To America, from China — 1922

The Klein-bottle contortions of economic time and space between America and China are explored in an intriguing interview in Seeking Alpha:

The dollar rises in the East? Rick Newman

Think American workers have it bad? It’s worse in China.

I’ve documented this.  China’s property markets are crashing far worse than ours are – and as our recent experience shows, crashing property prices foretell a dramatic economic slowdown.

You may not know that by scanning the headlines. Late last year the Chinese government passed its own stimulus package of about $600 billion, to meet its target of 8% GDP growth. That’s right, 8%. That would be outlandish growth here, where the economy is now shrinking, not expanding.

But in China, that’s barely enough to keep a restless workforce employed. And the government might not be able to make its 8% target. Unemployment is soaring, and there’s even a possibility that economic woes could lead to angry public protests like those that preceded the 1989 Tiananmen Square massacre.

There was a flicker of decency … and then there was a massacre

Since Tiananmen, America and China have become deeply linked to each other.

In the 1960s, I remember a Piet Hein grook:

Coexistence/ Or no existence

Piet Hein: lived to be 91

Although he was speaking of geopolitics, the principle applies equally well to geo-economics.

Americans, obviously, buy a huge amount of imported Chinese goods—about $340 billion worth in 2008.

That’s a lot even in Obama-budget-deficit terms!

Much of the cash that flows back to China gets invested in U.S. government securities, which helps keep U.S. interest rates low.

As I pointed out in Filling a Sieve, capital cycles, and as we’ve seen in Slums: a wealth-extraction machine, capital always finds its best investment, and communities need continuous capital reinvestment.

I hold trillions of your paper in my red-gloved hands

That’s happening now with China, either in our debt or in equity:

China even invests directly in American firms. In 2005, Chinese computer maker Lenovo (LNVGY.PK) bought IBM’s PC division for $1.75 billion. In 2007, the Chinese government bought a $3 billion stake in the Blackstone Group, the American private equity firm.

We Americans have a habit of selling at the top J.

Historian Niall Ferguson, author of The Ascent of Money, even conflates the two nations as one: Chimerica.

Niall Ferguson at Harvard Commencement

Since the two countries are so closely linked, I asked Wei Li, a business professor at the University of Virginia’s Darden School of Business who also teaches at the Cheung Kong Graduate School of Business in Beijing, for an update on the Chinese economy, and how changes there are likely to affect the United States.  Excerpts:

How is the global recession affecting China?

The outlook for China is very grim. Much more grim than for the United States. There are two main drivers: Housing and exports.

Ten years ago there was a housing shortage in the cities. But now there’s a housing glut.

The glut exists at the market’s top end – affordability remains an enormous challenge.

One reason is there’s very little opportunity to invest elsewhere. That led to lots of speculation. It’s mostly urban. In rural areas, you still build your own house.

In rural environments, housing can be created without money, because land has minimal cash cost and you can use found materials and your own labor to build it.  Urban housing always costs money – and as we’ve seen before, the richer the society, the better its housing finance ecosystem, the longer the chunk of our future we’re willing to pledge in order to secure the home that we want.

Is the housing bust in China worse than in the United States?

Housing in China is a much bigger deal than in the United States because people just started buying. For many Chinese they were first-time homeowners.

\When tenure options are limited and housing is in short supply, such is our lust to own a home that we over-reach – and the tighter the supply, the greater the over-reach.

Prices haven’t really fallen yet, but they have to.

If they don’t let prices fall, something else has to adjust. Either the price falls or quantity adjusts. If the quantity goes to zero, nobody buys refrigerators or tiles, or hires electricians or architects.

We have to keep supply and demand in balance

The bust has been going on about one year now, and accelerated since the last quarter of 2008.

A housing price bust always precedes a big economic contraction.

Cut housing prices and watch demand shrink

What about exports?

There’s been a double digit decline. For every 1% rise or drop in U.S. consumption, Chinese exports go up or down by 10%. The effect is 10 to 1.

So with consumption down in the U.S. by about 2% or 3%, you mean that exports in China have fallen 20% or 30%?

That’s right.

Couldn’t keep up the payments

If exports are dropped, the Chinese economy will slow, and if that happens, then Chinese unemployment will rise, and with it Chinese unrest.

The unemployment rate in the United States is 8.1% right now. Is it higher in China?

