Monday, November 29, 2010

To Better Illustrate...

...why the Chinese economy will have great difficulty transitioning away from its dysfunctional export driven mercantilist system to a more healthy one that respects consumer sovereignty, I think I must come up with a better example than the division of labor arguments I have advanced so far.

Up to now, I've mostly made my case on theoretical 'arm-waving' grounds, which I think is my penchant as a scientist -- to see everything from an abstract, theoretical vantage point. Being a chemist just makes it worse, because I have to deal with things on a daily basis which I can neither touch nor see. I have to use abstract reasoning because I have little else to work with. So I happen to like arm-waving arguments -- I'm comfortable with them, so that's what I tend to produce, though I will confess that I often have trouble putting them into words. So, I suppose I can't really blame people for not being too convinced by inarticulate arm-waving. That's usually not very convincing to most people. Hard examples are usually better. And I think I finally have a good, hard example for my skeptics.

China's problems are rooted in a disfunctional division of labor that results in wanton waste and inefficiency. It is easy for me to say that, because I've been around it and I know. But it's hard for others to grasp when they see China and greater Asia as the epicenter of a productivity explosion like none the world has ever seen, and which I simply can't deny. It's true.  Even respectable Austrians like Gary North argue that it is simply a matter of 'retooling' so that factories can switch to producing goods more to the liking of Eastern tastes. This seems to me a case of trying to make a mechanical problem out of something that is decidedly not, which I think is a mistake.

Case in point:  my in-laws complained to my wife recently about the rising prices there. In the course of things, they started discussing the cost of clothing. Having been here and seen the Chinese imports sitting on our shelves, they have a unique window into how their system screws itself.

Here in the US, you can find a reasonably decent, run-of-the-mill 'Made in China' polo-style shirt for about $25-$30 US dollars. Now, granted that the Chinese central bank suppresses the exchange rate, we should guess that it really should cost more. Based on the Purchasing-Power-Parity (PPP) estimate of Chinese GDP, one could guess that the renminbi is roughly 50% undervalued against the dollar, so that without that particular subsidy, the same shirt would actually go for $50 to $60.

China's per-capita GDP is about $7000 per year, PPP, compared to America's at somewhere around $46,000. Under the assumptions of PPP, then, food costs and other such costs are about the same in both places. So you might guess "gee, a Chinese family must be spending almost all of its money on food. There's no cheaper substitute for that. Which means it can't possibly afford clothing like that shirt, which is the product of its industrial base. That must be the problem."

Actually, all of that is correct right up until the last point. It's not really a problem that the average Chinese household can't yet regularly afford $50-$60 polo shirts. Probably a lot of American households couldn't afford that, either. (Nice of 'em to subsidize it for us, huh?) All that would need to happen would be more growth and higher productivity until China reached a per-capita GDP approximating America's. In the meantime, factories would just have to 'retool' to produce cheaper clothes. (OK, so I'm ignoring some issues of returns on capital here. Just humor me, there's a much bigger point coming.)

No, the problem isn't that. The problem is that you couldn't get that $50 polo shirt in China even if you had $50 that you were ready to spend on it. That's because a shirt like that would actually run you somewhere between $100 to $200. A similar good costs around two to three times as much, depending on whether it is sitting on a rack at JCPenny halfway around the world, or a few hundred miles away from where it was produced in a Chinese mall.

That isn't supposed to happen. One of the 'laws' of economics states that identical goods are supposed to cost about the same everywhere, ignoring minor variability resulting from transport costs. This is because substantial price differentials are supposed to result in the transport of goods from regions where prices are low to regions where they are high in search of greater profits. Supply and demand, all of that. That is the principle underlying the use of PPP as a means of economic comparison. If anything, the US price should be slightly higher than the Chinese price of goods produced in China.

But it doesn't happen in this case -- not even close. Why? Beats me. I have a few ideas, but I can't prove them. Stocking a specialty item that probably won't sell at high volume might introduce a small premium, but not a 300% premium. I don't think that anything like that could explain it. Broadly speaking, it would almost have to be a serious case of economic parasitism, just from the looks of it.

There is an enormous 'grey market' in China, in the form of 'gifts' and money under the table which seems necessary to grease the skids of the business world there. Otherwise, things seize up. How exactly it works or if that's the main culprit, I don't know, but if I were looking for more exact answers, I'd start there.

Ultimately, though, it doesn't matter. What matters is that there is a serious, serious problem with the basics of doing business in China that has absolutely nothing to do with 'retooling.' It doesn't matter one whit what the factory is producing or how. If you can't get it a hundred miles down the road without a 200+% markup, you are not going to have a substantial division of labor or a highly productive, wealth generating economy. If that problem doesn't get straightened out, China will always be dependent on foreign markets and the sham wealth of mercantilism.

What people sometimes fail to understand is that 'Made in China' really should come with a second label underneath -- 'Made for X.' The goods coming out of China vary widely in quality depending on their destination market. I have a friend whose wife is from the Ukraine. She reports that Chinese imports there are of abyssmal quality. Clothes fall apart on the first washing, or shrink to a toddler's size, or completely lose all their color. Nobody trusts anything 'Made in China.'

Yet these constitute the majority of goods available to the average Chinese in the marketplace. He doesn't want them. They're 'fake,' and can't be trusted. As long as the market premium for genuine, decent quality goods remains that high, the domestic Chinese economy isn't going to work.

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