Yesterday, Mark DeWeaver did an interview with U.S. News & World Reports regarding his recently published book on China: Animal Spirits with Chinese Characteristics.

Below is the interview:

Also viewable at Google Hangout.

I previously interviewed Mark for TLS and reviewed Animal Spirits for TLS.

After six-months of interviews with over 40 experts and businesspeople.  After plowing through more than 1,200 citations to find hard data and statistics.  After hundreds of conversations, rebuttals and comments — my first book is finished.

Great Wall of Numbers: Business Opportunities & Challenges in China is neither a bullish or bearish take on the mainland.  I try to be even-handed and I do not wear rose-tinted glasses.  In some chapters at the beginning like food & beverage or luxury goods, it seems like the sky is the limit.  In others towards the end (17, 19 & 20) the overall findings are quite sobering, yet even among these hurdles (e.g., debt, regulations, rent-seeking) there are investment and business opportunities for those willing to take the risks.

And it is free.  You can read the entire book online permanently here or grab a Kindle edition from Amazon here.

This guide is up-to-date as of last week and does not contain any of the hype or hyperbole that is part and parcel to the investment literature market.  No get-rich-quick schemes or instant-millionaire lingo or gobbledygook.  In fact, as I mention repeatedly throughout, if you want to do business in any domicile you should do your own due diligence, consult with an experienced lawyer and perform a SWOT analysis.  Only fools rush in.

For doomers and apocaholics: there are any number of problems that China may be facing in the future (as I have noted in detail last year), but this is not to say that it will collapse or that there are no longer growth opportunities for entrepreneurs.  If you think the sky is always falling and it never does, you are actively participating in the self-defeating Prepper’s wager.

If you want to diversify to a new customer base, there is no need to subscribe to any gimmicky newsletter or perpetually-wrong financial prophet: check-out GWON por gratis and partake in the Entrepreneur’s wager.  Jiayou!

Note: TLS readers may be interested in Chapter 7 which includes an interview Stephan Kinsella (a regular TLS contributor), Chapter 13 which includes an interview David Veksler (who was previously interviewed here on TLS) and Chapter 20 which includes an interview with Mark Thornton (who was previously interviewed here on TLS).

There are certain books in life that upon reading them you think to yourself “I feel not only smarter but this is exactly the book I would like to have written.”

And that is in summation what Animal Spirits with Chinese Characteristics embodies.  It is written by nine-year China veteran Mark DeWeaver, now the hedge fund manager of Quantrarian Capital Management in Washington DC.  In addition to having worked as a broker and financial analyst in Guangdong (the most populous province on the mainland) and Hong Kong, DeWeaver received his PhD in economics from the University of Hawaii.  The title alludes to the ‘animal spirits’ invoked seventy-five years ago by John Maynard Keynes to describe how emotions influence human behaviors.  The other part of the title comes from Deng Xiaoping’s “reform and opening up” (改革开放) liberalization process that began in 1978 – what Deng called “socialism with Chinese characteristics.”

One of the shortcomings of many China-related non-fiction books today is that they generally try to discuss something that is impossible to penetrate: how and why the Standing Committee makes decisions.  Volumes have been and will continue to be written about the purported inner workings of Zhongnanhai (中南海), the Party headquarters in Beijing, yet this amounts to little more than the modern-day equivalent of Kremlinology.  Or as the popular and fitting English expression germanely (sic) describes this seemingly futile divination activity: trying to read the tea leaves in China (tasseography).

Animal Spirits is nothing like these quickly outdated books and will arguably be timeless in part because of its methodological approach.  While he uses dozens of empirical examples to illustrate the boom-bust cycle within China, DeWeaver’s epistemology is unique in that it utilizes the deductive strength of the a priorism of the Austrian School.  The Austrian School is perhaps best known by one of its thought-leaders, Ludwig von Mises who wrote Economic Calculation in the Socialist Commonwealth nearly a century ago.  In it, Mises explains that central planners, within a closed economy cannot rationally calculate or allocate resources in an efficient manner; that without organic prices an economy will stall and even deindustrialize.  And since prices only arise from market interaction between participants (entrepreneurs, investors, suppliers) we as observers can a priori reject central planner claims to theoretical success without having to actually implement them to see if they could indeed work.  That is to say, central planning a priori cannot work because of the calculation problem.   Consequently, dozens of books have been written about how and why both the Eastern Bloc and Soviet Union collapsed largely due to this inability to rationally calculate, yet very little has ever been written about the Chinese experiment especially from the 1949-1979 time period.

The sole focus of the book is an analysis of both the economic and financial systems within mainland China since the founding of the PRC in 1949.  And despite the aforementioned Sino-centric tomes being published at a steady clip, surprisingly very little has been written about this financial area; and that is our loss.  In fact, the English-based scholarly corpus regarding the Chinese business cycle is almost non-existent.  The reason is simple: you need to be a trained economist, fluent in Chinese and capable of rigorous analysis.  Just as there were only a handful of potential scholars capable of writing The Last Knight of Liberalism (e.g., need to be German-speaking, trained economist, familiar with historical documents) so too are there few capable of pouring through both the modern Chinese financial press but also to look through the historical record.

And that is where Animal Spirits shines.

For example, one of the assumptions is that nationally developed central plans promoted in Beijing – Five Year Plans (中国五年计划) – are followed and executed in a classical top-down fashion.  That there is a monolithic entity capable of devising and controlling cogs and chess pieces down to the county level.  Yet, in Chapter 2 DeWeaver notes that “[i]n the Chinese case, central planning has not even been carried out consistently.”

Specifically,

In China the problems with central planning were exacerbated by the devolution of investment decision making authority to lower levels of government.  This made economic coordination even more difficult and produced powerful incentives for overinvestment.  Ironically, some of the very instabilities the revolution was supposed to eliminate became more extreme.  Transferring ownership of the means of production to the state resulted not in a new age of rational resource allocation, but rather in an exaggerated version of the capitalist cycle.

For instance, in areas like steel, cement, coal and other commodities, there are state-owned enterprises that are championed by local governments.  In the case of steel production, as part of the Great Leap Forward, each county and locality was encouraged to smelt ore and scrap ingots to produce metals based on mandated quotas at a variety of administrative levels.  The end result was denuded forests (for use as a smelting energy source) and what is now termed as ‘oversupply.’  Since all localities were smelting irrespective of profit or loss, enormous output took place and continues to take place – China currently produces and consumes about half of the world’s steel.

 And after decades of championing these local steel mills, despite decisions at a national level to consolidate or in some cases to allow market forces to bankrupt inefficient mills, local policy makers continue subsidizing them due largely to the perceived integral role the mill has in the community (e.g., jobs).  While allowing them to close and consolidate would bring volume efficiencies in terms of economies of scale, from a local policy maker point-of-view there are a number of consequences and side effects that they would rather not deal with.  As a result, provincialism is rampant across the country – there is no unified harmonized market like there is in most of Europe or North America, making it prohibitively costly and time consuming for both foreign and domestic businesses to expand operations across the country.

 Or as DeWeaver aptly notes:

 The emphasis on regional self sufficiency led inevitably to local protectionism.  Local governments came to be evaluated on the extent to which they could independently produce various categories of products or even generate surpluses for “export to other localities” (Donnithorne, 1972, 610).  Protecting markets for local light industry was also desirable because high retail prices were often necessary in order to subsidize inefficient small-scale heavy industry (616).  Thus, in 1970 the Changchun Number One Department Store “exclusively” sold “light industry products” made in Jilin Province (Changchun being the provincial capital).  Shanghai and Tianjin “claimed record shipments of their own products to other parts of the country” (611).  Hubei Province even had a program to grow all its own sugar (609).

Thus, China developed into a “customs union but not a common market,” with “a common barrier against the outside world” but without “free trade within its national boundaries” (618-619).  In the absence of either markets or effective central planning, the economy fragmented into “a myriad of small discrete units” (605) while the ideology of self-sufficiency became an excuse for local-level mercantilism.

And as noted above, some of much of this provincialism continues today in markets such as tobacco, Chinese wine (baijiu) and even in areas of skilled human labor.  For example, nearly every semester a number of my students will travel outside of the college or school to attend job fairs in neighboring regions.  There is always at least one or two that come back frustrated and focused because they have been told that the job fair is only open for people from that province.  In fact, one of my expat friends has a wife from Anhui who traveled to Nanjing to attend a fair and was told “no outsiders.”  And when I lived in Guangdong (Canton) a number of Chinese friends from other regions of the mainland explained that they faced various levels of discrimination due to being an “outsider” (e.g., speaking Putonghua instead of Cantonese).

Booms and busts

Another epistemological strength of the Austrian School is its inherent deductive capability to predict and asses the consequences of certain economic policies.  In particular the boom-bust cycle (or business cycle) describes the relative scarcity of credit in a financial system.  For example, if credit – which is typically managed by central banks and central planners – is loosened and made “cheaper” (e.g., subsidized), activities that were previously cost prohibitive now become relatively easier to finance.  Yet when the credit tap is proverbially tightened, many of these same unsustainable and unprofitable ventures go bankrupt as part of the market purge known as a “bust.”

And in China, economic laws are as immutable as in the rest of the world, as DeWeaver explains:

Central planning never worked as advertised in any of the countries where it was tried.  Even under ideal conditions it would never have been possible for central planners to identify optimal allocations of scarce resources.  It is unlikely that any such allocations could be realized in any case.  With decision makers’ incentives skewed by expansion drive and soft budget constraints, it is probably inevitable that socialist economic management is driven primarily by political considerations.  Investment booms and busts have been the result.

In the Chinese case, these problems were compounded during the command economy era by attempts to limit the role of central planning itself.  With Chairman Mao’s great principle of self reliance as the watchword, lower-level authorities enjoyed a degree of autonomy that made it practically impossible for the central government to coordinate economic development.  Even the Third Front, where many of the projects were national priorities, was not immune.  The result was a pattern of decentralized boom followed by centrally imposed bust.

In an inversion of Keynes’ assertion, the Chinese experience shows that “the duty of ordering the current volume of investment” cannot safely be left solely in public hands.  Government entities are, if anything, even more at risk of possession by animal spirits than private-sector companies.  They almost invariably tend to prioritize ideological or political considerations over cost-benefit calculations.

Yet as any China-watcher can attest, while these boom-bust cycles still continue, they have changed in nature.  Instead of having wild swings in agricultural productivity (due to credit to specific farms or agricultural segments), as China has developed over the past three decades, the booms occur in other areas.

For example, large portions of the manufacturing sector (e.g., textiles) that focus on exports receive perks and subsidies from nearly all levels of government, creating an unsurprising boom in production:

In each case, the booms were driven primarily by local governments while the busts, as had generally been the case ever since 1949, were brought about by central government policy.  At the same time, as product markets were introduced and the economy gradually became internationalized, inflation and trade deficits began to replace agricultural shortfalls as the primary constraints on investment.  These problems became less severe as high rates of accumulation along with productivity growth resulting from the economic reforms led to excess capacity.  This in turn generated both disinflation and a steady improvement in the balance of trade.