According to Chinese Academy of Social Sciences (CASS), the unemployment rate in urban areas in the end of 2008 was 9.4%, significantly higher than official jobless rate of 4.0%. It’s probably higher now, since the Chinese economy experienced a marked slowdown since the last quarter of 2008. In addition, in 2009, 6.1 million college graduates are looking for jobs. These figures all underestimate the severity of unemployment in China. The unemployment stats count only jobless rate in urban areas. When rural migrants cannot find jobs, they often return home and subsist on their land.

To keep people employed, China will need to keep exporting – which may mean it’ll keep buying dollars to keep the American economy humming, so as to keep consuming the goods on which Chinese prosperity depends.

Will I keep buying your paper?  That depends, mon capitaine

Can’t the Chinese government pull the old levers of a command economy, crank up spending, and keep people employed?

That’s what people may think, but the Chinese economy is so much bigger than the government can control. If you think U.S. consumers are scared, Chinese consumers are equally scared, if not more. Stocks in China are down 60%. The new middle class who owns multiple apartments is living on a lot of borrowed money. They’re in very bad shape.

As an asset class, housing is the most resistant to price drops … but in turn, that means people become economically immobile as they cover their housing-consumption-cost deficits.

At least I’ve got security of tenure

Houselocking is a real phenomenon, one that will complicate the world’s recovery.  Rental flexibility is a strategic national resource.

Some people worry about the fact that the Chinese government owns several trillion dollars worth of U.S. government securities. You know the argument: If the Chinese sold their holdings the U.S. economy would collapse.

For the Chinese to sell, who would buy?  American interest rates would rise – and probably, American currency would inflate.  The Chinese hold so many dollars that if they sell too many too quickly, they risk killing the market for their own assets.  They’re caught in their excessive liquidity even as we’re caught in our excessive illiquidity.

Maybe I’ll even buy your uniforms, Jean-Luc

China could conduct economic warfare against America. People worry about China buying Treasuries, but for China, they don’t have a choice. There’s really no place else they can put their money. To say that China is somehow controlling the U.S. economy is laughable.

Pretend for the moment that China and America were two adjacent US states.  The one with excess liquidity would be desperately looking for a place to invest; the one with illiquidity would be desperately seeking capital.

Each of us complements the other

In global terms, China has no potential investment partner other than the US remotely close in scale and attractiveness.  And we have no liquidity provider other than China remotely close in scale and attractiveness.

Can it be that I need you, mon ami?

We need each other, whether we like it or not.

So with China in tough shape, will Chinese influence fade?

I think Chinese influence will still grow, but it has to be different. The Chinese approach used to be, speak softly and make a lot of money. That’s not working any more. The system is flawed. If China wants to continue to benefit from globalization, China needs a voice.

Might the best economic safety be rational interdependence, where each of us is stronger when the other succeeds, and each of us relies on all of us acting in our rational self-interest?

Or am I being Pollyanna?

As Star Trek’s Q himself said, “You don’t get it, do you?  The trial never ends.”

“See you around – out there!”

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Yesterday’s post highlighted a deliberately provocative Washington Post Op Ed, What OPEC Teaches China, by Sebastian Mallaby, arguing that our pricing expansion – and now the painful contraction – were caused by deliberate currency manipulation from China.

I am offended that you question my motives

The second rival account of the crisis … blames the bubble on two mistakes at home rather than on the glut of capital from China.

Mallaby’s already exculpated us consumers; now he raises, only to knock over, the straw man of Federal Reserve policy:

 [2] And the Fed should have shut down the easy-money party by raising interest rates.

A lot of people have leveled this criticism, much of it landing at the doorstep of former Federal Reserve Chairman Alan Greenspan.  Mallaby says he’s innocent:

Don’t I look innocent?

If Americans’ insatiable appetite for loans explained the flood of Chinese capital into the United States, we would have seen the evidence in a rising price for those loans — that is, higher interest rates in the bond market.

This is a big assertion – is it true? 

Mallaby doesn’t prove it, so let me test out its logic sequence.

1.  The Fed sets rates.  The central bank can manipulate the money supply, and it can force sovereign interest rates (interbank Fed rates) down really low.  Or the Fed can push those sovereign rates up.

2.  The risk curve must be rational.  As previously posted at length, the risk curve presumes that investments can be ranked by the categories of risks their investors will take.  Since all business activity within a nation is denominated in that nation’s currency, the Treasury gnomes who print the money live in the basement of our national money store.  Toiling in obscurity down there, they take the sovereign risk.  Every other investment, denominated in those self-same dollars, takes those risks and more. 

