[A-List] China - The Consequences of Keynesism

["Anne Williamson" <annewilliamson@xxxxxxx>]

Issue 670                                           July 24, 2007

               THE OLD MERCANTILISM AND THE NEW

    The United Nations Population Fund in June released a
report, "The State of World Population 2007."  In discussing
China, the report provided the official estimate made by China's
government that 18 million people migrate from rural areas to
cities each year.  These are predominantly men.

               http://GaryNorth.com/snip/224.htm

    Consider the meaning of this figure.  This is approximately
1,500,000 people each month.  This is the equivalent of Phoenix's
population, or a little more than Philadelphia's.

    Think of what it costs in resources and labor to build
enough living space and infrastructure to make room for an influx
of residents that would equal the population of Phoenix, month
after month.

    These are poor people.  They do not come with capital, other
than their willingness to work at whatever wage will feed them
and provide minimum shelter.  They are moving from low-
productivity farms.  They are younger sons who will not inherit
the family farm, or else they are the oldest sons, who correctly
see no economic future in small-scale farming.

    They cannot afford wives.  Even if they could, 20% of them
would not find a wife.  The policy of one child per family,
announced in 1979 and enforced, has created an historically
unique population distribution: 1.2 marriageable age men for each
marriageable age woman.

    Millions of men cannot find single women who are willing to
marry them.  Women can now afford to be picky.  So, there is
tremendous pressure on young men to get to a city, find
employment at above-average wages, and find suitable living
quarters.  There is no time to waste.  These men are highly
motivated.

    They are competing against women in factories.  So, there is
even more pressure to get into the labor force.  There is only
one way for men with no capital, poor educations, and short time
frames to do this: wage competition.

    This wage competition is felt in the open labor markets of
the West.  The products exported by China are produced by
laborers who are desperate.  They will work for wages that are a
small fraction of Western employees.  The downward pressure on
Western wage rates comes through the actual products exported by
China.  Western companies must meet the competition by keeping
prices low.  They can bargain with workers.  If they fail to
survive, the jobs disappear.  Think "Detroit."

    This process will not end in my lifetime, or theirs.  China
is estimated to be 37% urban.  It is expected to be 60% urban in
2050.  This means that the mass migration of young men from rural
areas will continue.  The wage pressure will be permanent.

    To this wage pressure is added a similar movement from rural
India to urban India.  These two nations account for at least a
third of the world's population.  The move from farms to cities
is masculine, irreversible, and permanent.

    The only way that the West's workers can compete is to
compete in those sectors of the world's economy that rely on
advanced education, innovation, and very high capital investment
per worker.  This requires, above all, a social climate favoring
entrepreneurship: consumer-directed innovation.  This requires
low or no taxes on capital gains, low government regulation, and
a reduction in the supply of lawyers.

    The United States has about a million lawyers, the highest
number on earth.  Tax-supported state university law schools
crank them out by the tens of thousand per year: a subsidized
industry.  Meanwhile, the U.S. Government's "Federal Register"
prints 76,000 three-column pages of regulations per year.

    The household savings rate in the United States has now gone
slightly negative.  Americans assume that tomorrow will take care
of itself.  After all, look how inexpensive it is to buy goods
that are made in China.  And the government has guaranteed
Americans that the physical crises of old age which once depleted
family capital will be paid for by taxpayers.

    So, young men from rural China move to the cities.  They
hope to get wives for themselves by manufacturing toys for
Westerners.  We keep buying.


SELECTIVE ABORTION AND SOCIAL DISORDER

    Consider the effects of Deng's one child per family plan.
It has produced side effects.  The biologist Garrett Hardin has
defined "side effects" as "effects we don't like."

    The problem in China is selective abortion.  Asian rural
societies for millennia have wanted sons.  Sons support parents
in their old age.  Daughters marry into other men's families and
will support their in-laws.  So, from 1980 on, Chinese families
began aborting females, just as Western commentators said at the
time that they would.  But the Communist government ignored these
warnings.

    In April, 2006, CBS News' "60 Minutes" devoted a segment to
China's population problem: "China: Too Many Men."  The report
did not discuss infanticide.  Instead, it discussed abortion.
The technology of the law's enforcement made abortion a low-cost
option.

    To make sure the women kept their birth control devices
    in, the government -- starting in 1982 -- sent portable
    ultrasound machines all over the country. They are
    compact and lightweight and even some small villages
    got as many as two or three. But in a classic case of
    unintended consequences, pregnant women realized that
    the machines could also identify whether they were
    having a boy or a girl. And, as a result, by
    conservative estimates, more than 8 million girls were
    aborted in the first 20 years of the one-child policy.

