The Death of Money

by James Rickards

  The centralized ancient dynasties include the Zhou, from around 1100 B.C.; the Qin, from 221 B.C.; and the Han, which immediately followed the Qin and lasted until A.D. 220. In the middle period of Chinese civilization came the centralized Sui Dynasty in A.D. 581 and the Tang Dynasty, which followed the Sui in A.D. 618. The past millennium has been characterized more by political centralization than disorder, under four great centralized dynasties. These began with Kublai Khan’s legendary Yuan Dynasty in 1271 and continued through the Ming in 1378, the Qing in 1644, and the Communist Dynasty in 1949.

  Famous episodes of decentralization and discord include the Warring States period around 350 B.C., when fourteen kingdoms competed for power in an area between the Yangtze and Huang He Rivers. Six hundred years later, in A.D. 220, another decentralized phase began with the Three Kingdoms of the Wei, Shu, and Wu, followed by rivalries between the former Qin and the rising Jin Dynasties. Instability was intermittent through the sixth century, with fighting among the Chen, Northern Zhou, Northern Qi, and Western Liang kingdoms, before another unified period began with the Sui Dynasty. A final period of disunity arose around A.D. 923, when eight kingdoms competed for power in eastern and central China.

  However, discord was not limited to the long decentralized periods. Even the periods of centralization included disorderly stages that were suppressed or that marked a tumultuous transition from one dynasty to another. Possibly the most dangerous of these episodes was the Taiping Rebellion, from 1850 to 1864. The origins of this rebellion, which turned into a civil war, seem incredible today. A candidate for the administrative elite, Hong Ziuquan, repeatedly failed the imperial examination in the late 1830s, ending his chance to join the scholars who made up the elite. He later attributed his failure to a vision that told him he was the younger brother of Jesus. With help from friends and a missionary, he began a campaign to rid China of “devils.” Throughout the 1840s he attracted more followers and began to exert local autonomy in opposition to the ruling Qing Dynasty.

  By 1850, Hong’s local religious sect had emerged as a cohesive military force and began to win notable victories against Qing armies. The Taiping Heavenly Kingdom was declared, with its capital in Nanjing. The Heavenly Kingdom, which exercised authority over more than 100 million Chinese in the south, moved to seize Shanghai in August 1860. The attack on Shanghai was repulsed by Qing armies, now led and advised by European commanders, supplemented with Western troops and arms. By 1864, the rebellion had been crushed, but the cost was great. Scholarly estimates of those killed in the rebellion range from 20 million to 40 million.

  A similarly chaotic stage emerged in the so-called Warlord Period of 1916 to 1928, when China was centrally governed in name only. Power was contested by twenty-seven cliques led by warlords, who allied and broke apart in various combinations. Not until Chiang Kai-shek and the National Revolutionary Army finally defeated rival warlords in 1928 was a semblance of unity established. Even then the Chinese Communist Party, which had been ruthlessly purged by Chiang in 1927, managed to survive in southern enclaves before undertaking the Long March, a strategic retreat from attacking Nationalist forces, finally finding refuge in the Shaanxi Province of north-central China.

  The most recent period of decentralized political chaos arose in the midst of the Communist Dynasty during the Cultural Revolution of 1966 to 1976. In this chaotic period, Mao Zedong mobilized youth cadres called Red Guards to identify and root out alleged bourgeois and revisionist elements in government, military, academic, and other institutional settings. Millions were killed, tortured, degraded, or forcibly relocated from cities to the countryside. Historic sites were looted and artifacts smashed in an effort to “destroy the old world and forge the new world,” in the words of one slogan. Only with Mao’s death in 1976, and the arrest of the radical Gang of Four, who briefly seized power after Mao’s death, were the flames of cultural and economic destruction finally extinguished.

  Historical memories of these turbulent episodes run deep in the minds of China’s leadership. This explains the brutal suppressions of nations such as Tibet, cultures such as the Uighurs, and spiritual sects such as Falun Gong. The Communist Party does not know when the next Heavenly Kingdom might arise, but they fear its emergence. The slaughter of students and others in Tiananmen Square in 1989 sprang from this same insecurity. A protest that in the West would have been controlled with tear gas and arrests was to Communist officials a movement that could have cascaded out of control and therefore justified lethal force to suppress.

  David T. C. Lie, a senior princeling, the contemporary offspring of Communist revolutionary heroes, recently said in Shanghai that the current Communist leadership’s greatest fear is not the U.S. military but a volatile convergence of migrant workers and Twitter mobile apps. China has over 200 million migrant workers who live in cities without official permission to do so, and they can be forcibly returned to the countryside on Communist Party orders. China exercises tight control over the Internet, but mobile apps, transmitting through 4G wireless mobile broadband channels, are more difficult to monitor. This combination of rootless workers and uncontrolled broadband is no less dangerous in official eyes than the zeal of a failed mandarin who believed he was the brother of Jesus Christ. This potential for instability is why economic growth is paramount to China’s leadership—growth is the counterweight to emerging dissent.