Hence any rational risk curve is positive:

Or said in English, if lending is rational, any boost by the Fed should ripple through in higher interest rates for all. 

(We’ll ignore the yield curve, which tracks by maturity, and the potential yield restructuring efficiencies of securitization, both for simplicity and because right now nobody can see securitization’s benefits.)

3.  Foreign lenders/ investors would be rational.  Foreign investors wouldn’t necessarily have to limit their purchases to Treasuries; they could buy anything they wanted.  But as long as they were rational – with their hyper-appreciated or hyper-depreciated currency – their capital would be appropriately risk-priced.  So like the lead sled dog the Fed would, in fact, call the shots for sovereign finance.

I’m the Fed and I call the shots here!

Here I think Mallaby’s reasoning is rickety.

Entirely sound!

A nation that wanted to use its capital as a weapon would in fact accept lower risk spreads, in the sectors it wanted to over-stimulate.  If it had trillions at its disposal – which the Chinese government does – and could act in a coherent and coordinated fashion – which I think the Chinese government can and does – then for every Fed move, the Chinese could make a neutralizing countermove.

Fie, sirrah!  I block your interest rate hike!

I have no idea whether this could be demonstrated – international currency flows aren’t my bag.  Maybe somebody like Ken Rogoff will have studied it.

In any case, let’s return from our detour into speculation and grant Mallaby his (and by imputation, Geithner’s) thesis:

But bond rates were strikingly low at mid-decade. This strongly suggests that it was the supply of lending that went up, not the demand for it.

Or, as we previously suggested, starvation for yield.  Remember, if you’re a sovereign nation – or even a semi-sovereign plutocratic oligarchy of a wealth-producing nation – then you face the problem, where do I park all those billions?  And you examine your choices first and foremost in national terms.  If you move money into a country, you want:

* Safety from violence and insurrection.

* Its currency to be solid.

* A strong rule of law and property rights.

* Good assets to buy – good loans or good investments.

You want, in short, to have a positive vision of where that nation’ will be in a decade. 

If you were really rich, where would you feel most comfortable, geopolitically and geoeconomically? 

Personally, I like the USA.

We’re the global geo-economic boss!

Chinese money flooded into the United States because of the push factor from China, not the pull factor from Americans.

Yes, I buy that – but I don’t need to buy nefarious motivations to get there.

Suppose you were making double potfuls of money in your home country, which was experiencing unprecedented growth – unprecedented for itself and its history, unprecedented for its aggregate scale in the global arena.  Wouldn’t you want to diversify your national risks? 

Maybe I should diversify?

(Remember, Enron or Fannie Mae employees who put all their 401(k)’s into stock in their own company are now being derided for their credulity.)

Again, if you’re China, you want to balance your portfolio, and you’re grossly underweighted in US assets.  What better time to buy them than when your currency is strong?

Could the Fed have raised interest rates to avert the bubble? The Fed’s monetary policy was indeed too loose. But as Martin Wolf argues in his recent book, “Fixing Global Finance,” it’s not clear that higher interest rates could have prevented the trouble.

I posted at length on Wolf’s interesting hypothesis – which seemed really plausible to me.

Once China decides to export vast quantities of capital, that capital has to go somewhere.

The Law of Economic Pressure returns!

Now Mallaby’s argument starts to run into itself.

Higher interest rates in the United States might have encouraged the world’s savers to park even more of their capital in this country.

Exactly!  The Law of Economic Pressure is no more resistible than the forces of nature tearing up Saruman’s palace at Isengard. 

That for your currency restrictions

Nevertheless, Mallaby rallies in an interesting protectionist way:

So there is no getting around China’s culpability.

Huh?

I wouldn’t bet on that.

The country relies on the sort of export-focused growth strategy that other Asian Tigers have pursued, with the difference that China is too big to go this route without destabilizing the world economy.

As far as I can tell, this argument boils down to curse them for driving their economy to expand so much, and not consume what they’re generating, leaving them with scads of dollars that have to go somewhere.

Meanwhile, as we’ve seen in The clatter of breaking China and As the China breaks, the Chinese property markets are just plain crashing – not dropping like ours are, but crashing – so they’re going to pay their own price for our global problem.

The real question is whether it is diplomatically fruitful to push China to change.

The Bush administration tried and failed. Why would the new team fare better?

Change what?  Change how?