This is not to say that private companies are not guilty of waste, inefficiencies or miscalculation.  For example, in the US 56% of all start-ups fail within the first 4 years.  Each week the business press highlights both successes and poor investments made by entrepreneurs.  Three notable misallocation examples that come to mind are the Itanium project by Intel which was supposed to replace the x86 line of CPUs ten years ago, yet despite billions in investment it has gained negligible traction or marketshare.  In April 1999 Mark Cuban (now owner of the Dallas Mavericks) sold his internet company, Broadcast.com to Yahoo for $5.7 billion in stock.  The site fizzled and no longer exists.  And in November 2012 HP took a $8.8 billion write-down on the value of a company (Autonomy) that it had purchased in 2011 due to overstated revenue by Autonomy’s management team.

Yet as DeWeaver explains in Chapter 8, under a market-based economy one of the advantages is that ‘creative destruction’ (originally described by another Austrian, Joseph Schumpeter) the process of purging unproductive or misallocated assets can not only take place, but also take place at a faster pace than it would in a command economy of perpetual bailouts.  For example, at the turn of the 20^th century, the horse-and-buggy industry employed tens of thousands of laborers in the West.  In 1900, the US industry alone employed 109,000 carriage and harness makers.  And with the advent of the automobile these workers were effectively handed a collective pink slip, yet many of these laborers were reabsorbed back into the overall economy remaining a footnote in history books.  Yet in China, bankruptcy is warded off through the aid of patronage networks:

 This state of affairs is unlikely to be preferable to the “creative destruction” that takes place in a private enterprise economy.  Political competition in China is not normally rooted in economic issues.  While power struggles like the one that followed the Sixteenth Party Congress put many investors out of business, the threat of bankruptcy creates much stronger incentives to avoid overinvestment.  When the CCDI is the disciplining force, staying on the right side in factional struggles will be more important than optimizing resource use.  Investors with the strongest patrons will not necessarily be those with the best projects from a social welfare point of view.

Economic domination

Despite three decades of reform and privatization, an estimated 110-150,000 state-owned enterprises still exist in China contributing to roughly 62% of the GDP.  And at one point prior to Deng’s reforms that number was in the 90th percentile, in fact in 1995 there were 1.2 million SOEs.  Yet arguably a level of 100% never occurred even during the height of the Great Leap Forward as it would have meant every economic producing activity including human action itself would be owned by the state (e.g., slavery), something that has not legally occurred since just before the Qing dynasty collapsed (e.g., as Marx defined in Das Kapital, in a socialist system the means of production are in the hands of the state).  Consequently, these reforms illustrate the productive power of market forces and coordination, as the GDP of China increased from $10 billion in 1978 to over $7 trillion in 2012.

Yet because much of the economy is still dominated and controlled by the state, most decisions are left to local officials and policy makers (e.g., the vast majority of SOEs are owned and operated at the  local level).  However, any person in this artificial position – irrespective of culture, education or locality, will be left with little more knowledge to rationally calculate than the next.  The reason why is what DeWeaver weaves throughout the book, it is a case of the Hayekian “local knowledge problem.”  (Frederick Hayek was another Austrian economist and contemporary of Schumpeter and Mises.)  What this means is that because all information is currently distributed among individuals spread across any superficially defined region, there will always be some information and data missing from the datasets collected by central planners (Leonard Read illustrates this in “I, Pencil”).  The only conceivable solution to this knowledge problem and one that planners have been trying for a century to accomplish is to create an omniscient computer system capable of total awareness of all information at all times, simultaneously.

However even in the event of having this knowledge, assuming that such a machine could be built, planners still are left with the calculation problem: they may have every datum imaginable, yet they still do not know what actions are profitable or which activities may end in bankruptcy.  And thus any action they decide to make, while seemingly educated and ‘scientific’ is in fact arbitrary.  In contrast, the only planners per se of market-based economies are entrepreneurs who fundamentally only need to collect a single data point: prices (e.g., once a price is known and discovered rational economic coordination can take place).  In doing so they can rationally allocate resources and conduct business transactions or after doing market research decide simply not consume capital at all; preferring to forgo capital consumption today by investing in higher-order goods (e.g., factories) that require long-term periods of illiquidity (yet offer higher returns on investment).  This last point is called capital ‘roundaboutness’ (e.g., the time preference usage of capital) and originally comes from another Austrian economist, Eugene Böhm-Bawerk, the instructor of Mises and Schumpter (Hayek studied under Friedrich von Wieser the brother-in-law of Böhm-Bawerk).

DeWeaver also touches on a tangential issue, one that Mises and other 20^th century economists wryly explained: that central planners in command economies need to continuously collect reams upon reams of statistical data to accomplish an inherently futile task – productively and efficiently coordinate economic activity as noted above.   There is an old economic joke used during the Cold War noting that the Soviets would absorb and expand to cover the entire globe, except New Zealand.  New Zealand would be left alone so that market activities would create prices, prices which Soviet planners could then input into their models and equations.  A similar story comes from economist Gordon Tullock who visited Gosplan (the top planning administration in the Soviet Union) and discovered that planners were using an old Sears Roebuck catalogue to price their wares.  But the inherent problem with their approach (whether the story is true or not) is that all such prices reflect the local inputs that created them; thus the Sears prices are only relevant to the US and do not reflect the local conditions, the local inputs in the Soviet Union.  Or as Bruce Barton once quipped, “the easiest and most effective way to fight the Cold War would be simply to swamp the USSR in Sears catalogs.”

And Chinese planners, as educated and enlightened as they may be, are fundamentally faced with similar calculation constraints.  Compounding this issue is that local officials are motivated to maximize GDP growth irrespective of sustainability or profitability and also have ‘soft budget constraints.’  ‘Soft budget constraints’ is an economic term coined by János Kornai, a Hungarian economist that DeWeaver cites several times throughout.  Among his other academic contributions Kornai explained that the planners of command economies in the Eastern Bloc had created chronic ‘shortage economies’ through the pricing mechanism.  That in retrospect, the relatively low prices set by planners incentivized increased consumption by consumers and thus vast amounts products – both consumer and producer goods – were continuously in short supply.  In other words, when you intentionally or unintentionally subsidize an activity, demand may eventually outstrip the supply of it (e.g., lower prices send a signal to consume rather than save).  In the case of all the Eastern Bloc, the Soviets and even Chinese experiments with artificially price fixing the end results are long queues that are now immortalized in iconic black-and-white pictures.

Booms and busts

And because each county and each province is actually overinvesting (or malinvesting) in their SOEs, this gives rise to collective investment booms in a variety of market segments.  While the traditional boom-bust cycle scholarship investigates the causality of interest rates relative to monetary and credit expansion (there is also a corresponding component in China), what DeWeaver illustrates in each chapter is how central planners and policy makers at each administrative level spur unsustainable booms based on a plethora of plans including to meet GDP quotas or to fulfill a part of the overall Five Year plan.  For instance, these booms as noted above can take place in what Lenin termed the “Commanding Heights” (e.g., heavy industries) or in other areas such as infrastructure development like high speed railroads, highways, stadiums and airports.  For example, in Chapter 9 DeWeaver cites more than a handful of such projects including:

Consider the city of Fuyang in Northeastern Anhui Province, for example.  Located in a relatively remote location in one of China’s poorer interior provinces, the city originally had only a small landing field for flights to Hefei, the provincial capital.  In the 1990s, the local government decided to “raise the city’s profile” by building an international airport.  The original airport’s 400 meter runway was expanded to 2,400 meters (long enough for commercial flights to most Asian destinations) and a 7,200 square meter terminal and other amenities were built at a total cost of 320 million yuan (Wang, 2002).

In 2004, after being open only a year, the new facility had to be closed because there was not enough traffic to keep it operating.  While it was finally reopened in 2008, as of the beginning of 2011 its website showed only three flights a day.

When I taught in Anhui last year I asked several students from the area if they had ever used the airport.  They said it was more practical to use the large train station because the airport only had flights to just a couple of cities (Beijing and Shanghai) during the day.  While there is potential growth due to the population size (Fuyang itself is either the 1^st or 2^nd largest county in Anhui depending on which areas are included), this represents an unproductive asset that would probably not have been built in this location or time frame if left to market forces.

Is this an isolated incident and just a rare exception?  No.  According to the Financial Times, in 2010, three fourths of all airports in China lost money.  In 2011, of the 180 civil airports in operation, more than 70% lost money.  In fact, based on research from Li Xiaojin, an airport in China needs to handle 1 million passengers a year in order to turn a profit.  Yet according to his estimates, 80% of airports do not hit this mark.  And according to the Civil Aviation Administration of China (CAAC), these losses last year amounted to more than $314 million.

Reimposing economic rationality in China historically requires central government intervention because of the disconnected incentives at the local level (i.e., biting the hand that feeds you), which consequently leads to purges and busts.  Thus the Chinese investment cycle is entirely different from the cycles described in conventional business-cycle theory.  It is not driven by mistakes or miscalculations on the part of private-sector investors because their role is substantially diminutive (representing roughly 1/3 of GDP).  It also does not really have anything to do with money creation by the central bank although this can exacerbate the systemic issues as state mandated lending quotas are excised through state-owned banks.  It is instead essentially a continuation of the same investment cycle China had during the command economy period.

Conclusion

This is not to say that the Chinese growth story is over, that it will collapse and we will have to find a new labor source to make our athletic shoes and smartphones.  Rather if anything DeWeaver’s manuscript illustrates that despite what the market has ‘giveth’ central planning inadvertently (axiomatically) ’taketh’ away.  China will most assuredly endure either way, yet for perhaps the first time the English-speaking world now has a usable corpus to use and later stand on (e.g., nanos gigantum humeris insidentes) in expanding the financial and economic scholarship of the Middle Kingdom.

[Note: Animal Spirits is available starting December 24, 2012]

See also: TLS interview with Mark DeWeaver  and an excerpt from Chapter 1

You have heard of Pascal’s wager and the atheist wager.

Based on the comments from my last post and this Reddit thread, I have formulated two new wagers.

The first is the typical sky-is-falling-bernanke-will-eat-your-babies-carbs-kill-unicorns-i-hate-the-verizon-can-you-hear-me-now-guy-and-flouride-is-destroying-our-precious-bodily-fluids-!!!!111oneone.

If you believe a financial apocalypse will occur and/or there is a “revolution” that somehow magically “restarts” civilization, this is your wager:

The second wager below is an illustrative rebuttal to the above self-delusional, self-defeating, borderline-anti-capitalistic, eschatological fantasy.  The hero of this story is the entrepreneur who tries either way.

Go get ‘em tiger:

The point of this carnal, non-supernatural exercise is clear, that no matter what happens,there is no net negative consequences for promoting entrepreneurship or partaking in it yourself.

To use a sport analogy, why be a fair weather capitalist?

If capitalism and markets can outproduce state consumption, why not promote libertarianism and entrepreneurship?  Why wait around until “just the perfect political atmosphere” is created?  Why wait until there is no more government debt?  Why wait until the stars are aligned just right?  Why wait until after a collapse or after a “revolution?”

Parlez-vous Français

Voltaire had a germane quote, “Le mieux est l’ennemi du bien” or in English, the best is the enemy of the good.

To counter some of the comments noted above, regular readers know how bearish I can be about the tech sector and capital formation, but that does not mean there are still no growth opportunities.  You just have to be open to new ways of doing business, even if the conditions are not ideal, perfect or “the best.”

Every country has lots of debt — even China (1 2 3 4) — how does that preclude you from being a good, small time entrepreneur or finding good SME’s to invest in?  Angel investors like Ron Conway manage to keep on trucking in this environment.  He must be a state-monger right?

