Beginner's Guide to the Chinese Economy

I'm going to take on an insanely difficult topic here, and will undoubtedly fail to do it justice. But with all the mysteries and misunderstandings surrounding the role of China in the global economy, particularly its trade relationship with the West and "globalization," I thought I'd take a crack at trying to shed some light on this complicated mess. If you're going to try to get a handle on exactly what is going on and what it is that ails China's economy, just as with the US and the FED, probably the best place to start is with China's central bank. The People's Bank of China China's central bank is called the People's Bank of China, or the PBoC. On top of the powers which our own FED has to purchase assets and inflate the currency to high-heaven, the PBoC has several powers that our own FED either does not have or does not use extensively. These are:

• the power to issue debt
• the power to pay interest on reserves
• the power to buy foreign currencies and debt instruments

Aside from these differences, the PBoC is directly integrated into the Chinese government rather than being an ostensibly "private" institution. Theoretically, at least, the FED could refuse to toe the government's line and fund federal deficits at Congressional whim if it went against the wishes of the American banking cartel that the FED serves. The same is not true of the PBoC, and in China, the banks are state owned. The PBoC, like pretty much all central banks, has a long history of instigating inflation. So, like the American economy, the Chinese economy suffers from malinvestment as the pricing structure is warped by an ever expanding money supply. On top of this, extensive use of these additional powers and the lack of even modest separation between the government and the central bank means that the PBoC tends to behave in a manner somewhat more extreme than the FED, and like many other economies throughout history, to favor a policy of export subsidy through purchase of foreign assets in addition to domestic assets. The power to issue debt provides an important avenue for sterilization, as it allows the bank to "mop up" the very money it creates through inflation by simply borrowing money out of the economy and sitting on it. Generally speaking, the PBoC engages in a policy more broadly known as mercantilism, and the development of the Chinese economy reflects this. Mercantilism and the Trade Deficit The mercantilist state attempts to use force to run a large surplus of exports over imports. The "mercantilist mentality" is the product of misguided economic thought with respect to wealth accumulation, namely, that a nation that is heavily exporting to another nation is "getting rich" at the expense of its trading partner. The "seller" is "making money" and "protecting jobs" while the buyer is running up large debts. You will encounter this sort of thinking in modern writings in terms of "exporting unemployment" and one nation being "more competitive" than another. An awful lot of myths and misinformation surround the "China phenomenon," and, frankly, the entire concept of globalization. On first glance, it makes sense that a country with lower average wages would come to dominate labor intensive economic activities, so a country with low wages should be much more competitive industrially and export lots of products to "rich" countries, without much flowing the other way. Simple enough right? That's just basic economics! No controversy here, it would seem. The truth is that no state can run a permanent trade surplus without extensive manipulation. The idea of comparative advantage applies only to individual goods and says nothing about the volume or net direction of trade between two countries. No matter how "competitive" China becomes, it cannot trade more with America than America has to trade in return, or put another way, Chinese companies cannot sell more goods to America than the quantity of goods which Chinese customers are willing and able to buy from America. China cannot simply displace the American economy by becoming uber-competitive. Accounts must balance, otherwise trade is a giveaway, and there are never, ever any free lunches. The main check on mercantilism is the effect that a trade surplus has on currency valuations. In order to import goods, the importing business must first purchase foreign currency with its own currency in order to make its purchase of foreign goods. By buying Chinese currency (yuan) with US currency (dollars), American importers cause foreign markets experience an increase in the supply of dollars relative to yuan, making yuan scarce and driving up its value for other importers looking to buy Chinese goods. This, of course, makes it an ever more expensive proposition to import each additional increment of Chinese goods. This is perfectly fine. So long as there are Chinese buyers looking to purchase American goods, there will also be Chinese bidders for dollars that will counteract the effect of American bidders for yuan. Constructive, wealth building transactions can and will occur spontaneously according to the comparative advantage each country experiences with respect to individual goods. On the whole, then, for continual trade to occur in the absence of manipulation, trade must balance. When trade does not balance, the market value of one currency will rise against the other until a trade balance is re-established. The market manipulating mercantilist does not want this to occur. At least, he does not want it to occur with respect to the goods in which he takes an interest. Typically, this means manufactured goods and the goods of favored industries. But the currency markets create a dilemma for him which he must surmount. So how do China and so many other mercantilist nations manage to import very little while exporting a great deal? Very simple. First, importation is usually regulated into oblivion. Second, to compensate for the absence of Chinese importers bidding for foreign currencies, the PBoC