Given the history of crashes and panics in both developed and emerging markets over the past thirty years, Chinese leaders may be overly sanguine about their ability to avoid a financial disaster. The sheer scale and interconnectedness of SOEs, banks, government, and citizen savers has created a complex system in the critical state, waiting for a spark to start a conflagration. Even if the leadership is correct in saying that these specific problems are manageable in relation to the whole, they must still confront the fact that the entire economy is unhealthy in ways that even the Communist Party cannot easily finesse. The larger issue for China’s leadership is the impossibility of rebalancing the economy from investment to consumption without a sharp decline in growth. This slowdown, in effect the feared hard landing, is an event for which neither the Communists nor the world at large is prepared.
Understanding the challenge of rebalancing requires taking another look at China’s infrastructure addiction. Evidence for overinvestment by China is not limited to anecdotes about colossal train stations and empty cities. The IMF conducted a rigorous analytic study of capital investment by China compared to a large sample of thirty-six developing economies, including fourteen in Asia. It concluded that investment in China is far too high and has come at the expense of household income and consumption, stating, “Investment in China may currently be around 10 percent of GDP higher than suggested by fundamentals.”
There is also no mystery about who is to blame for the dysfunction of overinvestment. The IMF study points directly at the state-controlled banks and SOEs, the corrupt system of crony lending and malinvestment that is visible all over China: “State-owned enterprises (SOEs) tend to be consistently implicated . . . because their implied cost of capital is artificially low. . . . China’s banking system continues to be biased toward them in terms of capital allocation.” State-controlled banks are funneling cheap money to state-owned enterprises that are wasting the money on overcapacity and the construction of ghost cities.
Even more disturbing is the fact that this infrastructure investment is not only wasteful, it is unsustainable. Each dollar of investment in China produces less in economic output than the dollar before, a case of diminishing marginal returns. If China wants to maintain its GDP growth rates in the years ahead, investment will eventually be well in excess of 60 percent of GDP. This trend is not a mere trade-off between consumption and investment. Households deferring consumption to support investment so that they may consume more later is a classic development model. But China’s current investment program is a dysfunctional version of the healthy investment model. The malinvestment in China is a deadweight loss to the economy, so there will be no consumption payoff down the road. China is destroying wealth with this model.
Households bear the cost of this malinvestment, since savers receive a below-market interest rate on their bank deposits so that SOEs can pay a below-market interest rate on their loans. The result is a wealth transfer from households to big business, estimated by the IMF to be 4 percent of GDP, equal to $300 billion per year. This is one reason for the extreme income inequality in China. So the Chinese economy is caught in a feedback loop. Elites insist on further investment, which produces low payoffs, while household income lags due to wealth transfers to those same elites. If GDP were reduced by the amount of malinvestment, the Chinese growth miracle would already be in a state of collapse.
Nevertheless, collapse is coming. Michael Pettis of Peking University has done an interesting piece of arithmetic based on the IMF’s infrastructure research. In the first instance, Pettis disputes the IMF estimate of 10 percent of GDP as the amount of Chinese overinvestment. He points out that the peer group of countries used by the IMF to gauge the correct level of investment may have overinvested themselves, so actual malinvestment by China is greater than 10 percent of GDP. Still, accepting the IMF conclusion that China needs to reduce investment by 10 percent of GDP, he writes:
Let us . . . give China five years to bring investment down to 40% of GDP from its current level of 50%. Chinese investment must grow at a much lower rate than GDP for this to happen. How much lower? . . . Investment has to grow by roughly 4.5 percentage points or more below the GDP growth rate for this condition to be met.
If Chinese GDP grows at 7%, in other words, Chinese investment must grow at 2.3%. If China grows at 5%, investment must grow at 0.4%. And if China grows at 3% . . . investment growth must actually contract by 1.5%. . . .
The conclusion should be obvious. . . . Any meaningful rebalancing in China’s extraordinary rate of overinvestment is only consistent with a very sharp reduction in the growth rate of investment, and perhaps even a contraction in investment growth.
The suggestion that China needs to rebalance its economy away from investment toward consumption is hardly news; both U.S. and Chinese policy makers have discussed this for years. The implication is that rebalancing means a slowdown in Chinese growth from the 7 percent annual rate it has experienced in recent years. But it may already be too late to accomplish the adjustment smoothly; China’s “rebalancing moment” may have come and gone.
Rebalancing requires a combination of higher household income and a lower savings rate. The resulting disposable income can then go into spending on goods and services. The contributors to higher income include higher interest rates to reward savers and higher wages for workers. But the flip side of higher interest rates and higher wages is lower corporate profits, which negatively impacts the Chinese oligarchs. These oligarchs apply political pressure to keep wages and interest rates low. In the past decade, the share of Chinese GDP attributable to wages has fallen from over 50 percent to 40 percent. This compares to a relatively constant rate in the United States of 55 percent. The consumption situation is even worse than the averages imply, because Chinese wages are skewed to high earners with a lower propensity to spend.