Also, think for a moment, how many RSS feeds and websites you visit each week that solely focus on doom, reckoning and gloom?  Don’t you think these contribute to overall incestuous-depression-the-end-is-nigh-groupthink?  Do you read as many hours about how to start your own company as you do on how to cure your apocaholic habit?  Do you drown your emo sorrows with misery, the loving companion?

While I have distanced myself over the past several years from most aspects of the libertarian “movement” — from recent top stories on thought-leader blogs and websites it seems as if the libertarian movement has almost become a poverty movement.  Where are the motivational stories to become another Peter Thiel?

Our hero is supposed to be the entrepreneur, yet so many of the revolution-addicts are angry bums that believe they are somehow defeating the state, by not participating in the economy.  By dropping out and making a subsistence income.  How is that starving the state?

To use a cliche ’90s phrase, such curmudgeons are a tool.  Don’t be a tool.

So are many of these boisterous paper tigers, continuously talking about “collapse” for years on end.  Talk is cheap.  Excuses are infinite.  Suck it up and go out and walk the walk, create a “revolution” by inventing the physical future.  You don’t have to be Steve Jobs, but think about this: SOPA.  Google was able to help kill it in one day and it doesn’t even “own” a seat in Congress.  It did more in one day than most Congresspersons can do in a decade.  And assuming you don’t buy Bryan Caplan’s irrational voter theory, perhaps you’ll give Ferguson’s investment theory another look.

In contrast, all of this preparation for a financial Armageddon, is akin to believing you are special and the time you live in are special.  Unique, yes, but not special.  The odds of another large-scale peaceful revolution working like the Velvet revolution or the peaceful transition in Apartheid South Africa, in my opinion are low.  The odds that a libertarian-order will rise out of a “revolution,” in my opinion, are even lower.  Why would everyone who used to benefit from state largess magically wake up one day and want to use commodities like gold and immediately cherish libertarian values (e.g., NAP)?

I think it is silly and counterproductive to talk about “revolution” in most contemporary First World political movements.  I think peace should be preached and one of the easiest peaceful ways for change is to educate individuals and/or become so affluent you can invent the future and perhaps build your own homesteads elsewhere (e.g., seasteading, brainsteading).

I think those advocating a Jeffersonian “revolution” have no clue what that would all entail after the first month, plus they would probably lose.

Either way, I think Robert E. Lee’s old quote is also instructive: “It is well that war is so terrible – otherwise we would grow too fond of it.”  Substitute “revolution” for “war” for the 21st century First World analog.  You think “the enemies” guns stop working after a hypothetical financial collapse?  Think your bars of gold will instantly turn sewage into drinkable water?

Why are you choosing to become a martyr?

I think this election cycle – and in particular various vocal members of the Tea Party – have inadvertently inspired a group of martyrs, willing to impart physical harm in some pseudo-religious, fatalistic fantasy for an end-game that would somehow be “freedom” incarnate.  Freedom sounds great on TV, it is like babies — it is the ultimate soundbite (“my opponent hates freedom,” “my opponent hates babies”) — but how can you actually achieve that?

One conceivable way agorism and/or ancapism could come into being peacefully is by literally out-inventing, out-innovating, out-producing the state so much that state intervention is entirely marginalized and/or you physically create a new landmass (… or move to another planet).

Whether or not this is attainable is certainly up for debate.  Though, I think it is a complete waste of time and actually counterproductive to do what some libertarians are try to do via the political process that has achieved little in the way of measurable results in the past four decades.

Instead, if they refocused their energies and capital on physically inventing the future — cryptoanarchy, technological singularity, seasteading — they might actually be able to achieve that goal of agorism and ancapism.

I am also reminded of the old Patton quote as well, “No bastard ever won a war by dying for his country. He won it by making the other poor dumb bastard die for his country.”  So why would you want to be a martyr for a nebulous, ill-defined, civil-war-like “revolution” that probably would result in more death and misery?  Close your signed copy of The Politically Incorrect Guide to… and come outside your RDF, this is meat space.   Welcome.

An outline to move from a mixed-economy to libertopia

There is probably no apriori strategy for an effective “revolution” at the level these libertarians are claiming.  It all runs into what Moltke the Elder who said, “no plan of operations extends with any certainty beyond the first contact with the main hostile force.”

And unfortunately, many libertarians, especially those involved in party politics have wanted to fight the equivalent of Kurskian warfare head on with their puny budgets and man power  — a fatal recreation of Krojanty.  You can’t win a conventional war like that.  You have better chances doing it asymmetrically.

And in my opinion, the best way of practicing what you preach is to become an entrepreneur.

1) Decide you want to be an entrepreneur
2) Slowly build up one or more revenue streams
3) Save and become wealthier
4) Do not invest in gimmicky newsletters and get-rich-quick schemes
5) Rinse, wash, repeat

Sure there are lots of gaps and missing steps, but that is what your role of an entrepreneur is: the economic coordinator that uses price signals to figure out what actions or inactions are profitable.  To satiate consumer demand.  Talk to Siri, she can probably tell you more.

In turn you can use your wealth to:

- deconstruct the state via Ferguson’s investment theory
- build a new island (ATNB)
- build an off-shore artificial island (TSI)
- build a giant yacht (FS)
- launch yourself to the GEO/moon/Mars (Brainsteading)
- cryptoanarchy, singularity, Second Realm, etc.

I actually think Matthew Alexander’s book Wĭthûr Wē touches on all of these issues in detail; you don’t have to physically blow up the state “to win.”  There are many of other peaceful solutions.  Apartheid in South Africa ultimately ended without shots fired.  Mandela & Co. didn’t run whitey over with tanks and vice-versa.  Truth and reconciliation and all that.  The Velvet revolution in Europe is another.

Thus entrepreneurship, not prepperism, not only makes everyone materially wealthier (and perhaps even healthier) – but can potentially dismantle the state.  I am not saying you personally should take out a small business loan or mortgage your home tomorrow.  But it certainly wouldn’t hurt to have some more non-poor libertarians running around.

Typical internet forum conversation with revolutionholics:

Bob the tool: “Oh I hate the state, I don’t want to produce anything until the state is gone.”
Guapo: “But can’t you change the state by generating more wealth than it taxes?”
Bob the tool: “I don’t want to give them another red cent.”

[3 months later]

Bob the tool: “Oh for effs sake, why doesn’t the state GTFO and die already?”
Guapo: “You haven’t worked for 3 months and yet the state still exists?”
Bob the tool: “Well at least I helped starve the state!”
Guapo: “You actually just starved your family.”

What I am suggesting is that libertarians be encouraged to do something different, earn more, make more, create more wealth.  The only downside is everyone is materially wealthier than before.  Yet for some reason this is not being advocated to the degree prepperism and collapsism are.  Many libertarian sites this past year have been filled with what at times has become vapid counterproductive motivations to push specific political candidates: yet accomplished almost nothing compared with say, Google.

For as good as libertarians are good at quoting Bastiat’s parable of the broken window, let us look at the practical question of: what are the alternative productive uses that could have been done with the millions of dollars that were donated to push specific candidates?  You could have a least bought shares in The World, perhaps even created an offshore Blueseed concept.

The forum conversation continues

One of the comments some libertarians state when you ask them “why don’t you start a new company?”

Bob the tool: “but the state will tax it away!”
Guapo: “but if you’re successful, it won’t matter, you will have much more money in aggregate.”
Bob the tool: “I don’t want to give another cent to the state.”

So they’ll take a menial job or work in the “black” or “shadow” market so they can avoid taxes.  Thus giving them subsistence wages yet having made zero impact to the tax regime or the state purse.  Yet they justify this by telling themselves “yea, the imperialist state has one less cent from me to use, I am starving it!”  And then posts such self-delusions on forums and libertarian websites — filled with other such self-delusioned tools.

Whereas if you acknowledge that sure, the state sucks but griping about non-stop it won’t change it.  You can start a company, build it up — get taxed in the process — and eventually become relatively wealthier.  Then perhaps you can influence the tax rates or whatever your first-strike against statism is.

Again, for all the talk about Bastiat’s lessons on opportunity costs, many libertarians don’t take the same principles and apply it to their careers.

Unplug yourself from the drug of collapsaholicism, apocaholicism, revolutionism, prepperism.  Remove yourself from newsletters and twitter feeds that do not teach you how to be better entrepreneurs and businesspersons.  Just like an alcholic stays sober by not drinking so to can you actually create a better world instead of continuously griping about the one you have.  It could always be worse.  And despite the rhetoric of some libertarian thought-leaders, today’s relative morass is not all the state’s fault.  Government debt isn’t stopping you from creating a new part-time job for yourself in your abode.  Beat the state by out-producing it.

The sound of one hand clapping

Starting right now, don’t be a negative Nancy or a Debbie downer — the state is not going to collapse because you merely want it to.

Check out The 4 Hour Workweek from Tim Ferris, 100 Business ideas from Young Entrepreneur magazine as well as resources from Startup Nation and Entrepreneur magazine.

There are lots of small jobs you can start-up without much investment — maybe after a few months, you can be the 44% that doesn’t fail.

And to help motivate you, let us part with the following neo-proverb.  At the beginning of the reform and opening up in late 1978 when China’s GDP was a mere $10 billion, Deng purportedly said: “to get rich is glorious.”  What he actually probably said was “to gain wealth is glorious” in terms of knowledge and material, but the message is clear: living in Hobbesian subsistence is for the pre-industrial, stone age third world.  And also for preppers, wanna-be revolutionaries and keyboard commandos (like Fatbeard).

If alcoholics go to rehab, then consider this an intervention and your first day of doomsday sobriety.  These guys are your support group.

Go get ‘em tiger.

[Special thanks to Matt Mortellaro for his comments and suggestions.  Recovering collapsaholics are also encouraged to peruse: Apocalypse Not, The NASA Scientist Who Answers Your 2012 Apocalypse Emails, A Year After the Non-Apocalypse, and Why Credit Deflation is More Likely than Mass Inflation]

Quick quiz, name the country:

-  whose farms produce 20% of the world’s calories
-  who is the leading semiconductor manufacturer and exporter (and this country’s top export industry)
-  whose manufacturing base is the world’s largest
-  who is the largest recipient of FDI and the second largest exporter
-  whose entertainment and culture are pirated, siphoned, copied and continuously consumed globally (go to kat.ph/movies, how many of the top 100 are made in China?)
-  whose labor participation rate is at a 30 year low yet still produces the same amount of economic activity as ever before

Why are some misanthropic analysts throwing the baby out with the bath water when it is clear that the US has not collapsed or will collapse in the near future?

For example, not to single this reader out, but the comment from Mangix in yesterday’s blog post touches on a number of myth’s that are currently popular in some corners of the blogsphere:

so if china doesn’t present a particularly strong growth opportunity, what does?

According to Jim Rogers, capital has slowly been moving from the west to the east and since you can’t have capitalism without capital…

It boggles the mind that anything in the west would have any growth opportunity since most western governments are loaded with billions and trillions dollars of debt.

There are at least three problems with this:

1) Jim Rogers may have been correct with his investment strategies in commodities and agriculture, but his calls and timing regarding East Asia, especially China, have been wholly incorrect.  If someone is continually incorrect with their predictions, why continue listening to them and taking their advice in that domain?

No one listens to the Millerites or Harold Camping anymore, so why pay heed to Rogers & Co.?  Because it feels good?  Perhaps you are an apocaholic.