intervenes and makes purchases US dollars or other foreign currencies as if to purchase foreign goods but without actually buying any goods with those foreign currencies. It thus maintains a "bidding" pressure from the Chinese side of transactions to counteract foreign bids for yuan, but does nothing with the currency that it purchases! These accumulating currencies pile up as reserves in the vaults of the PBoC. In case you were wondering how a country manipulates exchange rates, well, now you know. If the PBoC does make purchases with its foreign currency, it buys the debt of foreign governments, like Treasury debt, since, after all no jobs or industry is needed to produce government debt. Just as the FED purchases Treasury debt to create money and back the US dollar, the PBoC purchases US dollars and Treasury debt, creating yuan in the process and pushing down the value of the yuan relative to other currencies in order to maintain its supposed trade surplus. This activity is readily visible by taking a look at China's "foreign reserves," the PBoC's holdings of foreign currency, kind of like one component of the FED's Adjusted Monetary Base (AMB): (Click on the pictures to enlarge) Most commentators coo over China's "strong" financial position as a creditor nation, with so many assets and so much foreign currency backing the yuan, but in light of this discussion, your first interpretation is probably the correct one: the PBoC is forced to buy ever more dollars over time just to maintain the status quo, which is to say, the illusion that all this economic activity is actually an intelligent thing to do. It is not enough to say that there has just been a lot of growth in recent years. Yes, but go back as far as twenty years, adjust the graph's axes, and you will see the same shape of curve. It is classical exponential growth! Ever increasing purchases are necessary just to maintain the dollar peg, which is now a "loose" dollar peg. This phenomenon should look familiar -- it is just another manifestation of the business cycle, viewed from a different angle. Once initiated, a constantly growing stream of new money is necessary to sustain a boom. Otherwise, prices correct, and the boom becomes a bust. China's export boom is no different from any other economic boom. Most of these reserves are US dollars, and over just the past few months, those dollars have lost about 30% of their value relative to other currencies. Meanwhile, China is forbidden from tapping in to its dollar hoard for fear of disrupting export markets and destroying the value of its present holdings. So, China attempts to "win" in its trade arrangements with foreign nations by exporting things that the foreigners simply print worthless counterfeit money to buy. Chinese workers are laboring, in effect, for free. If I didn't know better, I'd call this slavery. Is it any wonder that they are now in such a pickle? The mindset that leads to this behavior is one of those typical human failings: the confusion of a success indicator (money) for actual success (wealth). Trade is not combative, wealth accumulation is not a zero sum game, and being rich isn't sitting on a great big pile of money. Instituting slavery under a different guise certainly isn't the path to riches. (And isn't it ironic how humans manage to find such innovative ways to re-implement the abominations of the past under a disguised rubric? We are an innovative species!) But such is the state of economic understanding that 99% of the economic commentariat will tell you that China is poised to take over the world. Not likely, at least in the near term. The Bigger Picture If rapacious money printing and hoarding of foreign currencies isn't the path to riches, then what is? By almost all measurements economists typically use, China should be catapulting itself into an economic superpower. To better understand the phenomena of societal wealth generation and China's predicament, let's first ignore the mechanical aspects of capital formation and the like and take a look at an underlying and very ancient human dilemma. In almost every way, humans are limited beings. Their limitations are numerous: intelligence, physical capacities, and time on earth to accomplish their goals, just to name a handful. To produce wealth in greater abundance requires greater capital and other economic gobbledygook, of course, but thanks to human limitation it also requires specialization. Few people can become a jack-of-all trades, and nobody can become a master of them all. We must excel to increase our productivity, and we must specialize in order to excel. In doing so, however, we become dependent on others to meet our varied needs as a direct result of specializing on one or a few modes of production. On top of capital formation, and far more fundamental to the central problem of economics, increased wealth generation requires the ability of individuals to come together to form productive associations with one another. This is the division of labor, and its extension and ever increasing complexity is the true central problem of wealth generation. Viewed in this light, certain demands of individual behavior far external to the mechanical world of the accountant and the engineer are brought to bear on aspirations of wealth that are no less laws of the universe than the laws of physics. Complex systems with a great number of individual actors come with a number of requirements if they are to function properly: coordination of behavior, communication, and most importantly, the expectation and practical realization of fair play. Complex economic systems capable of generating substantial wealth require that economic actors abstain from self-serving activities that inflict harm on others and erode the incentives to interact and cooperate in a productive manner. That's right: cooking the books and phony accounting are a big no-no. Can you believe it? Some months ago I attempted to derive a semiquantitative description of this phenomenon by relating the data compiled by