Long-term bearish on China and the US

Steve Saville
email: sas888_hk@yahoo.com
Posted Mar 29, 2011

Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 24th March 2011.

When it comes to their outlooks for China's economy, most analysts fall into one of two groups. The first group is outright bullish on China's prospects over all time frames, while the other is very optimistic on a long-term basis but is concerned about the potential for a painful short- and/or intermediate-term 'correction'. In other words, most analysts are long-term bullish.

As discussed in the past, we fall into neither of these groups. We also can't be counted amongst the naive souls who labour under the delusion that the US is still the "land of the free" and that China is still a Soviet-style basket case.

We are long-term bearish on the economies of both the US and China, primarily because the governments of both countries are now headed down paths that involve using monetary inflation and greater government control of the economy in an absurd effort to counteract the disastrous effects of earlier monetary inflation and controls (China spent much of the past three decades in a bullish trend as far as government involvement in the economy is concerned, but that trend appears to have ended). We are also concerned that there is very little understanding amongst economists, politicians and members of the general public as to what caused the global financial crisis and what should be done to ensure greater stability in the future. In particular, hardly anyone fully understands how monetary inflation affects the economy. Most of the people who appreciate that there is a link between money supply and prices believe that money-supply growth is only a problem to the extent that it brings about an increase in the general price level.

The reality is that an increase in the general price level, which can more aptly be described as a decrease in the purchasing power of money, is just one of the effects of monetary inflation. And of these effects, a decrease in the purchasing power of money is the LEAST important.

Of greater importance is that substantial monetary inflation results in mal-investment on a grand scale, which means that it leads to the economy-wide wastage of resources and reduction of wealth. It does this in two ways, the first being its non-uniform mode of operation (the way that some prices rise earlier and faster than others in response to the increasing money supply). Changes in relative prices are the signals upon which the market economy relies, and when these signals are artificial (meaning: due to additional money rather than due to sustainable changes in consumer demand) the result is a cluster of investing and resource-allocation errors. The errors occur during the inflation-fueled boom, but they don't become apparent until the ensuing bust. The bust is effectively the period when the "chickens come home to roost".

Monetary inflation also leads to mal-investment by creating the impression that there is a greater amount of real savings than is actually the case. It has this effect because it lowers the interest rate.

Here's what is supposed to happen: people reduce their current consumption and save more, with the goal of increasing their wealth and being in a position to consume more in the future. This causes the interest rate to fall, which entices entrepreneurs and other businessmen to invest in long-term projects (property developments, new manufacturing facilities, mines, major expansions and upgrades, etc.). Although most individual entrepreneurs and businessmen won't think of it in this way, they are responding to a signal that the public is saving more today in preparation to spend more in the future.

What happens, though, if the fall in the interest rate is induced by the central bank boosting the money supply? In this case the same signals will initially be sent to the capital markets, but there will have been no reduction in present consumption and no concomitant increase in real savings. Entrepreneurs and businessman will undertake long-term projects based on the assumption that the public will have more real wealth to spend in the future, while the public is REDUCING its future capacity for real spending by consuming aggressively in the present. In other words, a mismatch emerges. This mismatch can continue to develop for years, but the longer it develops the worse the inevitable bust will be when reality strikes.

The effects of the mal-investment wrought by the past decade's monetary inflation in the US are evidenced not only by the dismal state of that country's residential real estate market (the focal point of the boom), but also by the state of the labour market. The following chart from the St Louis Fed's web site shows that total private sector employment in the US today is at around the same level it was at the beginning of 1999. To put it another way, the chart shows that there has been no net-increase in US private-sector employment over the past 12 years. This poor performance has a number of policy-related causes, but in our opinion the mal-investment associated with Greenspan's two inflation-fueled booms is by far the most important.

Unfortunately, Bernanke is now trying to create another inflation-fueled boom.

The problems that stem from many years of monetary inflation and bad government policy are obvious in the US, even if they are usually misdiagnosed. They are obvious because the boom has already turned to bust. They aren't obvious yet in China, though, because the inflation-fueled boom is still going.

Due to many years of mal-investment on an unprecedented scale, China is an economic bust waiting to happen. In itself this wouldn't be a good reason to be long-term bearish, because left to its own devices an economy is capable of recovering from a major misalignment of production and consumption within a couple of years. This would especially be so in the case of China due to the strong work ethic and self-reliance of its population. The reason we are long-term bearish is that there is little chance of China's economy being left to its own devices. Based on the fact that China's policy-makers have made similar mistakes to their Japanese and US counterparts up until now, it's a good bet that they will continue to do so.

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Steve Saville
email: sas888_hk@yahoo.com
Hong Kong

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