In Part I of "The Iron Triangle" we interacted with Ethan Devine's, The Japan Syndrome, published recently in Foreign Policy. Devine traces the artificial boom of the Japanese economy and its subsequent bust--and long, lingering decline since. Japan is now a no-growth economy, with a burgeoning government debt that bodes an eventual second implosion.
But what of China? Well, China, which has now replaced Japan as the second-largest economy, has been following the Japanese prescription of export-led economic development.
The funny thing is that China borrowed much of its economic model from Japan: producing low-cost exports to fund investment at home while aggravating trading partners. At times, it seems like only the names have changed. Where Detroit automakers once denounced Honda and Toyota for dumping cheap, fuel-efficient sedans on American housewives, Treasury secretaries now wring their hands about the undervalued renminbi while China's trade surpluses yawn.Then Devine issues a sober warning:
As pleasurable as it must be for China's leaders to have beaten Japan at its own game, the joke might soon be on them. In fact, they would do well to veer off of Japan's development path promptly. Sure, Japan's export boom funded stellar growth for four decades. But its undervalued currency eventually helped blow one of the largest bubbles in history, the bursting of which still hobbles Japan today. Japan's famously dismal demographics didn't help, but China's aren't much better. Beijing's one-child policy, introduced in 1979, has worked its way up the population pyramid such that China's supply of rural workers ages 20 to 29 will halve by 2030. Worse yet, China is much larger than Japan -- which means that the global consequences of a crash would be far greater. For the moment, Beijing is riding high, but China's sustained success depends on understanding where Japan went so badly wrong.
Once again the pattern is repeating itself. Centrally planned economies do not work: they create painful bubbles. It happened in Japan. It is happening in China. When government arrogate to themselves powers beyond that ordained for them by God, disaster inevitably results. How long will modern man insist on being so stubborn and stupid? is fast becoming an apt question.
Bulging foreign exchange reserves don't only irritate trading partners; they also stoke inflation pressures at home. Inflation is dangerous in a still-poor country where much of the population cannot tolerate higher prices for basic essentials, but it is a natural consequence of an undervalued currency. When Chinese exporters give their dollars to the Chinese central bank (PBOC), the renminbi they receive in exchange increase the domestic money supply and cause inflation. Official inflation statistics are rising, but they only tell part of the story. Massive liquidity in the system has caused a number of mini-bubbles such as garlic's hundredfold price increase over the last two years.
Giving exporters four renminbi per dollar instead of six would be the quickest fix, but China prefers "sterilization" instead of currency appreciation. In sterilization, the central bank issues bonds to soak up the extra renminbi. The catch is that China's dollar reserves earn dollar interest rates, so if the PBOC pays a higher rate on its own bonds, it pays out more interest than it earns. To keep from hemorrhaging money, the PBOC must keep China's interest rates close to U.S. rates. But U.S. rates are far too low for China, particularly with food prices rising and assets looking bubbly. The government has tried targeted policies such as price controls on certain foodstuffs and restricted lending to asset speculators, but the inflationary pressures are so great that this piecemeal policy resembles a game of whack-a-mole. (Emphasis, ours)
China's economy is starting to look remarkably like Japan's in the late nineties: bridges, bridges everywhere, rusting in the sun, whilst the domestic population suffers.
Although there is no doubt that this new growth strategy created tens of millions of jobs and a glistening national infrastructure, the attendant imbalances have created problems. Huang notes that by suppressing personal consumption and small-scale entrepreneurial activity in favor of state-owned enterprises and select multinationals, China's 1990s growth did not sufficiently benefit its citizens. "The story of the 1990s is one of substantial urban biases, huge investments in state-allied businesses, courting FDI [foreign direct investment] by restricting indigenous capitalists, and subsidizing the cosmetically impressive urban boom by taxing the poorest segments of the population."
Chinese authorities appear to have realised they, like Houston, have a problem. But, as in Japan, it it strains credulity to think that Communist Party central planning will solve it. The solutions lie in less planning, more freedom, and a willingness to embrace (relative) chaos that inevitably occurs when people and businesses are given freedom to do what they want to do. No more permits in order to blow one's nose.
To be sure, the government appears to be making an effort.
Using the full suite of policy tools available to a command economy, the government has removed tax incentives for some exports and added new ones for research and development while directing banks to curb lending and utilities to raise power prices for certain heavy industries. At the same time, new pension schemes, health-care coverage, and even a budding tolerance for collective bargaining with underpaid workers are intended to boost consumption. Although the Chinese authorities have long frowned on labor unrest, they have looked the other way at a recent spate of strikes and demands for higher wages. In fact, in some cases, local authorities have done the collective bargaining for their citizens by mandating higher minimum wages. Higher wages are easy political sells, but several initiatives even centrally plan creative destruction.
One of the more ambitious initiatives appeared on the website of China's Ministry of Industry and Information Technology one Sunday afternoon this August. The ministry lists 2,087 steel, cement, and other factories that must be closed by Sept. 30 of this year. . . . Chinese authorities have been known to dynamite inefficient factories to be absolutely certain they are closed for good -- not simply fired back up again by conspiring local authorities and businesses once the heavies return to Beijing.
But the problems are immense. Firstly, the service sector, which is what needs to grow rapidly, necessitates the flourishing of entrepreneurial freedom.
Dynamic service sectors are not generally compatible with central planning because service economies are naturally discombobulated. Technocrats can calculate where a new bridge or airport will have the greatest positive impact and then build that bridge or airport -- but it is much harder to dictate from on high the creation of the next Facebook or to manifest a thriving small business sector.
Then there is the issue of the aging population.
While none of these reforms is easy, China's ticking demographic clock makes them urgent. China's one-child policy produced a large demographic dividend in the 1980s and 1990s as those of working age had fewer dependants to support. Starting in 2015, however, China will suffer the inverse -- a growing number of aged relying on a shrinking pool of young workers.
Anyone want to go long on China? Be very, very cautious. Central planning creates bubbles, and bubbles burst. And when the China bubble bursts, it is likely to be a doozy.
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