    The government today claims that it illegal for a physician
to inform the mother of her baby's gender.  He would be fired if
he did this.  But the free market has intervened.  Chinese mass
production has made the ultrasound machines inexpensive.

    Ultrasound machines are inexpensive in China; they cost
    about $360 and, as 60 Minutes saw, they are small
    enough to be hidden in a closet or even in the trunk of
    a car to do scans on the run. And that's made it
    difficult to crack down.

    We showed the minister some Chinese newspaper photos of
    a van parked in a Beijing suburb doing ultrasounds in
    the back.

    "We need a more enforcement," Zhao said.

    "Well, one of the ways that this imbalance came about
    is through abortion. Millions and millions and millions
    of abortions. Why didn't the government clamp down on
    that?" Stahl asked.

    "Let me go to another point," the vice minister
    replied.

    This is what every government bureaucrat prefers to do when
confronted with the unwanted effects of government policy.  Call
it verbal abortion.

    Her "other point" was that China's abortion rate is
    going down, but she didn't explain why abortions are
    still free and legal right up to the ninth month, even
    as the boy-girl imbalance grows.

    China now faces a major problem: crime goes up when young
unmarried men increase as a percentage of the population.

    The politicians now are trying to respond to the effects of
their earlier -- and continuing -- population-control problem by
setting up counter-programs.  They are imitating the National
Socialist and Fascist regimes of the 1930's.  They are offering
subsidies for female children.

    And so the government has launched a campaign to
    convince parents that having daughters is a good thing:
    propaganda street banners preach that preferring boys
    over girls is old thinking; while school fees for girls
    have been reduced, and laws changed so daughters can
    inherit land.

    And state-run TV programs show the government handing
    out cash to parents with only daughters. A pilot
    project rewards these parents from age 60 on with what
    amounts to $150 a year, a doubling of their yearly
    income.

    These programs are not working, any more than the European
socialist regimes' subsidies worked in the Great Depression.  The
imbalance is getting worse.

               http://GaryNorth.com/snip/226.htm


FROM COMMUNISM TO MERCANTILISM

    Karl Marx offered a stage theory of history: from primitive
communism to feudalism to mercantilistic capitalism to free
market capitalism to socialism to final communism.  China is
proving him wrong.  It has moved "backward" in Marx's stages from
socialism to mercantilism.

    The Chinese government is still Communist in terms of its
centralization of political power in a one-party state.  Like all
Communist parties, the Chinese Communist Party is filled with old
men.  They grew up in a very different world.  They survived
Mao's purges through unquestioning loyalty to Mao.  Then, three
years after Mao's death in 1976, they declared their loyalty to
Deng, accepting his reversal of central economic planning.

    What are they really loyal to?   This: political stability,
with themselves at the top.

    They now find that they are sitting on top of a Chinese
firecracker factory of enormous proportions.

    What they must achieve above all is low unemployment.  If
unemployment rises, the dreams of wealth for the urban masses
will get sidetracked.  There are now 400 million people living in
cities, compared to 900 million in rural areas.  These cities are
political powder kegs: "fireworks factories."

    To kick-start the Chinese economy after 1980, the Communist
Party adopted a strategy used by the Asian tigers after 1950 to
grow their economies: export to the Industrial West.  The
Communist politicians did not allow strictly free market
competitive forces to govern the allocation of workers and
capital.  They would not turn loose of the steering wheel.

    What was the steering wheel?  The money supply.  The Chinese
central bank has copied what Keynesian economists recommended for
decades, from Keynes' day until today.  They increased the money
supply in order to increase effective demand.  They, like all
Keynesians, see effective demand dependent on government central
planning: tax (fiscal) policy and monetary policy.  Keynes
emphasized fiscal policy, yet his system depends on monetary
policy: lowering real wages through monetary inflation, thereby
increasing employers' demand for workers.

    Full employment is the key of political survival all over
the urban world.  When there are unemployed men in the streets,
there may soon be revolution in the streets, especially if these
men are recent arrivals from the countryside and have no local
roots, especially wives and children to feed, clothe, and house.

    Thus, China's politicians did not block the decision of the
bureaucrats of the People's Bank of China when they adopted
policies of very high monetary inflation.