Another force, more powerful than financial warlords, is standing in the way of consumer spending. This drag on growth is demographic. Both younger workers and older retirees have a higher propensity to spend. It is workers in their middle years who maintain the highest savings rate in order to afford additional consumption later in life. The Chinese workforce is now dominated by that midcareer demographic. In effect, China is stuck with a high savings rate until 2030 or later for demographic reasons, independent of policy and the greed of the oligarchs.
Based on these demographics, the ideal moment for China to shift to a consumption-led growth model was the period 2002 to 2005. This was precisely the time when the productive stage of the investment-led model began to run out of steam, and a younger demographic favored higher spending. A combination of higher interest rates to reward savers, a higher exchange rate to encourage imports, and higher wages for factory workers to increase spending might have jump-started consumption and shifted resources away from wasted investment. Instead, oligarchs prevailed to press interest rates, exchange rates, and wages below their optimal levels. A natural demographic boost to consumption was thereby suppressed and squandered.
Even if China were to reverse policy today, which is highly doubtful, it faces an uphill climb because the population, on average, is now at an age that favors savings. No policy can change these demographics in the short run, so China’s weak consumption crisis is now locked in place.
Taking into account the components of GDP, China is seen to be nearing collapse on many fronts. Consumption suffers from low wages and high savings due to demographics. Exports suffer from a stronger Chinese yuan and from external efforts to weaken the dollar and the Japanese yen. Investment suffers from malinvestment and diminishing marginal returns. To the extent that the economy is temporarily propped up by high investment, this is a mirage built on shifting sands of bad debt. The value of much investment in China is as empty as the buildings it produces. Even the beneficiaries of this dysfunction—the financial warlords—are like rats abandoning a sinking ship through the medium
of capital flight.
China could respond to these dilemmas by raising interest rates and wages to boost household income, but these policies, while helping the people, would bankrupt many SOEs, and the financial warlords would steadfastly oppose them. The only other efficacious solution would be large-scale privatization, designed to unleash entrepreneurial energy and creativity. But this solution would be opposed not only by the warlords but by the Communist Party itself. Opposition to privatization is where the self-interest of the warlords and the Communists’ survival instincts converge.
Four percent growth may be the best that China can hope for going forward, and if the financial warlords have their way, the results will be much worse. Continued subsidies for malinvestment and wage suppression will exacerbate the twin crises of bad debt and income inequality, possibly igniting a financial panic leading to social unrest, even revolution. China’s reserves may not be enough to douse the flames of financial panic, since most of those reserves are in dollars and the Fed is determined to devalue the dollar through inflation. China’s reserves are being hollowed out by the Fed even as its economy is being hollowed out by the warlords. It is unclear if the Chinese growth miracle will end with a bang or with a whimper, but it will end nonetheless.
China is not the first civilization to ignore its own history. Centralization engenders complexity, and a densely connected web of reciprocal adaptations are the essence of complex systems. A small failure in any part quickly propagates through the whole, and there are no firebreaks or high peaks to stop the conflagration. While the Communist Party views centralization as a source of strength, it is the most pernicious form of weakness, because it blinds one to the coming collapse.
China has fallen prey to the new financial warlords, who loot savings with one hand and send the loot abroad with the other. The China growth story is not over, but it is heading for a fall. Worse yet, the ramifications will not be confined to China but will ripple around the world. This will come at a time when growth in the United States, Japan, and Europe is already anemic or in decline. As in the 1930s, the depression will go global, and there will be nowhere to hide.
CHAPTER 5
THE NEW GERMAN REICH
But there is another message I want to tell you. . . . The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
Mario Draghi
President of the European Central Bank
July 2012
If there is no crisis, Europe doesn’t move.
Wolfgang Schäuble
German minister of finance
December 2012
■ The First Reich
Those blithely predicting the breakup of Europe and the euro would do well to understand that we are witnessing the apotheosis of a project first begun twelve hundred years ago. A long view of history repeating itself reveals why the euro is the strongest currency in the world. Today the euro waits in the wings, one more threat to the hegemony of the dollar.
Europe has been united before: not all of it in the geographic sense, but enough to constitute a distinct European polity in contrast to a mere city, kingdom, or country in the area called Europe. That unity arose in Charlemagne’s Frankish Empire, the Frankenreich, near the turn of the ninth century. The similarities of Charlemagne’s empire to twenty-first-century Europe are striking and instructive to those, especially in the United States, who struggle to understand European dynamics today.
While many focus on the divisions, nationalities, and distinct cultures within Europe, a small group of leaders, supported by their citizens, continue the work of European unification begun in the ashes of the Second World War. “United in diversity” is the European Union’s official motto, and the word united is the theme most often overlooked by the critics and skeptics of a political project now in its eighth decade. Markets are powerful, but politics are more so, and this truth is slowly becoming more apparent on trading floors in London, New York, and Tokyo. Europe and its currency, the euro, despite their flaws and crises, are set to endure.