  Prior to 1979, the Chinese economy operated on the “iron rice bowl” principle. The leadership did not promise high growth, jobs, or opportunities; instead, it promised sufficient food and life’s basic necessities. Collective farms, forced labor, and central planning were enough to deliver on these promises, but not much more. Stability was the goal, and growth was an afterthought.

  Beginning in 1979, Deng Xiaoping broke the iron rice bowl and replaced it with a growth-driven economy that would not guarantee food and necessities so much as provide people the opportunity to find them on their own. It was not a free market by any means, and there was no relaxation of Communist Party control. Still, it was enough to allow local managers and foreign buyers to utilize both cheap labor and imported know-how in order to create comparative advantage in a wide range of tradable manufactured goods.

  The China Miracle resulted. Chinese GDP rose from $263 billion in 1979 to $404 billion in 1990, $1.2 trillion in 2000, and over $7.2 trillion in 2011, an astounding twenty-seven-fold increase in just over thirty years. Total Chinese economic output now stands at about half the size of the U.S. economy. This high Chinese growth rate has led to numerous extrapolations and estimates of a date in the not-so-distant future when the Chinese economy will surpass that of the United States in total output. At that point, say the prognosticators, China will resume its role in the first rank of global powers, a position it held in the long-ago days of the Ming Dynasty.

  Extrapolation is seldom a good guide to the future, and these predictions may prove premature. Close examination of the economic growth process from a low base shows that such growth is not a miracle at all. If reasonable policies of the kind used in Singapore and Japan had substituted for the chaos of the Cultural Revolution, high growth could have happened decades sooner. Today the same analytic scrutiny raises doubts about China’s ability to continue to grow at the torrid pace of recent years.

  Dynamic processes such as economic growth are subject to abrupt changes, for better or worse, based on the utilization or exhaustion of factors of production. This was pointed out in a classic 1994 article by Princeton professor Paul Krugman called “The Myth of Asia’s Miracle.” This article was widely criticized upon publication for predicting a slowdown in Chinese growth, but it has proved prophetic.

  Krugman began with the basic point that growth in any economy is the result of increases in labor force participation and productivity. If an economy has a stagnant labor force operating at a constant level of productivity, it will have constant output but no growth. The main drive
rs of labor force expansion are demographics and education, while the main drivers of productivity are capital and technology. Without those factor inputs, an economy cannot expand. But when those factor inputs are available in abundance, rapid growth is well within reach.

  By 1980, China was poised to absorb a massive influx of domestic labor and foreign capital, with predictably positive results. Such a transition requires training that starts with basic literacy and ultimately includes the development of technical and vocational skills. The fact that China had over half a billion peasants in 1980 did not necessarily mean that those peasants could turn into factory workers overnight. The transition also requires housing and transportation infrastructure. This takes time, but by 1980 the process had begun.

  As labor flowed into the cities in the 1980s and 1990s, capital was mobilized to facilitate labor productivity. This capital came from private foreign investment, multilateral institutions such as the World Bank, and China’s domestic savings. Finance capital was quickly converted into plant, equipment, and infrastructure needed to leverage the expanding labor pool.

  As Krugman points out, this labor-capital factor input model is a two-edged sword. When the factors are plentiful, growth can be high, but what happens when the factors are in scarce supply? Krugman answers with the obvious conclusion—as labor and capital inputs slow down, growth will do the same. While Krugman’s analysis is well known to scholars and policy makers, it is less known to Wall Street cheerleaders and the media. Those extrapolating high growth far into the future are ignoring the inevitable decline in factor inputs.

  For example, five factory workers assembling goods by hand will result in a certain output level. If five peasants then arrive from the countryside and join the existing factory labor force using the same hand assembly technique, then output will double since there are twice as many workers performing the same task. Now assume the factory owner acquires machines that replace hand assembly with automated assembly, then trains his workers to use the machines. If each machine doubles output versus hand assembly, and every worker gets one machine, output will double again. In this example, factory output has increased 400 percent, first by doubling the labor force, then by automating the process. As Krugman explains, this is not a “miracle.” It is a straightforward process of expanding labor and productivity.

  This process does have limits. Eventually, new workers will stop arriving from the countryside, and even if workers are available, there may be physical or financial constraints on the ability to utilize capital. Once every worker has a machine, additional machines do not increase output if workers can use only one at a time. Economic development is more complex than this example suggests, and many other forces affect the growth path. But the fundamental paradigm, that fewer inputs equals lower growth, is inescapable.

  China is now nearing this point. This does not mean growth will cease, merely that it will decelerate to a sustainable level. China has put itself in this position because of its one-child-per-family policy adopted in 1978, enforced until recently with abortion and the murder of millions of girls. That drop in population growth beginning thirty-five years ago is affecting the adult workforce composition today. The results are summarized in a recent report produced by the IMF:

  China is on the eve of a demographic shift that will have profound consequences on its economic and social landscape. Within a few years the working age population will reach a historical peak, and will then begin a precipitous decline. The core of this working age population, those aged 20–39 years, has already begun to shrink. With this, the vast supply of low-cost workers—a core engine of China’s growth model—will dissipate, with potentially far-reaching implications domestically and externally.

