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Animal Spirits is nothing like these quickly outdated books and will arguably be timeless in part because of its methodological approach.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

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 best illustrations of hyperbole regarding China in some financial circles is the disingenuous belief that the PBoC, SAFE, CITIC and other Chinese agencies could use a mythical financial “nuclear” weapon by selling all of their US treasuries at one time — which in their RDF-minds would somehow decimate the US bond market.

And while I am hardly bedfellows with the Pentagon, some analysts at the DoD put together a well-reasoned bucket of cold water to throw on the faces of hysterics this election cycle.

Below are quotes from a thorough Bloomberg report (which is still blocked out here) regarding the DoD analysis:

China’s holdings of more than $1 trillion in U.S. debt and the prospect that it might “suddenly and significantly” withdraw funds don’t pose a national security threat, according to a first-ever Pentagon assessment.

Again, the Federal Reserve and oodles of other non-governmental organizations, banks and institutions could easily step in and buy the notes without much of a blip.  And any asset the Chinese buy will necessarily increase in value — thus costing them more.  Over the past several years there have been a few officials at SAFE and PBoC that have publicly discussed this issue — they are aware that they are stuck between a rock and a hard place.

And on that note

Since we have now broached the topic of what country is really reliant on the other, China depends much more on the US than the US does China.  The US exports substantial amounts of agricultural products to China whereas Chinese manufacturers are heavily dependent on US consumers.

There is also so much subsidization at all levels of the exporting industry along Chinese coastal provinces at the detriment of the domestic consumer/resident (exporters receive preferential tax breaks and many manufacturers also receive preferential loan treatment, which must be paid by someone).  This is hardly a new discovery either, see this 2007 story from the NYT for one example.

In fact, one reason the PBoC and SAFE continue to buy and hold treasuries, as the Bloomberg report notes,  is to maintain their yuan peg (to the detriment of the Chinese importer).  And they are not floating it anytime soon.  In fact, the yuan has depreciated relative to the USD over the past 6 months to help exporters (1 2 3).

On a tangential note, while the US solar panel lobby has won regulatory capture (if you thought Solyndra was bad, US manufacturers convinced policy makers to impose duties on Chinese-made solar panels increasing the costs to consumers), the same thing has occurred in Guangdong and Zhejiang with manufacturers that lobby and bribe (hong bao) Party members in Beijing.  Also, not to justify the ridiculous duties placed on Chinese solar panels, but the Chinese solar panel industry is also heavily subsidized and assisted.  See also this good overview from Reason.

When should an entrepreneur or firm consume capital instead of accumulate it?  Earlier this week Google executive chairman Eric Schmidt debated techno-guru-investor Peter Thiel regarding innovation and finance — and never once used the word capital.

Reason – among many other sites – is covering this story and published Thiel’s following comment:

I’m Libertarian, I think [technological stagnation is] because the government has outlawed technology…I think we’ve basically outlawed everything having to do with the world of stuff, and the only thing you’re allowed to do is in the world of bits. And that’s why we’ve had a lot of progress in computers and finance. Those were the two areas where there was enormous innovation in the last 40 years. It looks like finance is in the process of getting outlawed….

[Google]has 30, 40, 50 billion in cash. It has no idea how to invest that money in technology effectively. So, it prefers getting zero percent interest from Mr. Bernanke, effectively the cash sort of gets burned away over time through inflation, because there are no ideas that Google has how to spend money….

if we’re living in an accelerating technological world, and you have zero percent interest rates in the background, you should be able to invest all of your money in things that will return it many times over, and the fact that you’re out of ideas, maybe it’s a political problem, the government has outlawed things. But, it still is a problem….

the intellectually honest thing to do would be to say that Google is no longer a technology company, that it’s basically ‑‑ it’s a search engine. The search technology was developed a decade ago. It’s a bet that there will be no one else who will come up with a better search technology. So, you invest in Google, because you’re betting against technological innovation in search. And it’s like a bank that generates enormous cash flows every year, but you can’t issue a dividend, because the day you take that $30 billion and send it back to people you’re admitting that you’re no longer a technology company. That’s why Microsoft can’t return its money. That’s why all these companies are building up hordes of cash, because they don’t know what to do with it, but they don’t want to admit they’re no longer tech companies.

