THE BEAR'S LAIR China points to Weimar exit
By Martin Hutchinson
I have written in the past that while Keynesian stimulus spending made no sense
whatever for Western countries whose budgets were substantially in deficit
before the 2008-09 recession began, it was more justifiable in China, with a
substantial budget surplus at the start of the recession. However it now
appears I was wrong.
Far from rescuing their economy by Keynesian stimulus, the Chinese regime
overdid it, even by the most demented Keynesian standards. Rather than
financing spending directly, they encouraged the state-owned banks to go on a
lending spree. The result was an astonishing surge in bank lending, 42% of
gross domestic product (GDP) in 2009 and 2010 and 37% in 2011, around US$2.8
The result has also been galloping inflation and a banking system now truly
close to collapse. Mao Zedong tried for 30 to destroy
the entrepreneurial Chinese economy; where he failed, John Maynard Keynes may
have succeeded from the grave.
Keynesians will object that their recommendation in times of recession was for
heavy doses of government spending, not bank loans. However that won't wash.
When the great majority of the banking system is controlled by the government,
and a high proportion of the loans is going to infrastructure projects
sponsored by government departments, government-owned companies and local
governments, it's absurd to claim this to have been something other than
classic Keynesian stimulus.
The only difference is in the financing, which was less directly inflationary
than the Weimar/Keynes approach of printing the money, but more damaging to
what remains of the Chinese banking system.
The projects financed by the stimulus were the usual mix of the moderately
useful, the thoroughly corrupt and the staggeringly inappropriate that you'd
expect from recession-driven stimulus. China has the enormous advantage over
the United States that it treats environmentalists with the contempt that they
While this produces some environmental monstrosities like the Three Gorges
hydroelectric dam, it allows China to construct infrastructure at a staggering
speed and with great efficiency. Thus while the United States got very little
for its US$800 billion of stimulus, China has got a gleaming new high-speed
rail service (albeit with corruption and shoddy construction making it pretty
life-threatening to ride on) lots of new toll roads that few people use and
some entirely empty but very impressive office complexes.
As with other Keynesian stimulus, the problem here is one of malinvestment, in
the Austrian economic sense. The high-speed railroad is probably not worth what
it cost, but certainly has some substantial economic value. The roads have less
economic value because their tolls are so high that it may well be a decade
before China's people can afford to use them. The empty office complexes will
in some case have value, giving room for expansion as Chinese economic growth
continues, but in other cases will have been built in the wrong place or to the
Midtown Manhattan's Empire State Building, completed in 1931, stood largely
empty for a decade, but eventually paid off well for its long-suffering
investors as the local economy soared. Detroit's Renaissance Center, completed
in the much more benign economic environment of 1977, has been a boondoggle
ever since it was opened, in the middle of blighted downtown Detroit. In
China's case, since much of the investment was wasted, either partially or
totally, it can be expected to drag on the economy for many years to come.
Officially, China's consumer price index rose at only a 6.3% annual rate in the
third quarter. That's slightly below the People's Bank of China benchmark
interest rate of 6.56% - which appears to indicate a monetary policy that by
recent US interest rates is positively restrained.
However, two factors suggest this apparent moderation is an illusion. First,
the "free market" interbank interest rate is far below the People's Bank of
China policy rate, at an average of 1.62% in August, while even the one-year
deposit rate is only 3%. Second, the GDP deflator, a more accurate (because
more complex and difficult to fudge) measure of inflation than the CPI, rose by
10.3% in the third quarter. The two figures taken together suggest a real
interest rate close to minus 9%, equivalent to that prevailing in Dubai in
early 2008, before its real-estate bubble burst.