2) China has strict capital controls that prevent capital from flowing East to West.  If these were relaxed, domestic savers would now have alternatives to park their funds.  Currently Chinese savers have few choices: place the funds in state-owned banks whose repressed interest rates sit below CPI and/or purchase investment properties and hope to rent them out (though many of these properties remain dormant for years).  Also, look at China’s FDI.  As an investor why would you risk sending your capital to a country whose means of production is owned by the state?

3)  Presidents, the Supreme Court, drones, OWS, Tea Partiers, carbs, conspiracies, chupacabras and autotune are all easy scapegoats.  But it is also your responsibility as a potential entrepreneur to think of new growth opportunities in whichever country you live in (regardless of “East” or “West”).   Sure 56% of start-ups fail in their first 5 years, sure you might dislike the political environment in whatever domicile you live in, but there are probably still opportunities if you are creative.  Stop blaming the state, stop blaming political parties and “gridlock,” you alone can invent the future and become so rich that tax rates just make you blush.

Mark DeWeaver, who I interviewed here, has found opportunities in the most unlikeliest of places: Iraq.  Here is the official webpage of the Iraq Stock Exchange.  Here is a wiki entry about it.  Here is a story about it on Bloomberg (which is still blocked here in China).

One last note

Just because there have been riots in Greece and Spain in the past year, it does not follow that there will be a future, global societal collapse such as those continuously prophesied by doomsday radio-hosts and the hyperbolic (sic) blogosphere… who make a living off of preaching gloom.

Nor does it follow from such a collapse, that some wise libertarian-minded order will rise from the ashes.  This is a weird teenage eschatological fantasy.  Not once in history have “the masses” - hoi polloi – become instantly enlightened with agorism and libertarian thought following a “collapse.”   In fact, the last time a grand civilization collapsed we had 1000 years of Dark Ages.  Brutish and miserable.  Why would anyone want that to happen again?

And there is little evidence to suggest that gold/silver owners would be kings.  It is all a non sequitur.  More than likely, they would be the first ones <insert morbid death>.  Plus, if you dislike your USD so much, feel free to donate them to TLS.

See also: cryptography realists by XKCD.

A reader (Alice) recently emailed me a rather interesting claim, that China is well on its way of becoming a $123 trillion economy.  Alice links to a MarketWatch piece that repeats some of the same flawed myths that Michael Pettis and others continually debunk.  Pettis for example argues convincingly in his latest piece (not up yet on his site) that China today is more like Japan in the late ’80s and thus will be growing at much smaller percentages in the future.

In contrast, the MW piece essentially says:

1.  China grew ~8-10% annually over the past three decades
2.  ???
3.  China continues to grow ~8-10% for infinity plus one

The MW piece in turn quotes from a slightly older Foreign Policy piece, written by Robert Fogel, whom argues a very bullish case for China based on five criteria.

The first of which, Fogel notes that educational investment pursued by Chinese policy makers will somehow reap large dividends.  Par for the course, a recent WSJ article notes that the US and UK spend the most per student and that Chinese policy makers are trying another top-down approach to overtake the US in this metric as well — by pumping out ever larger numbers of graduates.  Yet ceteris paribus, quantity of graduates does not equal quality.  Or in other words massive state funding does not necessarily equal to (!=)  massive gains in worker productivity.   Their approach is indirectly debunked at the WSJ (here) and by a piece I recently wrote.

Fogel’s piece also suggests that there will be continued, substantial contributions from the rural countryside.  While there is no doubt that Chinese subsistence farmers (~45% of the population) that average roughly $1,100 in earnings each year will probably continue to be measurably productive and generate wealth, it does not follow that they will somehow generate massive GDP multiplier coefficients.  If that were the decisive case then rural-heavy, developing countries like India, Indonesia and Pakistan are all up for double & triple digit trillion dollar economies soon as well.

What matters in terms of GDP (the sole metric in Fogel’s exercise) is what these unskilled rural workers can increasingly produce with same amount of (or less than) inputs (e.g., marginal productivity gains & TRP).  And unfortunately, there is no clear connection between: state education + rural migrants -> Sheenian $123 trillion winning.  In fact, there are at least two large barriers facing migrant workers:

1) Rural migrants typically do not have the funds (even when pooled together) to afford many of the new apartments being constructed, thus becoming part of an evergrowing disenfranchised “ant tribe“  (yizu).  And because of subsidized loans and relatively scarce land (which was sometimes confiscated by local governments from these same rural migrants) domestic developers such as SoHo (crying or not) have the potential to receive larger revenue margins by constructing high-end condos instead of low-cost housing in real estate boom towns (e.g., every city) throughout the country.  Thus there is a disconnect between supply and demand (which unfortunately the government is trying to band-aid over).  This indirectly leads to relatively high vacancy rates in some cities and NPL financial problems.

2)  In the event that they do find work, they are actively discriminated against due to hukou restraints (household registration).  The hukou is two-tier caste system which prevents these same rural workers that pay taxes and build the infrastructure, the public buildings, the schools and the hospitals from being able to receive access to the said services (e.g., cannot send their children to public schools or utilize the public hospitals).  Every few months hukou reform receives lip service from various political and academic circles.  Yet if the average Wang had a penny (or yi jiao) for every time reform was mentioned, they might actually be able to afford those high-end condos.

However as Bill Bishop noted, there is no political indication this rural reform will ever take place largely because it is simply too costly for cities to implement.  Or in other words, if it were possible to do those reforms they would have probably done them already.

Rural schmural

Speaking of property, another unintentional twist that directly effects every Chinese person, especially rural residents, is land eviction.

For example, in Mark DeWeaver’s upcoming book he notes that because land sales by local governments make up significant portions of their revenue, there  are numerous instances of rural farmers being evicted from their land due to eminent domain and/or coerced buyouts by state-owned enterprises — to raise government revenues.  This same fertile farm land is paved over and turned into unproductive assets such as malls no one goes to or housing development that now lay dormant.

And since this is the rule, rather than the exception, because there are fewer fertile farms to grow food — one of the unintended consequences is higher food prices (e.g., less supply, same demand) — and as a consequence China has become one of the largest importers of US agriculture; they are now dependent on the US for food security.  Some have noted this is equivalent to the Western dependence on Middle East petroleum.

Back to $123 trillion

Fogel’s third point has to deal with underestimating China’s service sector and in particular the health care industry.  While statistics gathering may not be as “professionalized” as it is in the West as Fogel contends, China actually is facing severe problems in health care now and certainly into the future.

For example, in a recent Nature paper Virginia Hughes notes that in China “chronic obstructive pulmonary disease (COPD) will kill 3 million people a year by 2030.”  This is on top of the 1.2 million smoking-related deaths that already occurs in China annually.  Some other highlights of that paper noted by Shanghaiist:

• Over half of all men, and about two-thirds of middle aged men, smoke.
• 41% of male Chinese doctors smoke, and about 15% have smoked in front of their patients.
• An anti-smoking clinic in Shanghai only sees about 300 people per year.
• 82.5% of women are exposed to second-hand smoke, despite the fact that only 1 in 50 Chinese women smoke themselves.
• Of the 240 million people in China over 50 in 2007, 1.9 million non-smokers died due to second-hand smoke.
• Women exposed to second-hand smoke were 2.3 times more likely to die from COPD.
• Rural Guangdong has the highest prevalence of COPD, at over 12%, compared to less than 4% in Shanghai.
• A lack of specialized medical equipment means that a large number of Chinese doctors are unable to diagnose COPD and prescribe patients antibiotics, which doesn’t do anything.
• The total cost per year of COPD medication is over 10,953 RMB ($1,732).

While smoking-related deaths and illnesses may not have the same direct economic consequences as HIV/AIDS has had on south African countries like Botswana — the economic impacts are both pronounced.  HIV/AIDS laid waste to significant portions of Botswana’s able-bodied working-aged populations, stunting the country’s economic performance.  Likewise, while the effects of smoking are more pronounced and detrimental in later stages of life, the total health care costs borne by friends and relatives (and insurance) will create an economic divot considering that the funeral bills, hospital visits, treatments and medicine for 3 million now-dead individuals is not chump change.  That is equivalent to a large city, dying each year.  Also for some perspective, the roughly 42,000 people that die in the US each year to second-hand smoke represent $6.6 billion in lost productivity.

And unfortunately the incentives for preventing smoking is diametric to preventing AIDS/HIV: no one economically gains from spreading these autoimmune disorder diseases.  Whereas the Chinese government received $95 billion in taxes from tobacco sales last year alone (see more details from this CNN piece).  To pre-empt all the angry emails from African-based NGOs, as bad as 3 million smoking-related deaths are, relative to China’s total population it is not nearly as devastating as the double-digit percentage that has decimated Botswana and neighboring countries.

Again, while I think nationalizing the US health care system and subsidizing it is detrimental both to the consumer and economy (see this excellent essay from Vijay Boyapati), the health insurance system in China is in a deeper financial hole.  It is so problematic that it is actually discussed in the Chinese press; yet unfortunately there is no quick political solution to the issue aside from overpromising taxpayer funds.

Making the sausage

Fogel’s fourth point has to deal with China’s political system which in his words “has become much more responsive and open to new ideas than it was in the past.”

But how does he know this?  There is still little transparency: we did not even know where Xi Jinping, the next president, was for 2 weeks this summer.  Minxin Pei argues that there is no meritocracy and other research indicates that it is nepotistic Corleone-style families (Crown Prince Party, princelings, Shanghai clique) that make the key decisions behind closed doors (see John Garnaut’s excellent piece regarding princelings).

Which brings us to state-owned enterprises: if state planners were “open” to further reforms, then why have they not privatized the 110,000 SOE’s?  They represent roughly 62% of the countries GDP.  In our recent interview here at TLS, Mark DeWeaver noted that:

I don’t see how we can speak of a country as capitalist if the majority of the means of production are state owned.  If capitalism means anything, it means that the means of production are in private hands.  “State capitalism” is an oxymoron.

So not only is China not-a-capitalist country (which Fogel spuriously asserts on p.3), but as The Economist noted three days ago, the state-owned interests are actually growing at the expense of private companies:

Though fewer in number, today’s SOEs are more powerful than ever. One reason is that they can be vast (see chart) and so their market power is often greater in a given industry. Their shrinking number is the result of a concerted effort to consolidate disparate SOEs into national champions in a range of “strategic industries”, which range from telecoms to shipbuilding.

Liberal reforms got a boost with China’s WTO entry in 2001—but slowed after 2006, and then, argue critics, went into reverse as the stimulus spending of the past few years flowed to SOE coffers. GK Dragonomics, a consultancy, estimates that the SOE share of investment, which had been in decline, has risen in property, communications and finance. In 2004 the average industrial output of SOEs was six times that of the average private firm; by 2010 it had shot up to 11 times as much.

In addition to sheer size (and a nod and a wink from the antitrust authorities), SOEs enjoy a range of unfair advantages. In return for guaranteed profits and state backing, official banks lend to SOEs at a third of the cost of credit available to private companies (those that can get official loans at all). The government showers a range of tax breaks and subsidies on state firms, and favours them in procurement contracts. Unirule, a Chinese think-tank, reckons not having to pay for the land SOEs sit on was a subsidy worth some 4 trillion yuan ($640 billion) in 2001-09.

Contra Fogel, even if state planners were more responsive, several million Party members and their relatives directly benefit from the status quo.  I believe Public Choice economists call this regulatory capture and intractable decision-making: or in other words, special interest groups will fight against such reforms.