Brian Doherty of Reason asks readers if there was a way to poke holes into Thiel’s position.

The problem is, on one hand Thiel is accidentally right.  Though in fairness it is not Google’s fault for the Federal Reserve’s low-interest rate policies (LIRP) and QE policies.

The problem facing innovation as a whole – one that I argue at length at Prometheus Unbound – has to do with capital structure.  It is the Federal Reserve’s fault – not Google’s – for manipulating interest rates (no offense LIBOR-gate) and thus creating a poor investment climate, poor incentives to accumulate capital.

If I may quote myself, there is actually a two-front economic war on the development of technological innovation and building a singularity.

National debt is cannibalizing and monopolizing funds that could otherwise be spent by individuals and enterprises on innovative products and services.  This same debt further crowds out private competition and productive endeavors as government agencies continue to promote national taxpayer-financed initiatives.

This phenomenon creates a disincentive to compete with national agencies working on similar projects; after all, how can you convince a VC to privately invest in space flight when nearly a dozen government agencies worldwide already do that — you have to compete against what your taxes provide!.  In addition, skilled human capital is tied up in national programs and they are apriori ducat-for-ducat less productive in government-managed projects than in private endeavors. Imagine the innovations that could come from startups if this human capital was no longer tied up in impractical, unproductive Big Science projects.

The other attack is inadvertently from central banks, whose artificially low-interest rates, and sometimes zero-interest rates (ZIRP), creates a disincentive to save as well as inflationary conditions that drive up the price of commodities, rare-earth minerals, and other materials that are used in the construction of smartphones, telecom gear, computers, fab tools, and robots.  In order to finance capital construction, in order to finance research, in order to finance an enterprise someone has to save.

When interest rates are being systematically suppressed globally this distorts time preference; it will cause planned investment by entrepreneurs to exceed planned savings by consumers.  Or in other words, ZIRP signals to entrepreneurs to consume capital (borrow credit) which ultimately leads to malinvestment in a particular asset class or classes.  As a consequence, because time preference is being distorted, market participants who would otherwise be saving or abstaining — and thus replenishing the stock of capital — take out loans to finance dubious projects that would otherwise not have been undertaken if interest rates were higher.  This leads to an unsustainable boom and inevitably a bust.

The end result, on top of innovation stagnation, is that this environment hinders consumers from being able to purchase high-quality computronium, and higher commodity prices have an unseen effect on manufacturers who are pinched from being able to produce and sell relatively cheap devices into consumer markets.

Another problem with Thiel’s argument is that he, as an outside observer, is claiming to know what is and is not the right amount of war chest a company should and should not have.  Unfortunately, there is no such thing as a “right” amount — it is entirely a decision left for market participants to figure out.  Perhaps tech firms would be better off accumulating $100 billion in capital assets.  Perhaps only $1 billion.  It is impossible to know apriori.

Perhaps Intel’s recent $2.1 billion investment in ASML will ultimately be a poor decision in the long-run.  Maybe if the Federal Reserve and other central banks were not suppressing interest rates and trying to reflate their way out of a recession — interest rates would be much higher.  And thus the decision makers at Intel (e.g., asset managers) would have faced a set of different incentives to work with — maybe they would have done a share repurchase instead.  Or issue a dividend.  Or create a skunkworks subsidiary.

Similarly, if interest rates were 500 basis points higher, firms with relatively large war chests like Google and Microsoft would also have alternative investments to consider.  Consuming capital is not always the most efficient choice — in fact, one could argue that there has been too little capital accumulation going on in the past five years and note enough accumulation — hence massive imbalances that various purging actions (e.g., recessions) are trying to rectify but cannot due to government intervention.

One last quibble: the central planners at national banks and treasury departments are (unintentionally) creating a climate of uncertainty (e.g., bailouts, subsidies, nationalizations) that sends conflicting signals to market participants.  Perhaps tech firms such as Google or Microsoft are holding out for more certain fiscal environments.  (For those interested, as an aside, Ludwig Lachmann made an entire career discussing the role uncertainty played in human action and economic coordination.)

For a thorough discussion regarding the boom-bust cycle, see p. 40 in Interventionism: An Economic Analysis by Ludwig von Mises.