You'd think that, with China's third-quarter growth rate still 9.1% and
inflation a real threat, the Chinese authorities would be tightening monetary
policy, at least gradually. Not a bit of it. Premier Wen Jiabao on October 25
warned against tightening credit conditions, urged credit support for small
companies and suggested that price controls should be used to control
Make no mistake, the forces leading to a Chinese crash are strong. If we assume
that around half of the bank credits extended in the last three years are
economically justified arms-length deals, a generous assumption, then the
excess extension of credit has been around $1.4 trillion annually, 21% of GDP
in 2009 and 2010, dropping to 18.5% of GDP in 2011.
Thus, through bank-directed financing, China has been running as big an
effective budget deficit in cash terms as in the United States, which has an
economy more than double the size. Greece has not got close to a budget deficit
of 20% of GDP, and the United States only did so in 1944, in the depths of
World War II. Like everything else in China, their Keynesian stimulus has been
much bigger - and looks likely to have correspondingly more adverse long-term
Chinese policy errors may be exacerbated by trade considerations. With true
inflation at least 10% and the yuan up over 5% against the dollar in the last
year, even legendary Chinese productivity increases may be stretched to remain
competitive. A Boston Consulting Group study recently suggested that several of
the sectors which the US has "outsourced" to China in recent years may return
to the United States, as China is becoming uncompetitive.
Even more dangerous for the Middle Kingdom is competition from Vietnam, India
and even parts of Africa, as the collapse in barriers due to globalization
spreads global sourcing further into the world's impoverished hinterlands.
China's trade surplus in the first nine months of 2011 fell 10.6% from a year
earlier to only $106 billion - less than 3% of China's GDP. Since exports still
represent 38% of China's GDP, a swing into substantial deficit seems likely.
Faced by a trade deficit and a gigantic bad debts problem in its banking
system, China is likely once again to attempt financial repression - keeping
deposit rates far below inflation while lending rates remain high, thereby
allowing the banks to recapitalize themselves through jumbo profits on new
Britain took the same approach in the 1950s and 1960s, keeping interest rates
low and inflation relatively high (albeit suppressed from time to time by price
controls) thereby successfully working down the massive World War II debt at
the cost of impoverishing savers who, like my Great Aunt Nan, unwisely invested
their life savings in supposedly risk-free government bonds.
Like Britain in 1945-79, China has tight exchange controls that allow her to
oppress her citizens in this way. Foreign governments that were truly concerned
with the Chinese government's oppression of its people would demand that these
controls be lifted forthwith, thus both remedying a major human rights abuse
and forcing the government to face up to the banking system's current
This is unlikely, and judging by Wen Jiabao's remarks China has no intention of
tackling its inflation problem anytime soon, other than by draconian government
controls that will further destabilize the economy. It's possible that this
will lead to depression but more likely, given the Chinese penchant for rapid
money creation (M2 money supply was up 19.2% in the year to August) that the
increasing distortions in the economy will cause inflation to accelerate from a
trot into a wild gallop.
There's a precedent for China's current approach, with a mass of controls and
rampant money printing to disguise a yawning budget deficit - and it's Weimar
Germany in 1919-23. That ended in 1 trillion percent inflation and economic
collapse. It also wiped out the savings of the middle classes (something very
likely under China's current policies) and thereby led to the rise of Adolf
Hitler a decade later.
Sixty-five years after his death, Maynard Keynes has a lot to answer for. Not
only are the failed stimulus policies, massive deficits and renewed economic
crisis due largely to misguided application of his theories, but so also are
the monetary errors, in China and throughout the world, derived at least in
part from his ignorance and insouciance about the effect of interest rates.
However China's government, faced with not even a recession but simply a
slowdown in activity caused by external factors, appears to have applied
Keynesian theories with unprecedented vigor, such that even those on the left
who bemoan the inadequacy of the 2009-10 US stimulus should be satisfied.
Regrettably, if China descends into Weimar inflation and their response is
international aggression, the rest of us will have to pay the price.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found on the website www.greatconservatives.com -
and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley,
2010). Both are now available on Amazon.com, Great Conservatives only in
a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com.
Copyright 2005-11 David W Tice & Associates.)