fair, the American debt bubble had tremendous positive implications for China. Factories were built and there were thirty years of brisk economic growth. That's an exellent result. It's always a good thing when factories are being built even if they were built based on wrong assumptions. Eventually, after the bankruptcy of the original owner, someone if going to take over them and put them to good use. But the same bubble grown domestically would bring the same advantages while avoiding the main disadvantage- the net transfer of wealth from China to America.

That's why decoupling is the main challenge facing China at the moment. With a trillion dollars' worth of US treasury bonds already accumulated, it's becoming harder and harder to run things the old way while hiding the losses or ignoring the real devaluation of this dollar reserve as inflation destroys its purchasing power. The next stage would be a Japanese-style stagnation, when exports run in trillions and still fail to provide capital to jump-start the next stage of growth because of the intrinsically money-losing nature of the whole enterprise.  On the other hand, reorienting the economy towards domestic consumption would result in a far more sustainable growth model. Let's not forget, that's how America rose to Number 1 without linking its growth to any foreign country.

And what it it means is that the real interests of China are very different from what American commentators talk themselves into believing. In the real world, China should be interested in:

a) Reducing the percentage of its exports going to the US,

b) Charging the full price for its exports by letting the yuan rise and the dollar fall.

c) Putting an end to its misdirected investment in American treasuries and using the capital to create its own domestic bubbles, boosting the purchasing power of the domestic consumer.

Let's consider some objections to this and the answers to these objections.

1.  "US treasuries are the safest store of monetary value".

Reality. US treasuries are a safe choice - on a short time interval, because the negative real rates of return will dominate on a longer time scale - if you're expecting your currency to drop like a stone because it's currently overvalued or buoyed artificially by high commodity prices. But China is not Kuwait. The yuan is destined to rise against the dollar because it's now dramatically undervalued and because commodity trends (falling oil and metals) are actually working to China's advantage. Under these conditions, a dollar hoard is a very poor store of value.

2. "If China lets us down, we go into a recession, and they can't sell their goods to us"

Reality: A recession would force American consumers to buy more Chinese goods because even with a stronger yuan, they will still be the cheapest game in town, and during a recession you can't afford anything expensive. In this way, China will benefit from a recession in America.

3. "If we go down, we won't be in a position to lend or invest in China. This will hurt them a lot".

Reality. The talk of lending is baloney because China is the biggest lender to the US. The bulk of investment in China comes from its own population and from the Chinese diaspora abroad. What China does need is American industrial equipment, which will be much cheaper to buy if America enters recession and the dollar collapses.  Thus, American recession=lower cost of investment for China.

4. "If we go down, poof goes the 1 trillion dollars of Chinese savings." 

Reality. It was a mistake on China's part to buy so many bonds which are destined to default or to go down in value when China gets tired of supporting the bubble. It's not a valid reason to persevere in that direction. The sooner China recognizes its mistake, the less painful it will be. At this stage, most of the value of the Chinese dollar hoard can be recovered if China dumps these bonds, lets the US mortgage market collapse and then buys what's left of the US economy, which, let's not forget it, should do just fine in the long run after the dust settles.   

The conclusion is obvious: China can and should decouple from the US, and, in this particular case at this particular time, the economic game happens to have a zero sum.

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