The last point Fogel makes is that Chinese consumers are repressed and their pent up purchasing will be unleashed.  In his words:

Finally, people don’t give enough credit to China’ s long-repressed consumerist tendencies. In many ways, China is the most capitalist country in the world right now. In the big Chinese cities, living standards and per capita income are at the level of countries the World Bank would deem “high middle income,” already higher, for example, than that of the Czech Republic. In those cities there is already a high standard of living, and even alongside the vaunted Chinese propensity for saving, a clear and growing affinity for acquiring clothes, electronics, fast food, automobiles — all a glimpse into China’s future. Indeed, the government has made the judgment that increasing domestic consumption will be critical to China’s economy, and a host of domestic policies now aim to increase Chinese consumers’ appetite for acquisitions.

There are several problems with this.  The first of which is, as Michael Pettis has showed over and over again, consumption as a percentage of GDP has dropped every year for the past decade.  According to Yukon Huang, it has actually dropped “from 50 percent to below 35 percent [of GDP] over the past 15 years.”  And it continues to drop because of the silent bailouts that consumers (taxpayers) are giving to debtors.  This is done through repressed interest rates offered by state-owned banks who are required to fulfill loan quotas set by agencies such as the NDRC.  The banks and SOEs then service and refinance the subsequent non-performing loans with relatively low rates.  Thus until the banking system is reformed and banks are allowed to function as banks (by setting higher lending standards and raising rates to reflect risk), consumer spending will continue to remain repressed because of this wealth transfer.

As far as bigger Chinese cities with high “living standards” and high “per capita income” comparable to the Czech Republic (at ~$20,500/capita), I am curious to know which metros Fogle is thinking of: Shanghai (~$13,000/capita), Beijing (~$12,500) and Guangzhou (~$13,000) are somehow comparable with the West?  I have lived throughout China and I think Shanghai, where I have spent the last six months, is by far the most expensive city relative to the income earned.  In fact, Mercer’s 2012 report on the most expensive cities – the cost of living for expats illustrates this: Shanghai (16), Beijing (17), Guangzhou (31) yet Prague is 69th.

Notes in the margin

I enjoy receiving emails, especially from readers curious about China.  Alice mentioned a few other things in her email:

1) “China will have more skyscrapers than US in 5yrs” (Yahoo).  I am not sure why this is a objective metric to measure wealth or growth by.  Mark Thornton’s Skyscrapper Index suggests that certain central bank policies can distort the capital structure and capital formation — incentivizing firms to embark on real estate construction projects that are wholly unsustainable once interest rates rise and “cheap” credit is removed from the system.  We have already seen construction booms that have stopped.

2) “Glut of Solar Panels Poses a New Threat to China” (NY Times).  This certainly did not help her bullish case.  In a nutshell, central planners in China have dumped massive subsidies into renewable/green technology in an unprofitable industry resulting in large losses for banks.

According to the NYT:

The result is a looming financial disaster, not only for manufacturers but for state-owned banks that financed factories with approximately $18 billion in low-rate loans and for municipal and provincial governments that provided loan guarantees and sold manufacturers valuable land at deeply discounted prices.

Readers are encouraged to peruse an earlier post from Reason magazine, “China Is Winning the Race to Lose Billions on Solar Power.”

One last note, in her email Alice mentioned that there were two American asset managers who held the same view as the MarketWatch writer:  Jim Rogers who has said “America is More Communist than China” and Peter Schiff who said, “China More Capitalist Than America.”  I do not think their hyperbole helps her case.

As I have mentioned previously, if central planning and state ownership of the means of productions does not work anywhere, why will it work in China?  Emboldened Chinese planners may be biting off more than they can chew by trying to: build a moon base, build a blue water navy, build stadiums in South America & Africa (for free), build mian zi gong chen (face projects), etc.

Attempting to implement grand plans by ignoring markets may run into Misean coordination and calculation problems eventually leading to planned chaos.  While Yogi Berra was correct to say it is  impossible to guess or forecast what will happen in the next 30 years, the reasons laid out by Fogel, Rogers and Schiff are simply non sequitur — China may become wealthier than it is today, but probably not for the reasons they claim.

[Are China's go-go day's behind it or will it roll with the punches?  Below is an interview with Mark DeWeaver, author of the forthcoming book Animal Spirits with Chinese Characteristics -- to be released on December 11.  Mark received his PhD in economics from the University of Hawaii in 1998.  He is the co-founder of Quantrarian Capital Management a DC-based emerging markets hedge fund.]

Tim: Tell us a little about yourself, your academic background and what drew you to China?

Mark: I originally went to China in 1985 to study Chinese.  Later, as it started to seem that China would follow in the footsteps of Eastern Europe and the Soviet Union, I became interested in the transition from socialism to a market economy.  I ended up going back to school to study economics at the University of Hawaii, where I had an East-West Center scholarship.

Tim:  Why did you move to Hong Kong and what did you do there?

Mark:  I worked for Hong Kong brokerages but lived just over the border in Shenzhen.  I spent most of my time writing reports on the mainland projects of Hong Kong-listed companies and sometimes also translated meetings for visiting clients.

Tim:  What made you interested in writing a book?  Why now?

Mark:  The idea for the book occurred to me in the mid-2000s.  At that time our fund was entirely invested in Hong Kong and Chinese-listed stocks so I got pretty focused on the volatility of Chinese investment growth.  I noticed that little had been written on this subject in English so I thought I could fill an interesting niche for the English speaking reader.

It turns out that this is a pretty good time for the book to be coming out as people are beginning to talk about China’s economy slowing down.  But of course I didn’t originally anticipate this.

Tim:  Great title, what is the inspiration for it?

Mark:  Keynes believed that capitalist booms and busts are attributable to the “animal spirits” of private sector investors—spontaneous urges to act that are unrelated to objective calculations of profit and loss.  I wanted to emphasize that socialist economies are also subject to this kind of irrationality, though for different reasons.

Tim:  What made you gravitate towards the Austrian School of economics versus say something more mainstream like New Keynesianism or Monetarism?

Mark:  I think the Austrian economists are particularly interesting because of their analysis of the problems with the idea of central planning.  Other schools of economics are generally focused entirely on free enterprise economies and therefore have little relevance to China.

Tim:  You cite Mao, Marx, Engels and a number of other historical figures, notably János Kornai – a Hungarian economist – throughout your book.  What resonated from these characters?  What can their literature tell us that we may overlook today?

Mark:  I think the early economists are important because, as Keynes put it, “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist.”  We need to reread the long-dead economists to understand our own unstated assumptions.

Kornai is more recent, of course.  His 1992 book, The Socialist System, was particularly useful because it helped me to understand the similarities between the current Chinese investment cycle and those observed in the Soviet Union and the formerly socialist economies of Eastern Europe.

Tim:  Karl Marx’s magnum opus was all about Capital and was first published about decades ago, in 1867.  Yet after more than a century with over a hundred experiments in large scale, long term socialism: countries that had open markets, freer trade and political liberalizations are measurably wealthier and healthier.  Why is there still a debate regarding how capital is allocated, owned, created, pooled, consumed and distributed?

Mark:  I think the debate continues because so few people have any experience as proprietors.  People who have never run a business have difficulty really understanding how capitalism works. It is easy for them to be convinced that some other system could work better because they tend to assume away the information and coordination problems that the free enterprise system solves for us.

Tim:  So tell us about China.  Not a day goes by without ginourmous 50 size font headings published in newspapers around the world.  Are they, as Jim Chanos proclaimed “Dubai times 1000″?

Mark:  They are certainly some multiple of Dubai but I’m not sure it’s a thousand.  Also, unlike Dubai, China has a long history of misallocating investment.  While China is clearly headed for a slowdown at this point, I don’t know why this should be particularly more extreme than the many investment busts that the country has experienced in the past.

Tim:  One of the many stories we are continually told about China is that its growth is not only sustainable but its policy makers have the Midas touch.  Why is this not the case?

Mark:  Claims about the Midas touch overlook the poor quality of Chinese growth, much of which relies on investment in sectors that are already experiencing overcapacity.  Like Soviet communism, China’s economic system incentivizes quantity rather than quality.

Tim:  What about the Chinese consumer?  Michael Pettis has noted that every year for the past 10 years, consumption as a percent of GDP has gone down, despite the jawboning of policy makers.  Martin Wolf suggested earlier this year that some kind of rebalancing will take place and consumption will rise dramatically over the next decade.  Who is right?

Mark:  Rebalancing would require a redistribution of national income from the powerful to the powerless.  I don’t think anybody should hold his breath waiting for this to happen.

Tim:  Another one of the stories prevalently told is that this next century will be China’s.  Do you think that this is the case?

Mark: If that is the case I don’t know why wealthy Chinese go to such great lengths to get foreign passports for themselves and send their children abroad to study.  If they don’t believe in the Chinese century I don’t see why I should either.

Tim:  Despite a concerted marketing campaign, State-owned enterprises continue to dominate the economy as a whole, producing roughly 62% of all GDP and growing again.  Do you see these government managed agencies reforming and ultimately privatizing as proposed by the World Bank?

Mark:  These reforms are not going to happen in the absence of political change.  The powerful Party members that control these assets are not going to give them up voluntarily and the central government is not powerful enough to override them.

Tim:  In Godfather III, various mafia leaders attempt to legitimize their vast holdings, casting aside all illicit enterprises such as drug running.  One of the arguments Western expats have made in the past is that similarly, the Communist Party will also purportedly cast aside any and all taboo enterprises and begin promoting “best practices” much akin to large multinational companies.  The key difference of course is that Michael Corleone had to bribe senators and policy makers whereas the Communist Party is answerable and accountable to no one outside the party — the hongbao (red envelope) is simply moved around internally.  Is there any incentive for Xi Jinping and his new leadership team to reform and privatize?

Mark:  Actually I think the Party has a lot in common with the Corleone’s.  Even if the top leadership wanted to move to a “100 percent legitimate” way of doing things, it wouldn’t really be possible.  There would be too much resistance from the lower level cadres who are the main beneficiaries of the current system.

Tim:  Various China bulls have speculated that China is supposedly discretely buying up gold, silver and other commodities with the end goal of pegging the RMB to “hard money.”  Based on the Chinese financial press, does it appear that anyone within the PBoC, SAFE or other state financial organs plans to move towards a commodity-based currency?  Or will they continue the status quo in a post-Bretton Woods world — meaning Chinese policy makers are still at the mercy of the Federal Reserve?

Mark:  I think they are still at the mercy of the Fed.  There isn’t any place other than US treasuries where they can park USD 3 trillion in forex reserves. A commodity-based currency just wouldn’t be practical.

Tim:  One argument by China bulls have used is that Chinese policy makers have “plenty of ammo” left in their toolbox.  That the political class has ~$3.4 trillion in assets to dig themselves out of a quagmire, out of a “hard landing.”  Yet others suggest this is a sign of weakness, that neither SAFE nor the PBoC can actually use the assets without causing, for example, commodity prices to dramatically rise.  Who is right?

Mark:  Forex reserves aren’t useful for anything except financing imports and overseas acquisitions.  They don’t have any relevance to a “hard landing” caused by domestic imbalances.

Tim:  Jim Chanos has suggested that if you factor in non-performing loans (such as the $1.7 trillion recently “flipped over“) and inflation, there probably has not been any real growth in China for the past several years.  What do you think, do the GDP numbers reflect reality?