  Importantly, when labor force participation levels off, technology is the only driver of growth. The United States also faces demographic headwinds due to declining birth rates, but it is still able to expand the labor force 1.5 percent per year, partly through immigration, and it retains the potential to grow even faster through its technological prowess. In contrast, China has not proved adept at inventing new technologies despite its success at stealing existing ones. The twin engines of growth—labor and technology—are both beginning to stall in China.

  Still, official statistics show China growing in excess of 7 percent per year, a growth rate that advanced economies can only watch with envy. How can these sky-high growth rates be reconciled with the decline of labor and capital factor inputs that Krugman predicted almost twenty years ago? To answer this, one must consider not only the factor inputs but the composition of growth. As defined by economists, GDP consists of consumption, investment, government spending, and net exports. Growth in any or all of those components contributes to growth in the economy. How does China appear to increase these components when the factor inputs are leveling off? It does so with leverage, debt, and a dose of fraud.

  To understand how, consider the composition of China’s GDP compared with those of developed economies such as the United States. In the United States, consumption typically makes up 71 percent of GDP, while in China, the consumption component is 35 percent, less than half the United States’. Conversely, investment typically makes up 13 percent of U.S. GDP, while in China investment is an enormous 48 percent of the total. Net exports are about 4 percent of the economy in the United States and China, except the signs are reversed. China has a trade surplus that adds 4 percent to GDP, while the United States has a trade deficit that subtracts 4 percent from GDP. In concise terms, the U.S. economy is driven by consumption, and the Chinese economy is driven by investment.

  Investment can be a healthy way to grow an economy since it has a double payoff. GDP grows when the investment is first made, then grows again from the added productivity that the original investment provides in future years. Still, this kind of investment-led expansion is not automatic. Much depends on the quality of the investment: whether it in fact adds to productivity or whether it is wasted—so-called malinvestment. Evidence from recent years is that China’s infrastructure investment involves massive waste. Even worse, this investment has been financed with unpayable debt. This confluence of wasted capital and looming bad debt makes the Chinese economy a bubble about to burst.

  ■ The Investment Trap

  The recent history of Chinese malinvestment marks a new chapter in the repeated decline of Chinese civilization. This new story revolves around the rise of a Chinese warlord caste, financial not military in kind, that acts in its own self-interest rather than in China’s interest. The new financial warlords operate through bribery, corruption, and coercion. They are a cancer on the Chinese growth model and the so-called Chinese miracle.

  After the 1949 Communist takeover of China, all businesses were owned and operated by the state. This model prevailed for thirty years, until Deng Xiaoping’s economic reforms began in 1979. In the decades that followed, state-owned enterprises (SOEs) took one of three paths. Some were closed or merged into larger SOEs to achieve efficiencies. Certain SOEs were privatized and became listed companies, while those remaining as SOEs grew powerful as designated “national champions” in particular sectors.

  Among the best known of these super-SOEs are the China State Shipbuilding Corporation, the China National Petroleum Corporation, the China Petrochemical Corporation (SINOPEC), and China Telecom. There are more than one hundred such giant government-owned corporations in China under centralized state administration. In 2010 the ten most profitable SOEs produced over $50 billion in net profits. The super-SOEs are further organized into sixteen megaprojects intended to advance technology and innovation in China. These megaprojects cover sectors such as broadband wireless, oil and gas exploration, and large aircraft manufacture.

  Regardless of the path taken by state enterprise, corruption and cronyism permeated the process. Managers of SOEs that were privatized received sweetheart deals, including share allocations ahead of t
he public listing, and executive appointments in the privatized entity. For the enterprises that remained as SOEs, opportunities for corruption were even more direct. Board members and executive officers were political appointees, and the SOEs were protected against foreign and domestic competition. SOEs received cheap financing from government-owned banks and got orders for goods and services from government agencies as well as other SOEs. The result was a dense, complex network of government officials, Communist Party princelings, and private owner-managers, all being enriched by Chinese growth. The elites became a parasite class gorging themselves at the expense of an otherwise healthy and normal growth process.

  The rise of a parasitic elite is closely linked to the prevalence of malinvestment. The need for the Chinese economy to rebalance from investment to consumption, as urged by the IMF and other official institutions, has run headlong into the self-interest of the elites who favor infrastructure because it keeps the profits flowing at their steel, aluminum, and other heavy industrial enterprises. The new financial warlords are addicted to the profits of infrastructure, even as economists lament the lack of growth in services and consumption. The fact that this problem is recognized does not mean that it will be managed well. As in all societies, including the United States, elite interests can prevail over national interests once elite political power is entrenched.

  Specific examples of infrastructure projects illustrate the waste. Nanjing is one of the largest cities in China, with a population approaching seven million. It is also one of the most historically significant cities, having served as China’s capital under several dynasties as well as capital of the Taipei Rebellion’s Heavenly Kingdom. More recently, Nanjing was the seat of government, intermittently from 1912 to 1949, during the Chinese Republic of Dr. Sun Yat-sen and later Chiang Kai-shek.