the Index of Economic Freedom to per-capita income using a statistical thresholding calculation: (click to enlarge) Though the attempt was crude and open to debate, the broader relationship is abundantly clear: to the degree a particular society embraces the ethic of respect for others and their liberty and property, it prospers. To the degree it rejects this basic ethos, it stagnates. This is not simply a problem of socialism or capitalism, oppression or freedom. A closer look at the individual components of the index will quickly reveal that the single best predictor of per-capita GDP is the level of corruption. The importance of economic "freedom," it seems, is more likely a subcomponent of the larger issue of the ability and willingness to respect the rights of others and refrain from acts like violence, fraud, and coercion. What socialist and non-socialist third world countries have in common is abhorrent levels of corruption and a low, unproductive division of labor. What the socialist economies of Scandinavia and the rest of the first-world have in common is unusually low levels of corruption and a highly productive, complex division of labor. All of which tends to indicate that individual behavior in places showing high levels of corruption is not nearly as conducive to economic cooperation as it is in places where such a level of corruption does not manifest itself. As Duyen has pointed out, it takes more than a bad government to create a sufficient level of oppression to really ruin things. An awful lot of effort goes into making a system really, really bad. On the bright side, China appears to have left its worst days behind it. The brutal days of the cultural revolution are over, and indeed a great part of the vast improvement in economic conditions of late are due largely to the abandonment of the more radical attitudes of that time. This is all well and good, but in the West at least, the greater dilemma has typically been addressed through codification of behavioral ethics by religious organizations, free discourse and debate, "family values" and the like. These types of activities find themselves under siege in China, though to their credit, this tendency is decreasing, and some such organizations are at least taking root, if not yet flourishing. With respect to law, basic regard for property and the autonomy of others still appears wanting, even where and when the law is respected, which is often not the case. Top-down efforts by government to "inflict morality" on the populace by force have typically been counterproductive wherever they have been tried throughout history, while some might even argue that government attempts at the reverse have usually met with fantastic success. Unfortunately, minds on both sides of East and West appear to have focused their attention exclusively on government as the answer to every question. Government action appears to have become the method of first resort for every problem, no matter how many failures it manages to rack up or how inappropriate the situation. This does not bode well for any of us. China appears to want the affluence of the West without being particularly eager to develop values and behaviors that make it work. On the other hand, up until recently, trend lines were at least pointing in the right direction, however weakly, unlike in the West. Perhaps in the very long run, these developments might flower into genuine prosperity on the order now enjoyed by the West. But in the short term, the response to the financial crisis has been revealing. China does not appear ready to do what it takes to meet the crisis on the proper terms, and its actions thus far have been highly counterproductive. China's Present Predicament The net effect of behavior on the part of the PBoC is that China has put itself in a curious predicament. Like America's vastly overbuilt suburban neighborhoods now sitting unsold or in foreclosure, and endless strip-malls sitting vacant, thanks to the interference of the PBoC, China, too, has accumulated a mountain of malinvestment. In particular, it has acquired an enormous industrial capital base over the last 20 years fine tuned for generating cheap exports to ship to Western consumers. It has also introduced a modern financial system, complete with a central bank and fractional reserve banking. Whatever their merits, these two modern capitalist behemoths now find themselves in the midst of a pre-industrial, pre-capitalist culture with values and tastes very different from what this infrastructure was designed to serve. This is usually the case where government interferes with economic development: the economy fails to develop in such a way as to satisfy real consumer demand. It develops in a contorted fashion in response to the financial incentives placed before it, often with disastrous results. That was fine at least so long as the capital could be put to use serving others with a more appropriate set of tastes. But the monetary shell games of the PBoC have been revealed for the fraud that they are, as was inevitable. The dollar appears wobbly, as it should, and the jig appears to be up. China's industrial base is being cut off from her former customers. The plan now is for the hulking industrial monstrosity the PBoC has nurtured for all of these years to turn its attentions to serving the populace of China itself. It should be quite obvious that this is not going to work, for the very simple reason that the average Chinese Wan or Zhen doesn't want to buy what China's manufacturers have to sell. Consumer Sovereignty in China At least, he doesn't want to buy on the terms available to him. Satisfying the Chinese consumer on his own terms is a far more challenging proposition for the Chinese economy than satisfying foreigners, because no economy has ever been developed to do so. It cannot be copied from the West. It requires far more Chinese participation in the production structure and cannot depend on vast swaths of foreign economic structures to prop it up. And most importantly, it