Mark:  It really depends on what reality we are trying to reflect.  I think the GDP numbers are probably as good a measure as any of the output of the economy.  If it’s a question of whether or not this output is useful for anything, then of course Chanos is right to be skeptical.  But it is still a bit unclear exactly what is meant by “real growth” and how this should be measured.

Tim:  It seems as though there has been a lot of wishful thinking on the part of Western analysts regarding what China is and will be — and what role the US will have in the future.  For example, just like Hayek justified Pinochet’s autocratic rule, so to have some libertarians white washed China’s totalitarian police state.  Why is this?

Mark:  I think libertarians have confused being free with being above the law.  In China well-connected people enjoy considerable freedom from government intervention.  Investors are free, for example, to violate environmental regulations with all but complete impunity.  But this isn’t real freedom.  The people who suffer the consequences are profoundly unfree.

Tim:  Bill Bishop has suggested that the Great Firewall has effectively created one world, two internets.  What are the negative economic consequences of not protecting free speech?  Does this censorship regime stifle innovation and creativity in the workplace and ultimately the marketplace?

Mark:  Intuitively it seems that the Great Firewall must have negative economic consequences but I can’t seem to think of any.  Most subjects can be discussed openly and those that can’t (e.g. the legitimacy of one-party rule) don’t generally seem to be the kinds of things that would have an impact on innovation.  I’m also not sure that Chinese places outside the Great Firewall (e.g. Taiwan) are any more innovative.  This is a puzzling question.

Tim:  Myanmar (Burma) recently began abolishing direct media censorship in August.  Do you think Chinese policy makers can and will eventually abolish the Great Firewall and other censorship apparatus’?

Mark:  I don’t see why they should.  The Burmese wouldn’t be doing this either if they weren’t so keen to have economic sanctions lifted.

Tim:  Let’s talk about science and technology in China.  You note that in Chapter 9 that “Central government officials will make up the research agenda; scientists will carry it out.”  Several western futurists such as Hugo de Garis and Ben Goertzel contend that China will be at the forefront of technological innovation, perhaps even creating a hypothetical “singularity.”  In contrast, Duncan Clark, a technology consultant in Beijing contends that China does not have the right kind of system to germinate and foster the needed innovation and creativity to build a new “Silicon Valley.”  What can the Japanese and Soviet planners (pdf) of the 1980s teach us about centrally controlled research and development?

Mark:  The governments of both Japan and the Soviet Union made unsuccessful attempts to stimulate technological innovation during the 1980s.  The Soviets focused on computers and machine tools, the Japanese on artificial intelligence.  Both failed to make any breakthroughs.

I think what this history teaches us is that innovation isn’t really amenable to central-government control.  The problem is that no one can really know in advance what ideas are worth pursuing.  Progress happens by accident, by trial and error.  It cannot be planned.

This makes it very unlikely that a country like China, where the majority of the economy is state owned, would be at the forefront of technological innovation.

Tim:  In terms of semiconductors sales, five out of the top 10 and eleven out of the top 25 semiconductor firms are US companies.  The others are from a handful of developed countries such as Japan and South Korea.  Yet one of the claims China bulls have made is that domestic players like SMIC will one day soon, replace the US as the dominant player.  Even with preferential policies (guanxi from Jiang Mianheng) can SMIC and other Chinese design houses leap-frog their counterparts in developed countries?  Since fabrication plants are extremely capital intensive, would Western firms be willing to risk building a new fab plant in China with the possibility that it would be “nationalized” and technology copied (e.g., similar to what happened with the French, German and Japanese rail technology that was copied)?

Mark:  It’s hard to see how any foreign firms would be willing to build fab plants in China, given the country’s abysmal record on protecting intellectual property rights.  The Chinese are going to have to build these plants themselves and I don’t see what advantages they will enjoy (other than a protected domestic market) vis a vis competitors in other countries.

Tim:  You mention some of the seen and unseen consequences of Chinese policy makers in erecting face projects.  For example in Chapter 5 you note a number of amusement parks that have been built with much fanfare, which were later reclaimed by nature and its weeds.  You also note how numerous airports have been erected and now lay dormant, such as the case of Fuyang in Anhui province.  And then you also mention how the high-speed rail initiative is a gigantic money pit, in which numerous billion dollar scandals have taken place and corruption running all the way to the top, with the firing of railway chairman Liu Zhijun.  What role does a lack of transparency, face-projects (mian zi gong cheng) and institutionalized nepotism (guanxi) play in these cases?

Mark:  Clearly all three are part of the problem.  The performance evaluation system for local officials incentivizes them to maximize GDP growth at the expense of economic efficiency while the lack of accountability allows them to push wasteful projects solely for the sake of bribes and kickbacks.

Like the owners of capitalist firms, Chinese officials are motivated by the desire for personal gain, but there can be no presumption that their machinations will generate socially optimal outcomes.  In this case, greed is not good.

Tim:  In the first couple of chapters you note how provinces basically operate as independent fiefdoms, with huge intra-state barriers to prevent neighboring competition.  Several industries impacted directly from this feuding are cement, steel and coal production.  You note that despite decades of jawboning, legislation, guided-consolidation and even (rarely) allowing market forces to clear unproductive assets — each province still owns and operates cement, steel and coal producers that bleed capital.  How did this come into being?  Why have past efforts seemingly failed?

Mark:  Again, the main problem is that officials are incentivized to maximize GDP within their jurisdictions.  This means that local-government sponsored entry in any given sector will continue as long as some official’s ranking will improve relative to others in his or her peer group.  It doesn’t really matter whether or not the new entrants will be profitable.  What’s important is the race for GDP growth.

The problem for the central government is that it has no effective means to bring about creative destruction.  Local governments have little trouble resisting attempts to eliminate excess capacity.  They may simply ignore central government directives or even go through the motions of dismantling plants only to reassemble them later on.

Tim:  At the height of the financial crisis in November of 2008, Hu Jintao promoted a large nationwide stimulus to purportedly prevent the country from falling into a recession.  Because this involved lowering interest rates and forcing the banks (all of which are state owned) to loan a certain quota, one of the unintended consequences was that asset bubbles formed in numerous industries, such as the real estate market.  And rather than raising interest rates, the policy makers have created what amounts to band-aids to prevent housing prices from rising.  One of these is a new property tax, which along with other legislation is supposed to stymie speculation.  Yet because of capital controls there are few choices for savers to park their funds.  Is this a classic case of a boom-bust cycle?  Can policy makers guide any of the asset classes to a “soft landing?”

Mark:  Yes, it certainly looks like a classic case.  I think administrative measures like changes in the tax code are unlikely to be enough to guarantee a “soft landing.”  The only way to keep asset prices up is to allow bank credit to continue to flow into speculation.  That, however, will eventually return the banks to the condition they were in in 2000, when their non-performing loan ratios were, by some accounts, as high as 50%.

Tim:  One of the unlikeliest of anti-property-tax proponents has been members of the political class themselves.  Because now they would have to divulge all of their assets, including those owned by mistresses, family members and business associates (70 Communist Party members alone are worth ~$90 billion).  Thus the fight against this measure is somewhat similar to the past struggles against official resumés and CV’s — once something is down on paper it is much harder to deny what your credentials and work history are, or in this case: what assets you are legally connected to.  What do you think the ultimate outcome will be?  Is this a positive harbinger for transparency?

Mark:  I think China’s elites will always be able to find a way around attempts to make them divulge all of their assets.  Transparency is not really possible when the people who have something to hide are the only ones with any real political power.

Tim:  Orville Schell has complained that the US government does not operate enough like the Chinese government, that more central planning and social engineering need to be undertaken.  Last spring he suggested that in contrast to a “gridlocked Congress,” Chinese policy makers are not bogged down and “get things done.”  Do you think Schell’s prescription will be effective and productive long term?

Mark:  The history of Beijing’s many failed efforts to eliminate excess capacity indicates that the Chinese government is not as good at “getting things done” as is commonly imagined. The central government can easily get things done if lower-level officials want to do them.  When central government policy runs counter to local interests, however, central government regulatory bodies often seem to be practically powerless.  Beijing can engineer investment booms in particular sectors without difficulty.  Eliminating excess capacity is much more difficult.

Implementing the Chinese system in the US would actually mean allowing US state and local governments to run the economy.  I doubt Schell, or anyone else, would like the result.

Tim:  As of this summer, there are a million USD millionaires in China now.  Do you think these are legitimate paper numbers or that once the fallout from the housing and other asset bubbles settles, there will be a large readjustment downwards?

Mark:  There would certainly be a large readjustment downwards.  These people aren’t keeping all their money under the mattress.  I imagine that many of them hold the majority of their net worth in the form of property.

Tim:  Earlier this summer, there was a paper (pdf) from the Brookings Institute that suggested that Shanghai will be an international financial center by 2020.  What do you think?  Isn’t there already a financial center in China called Hong Kong?

Mark:  Yes, Hong Kong has been China’s international financial center since the 1980s and this is unlikely to change.  There is certainly no likelihood of Shanghai being an international financial center as long as the Chinese yuan is not convertible.  Hong Kong also benefits from having a much more credible regulatory regime.

Tim:  Can you explain what kind of investment booms and busts there have been in the past six decades here in China.

Mark:  Chinese investment booms always begin with a relaxation of central government administrative policy.  This allows local governments to push all manner of projects within their jurisdictions, many funded with loans from the state-sector banks.  Under the pre-1978 command economy, this led to resource constraints.  Today the main result is inflation.

In either case, the central government eventually has to tighten policy for the sake of social stability.  This tightening takes the form of crackdowns on projects that went ahead without the required approvals or violate industrial policy, along with restrictions on bank lending.  Investment growth then falls abruptly.

Eventually the situation returns to normal.  It then becomes only a matter of time before the central government yields to pressure from local governments and relaxes policy.  Thus the cycle begins again.

Tim:  One of the complaints some foreign firms have in doing business with local firms is that it is a fragmented market (pdf), akin to the EU.  Why is there so much provincialism and protectionism within local markets?

Mark:  This gets back to the incentives facing local officials.  If they allow outsiders to sell within their jurisdictions GDP growth will suffer because there will be less local production.  Tax collections may suffer as well because VAT is collected at the factory rather than at the point of sale.

Tim:  There are a number of investors such as Jim Rogers who claim that China is extremely capitalistic, hinging on the free-market mecca — that China will never be Communist again.  Earlier this spring Peter Schiff debated the question as to whether or not China does capitalism better than the US.  He said yes.  I said no.  What do you think?  Despite having 82 million members in the Communist Party, has Communist ideology disappeared from China?

Mark:  I don’t see how we can speak of a country as capitalist if the majority of the means of production are state owned.  If capitalism means anything, it means that the means of production are in private hands.  “State capitalism” is an oxymoron.

Tim:  If central planning of the real-estate market could not work in the US, Spain, Ireland, Dubai and every other country it has been tried it, can it work in China?

Mark:  Not likely!  The actions of the myriad participants in a real estate market can’t even be predicted, let alone controlled.

Tim:  What are some other understated problems that China may have that are not receiving the attention it deserves?

Mark:  I think the main problem that is routinely overlooked is that the central government is not powerful enough to control local governments.  Even when there are solutions to China’s problems, it is often not politically possible for Beijing to implement them.

Tim:  Are there special interests groups in China?  Do they operate any differently than SIGs do in other countries?