[Note: a revised edition of this was originally scheduled to be published in an upcoming newsletter but I have (temporarily) moved back to Shanghai and think all this information should be pushed to a broader audience]

On March 15 Bo Xilai, a prominent Party secretary was publicly sacked.  A week later rumors of a coup were reported to have taken place by Bo’s allies in Zhongnanhai, the central leadership compound in Beijing.  Several days later a Ferrari crashed at 4am in the morning in Beijing but was immediately scrubbed from the media, prompting speculation that it was possibly driven by Bo’s playboy son.  And earlier this week Bo Xilai was officially removed from the Politburo while simultaneously his wife was arrested in connection to the murder of a British expat.

Quite a wild month.

To make matters more colorful, in the West it seems everyone from farmers to factory workers, from interns to captains of industry has an opinion about what is going on in the middle kingdom.  But the truth is, outside of the Politburo, no one really knows what has been decided and what will be implemented.  And this is by design.

 While the Party no longer owns all forms of communication, it does control and screen what all media outlets publish via strict censorship regulations.  Foreign owned and operated media are selectively blacklisted and social media sites such as Facebook and Twitter have been blocked since July of 2009.  Domestic Twitter-like services such as Sina Weibo are routinely ‘harmonized’ (hexie) of politically sensitive material.  This includes crashes such as the aforementioned Ferrari, the Wenzhou high-speed train incident that killed 40 last summer and thousands of other documented taboos.  In fact, last week all Twitter-like services had their comments disabled in a governmental effort to eradicate and purge “rumors” from the interweb.   Thus, the continued existence of this ‘Great Fire Wall’ creates as IT guru Bill Bishop laments: one world, two internets.

In short, today’s China watchers, Sinologists and tea-leaf interpreters are yesteryears Kremlinologists.

Beijing is a black-box.  We can analyze the inputs and outputs but as Bismarck might say, we never really get to see how the sausage gets made.

For example, throughout the dark days of the fourth quarter of 2008, analysts at banking and energy firms hired lookouts in Hong Kong, to observe and note the arrival of coal and iron ore shipments.  The analysts believed that by tracking these bulk deliveries it would allow them to accurately gauge the potential economic activity that could be taking place on the mainland.  Similarly, by looking at output statistics such as energy consumption and energy production levels analysts can predict what the economic growth rate is – after all, without electricity you cannot power homes, factories or offices.

However one of the problems at looking just at these inputs and outputs is that they cannot accurately gauge what kind of productive activity has taken place.  This is not an argument regarding whether or not activity is taking place, but rather the argument should be whether or not the activity is productive, profitable and sustainable.  The answer to that is, no.

Productive and unproductive economic activity

However before we look at the various economic indicators being reported by intelligence firms, let us take a step back and look at this economic black box from a theoretical standpoint.

Does central planning work?

If you follow the Misean or even Hayekian belief that socialists economies cannot inherently calculate, that central planners cannot effectively and efficiently allocate resources in a productive and profitable manner a priori, then the answer to this question is always no.

Central planning of the mortgage industry was disastrous in the US and everywhere it has been tried, as illustrated most notably by Michael Lewis in Ireland, Spain and Dubai.  A century of central planning of interest rates throughout the East and West has resulted in a continuous series of deleterious boom-bust cycles that distort risk and misallocate resources on a massive scale, a fatal experiment that continues to this day.  Similar attempts to governmentally coordinate and manage healthcare, education and any other industry results in similar regulatory capture, cronyism, misallocations and monetary sink holes.

If socialism and central planning does not work in theory or in practice, if you recognize the Soviet Union fell apart because as Thatcher suggested, you eventually run out of other people’s money, then the latest incarnation – an experiment of socialism-with-Chinese characteristics cannot work too.  Period.

Selling snake oil

In a recent debate held in NYC, financier and China-bull Peter Schiff argued that China is headed in the right direction and that it does capitalism better than the US.  To back up his bold claims he suggested that China’s balance-of-trade surplus and seemingly low debt-to-GDP ratio were virtues that reflect a healthy economy.

The problem with these claims is that China’s balance-of-trade is wholly unsustainable based upon the mere fact that it is spurred by guihua, centrally managed five-year plans.  The Soviets called them Pyatiletka and the Indians called it License Raj.  The end result is planned chaos.

