CHINA, A PAPER TIGER?

I've heard people compare the 1980's to this past decade. Ok, maybe Lady Gaga is a techno-pop version of Madonna circa 1988 when she pranced around wearing those cone tits. And true, conspicuous consumption became the reigning zeitgeist just as it had when the sitcoms, excuse me, TV dramas like Dallas and Dynasty were cultural epitomes. Up until recently, everybody was making a lot of money, and greed was cool again. Instead of corporate raiders like Gordon Gecko, we've witnessed the rise of the Hedge Fund Man, whose basic value system isn't that much different from Gecko's.

Both decades did begin and end with recessions. Both the end recessions had as their root causes a real estate bust that lead to a banking crisis (remember the Savings and Loans?). Although the late 80's/early 90's downturn was not nearly as severe as the 2008 Great Recession, both economic lapses caused Americans to feel much less secure about the standing and role of the US in the world. A sort of fin de siecle gloom descended over the end of the 80's as well as the end of the 00's. Both the late 80's and 2010 were filled with much talk that hailed or mourned the decline of the US, with left wingers doing the hailing and conservatives the mourning.

Of course one nation's descent presupposes another nation's ascent. Back in the 80's the nation on the ascent was Japan. The sun certainly seemed to be rising over Japan back then. People like Lester Thurow and Paul Kennedy declared that the Japanese would be the world's greatest economic power by 2010, supplanting the US; and the only way the US could even stay in the race would be to put the economy in the capable hands of Washington politicians/bureaucrats and smart people like Lester Thurow and Paul Kennedy. Japan did indeed seem formidable at the time, with a booming economy driven by exports, a genius for manufacturing and the best educated and motivated work force in the world. America's insecurity vis-a-vis Japan was aggravated by the insatiable appetite Japanese seemed to have for American trophy properties. They were buying up Rockefeller Center and Pebble Beach and just about anything worth buying in between. Goofy numbers were bandied about, like how the square mile around the Japanese Royal Palace was worth more than all the real estate in LA. The Japanese were on their way to taking over the world not with ships, planes and tanks as during WWII, but with economic superiority. The Nikkei moved above 36,000. Hirohito was having his revenge.

But suddenly all that changed, reversed. Japan fell into a slump in the late 80's that persists in some respects even today. Japan's economic decline has sowed a deflation that won't reflate away despite massive government deficit spending which has take public debt to 200% of GDP. Notwithstanding two or three recessions, including the Mother of All Recessions, over the past two decades the US is still the great economic power, without a close second. We managed to get through a couple of busts and still initiate the age of the Internet. We have the most productive work force in the world. We continue to dominate in Nobel Prize winners. Manufacturing has taken a hit over the past 20 years, but US manufacturing is still 67% higher than it was in 1967, inflation adjusted. Be prepared to be shocked, but the US is still number one in terms of manufacturing output.

Why were people like Thurow and Kennedy so wrong? Americans are acutely conscious of the US's place in the world and therefore insecure about any challenges to its top ranking in terms of the economy, military, global leadership. We're always looking over our shoulder to see who's gaining. Consequently, we emphasize a potential rival's strengths without taking due consideration of its weaknesses. With hindsight, we now see that Japan had glaring weaknesses that would hinder it's move to the top, i.e. a dysfunctional political system; incestuous "horizontal" relationships between industrial companies and banks; a deep and culturally ingrained inability to recognize problems, like bad loans, leaving "zombie" banks to haunt the economic landscape; flatline growth in population due to an innate zenophobia; a housing market so unsophisticated financially that the average Japanese has to save a lifetime in order to buy a home, which leads to high savings and low consumption. The sun rises, but it also sets, even over the exporting juggernaut, Japan.