Charlemagne, a late eighth- and early ninth-century Christian successor to the Roman emperors, was the first emperor in the West following the fall of the Western Roman Empire in A.D. 476. The Roman Empire was not a true European empire but a Mediterranean one, although it extended from the Roman heartland to provinces in present-day Spain, France, and even England. Charlemagne was the first emperor to include parts of present-day Germany, the Netherlands, and the Czech Republic with the former Roman provinces and Italy, to form a unified entity along geographic lines that resemble modern western Europe. Charlemagne is called, by popes and laymen alike, pater Europae, the Father of Europe.
Charlemagne was more than a king and conqueror, although he was both. He prized literacy and scholarship as well as the arts, and he created a court at Aachen comprised of the finest minds of the early Middle Ages such as Saint Alcuin of York, considered “the most learned man anywhere” by Charlemagne’s contemporary and biographer, Einhard. The achievements of Charlemagne and his court in education, art, and architecture gave rise to what historians call the Carolingian Renaissance, a burst of light to end an extended dark age. Importantly, Charlemagne understood the significance of uniformity throughout his empire for ease of administration, communication, and commerce. He sponsored a Carolingian minuscule script that supplanted numerous forms of writing that had evolved in different parts of Europe, and he instituted administrative and military reforms designed to bind the diverse cultures he had conquered into a cohesive realm.
Charlemagne did not pursue his penchant for uniformity past the point necessary for stability. He advocated diversity if it aided his larger goals pertaining to education and religion. He promoted the use of vernacular Romance and German languages by priests, a practice later abandoned by the Catholic Church (and belatedly revived in 1965 by the Second Vatican Council). He accepted vassalage from conquered foes in lieu of destroying their cultures and institutions. In these respects, he embraced a policy the European Union today calls subsidiarity: the idea that uniform regulation should be applied only in areas where it is necessary to achieve efficiencies for the greater good; otherwise local custom and practice should prevail.
Charlemagne’s monetary reforms should seem quite familiar to the European Central Bank. The European monetary standard prior to Charlemagne was a gold sou, derived from solidus, a Byzantine Roman coin introduced by Emperor Constantine I in A.D. 312. Gold had been supplied to the Roman Empire since ancient times from sources near the Upper Nile and Anatolia. However, Islam’s rise in the seventh century, and losses in Italy to the Byzantine Empire, cut off trade routes between East and West. This resulted in a gold shortage and tight monetary conditions in Charlemagne’s western empire. He engaged in an early form of quantitative easing by switching to a silver standard, since silver was far more plentiful than gold in the West. He also created a single currency, the livre carolinienne, equal to a pound of silver, as a measure of weight and money, and the coin of the realm was the denire, equal to one-twentieth of a sou. With the increased money supply and standardized coinage, along with other reforms, trade and commerce thrived in the Frankish Empire.
Charlemagne’s empire lasted only seventy-four years beyond his death in A.D. 814. The empire was initially divided into three parts, each granted to one of Charlemagne’s sons, but a combination of early deaths, illegitimate heirs, fraternal wars, and failed diplomacy led to the empire’s long decline and final dissolution in 887. Still, the political foundations for modern France and Germany had been laid. The Frankenreich’s legacy lived on until it took a new form with the creation of the Holy Roman Empire and the coronation of Otto I as emperor in 962. That empire, the First Reich, lasted over eight centuries, until it was dissolved by Napoleon in 1806. By reviving Roman political unity and advancing arts and sciences, Charlemagne and his realm were the most importa
nt bridge between ancient Rome and modern Europe.
Notwithstanding the institutions of the Holy Roman Empire, the millennium after Charlemagne can be seen largely as a chronicle of looting, war, and conquest set against a background of intermittent ethnic and religious slaughter. The centuries from 900 to 1100 were punctuated by raids and invasions led by Vikings and their Norman descendants. The period 1100 to 1300 was dominated by the Crusades abroad and knightly combat at home. The fourteenth century saw the Black Death, which killed from one-third to one-half the population of Europe. The epoch starting with the Counter-Reformation in 1545 was especially bloody. Doctrinal conflicts between Protestants and Catholics turned violent in the French Wars of Religion from 1562 to 1598, then culminated in the Thirty Years’ War from 1618 to 1648, a Europe-wide, early modern example of total war, in which civilian populations and nonmilitary targets were destroyed along with armies.
The sheer suffering and inhumanity of these latter centuries is captured in this description of the siege of Sancerre in 1572. Sancerre’s starving population successively ate their donkeys, mules, horses, cats, and dogs. Then the sancerrois consumed leather, hides, and parchment documents. Lauro Martines, citing the contemporary writer, Jean de Léry, describes what came next:
The final step was cannibalism. . . . Léry . . . then says the people of Sancerre “saw this prodigious . . . crime committed within their walls. For on July 21st, it was discovered and confirmed that a grape-grower named Simon Potard, Eugene his wife and an old woman who lived with them . . . had eaten the head, brains, liver, and innards of their daughter aged about three.”
The Death of Money Page 13
