On China Part 2

Here is my first post.

The discussion below is mostly inspired by Michael Pettis’ piece. I wanted to strictly write a review of his ideas, but got totally carried away (this is long).

One general comment I’d make, though, is that Pettis take cares to relate his conclusions and insights back to historical examples. We get a lot of vacant speculation among the talking heads; this was a refreshing change of pace.

Ok, let’s get started.

GDP is measured as G + I + C + NX. Government spending, investment, consumption and net exports.

Your living standard is what you get for C, not what you spend on C. In China, C is a (relatively) small and declining share of GDP. Judging by the lack of popular uprising, the Chinese must feel they’re getting more C each year. Good for them.

This also means that there’s a big bullet sitting in the macroeconomic gun. C can (will? ok, will) eventually rise. Pettis points to Japan’s “stagnation” where the Japanese economy went from an investment-driven growth machine to a consumption-driven leisure zone. Are they worse off? Gosh, perhaps they aren’t.

[I’ve got this pet theory that Chinese leaders are terrified of getting their brains blown out (literally?) when the demographic transition lands at exactly the same time as the end of the catch-up growth / investment boom. It’s like a brick wall at the bottom of a ski hill; it’s gonna hurt. Maybe the consumption transition is the free pass?]

I’m going to avoid the net exports part, because I’m sick of hearing about it. Let’s talk about I. China’s got a lot of that, too. How does one (economy) get so much I?

Well, the answer here, it seems, might be government-directed construction projects funded by state-bank debt issuance.

That’s right, debt. Heaps of the stuff.

Now, you can only build so much infrastructure; eventually you just catch up and investment slows down. That’s ‘realignment’. Well, if it’s coming anyway, muses Pettis, maybe wise technocrats will get ahead of the trend and voluntarily nudge things along? Yeah, right.

Enfranchised players hold all the cards in an autocracy (the bums don’t ever kicked out), so they’ll ride this structure, tweaking the system only to perpetuate the status quo, until it breaks underneath them. In other words, autocratic governments are pro-cyclical institutions.

The result is more debt at the peak and this probably means debt crisis.

Wait, ANOTHER debt crisis?

Debt, on a macro level, is a very strange thing to think about. Debt comes from banks, which get their money from savings. Bad debts means that the bank is taking your hard-earned-and-saved money and destroying it without telling you (liabilities aren’t marked to market!).

The debt crises is the moment that ‘everyone’ finds out this has been happening right in front of them for years and it’s too late.

Imagine that you’re a hard-working citizen in a country having a debt crisis. Here are the ways forward:

1. If deposit insurance doesn’t exist, you just lose all your savings. Liquidations affect all asset values, so don’t go thinking you’re safe with your money in your house. You aren’t. You’re toast, too, just toast with a roof.

2. Under deposit insurance, the government pays for everything

Ah, but #2 is no free lunch. How does a government pay for deposit insurance if it really needs to use it?

2a) “bloody liberals!”: taxes go way up, either increasing the cost of stuff (consumption tax) or decreasing income (income tax).

2b) “Zimbabwe!”: Print money and inflation skyrockets, increasing costs of stuff relative to increases in income. Those savings you protected by choosing door #2 are destroyed here, too.

2c) “turn back the clock!”: governments stop doing things. This ain’t no tea party, though, ’cause rolling back health care and social security (let’s ignore defense) doesn’t lower taxes. That money’s for debt repayment. Now you just need to replace the social safety net with those private savings you got to keep.

2d) “Argentina!”: the government just defaults on the debt. Most debtors are domestic, so there go your savings again. The currency collapses, which causes that inflation you skipped in 2b.

Pettis makes a few interesting observations: choosing from the above resolutions is a political question and politicians struggle when the path is murky and the stakes are high (someone is getting effed over). In practice this means radicalized parties, finger-pointing and the dance of the cognitive-bias fairies. Truth has no place in this sausage factory.

I don’t even know who I’m talking about anymore as this situation is (an admittedly extreme version of) what’s going on everywhere.

And what happens when you put this kind of pressure on an autocracy? Who knows.

Anyway, There is a solution #3: do nothing and hope. Extend maturities, cut the interest rate, hope to God the problem takes care of itself.

Growth always fixes these problems, right?

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