Streetwise Professor

August 23, 2015

China’s Michael Jackson Moment Has Arrived

Filed under: China,Economics,Politics — The Professor @ 7:05 pm

About 6 years ago, reflecting on China’s massive stimulus effort in the aftermath of the crisis, I referred to the country as the “Michael Jackson economy,” sustained by artificial stimulants, and extending the analogy, predicted it would not end well. In the years since, Chinese economic statistics have performed according to plan with metronomic regularity, but all of the distortions inherent in an investment-driven, credit-financed boom only accumulated. Throughout this period, China interfered in markets, by the manipulation of crucial prices, notably interest rates and the exchange rate, and the implementation of measures to direct capital to favored sectors and firms.

Signs of resource misallocation have abounded most notably in the form of massive overcapacity in myriad industries (e.g., steel), the construction of vacant cities, and a relentless rise in debt-to-GDP that is approaching the stratospheric levels attained by Japan before its crash in the early 1990s.

It was inevitable that this was not sustainable. But although Chinese authorities indicated at some level they understood this, and talked about transitioning away from the credit, export and investment-driven growth model towards a consumption-driven one, political economy considerations that tend to favor established interests, and no doubt a deep fear about their inability to maintain control and social peace during a transition, kept them from kicking the old habits. And now it appears that the Michael Jackson-esque denouement is nigh.

All signs are of an impending economic crisis in China. The recent stock market decline is one symptom (but mainly a symptom), as are other economic data. But the surest sign is the panic evidenced by truly gargantuan stimulus measures (totaling around $2 trillion, or four plus TARPs, according to Christopher Balding’s figuring) and the recent decision to devalue the yuan.

The real slowdown is an especial concern because of the Rube Goldberg nature of the Chinese financial system, and the massive amounts of debt that has accumulated since 2009. The government is using a variety of measures to take the associated risk on its balance sheet (although it is using indirect means to conceal this fact), but even the government balance sheet is not bottomless. In such a debt-dominated and opaque financial system, a full-blown financial crisis that would greatly exacerbate the real slowdown is quite possible.

There are a couple of lessons here that need to be emphasized. The first is the dubious value of GDP as a measure of economic performance, especially in an investment-driven, highly managed economy. Investment is a cost incurred in the expectation of realizing a greater benefit in the future: it is not a benefit  in itself. In an economy where price signals and incentives are deeply distorted by financial repression, capital controls, and crucially a high-powered incentive system that ties remuneration and promotion of government officials to GDP targets, there will be massive malinvestment. With this malinvestment, future returns will be small and negative, and often insufficient to service the debt used to finance it.

When the investment is made it looks great in the GDP figures. But in an economy where investment accounts for upwards of 50 percent of GDP, the destruction of value caused by the malinvestment is staggeringly large.

The GDP-linked high powered incentive system is likely especially pernicious. Investment decisions should be forward looking, but the incentive system drives officials to make “investments” based on their current cost, not the expectation of their future returns.  Big investment (cost!) today means big GDP today means life is good for the cadres. This is beyond perverse.*

Another lesson is that no one should be surprised. Logic and experience lead to the same conclusion. Economic logic teaches that distortions of prices and top-down resource allocation mechanisms destroy wealth rather than create it. Experience, from extreme cases like the USSR to less extreme ones like Japan, illustrate vividly the hard reckoning that a managed system must eventually face.

I am only surprised that people are surprised. Even though logic and experience should have led people to question the Chinese “miracle,” and to doubt rather than tout its GDP figures, for years Smart People** have marveled at Chinese economic performance and sang paeans to its wise government steersmen. They were mesmerized by GDP figures, and confused costs with benefits. But just as it was inevitable that Michael Jackson’s dependence on artificial means would eventually result in a health crisis, it was inevitable that China’s dependence on artificial stimulants and distortionary interventions driven by political agendas and warped incentives wold result in an economic crisis.

And there are mounting signs that that moment has arrived. Perhaps it will result in a serious crisis. Perhaps it will result in multiple lost decades (a la Japan). But one way or another, forecasts of future Chinese economic dominance are going to look quite embarrassing.

* This is a different issue than whether Chinese officials routinely falsify economic data. Given the high powered incentives at the lower and middle levels of the governing hierarchy, and the need for the government to demonstrate its alleged economic competence at the upper levels, the incentives to falsify data are acute.

** H/T @soncharm, of Rhymes With Cars and Girls.

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  1. But, Paul Krugman….

