Another high speed crash on the way

The collision of two Chinese bullet trains on 23 July 2011 has elicited public outrage on its microblogging services. The crash caused by a lightning strike that stalled a train was not totally unexpected as China has been expanding its high speed rail network at breakneck speed. Still this is nothing compared to the disaster that will be visited upon China when another of its fast speeding contrivances, that is, its economy, starts to hit the skids.

China has been copying and modifying imported rail technology in order to breach the speed limit. Its meddling with its trains is akin to its tinkering with its economy writ small.

A picture tells a thousand words. The two charts from The Financial Times on the left demonstrate that China is dangerously breaking the economic speed limit.

The most revealing information from these charts is that China's net exports, much ballyhooed as the driver of China's GDP is not what it was made out to be. Instead it's its gross fixed asset investment or gross fixed capital formation, i.e., before depreciation, that's the real engine of growth.

Compared to Japan's fixed asset investment in its bubble years, which topped out at 35 percent of GDP, China's figure is now approaching 50 percent of GDP. Even the US registers only 20 percent.

China's investment, mostly debt financed, has gone past diminishing returns, swinging into negative territory. Its rail accident may be due to its failure to grasp the need for the rail signalling software to keep pace with advances in the hardware. Similarly, its breakneck economic growth would be incomplete without a corresponding growth in debt financing. Rushing headlong into capitalism just after ditching communism is hazardous for a nation that hasn't grasped the dark side of capitalism.

The final chart from The New York Times is more alarming. The difference between this chart and the above is that the fixed asset investment includes expenditure on land and inventories which the gross fixed capital formation excludes. This chart shows that China's GDP closely tracks its fixed asset investment. The investment, at a staggering 70% of GDP, is unprecedented in economic history.

One Chinese microblogger perfectly summed up the bleak situation that is dawning over China: "China today is a train travelling through a thunderstorm. None of us are spectators; we are all passengers." The two colliding high-speed trains with 1,400 passengers registered only 39 fatalities. Its economic train with 1.3 billion passengers however won't be so lucky.

Absolutely zero comparative advantage

Free trade has its economic underpinning in the law of comparative advantage, first formulated by the English economist David Ricardo (1772-1823). Legions of economists have accepted this law unquestioningly, ignoring the context in which it was first written. Going back in time, the law of comparative advantage made its first appearance in 1817 in David Ricardo's book, On the Principles of Political Economy and Taxation. More important, it was written during the dawn of the Industrial Revolution which can be roughly dated to have begun in 1780.

It was in the 1780s decade that the fossil fuel mechanical engine began to mechanise industrial production with the improvement by James Watt from the to-and-fro movement of his steam engine into a rotary motion in 1781. Of course, credit for the engine lies with Thomas Newcomen who invented the unidirectional steam engine in 1712 and James Watt who added a condenser and turned the movement into a back and forth motion in 1774. But both these machines found their uses in the mines only. With the improved engines, Richard Arkwright began using them in his factories in 1783.

Of the three hallmarks of the Industrial Revolution, one of them was the dictating of the work pace by machines instead of humans. And the factory was the right setting for it. In the underground mine, the steam engines only pumped the water out, not set the rhythm of miners' work. Admittedly, in the factory, Richard Arkwright's water-powered spinning mill preceded the steam engines in 1771 but the water-powered machines were limited to areas with flowing streams. Also their operating months in winter were constrained by the frozen streams. Edmund Cartwright's invention broke the geographical and seasonal constraints, leaving production running uninterruptedly. As long as the factories were not far off from rivers, canals could always be built to move coal.

As a result of these innovations, the Industrial Revolution radically shifted the paradigm. Before, mankind always had to contend with inadequate production of agriculture and manufactured goods. After the Industrial Revolution, the periods of inadequate supply have alternated with periods of excess supply, each period succeeding the other in a predictable pattern.

The timing when one or the other prevails is important because it determines whether the economic condition is inflationary or deflationary. How can we know which one is dominant? Simple. Using 1780 as the starting point, you add 60 for every Kondratieff Wave. So you have 1840, 1900 and 1960 as the start points of the Second, Third and Fourth Waves. The Fifth and final wave will begin in 2020. For each wave, the first half or 30 years is the inflationary period and the subsequent 30 years is the deflationary period. The pattern is generally regular despite our perception that the rate of innovation has hastened in the last few decades. In fact, it's getting harder because as the start base becomes bigger, the leap needed to achieve the same level of incremental progress as before gets more difficult. If you begin with 10, a 10 percent increment needs only 1 but if you start with 100 you'll need 10.

