China’s Continuing Credit Expansion is Starting to Worry the IMF

Posted by PITHOCRATES - September 15th, 2013

Week in Review

As the U.S. fiscal year draws to a close the Republicans and Democrats are digging in their heels over the upcoming debt ceiling debate.  The Republicans want to cut spending and taxes to rein in out-of-control spending.  So they don’t have to keep borrowing money.  Running up the national debt.  The Democrats, on the other hand, say, “Who cares about the debt?  We’ll be dead and buried when the nation collapses under the weight of this mammoth debt load.  As long as we get what we want why should we care about future generations?”  At least, that’s what their actions say.

A lot of leading economists on the left, Keynesians economists, see no problem in running up the debt.  Print that money, they say.  Keep that expansion growing.  What could possibly go wrong?  Especially when the federal government has the power to print money?  Just look at what the Japanese did in the Eighties.  And what the Chinese are doing now (see As the West Faltered, China’s Growth Was Fueled by Debt by Christina Larson posted 9/12/2013 on Bloomberg Businessweek).

As demand for Chinese exports diminished in the wake of the financial meltdown, the Chinese economy kept humming at more than 9 percent annual gross domestic product growth each year from 2008 to 2011. The trick? “A huge monetary expansion and lending boom,” says Patrick Chovanec, chief strategist at Silvercrest Asset Management and a former professor at Tsinghua University’s School of Economics and Management in Beijing. With bank lending restrictions loosened in late 2008, “Total debt accelerated from 148 percent to 205 percent of GDP over 2008-12,” according to a May 2013 report from research firm CLSA Asia-Pacific Markets. When Beijing tried to rein in the banks beginning in late 2010, shadow banking—lending outside the formal sector—exploded. Today “China is addicted to debt to fuel growth,” according to the CLSA report, with the economy hampered by “high debt and huge excess capacity with only 60 percent utilization.”

The Beijing-based firm J. Capital Research dubbed 2012 the “Year of the (White) Elephant” in a report detailing some of China’s questionable infrastructure build-out. To take one example, 70 percent of the country’s airports lose money, yet more are being built in small and remote cities. At the shiny new Karamay Airport in far western Xinjiang province, there are four check-in counters serving two flights daily. Local governments have splurged on “new towns” and “special zones,” many of which have already fallen into disrepair. The $5 million Changchun Zhenzhuxi Park, intended as a scenic area, is now a large public garbage dump, as the local landscaping bureau never agreed to provide maintenance. Near the southern city of Hangzhou, a forlorn replica of the Eiffel Tower overlooks a faux Paris—the ersatz arrondissement attracted hardly any residents, and local media have dubbed it a ghost town.

“In China, you often hear people say they’re building for the future,” explains Chovanec. “But if you build something and it’s empty for 20 years, does that make any sense? By that point, it may already be falling apart.”

The classic Keynesian argument for economic stimulus is the one about paying people to dig a ditch.  Then paying them to fill in the ditch they just dug.  The ditch itself having no economic value.  But the people digging it and filling it in do.  For they will take their earnings and spend it in the economy.  But the fallacy of this argument is that money given to the ditch-diggers and the fillers-in could have been spent on something else that does have economic value.  Money that was pulled out of the private sector economy via taxation.  Or money that was borrowed adding to the national debt.  And increasing the interest expense of the nation.  Which negates any stimulus.

If that money was invested to expand a business that was struggling to keep up with demand that money would have created a return on investment.  That would last long after the people who built the expansion spent their wages.  This is why Keynesian stimulus doesn’t work.  It is at best temporary.  While the long-term costs are not.  It’s like getting a 30-year loan to by a new car.  If you finance $35,000 over 5 years at a 4.5% annual interest rate your car payment will be $652.51 and the total interest you’ll pay will be $4,018.95.  That’s $39,018.95 ($35,000 + 4,018.95) of other stuff you won’t be able to buy because of buying this car.  If you extend that loan to 30 years your car payment will fall to $177.34.  But you will be paying that for 30 years.  Perhaps 20-25 years longer than you will actually use that car.  Worse, the total interest expense will be $23,620.24 over those 30 years.  That’s $58,620.24 ($35,000 + 23,620.24) of stuff you won’t be able to buy because of buying this car.  Increasing the total cost of that car by 50.2%.

This is why Keynesian stimulus does not work.  Building stuff just to build stuff even when that stuff isn’t needed will have long-term costs beyond any stimulus it provides.  And when you have a “high debt and huge excess capacity with only 60 percent utilization” bad things will be coming (see IMF WARNS: China Is Taking Ever Greater Risks And Putting The Financial System In Danger by Ambrose Evans-Pritchard, The Telegraph, posted 9/13/2013 on Business Insider).