Mark:  There are clearly special interest groups and many of them are quite powerful.  I think the main difference with SIGs in other countries is that in the Chinese case they often operate entirely above the law.

Tim:  Over the past several years The Economist  and other demographers have suggested that China will grow old before it grew rich, do you think there is a demographic wall approaching?  How can the policy makers avoid this?

Mark:  There is no doubt about the demographic wall and I think it is already too late to do anything about it.  Relaxing the one child policy seems an obvious place to start, but it’s not even clear that this would raise the birth rate that much.

Tim:  Several financial commentators have suggested that China could solve their demographic issues with more immigration.  Yet over the past year, the PRC has passed a number of laws making immigration more difficult, even for simple activities like tourism.  Is there any quick fix to alleviate the gender imbalance (~117 male:100 female), the relative low birth rate (roughly >1.5/mother due to the OCP) and a quickly aging population?

Mark:  No I don’t think immigration is going to be the answer.  It’s just not clear who would want to move there.  And I don’t think anything short of World War III is going to solve the gender imbalance.

Tim:  There has been some discussion as to whether or not Westerners, in particular young college graduates, should immigrate to China.  I recently weighed in on the matter. What are your thoughts?  Do you think the possible career opportunities of China outweigh the costs of working and staying in the developed world?

Mark:  I don’t think immigrating to China would be a logical choice for must foreigners.  There just wouldn’t be that many job opportunities for them, particularly if they don’t speak the language.  They would also be competing with the many Chinese graduates of US colleges that return home after graduating.

Tim:  You state on p.211 that “Following the 2003-2004 investment boom, for example, the State Council approved a policy designed to “advance the adjustment of the industrial structure” in over 20 industries.  This 2005 initiative was accompanied by a detailed list of project types, specifying which were to be “eliminated” (399 project types), “restricted” (190), or “encouraged” (593).”  This sounds like central planners are picking winners and losers.  Some China bulls say this does not occur.  How pervasive is it?  Does it only occur in industries like auto and aeronautics, where China has been trying to consolidate the industry into a few players?

Mark:  Yes, that certainly counts as picking winners and losers.  And this goes on in a wide range of industries.  In addition to high-profile cases like autos and aeronautics, we also find the central government trying to micromanage things like the sizes of cement kilns and steel mills.  In a lot of cases, however, the State Council can pick winners a lot more easily than it can pick losers.  When a factory is supposed to be eliminated, the local government will generally do everything it can to keep it open.

Tim:  On p.219-220 you explain the 90-70 rule.  Why are rules like this impossible to carry out even if described in explicit detail by central planners?

Mark:  The rule that 70% of residential construction consist of units no larger than 90 square meters could conceivably have been carried out in a Soviet-style command economy.  In today’s China, however, it made little sense because so much of the development is carried out by private companies on land purchased from local governments.

Of course such a rule would never really make sense from an economic point view.  70% and 90 square meters are arbitrary numbers.  It is highly unlikely that these would be optimal for every neighborhood of every city or even as city-wide averages for every municipality.

Tim:  You present case after case of central planning gone amok at every level of government in China.  Among others, the Tieben Steel quagmire in Changzhou comes to mind.   How are these favored projects different than say, Solyndra in the US?  Or more to the point, what are the differences between the problems China faces today, with those that the US faces?

Mark:  These problems are basically the same in every country.  The main difference between China and the US is simply one of degree.  If most of the US economy was controlled by local governments you would see pretty much the same results here.

Tim:  The Communist Party now has more than 80 million members, and each member directly supports 4-5 friends and relatives with their Party subsidies.  As a consequence, a large portion of the population has come to rely on direct financial assistance from these members.  What kind of institutional inertia does this special interest group cause for policy makers that try to reform and privatize Party owned and controlled assets?

Mark:  The more wealth Party members control, the more powerful they become and the harder it is to reform.  In the 1980s Party members had to give up some of their perks but were happy to embrace the reform and opening policy because it gave them a chance to get rich.  Now that they are already wealthy, it’s hard to see what they could be offered in exchange for changes to the status quo.

Tim:  You mention the evolution of the commercial Big Four banks in China.  For example, in the 1980s ICBC absorbed many of the divisions and activities that the new PBoC (central bank) used to maintain and manage.  And that China Construction Bank formed from a split with its parent, the Ministry of Finance.  Recently the PBoC told commercial lenders to “roll over government loans” — all $1.7 trillion coming due in the next three years.  Has the banking sector truly reformed like the NDRC and various Western financial consultants claim it has?

Mark:  Evidently not.  The many organizational changes at the state-sector banks have failed to get to the root of the problem, which is Party control of bank lending.

Tim:  As the story goes, when Ludwig von Mises was asked if there was anything that separated a free-market economy from a socialist endeavor, he said “a stock market.”   China has several, by volume the two largest of which are in Shanghai and Shenzhen.  What do you think Mises would say about that?  Is there any firm division between a socialist state and one that is free-market driven?  Are these ‘cargo cult‘ stock markets?

Mark:  I don’t think Mises was thinking of stock markets where most of the shares are state owned.  You can’t really have a free market economy as long as the means of production are in the hands of the state.  Securitizing the state’s ownership rights doesn’t change this reality.

At the same time, however, Chinese companies do raise money by selling shares.  So we can’t really call the stock markets ‘cargo cult’ markets.  The real cargo cultism occurs when local governments build absurd projects such as replicas of Beijing Olympics venues or grandiose “international” airports.

Tim:  I frequently hear bullish expats explain that the bearish ‘pessimism’ reported from the WSJ and Bloomberg are merely exceptions to the rule.  That beyond the marginal freedoms that the average Chinese person enjoys (e.g., fewer restrictions on marriage, hours of work, entertainment, where to shop), that the average Chinese entrepreneur has better chances, easier chances to set-up shop and satiate market demand — than they would have in Western countries like the US.  Do you think this is the case?

Mark:  I think that’s the case for well-connected Chinese entrepreneurs but not for anybody else.  Lack of government interference is something people enjoy because they are above the law, not because they are free.

Tim:  In one egregious case of bank fraud you note a case-study:

One of the largest cases to be made public came to light almost immediately following the CBRC’s urgent notification.  The Huanghe Rd. branch of the China Construction Bank in Luohe, Henan Province, was found to have accepted 319 million yuan worth of bills without authorization.  As a “second tier” branch, it was only authorized to accept bills with 100 percent margin deposits.  To get around this requirement, the management simply began to do an off balance sheet business, accepting bills with less than 100 percent margin and not reporting them to the head office.

This does not seem to be an exception to the rule, as you note moments later that stock market speculators, that used such techniques went into a frenzy to liquidate their holdings.  And that,

One effect of the crackdown was that stock market speculators using discounted bills to finance trades were suddenly forced to liquidate their positions.  This appears to have been one of the main reasons for the nine percent decline in the Shanghai Stock Exchange index from July 3 to July 31, 2006.

Is there any way as an outside, foreign investor, to trust the financial books of banks in China?  After all, during the height of the financial crisis, many financial pundits lauded the seemingly conservative banking environment in China — which supposedly sheltered the country from the subsequent fallout.

Mark:  No I don’t think anyone should trust the banks financials.  They are obviously not doing enough provisioning for non-performing loans, particularly loans to local government investment platforms.  Judging from how the Hong Kong-listed banks have performed, it’s clear that most market participants don’t believe the banks’ reporting either.

Tim:  With all this bearishness, what are some bright gems about China?  Is the typical Chinese better off today than they were at any other time in the past 200 years?

Mark:  Yes, it certainly must be true that the typical Chinese is better off.  And there’s no doubt that China’s post-1978 economic ‘miracle’ is real.  The point I’m making in my book is that investment during booms tends to be inefficient, not that all of the projects are Potemkin villages.

Tim:  What are your future plans with Quantrarian?

Mark:  At the moment our fund is entirely invested in Iraq Stock Exchange listed companies (mostly banks).  This is likely to continue to be the case for the foreseeable future.

Tim:  Any other parting words regarding the financial future of China, the US and the global economy?

Mark:  I think China is likely to experience a protracted deceleration over the next decade, much as it did following the investment boom of 1993.  That time, GDP growth trended downward for almost a decade.  I don’t know why this time should be different.

Future investment booms will also have a much greater inflationary impact on the world economy than has been the case so far.  As China’s share of global GDP continues to rise, I think Chinese investment is likely to become a major driver of the global business cycle.

Tim: Thanks again for your time.  Readers may be interested in Mark’s writings at the Mises Institute, Iraq Business News, Project Syndicate and Asia Times.

Over the past several months I have noticed on a number of blogs promote a Quixotic theory — an underlying desire for some kind of economic Armageddon in which:

1) US financial system collapses
2) ???
3) Gold owners become the new kings*

While I am certainly not a fan of the status quo, I just do not see much direct evidence to support the thesis that Apocalypse Now is just around the corner, if ever.

Other theories circulated by self-proclaimed financial contrarians are along the lines of:

1) Conspiring central bankers induce a global hyperinflationary storm
2) ???
3) No more politicians or central planners — everyone uses gold and silver*

Again, not that I am for the status quo — I certainly would love freer markets, freer trade, no war, etc. — but simply wishing for it to happen and nirvana happening does not follow.  It is a non sequitur.  Furthermore, wishful thinking is also fallacy.

Or in other words, if simply wishing for something X to happen made something X to actually occur, then every ideological goal would be achieved, including the ones that contradict one another!  Perhaps this desired apocalypse will take place sooner if it is blogged about more often!

Yet, in the event of another financial purge similar to 2008-2009, it is not like the central bankers and treasury policy makers in 200-some-odd countries are going to wake up the next day and resolve immediately to be “Austrian” or libertarian.  In fact, since 2008 central banks and treasuries have arguably become more emboldened and lionized.

Thus, there is academically crafting an ideal market process and then there is reality by which government intervention is the rule not the exception.  Those living within a reality distortion field are no better off financially than Y2K preppers, Millerites or doomsayers of yore (for more on apocaholic’s see also this excellent piece from Wired).

Labor inputs and productivity outputs

This also touches on my NBER post a couple weeks ago.  I briefly mentioned it: the positive labor issues that have gone left unsaid, that despite a relatively low participation rate (the lowest in 30 years), the US is still producing the same and perhaps even more “economic activity” than ever before.

While this could be due to labor saving technologies and/or replacements (e.g., automated robots in the factory & warehouse), I think this is a very positive attribute that is overlooked in all of the election-year pandering.

For example, according to CNBC and Huffington, workforce participation is the lowest since 1981.  Yet this loss in labor input has not resulted in a dramatic drop in productive output.  As I mentioned in the post above, I think this has a lot to do with several factors: labor saving technologies, freer global trade, more countries producing on the open market, fewer ginormous wars, etc.

With that said, I also think that one of the reasons welfare projects like Social Security probably “won’t run out” is because of the continued growth in non-human productivity.  And, in the event this robotic labor force does not fit the bill, I would argue that future US population pyramids (like this one) illustrate that unlike the rest of the world, the US will have enough Peter’s to subsidize elderly Paul’s.  Again, these subsidies and government programs are not something I endorse, but rather the above statements are simply a reflection of reality, of what is actually taking place in meat space.

In contrast, by 2050 China’s population problems (see this moving pyramid) are thus: 30% of the population will be 60+ and only 48% of the population will be of working-age.   In fact, BusinessSpectator recently published a well-written, in-depth exposition about the looming demographic challenges facing China.