Now if we view the situation that David Ricardo was in, the conditions then were at the beginning of a deflationary cycle. However, he would have grappled with the idea long before it was put on paper. Most likely, he would have known only life in an inflationary environment. Thus what Ricardo wrote was not wrong but it was right in the conditions that he was in. What the economists after him have failed to do is to reexamine the context. Had they done so, they would have restricted the applicability of the law of comparative advantage only to the first half of each Kondratieff Wave.

Let's analyse what the law is really about. Below is a hypothetical example of two countries, the USA and Australia, that produce two items, bolts and nuts. It just so happens that the US and the Aussie dollars are on a par with each other. So that makes it easier to focus on the workings of the law of comparative advantage itself. Later we'll see the impact of tweaking the exchange rate in order to spirit wealth away from one's trading partners.

In the above example, Australia's output for both items is higher than that of the US. For every bolt that the US produces, Australia can produce 1.16 bolts with the same input. For nuts, it's 1.20. As Australia has the edge in both items, it is said to have an absolute advantage. Assuming that each nut is priced at US$1 or A$1, the price of bolt in each country is different because of the different productivity level required to produce bolts relative to nuts. In reality, the relative prices are not determined solely by labour productivity. Land and capital have to be factored in and this complicates the matter. In our simplified example which calculates labour input only, the price of bolt in the US would be $1.05 while in Australia it's $1.09.

Assuming that each country produces both items, the total output for every two manhours of input is 205 bolts and 220 nuts, with one hour each spent on producing bolts and nuts, as shown in the top part of the table below.

Although Australia has an absolute advantage, its comparative advantage lies in producing nuts because it can produce 1.20 nuts for every nut that the US produces compared to 1.16 for bolts. Suppose it focuses on nuts while the US on bolts, the total output now is 190 bolts and 240 nuts. Using $1 as the price of bolts and $1.0909, as the price of nuts, the specialisation has increased the economic return by $3.64.

But Ricardo's law has its fundamental flaw exposed when the economic conditions change as a result of technological advances. One major change brought about by modern technology is the almost limitless production capacity. Assuming that the cost remains constant, Australia can now produce both products for both countries. The US workforce can remain idle, which is what it is doing right now as China takes over the manufacturing of most stuff.

In our hypothetical example, can the US turn the table on Australia even if its labour productivity lags that of Australia? It can by devaluing its currency. Suppose it depreciates its currency by 50 percent, its 200 nuts would cost the same as Australia's 120 nuts. As for bolts, it's 190 to 110. The Australian workers would now be out of work. The US workers would get less pay since the currency is now worth half but it's a hundred times better than having no pay. Australia can nullify the US action by carrying a similar competitive devaluation. In our current real life situation, the US cannot devalue because China will match any US devaluation with one of its own, thus keeping the exchange rate stable.

If this one-sided trade is allowed to persist, it's the surplus accumulating country that would suffer a blowback. In international trade, each country's trade account must balance out for the long-term benefit of all nations. Surely, trade in this manner is inefficient since the cheapest goods may not be available to all. But more important than economic efficiency is social stability. In ecology, predator and prey cannot outwit one another all the time. They must achieve a stable relationship with one another or else an ecological collapse, disastrous for both parties, will set in. The root cause for the Middle East upheaval is the region's inability to produce stuff; the seeming demand for freedom is a symptom, now confused by many for causation.

What sort of blowback would hit China? The same one that hit Japan in the early 1990s for which until now Japan has not been able to recover from. In fact Japan's financial wave tsunami is insidious but more devastating than its tidal wave tsunami. A trade surplus country would naturally experience a rising currency as it holds more of the trade deficit country's currency. In relative terms, China's supply of yuan will increase at a slower rate than that of the US dollars (USD) as the US has to issue more dollars to finance its trade deficits. Simple mathematics will tell you that the yuan value must rise. China, infatuated with increasing the foreign currency amount in its vault, would have none of that. To sterilise its increased value, it must create more yuan, not through big government deficits as carried out by Obama, but by large scale private lending.