One could take all the headlines from the late 80's trumpeting the triumph of Japan and insert China for Japan and get similar headlines today touting the rise of China as the successor to the US as the world's great power. Just like Japan, China is a manufacturing, exporting dynamo. Thanks to its ability to harness its teeming, billion plus population to the yoke of low wage manufacturing, China has become the place to make things. And with a currency, the yuan, artificially cheapened through government actions and relatively open trade borders in the US and Europe, China has managed to create enormous reserves of dollars and euros. China is more than happy to lend some of those reserves back to the USA, the country from whence most of those reserves were generated.

With a 1.2 billion population and over $2 trillion in reserves, China certainly seems destined to be a great power, maybe even the greatest power two or three decades down the road. And with the US being the largest debtor nation in the world and owing so much money to China, some would say that we are already second rate. Isn't every lender in a superior position to its borrowers?

But are we once again overlooking weaknesses that a potential rival, in ths case China, must overcome to ever reach the level of dominance that the US currently has? People forget that over half China's population live in the countryside as barely subsistence farmers, peasants really. China must maintain a GDP growth rate of at least 8% to take care of the millions yearly moving from the farms to the cities. The possibility of social upheaval if such jobs aren't provided certainly must motivate China's leaders to keep the foot on the pedal and do whatever it takes to keep growing. Given the doomsday possibility of social revolution, manipulating the currency is a venial matter in the eyes of China's leaders.

Moreover, this peasant population provides very little in the way of domestic demand for goods relative to the export market. Like Japan, China's power comes from exports. Ironically, like Japan, that strength is also its weakness. China is so levered to demand abroad that a global slowdown could result in a wave of factory closing and massive job losses. China has been fortunate that most of Asia kept growing while the US and Europe were in the throes of recession. But even though the US is slowly crawling back, much of the world seems to be slipping back into a synchronized slowing. Maybe a serious slump causes unemployment in China to rise only few percentage points, but when you are talking about over a billion people, that's a huge number. Japan has been able to muddle through its deflation, but China can't afford to, given the less developed state of its economy and its gargantuan size. Japan also has a social safety net, while China, with all its wealth, doesn't.

Which raises a question: What is China doing with its 2 plus trillion in reserves? Why isn't it using that to develop local demand? Instead, some of those reserves are being used to purchase resources like oil, iron ore, cooper all across the globe, and some to buy dollars to keep the yuan cheap.

Besides the basic structural problems with China's economy, the same type of problems that kept Japan down, there is a even more fundamental reason why I think China will never be the great power that the US is. To attain the level of the US, China will have to become a technological innovator, be an incubator for companies like Intel, Microsoft, Apple. American technology is what propelled the US from being the last man standing after WWII to still the dominant global power 50 years later. Maybe centuries ago the Chinese were creative, innovative, technologically superior, but the only technology that the Chinese have today is what they stole or copied from the West, particularly the US.

But with such huge population producing waves of engineers and scientists and with such a hoard of funds, why can't China become a technological powerhouse?
The answer to that can be found in photo I saw on the front page of the Wall Street Journal showing the ten dudes who run the country. I forgot what they called themselves but they all looked almost like carbon copies of each other, with the glasses, blue suits, red ties. No matter how much economic freedom has been loosened in China the past twenty-five years, its is still politically and culturally repressed. It may not be Communist any longer, but it's still a totalitarian state. Tiannem Square massacre occurred only twenty years ago and guys of the same ilk are still running the show.

The recent spat about Google not willing to censor certain websites in China illustrates the point. How can a nation that is hellbent on controlling everything from the media to education, in short, the thoughts and expressions of its people, produce a Steve Jobs or a Bill Gates. Such a stifling, repressive milieu is not conducive to ingenuity and creativity, outside-the-box thinking. Mavericks don't make it in China; conformists do.

And so I don't buy the possibility that China one day will rule the world, at least China as it presently is, a mercantilist, totalitarian state. In fact, I wouldn't be surprised if China sometime over the next five years takes a serious fall, whether it's from some economic disaster, like an implosion of the bubble real estate market there (we've heard that one before), an out-of-control inflation that forces the monetary authorities to induce the Chinese version of the Great Recession. More likely is some eruption of the social distress that seems to be always burbling just beneath the surface there. Maybe the masses there who want the middle class standard of living that they see in Taiwan and South Korea (despite the past best efforts of the government to keep them from seeing), will finally lose patience and revolt. I've read reports that the wealthy in China are looking for other countries to move to in the case of such an event. Such class resentment is not surprising in a nation that for most of its modern history has been communist.