Now of course as a libertarian this is not the kind of economic world that I laude or that I would applause, but I think this is an accurate description of the world as it is today and will be in the foreseeable future.

Credit deflation, not mass inflation

Short of handing out envelopes with bundles of cash, what can the Fed do, that it already has not that could possibly lead to an immediate Schiffian apocalypse?  (Peter Schiff recently called QE3 the “final nail” in the USD coffin… yet he and many others like Gerald Celente, have used similar phrases for years; how many nails has Schiff used now?)

And assuming it can create an actual Schiffian apocalypse, how does this then lead to a world in which more exchanges are done via gold/commodity-based currency and a proverbial libertarian nirvana?

The problem with most of the libertarian movement and large portions of the Austrian school since 2008 has been their inability to admit that they are wrong about the Fed’s power today versus 70 years ago (I admitted I was wrong about China). Or how a transition towards “Austrian-friendly” policies would ever take place.

Some Austrians are worried about the money multiplier mechanism producing mass inflation. That the Fed increases its balance sheet by a trillion dollars, the banks lend this out 10 times over, producing $10 trillion in new money supply.  Nothing of the sort, or anything remotely like it happened.

The Fed on the other hand is trying to spur lending by increasing the demand for loans. There are two problems going on:

1. Credit standards are way tighter now than in 2002-2006
2. The demand for loans is much lower

They are trying to fix two issues by lowering long term interest rates in the mortgage market to lower the cost of buying/owning — reflating the previous asset boom.  This of course is not helping purge the malinvestment from the system, but it is also not creating a Misean crack-boom either.

Thus, if you’re willing to entertain for the moment that hyperinflation might not occur, I highly recommend a thorough explanation for “Why Credit Deflation is More Likely than Mass Inflation” — I think it arguably explains the financial phenomenon we have witnessed.

Furthermore, because of the numerous dollar-pegs and currency reserves, many other countries effectively import the Fed’s monetary policy.  China and most of “emerging” East Asia strive to have “weak” currencies to help their exports, this is actually done to the detriment of their domestic economies (it makes it more expensive to import needed commodities to develop).  Yet there are so many entrenched interests that benefit from this (e.g., large exporters in Guangdong and Zhejiang) that it will continue unabated.  Thus through their myopic neo-mercantilistic policies they will continue to import US fiscal policy even during another financial purge or three.

Is there really a time limit to the mixed economy that is the US?

It is impossible to predict because the market can produce things that were never imagined in the past.  The market giveth, the state taketh away.  Which force is dominant is empirical.  Unfortunately, many apocaholic libertarians are entirely too confident in their predictions of imminent doom.  Yet refuse to acknowledge that they may indeed be wrong.

One final note: regarding perpetual European bailouts, for some backstory I recommend Philipp Bagus, The Tragedy of the Euro (pdf).  As loathsome and perverse as this situation is, this is just one more reason to move back to the US — residents of the US benefit greatly from this predicament.

[* both of these theories line of reasoning is similar to the Underpant Gnomes in South Park as well as the encryption realists from XKCD.  Also, many thanks to Vijay Boyapati, James Miller, Wirkman Virkkala, and Anthony Gregory for their comments and suggestions.]

One of the videos that has taken the internets by storm comes way of South Korea, called Gangnam Style.  The Atlantic has a fantastic overview of its back-history and why it is so popular both in the Hermit Kingdom and globally.

Here is a copy via Youku (Youtube is blocked out here).

It has racked up more than 274 million views and its success is in part not just because of the subtle parodies of the posh Korean gu of Gangnam, but because its creator, Psy, waived all copyrights.  This (in)action thus paved the way for remixing and covers (among other creations).  The Guardian has more details:

The video also contains the seeds of its own reconstruction – which goes a long way to explain its success. The dance moves are simple enough to mimic and easily copied scenarios – such as the elevator scene – call out to be aped. Psy has produced a video that is born to spawn and has further facilitated this by waiving his copyright. This stands in high contrast to many western hip-hop stars who have been slow to relinquish control of their “intellectual” property in the same way (take Jay-Z’s Empire State of Mind, for example, which quickly generated a host of YouTube tributes that were quickly removed by EMI).

See also: Against Intellectual Property (pdf) by Stephan Kinsella.

Update:  Be sure to also read Mike Masnick’s detailed post over at TechDirt  and Evan Osnos’s excellent piece from The New Yorker, Why China Lacks Gangnam Style

No.

Contrary to the hyperbole of the blogosphere, this year neither the US nor China will burn to the ground in some grotesque fashion.

No the Chinese yuan (RMB) is not taking over the international markets (it accounts for a mere 0.6% of letter-of-credit transactions), no there is no concerted war on the USD.  In fact, despite incredulous hypotheticals to the contrary, China is still buying US treasuries.  The RMB has also depreciated relative to the USD.

Exaggerations sell and exaggerating more than the next Joe is even more sellable (sic).   Or  as Matt Ridley wrote in a recent Wired piece, many westerners have become apocaholics.

There won’t be a nuclear exchange between the US and China or China and Japan (the Chinese arsenal by the way, is overstated and exaggerated by the same hawks that brought us the second Iraq wars).  In fact, Bill Gertz, among others is flat out wrong regarding his assertions of China’s secret nuclear stockpile.

In fact, despite a concerted effort by the CCP and state media (like Xinhua) to paint Japan (and the US) as foreign devils, there probably will not be any military confrontation between China and Japan.  In part because there is approximately $350 billion in bilateral trade and also, for what Bill Bishop has recently written: cooler heads on both sides want a dialogue.   Similarly, never in the history of the modern world have the two largest trading partners, let alone the two largest economies, gone to war with one another.

Or in other words, US and Chinese businesses would not want to torpedo their cargo ships, bomb their own factories, blow up their employees, burn their shareholders, decimate the infrastructure that provides electricity, water and telecommunication services to their retail stores and/or otherwise destroy their property.  (As an aside, to assuage those electoral fears of a purported Chinese invasion: the Chinese military complex can’t even make decent jet engines yet, what jets will protect this phantom invasion fleet?)

Pandemonium might be the lucid dream of certain bloggers who enjoy hyping a story but wishful thinking is of course, fallacious at best.

What problems will China face internally?

Michael Pettis’ latest newsletter is fantastic, he highlights many of the problems that a China bull faces and how these “small hiccups” have turned into large quagmires.

In particular he takes to task a recent piece from The Economist which stated:

But China’s high investment is backed by even higher saving. As a consequence, China does not need its investment to generate high returns in order to pay back external creditors. China has, in effect, already set aside the resources that will be lost if its investments turn sour.

Here was Pettis’ excellent reply:

This doesn’t make sense to me at all and illustrates, I think, some of the confusion about what savings mean. The passage seems to assume that the main economic problem facing a developing country is paying back external creditors.

But this isn’t the case. External debt is generally is a problem for smaller countries, but as the Reinhart and Rogoff book, This Time is Different, makes clear (and this is something that most financial historians already knew), most economic or financial crises are domestic, not external. It is true that many of the crises in the 1980s and 1990s were external debt crises, and this has colored our view of what a financial crisis must be, but this shouldn’t lead us to think that countries only have crises if their savings are insufficient to cover investment (I.e. they are running a current account deficit).

After all the US had no problem paying back external debt in the 1930s and Japan had no problem paying external debt in the 1990s. In both cases domestic savings far exceeded domestic investment – or, to put in the same terms as The Economist, their high investment was backed up by even higher savings – and yet both suffered tremendous slowdowns in economic growth and the US had a financial crisis.

Likewise China of course will also have no problem paying back its external debt, but losses do not occur when you borrow in foreign currency to fund investments. They occur when you invest in projects that are not economically viable, no matter how they are funded.

What is more important, it is not meaningful to say that China’s high investment is “backed” by higher savings. The Chinese growth model forces up savings, by constraining consumption growth, in order to fund investment (a higher savings rate is the same thing as a lower consumption rate) just as Alexander Gershenkron prescribed in the 1950s and 1960s. But once investment is misallocated (or “malinvested”, as The Economist prefers) higher savings is not a solution to the problem but rather a manifestation of the problem itself. If you do not believe this, then Japan’s Lost Decade(s) is very hard to explain.

Perhaps the easiest way to prove this is with a simple thought experiment.  Let us assume that Beijing decides immediately to tax half of Chinese household income and to use the money to build a bunch of useless bridges. Would this be good for China? Certainly not, and the impact would be more debt and slower future growth as the cost of the excess debt was absorbed. What happens to the investment rate? It goes up, of course, along with GDP.

But what happens to the savings rate? It also goes up. Why? Because if you cut the disposable income of Chinese households in half, presumably you would cut consumption by nearly that amount. Since savings is simply GDP minus consumption, savings will soar.

Notice that the condition – that savings exceed investment – will still be met, and by definition as long as China runs a current account surplus savings must exceed investment. And yet it doesn’t help. Wasting money is always value destroying, and the fact that it is funded by domestic savings – as in Japan in the 1980s, the USSR in the 1950s and 1960s, and Brazil before 1975 – or foreign savings – as Latin America after 1975 and much of Asian in the 1990s – makes little difference except in the resolution.

Pettis also raises a few question of his own and notes that hidden bad debt (e.g., an additional 1 trillion RMB of non-performing “stimulus” loans on top of the 17 trillion RMB of possible non-performing loans) must be accounted for in any system, especially one like China that lacks transparency.

Here is a quick taste of the relevant news coming out of the land I currently reside:

• Ghost warehouse stocks haunt China’s steel sector (Reuters)
• Construction and Real Estate Hinder China’s Growth (NYT)
• End of Construction Boom Sparks Frenzy of Sales Aided by Credit—And Worries of Customer Defaults (WSJ)
• Car Dealers See Market Shift to Lower Gear (Caixin)
• Economist Lin Yifu on State-Sustained Growth (Caixin)
• China’s urbanization lacks quality, requires huge investment: green paper (Xinhua)
• Moneyless Pensions Yield No Gold for the Old (Caixin)
• China to Expand Insurance So Sick Don’t ‘Lose Everything’ (Bloomberg)
• China Stocks Fall to Lowest Level Since 2009 on Japan Row, Data (Bloomberg)
• Wu Jinglian: Local Governments’ CNY17Trl Investment Unsustainable (Caijing)
• China’s Slowdown May Be Worse Than Official Data Suggest (DallasFed)
• China’s a ‘Roach Motel’; Don’t Trust the Numbers: Chanos (CNBC)
• Building And Operating A China Factory. Why Even Bother? (CLB)
• BHP Says Pace of China Iron Ore Demand Has Slowed by Half  (Bloomberg)
• Re-Examining Re-Education Through Labor (WSJ)
• China builds its own military-industrial complex (Reuters)

Notes in the margin

A friend recently asked me if he should buy property in China.

My response was that you actually wouldn’t “own” the land.  You take out a lease that is at maximum, lasts for 70 years.  Here is a detailed NYT piece on this issue as it pertains to Chinese men without brides and an in-depth FT article on the same topic (speaking of which, here is an excellent piece on China’s gender imbalance from TCS) .

Furthermore, it can be confiscated without restitution.  Unlike the US and other western countries with lawyers and legal recourse, trying to own property in China would be risking a lot because if your is successful, and even if you are not, a local gang/politician could easily confiscate it and/or demand some kind of bribe.  All without any compensation.  Caveat emptor.