Since China does not buy as much imported goods as its exports, that money is chanelled internally towards a real estate frenzy. Everybody in China thinks property prices can only go up, that is, until he meets an American homeowner. In fact China's yuan value should move lower relative to that of the USD since total credit supply in the US has been static over the last two years. The only thing keeping its value high is the influx of speculative inflows hoping to cash in on the supposed China growth story. Certainly, the stratospheric property prices are never supported by matching rental income. When the owner-speculators could no longer flip the properties to suckers, the prices will crash to the bottom pulling the banks down with them. Money supply will vanish as the bank loans get written off. By then the yuan value will rise because its supply relative to that of the USD will decrease. That's the reason why the Japanese yen is stubbornly high even though its economy is in the doldrums. Similarly China's absolute advantage will turn full circle.

In the short term, this exchange rate setting mechanism is distorted by the hot speculative money. Actually politicians must not allow liberal currency movement because it negates their control of the economy and by extension politics. This also extends to trade, especially in the second half of the Kondratieff Wave. Notice that Ricardo's treatise is titled Political Economy. In the 18th and 19th centuries, economics did not stand alone but was studied with politics because the scholars then understood that economics undergirded politics. You split the two at the expense of the nation's stability. Now economics is being used to rigorously test mundane matters, of no importance to a nation well-being. That's why you find economists accepting the law of comparative advantage as the irrefutable truth. And politicians, clueless as ever, cling on to this dangerous notion without a hint of the tragedy that this blind adherence will inflict on the nation.

Clutching at the recovery straws

"A specialty of martial arts is to see that which is far away closely and to see that which is nearby from a distance." wrote Miyamoto Musashi in The Book of Five Rings. That statement aptly applies to fields as distant from martial arts as economics and politics. More so now that we are enmeshed in conflicting signals about the global economy so much so we can't make head or tail about which way the economy is heading. The confusion stems from the absence of a guiding pattern as reflected in our anxiety for any indicative news on the economy. There's no way to strategise when your only beacon is the unfolding news.

A typical confusion is exemplified by none other than two well known professors, both having divergent views on how the economy will turn out. In one corner is Niall Ferguson, an economic historian at Harvard whose contention is that the money printing by Bernanke will lead to rampant inflation and consequently high interest rates. In the other is Paul Krugman, an economics professor at Princeton and a Nobel Prize winner to boot. Krugman believes that Obama's deficit will lead to recovery and any rise in interest rates is an indication of funds moving to stocks and investments.

How these two icons of erudition in economics could go wrong is easy to see. They both rely on analytical inquiry; with one or two steps you can plausibly argue out your position. Instead, we should use a different approach, that is, pattern recognition. This approach takes five or more steps in one thinking cycle. For example, using the investment clock as a pattern (see Ticking towards midnight), it's safe to predict that cash will be precious in this depression because of its scarcity. The likelihood of high nominal interest rates is low but because of falling general prices, real rates will be high. We will see major debt write-offs and financial sector deleveraging (loans being called in as banks' capitals get eroded from debt write-offs). Now it appears that cash is aplenty with Bernanke furiously printing money. But don't be so sure that this can continue indefinitely.

We first need to understand the reasons for the temporary growth spurt and why this is just an aberration in a secular downsliding global economy. The refrain about the coming recovery stems from the actions of three men: Bernanke, Obama and Hu Jintao. I will tackle each in turn and debunk their claims to reversing the depression. But first, an overview of the common structural weakness of their actions.

Their failing lies in their inability to perceive the cause of the depression as more than just a liquidity crisis. If it were so, it would have been easily solved by Ben Bernanke's money printing. The fact that it hasn't proves that it's more than merely a liquidity issue.

In my earlier post, I've argued that this depression is actually a capacity crisis (see It's capacity, not liquidity, stupid). Actually, it's more than that; to find out, we need to take a step back. The real reason is the absence of a new growth driver, not only to propel growth but also to creatively destruct the present growth engine. The alternative is annihilative destruction as exemplified by Hitler's WW2 legacies in Europe. The mind can't even contemplate such a nightmare scenario.

The term 'creative destruction' was coined by Joseph Schumpeter of the Austrian school of economics. This school has been disdained by mainstream economists because of the Austrian school's eschewal of mathematical models. The Austrian school has a valid reason since human behaviours are too complex to avail themselves to modelling.

