Lessons From China-Google Schism

The China Google rift has given us some interesting insights.


This from the New York Times, (all bold highlights)

``The story behind the success of these companies is a simple one, some analysts say. The young people who dominate Web use in China are not just searching for information; they’re searching for a lifestyle. They are passionate about downloading music, playing online games and engaging in social networking.

``“Sixty percent of the Internet users here are under the age of 30,” said Richard Ji, an Internet analyst at Morgan Stanley. “In the U.S., it’s the other way around. And in the U.S. it’s about information. But in China, the No. 1 priority is entertainment.”

``Experts say American companies have largely failed here because they don’t have local expertise, are too slow to adapt and don’t know how to deal with the Chinese government.

``“Internet companies in China have to work so closely with the government,” said Xiao Qiang, of the China Internet project at the University of California, Berkeley. “And that means the government’s political agenda can become the company’s business agenda.”

``The need to censor Web sites, for example, can overwhelm smaller companies, Mr. Xiao said. “This becomes a growing business cost. So often, small companies don’t develop.”

``At this stage, analysts say the Web in China is less about innovation than about quickly delivering on the latest online trend.

``“People here are quick to see trends, and to clone and innovate,” said William Bao Bean, a former Internet analyst who is now a partner at Softbank China & India Holdings. “If one company is doing well, other companies will quickly clone it and roll it out.”...

My observations:

1. cultural difference in the use of the web: "And in the U.S. it’s about information. But in China, the No. 1 priority is entertainment.”

2. American companies outside the China's intrusion has failed to grab a substantial share because of the lack of local knowledge or expertise.

This is very Hayekian. From the Use of Knowledge in Society, ``But a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation."

How does this relate to macroeconomics-alot!

Google's failure involves one of risk money plus a real attempt to establish or gain a foothold in China's market. Whereas people or even officials condemning China, have not been there nor have they a real or working knowledge of how things operate in China. All they base their polemics is on aggregate assumptions. If Google can be wrong how much more with personalities suffering from "fatal conceit".

3. Government intervention have limited competition to the locals and may have even politicized the distribution.

More insights from the New York Times, (bold highlights mine)

``One advantage local companies have is government protectionism. Because the Communist Party wants to maintain tight control over communication and the media, foreign Internet companies come under suspicion.

``For instance, YouTube has been blocked inside the country for over a year, ever since a user uploaded a video that was said to show human rights violations in Tibet.

``YouTube, which is owned by Google, had a large following here. But now online video in China is being championed by companies like Youku.com and Tudou.com. They may have dominated anyway, analysts say, but it certainly helps to have few big competitors.

``And without competition here from Facebook, which has not yet tried to develop a site for the Chinese market, a social networking site called Kaixin001.com has managed to register over 70 million users.

``But some experts say Google’s departure will leave Internet users here with fewer options, making the country’s Internet market less competitive and less open.

“The biggest loser is Netizens,” says Fang Xingdong, chief executive of Chinalabs.com, a research firm. “Google is a multilinguistic search engine, but Baidu is a Chinese-language one. Chinese information only occupies a small fraction of the Internet.”

Additional observations:

4. It's odd that the New York Times can be promoting competition (selectively though), apparently this depends on which interest groups benefits.

5. As the article suggests, government protectionism is considerably hindering the development of social networking sites. This translates to endemic disadvantages or obstacles from developing the local market (even if the Yuan appreciates!) and from attaining productivity enhancing facilities that would enable them to even be more competitive in terms of value-added products.

Put differently, in a world being revolutionized by Web 2.0, China will unlikely match the level of capital structure of economies that fosters open competition in the cyberspace that would lead to more innovation.

So unless China opens up, the pace of growth will be constrained by the current industrial framework. But she will lag in the advances of technology, which I think will be a significant growth driver for the world over the coming years.

Distinguishing Political Indentity From Ideology

This is excellent stuff from Brink Lindsey on Partisanship published at the Cato Unbound. (Pointer to Bryan Caplan of Econlog).

Here, Mr. Lindsey observes that partisanship is much about identity more than ideology.

Here is an excerpt: (bold highlights mine)

``It’s not just that partisans are vulnerable to believing fatuous nonsense. It’s that their beliefs, whether sensible or otherwise, about a whole range of empirical questions are determined by their political identity. There’s no epistemologically sound reason why one’s opinion about, say, the effects of gun control should predict one’s opinion about whether humans have contributed to climate change or how well Mexican immigrants are assimilating — these things have absolutely nothing to do with each other. Yet the fact is that views on these and a host of other matters are indeed highly correlated with each other. And the reason is that people start with political identities and then move to opinions about how the world works, not vice versa."

``So yes, most partisans are “better informed” than most independents, because they have a political identity that motivates them to have opinions and then tells them which ones to have as well as the reasons for having them. Consequently, partisans may have more information in their heads, but their partisanship ensures that this information is riddled with biases and errors and then shields those biases and errors from scrutiny. This is not a state of affairs worth defending.