The International Monetary Fund has warned that China is taking ever greater risks as surging credit endangers the financial system, and called for far-reaching reforms to wean the economy off excess investment…

The country has relied on loan growth to keep the economy firing on all cylinders but the law of diminishing returns has set in, with the each yuan of extra debt yielding just 0.20 yuan of economic growth, compared with 0.85 five years ago. Credit of all types has risen from $9 trillion to $23 trillion in five years, pushing the total to 200pc of GDP, much higher than in emerging market peers…

China’s investment rate is the world’s highest at almost 50pc of GDP, an effect largely caused by the structure of the state behemoths that gobble up credit. This has led to massive over-capacity and wastage.

“Existing distortions direct the flow of credit toward local governments and state-owned enterprises rather to households, perpetuating high investment, misallocation of resources, and low private consumption. A broad package of reforms is needed,” said the IMF.

Just like the miracle of Japan Inc. couldn’t last neither will China Inc. last.  Japan Inc. put Japan into a deflationary spiral in the Nineties that hasn’t quite yet ended.  Chances are that China’s deflationary spiral will be worse.  Which is what happens after every Keynesian credit expansion.  And the greater the credit expansion the more painful the contraction.  And with half of all Chinese spending being government spending financed by printing money the Chinese contraction promises to be a spectacular one.  And with them being a primary holder of US treasury debt their problems will ricochet through the world economy.  Hence the IMF warning.

Bad things are coming thanks to Keynesian economics.  Governments should have learned by now.  As Keynesian economics turned a recession into the Great Depression.  It gave us stagflation and misery in the Seventies.  It gave the Japanese their Lost Decade (though that decade actually was closer 2-3 decades).  It caused Greece’s economic collapse.  The Eurozone crisis.  And gave the U.S. record deficits and debt under President Obama.

The history is replete with examples of Keynesian failures.  But governments refuse to learn these lessons of history.  Why?  Because Keynesian economics empowers the growth of Big Government.  Something free market capitalism just won’t do.  Which is why communists (China), socialists (the European social democracies) and liberal Democrats (in the United States) all embrace Keynesian economics and relentlessly attack free market capitalism as corrupt and unfair.  Despite people enjoying the greatest liberty and economic prosperity under free market capitalism (Great Britain, the United States, Canada, Australia, Hong Kong, Taiwan, South Korea, etc.).  While suffering the most oppression and poverty under communism and socialism (Nazi Germany, the Soviet Union, the communist countries behind the Iron Curtain in Eastern Europe, the People’s Republic of China under Mao, North Korea, Cuba, etc.).

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GDP Growth, Recession, Depression and Recovery

Posted by PITHOCRATES - March 18th, 2013

Economics 101

Gross Domestic Product is basically Consumer Spending and Government Spending

In the 1980 presidential campaign Ronald Reagan said, “A recession is when your neighbor loses his job.  A depression is when you lose yours.  And a recovery is when Jimmy Carter loses his.”  A powerful statement.  And one that proved to be pretty much true.  But don’t look for these definitions in an economics textbook.  For though they connect well to us the actual definitions are a little more complex.  And a bit abstract.

There is a natural ebb and flow to the economy.  We call it the business cycle.  There are good economic times with unemployment falling.  And there are bad economic times with unemployment rising.  The economy expands.  And the economy contracts.  The contraction side of the business cycle is a recession.  And it runs from the peak of the expansion to the trough of the contraction.  A depression is basically a recession that is really, really bad.

But even these definitions are vague.  Because getting an accurate measurement on economic growth isn’t that easy.  There’s gross domestic product (GDP).  Which is the sum total of final goods and services.  Basically consumer spending and government spending.  Which is why the government’s economists (Keynesians) and those in the Democrat Party always say cutting government spending will hurt the economy.  By reducing GDP.  But GDP is not the best measurement of economic activity.

Even though Retail Sales may be Doing Well everyone up the Production Chain may not be Expanding Production

One problem with GDP is that the government is constantly revising the numbers.  So GDP doesn’t really provide real-time feedback on economic activity.  The organization that defines the start and end points of recessions is the National Bureau of Economic Research (NBER).  And they often do so AFTER the end of a recession.  One metric they use is GDP growth.  If it’s negative for two consecutive quarters they call it a recession.  But if there is a significant decline in economic activity that lasts a few months or more they may call that a recession, too.  Even if there aren’t two consecutive quarters of negative GDP growth.  If GDP falls by 10% they’ll call that a depression.

There’s another problem with using GDP data.  It’s incomplete.  It only looks at consumer spending.  It doesn’t count any of the upper stages of
production.  The wholesale stage.  The manufacturing stage.  And the raw commodities stage.  Where the actual bulk of economic activity takes place.  In these upper stages.  Which Keynesian economists ignore.  For they only look at aggregate consumer spending.  Which they try to manipulate with interest rates.  And increasing the money supply.  To encourage more consumer spending.  But there is a problem with Keynesian economics.  It doesn’t work.