The purpose of creative destruction is to keep the wealth moving from those who have succeeded under the present growth paradigm to those who will succeed under the new growth paradigm. Without this changeover, whatever deficits and money printed will benefit only those who prosper under the existing growth paradigm. Within the context of the global economy, the higher the budget deficits of the US government, the more will be the US current account deficits as China and the oil exporting countries siphon off the surpluses. And for any national economy, the sizes and debts of almost all governments keep burgeoning to meet the demands of their populace until they collapse under their own and their debts' weights. Take Japan, while its public debt has exceeded 200 percent of GDP (second only to Zimbabwe), its household financial assets amount to US$16 trillion (second only to the US).

Ancient societies had ways of dealing with this imbalance through debt cancellation in times of crisis and famine. Our inability to recognise this unsustainable imbalance condemns us to tackling the symptoms while the real problem remains misunderstood. It seems despite our technological advances, we are way behind the ancients in the understanding of social and economic issues.

A similar ineptitude afflicts our three key decision makers. I have written an earlier post on Bernanke (see Bernanke vs The Market), so what's described here are additional comments on his perverted beliefs. Ben Bernanke has earned the nickname Helicopter Ben for his remark that he would drop dollar notes from a helicopter in order to keep the economy going. If only it were that easy. Ben is in need more of a helicopter view to overcome his myopic sight than a helicopter ride. Actually, he has to call upon Obama and Congress to drop money because only they can authorise the spending budget. What Bernanke or the Fed can do is to swap the printed money with existing debts, not willy nilly throwing away money.

Most of his swaps (or purchases, to be exact) comprise treasury bills and mortgage backed securities (MBS). There are limits to both. In the case of T-bills, his holding has exceeded US$700 billion. Any further increase depends on the US government getting deeper into deficits or the holders of existing T-bills continue selling to the Fed. The first is getting tougher as Obama has come under increasing pressure to balance the US government budget. The latter option can only be made at increasing prices as supply of T-bills gets scarcer with greater Fed purchases.

As for the MBS, for which the Fed now holds more than US$800 billion, more purchases of it exposes the Fed to higher risks as following the law of diminishing returns, incremental debts tend to carry greater risks of default, more so in times of deflating prices.

Bernanke's artificial suppressing of interest rates through his flooding of liquidity is not helping the economy either. The sloshing liquidity is sending wrong signals, such as higher commodity prices. Commodity producers are encouraged to increase capacity at a time when the commodity prices are going to collapse as they eventually will when their supplies overwhelm the shrinking demand. The only time when the money floodgate should be opened is during a panic and that moment passed in March 2009. Now is the time to allow the liquidity to gradually decline.

The next decision maker, Pres. Barack Obama is facing many critical issues: economic depression, unemployment, health care, global warming, Afghan and Iraq; all of which offer no easy solutions. To tackle them he must first acknowledge that the US is no longer a hegemon especially when the survival of the nation-state itself is precarious. His priority is to the American voters. He can thus safely ignore global warming, Afghan and Iraq.

Global warming, even if it really is caused by carbon emissions, cannot be solved by government edicts and regulations. Only technology can address it. Furthermore, in a severe depression, it will eventually be relegated to the back burner. Iraq is a goner when oil prices crash. The reason the Iraq surge succeeded was because it was accompanied by cash bribes to the Sunni tribal chiefs who then rallied the Sunni tribes against Al-Qaeda. This lesson has been lost on the American generals who still believe that it was the surge alone that turned the tide. American intelligence in preventing attacks in its homeland has improved tremendously that the US doesn't need to be present in Afghanistan. It should allow Taliban to rule Afghanistan and use the threat of the missiles to get them to put on their best behaviour. Israel's experience with Hamas after Hamas's rule of Gaza is instructive. For invisible enemies, the key is to make them visible so that they can be contained.

Health care, the last pocket of inefficiencies in the private sector, is a secondary issue in a downturn. The way health care is administered now, with practitioners operating autonomously within a hospital, engenders perverse incentives and is predatory on the consumers. The US should look into certain revolutionary health care practices, especially in India where salaried doctors using factory line style procedures focusing on volumes, have improved quality and lowered costs.

The economic depression is a given as the moment Obama reduces the US deficits, if not balances its budget, the global economy will keel over once again. That leaves unemployment as the critical issue that Obama should redirect his attention to. To solve this, he must first institute trade barriers and capital controls. It's no point incurring massive deficits if the money eventually flows out. Of course, these measures are economically inefficient.