``Virtue as well as truth is a casualty of partisan zeal. Even when partisans know what the score is, they’re constantly tempted to shade the truth, or at least keep silent, in order to be a good team player. Recall, for example, the fury unleashed this past fall on the handful of conservative commentators who were willing to admit the obvious: Sarah Palin was obviously, embarrassingly unprepared for the office she was seeking. In coalitional psychology, the only thing worse than an infidel is a heretic, and that fact ensures that most partisans keep their heterodox opinions to themselves. Good for the team, perhaps, but bad for the soul — and the republic."

My comment:

Mr. Lindsey' observation, in my opinion is spot on.

In the Philippines, the partisan crowd think that they argue about issues, but all the while their arguments revolve around identity or personality. Definitely not ideology. That's why I call this Personality Based politics, where leadership preferences are based mainly on popularity, symbolism or connections.

For example, the public's impression of corruption appears mainly a moral issue. Lost in the argument is the interrelationship between regulatory structure and how these affects behavior of affected agents, the bloated bureaucracy, the quality and web of laws, the incentives governing the officials and the bureaucracy, patronage system, election spending, restrictions, and many more.

And it's why the elixir of "clean" government won't happen. Not when the critical decisions affecting the economy are determined politically.

It's just that democracy allows people to vent changes in terms of hope-even when they are false hopes.

In addition, it is also true that highly partisan people engage in analysis that are highly biased and full of logical errors. Although this would seem like economic creed, perhaps identity indeed is more the culprit for such incoherence. The confusion perhaps stems from forcing to fit data mined facts to the belief adhered to by the leaders.

Mr. Lindsey sees a change in the shape of politics as a sign of hope,

``In America until relatively recently, and in less developed democracies today, the predominant form of partisanship has been a concrete, personal loyalty to specific leaders and comrades. This is the partisanship of patronage and clientelism — of the Jacksonian spoils system, Tammany Hall, and the Chicago machine. In the twilight of this phase of American democracy, 64-year-old Illinois state legislator John G. Fary won a seat to Congress and made this statement of his plans: “I will go to Washington to help represent Mayor Daley. For twenty-one years, I represented the mayor in the legislature, and he was always right.”

``In the newer style of partisanship, which has emerged with a richer and better educated electorate, loyalty has grown more abstract. Now shared allegiance to broad principles of public policy is the defining element of party ID. Parties have grown more ideological, and so have partisans. Polarization is the name we’ve given to this development.

``I regard the shift toward a more ideological politics as progress. Broadly speaking, we have been moving away from politics as an amoral struggle between rival gangs and in the direction of politics as a contest of competing values. Because people have differing values, and assign different weights to the values they share, there can never be an end to politics. Accordingly, even in an ideal world where all citizens are completely rational and equally public-spirited, a politics and thus a partisanship of values would still be necessary. Here, then, in the realm of values, is the purest and most durable source of political identity."

My comment: Somehow, the web should be able to amplify on such shift as people learn more about ideals and form groups 'tribes' that eventually command the public's attention, draw a larger following and eventually acquire political heft.

Albeit perhaps, this would take longer to happen in the Philippines. Nevertheless, as a Confucian saying goes, a journey of a thousand miles begin with a single step.

US Protectionist Pressures: India Is Feeling The Heat Too

One of the misguided notions held by the liberal view in the US is that the proposed protectionist measures targeted to resolve so-called "global imbalances" will likely be confined to a US-China affair.

Unfortunately, this view, which panders to sensationalism, fails to take to account the repercussions of rabble rousing. In the other words, the likely side effect from demagoguery is to fuel a nationalist hysteria that would brook xenophobia and or racism. (These people seem to have forgotten the ultra-nationalism of Nazism which triggered World War II during the last century)

And it appears that India has also been taking the heat from such pressures.

India's commerce minister has been reported by Financial Chronicle as rebutting allegation that India has been taking away American jobs.

Here is the Financial Chronicle,

``Urging the US to reform its visa policies, commerce minister Anand Sharma said here today that the paranoia of the Americans about Indians taking away their jobs, especially in the IT and services sectors, is a myth.

``There is an incorrect perception in the US that Indians are taking away the jobs of Americans, which is driven more by the fast-paced growth India in the IT and services sectors, Sharma told newsmen.

``Citing three recent reports, including one by PricewaterhouseCoopers and International Business Forum, Sharma said, "contrary to popular perception, Indian BPO companies have created income worth USD 106 billion inside the US in the past three years ending 2009, and generated 3,00,000 jobs out of which 2,50,000 were filled by Americans."

"These are jobs for Americans created in America but by Indian companies. This is a myth that jobs are being taken away by Indians," Sharma said"

There seems to be a sense of desperation that has been creeping into the progressive camp as seen in the recent actions of politicians and their intellectual followers as election season nears.