I am less confident that I used to be about the future of the US, given that we are currently speeding down the wrong track. It's amazing how forgetful we are, about the things that pulled us out of the last truly nasty recession, that of 1982. Lower taxes, less regulation, strong dollar, tight monetary policy; in other words, the exact opposite of all the things Obama is doing.

Notwithstanding my uncertainty regarding the future of the US, I am confident that we are not at the dawning of the Sino Century.

CHINA, CAN YOU SPARE A DIME?

Now that Obama is close to getting a belated Christmas present in the form of a healthcare bill, you would hope that he would lighten up on his wish list and focus on doing something about the trillion dollar plus budget deficits that stretch as far as the eye can see. (Remember all the angst during the Reagan years about "100 billion dollar deficits as far as the eye can see"?) But no, his appetite for spending appears to be insatiable. Take the unused TARP funds (and he is more than happy to take them). Why not use that $200 billion to pay down the deficit? Instead, Obama wants to spend it on another stimulus bill in the guise of a "jobs program." And so the beat goes on.

I wonder what the Chinese are thinking, given that they are the ones who are lending most of the money for all these dreams and schemes.

They are probably thinking the same thing that your local banker would be thinking if you, Mr. Valued Customer, paid him a visit with a similar wish list but scaled down to your individual circumstances.

"Hi Dan," you say to your friendly "personal financial advisor" as you plop down into the cushy chair facing his fake Louis XV desk. You pluck one of the Jolly Roger candies from the little brass bowl on his desk.

"What's up, Mr. Valued Customer. What can I do for you today?"

"I'm looking for a loan, Danny." Apprehension fills his eyes.

"A loan, huh? What type of loan?" He quickly presses his tortoise-shell eye glasses against the bridge of his nose.

"Oh you know, just a personal, unsecured loan," you say as you suck on the hard candy.

"Ah huh...and what amount are you looking for?"

"I was thinking a million to start."

Dan gags and almost spews out his mouth the coffee that he just took a big sip of.

"A million dollars! For what?"

"Oh, you know, I was thinking about making an addition to my house, another 1500 square feet or so. I really need a place to hang out away from the wife and kids. Sort of my own personal Valhalla, if you know what I mean. A place where me and my buddies can do what we like to do, shoot pool, catch games, drink beer...guy stuff." You don't need to mention porn watching as one of those activities because you know that Dan gets your drift.

"And you think that addition will cost as much as a million dollars?" Dan asks with a tremulous voice.

"No, but I also had in mind putting in that swimming pool that Betsy's been bugging me about for ten years. Labor's cheap right now with the Great Recession and all. So I figured that now is as good a time as any to git her done."

"But Valued Customer, we already have a two million dollar mortgage on your house. And if we did an appraisal today on it, I'd be worried that the value doesn't even cover our mortgage."

"C'mon, Dan, I'm talking infrastructure! I'm improving my house and putting a lot of local workers to boot besides."

"I don't know, Valued Customer. Even if I thought we could make the loan, I still don't see how it would amount to a million dollars. I mean, you're talking about us increasing our exposure to you by 50% in one year."

"I didn't realize that you looked at me as something that you're exposed to, Dan," you say with a hint of indignation in order to put him on the defensive. "What am I, some kind of disease?"

"No but, you know..." Dan stammers. "So what else you got in mind with the money?" he asks to get back to the main subject.

"For some good purposes, Dan. Like healthcare. With medical costs running like they are, I figured that it might be smart to prepay the next 10 years of my family's out-of-pocket medical costs. Something wrong with that?"

"Nothing's wrong with that, I guess. It's just that you can't expect me to pay for it."