Since its victory over the Kuomintang, the CCP at every level has tried one ham-fisted development plan after the other.  In his upcoming book, Mark DeWeaver meticulously details Chinese investment cycles over the past six decades and notes that the current boom-bust is fundamentally no different than myopic agricultural and iron smelting projects of the 1950s.  Behind a veneer of opening and reform, the central government and its subordinates at the provincial level continuously creates quantitative output goals for each province (or as Chanos and DeWeaver have both noted: local governments exceed the central government targets, coincidentally).  The end result is a total Balkanization of intra-provincial trade, massive subsidies and ultimately overcapacity.

For illustrative purposes let us assume that GDP can and does measure what it is supposed to.  In the New York debate and on his radio show Schiff continually points to officially published GDP metrics that suggest China’s debt-to-GDP is roughly 65% compared to 100% in the US and 200% in Japan.  However professor Victor Shih has suggested that the Chinese number is really over 100% GDP because of local and provincial government debt which has been and will continue to be “bailed out” by the national government.  Though the fact of the matter is we really do not know what percentage level because there is no transparency; the media blackout coupled with the fact that national initiatives are difficult to follow through with at local/provincial levels: it is a bit hard to figure out what the truth is.  Or more to the point, it is a Herculean task to investigate and write about a country with a continuously changing past!

Other China-bulls such as Jim Rogers lambast the BLS and routinely cite independent analysts such as John Williams who thrive by publishing alternative macroeconomic metrics, yet seemingly embrace the statistics published by the CCP.  Which begs the question: why central planning somehow works this time around because it is China?

In the same New York debate, Ian Bremmer noted that 62% of China’s GDP is comprised from state-owned-enterprises (SOEs).  In fact, to give you a more clear picture of just how dominating the government still is, here is a quote from a very informative book published last year, China’s New Place in a World of Crisis:

After several stages of reform, Chinese SOEs still dominate among large enterprises in China to a remarkable degree.  SOEs   account for 70 per cent of the Chinese top-500 enterprises, 94 per cent of assets and 88 per cent of profits.  The Chinese SOEs also contribute 93 per cent of taxes generated from, and employ 89 per cent of the total workforce in the Chinese top-500 enterprises.

 And as both Ian and Minxin Pei noted, post-2008 these SOEs are not being privatized.  In fact, Minxin would later state that there are over a dozen nationalized industries that private entrepreneurs cannot enter, including energy, banking and telecom.  These are the “commanding heights,” the key industries that Vladimir Lenin believed were strategic to controlling the country.  And since the financial crisis in 2008, SOEs have grown once again, reversing the trend since 1985 (where SOEs accounted for approximately 70% of GDP).

Or as Minxin noted: the Chinese government effectively still owns and controls a lion’s share of China’s economy, in contrast the US government – despite its faults and foibles – owns perhaps a mere 1% outright.

Investment opportunities

So as an investor, what can be known in this seemingly nihilistic information environment?  China-bears such as Jim Chanos have looked at shorting companies and enterprises that have exposure to China.  In particular, organizations that deal with Chinese real-estate.  This includes mineral sourcing companies like BHP and Paribas and complementary earth moving firms such as Caterpillar.

The charts above are from The Wall Street Journal, which calculates the average of the change in house prices in 70 cities.  As you can see, coupled with artificially low interest rates, the $586 billion infrastructure stimulus Hu Jintao announced in November 2008 resulted in a surge, a boom in real-estate prices due to the frenetic lending and loosening of loan requirements.

However in an effort to fight the inflation forces it had unleashed and to contain the potential fallout of defaults, the People’s Bank of China began raising capital reserve requirements for the domestic banks and enacted a series of down payment increases.  The net result – along with other policies and the simple fact that this phenomenon was economically unsustainable – was the subsequent crash.

Patrick Chovanec of Dragonomics explains this phenomenon, stating that in China:

Developers kept expanding investment by 30% a year, piling up nearly a year’s worth of unsold inventory, confident that the government needed them – and would ultimately support them – to maintain growth. In the meantime, the central bank was reining in credit to counter rising inflation, including spiraling home prices. When developers finally ran out of financing options, they had to start dumping their unsold inventories to raise cash – and the market tanked. Drop one ball and others follow. Land sales – which local governments are relying on to fund basic services, as well as repay their stimulus bank loans – are at a standstill, and some analysts expect private housing starts to fall by 20% this year.