This desperation appears to have been manifested yesterday when the liberals finally got into the act to successfully ram down the throats of the American public, the highly controversial and unpopular Obama Health reform legislation in the House of Congress, a year after President Obama's assumption to office.

And such impetuousness appears to be 'throwing the gauntlet' to any party that crosses path with their desired political agenda. And India appears to be a victim of such emergent antagonistic sentiment.

Nevertheless the apparent anxiety is likely to be reflected on the outcome of the next elections.

So, the current crop of leaders are doing whatever they can to generate a sense of emergency for them remain in power, regardless of the consequences of their actions. It's a case of when "push comes to shove".

Be careful what you wish for.

US-China Trade Imbalance? Where?

Mercantilists claim that the huge trade imbalance between China and the US serves as justification for enabling protectionist measures.

Well not so fast.

Even based on accounting, where financial securities are added to the equation, such claims are shown to be unfounded.

Professor Mark Perry elaborates,

``1. In 2009, the U.S. imported more from China ($354 billion) than it exported ($93 billion), resulting in a "trade deficit" of -$263 billion on our "current account" (data here).

``But that is only part of the international trade story, since there are also financial transactions that have to be accounted for, and that deficit on the current account has to be offset somehow, since all international trade has to balance (it's based on double-entry bookkeeping).

``2. The offsetting balance came from the $263 billion capital account surplus in 2009, as a result of $263 billion of net capital inflow to the U.S. from China to buy our Treasury bonds and other financial assets.

``3. The $263 billion capital account surplus exactly offsets the current account deficit.

Bottom line:

Professor Perry: ``There really is NO trade imbalance, when we account for: a) exports and imports of goods and services, AND b) capital inflows/outflows. Stated differently, the balance of payments is always ZERO. We buy more of China's goods than they buy of ours, but then China buys more of our financial assets (bonds and stocks) than we buy of theirs. So in the end, international trade with China, is balanced, not imbalanced." (emphasis original)

My comment: Experts twist facts to provide intellectual cover to populist politics. It's called political hysteria.

Learning From Sweden's Free Market Renaissance

The popular impression of Sweden is that her success had brought about by big welfare government.

In the following video, the Center for Freedom and Prosperity gives a succinct economic history on how Sweden attained her wealth based on limited government, rule of law and property rights, and how Sweden's success had been stalled by the emergence of big government.

And in learning from the recent mistakes, Sweden has embarked on a reform to scale down big government. (hat tip: Cafe Hayek)

After The Philippine Peso’s Breakout, Is The Phisix Next?

``Every restriction on the freedom of entry into a trade reduces the security of all those outside it.” Friedrich A. Hayek, Road To Serfdom

It didn’t take long for our expectations to happen.

Last week we argued that while the local mainstream media and the public have been overly fixated on politics, which they presumed as THE overwhelming force that would drive the domestic markets, external forces seemed to have a greater influence[1].

In contrast to the local mainstream mindset where many have argued for “election risks” and henceforth suggested a “sell” we have been taking the opposite stance, the PESO and the PHISIX have, in colloquial, been “rarin’ to go”-ergo a BUY!

And true enough, the first phase of the impact of our external influence theory have manifested in the markets as the Philippine PESO hit a 19 month high!

And local media appears lost for explanations!

One outfit imputed the Peso’s rise to the recent actions of the US Federal Reserve. Another pointed to a firming US recovery. A foreign report alluded to an alleged arbitrage between offshore and onshore funds and finally the Bangko Sentral ng Pilipinas (BSP) reportedly said that the strengthening Peso has been due to “country’s higher export earnings, in spite of jitters about the coming elections and sovereign debt concerns in some European countries”[2].

My reply: DUH!

Since the Peso’s gain have been in a winning streak, instead of just an outsized aberration or anomaly as signified by a one week jump, hardly any of these explanations “fit” the actuations from which underpins the true dynamics of a buoyant Peso.

Say for example, if a strong peso had been a result of an arbitrage, then the impact is likely to be a short-term reaction. But why a 4 straight week of gains?

In addition, how can ‘jitters about elections’ explain the gains of export earnings? If global consumers see the output from local producers as being ‘affected’ or disrupted by elections, then the former would have probably coursed their transactions with producers of some other nations than from the Philippines. But has this been so? Based on the reply of the BSP official, the answer is an obvious NO! The official’s reply reveals of the apparent self-contradiction or cognitive dissonance.

So how can we SQUARE election jitters with, not only advances in the Peso, but also of export earnings?

Moreover, if these have all been about the US, then an outperformance by the US relative to Asia or the Philippines should translate to a gain in the US dollar vis-a-vis the Peso. What a dichotomy!