    Once adopted, the simulative effects begin to wear off as
wage rates rise due to more money in circulation.  Price
inflation is manifested in wage inflation.  Wages constitute well
over half the cost of production -- close to 70%.  So, rising
wages in terms of money tend to undermine the policy's goal: to
increase employment by keeping real wages low.  Workers can pay
more as money wages rise, meaning real wages are rising.

    What has kept money wages from rising among the urban masses
is the influx from the farms.

    Chinese export-oriented firms can keep hiring new workers.
To do this, they need buyers abroad.  Buyers abroad want to buy
cheap yuan.  This has forced the Chinese central bankers to
retain monetary inflation, so as to lower the international value
of the yuan, so as to keep foreign consumers happy with low-cost
Chinese goods.

    Chinese central bankers have bought what most central
bankers have bought: government debt instruments.  They buy their
own governments' debt certificates.  But if they are pursuing
modern mercantilism, they also buy the debt certificates of the
governments to which the national planners intend to sell the
exported goods.

    This means the United States.

    As of May, 2007, China held about $1.2 trillion worth of
foreign currency reserves.  This is not all in dollars.  This
figure rose by $136 billion in the first three months.  This
increase was so rapid that the People's Bank of China raised the
foreign currency reserve requirement from 4% to 5% for private
banks that hold foreign currency investments.

               http://GaryNorth.com/snip/227.htm

    To keep the economy booming, the People's Bank of China has
forced down the overnight interest rate -- the equivalent of the
United States' Federal Reserve-manipulated federal funds rate --
from 2.7% in late 2006 to 1.6% in mid-May.  Paul Kasriel of the
Northern Trust Company has provided a useful graph of this.  He
has also offered a graph of the increase in the rate of growth
for reserve money base.  The year-to-year rate fell to 8% in
early 2007.  It moved up sharply to 23% by March.

    Kasriel's analysis is on target.  The Chinese central bank
is trapped.  It wants to expand exports, which means it must keep
the international price of the yuan low.  This means that it must
increase the supply of yuan.  But it is now facing rising prices
domestically: up from 1% in early 2006 to 3% today (official
figures), an increase by a factor of three -- high.  Kasriel
poses the problem very well.

    A slowdown in bank reserve provision would lead to a
    rise in the overnight interbank interest rate. The rise
    in this rate also would put upward pressure on the
    yuan/dollar exchange rate. And the PBOC also announced
    that it would allow the yuan/dollar relationship to
    vary more on a daily basis -- from 0.3% to 0.5%. Under
    current conditions, the only way the PBOC can rein in
    consumer and asset price inflation is to slow down the
    provision of bank reserves and that will entail a rise
    in the yuan relative to the dollar. The PBOC has to
    make a decision -- does it want to maintain a
    relatively steady yuan/dollar relationship or does it
    want to prevent Chinese inflation? It can't have both.

               http://GaryNorth.com/snip/228.htm

    Adding fuel to the fire is a shift from the mercantilism of
Bretton Woods to something new.


THE EVOLUTION OF MERCANTILISM

    Early mercantilism goes back to the seventeenth century:
trade wars that turned into real wars, such as the Anglo-Dutch
wars of the mid-seventeenth century.  The Bank of England was
founded in the this period: 1694.  The goal of government policy
was to increase the supply of gold in its treasury.

    Adam Smith challenged this outlook in "The Wealth of
Nations" (1776).  He called for freer trade and the abandonment
of export-driven policies that led to gold in government
treasuries.  The West had generally moved to Smith's position by
1850.  But in the aftermath of World War I, governments reverted
to mercantilism.  But there was a change.  The goal since 1922
has been to increase the supply of foreign governments' interest-
paying debt obligations, not gold, in the central bank's coffers.
This policy favored Great Britain until World War II broke out in
1939, and favored the United States thereafter.  It was put into
law by the Bretton Woods agreement of 1944.

    When Nixon severed the dollar from gold on August 15, 1971,
the threat to foreign governments was that they would buy U.S.
government debt obligations with their central banks' newly
created fiat money, only to be paid back in newly created fiat
dollars.  That is, central bank counterfeiters trusted each other
less.  But since governments wanted to subsidize their export
markets, central bankers continued to abide by the new
mercantilism of Bretton Woods.  U.S. debt certificates piled up
in central banks' portfolios.

    The central banks of China and Russia have been big buyers
of these debt certificates.  China exports trinkets; Russia
exports oil and natural gas.  In exchange, they receive promises
to pay interest. But what will the money paid as interest actually
buy?  The main export of the United States: more debt. The West
gets the trinkets and energy, while the
central banks in China and Russia get paid money which buys . . .
what?