When economic activity slows Keynesian economic policies say the government should increase spending to pick up the slack.  So they expand the money supply.  Lower interest rates.  And spend money.  Putting more money into the hands of consumers.  So they can go out and spend that money.  Thus stimulating economic activity.  But expanding the money supply creates inflation.  Which raises prices.  So consumers may be spending that stimulus money but those businesses in the higher stages of production know what’s coming.  Higher prices.  Which means people will soon be buying less.  And they know once these people spend their stimulus money it will be gone.  As will all that stimulated activity.  So even though retail sales may be doing well everyone up the production chain may not be expanding production.  Instead, wholesalers will draw down their inventories.  And not replace them.  So they will buy less from manufacturers.  Who will buy fewer raw commodities.

The continually falling Labor Force Participation Rate suggests the 2007-2009 Recession hasn’t Ended

So retail sales could be doing well during an economic contraction.  For awhile.  But everything above retail sales will already be hunkering down for the coming recession.  Cutting production.  And laying off people. Making unemployment another metric to measure a recession by.  If the unemployment rate rose by, say, 1.5 points during a given period of time the economy may be in a recession.  But there is a problem with using the unemployment rate.  The official unemployment rate (the U-3 number) doesn’t count everyone who can’t find a full-time job.

U-3 only counts those people who are looking for work.  They don’t count those who take a lower-paying part-time job because they can’t find a full-time job.  And they don’t count people who give up looking for work because there just isn’t anything out there.  Getting by on their savings.  Their spouse’s income.  Even cashing in their 401(k).  People doing this are an indication of a horrible economy.  And probably a pretty bad recession.  But they don’t count them.  Making the U-3 unemployment rate understate the true unemployment.  A better metric is the labor force participation rate.  The percentage of those who are able to work who are actually working.  A falling unemployment rate is good.  But if that happens at the same time the labor force participation rate is falling the economy is still probably in recession.  Despite the falling unemployment rate.

The NBER sifts through a lot of data to decide whether the economy is in recession or not.  Do politics enter their decision-making process?  Perhaps.  For they said the 2007-2009 recession ended in 2009.  The U-3 unemployment rate had fallen.  And GDP growth returned to positive territory.  But the labor force participation rate continued to fall.  Meaning people were disappearing from the labor force.  Indicating that the 2007-2009 recession hasn’t really ended.  In fact, one could even say that we have been in a depression.  For not only did a lot of our neighbors lose their jobs.  A lot of us lost our jobs, too.  And because the president who presided over the worst economic recovery since the Great Depression didn’t lose his job in 2012, there has been no recovery.  So given our current economic picture the best metric to use appears to be what Ronald Reagan told us in 1980.  Which means things aren’t going to get better any time soon.

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Recession and Depression

Posted by PITHOCRATES - June 25th, 2012

Economics 101

A Depression is an Exceptionally Bad Recession 

When campaigning for the presidency Ronald Reagan explained what a recession, a depression and a recovery were.  He said a recession is when your neighbor loses his job.  A depression is when you lose your job.  And a recovery is when Jimmy Carter loses his job.  This was during the 1980 presidential election.  Where Reagan included that famous question at the end of one of the debates.  “Are you better off now than you were four years ago?”  And the answer was “no.”  Ronald Reagan surged ahead of Jimmy Carter after that and won by a landslide.  And he won reelection by an even bigger landslide in 1984.

There are a couple of ways to define a recession.  Falling output and rising unemployment.  Two consecutive quarters of falling Gross Domestic Product (GDP).  A decline in new factory orders.  The National Bureau of Economic Research (NBER) in Cambridge, Massachusetts, officially marks the start and end dates of all U.S. recessions.  They consider a lot of economic data.   It’s not an exact science.  But they track the business cycle.  That normal economic cycle between economic expansion and economic contraction.  The business cycle has peaks (expansion) and troughs (contraction).  A recession is the time period between a peak and a trough.  From the time everyone is working and happy and buying a lot of stuff.  Through a period of layoffs where people stop buying much of anything.  Until the last layoff before the next economic expansion begins.

A depression has an even more vague science behind it.  We really don’t have a set of requirements that the economy has to meet to tell us we’re in a depression.  Since the Great Depression we haven’t really used the word anymore for a depression is just thought of as an exceptionally bad recession.  Some have called the current recession (kicked off by the subprime mortgage crisis) a depression.  Because it has a lot of the things the Great Depression had.  Bank failures.  Liquidity crises.  A long period of high unemployment.  In fact, current U.S unemployment is close to Great Depression unemployment if you measure more apples to apples and use the U-6 rate instead of the official U-3 rate that subtracts a lot of people from the equation (people who can’t find work and have given up looking, people working part-time because they can’t find a full-time job, people underemployed working well below their skill level, etc.).  For these reasons many call the current recession the Great Recession.  To connect it to the Great Depression.  Without calling the current recession a depression.