Available bias is an intuitive attribution of activities in the marketplace to current events. Unfortunately, market signals appear to have completely diverged from popular sentiment to even warrant the use of such behavioural lapse.

In short, popular sentiment has been so confounded. Yet media, and even officials, obstinately insist on the claptraps of false linkages!

In essence, popular sentiment is all about SENSATIONALISM!

Commons sense is, thus, sacrificed for irrational passion.

To further exacerbate the mainstream anguish of cognitive dissonance, the Philippine equity benchmark, the Phisix, added another week of gains to score its SIXTH straight.

The Phisix is just about [less than] 1% away from a breakaway run.

And if we earlier exhibited how the Peso tracked Asian currencies, then this week’s first chart features Asian equities (see Figure 1)

Figure 1: Bloomberg: ASEAN and the MSCI Asia Pacific Index

At the upper window is the performance of our main ASEAN neighbours.

One would note that Thailand (SETI-orange) and Indonesia (JCI-red) appear to be on a turbocharged performance following recent resistance breakouts.

Singapore [FSSTI-yellow] echoes the price activities or the chart of the Phisix [not included] and appears poised to test on the resistance levels set last January.

Only Malaysia [KLSI-green], which also broke out earlier, seemed to have lost momentum. While bears may take the Malaysian case to argue that this could serve as an indicator for the rest of the region, in my opinion, this isn’t likely so.

Why?

Because the actions of the MSCI Asia Pacific index, a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed and emerging markets in the Pacific region. As of June 2007, the MSCI AC Pacific Free Index consisted of the following 12 developed and emerging market countries: Australia, China, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, Philippines, Singapore, Taiwan, and Thailand[3], suggest that Malaysia is an exception rather than the rule.

The MSCI, as exhibited in the lower window, replicates the actions of the Phisix and Singapore and appears in position for the same momentum as we have seen in Thailand, and Indonesia and somewhat in Malaysia.

In short, the overall story that can be gleaned from the region’s equity markets today is one of RISING and not falling markets!

Besides, the foundering momentum in Malaysia may not last long, given the constructive general ambiance, unless of course there is an untoward quirk which we have yet to identify.

Finally, only one article seemed to have referenced on what truly mattered most, a Chinese yuan/renmimbi revaluation as we will discuss below.

In essence, two factors, one structural and one cyclical, will drive the global financial markets over the medium to long term; specifically, the record steep yield curves and the prospects of a rising Chinese yuan.

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[1] see Philippine Markets And Elections: What People Do Against What People Say

[2] Manila Times, March 13, 2010 Foreign money in RP financial assets keeps flowing

[3] MSCI Barra, Index Definitions

Influences Of The Yield Curve On The Equity And Commodity Markets

``The interest rates for more distant maturities are normally higher the further out in time. Why? First, because lenders fear a depreciating monetary unit: price inflation. To compensate themselves for this expected (normal) falling purchasing power, they demand a higher return. Second, the risk of default increases the longer the debt has to mature.-Gary North

The first structural factor, the record steep yield curve, should be a familiar theme to those who regularly read my outlook.

This accounts for as the “profit spread” from which various institutions take advantage of the “borrow short term and lend or invest in long term assets”[1].

The Yield Curve (YC) is a very dependable tool for measuring boom bust cycles (see figure 2).

That’s because artificially lowered interest rates, a form of price control applied to time preferences of the individuals relative to the use of money, creates extraordinary demand for credit and fosters systematic malinvestments or broad based misdirection of resources within markets and the economies.

Figure 2: Economagic.com: Yield Curve and the Boom Bust Cycle in the S&P 500

Sins Of Omission: The Influences of Habit or Addiction

It’s fundamentally misplaced to also conclude that just because balance sheet problems exist for many consumers, particularly for developed economies in the West, as they’ve been hocked up to their eyeballs on debt, that they would inhibit themselves from taking up further credit to spend. This also applies to some corporations.

Such presumption fatally ignores individual human action, particularly, for people to develop and sustain irrational habits. Some of these habits grow to the extent of addiction, which could have a beneficial (reading) or negative or neutral effect (mowing lawns). Albeit, addiction has a predominantly negative connotation.

While addiction[2] has many alleged modal causes, e.g. disease, genetic, experimental, and etc., some models have been argued on the basis of purely psychology, specifically:

-choice [The free-will model or "life-process model" proposed by Thomas Szasz],

-pleasure [an emotional fixation (sentiment) acquired through learning, which intermittently or continually expresses itself in purposeful, stereotyped behavior with the character and force of a natural drive, aiming at a specific pleasure or the avoidance of a specific discomfort."- Nils Bejerot]

-culture [“recognizes that the influence of culture is a strong determinant of whether or not individuals fall prey to certain addictions”]

-moral [result of human weakness, and are defects of character]

-rational addiction [as specific kinds of rational, forward-looking, optimal consumption plans. In other words, addiction is perceived as a rational response to individual and/or environmental factors. There wouldn’t be an addict or substance abuse problem, if those affected are disciplined enough to correct habit abuses.]