must develop on its own as it seeks out the most efficient ways to ascertain and satisfy consumer demand. The Chinese system of micromanagement, excessive corruption, and mass interventionism does not appear willing to let this take place at this time or in the foreseeable future. Quite the opposite, actually, and from the looks of it we can expect further disservice, disrespect, and disdain for Chinese consumer sovereignty. Most commentators, Keynesians that they are, have focused on the Chinese savings rate. The standard Keynesian drivel is that Chinese consumers save too much and spend too little, and therefore, the domestic consumer market cannot absorb China's manufacturing output. This is completely wrong-headed. Despite what the Keynesians will tell you, consumer spending does not drive economic growth. Savings does. The savings rate does say something: that there is great potential for growth of the Chinese economy. There is plenty of capital and resources available for investment since by saving his money, the Chinese consumer is showing that he has the discipline not to consume everything available to him. But this is not and never has been the primary human limitation of the Chinese economy. Consumer discipline might be a human limitation holding back the American economy, but not the Chinese economy. Ask anyone from mainland China his primary political concern, and he will tell you corruption. Ask him what kinds of products he prefers to spend his money on, and he will tell you high-quality goods, which he really is willing to spend money on. But not the goods produced by Chinese manufacturers that are available to him in the market. The fact is, this has always been China's problem, and indeed it is the most fundamental economic problem: all economic activity is the result of individual human action. If individual human beings do not like the deal being proffered, they do not partake. They stay home with their families, love their children, and do the least necessary to get by. Without the monetary shell game, the illusion of easy profits made by selling cheap goods to Americans goes away. The motivation to keep working dies. Human Action The fact is, the average Wan is sick and tired of being ripped off. Never mind the ultimate source of this problem for now -- just consider the effect on the choices facing the average Wan trying to make a living. He goes to work every day, but finds that after he has been bilked by his boss, his co-workers and superiors, the vendors he buys from, his family, his government, and his central bank, being nickeled and dimed left and right, what is left for him to obtain as a consumer in return for all his efforts simply isn't worth it. He doesn't like the goods up for sale; they don't appeal to him at the asking price, and in an awful lot of cases, at almost any price at all. He's tired of being deceived, and he's tired of paying for steak and getting hamburger. So why should he proffer up all the effort in exchange for something he doesn't want? The corruption of the system he operates in siphons off too much. His heroic savings and effort are all for naught, in his eyes, since the return for his efforts are so minimal. The division of labor acts as a tax upon him, rather than a tool for his betterment. So he wisely will not take part in it. It will contract until it reaches that point which it does pay for him to join in. But this will be at far lower productivity than what we nominally see today. Likely, the average Joe, or Juan, or Dmitri, or Raj, all find that they are looking at a similar situation in their own economies to greater and lesser degrees. This is a global phenomenon. As prices correct, and the reality of the economic situation is revealed, dreams are shattered and expectations are adjusted downward. Expect people to realize that they've gotten a raw deal as they watch their retirements and lofty plans evaporate away. They will throw up their hands and look for better uses of their time rather than participate in a shell game they can't win. I know I am. And it is going to take a lot of persuasion or a really, really good fraud to change anybody's mind. That is the first, and in my opinion, most likely scenario for the future of the Chinese economy in the near (e.g. 5-10 years) term. Not all that different from our own likely futures, though I think the bubble in China was inflated much further and has much further to fall. To play the part of my own devil's advocate, there are two possibilities that I can see for the opposite to happen. Scenario I: More Shell Games First, and the more likely of the two, the Chinese bigwigs find some new grand-accounting scam to fuel another frenzy of wasteful activity. Actually, that appears to be the plan as we speak. The PBoC has attempted to stimulate the economy by taking several drastic measures. It has inflated the money supply and slashed interest paid on reserves, effectively putting a gun to the heads of the banks and forcing them to lend to anyone and everyone. Otherwise, they can watch their holdings evaporate in a puff of inflationary smoke. M2 and overall lending have increased spectacularly as a result, precisely when investing caution should be in order. This is part of the larger plan to "shift to a base of domestic consumption," which as I have pointed out is going to be an insurmountable challenge. Indeed, it looks so far as though it has been, and there appears to be some chicanery going on in an attempt to make it look as if the plan is working. Several glaring inconsistencies have been noted, including a massive increase in automobile production -- coupled with stagnant gasoline sales. Which begs the question: what is happening to all those cars? They sure don't seem to be getting much use... In the meantime, the PBoC is still buying US dollars and Treasury debt in an attempt to prop up exports, if you can believe it. But they are being more cautious about it. They are piling up on the short end of the lending curve, i.e., buying short-dated