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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Can’t see the Fiscal Forest for the Monetary Trees

Posted by PITHOCRATES - June 24th, 2011

He won’t Drill but he will Draw from the Strategic Reserve

The Great Recession lingers on.  As high oil prices hit consumers hard.  Gas prices are back to $4/gallon territory.  Leaving consumers with less disposable income.  Home values are declining in a deflationary spiral.  Wages are stagnant.  Unemployment is high.  And there’s inflation in food and consumer goods.  All driven by the high price of oil.  And all that quantitative easing (QE) that has depreciated the U.S. dollar (which we buy and sell oil with in the global market).

The demand for oil is soaring.  And yet President Obama put a moratorium on drilling in the Gulf of Mexico.  In fact, the U.S. isn’t drilling anywhere.  Which has forced the U.S. to import more foreign oil.  Because of this squeeze on supply.  Economics 101 tells you when demand increases supply should increase to meet that growing demand.  When it doesn’t, prices rise.  Like they are.  And the QE just compounded that problem.  When the dollar is worth less it takes more of them to buy the same amount of oil it used to.  Which means higher prices at the pump.  From demand outpacing supply.  And a weaker dollar.

The president’s solution to the high gas prices?  Blame the oil companies.  Because their profits were too high.  It had nothing to do with his policies that restricted the supply of oil on the market.  Of course, with an election coming up and gasoline prices too close to $4/gallon, he’s changed his position on that (see Loss of Libya oil bigger disruption than Katrina: IEA by Simon Falush and Zaida Espana posted 6/24/2011 on Reuters).

On Thursday, the International Energy Agency which represents the major oil consumers agreed to release 60 million barrels from emergency stockpiles, sending crude prices tumbling.

Imagine that.  Increase supply.  And prices fall.  For awhile, at least.  Because once these 60 million barrels are gone, the prices will just go back up where they were.  Unless there is a real increase in supply.  Like more drilling in the Gulf.  The Atlantic.  The Pacific.  In Alaska.  We know it works.  Increase supply.  And prices fall.  So why not just increase supply with more drilling?  Instead of drawing down our strategic reserves (America’s share being 30 million of the 60 million barrels).  Which, incidentally, we’ll have to replace.

Energy Policy Driven by the 2012 Election

Even the White House is all but admitting this move is purely political (see The wrong reason for depleting the strategic oil reserve posted 6/23/2011 on The Washington Post).

So on Thursday Obama administration spokesman Jay Carney argued that oil demand is likely to rise over the summer. In other words: It’s vacation season, and the White House is worried about high prices through the summer driving months.

Therein, perhaps, is a political emergency, at least in the White House view: President Obama’s reelection prospects will be harmed if national discontent over high gasoline prices continues. The oil release could be seen as a way for the president to take credit for gas prices that are falling anyway, or as an indirect, pre-election stimulus.

Personally, the president doesn’t have a problem with the high cost of gasoline.  His administration wants it high.  The higher the better.  They’d like to see it European high (see Times Tough for Energy Overhaul by Neil King Jr. and Stephen Power posted 12/12/2008 on The Wall Street Journal).

In a sign of one major internal difference, Mr. Chu [who became Obama’s Energy Secretary] has called for gradually ramping up gasoline taxes over 15 years to coax consumers into buying more-efficient cars and living in neighborhoods closer to work.

“Somehow we have to figure out how to boost the price of gasoline to the levels in Europe,” Mr. Chu, who directs the Lawrence Berkeley National Laboratory in California, said in an interview with The Wall Street Journal in September.

To make the more expensive green energy less expensive in comparison.  And an easier sell to the American people.  Pleasing his liberal base.  But there’s an election coming.  And high gas prices don’t help you win elections.  Especially during record long-term unemployment.  Even though it goes against every fiber in his body to act to bring down the cost of gasoline, he will.  If it’ll help his reelection chances.  It’s not like he’s going to lose his liberal base.  Who else are they going to vote for?  The conservative?  Not likely.  They’re always going to vote for the most liberal candidate in the race.  And that will still be him.  Despite encouraging more oil consumption.

