Sunday, July 18, 2010

Inflating Bubbles and the Coming Pin Prick

Recent conversations about inflation, consumer price index and confidence, and “recovery” in much of the G-20 have been fascinating and terrifying at the same time. I remind myself that the economists currently assessing the state of recovery are the same ones who “didn’t see” 2008 coming. I guess that may contribute to the terrifying side of the equation. The fascinating side is the lack of recollection of 1986 – 1994 negotiations around the General Agreement on Tariffs and Trade (GATT) which led to the 1995 creation of the World Trade Organization (WTO) on January 1 that year. One of the anchor tenants of the WTO was the non-discrimination objective on trade for products and services. Plainly, what this means is that no country is allowed (though they all violate the rule with countless caveats to the rule) to purchase based on favorable biases that which can be supplied by another at a better price. As we moved to a service industry, this meant that, to be competitive with qualified international bidders, companies in Occidental markets needed to reduce their cost of labor by reducing the average wage to one that reflects international competitor wages. However, as the recent wage dispute in China has brought into sharp focus, WTO failed to realize that this non-discrimination impulse (a major factor in justifying out-sourcing of labor to artificially deflate competitive pricing) would actually create a hyper-inflationary bubble that is about burst.

Some background will be helpful. If we had a Keynesian system working in a vacuum, labor, wages, productivity, consumption and monetary supply would all work in an utopian harmony. Consumers – both laborers and the public sector – would be constantly choosing to spend or save based on wages or revenue available to spend and the products and services that they would be purchasing would reflect an aggregate value compromised of cost of production plus a variable profit. However, a factor that serves as a spoiler in this utopian ideal is debt-based consumption both on the sovereign and personal level. For the life of the WTO, we have had an anomaly building which is coming to a terminal end. Occidental consumers (both public and private) have been consuming far greater amounts than would be appropriate in a properly functioning system under the myth that inflation has been held in check. And, devoid of any sense of consequence for future economic parity, have been deluded into believing that this hyper-consumption can be done on debt. However, there is a huge problem in this line of thinking purely on economic terms.

The Chinese labor pool, not unlike the Singapore miracle of 20 years ago, is beginning to seek greater wage parity with the consumers who are buying its products. Not surprisingly, this impulse is coming at the exact same time as the Chinese government is realizing that its exposure to U.S. debt is at an unacceptably high level. Further, it knows that its greatest threat to its very existence is the fact that millions of Chinese want to see direct benefit for their willingness to labor for the benefit of their collective debtors. In short, China is left with no option but to further invert their historical export activity to supply a greater number of domestic consumers. The recent increase in wages in China will accelerate a major global economic instability. By increasing wages, local purchasing power will increase. Revenue from taxes will also increase adding to the Chinese government’s economic reserves. Savings – especially those associated with pension programs will increase the amount of money held within the country for investment. This investment is already driving greater Chinese ownership of its own production base as well as the ownership of supply chains around the world. And ironically, this is where the bubble pops.

As early as 2004, reports of labor shortages were coming from China. That’s right. In a country of 1.3 billion people, there were labor shortages. These were not based on a holistic economic ecosystem however. The shortages were in labor willing to work for paltry sums to supply the Wal-Marts of the world. The Chinese workforce, highly motivated, educated and a bit pissed off by the fact that they were supporting a consumption orgy in the West, were seeking better paying jobs. For a few years, the Chinese government did little to respond. However, in the current 5 year plan, that’s changing. The manufacturing base in China is rapidly being transformed to compete on big ticket, high technology items. China just agreed to a $12 billion railroad project in Argentina. China and Siemens recently signed a joint venture on steam and gas turbines. And the list goes on in Pakistan, Africa, South America and Europe.

I recall a conversation that I had with President Bush’s Commerce Secretary Donald Evans’ staff before is farewell visit to China. Secretary Evans was going to do what U.S. Commerce Secretaries are famous for doing. He was going to go over the China and, with typical impudence, deride the Chinese for their lack of global respect for trade policy, intellectual property protection, and currency policy. I strongly recommended that his speech be modulated for fear that one day it would be used against us. That day has come. And inflation is just around the corner. However, that’s not our biggest worry. We’ve got far more at stake and all the inflation talk is a nonsensical diversion masking a much bigger monetary seismic shift.

In the coming few months, we will see that the U.S. economic interest in the People’s Congress is on the wane. One of the tell-tale signs of the coming change is the grossly misreported comments made by State Administration of Foreign Exchange. “Any increase or decrease in our holdings of US treasuries is a normal investment operation,” has been interpreted to mean that the Chinese are not going to pull the plug on our dollar. However, the $2.45 trillion of U.S. exposure sitting in Chinese reserves is going to be dumped at the precise moment when it is in the “fiscal benefit” of Chinese economic policy. And here’s where we come full circle to the GATT / WTO bubble.