Clear enough?

The wrong answer is to say that Barack Obama’s guys will be tougher. However egregious China’s currency policy may be –

Again, probably this is just my ignorance, but I don’t know what’s egregious about China’s policy.

– it’s counterproductive to punish Beijing with sanctions. For one thing, a trade war is the last thing the world economy needs.

I’m genuinely baffled here.  Should China grow less?  Should it consume more domestically?

What should I do differently?

For another, as Geithner explained, the immediate priority is to get global growth going, so it’s more important to persuade China to extend its fiscal stimulus than to revalue its currency.

If they can.  China’s about to slow down big time.  Maybe not stop growing, but slow down.

Besides, reforming China’s exchange-rate policy is not the only way to wean the country off its high-savings, high-export model. The savings rate partly reflects China’s lack of social safety nets. If the Chinese spend some of their stimulus on pensions and health care, they will be heading in the right direction.

Undoubtedly such a move ought to be part of Chinese domestic policy.  The nation has a huge aging population and a low birth rate, plus a crush of urbanization without parallel (for sheer scale) anywhere in the world.

China’s leaders are not fools: They can see the effects of their policy not only in collapsing Wall Street banks but also in their own collapsing exports. The bubble that China inflated has brought China’s foreign customers to their knees. Because China pushed its export model too aggressively, its export markets have cratered.

And with them, its property markets.  The financial boomerang returns.

I couldn’t throw it away no matter how much I tried

Think of it this way: China’s position is akin to that of OPEC in the early 1980s. Two oil shocks taught oil producers the limits to their power: When they jammed prices up, the world economy sputtered and motorists bought smaller cars — and oil prices fell precipitously.

We’re seeing that now.  High oil prices allow despots to swagger.  Low oil prices may foment democratic revolution (or other revolutions less democratic, but let’s not worry about that just now).

OPEC learned to balance its lust for higher oil prices with the fear that customers might revolt.

OPEC’s leadership is also learning that gouging your customer is a bad strategy.  Symbiosis means the host gets healthier and stay healthy.

China’s leaders may be ready for the same lesson — and Geithner’s words may encourage them to learn it.

The Law of Economic Pressure says if there are very rich adjacent to very poor, no walls are high enough to prevent the very poor from scaling them.

The best world is one where we all get rich – or at least, less poor.

“I’ve had rich and I’ve had poor, and baby, rich is better.”

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I couldn’t make things ADD up …

Not subprime lending.  Not CRA.  Not US profligacy.  Maybe it’s starvation for yield, or maybe it’s a kind of currency smuggling by manipulating the exchange rate by China, as speculated in a deliberately provocative Washington Post Op Ed, What OPEC Teaches China, by Sebastian Mallaby.

Pointing the finger in print

At his confirmation hearings last week [January 25, 2009 –Ed.], Tim Geithner branded China a currency manipulator.

One of us has tentacles … the other is a manipulator

Geithner is correct that China manipulates its currency. What’s more, this manipulation is arguably the most important cause of the financial crisis.

As we examine Mallaby’s exegesis of Geithner’s accusation, we should see it as merely a particular example of the much larger Law of Economic Pressure, the evil twin of the Law of Economic Gravity (uneconomic endeavors will not survive):

One of us is the Law of Economic Gravity …

The other’s the Law of Economic Pressure

For the last decade or more, capital has been global, and as a result, money-investing pressure from elsewhere found its expression in the US.  The result was cheap credit:

Being a commodity, money has a demand – people who go to the money store needing it for investment – and a supply, people who come to the money store looking for yield. 

When the supply of money (that is, people who want to invest) exceeds its demand (quality investments to make), two things happen:

* Yields go down because money becomes cheaper.

* Investments increase as new products are invented and come into the marketplace.

If the world has more wine drinkers than vineyards, marginal soils are planted and plenty of plonk is sold and drunk.

Because of the pricing equilibrium, cheap credit drove up prices of assets like homes. 

All that would be challenging enough if the game were entirely fair.  What if it was rigged?

Don’t go in there, you’re not Mature enough

Starting around the middle of this decade, China’s cheap currency led it to run a massive trade surplus. The earnings from that surplus poured into the United States. The result was the mortgage bubble.

Here’s a corollary of the law of Economic Pressure – if you’re trying to keep money in a country where it wants to flee, currency restrictions and aid flows are like filling a sieve.  If the Chinese really thought that by manipulating their currency they could gain a huge financial advantage, all the world’s trade restrictions wouldn’t have stopped it. 

