Fearing (for) China

For a while, it was convenient to focus on the "threat from China" in military and economic terms.  These days, not as much, in spite of the occasional Drudge headline.  Consider this:

• Even though it may be making some progress, China is the world's worst polluter.  It will take time effort and wealth to remedy the situation.
• China's working age population is declining, putting upward pressure on wages.
• Already China is experiencing high wage inflation, making it less competitive in manufacturing exports.  Meanwhile, U.S. manufacturing is enjoying a resurgence due to higher productivity and cheap natural gas.
• China's infrastructure is crumbling, and not because it is old, but because corruption pervades the building process.
• The official banking system in China is heavily dependent on government directed loans to favored industries.  I always found it laughable that some conservatives would claim that Chinese investment was causing them to overtake the U.S. while criticizing U.S. government involvement in the auto industry.  Both sets of polices are bad for the economy of their respective countries.
• Small businesses in China are served by a gray-market banking system that lacks transparency and lacks safeguards.  A collapse of this system could threaten the whole economy.

Every story I cited is both recent and slow moving.  There is almost nothing that Chinese leadership can accomplish in the short run to solve these problems.  China doesn't have long, perhaps a decade, before its demographic curve pushes it towards Japanese levels of growth.  Unfortunately, because of these problems, it will not have the store of wealth that Japan has drawn against to prevent social unrest.  (Hint to opponents of greater legal immigration, population growth drives economic growth.)  I think that it is more realistic and worrisome to consider what a Chinese economic collapse would do to the world, rather than worrying about an economically dominant China.  A collapse would send the consequences around the globe.

I leave you with this admittedly older picture of Chinese pollution heading east.

What You Should Be Reading

• One more piece of evidence that the Obama administration has been lying about Benghazi.
• The IRS might still be targeting conservative groups; there is no way of knowing, since they keep stonewalling.
• The Bob Filner recall petition, and signing it as well, because he is hurting our city economically.
• Nice little newspaper you got there, it would be a shame if something happened to it.

Concerns Over China

While others have been worried about China's supposed strengths, I am actually worried about its weaknesses and potential impact on world politics. I have already discussed that their industrial pollution and lack of affordable housing are unsustainable. The housing issue arises from two policies that work to prevent a healthy real estate market. First, Chinese workers are forced to save with state sponsored banks at low interest rates. Lacking healthy returns, they cannot effectively save to purchase real estate. Second, the banks, while flush with cash, have been directed to loan to "strategic" businesses. Until lately, that has not included businesses building apartments or homes.

A new trend is appearing that also bodes ill. China's economic expansion to date has been largely dependent upon export driven growth, but limits on its ability to export might drive its foreign policy in a more belligerent direction, since the benefits of free trade that accompany peaceful accommodation are lowered. We are now seeing wage inflation in China continuing unabated. Over at Carpe Diem, Professor Perry has posited that the rise in Chinese wages has contributed to significant reshoring of American manufacturing capacity. This has the same net effect as trade restrictions on Chinese exports. I believe that China's military bellicosity has been held in check because their economic dependence on exports gave them an interest in preventing overt actions that would disrupt world trade. As a result, they have confined their military efforts to a build up of capability and to cyber attacks and espionage because these would not harm exports.

If export driven growth dries up, causing a recession, I believe the incentives regarding threatening a Taiwan invasion will change. Chinese annexation of Taiwan, against the wishes of those people would be a disaster for the world order. One of the bedrock principles of American foreign policy has been that borders of nation-states may not be changed by force. It is in our interest to keep this concept sacrosanct, in order to prevent a tipping point of global land grabbing that we lack the military might to stop on more than one front at a time. If Taiwan resisted by force of arms, with U.S. aid, it would be bloody and highly disruptive to the world economy.

I don't think the trend line is so drastic that China's exports will dry up overnight, but it is a long term strategic trend that requires watching.

Agreeing With Krugman on China - Truly Scary

Paul Krugman is the economist/columnist that I love to hate. He is probably brilliant in some way that I cannot understand, because I almost never see it in his work at the New York Times. He is a Nobel Prize winner, but I often wondered if his award was not politically motivated, in much the same way that Obama's clearly was. I was surprised to find his analysis of China's economic situation quite penetrating. I had argued against Glenn Beck and others that China was not the formidable foe they thought. My unlikely ally in this regard is Krugman. Some key points.

Still, even the official data are troubling — and recent news is sufficiently dramatic to ring alarm bells.

The most striking thing about the Chinese economy over the past decade was the way household consumption, although rising, lagged behind overall growth.

. . .China increasingly relied on trade surpluses to keep manufacturing afloat. But the bigger story from China’s point of view is investment spending, which has soared to almost half of G.D.P.