If affected persons, in recognition of such problems, simply applied self-medication or took preventive measures to avoid the worsening development of negative addiction, then obviously we wouldn’t have addiction problems at all! But certainly this hasn’t been true.

From a psychological standpoint, it would seem quite apparent that addiction is largely a stimulus response feedback mechanism or very much a behavioural predicament.

In other words, negative addiction is fundamentally a choice between temporal happiness over future consequences (frequently adversarial outcomes) or where habit interplays with choices, rational alternatives, environment, moral frailty, cultural influences or seductiveness of pleasure vis-a-vis normal behaviour.

Simply put, there is an incentive for people to develop different forms of addictions.

Applied to the markets or the economy, what if the source of profligacy [or Oniomania[3] or compulsive shopping or compulsive buying], a form of addiction, stems from government initiatives, by virtue of artificially suppressed interest rates?

And what if government induces people to spend on things they can’t afford with money they don’t have, out of the desire to fulfil economic ideology or to promote certain industries?

Will the teetotaller refuse government’s offer of free drinks?

How much of government induced behaviour from reckless policies will force individuals and businesses to take the low interest rate bait?

And this seems to be the story behind the yield curve.

The Stock Market And The Yield Curve Over The Long Term

Notice that every time the long term yield (30 year treasury constant maturity-red) materially diverges from the short term yield (1 year treasury constant maturity-blue) to form a steepened yield curve (black arrow pointed upwards), the S&P 500 (green) blossomed.

On the other hand, inverted yield curves, where short term yields had been higher than the long term yields (green arrow pointed downwards), had preceded recessions and severe market corrections.

Like normal yield curves, the yield curve’s impact on the economy has a time lag, a 2-3 year period.

Even the October 1987 Black Monday crash appear to have been foreshadowed by an account of relatively short inversion in 1986.

And the inflation spiral of the late 70s saw short term rates race ahead of short term rates for an extended period.

So why does an inverted yield curve occur?

Because the debt markets reveal the amount or degree of misallocations in the market ahead of the economy.

According to Professor Gary North

``This: the expected end of a period of high monetary inflation by the central bank, which had lowered short-term interest rates because of a greater supply of newly created funds to borrow.

``This monetary inflation has misallocated capital: business expansion that was not justified by the actual supply of loanable capital (savings), but which businessmen thought was justified because of the artificially low rate of interest (central bank money). Now the truth becomes apparent in the debt markets. Businesses will have to cut back on their expansion because of rising short-term rates: a liquidity shortage. They will begin to sustain losses. The yield curve therefore inverts in advance.”[4]

This means that when consumers and businesses compete for short term funds, demand for short term money raises interest rates. Nevertheless, as the fear of inflation recedes, “an ever-lower inflation premium”[5] forces down long term yields.

As a caveat, since corporations operate on the principle of a profit and loss outcome, they’re supposedly more cautious. But this hasn’t always been the case. And it should be a reminder that a fallout from an imploding bubble does not spare so-called blue-chips, as in the case of the US investment banking industry, which virtually evaporated from the face of earth in 2008.

Industries that have been functioned as ground zero for bubbles are usually the best and worst performers, depending on the state of the bubble.

Figure 2: Business Insider: Falling Net Debt To Cap

Figure 2 is an interesting chart.

Interesting because the chart shows of the long term trend of the S & P 500 Net debt to Market cap-which has been on a downtrend, for both the overall index (red spotted line) and the ex-financials (blue solid line).

Since it is a ratio, it could mean two things: debt take up has been has been falling or market cap has been growing more than debt. My suspicion is that this has been more of the growth in market cap than of debt (since this is a hunch more than premised on data, due to time constraints, I maybe wrong).

In addition, since the tech bubble, corporate debt hasn’t grown to the former levels in spite of the antecedent boom phase prior to the crash of 2008.

Nevertheless, the substantially reduced leverage from corporations, particularly the net debt (red spotted line) which has reached the 2005 low, suggest of a recovery. This could signify a belated play on the yield curve.

Prior to the recent crisis, the S&P net debt began to recover at the culminating phase of the steep yield curve cycle.

Could we be seeing the same pattern playout?

Commodities And The Yield Curve

Finally, the link of the yield curve relative to US dollar priced commodities has not been entirely convincing. (see figure 3)

Figure 3: Economagic: Yield Curve and the Precious Metals

Over the span of 3 decades, we hardly see an impeccable or at least consistent correlation.

Precious metals in the new millennium soared during the steep yield curve. But it also ascended but at much subdued pace during the inversion.

In the late 70s precious metals exploded even during inverted yield curve. While it may be arguable this has been out of fear, it does not fully explain why gold and the S & P moved in tandem see figure 4.