But look at the factory floor, you can only be very efficient in only one area of your choosing; it's either labour, machine or space. Similarly, if you want cheap quality goods, you must tolerate continual deficits and high unemployment. It's Linear Programming 101: you can only maximise efficiency in only one area, but subject to the constraints or minimum thresholds that you have specified for the others. In the case of the US economy, it's maximising goods production efficiency without regard to any constraints on the level of unemployment nor on the deficits.

Finally, Hu Jintao who is the President of China, a country living on borrowed time. China is probably the last in a series of countries ranging from Japan to the East Asians and South East Asians that have been or about to be humbled by the deflationary plague. The Tibetan and Uighur riots in 2008 and 2009 were just mild foretastes of worse things to come. The riots were easily quelled because they were initiated by minorities. When the turn of the Han Chinese comes, not even the biggest army in the world can subdue it. Even Suharto, politically once the strongest man in Asia had to shamefully step down in 1998 after 30 years of iron rule when the whole region was steeped in economic turmoil.

China survives for the moment because of its US$586 billion stimulus and the US$1.2 trillion in additional bank credits. These packages are being used to increase capacity when it is least needed. Soon abandoned factories and real properties will dot China's landscape. The cost in terms of massive bank failures and lost jobs will be closely followed by a social breakdown of immense proportion.

At least Japan were rich when they were hit by the crisis in 1990 while the East Asians and South East Asians were partially saved by the devaluation in 1998. China may be the world's second biggest economy but its per capita GDP is still low. The devaluation option is no longer available as, given its economic impact, all eyes are watching its actions. As the negative forces of unsustainable debts, falling asset prices, rising unemployment and shrinking exports close in on their quarry, China, we can only watch with trepidation the strangulation of a would-be superpower. How fortunes change ― from greatness to wretchedness, from prosperity to calamity, from mastery to misery, from predator to prey, all it takes is a spin of the economic wheel.

Not Super Power but Super Trouble

China has often been proclaimed as the next superpower by many commentators. This is an ill-informed judgment. A proper pattern recognition would reveal that it is in line for vary bad days ahead. A brief look at China's history is in order. Throughout its history, China has always been infatuated with being solidly unified as one nation. Its writing system reflects such preoccupation. The Chinese have many dialects, each unintelligible to one another, yet these dialects share the same written characters.

However, beneath the seeming tranquility lies stresses that creep up over time. Like the geological earthquake that needs to take place in order to release the stress deep inside the earth, China must every now and then suffer upheavals to dissipate the stress build-up. China's past upheavals occurred in timely intervals of 50 years. Any delaying of the upheaval will ensure that the next will be cataclysmic.

China also was never interested in what the outside world had to offer. It built the Great Wall to keep the barbarians out. Instead it was the outside world that tried to nuzzle its way into China. The Qianlong Emperor of the Qing Dynasty summed up this attitude perfectly in his writing to King George III after receiving Britain's mission in 1793 "Our ways have no resemblance to yours. As your ambassador can see for himself, we possess all things. I see no value on objects strange or ingenious, and we have no use for your country's manufactures". His grandfather, the Kangxi Emperor whose reign of 61 years is the longest in Chinese history, issued a prescient warning in 1717 regarding the British presence in Canton, "There is cause for apprehension lest in centuries or millennia to come China may be endangered by collision with the nations of the West."

Mao Zedong was one leader who perfectly understood China's peculiarities because he was an avid reader of history. He initiated the Great Leap Forward in 1958 and the Cultural Revolution in 1966 to release the tension within the system. Millions died. However both were controlled releases. He could end what he started. Mao was cruel but he achieved his objective, which was to ensure China remained united as a nation. The alternative could have been much worse; possibly a prolonged anarchy had the state fractured.

Deng Xiaoping who succeeded Mao in 1978 embraced free market and opened up to the world. It was a foolhardy decision. Now China has no control over its future. The prosperity that Deng wrought buys respite only as long as it lasts. He had a mild foretaste in 1989 with the Tienanmen Square protests which was triggered by a price inflation. But inflation can be easily tamed compared to the catastrophic oncoming deflation which has practically no remedy.

Capitalism is like riding a bike or spinning a top. Growth that it engenders cannot be allowed to falter. China is now moving fast. Unfortunately it is not on a bike but a runaway juggernaut with failed brakes. The coming crash that we are about to behold wouldn't be an interesting sight indeed.