. . .it [the motivation for this investment] depended on an ever-inflating real estate bubble. Real estate investment has roughly doubled as a share of G.D.P. since 2000, accounting directly for more than half of the overall rise in investment.

Do we actually know that [Chinese] real estate was a bubble? It exhibited all the signs: not just rising prices, but also the kind of speculative fever all too familiar from our own experiences just a few years back — think coastal Florida.

. . . it’s impossible not to be worried: China’s story just sounds too much like the crack-ups we’ve already seen elsewhere.

Krugman also takes to task those who think that China's "strong, smart leaders" who don't have to bother with democratic niceties will somehow handle the situation. He points out that endemic bribery at the local level limits the central government's ability to govern. I would add that even dictatorships are subject to political pressures, which ultimately cannot be ignored.

We have a good news, bad news situation. Despite all of the troubles of the Unites States, there is no other nation close to being able to challenge our leadership, not the Europeans, not China and not Russia. However, if China also starts to suffer serious economic hardship, then a global depression seems possible.

Betting Against China - Update

But not much available to buy.

Because I think creating bogeymen undermines conservative credibility, especially when there are so many real threats, I have taken exception to Glenn Beck and others characterization of China as a huge competitive threat. In my last post, KT commented on the incredible pollution in China.

Polluting your environment is like taking on debt. You're getting a big rush of income now, but you'll have to pay it back later. In this case, you'll have to pay it back in clean up costs.

The them of taking on debt in China is discussed in today's Bookshelf column by Edward Chancellor where Red Capitalism by Carl E. Walter and Fraser J.T. Howie (what a great name) is reviewed.

In Red Capitalism, Carl Walter and Fraser Howie detail how the Chinese government reformed and modeled its financial system in the 30 years since it began its policy of engagement with the west. Instead of a stable series of policies producing steady growth, China's financial sector has boomed and gone bust with regularity in each decade. The latest decade is little different.

China's financial sleight of hand, in which savers are paid low interest rates and capital controls prevent the outflow of savings, and then this money is recycled into trophy projects is unsustainable. China's banks and Ministry of Finance have been hiding dud loans for a decade. This will not continue indefinitely. Meanwhile, consumers can't buy products because of the capital controls. A few are getting wealthy of course, but the paper wages of the masses can't buy the luxury goods they see pouring in for the chosen few. How long will this last? People are ingenious at evading controls, even in former communist dictatorships. (Take note, Thomas Friedman, you miserable hack.) Think of the capital controls as a dam that can only withstand so much pressure. The more wages rise without corresponding goods for purchase nor a chance for that money to grow to buy goods in the future, the more pressure will build. This isn't really capitalism, it is confiscatory, crony capitalism and it never works in the long run.

Betting Against China

In a previous post, I took Glenn Beck to task for fear mongering on China. The crux of my argument is two-fold. First, China's demographics portend long-term problems for the nation, due to lack of young people to support retirees in a few decades and a lack of young women compared to young men that will have negative social impact. Second, China's growth is driven by the direction of credit at the national level to favored industries. Such a model is unsustainable for two reasons. Inevitably, mistakes will be made and political pressures will cause investment to be redirected.

A couple of articles in today's WSJ reinforce my points.

Beijing Directs More Funds Toward Affordable Housing

Low and behold even the dictators in Beijing aren't immune to political pressure, take note Thomas Friedman, you miserable hack. So China is worried about the political problems caused by a lack of affordable housing including middle class anger. And where is the money coming from?

Only a portion of those sums comes from spending by central and local governments, with the rest coming from bank credit and corporate investment.

That means there is $200 billion less for investment in so called strategic industries.

Inflation in Asia Strikes at Core
It's Not Just Food Prices Anymore; Too-Fast Growth Strains Countries' Capacity, Raises Labor Costs

While China is not the main subject of this article, its labor costs are rising (and common sense tells me that demographics are a factor.)

Recruiters say it is getting harder to lure workers from places like China, where rapid economic growth of recent years has pushed wages higher and created more opportunities at home.

The rising labor costs will inevitably mean that China's global competitive advantage will erode. Since their work force doesn't speak English, the international language of commerce, to the extent that India's does, they are put at a competitive disadvantage.

China Logs Surprise Trade Deficit

This headline speaks for itself. While it only refers to one month's data, the trend of a reduced trade deficit is likely to continue. Why does this matter? The trade deficit allows Beijing to hoard dollars for direct investment, which may now be curtailed.


Like an idiot, I didn't check on Professor Perry's Carpe Diem blog before starting this post. He has evidence that U.S. small businesses are reversing the offshoring trend. It seems like shipping costs and rising labor costs in China, as well as inconsistent quality are making China an unreliable business partner. The comments section is worth the read as well.