Figure 4: Economagic: Precious metals and the S&P 500

Moreover, between the 80s and the new millennium, correlations have been amorphous.

And perhaps as we earlier averred this could have been due to the formative phase of globalization where much of liquidity provided by the US Federal Reserve had been “soaked up” by the inclusion of China and India and other emerging markets in global trade as a result of policies from Reaganism and Thatcherism and the collapse of the Soviet Union.[6]

The various bubbles around the globe, during the said period, serve as circumstantial evidence of the core-to-the-periphery dynamics.

Overall, as the yield curve remains steep, we believe that the upward thrust of markets should continue to hold sway as the public will be induced to take advantage of the “profit spread” as well as with central banks continued provision of stimulus conditions that would revive the compulsive manic behaviour seen in persons afflicted by varied forms of addiction.

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[1] See Does Falling Gold Prices Put An End To The Global Liquidity Story? and Why The Presidential Elections Will Have Little Impact On Philippine Markets

[2] Wikipedia.org, Addiction

[3] Wikipedia.org Oniomania

[4] North, Gary; The Yield Curve: The Best Recession Forecasting Tool

[5] North, Gary; When the Yield Curve Flips. . . .

[6] See Gold: An Unreliable Inflation Hedge?

Spurious Mercantilist Claims And Repercussions Of A Strong Chinese Yuan

``As no one can purchase the produce of another except with his own produce, as the amount for which we can buy is equal to that which we can produce, the more we can produce the more we can purchase.” John Say to Thomas Malthus

The second cyclical variable that should drive the markets over the short to medium term could be the Yuan factor.

For those reading the international scene the Chinese currency the yuan has hugged the limelight of late. That’s because prominent personalities associated with leftist politics have stridently assailed the Chinese government for allegedly perpetuating what they claim as “global imbalances”. It’s a spurious populist claim though, specifically meant to divert the public’s attention from their failed policies.

Nevertheless some variables are proving to be very compelling to suggest for a Yuan appreciation (see figure 5)

Figure 5: Danske Research: Implications of the Rising Yuan

The money printed by China’s central bank, the People’s Bank of China, utilized to accumulate foreign exchange has been generating unwieldy inflation and bubble-like pricing activities in the housing markets. This hoard has reached $2.4 trillion in foreign exchange reserves as of 2009.

China has attempted several times since last late year to arm twist several industries to stem credit expansion which has led to inflation. Lately she has threatened to nullify loans granted to local governments and has similarly instructed 78 state owned enterprises (SOE) to quit the real estate market leaving 16 SOE property developers.

And economic overheating presents as a real risk. There has been an acute shortage of labor where factory wages have risen by as much 20% as the inland now competes with the coastal areas and reduced migration in search of jobs.

We are now witnessing a classic adjustment in trade balances as taught in classical economics. As Adam Smith once wrote, ``When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation.”[1] (emphasis added)

In short, this leaves the Chinese government little or no option but to allow its currency to rise as a safety valve against a runaway inflation.

As shown in Figure 5, left window, USD-China’s yuan currency forward has been trending downwards which shows how the markets today have been factoring in the rise of the yuan. The right corner shows how adjustments were made in 2005 to reflect the advances in inflation. So yes, the Chinese policymakers in 2005 have responded to such scenario, and is likely to apply the same soon.

This means political pressure or no political pressure, China’s yuan will need to appreciate soon, simply because the economic pressures have been endogenously seething which will require for policy adjustments.

This leads us to the next issue which deals with why the cry for protectionism is spurious and the potential impact of the rise of the China’s yuan.

Mercantilism is a form of economic nationalism, which has long been rebuked by Adam Smith in his magnum opus, the Wealth of Nations. Mercantilism today has served as a basis for calls of protectionism.

Here we will unmask the partisanship of protectionist overtures against China.

First, the fallacy of the notion that trade is a zero sum game.

For the myopic protectionists who sees the world as confined to the equation GDP= C (Consumption) + I (Investments) + G (Government spending) + X - M (Exports-Imports), the mathematical operation involved in the equation which subtracts exports from imports engender a negative connotation for imports on economic growth. Hence, the bias or slant against imports for exports.

For instance, as I walked out of the pizza house following a hearty meal, I realized that the Pizza house, which earned the money I spent on, incurred a trade surplus. This left me with lesser money in my wallet, which accounts as my trade deficit. Although after the delectable meal, I also realized that my need for nourishment has been satisfied, unfortunately this has not been represented for in the GDP equation.

If I continue going to the same pizza house because I enjoyed the food, the ambiance, the services, the pretty youthful waitress or for many other reasons, the Pizza house will continue to incur surpluses while my wallet gets drained by deficits.

In the view of mercantilists whom tunnels on the flow of money only, but not the impact of or the satisfaction attained from the voluntary exchange, I would demand from the government that the Pizza house ‘balance its trade’ with me, by forcing them to take my services as a stock market agent, even if the owner isn’t inclined to deal with stock markets. If this sounds nonsensical, that’s exactly how the protectionists think.

