China, The Shell Economy

Over the course of the past year, the market has been preoccupied with the soap opera in Europe. Will Angie kiss and make up with Nick? Can their sons Italy and Greece make it out of rehab? And what about the odd cousins that live by themselves on an island? Will they holiday with everyone in Spain?

The reason that everyone is so worried is we don’t exactly know the full exposure of firms to European sovereign debt, including our own Federal Reserve. We also know that if Europe slips into a recession, it’s not generally good for multi national American corporations although McDonald’s ($MCD) and KFC ($YUM) might benefit since it will be too expensive for traditional food there.

The real problem in the coming year for US markets might be China. People have been fascinated with mysterious China for a long time. Writers from the New York Times worship the way they have transformed their economy. Huge cities are built overnight.

There is a large rise of a new Chinese middle class. Conveniently, this meshes well with the left wing narrative that the US middle class is shrinking. What we have to look at is data. To be middle class in China means something far different than being middle class in the US. Chinese middle class income is far less. They define it broadly, 60,000 to 500,000 yuan per year in income. If you use US dollars it’s a range of to $9517 to $79,311! Millions are still below the poverty line in China. Still, they have so many people that it’s an attractive market for US goods.

But, never forget that the Chinese are communist. It makes a huge difference when you start to analyze data.

Years ago I met a person that defected from behind the old Iron Curtain. He and his wife got married and on their honeymoon went to Austria. They didn’t tell their family and didn’t go back. They made their way to the US where they are doing pretty well. I was intrigued by what they told me life was like in their old country. I imagine the Chinese way of life to be similar.

First, everyone had a job. You went to work and just sat around and smoked cigarettes. There wasn’t much production. The government provided you with health care, and benefits. If you made some extra money on the black market, or worked a side job, you didn’t say a word. The money you earned wasn’t deposited in the bank. You didn’t spend it lavishly because your neighbor might tell the secret police. The key is there wasn’t much production.

China has amended some of that-however they are still communist. Macau isn’t the hottest gambling mecca on earth because the Chinese love to place a bet. It’s hot because extremely wealthy Chinese are using it as a place to launder money out of the country to more secure places like Singapore.

I spoke with a person very knowledgable about China and the Chinese economy that leads me to believe they are now beginning to follow the typical communist full employment line of thinking.

China needs fresh water. They have several ways to try and get it. One way is to establish a large network of desalination plants along their coastline, and then pump the water in. However, because the Chinese don’t defend property rights, none of the companies that have the technology necessary will build plants there using Chinese labor. They bring in their own workers for fear of the Chinese stealing and commoditizing everything. On the Chinese side, operation of one of these water plants might create 30-40 permanent jobs. This method of solving the fresh water problem isn’t palatable to either side.

They still need fresh water. But armed with the job creation constraint, it makes the Chinese view the project very differently. Now, it doesn’t matter if the project is net present value positive in a financial sense. It only matters that it’s net present value positive in a job creation sense. What do they do? They decide to dig a trench. That trench is so big if placed in the US it would divert water from New York to New Orleans.

This is great news for the Chinese government and all the different factions it has to appease. They have just created millions of jobs. Not only that, but it will take years for this project to become complete, so they have appeased the apparatus for a few years before they have to concoct another project to employ those people.

Witnessing this line of thinking makes it possible for someone to understand the Obama line of thought that would cause him to say that, “ATM’s are putting people out of work.”. It also reminds me of the Milton Friedman story about shovels and spoons.

The story goes that Milton Friedman was once taken to see a massive government project somewhere in Asia. Thousands of workers using shovels were building a canal. Friedman was puzzled. Why weren’t there any excavators or any mechanized earth-moving equipment? A government official explained that using shovels created more jobs. Friedman’s response: “Then why not use spoons instead of shovels?”

Most media don’t get economics and net present value. That’s why the uninformed writers at publications like the New York Times and people like Ezra Klein pontificate the way they do. At this point in the Chinese economic growth cycle, the Chinese government is abandoning any pretense of classical economic principles. We have heard countless stories about roads to nowhere, shopping centers without people, apartment buildings with no inhabitants. For what? Because the government needs to employ people and they are awash in so much cash right now from trade that there are no financial constraints on them. The government has more fear of a popular uprising that would unseat it from power than it does a bunch of bond vigilantes that could cause financing costs to increase.

I have heard over and over again how the directed Chinese economy is so great. But, it’s been really simple to ride the bike so far. Most of it has been coasting downhill. Now they are forced to make some tough decisions on how to allocate resources. Centrally planned economies have always blown up when forced to make those decisions. The free market allocates resources much better-even if it seems more archaic or unfair.

Sometimes when you walk down the beach you see a pretty conch shell. You run over, pick it up, and there is nothing inside. Hold it up to your ear, and you hear air rush in and out that sounds like the ocean. But that sound can’t compare to a real crash of wave against a beach. That’s what is going on in China right now. It looks like there is economic development, but sooner or later they will prove that the multiplier effect of government spending is indeed zero.

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thanks for the link Ace!

  • I think that the major difference between the US and China (and even the rest of the world) is that the US is wayyy more efficient and productive. 
    China is going to have a problem with inflation if they keep building useless crap/cities that nobody uses. If no good and efficient production arises, they are eventually going to see an uprising as costs from inflation skyrocket. 

    You nailed it when u said “We have heard countless stories about roads to nowhere, shopping centers without people, apartment buildings with no inhabitants. For what? ”

    Exactly, Just to employ people, which is eventually going to lead to inflation which is eventually going to lead to an uprising (unless things change).

  • Anonymous

    “this meshes well with the left wing narrative that the US middle class is shrinking.”

    Substitute  ‘data that clearly shows’ for ‘left wing narrative’ and be more ‘truthy’ , or not.

    • Actually, the narrative is incorrect when you look at the data.  The data tells you that the income disparity from the most wealthy to the poorest can be explained mostly through immigration and education.   Immigrants when they first come over are not in jobs that make them a lot of money.  Many are in menial labor.  Additionally, people that have a college education earn more than high school educated people on average.