debt that can be held to maturity. This minimizes their exposure to interest rate and devaluation risks, as the bonds can be redeemed at face value in a shorter amount of time. (By the way, the FED itself appears to be the one holding down the long end of the curve, i.e. making large purchases of long dated, 7-35 year, debt). Like the American "Cash for Clunkers" program and housing tax-credits, this is supposed to be a mere "transitional" effort that will eventually be stopped when the economy "gets back on its feet." Yeah, right. Can the Chinese planners make this work? So far the answer appears to be no, but things could change. If they do, and some particular economic subterfuge manages to "take," expect the inflation of yet another gargantuan bubble, with another catastrophic bust some years down the road. Scenario II: Mass Cultural Shift The second approach is a mass cultural shift that will sustain a growing division of labor. Chinese consumer sovereignty will finally be able to assert itself, corruption and its destructive effects will subside, and the economy will develop sustainably to serve real consumer demand instead of the whims of the PBoC and the state. This is the true path to lasting wealth, and I sincerely hope that it happens, but I think it is the least likely of all the outcomes. If China were to embrace real, individual, cultural reform on a large scale, it would easily surpass the highest bar set by the most optimistic Sinophile. Just as America rose to superpower status on the basis of its embrace that so-far uniquely Western ethos, and the British before America, China would become a true world leader. But I do not think China will become so otherwise, without a collapse orders of magnitude larger than what I expect in the West. Without such a collapse, the residue of Western wealth and power will at least roughly equal or outshine the best that China can achieve for quite some time, in my opinion. In modern times, successful powers have required ever increasing doses of this ethos to outshine their rivals. Hopefully, this trend continues, but as the saying goes, trends have a way of continuing right up until the point that they don't. Conclusion Basing our expectations on what we linearly extrapolate from the familiar is one of the most pervasive human tendencies, and the inability to mentally grapple with very large differences in magnitudes is one of our greatest weaknesses. The widespread inability of Western commentators to intelligently analyze the Chinese economic situation, and pretty much all things Chinese to boot, is a direct result of these two failings. For the most part, they simply do not understand just how different we are and are unable to correct their frame of reference to get even a reasonable approximation of the Chinese perspective. And frankly speaking, I will admit that my own understanding is probably only modestly better. But at least I am not blind to this fact. I understand that there are very great differences that I will probably never be able to grasp in the slightest. China is not the United States, Chinese culture is very different from American culture, and the Chinese economy is very different from the American economy. China is not "just like the US," except with a higher savings rate and lower consumption, and the Chinese are not just like us, with a few minor differences easily corrected with a linear estimate. Yet virtually every economic commentator spouts the same tired line of "China should save less and consume more, America should save more and consume less." This is a positively mindless, boorish conclusion, and it is wrong. It doesn't even begin to address the actual problems. Economists would do better to start from scratch. They would do even better to study history and look for something more analogous, and start there. But for the most part, they don't. China's most pressing problem isn't under-consumption, over-production, over-capitalization, or any of the like. It is the pervasiveness of corrosive habits of thinking that inevitably lead to corruption and fraud, serious market distortions, destructive behavior and disincentives toward the extension of the division of labor in response to real market signals and in a constructive, wealth generating structure. Ultimately, though, China's problem is everybody's problem, in one manifestation or another. Money passed under the table in a paper bag in return for an illicit favor, or a fraudulent set of scales that cheats a buyer, look very different from a tax credit, a central bank, or an "economic stimulus," yet the outcomes can be remarkably similar. The stamp of "officialness" does not change much. But you won't see it if you are blinded by the pseudo-science of what passes for modern-day economics, where the importance of the cultural ethos is rarely taken to be an issue, everyone is a cog in a wheel, we're all "basically the same" and every problem is a mechanical problem that can be described by the same set of mathematical equations.

How the faithful city has become a harlot, She who was full of justice! Righteousness once lodged in her, But now murderers. Your silver has become dross, Your drink diluted with water. Your rulers are rebels And companions of thieves; Everyone loves a bribe And chases after rewards. They do not defend the orphan, Nor does the widow’s plea come before them. Therefore the Lord GOD of hosts, The Mighty One of Israel, declares, “Ah, I will be relieved of My adversaries And avenge Myself on My foes. I will also turn My hand against you, And will smelt away your dross as with lye And will remove all your alloy."

-- Isaiah 1:22-25

The spiritual is real. You just have to look in the right places to find it. Currency debasement, product tampering and fraud, bribery, theft, and every other corruption have been with us for a long, long time. The consequences haven't changed much since then, either. We would do well to stop listening to the know-nothing economists and politicians, and focus on the real problems.