If all the entities that I spent money on will be required to take on my services, from which rule applies to everyone, do you think the economy will prosper? Apparently not, that’s because people will probably stop trading with each other legally and do it behind the scenes.

In the above case, the pizza house will refuse me as a customer, that’s because they don’t need my services, even if I need them. In essence, forcing the people to buy or sell beyond their self-interests will cause a restriction of activities.

And be reminded that it is the individual that conducts trade. Whether it is done through personal, or through various forms of enterprises (proprietorships, partnerships or corporations), trade balances are incurred as individuals but only represented as enterprises or as states or nations.

In short, trade is exchange, where people conduct exchanges in order to fulfill a desire. The difference between local trade and trade with foreign enterprise is matter of classification. But the rudiments are the same, it is meant to satisfy some desires.

Hence, trade is not merely an accounting entry. It deals with human satisfaction.

In addition, trade balances do not include the sale of financial assets, as Robert Murphy writes, ``When economists compute the trade balance (or more accurately the current account), they don't include the sale of financial assets. So if foreign investors want to spend more (once we convert to a common denominator) on American assets than US investors want to spend on foreign assets, the trade balance is negative. The capital-account surplus is counterbalanced by a current-account deficit.”[2]

Once again Adam Smith[3], ``To import the gold and silver which may be wanted, into the countries which have no mines, is, no doubt, a part of the business of foreign commerce. It is, however, a most insignificant part of it.” (emphasis added)

Second, money isn’t wealth; inflation isn’t a Philosopher’s stone.

For instance current ploy of protectionists today is to arrive at a comparison of benefits. In such an instance, they distort the data to produce the account of which country is more dependent on trade. From here they argue, that by imposing trade restrictions, whatever vacuum left by closing the trading doors might be covered by money from central banks.

In other words, government can be relied to print money to produce jobs and investments. Had this logic been true then people don’t need to work at all, since the government can just print money.

Since voluntary exchange is aimed at satisfying human desires, then the role of money is essentially just as a medium of exchange.

And as medium of exchange, the valuation of a monetary unit, according to Ludwig von Mises, depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money.[4]

In other words inflating away out of protectionism will not achieve the desired prosperity.

What inflation will do is to vastly reduce the purchasing power of a nation which would redound to an erosion of wealth.

It is another absurdity to suggest that inflation won’t transpire because of output gaps. England has shown resilient inflation in spite of the similarities of condition with the US. To assume that the US is beyond the scope of the laws of scarcity is no more than living in a fantasy land.

Instead, it must be reminded that wealth is attained by accumulating capital, again Adam Smith ``The wealth of the country consists, not in its gold and silver only, but in its lands, houses, and consumable goods of all different kinds.”[5] (emphasis added)

Third, Protectionism Is Mutually Assured Destruction (MAD).

It is naive to believe that protectionism applied to China will not spillover to other countries. Such intellectual weenies fail to learn from the lessons of the Smoot Hawley act during the Great Depression.

To consider, should the US government engage in reckless inflation to finance the said gaps from protectionism with China, as the other holders of US treasuries realize of the scale of indirect default applied to their assets, many, if not all of them, will be panic sellers of US sovereign papers. And Americans will probably impose capital controls to curtail the exodus, and the ensuing capital controls would result to political counteractions.

And as reminder, the US is so dependent on oil that it imports 65% of what it consumes.[6] Guess who suffers more from a MAD policy?

According to Ludwg von Mises, ``The philosophy of protectionism is a philosophy of war. The wars of our age are not at variance with popular economic doctrines; they are, on the contrary, the inescapable result of consistent application of these doctrines.”[7]

Fourth, it is a myth that the appreciating Yuan and depreciating US dollar would expand US competitiveness while derail Chinese growth.

Pieter Bottelier and Uri Dadush writes in the International Herald Tribune, ``The immediate effect of renminbi appreciation will be to raise prices for U.S. consumers. A 25 percent revaluation of the renminbi, which some economists have said is needed, would — if not offset by a reduction in China’s prices — add $75 billion to the U.S. import bill. And since the United States imports three times as much from China as it exports there, higher U.S. exports to China would not nearly offset the welfare loss to U.S. consumers from higher Chinese prices.

``In the end, though some U.S. firms would gain and some export jobs would be created, the U.S. consumer would be the loser.”[8]

Fifth, fix currencies do not automatically equate to arbitrary currency manipulation, that’s because there is no free markets in currency, today. All governments control or somehow manipulate respective currencies to a certain degree.

The US dollar is pegged to 23 nations according to wikipedia.org. By definition of the protectionists, all 23 nations are also currency manipulators.