China’s state-owned banks have continually underestimated local government loan risks.  In fact, in February the Chinese government instructed all banks to “roll over government loans.”  Provinces and cities owe $1.7 trillion in construction related loans, “[m]ore than half those loans were scheduled to come due over the next three years.”  If banks are not allowed to carry out their primary function of measuring risk (via interest rates) or to approve and deny risky ventures, why call them a bank?

To give you a clearer example of property supply outstripping demand, a recent news report from Al Jazeera noted that the new Kingkey 100-floor skyscraper in Shenzhen – which opened last year – is only 20% leased and those are at discount prices. The same mania is illustrated with the $300 million skyscraper built in the village of Jiangyin in which a solid gold bull statue sits on the top floor.  Thus Mark Thornton’s skyscraper index theory is probably right once again.

Will the Chinese consumer save the day?

Some analysts such as Martin Wolf spuriously believe that a rebalancing will occur in the near-future in which the current export-oriented, fixed-asset dominated plan will give way to an economy increasingly dominated by private consumption.  Wolf is optimistic that this can occur because:

China may indeed manage the transition to a very different kind of economic growth. The country still has vast potential to catch up. But the challenges of adjusting to the new pattern will be huge. Plenty of middle-income countries have failed. It is difficult to argue against China, given past successes. The best reason for confidence is that top policy makers lack such complacency.

Wolf uses the following chart that includes some head-scratching future assumptions:

These assumptions play a central role in a more pessimistic and debatably more realistic future described by Michael Pettis, who argues nearly every week, that Chinese policy makers simply are not enacting the reforms or privatizations that would lead to a consumer-oriented economy, one in which the private citizens are no longer bailing out state-owned enterprises.  In his words:

And yet savings continue to rise.  This is the opposite of rebalancing, and it should not come as a surprise.  Beijing is trying to increase the consumption share of GDP by subsidizing certain types of household consumption (white goods, cars), but since the subsidies are paid for indirectly by the household sector, the net effect is to take away with one hand what it offers with the other.  This is no way to increase consumption.

Meanwhile investment continues to grow and, with it, debt continues to grow, and since the only way to manage all this debt is to continue repressing interest rates at the expense of household depositors, households have to increase their savings rates to make up the difference.  So national savings continue to rise.

China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption.
[...]
Repressed interest rates transfer wealth from household depositors to state and business borrowers, so interest rates must be gradually raised to approach nominal GDP growth rates, and as this happens the hidden transfers will be reduced to zero or close to zero.

Contrary to what Schiff, Rogers and others may claim, the Chinese economy is almost entirely driven by political considerations.  But lacking CSPAN, we are not privy to what discussions take place behind closed doors.  Perhaps Mao Yushi – a proponent of liberalization and privatization – is actually listened to.  Maybe Wang Yang is setting the stage for democratic elections and further political reforms.  However despite these hypothetical’s, one thing is clear: the CCP does more retcon and retretcon than just about anyone outside of Skywalker Ranch.  Who knows what will be in store next week.  And just imagine if the Soviets had photoshop!

The Seen and Unseen

The New York Times recently published a piece regarding the intersection of unemployed Western architects who have moved to China to work on these mammoth face-projects:

The client, in the case of the Harbin Wood Sculpture Museum, is the local government, which occupies a glass building with a red Chinese flag next door to the construction site. “The top-down system can make things very simple,” Gillen says. “The leader says, ‘I want it; you make it,’ and it’s done.” Never mind that the projected ticket sales for the museum’s exhibitions, which are anchored by the collected works of a locally renowned wood sculptor, could never match the building’s extravagant price tag.

Such an issue might stop a project in the United States. But in China, the primary concerns are prestige and development for its own sake, and the leaders would move heaven — and lots of earth — to get the museum built. “These projects are the Louis Vuitton bags of architecture,” says one foreign architect, who has worked on several marquee buildings in China. “Every city in China wants one now.”