The Fed doesn’t know why the Economy is in the Toilet

The president needs to get the price down at the pump.  Where people really feel the full weight of his economic policies.  Because the economy isn’t going to get better anytime soon (see Serial disappointment posted 6/23/2011 on The Economist).

THE Fed attracted attention this week for downgrading its forecast not just for this year, but for 2012, as well. More striking is how often it does this. As my nearby chart shows [follow the above link to see chart], the Federal Open Market Committee has repeatedly ratcheted down its forecasts of out-year growth. The latest downward revision is particularly large, and in keeping with the pattern: when the current year disappoints, they take a bit out of the next, as well.

There’s been a steady downward progression of economic projections.  Despite the stimulus.  And the quantitative easing.  Nothing has worked.  When the chairman of the Federal Reserve, Ben Bernanke, was asked why the economy was not responding to the government’s actions his reply was rather Jeff Spicoli: I don’t know.  And he’s supposed to be an expert in this field.

Mr Bernanke does not need lessons about the painful deleveraging that follows crises. His pioneering work with Mark Gertler on the Great Depression introduced the “financial accelerator”, the mechanism by which collapsing net worth crushes the real economy. This concept has been rechristened the “balance sheet recession” by Richard Koo. Stephen Gordon admits he is new to the term and notes (with some nice charts contrasting America with Canada) “it’s not pretty”. (HT to Mark Thoma). Yet until now Mr Bernanke seemed to think America had learned enough from both the 1930s and Japan to avoid either experience. Reminded by a reporter for Yomiuri Shimbun that he used to castigate Japan for its lost decade, Mr Bernanke ruefully replied, “I’m a little bit more sympathetic to central bankers now than I was 10 years ago”…

Mr Koo has argued that quantitative easing cannot help in a balance sheet recession; only fiscal policy can. Does Mr Bernanke secretly agree? He may believe as strongly as he did a decade ago that sufficiently aggressive monetary policy can prevent deflation, but not that it can create enough demand to restore full employment. This does not rule out QE3; it only means it will be pursued with less hope about the results than a year ago.

The Great Depression (during the 1930s) is a complex topic.  And monetary policy played a big role in making a bad situation worse.  In particular, the numerous bank runs and failures can be blamed on the Federal Reserve.  Starving the banks for capital when they most needed it.  But there was a whole lot more going on.  And it wasn’t the stock market crash that caused it.  World War I (1914-1918) is probably more to blame.  That war was so devastating that it took the combatants a decade to recover from it.  And during that time America exploded in economic activity and fed the world with manufactured goods and food.  We call it the Roaring Twenties.  But eventually European manufacturing and farming came back.  Those lucrative export markets went away.  And America had excess capacity.  Which had to go away.  (A similar boom and bust happened in the U.S. following World War II.)  Then all the other stuff started happening.  Including the Smoot-Hawley Tariff.  Kicking off a trade war.  It was all too much.

Japan’s lost decade (the 1990s) followed their roaring Eighties.  When the government partnered with business.  And interest rates were low.  The economy boomed.  Into a great big bubble.  That popped.  Because they stimulated the economy beyond market demand. 

The lesson one needs to take away from both of these deflationary spirals is that large government interventions into the private market caused most of their woes.  So the best way to fix these problems is by reducing the government’s intervention into the private market.  Because only the private market knows how to match supply to demand.  And when they do, we have business cycles.  That give us only recessions.  Not depressions.

Like a Dog having Puppies

The market is demanding more oil.  But the U.S. is not meeting that demand.  So gasoline prices are up.  To lower those prices we need to bring more oil onto the market.  And you don’t do that by shutting down the oil business.

We have high unemployment.  And excess capacity.  That’s not a monetary policy problem (interest rates).  It’s a fiscal policy problem (tax and regulation).  No one is going to borrow money to add jobs to build more stuff when no one is buying.  But if you cut taxes and reduce regulations to make running a business highly profitable, people will build businesses here.  Create jobs.  And hire people.  Even if they have to ship everything they make halfway around the world to find someone who is buying. 

Running the economy is not rocket science.  Because it runs itself.  Like a dog having puppies.  Everything will be fine.  If greedy politicians just keep their hands out of it.  But they don’t.  And they love printing money.  Because they love to spend.  But the problem is that they can’t see the fiscal forest for the monetary trees.

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