Whether Inventories sell or not Businesses have to Pay their People and their Payroll Taxes

So what causes a recession?  Good economic times.  Funny, isn’t it?  It’s the good times that cause the bad times.  Here’s how.  When everyone has a job who wants a job a lot of people are spending money in the economy.  Creating a lot of economic activity.  Businesses respond to this.  They increase production.  Even boost the inventories they carry so they don’t miss out on these good times.  For the last thing a business wants is to run out of their hot selling merchandise when people are buying like there is no tomorrow.  Businesses will ramp up production.  Add overtime such as running production an extra day of the week.  Perhaps extend the working day.  Businesses will do everything to max out their production with their current labor force.  Because expanding that labor force will cause big problems when the bloom is off of the economic rose.

But if the economic good times look like they will last businesses will hire new workers.  Driving up labor costs as businesses have to pay more to hire workers in a tight labor market.  These new workers will work a second shift.  A third shift.  They will fill a manufacturing plant expansion.  Or fill a new plant.  (Built by a booming construction industry.  Just as construction workers are building new houses in a booming home industry.)  Businesses will make these costly investments to meet the booming demand during an economic expansion.  Increasing their costs.  Which increases their prices.  And as businesses do this throughout the economy they begin to produce even more than the people are buying.  Inventories begin to build up until inventories are growing faster than sales.  The business cycle has peaked.  And the economic decline begins.

Inventories are costly.  They produce no revenue.  But incur cost to warehouse them.  Worse, businesses spent a lot of money producing these inventories.  Or I should say credit.  Typically manufacturers buy things and pay for them later.  Their accounts payable.  Which are someone else’s accounts receivable.  A lot of bills coming due.  And a lot of invoices going past due.  Because businesses have their money tied up in those inventories.  But one thing they can’t owe money on is payroll.  Whether those inventories sell or not they have to pay their people on time or face some harsh legal penalties.  And they have to pay their payroll taxes (Social Security, Medicare, unemployment insurance, withholding taxes, etc.) for the same reasons.  As well as their Workers’ Compensation insurance.  And they have to pay their health care insurance.  Labor is costly.  And there is no flexibility in paying it while you’re waiting for that inventory to sell.  This is why businesses are reluctant to add new labor and only do so when there is no other way to keep up with demand.

The Fed tries to Remove the Recessionary Side of the Business Cycle with Small but ‘Manageable’ Inflation

As sales dry up businesses reduce their prices to unload that inventory.  To convert that inventory into cash so they can pay their bills.  At the same time they are cutting back on production.  With sales down they are only losing money by building up inventories of stuff no one is buying.  Which means layoffs.  They idle their third shifts.  Their second shifts.  Their overtime.  They shut down plants.  A lot of people lose jobs.  Sales fall.  And prices fall.  As businesses try to reduce their inventories.  And stay in business by enticing the fewer people in the market place to buy their reduced production at lower prices.

During the economic expansion costs increased.  Labor costs increased.  And prices increased.  Because demand was greater than supply.  Businesses incurred these higher costs to meet that demand.  During the contraction these had to fall.  Because supply exceeded demand.  Buyers could and did shop around for the lowest price.  Without fear of anything running out of stock and not being there to buy the next day.  Or the next week.  And when prices stop falling it marks the end of the recession and the beginning of the next expansion.  When supply equals demand once again.  Prices, then, are key to the business cycle.  They rise during boom times.  And fall during contractions.  And when they stop falling the recession is over.  This is so important that I will say it again.  When prices stop falling a recession is over.

Jimmy Carter had such a bad economy because his administration still followed Keynesian economic policies.  Which tried to massage the business cycle by removing the contraction side of it.  By using monetary policy.  The Keynesians believed that whenever the economy starts to go into recession all the government has to do is to print money and spend it.  And the government printed a lot of money in the Seventies.  So much that there was double digit inflation.  But all this new money did was raise prices during a recession.  Which only made the recession worse.  This was the turning point in Keynesian economics.  And the end of highly inflationary policies.  But not the end of inflationary policies.

The Federal Reserve (the Fed) still tries to remove the recessionary side of the business cycle.  And they still use monetary policy to do it.  With a smaller but ‘manageable’ amount of inflation.  During the great housing bubble that preceded the subprime mortgage crisis and the Great Recession the Fed kept expanding the money supply to keep interest rates very low.  This kept mortgage rates low.  People borrowed money and bought big houses.  Housing prices soared.  These artificially low interest rates created a huge housing bubble that eventually popped.  And because the prices were so high the recession would be a long one to bring them back down.  Which is why many call the current recession the Great Recession.  Because we haven’t seen a price deflation like this since the Great Depression.

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