Four years ago we witnessed a garish display of televised glitz in Beijing.  The sparkly show-and-tell amounted to little more than unproductive monetary mausoleums — stadiums and entire venues were demolished after the Olympics.  Now we are seeing it in other areas throughout China, colossal monuments of misallocation and non-productivity. Take for instance Kangbashi, a carefully planned city built to accommodate 300,000 people, that remains relatively barren today.  Or the high-speed railway itself, deep in debt and mired in political favors.  In fact, $77 million was embezzled from the Beijing-Shanghai High-Speed Railway project alone.  Thus given the lack of media transparency, one can only guess at the graft involved with the airports, 3/4 of which lose money.

But this issue is wholly ignored by both the NY Times reporter and the architects themselves, concluding with:

Gillen is not paid to worry about the museum’s future or its development value — just to ensure that it is built. And that often requires handling shifting demands that would be almost unimaginable back home. When the pit for the wood-sculpture museum’s foundation had already been dug, for instance, the government made a startling request to double the area to 66,000 square feet. The demand meant drafting a new set of designs and digging the foundation several yards larger to create a new underground gallery space. “In the U.S., the contract would’ve been ripped up and renegotiated,” Gillen said. But MAD complied with the request without complaint. It was another lesson in the Chinese art of making guanxi, or cultivating relationships. Who knows what commissions a cooperative attitude might lead to in the future?

In an effort to celebrate Party grandeur, their face-projects will ultimately be no more economically productive than their blighted 18^th century Potemkin counterparts.  When the dust settles the CCP will be left with little more than a bevy of Ryugyong hotels, Pyramids on the Bund, dozens of financial white elephants whose razzle-dazzle amounts to financial stagnation and perhaps even decline.

While it may be a bit premature to predict a mass exodus, FDI dropped for its fourth consecutive month.  Perhaps foreigners have finally figured out that the CCP cannot calculate.  Or maybe it is 2008 all over again.  If I were a betting man, I would wager that the proverbial can will be kicked down the road yet again, perhaps another stimulus or three.  But we already know, a priori, what will ultimately happen at the end of that plan.  And contrary to what hucksters may say, the laws of economics are immutable and culturally agnostic.  This time will be no different than the last.

See also:

- Financial Reform in China?  Don’t Bet on it.  (China Law Blog)
- Chinese Banks ‘Great Shorts,’ Won’t Be Broken Up: Chanos  (CNBC)
- No, Chinese inflation isn’t a good sign  (CSM)
- China doomsayer sees crash coming  (MarketWatch)

Economist Brad DeLong has come out swinging against Austrian economics again, and once again he’s punched himself in the face. But he’s too numb to realize it. There’s a great response on the Mises Economics Blog by Jonathan Catalán, and I take a stab on my site, Wirkman Netizen.

It’s interesting that neither Catalán nor I attack, in our respective longer efforts, the worst calumny of DeLong’s, his insinuation that the Austrian distrust of fiat money comes down to anti-Semitism: “[I]n its scarier moments this train of thought slides over to: ‘good German engineers (and workers); bad Jewish financiers.’”

Since Mises was a Jew, and was treated badly for anti-Semitic reasons at times — why does DeLong think Mises left Austria? — and that  Mises never, ever supported anti-Semitism (nor did Hayek, for that matter), this is especially vile. It’s just another example of those leaning left (which means: technocrats who mislabel themselves as “liberals” and “progressives”) playing the racism/anti-semitism card when they lack a good hand.

DeLong should be ashamed of himself. But, then, one of the perks of being in the managerial class of the technocratic state means never having to say you are sorry.

• There is no such thing as a risk-free return
• There is no such thing as a perfect hedge

Federal prosecutors have alleged in their amended complaint against Full Tilt Poker that the gambling interest was a “Ponzi scheme,” apparently in part because of the company’s level of cash reserves.

FTP owed approximately $390 million to players around the world, with $150 million owed to U.S. players. FTP only had $60 million on deposit in its bank accounts, however, meaning over $300 million is owed to players worldwide.