Let’s assume that major power or infrastructure projects are going to be put out to tender. And, let’s assume that a Siemens / Shanghai Power joint venture is competing with, let’s say GE. Negotiations bounce back and forth and prices get within +/- 5% of each other. Concessions are being made and all the FCPA rules are being strictly monitored (oh, there I go being utopian). And just at the moment before a key award is announced, China dumps some U.S. Treasuries. This instantaneously adversely impacts GE’s cost of capital totally inverting the viability of the deal. China wins, U.S. loses. I wonder if our Commerce Secretary will be advising GE to suck it up and play by the rules when the best technology and price is on the other foot. Do you suppose that the U.S. Commerce Secretary will tell the U.S. public markets that we’re really happy to see China achieve the great objective of the WTO – poverty alleviation – as we watch the rest of our manufacturing infrastructure crumble into irrelevance? And when we realize that we forgot to protect U.S. intellectual property in Argentina because it was not a “viable market,” do you suppose our government will chasten the U.S. company’s oversight?

And inflation hits….. well, let’s see. I think that I have finally seen why the Mormons recommend storing up for a 10-year famine. I guess I didn’t realize that the dark horse of the apocalypse wears a yellow smiley face button under the “Welcome to Wal-Mart” moniker. We’ve got a fundamental day of reckoning coming. This judgment day is far less dramatic than the world ender’s would like. We’re getting to pay for 15 years of deflationary labor abuse and we’ll get to do so in very short order. We should have realized that our consumption cannot come on the backs of the world’s economically disenfranchised. Maybe we’ll learn to not repeat this mistake again.

Let’s stop worrying about nonsense economic metrics of an illusory past and wake up to what really matters – namely, our role as ethical, non-discriminatory members of a global market.

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4 comments:

  1. Magnus the DestroyerJuly 19, 2010 at 11:37 PM

    Um, I don't get it.

    This reminds me of the Underpants Gnomes from South Park:

    1. Collect Underwear
    2. ???
    3. Profit!!!

    How do we go from China cock-blocking us on large global industrial deals to hyperinflation....maybe? And why maybe? What about the hyperinflationary bubble that's about to burst? For that matter, what's a hyperinflationary bubble? I'm not familiar with that term. Do you mean a hyperinflationary currency collapse?

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  2. In response to the comment above, it is important to realize that the point is that: a) inflation is not going to be our main concern as domestic competitiveness will be impaired (see July 20, 2010 Financial Times article on China's posture on their Agreement on Government Procurement); and, b) the hyperinflationary effect will be that there will be a necessary inflation in China, deflation in the U.S. and Europe leading to a widening of the economic imbalance between the countries. This is going to create significant global market instability.

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  3. Magnus the DestroyerJuly 21, 2010 at 3:55 AM

    You still haven't answered my question. Your response re: hyperinflation doesn't make sense. Hyperinflation is a psychological event in which confidence is lost in the currency. Sellers, wary of the ever increasing inflation of the money supply, demand more to offset the reduced purchasing power of the currency. It is simple supply and demand of a commodity, in this case the currency.

    What is this "hyperinflationary effect" to which you are referring, and how does that relate to inflation in "China, deflation in the U.S. and Europe".

    I don't understand how "a widening of the economic imbalance between the countries" leads to hyperinflation.

    I kind of suspect you've never really studied the concept of hyperinflation.

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  4. Hyperinflation is a complex condition however, as addressed in the post, the following elements are contributory to the bubble risk:

    Monetary supply unsupported by production at an rapidly expanding rate - this condition is already in the system with U.S. money supply supported by foreign investors AND a artificial economic production supported by U.S. government, debt financed spend (in fact, a double risk);

    Untethered monetary backing - at the moment that we would like to link the dollar to something more tangible or to a production output, the Chinese have a controlling position on metals, infrastructure and energy meaning we don't have the tools to anchor the dollar;

    Geopolitical risk and social lack of confidence - there's no question that the market is already shocked at the decreasing competitiveness of the historical producer stalwarts in the U.S. and Europe at the same time that the People's Liberation Army is already talking about using our Treasury debt as a "weapon".

    While there are many other factors that will ultimately contribute to the thesis I am presenting, there's no question that any fundamental analysis of the current condition supports a rather manic (and potentially unprecedented) economic dynamic that will include hyperinflation.

    I would be delighted to expand a conversation with you on these topics but I would encourage the conversation to be respectful and would invite you to consider not hiding behind your anonymous nom de plume. Regards

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Thank you for your comment. I look forward to considering this in the expanding dialogue. Dave