If the economy is in trouble then we're all dead

I'm sorry. I know I should be writing from imagination, but the real world right now is so incredibly fascinating that I just can't think of anything else. We have a rising power that is dictating inflation, flooding the market with cheap goods and labour, and at the same time is really the last remnant of the original evil empire. We have our primary source of energy seemingly on a continually upward trajectory while the pundit forecasts still refuse to acknowledge they might be wrong, and following along beside it on the road to valhalla or perdition (i'm not sure it matters) is just about every raw material that we dig out from the earth. And we have a presidential election that seems to have entirely missed the point that there is something fundamental going on right now that is shifting the tectonic plates of our now frighteningly global economy in a way that is going to affect all of our lives for years to come.

It all starts with China.

I know I written this before. But it does. It really does. It used to all start with the US. Or the US and Japan and Germany. Or back in the early 20th, with England. But now it all starts with China.

It starts with China because, for all the wealth of the west, all of our houses and cars and weapons of mass destruction, at the moment China does two of the most important things that make the world go round.

1. China sets the prices for finished goods. In essence, it controls inflation of finished goods. This is because it is the low cost producer. It has the cheapest labour, and the most of it, and it has the infrastructure to build whatever it chooses to build. No American or Japanese or Russian firm can raise the price of anything they manufacture unless China is doing the same.

2. China sets the prices on raw materials. The one thing China needs for it to be able to manufacture the stuff it wants to manufacture is raw materials. It imports these raw materials from the places where they sit in the ground. Oil is not $50 because we are so worried about a terrorist attack. Oil is $50 because we are so worried that China's voracious demand for the black stuff is going to continue to escalate at the current rate and this is going to result in a permanent supply shortage.

But even China is not an island.

It truly is a global economy, and the world is now so terribly interconnected that to take one piece of it and examine it stand alone, without examining the ambilical cord that ties it to the rest of the world is to fundamentally misunderstand the problem. Many US economists seem to have a problem with this, as they still like the simply world where you could look at the US and Japan and maybe Europe and then point your finger in the direction you think things are going.

You can't do that anymore.

For example, China needs the US. Somebody has to buy the goods they manufacture. And in a bizarre way, China keeps the US buying. Here's how.

I talked in my last post about the current account deficit that the US runs with the world, and particularly with China, as it purchases more goods then it sells. An how China ends up with dollars and, in an attempt to keep their currency down, reinvests those dollars back into US debt.

Well this has an important effect on the US that I perhaps didn't explain that well in my last post. China's demand for US debt keeps the interest rates on that debt low. See, let's say you're trying to get a mortgage for your house. And you go around and no bank wants to give you a mortgage. Well what would you do? You would have to keep raising the interest rate you were willing to pay on that mortgage until some bank says, yeah ok, for 10% or 12% or whatever return I'll give you the money you want. But now lets say there's a new bank on the block and it is just awash in money it wants to loan out. It will undercut the other banks to get the loans. So the interest rate you will have to pay will go down.

China is like that bank. They have all these dollars and they want to exchange them for debt. The demand that they create puts downward pressure on interest rates. The net effect of this on the US is that people can get money really cheap. This is why you can get a mortgage at 20 year lows and all the car companies can offer 0% financing and the credit card companies can offer credit to just about anybody. There's such a demand for debt coming from China and the other foreign surplus nations that they are just begging you to take more on. So you take it on and buy more stuff.

Of course, even Americans stop spending at some point. Don't they?

Well I guess that's the wager. Will Americans keep spending, prop up the world's economy, keep the engine of growth going? Or is it going to end. Is there a point where the debt level just gets too high, and its time to retrench and save a little?

The thing is, if that happens, if there is a retrenchment, then it could be trouble. The rest of the world is quite dependent on Americans spending. Particularly, China is quite dependent on Americans spending. What if it stops? Or slows? What happens then? What happens then to all that capacity that was built on loans from Chinese banks(given that China has had loan growth of over 10% for more then a decade you know there's lots of capacity and you suspect that some of it is marginable)? What happens to the American dollar when China decides that its not worth it to keep the currency peg because it starts to hinder more then help? And what happens to long term interest rates in the US (and to their related mortgages and car payments and the like) when the foreign demand begins to slow?

Its like there's this giant perpetual motion machine going on right now, being run by low cost producers and insatiable consumers, and as long as it keeps perpetuating, its all good. But if it starts to slow, the interia of the whole affair (which really is the enormous debts that have been piled up) might bring it to a total stop.

But maybe not.

That's the funny thing. Nothing is certain. None of this is determinable. I'm not writing this to present a doomsday scenario that is inevitable. I'm not even drawing any conclusions. I'm only asking questions. Nothing is inevitable. What we are dealing with here, and what I'm trying to outline, is an extremely delicate balance going on in the world today. And to pretend that this type of balance is easily sustainable is just not common sense.

Keep some money under the mattress.

S
- posted by Sigurd10/09/2004 10:53:00 AM