The Wall Street Journal hits the nail on the head,

``At the core of this argument is a basic misunderstanding of monetary policy. There is no free market in currencies, as there is in wheat or bananas. Currencies trade in global markets, but their supply is controlled by a cartel of central banks, which have a monopoly on money creation. The Federal Reserve controls the global supply of dollars and thus has far more influence over the greenback's value than any other single actor.

``A fixed exchange rate is also not some nefarious economic practice rare in human affairs. From the end of World War II through the early 1970s, most global currency rates were fixed under the Bretton-Woods monetary system created by Lord Keynes and Harry Dexter White. That system fell apart with the U.S.-inspired inflation of the 1970s, and much of the world moved to "floating rates."

``But numerous countries continue to peg their currencies to the dollar, and with the establishment of the euro most of Europe decided to move to a fixed-rate system. The reason isn't to get some trade advantage against their neighbors but to gain the economic benefits of stable exchange rates—and in some cases a more stable monetary policy. A stable exchange rate eliminates a major source of uncertainty for investment decisions and trade and capital flows.”[9]

In short, the labelling of manipulation is a matter of political convenience than truth.

The real problem has been China’s non convertibility and capital controls.

Again the Wall street Journal, ``China's real problem isn't its peg to the dollar but the yuan's lack of convertibility to other currencies and capital controls. These controls have blunted the yuan's development as a tradable currency, which means private markets can't recycle the flow of dollars into China from its large trade surplus.” [10]

Finally, as we have long argued US trade deficits are a function of the US dollar standard.

The more the world engages in global trade, the bigger the need for US dollar to finance this trade, since it is the de facto, reserve currency of the world, where transactions are quoted, paid and settled through US dollars.

Hence, until the US dollar is replaced with another alternative it is a fairy tale to believe that a strong yuan would rebalance the global economy. What would occur instead would be more distribution of surpluses around the world, but US deficits will continue to swell as the global economy expands.

Although there are more to discuss including the transition to the information age or China’s internal economic structure we will leave this discussion here.

But for those wishing that April 15^th to be the fateful day where the US tags China as currency manipulator, good luck to you. Prediction markets, google trends or market indicators haven’t been pointing to such direction.

The appreciation of the Yuan will allow for cheaper imports and essentially reduce dependence to lend money to the US. This means that China would have more bandwith to employ resources for its own development, depending again on the degree of economic freedom embraced by China. And the impact is likely to be seismic.

Peter Schiff rightly argues, ``Absent Treasury-bond purchases, the value of the Chinese currency would rise sharply, causing goods prices to tumble in China. This long-delayed increase in purchasing power for everyday Chinese will unleash pent-up demand in what is already the largest middle class in the world. Chinese factories would retool in order to produce goods for their own citizens to consume. In RMB terms, commodity prices would plunge, making it easier for China to produce all kinds of stuff, such as automobiles, while also making it cheaper for the Chinese to buy gas. Millions will trade in bikes for cars, and Chinese oil imports will swell.”[11]

This means that there could indeed be temporary uncertainties from expectations of the Yuan appreciation, which will depend on the degree of the allowable strengthening of the Chinese currency.

As a caveat, while the Japanese Yen firmed over the past decades, the Japanese haven’t been transformed into a US consumer type of compulsive shopper or oniomania. Hence, habits or forms of addiction in a society should apply. In short, no society is homogeneous.

Figure 6: Danske Research: Strong Stock Markets And Commodities Post Yuan’s Revaluation

Nevertheless, if history would serve as precedent of the future, then the uncertainty from a revaluation is likely to be short-lived (see figure 6). And the impact from a revitalized yuan has could be tremendously salutary in terms of stocks, Asian currencies and commodities.

Finally another word of caution, every expert I know expects the Yuan to appreciate, while this is the most likely the political outcome, we can’t rule out policy errors. This means that inflation can go berserk, if China refuses to budge, perhaps out of the recalcitrance to bow to political pressure.

A bubble bust or a hyperinflation in China would cause massive outflows and reverse all these expectations [even without protectionism].

For protectionists, I suggest for you to just mind your own business as nature will force the hand of economic imbalances.

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[1] Smith, Adam Wealth of Nations, Book IV, Chapter 1 wikisource.org

[2] Murphy, Robert; Trade Deficits and Fiat Currencies, Mises.org

[3] Ibid

[4] Mises, Ludwig von; Stabilization of the Monetary Unit

[5] Smith, Adam Wealth of Nations, Book IV, Chapter 1 wikisource.org

[6] See The Delusion Of The Mercantilist Miracle

[7] Mises, Ludwig von Human Action, The Conflicts of Our Age, Human Action, oil.lbertyfund.org

[8] Pieter Bottelier Uri Dadush The Myths About China's Currency

[9] Wall Street Journal, The Yuan Scapegoat

[10] Ibid

[11] Schiff, Peter Paul Krugman Versus Reality