This was the result of FTP’s payment processing channels becoming so disrupted that “the company faced increasing difficulty attempting to collect funds from players in the United States. Rather than disclose this fact, Full Tilt Poker simply credited players’ online gambling accounts with money that had never actually been collected from the players’ bank accounts. Full Tilt Poker allowed players to gamble with — and lose to other players — this phantom money that Full Tilt Poker never actually collected or possessed.”

$390 million in liabilities and only $60 million in the bank? That means that FTP had a little more than 15% in cash reserves. According to Wikipedia,

A depository institution’s reserve requirements vary by the dollar amount of net transaction accounts held at that institution. Effective December 30, 2010, institutions with net transactions accounts:

• Of less than $10.7 million have no minimum reserve requirement;
• Between $10.7 million and $58.8 million must have a liquidity ratio of 3%;
• Exceeding $58.8 million must have a liquidity ratio of 10%

So because FTP had 15% in cash reserves, the whole operation is a Ponzi scheme. If only the proprietors had started a bank of the same size, they would have only needed 10% reserves!

Arnold Kling, at EconLog, relates Scott Sumner’s simple query as to why the 2008 financial crisis has caused such low or negative growth down even unto the present day, and offers four possible answers. I will comment only on one of them:

Because the Fed made forecasting errors. Right-wingers are fond of brandishing charts showing that the unemployment rate with the stimulus is on a worse trajectory than what was forecast without the stimulus. That may or may not be evidence that the stimulus failed, but it is evidence that standard forecasts were not sufficiently pessimistic about the economy. Assuming the Fed used standard forecasts, that would explain the inadequate monetary expansion back then. It doesn’t explain their reluctance to expand now, though.

There are several places where this answer (which Kling does not favor) goes wrong. Most noticeable, to me, regards the possibility that the forecasts “were not sufficiently pessimistic about the economy.” This is not the only possibility. It is not even the most likely possibility.

The problem was that the forecasts were too negative, and the policy response too extreme and witless. Had financial collapse been allowed, and some major banks and other financial institutions — and a whole class of conceited Wall Street players — gone the way of the Brontosaur and the Dodo, the downturn would have been dramatic (housing prices would have collapsed, and a lot of real estate and credit default fortunes would have evaporated), yes, but the rest of us would have recovered pretty quickly. The nature of the boom-period pricing problems would have become apparent, since those who failed would have signaled their failure. Recovery would have started before the lawyers would have finalized the first few bankruptcies.

But that’s not what happened. Instead, we were forced to witness a self-fulfilling prophecy: The too-negative forecasts spurred on hysterical over-reaction, the bailouts. Which, in turn, covered up the semiotic function of markets, and generally disabled markets from clearing.

A more positive forecast — one untainted, say, by having friends in anguish at Goldman Sachs and Bear Stearns et al. — would have yielded saner policy, and better consequences.

This is a problem with the welfare state as it applies to government-businesss relations. You work regulatory expectations up to an unrealistic frenzy, where people think government is somehow “managing” things. This requires experts from the industries to get involved, with their own agendas. And they corrupt any reasonable attitude towards big business. They cannot help but pay favorites, because they — who live and breathe the industry the hail from — have favorites.

And folks in power becomes craven with fear, and foolish regarding policy. We lurch from an impossible-to-scale micromanaging regulatory scheme where businesses often are forced to endure expensive and crazy “oversight” by bureaucrats . . . to “welfare for the rich.” It’s absurd. Current policy could hardly be more idiotic.

Until we can let big businesses (including big financial institutions) fail, America will stagger among several competing policies, with no coherent sense. Consequently, the general signal to market participants will remain incoherent.

And, amidst such regime uncertainty, nothing like a thriving business environment, or “full employment,” will be achieved.

Her Majesty’s Revenue and Customs, stressing “the need for employers to provide real-time information to the government so that it can monitor all payments and make a better assessment of whether the correct tax is being paid”, has proposed to modernize the UK’s income tax system.  Once employers provide payroll information in real-time, “it further proposes that employers hand over employee salaries to the government first.”

I’m sure that subjects of the Crown have nothing to fear.  The state can be trusted to process their paychecks promptly, correctly, and efficiently.  Only a crank would object to this modernization plan.  After all, everyone fondly remembers the Star Chamber that evolved out of a similar medieval program for keeping tabs on the Jews.  Since it worked out so well last time, how could anyone expect things to go wrong now?