    Comment by @pointsnfigures — August 23, 2015 @ 8:30 pm

  2. @pointsnfigures-I rest my case.

    The ProfessorComment by The Professor — August 23, 2015 @ 9:20 pm

  3. Presumably Krugman is the Macualay Culkin to China’s Michael Jackson.

    Comment by Tim Newman — August 23, 2015 @ 11:33 pm

  4. The essential global slave labor force will remain available to be tapped as required.

    Comment by pahoben — August 24, 2015 @ 6:38 am

  5. Michael Jackson economy, yes?

    There’s got to be space for a ‘Bubbles the Chimp’ joke in there somewhere.

    Never mind. You’re on fire Prof.

    My country is dead centre in the path of the deflationary wave emanating from China’s world-historical misallocation of resources. I’ve already moved as much of my assets as I dare out of the local currency. The only investment question I ask myself is, should I give in to the tin-foil hat brigade and buy some precious metals?

    Comment by Ex-Regulator on Lunch Break — August 24, 2015 @ 8:05 am

  6. @Ex-Reg: Thanks. I’ll try to get Bubbles in there in a future post 😉

    Yes, countries that are long commodities have benefited from the world-historical misallocation, but now they will pay the price, alas. I wouldn’t put on the tinfoil hat, though.

    The ProfessorComment by The Professor — August 24, 2015 @ 11:16 am

  7. @Tim-That’s a good one!

    The ProfessorComment by The Professor — August 24, 2015 @ 11:17 am

  8. Well, hopefully the Fed will restart quantitative easing and all will be well again. Because government bureaucrats managing resource allocation is not just for China anymore.

    Comment by aaa — August 24, 2015 @ 3:29 pm

  9. I read on blog, “China has decided it’s going to sell off some assets. It offered the Wall to Trump. Turns out, he needs one if elected President and is a buyer”

    Comment by @pointsnfigures — August 24, 2015 @ 4:24 pm

  10. @pointsnfigures If he plays according to form, Trump would borrow the money, and overpay, then leave the banks holding the bag.

    The ProfessorComment by The Professor — August 24, 2015 @ 5:16 pm

  11. Ah, memories of October 19th. I remember standing in front of a Quotron, hitting Send (with no entry). Instead of telling you where the Dow was, it told you the number of hours that the tape was behind. I hit it many times. It kept saying “2 1/2”. All of the prices were from 2 1/2 hours before.

    Not that’s a crash.

    Comment by Highgamma — August 24, 2015 @ 11:57 pm

  12. I meant, “Now, that’s a crash.” Sorry.

    Comment by Highgamma — August 24, 2015 @ 11:57 pm

  13. @Highgamma. Ah, the days of Quotron (and Telerate). My similar experience that morning was that we were doing a simple MMI index arb. We looked at the screen, and due to the huge delay that you mention, it looked like there was a gaping arb opportunity. But we always called the floor before trading. When my colleague called down to the S&P pit on the speaker phone and asked for where the market was, our phone clerk said (I don’t remember the exact numbers): “Somebody over there is quoting X. The guy across the pit is quoting X+100. Somebody else is quoting X-100. I have no fucking idea what the market is. Don’t call us. We’ll call you.”

    Needless to say, no arb trade that day (as if we could have gotten the cash leg done anyways).

    The ProfessorComment by The Professor — August 25, 2015 @ 8:38 am

  14. In slightly unrelated news, Rogozin is suggesting to save some money by not flying to Mars. Apparently tbe hard decision to not fly to Jupiter is being put off until the ruble sinks to 100 per USD.

    Comment by Ivan — August 25, 2015 @ 3:24 pm

  15. I generally agree with this post, but empirically some degree of central direction by a “developmental state” does not cause big problems and may speed up growth. For example, Taiwan and South Korea. But the key is that malinvestment must be limited by a) being backward enough that roughly copying the physical and human capital structure of developed countries is highly likely to be a good guide to investment and b) ensuring sufficient competition for domestic firms that they produce decent quality at low enough cost to be reasonable (the latter often accomplished via export-promotion policies that force the locals to compete abroad with developed-country companies). Once condition a) goes away due to partial or full development, centrally directed investment is likely to be really bad because you can’t just say “okay we’re going to need some steel plants and some cement plants and some housing and some electricity and some roads and some chemicals” etc.

    Comment by srp — August 26, 2015 @ 8:09 pm

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