Finally a picture sometimes says it all. How much longer will Chinese tolerate growth that results in this?

Disagreeing with Glenn Beck on China

Glenn Beck has been claiming that China is overtaking the United States as a global economic power. While he makes a number of good points he and his panel of experts have missed some key issues that will inevitably hold China back. Beck's experts, Jim Rogers, global investor, and David Buckner, economist, opine correctly that future national economic trends can be traced to people and capital. They then proceed to focus on capital and forget about the people. The fear that we are being overtaken is nothing new, in the 1980s there was widespread fear that we were being overtaken by Japan; then "Japan, Inc." tanked. Before it did, I remember reading a quote in Reason from Thomas Friedman's book The Lexus and the Olive Tree, "I am not afraid of Japan or the other Asians. Our Asians will beat their Asians any day." The quote was ascribed to a Silicon Valley entrepreneur, who was making the point that we are the only country attracting brain power through immigration. It is a source of strength not matched by our Asian competitors. So while our public education system isn't really building the home grown talent we would like, a point made repeatedly by Beck, it is not the only source of human capital for our nation.

My second objection is that the demographic trend line for China is following that of Japan's, which will cause domestic tension and considerably raise their labor costs as they bear the burden of an aging population. Consider the following demographic profiles from Simon Bond's blog:


Because of its one child policy, China is following Japan in having an aging population that lacks younger workers to support the pension benefits of their forebears. The United States has a problem, but not nearly as severe. Note too that India, with its English speakers, flatter population profile and commitment to education is a much greater long term threat to our economic supremacy. Note too, that their is a large gap between the male and female populations in the 20-24 age group, with a deficit of about 4 million against 65 million males. This is certainly going to cause societal problems.

Next, China's lack of regard for the environmental effects of its industrial policy will come under pressure as its workforce becomes wealthier. This is not a pretty picture:


Two final thoughts. First, China's investment is heavily directed by the central government. Beck professes belief in the superiority of the free market system over and over on his show, but loses his mind when it comes to China. "State capitalism" will prove no more robust than socialism in the long run as an economic system. The ability of a free market economy to outmaneuver other models is already proven. The question for America is how will we preserve the light regulation needed for capitalism to work, and not allow the heavy hand of government to strangle free enterprise. Second, China is still a repressive regime, which is incompatible with the agility of mind and freedom of choice necessary to a culture of free enterprise. Without those strictures, the party loses its power. With them, it will always be chasing countries with free markets.

Personally, I think we should be more concerned with India in the long term. They are a democracy and working through their problems slowly but effectively. I wish we would be allowing their best and brightest to immigrate to our country in much more massive numbers than we currently allow, to give us a head start on the inevitable economic competition.

Google Faster on Strategic Response to China than U.S.

On my other blog, I posted an article about Operation Aurora, the Chinese hacking effort aimed at Google and other IT service providers. Interestingly, my take on the situation was confirmed in a thoughtful article in the New York Times. If you care about the future of U.S. war fighting in cyberspace, then this is a must read article. A few quotes:

These recent events demonstrate how quickly the nation’s escalating cyberbattles have outpaced the rush to find a deterrent, something equivalent to the cold-war-era strategy of threatening nuclear retaliation.

So far, despite millions of dollars spent on studies, that quest has failed.

....

Participants in the war game emerged with a worrisome realization. Because the Internet has blurred the line between military and civilian targets, an adversary can cripple a country — say, freeze its credit markets — without ever taking aim at a government installation or a military network, meaning that the Defense Department’s advanced capabilities may not be brought to bear short of a presidential order.

.....

That is what makes the Google-China standoff so fascinating. Google broke the silence that usually surrounds cyberattacks; most American banks or companies do not want to admit their computer systems were pierced. Google has said it will stop censoring searches conducted by Chinese, even if that means being thrown out of China. The threat alone is an attempt at deterrence: Google’s executives are essentially betting that Beijing will back down, lift censorship of searches and crack down on the torrent of cyberattacks that pour out of China every day. If not, millions of young Chinese will be deprived of the Google search engine, and be left to the ones controlled by the Chinese government.

An Obama administration official who has been dealing with the Chinese mused recently, “You could argue that Google came up with a potential deterrent for the Chinese before we did.”

This requires deep thought about the asymmetry of the situation in cyber-warfare, where the identity of the enemy may not be initially known. It shows that excellent defense, while necessary is insufficient, I don't think anyone has a greater vested interest in good defense than Google, but they were still hacked. This is a very tough problem, and I wish I had more insight.