    What, indeed?

    There are hints that there is a new form of mercantilism
coming.  China, meaning the People's Bank of China, purchased
9.9% of the Blackstone hedge fund in May.  It paid $3 billion.
The PBOC has set up a rumored $300 fund for purchasing foreign
equities and other unnamed assets.  This is a shift from debt to
equity, from foreign governments' promises to pay to actual
ownership of foreign companies and assets.

    If pursued, this will change the face of international
trade.

    Why Blackstone?  Because Chinese bureaucrats will get access
to inside information about the previously private hedge fund's
investment strategy.  "The Economist" had a good article on this
purchase.

    Like China, whose proposed Blackstone stake is part of
    $300 billion that the government plans to set aside
    this year for investment purposes, dozens of countries
    have set up what are now commonly referred to as
    sovereign-wealth funds. They manage money drawn from
    reserves, natural-resource payments and the like. China
    is chiefly concerned to diversify its foreign reserves,
    but other sovereign-wealth funds own national, as well
    as international, assets.

But China is not alone.  Other export-driven nations are
beginning to enter the equity markets.  The numbers are
potentially immense.

    The top 12 each have anything from $20 billion to
    hundreds of billions of dollars to invest (see table).
    Recently, Japan, Russia and India have reportedly been
    considering setting up funds along similar lines. Some
    estimates put the size of the funds at $2.5 trillion by
    the end of this year (in contrast, hedge funds are
    thought to have a mere $1.6 trillion), with another
    $450 billion in transfers from reserves being added
    annually. Including capital appreciation, the amount
    could swell to $12 trillion by 2015.

               http://GaryNorth.com/snip/229.htm

    The central banks will become the equity buyers of last
resort rather than the government debt buyers of last resort.


COMMODITIES

    I think China's next move is obvious: commodities.  It is
building the equivalent of a city of Phoenix every month.  It
needs cement, copper, and everything else needed to grow new
cities and expand old ones.

    At some point, the Chinese central bankers are going to buy
commodity futures.  They will not be selling short.

    The central bank through its sovereign-wealth fund can take
ownership positions for 10% down or less.  Then, at some point,
it can begin taking delivery.

    The commodity futures markets operate on the assumption that
no more than 3% of the investors will actually take delivery.
The threat of "longs" taking delivery is the sword of damocles
over the heads of "shorts."

    When Bunker Hunt in 1979 began taking delivery of silver,
the price moved from about $6/oz to $50 in January, 1970.  The
futures exchange changed the rules, forbidding anyone to go long
unless covering a short position.  This bankrupted Hunt in 1980,
but it was a gross violation of contract.

    The Chinese are not Bunker Hunt.  They have deep pockets.  A
change of rules on one national exchange is not the same as it
was in 1979 -- not when the long demanding delivery has $1.2
trillion in reserves (in 2007).


CONCLUSION

    The Chinese Communist Party has a tiger by the tail: a 17%
per annum increase in the M-2 money supply, and a need to provide
employment for a 1.5 million of new arrivals every month in
Chinese cities.

    The Chinese economy is now dependent on long-term monetary
inflation higher than anything ever seen in a major nation in
peacetime.  The bust side of the monetary boom-bust cycle now
threatens the legitimacy of the rulers of China.  They dare not
let it happen.  But if the central bank slows the rate of
monetary inflation to a single-digit rate for a year, it will
happen.

    The basic infrastructure needed to accommodate 1.5 million
arrival each month must consume vast new quantities of
commodities.  This is the real world.  These are real people who
want real roofs over their heads.  Their employers requite oil,
electricity, and cement.

    The invisible digital economy eventually affects the see-
touch-feel economy.  Nowhere is this connection more politically
explosive than in China.

    The Chinese central bank is trapped.  It will try to walk
the tightrope between exports and domestic price inflation.  How?
By means of a 17% year-to-year increase in M-2 and a 23% year-to-
year increase in the monetary base.

    If the bureaucrats fall off, taking the domestic economy
into depression, the economic fallout will be international.

    In any case, if the central bank moves to the new
mercantilism and away from Bretton Woods mercantilism, the days
of low interest rates will end in the United States.  If Uncle
Wong decides that Uncle Sam's promises to pay cannot be trusted,
and therefore cement is a better deal, the U.S. government's
fiscal policy will soon have feet in cement.

    If this happens, the U.S. debt-driven economy will face the
problem faced by Luca Brassi in "The Godfather."  He sleeps with
the fishes.

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