Tuesday, April 1, 2008

The Chinaman

Calculated Risk has a post today about all things Chinese. The basic observation is that everything sucks -- the property market is off, the stock market is off, the economy's growth is projected to slow, inflation is already up, and new labor laws can't help but feed its further increase. It's hard to know how severe this will get, and how much it is caused by China's connection to the US versus their own home grown problems, but with the quantity of manufacturing that occurs there and the size of their dollar reserves, having some opinion about China seems increasingly important to developing any coherent macro economic picture.

So what would the immediate impact of a Chinese slowdown be? I can think of a few consequences, the most concrete of these being a drop in industrial commodity unit demand. But before you jump from this thought to the imminent collapse of the commodity bubble, consider the impact of inflation. China may want slightly less tin and copper, but they may be able to pay more for it. With the amount of dollar reserves they have built up, this is hardly a strange hypothesis, although it does mean that the Chinese would have to either accept a higher level of inflation or let the renminbi appreciate.

So what does this mean for the rest of the world? It seems clearly inflationary. And really, why wouldn't you expect this to happen at some point? For almost a decade now the US has been growing the money supply at an unbelievable pace, the latest monthly figure is 36.8%. The just-so-story would go that this monetary growth hasn't been inflationary so far because the US has been exporting it to the rest of the world, which has absorbed it through a combination of a lower dollar and increasing piles of foreign reserves in those countries that have pegged their currency to the dollar. This strategy worked fine as long as these countries were busy investing in their factories and infrastructure, and selling their products back to the US. The circle closes when you realize that the US was only able to buy this stuff on the back of an enormous mountain of household equity extraction facilitated by low interest rates caused by the Chinese being willing to hold so many low yielding treasuries.

Eventually though, the world is a closed system, and if you want people to buy more stuff, you have to give them more money. Since you can't give the American consumer any more money, you're going to have to start giving it to the Chinese -- i.e. wages increases. This might paradoxically mean that you could end up having high inflation in China and other export economies pegged to the dollar, even while you end up with deflation and de-leveraging in the US as the credit bubble unwinds. US import prices would increase, at the same time as the US balance sheet would contract, requiring us to save more.

I think, however, that there may be an alternative and perhaps far scarier scenario. What if an unhappy coincidence between the US credit bubble and political circumstances in export economies created a truly international bubble, call it the China bubble. China's forced march industrialization may be completely unsustainable without the bizarre coincidence of the inflated demand of the US consumer and the Chinese willingness to finance it. This would suggest that we are seeing the end of a period of globalization marked by increasing leverage and irrational exuberance world-wide (though in different forms in different places) similar to what happened on the eve of WWI. The fallout would be a period of de-leveraging and contraction in aggregate demand similar to what happened during the great depression. On this view, people like Brad Sester and Nouriel Roubini seem much more convincing.

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