China’s leaders protest that they are being unfairly scapegoated. Yet while there are rival accounts of the origins of the crisis, neither has the explanatory force of the blame-China narrative.

The Law of Economic Pressure is the basis behind every smuggling operation ever invented.  From Goldfinger’s transport of gold into India (as airplane seats, from Geneva where it arrived as the old Rolls Royce Silver Ghost) to the coyotes’ transport of Mexicans into America, smuggling is always pursued because it is, in the words of a suave villain from Harper, “dizzz-gust-in’ly lucrative.” 

Waiting for a coyote, Guadalajara

This applies not just to commodities, but also to money.

The first rival account is that the crisis reflected failings of U.S. financial regulation. Such failings exist, but most have been around for years. The mortgage bubble reached its craziest extremes in 2005-07, when China was flooding the world with cheap capital.

This is the global economy before Chinese capital exports

This is the global economy after Chinese capital exports

Because money is fungible – think of it as financially gaseous – any increase in pressure, coupled with any leak in security, equals a powerful jet of flow. 

Moreover, regulatory failings exist not just at one regulator but many.

We saw this; the phenomenon is global, but confined to a single nation.  As I listed before:

So far we’ve seen that almost everybody is wrong about what the financial crisis is …

1. Not an asset bubble … a systematic under-pricing of risk.

2. Not caused by subprime lending … although that was the miner’s canary.

3. Not principally about the GSEs … because other financial institutions are in much worse shape

4. Not just about housing … although that is the biggest asset class

5. Not specific to the US … although as the world’s biggest and probably fastest economy, we caught cold first.

… and who’s to blame …

America – putting the unum in everyone’s pluribus

6. It’s not proof of ‘under-regulation’ … provided we have a reasonable definition of ‘regulation’. 

7. It’s not the [US] government’s fault … or if it is, we’re e pluribus unum.

8. There’s no single culprit … plenty of blame to go around, step right up and claim your share.

9. It’s not really rational … but as John Maynard Keynes said, “The market can stay irrational longer than you can stay solvent.”

What I like about the Mallaby/ Geithner hypothesis is its scale. 

The Securities and Exchange Commission failed to check risks at broker-dealers such as Bear Stearns. State insurance regulators failed to prevent the collapse of AIG. The Federal Reserve failed to see that banks were pouring capital into toxic securities that they then held off their balance sheets.

It’s possible, of course, that each of these was a systemic failure, a Law of the Unobservant Herd or a case of global otherguy due diligence – the British, say, assuming that since the Americans were innovating these vehicles, they must be safe, and the Americans concluding that they were safe because even the stodgy old Bank of England had blessed them.

Perfectly safe, I assure you

European regulators were no better, even though they had adopted a supposedly more up-to-date set of capital standards.

Since the entire world got drunk on risk-taking, we need an explanation with a global scale – which means we need a capital-markets or money explanation, because only money can flow so swiftly across borders.

The lesson: Faced with a deluge of cheap money, no regulatory regime can be expected to prevent bubbles.

As we saw in Old New Orleans, we build physical dams to hold back the ocean, and yet the ocean can surge to levels that overwhelm even Corps of Engineers safety standards. 

Something similar happens to financial dams; we can block capital when it comes in individual wallets or even individual company transactions, but let the flows be those of sovereign wealth, let them be placed financially uphill by skewing the currency, and millions of individual transactions will all flow that way just like billions of water droplets.

The second rival account of the crisis accepts that its origins lie less in regulatory failings than in economic pressures.

Sir, the regulatory systems didn’t work quite as planned

Markets move faster than government; people are economically rational given the choices before them.  Tilt the currency and the people follow the money.

But it blames the bubble on two mistakes at home rather than on the glut of capital from China.

[1] Americans should have controlled the urge to splurge, the thinking goes, and borrowed less Chinese money.

The problem is this: when anything is cheap, people consume more of it.  Housing demand, like all forms of demand, is elastic.  When housing is cheap, people buy bigger houses, rent larger flats, reduce their household size (roommates become singles, stay-at-homes move out).  You can’t blame people for acting in what they think is their self-interest.

Controlling expenditure and managing the economy isn’t a job for consumers but for central bankers; if people weren’t to blame, can we blame the central bankers?

We won’t feel happy until we blame somebody

[Continued tomorrow in Part 2.]

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