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“The reason for the unreason with which you treat my reason, so weakens my reason that with reason I complain of your beauty.”

Miguel De Cervantes, Don Quixote

Commentary & Analysis
Only the free market can save China…funny how we romanticize

I appreciate Ludwig von Mises more than most and have for decades. So the yearning for free markets is high on my list. But the reality is we live in a world of controlled and quasi-free markets. Sometimes, however, we romanticize; most often when it fits our story we say markets are free—or at least they should be.

I have noticed a pattern; when some do well they tend to extol the virtues of the “market system,” but when badly it was because of manipulation or some other government or powerful “they” intrusion into the market. Gold bugs provide a perfect example. To the bugs it is the love of gold and all its glittering qualities of safety and demand and transparency which are praised while prices are going up; but on the way down many blame manipulation by the bullion banks and governments for suppressing gold prices. Investors aren’t the only ones who exhibit this behavior—corporate executives have long mastered the technique.

Now that China is showing signs of trouble those who used to say “China was more capitalistic than the West” are of course singing a different tune. And what might be the solution to help China solve its problems and stabilize Western financial and commodities markets? Why yes, more “free-market” reform:

There are indeed only three large population countries that have achieved catch up to living standards equal to or at least 70% of Western levels—Japan, Korea, and Taiwan. And these countries did not get rich with free financial systems, free capital flows, or even free trade. The precise policy mix differed by country, but in all it involved a significant role for industrial tariffs, financial repression, and directed credit. Indeed, they got rich by rejecting almost all the precepts of the subsequently dominant ‘Washington Consensus’ and of the neoclassical theories of economic efficiency on which that consensus was built.

That consensus of course, had not yet even developed when these countries launched their periods of rapid catch up. That was their good fortune. If the ‘Washington Consensus’ had been fully developed by 1950, and if Japan, Korea, and Taiwan had decided to follow its precepts, they would not have achieved such rapid growth.

Adair Turner

Between Debt and the Devil: Money, Credit, and Fixing Global Finance

Effectively these countries [and China] were able direct vast amounts of credit it to what they deemed vital industries. At the same time these countries employed significant capital controls to help avoid the boom-bust often created when private capital (hot money) is allowed to rush in. The problem becomes one of too much success. Back to Mr. Turner:

Credit creates purchasing power, which can fund productive investment. But it can also be used to fund wasteful investment, or purchase of existing assets (such as real estate and the land on which is sits), driving self-reinforcing cycles of asset price appreciation and further credit extension.

In an attempt to de-politicize this directed credit, the West, through a host of its sponsored institutions, told Asia free markets will “reduce the potential for cronyism” and ensure more efficient allocation of capital. And of course the Asian Financial Crisis was the outcome of these well-intentioned policies to bring “market reform” to the masses.

Japan’s bubble popped in 1990 (helped along by the Plaza Accord designed implicitly to push up the value of Japan’s currency) and South Korea during 1997 crisis. So we now have China and all its excess of playing catch up next on the hit parade.

So what will it be: more free market reform or more government control from China? Maybe China is sorry it achieved what it wished for—inclusion of its currency into the IMF basket that makes up the SDR. By gaining status it implicitly committed itself to market reform of its financial system, maybe at precisely the wrong time, as capital was running out the back door and more is likely to go should China follow-through with so-called “liberalization” of its capital account.

This is not a defense of Chinese policies or a call for shunning market reform. But it is to suggest there are serious vulnerabilities no matter the path from here.

Two things I suspect we will see from China:

  1. Increased capital controls
  2. Continued and powerful transmission of deflation

From Stephen Roach, writing in Project Syndicate, False Alarm on China [my emphasis]:

Still, fear persists that if capital flight were to intensify, China would ultimately be powerless to stop it. Nothing could be further from the truth. China’s institutional memory runs deep when it comes to crises and their consequences. That is especially the case concerning the experience of the late 1990s, when Chinese leaders saw firsthand how a run on reserves and a related currency collapse can wreak havoc on seemingly invincible economies. In fact, it was that realization, coupled with a steadfast fixation on stability, that prompted China to focus urgently on amassing the largest reservoir of foreign-exchange reserves in modern history. While the authorities have no desire to close the capital account after having taken several important steps to open it in recent years, they would most certainly rethink this position if capital flight were to become a more serious threat.

Ray Dalio, Master of the Universe hedge fund manager at Bridgewater, has been pounding the table and pleading for the Fed not to raise interest rates. In his mind, and a pretty darn good mind it is, he believes it is all about debt overhang; monetary policy focus on the old-school inflation battle is a big mistake.

An important point: We cannot avoid the deflationary impact of debt, according to Mr. Turner:

So while China’s credit boom after 2008 helped offset the deflationary impact of debt overhang and deleveraging in advanced economies, its slowdown in 2014-2015 has had a powerful deflationary effect. When debt simply shifts around the global economy, from private, to public sectors, or from one country to another, the deflationary consequences of debt overhang are delayed but cannot be permanently avoided.

Aren’t China’s problems of how to manage down debt the same problems faced by so-called advanced Western economies? To Dalio’s point, raising rates at the margin may not help, and may only hurt.

Of course why the potential deflationary impact is so great is because China’s debt has become so large and it is likely only to grow. Back to Mr. Turner once more [my emphasis]:

For if China continued to grow in its recent credit-intensive fashion, its debt stock would become daunting, not only in relation to China but also with respect to the whole world. By the early 2020s, China could have a nominal GDP of $20 trillion. If by then it had a nongovernment debt to GDP of 250% that would be $50 trillion of debt, 3.5 times the size of the U.S. mortgage markets which played such a major role in the origins of 2007-2008 financial crisis. And while China’s debt mountain today is owned almost entirely within China—and largely by banks, companies, and local governments all ultimately controlled or owned by the state—the more China progresses toward a more normal market economy and the more that it liberalizes its capital flows, the greater will be the danger that instability in the Chinese financial system is transmitted to the rest of the world.

So, if you don’t like US Government bonds now, you likely will in the not too distant future. Ditto for the US dollar…