"And also you got a problem with education? Cause I wanna fund my 529 college funds up to the gills with the money that you are going to lend me"

Dan looks at you with a befuddled, sad expression, like he's wondering what caused you to totally go insane.

Could the Chinese be wondering the same thing about the collective mental health of our nation? We are basically proposing to double our national debt this year. Foreigners now own over half of that debt outstanding and the Chinese own the largest percentage of foreign held debt. They hold close to $700 bil in US treasuries and almost two trillion dollars of US assets altogether. Is it any wonder that this week Chinese officials began to publicly raise questions about the future worth of their US Treasury holdings? During Obama's recent visit to China, leaders there treated him like he was some n'er-do-well in-law showing up the front door with his hand out. I don't think anyone seriously worries that the US might default on its obligations. After all, the US is in the enviable position of being the only country in the world that can borrow as much as it wants in its currency since the dollar is still the main reserve currency in the world. We can always print as many dollars as it takes to pay our obligations. But that's exactly what worries the Chinese and other lenders to the US. Assuming that the Feds at some point will have to open up the printing presses in order to loan money to the US TSY so that it can pay its obligations, a great debasing of the currency will occur. The dollars that we will be sending to our lenders will eventually be worth much less in those lenders' respective currencies.

Such curreny debasing causes inflation. The end of Obama's first term could witness an inflation rate that we haven't seen since the Carter years, thanks to this enormous expansion of the money supply. But maybe inflation is secretly or subliminally what Obama and his econ guys have in mind. After all, inflation is a boon to borrowers and anathema to creditors. Drastically devaluing the currency is a back door, "unofficial" means of defaulting as the borrower is in effect paying the lender back much less than what the lender has bargained for, in the lender's currency.

Notwithstanding this de facto default, the Chinese aren't going to dump their treasuries. The fact is the Chinese need us as much as we need them. The US GDP is almost one fourth of the world's total and US consumers consume almost a third of all the world's goods (ergo, our large trade deficit). The Chinese need the US to keep consuming those goods and will continue to lend to us so that we can continue to do so. The more we consume of their goods, the more dollars they will have and the optimal place to put those dollars is in dollar assets, particularly US treasuries. China can not unload its treasuries without causing harm to its gigantic US treasury holdings. Dumping would also cause US interest rates to soar and hurt their Most Valued Customer.

But that doesn't mean the Chinese will sit idly by while we go on a borrowing binge. They can, if they wish, exert the same leverage and control that any lender has over a heavily indebted borrower. And how might they exert this leverage and control? Don't be surprised if in the near future, some very hush-hush, closed door meetings take place between high government officials of the US and China. Maybe during such a meeting, the Chinese make it clear that they aren't happy with our spendthrift ways. Maybe they strongly suggest that we rethink that big Universal Health Plan that has been put on the table. Or even more likely and insidious, maybe they let it be known that they think our Dept of Defense budget is way too high and needs to be trimmed. Maybe they suggest that we cut back on the F-22 Raptor program or that new state-of-the-art destroyer that's on the drawing boards. After all, as much as the US and China might sometimes seem like two staggering drunks trying to hold each other up, China will increasingly become a military as well as an economic rival to the US. Yes, the Chinese want the US to remain strong economically since we are the primary end market for their manufactured goods; but that doesn't mean that they will not use their economic leverage to keep us from being too strong, particularly from a global strategic power point of view. The US-China relationship has more paradoxes and nuances than a Ingmar Bergman movie.

And what if we have the audacity to say in so many nice diplomatic terms, "Fuck you" to these "suggestions" from our Chinese lender? Then we can expect the Chinese to say, "Okay, then don't expect to see us at your next treasury auction." And since the Chinese have been buying roughly half the bonds at such auctions, that would be a mighty big "Fuck you" back.

Every lender has his borrower by the balls. The last thing a lender wants to do is kill his borrower. But that doesn't mean the lender can't squeeze those balls really hard.