China’s “Lewis Moment” and its consequences for the Economy

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MONDAY, MARCH 7, 2011

The Tweet version for the impatient, busy reader:  Developments in China will require the USA to adapt much more quickly than the comfort level inside the Beltway contemplates.  This is something you need to study as soon as time permits.

JBG

FULL ARTICLE PRINT LINK: http://jaygaskill.com/ALewisMomentInChina.htm

A MOMENT OF TRUTH

China’s “Lewis Moment” and its consequences for the Economy

Eventually the truth leaks out.  This happens when the knowledgeable elites cannot any longer contain it, and the clueless elites wake up to smell a coming storm. This happened this weekend.  It will continue to leak out over the next several news cycles.

In recent business reports (see Bloomberg, S F Chronicle, 3-5-11 *) we are told that China has arrived at its “Lewis moment” (after the Nobel winning economist of the same name).  This is the moment when a developing economy arrives at an employment saturation point, that economic stage when there is a shortage of workers.

Several things quickly follow:  Wages go up – in China’s case, wages probably increase at the rate of 15-20% per year.  The prices of Chinese goods go up.  Chinese worker consume more.  Chinese manufacturers begin outsourcing (this has already happened.)  Inflation hits China’s customers (and this has already started).  The cost of borrowing from the Chinese goes up.

Hint to the naïve:  The world stage, both as an economic playing field and as a power arena, is still a Darwinian struggle.  No, the game is not necessarily won by any single player, and the use of brute force is rarely the decisive factor.

The game goes to the most creative-adaptive players.

My formal economic courses (taken before law school) are no longer current, but was obvious even to me some time ago (See my Links*** below) that a major adjustment in the economic relationship between China and the USA is looming.

We have overplayed our run as a consumption-based, debt-fueled economy by about 20 years and China’s 20-year run as a consumption-repressed, production-based economy has run its course.

Enter Fed Chair Bernanke, a conventional Keynesian economist tasked to do the impossible.  With no power to change the fiscal policies of the administration, his agency is supposed to contain inflation and maintain sufficient credit liquidity to keep the economy humming using “monetary” policy, only.  POTUS and the Congress can, for example, run about 45% of federal expenditures on credit and the fed is left to pick up the pieces, and actually is doing just that as I write this.

Sometimes the pieces are just too big.

In fact, things are not going well with the fed.  In what is charmingly called QE-2 (not a nutritional supplement, not a cruise ship) the fed has embarked on the infusion of new liquidity into the economy by using fiat money (dollars created out of thin air) to buy back about .8 trillion dollars of US debt instruments via “quantitative easing”.  Even without the push from China and the coming spike is gasoline prices, real food price inflation is already evident.  More price increases will come.

This is very much like the little Dutch boy who sees a small leak in the dam.

The economy is on dialysis. The QE-2 infusion is to end on June.  A question will then arise – Who will be willing to buy the roughly $1 trillion dollars in federal debt needed to keep this mighty spending engine going?  [Links **] Whatever the configuration of investors that agree to buy the US debt in June and following, two things will be true, given the present course:

1. The price of federal borrowing will go up.

2. An endpoint, that dreaded day when it becomes just too hard for the USA to borrow what it needs, will appear on someone’s calendar.  That moment will be like turning a page in one’s date book and finding that your own funeral has already been scheduled.

So…the pressure on the fed to adopt the irresponsible path of least resistance will be hard to resist.  Will it be QE-3?  QE-4?

Here are the three dirty little secrets.

ONE:

It is too late for the US economy to “grow out” of its current indebtedness within the productive lifetimes of workers 40 and older.  The sheer magnitude of government debt dwarfs any stretch of GDP growth period in our modern history.

TWO:

Inflation will decrease the national debt by devaluing the dollars with which it must be paid, hence the Great Temptation.  Bernanke should and probably will resist, but…

THREE:

Runaway inflation will lead to catastrophic results.  Certain South American countries and the pre-Nazi Weimar Republic in Germany have already been there.  Savings, pensions, long term contractual arrangements are burned to ash in such inflations and damaging social unrest follows.

Back to the Darwinian struggle:  Creative-adaptive wins.  We will get through this only if we quickly reign in all the red ink, much as an EMT stops bleeding at the scene of an accident.  Then we notice that the change in the American-Chinese relationship is an opportunity.  And we seize the moment. This is our invitation to return to the earlier US status as a productive, investment-driven economy.

How in the world can we do that, you ask?

Things have radically changed since someone could credibly say, “What’s good for General Motors is good for the country” (1953, GM President Wilson).

Much of the USA’s manufacturing base disappeared during the period between 1985 and 2005, an exodus driven primarily by high domestic labor costs.  Does anyone remember the hysteria surrounding the advent of automated, robotized manufacturing?  The conversion to automation in the USA was delayed for two decades by the convergence of two factors:  American labor resisted change and cheap foreign labor – living cheaply elsewhere – filled the gap.

It is hard to escape the implications of the fact that there are almost no unions in the Silicon Valley industries.  As foreign labor costs rise, the time is ripe for a resurgence of American manufacturing driven by high tech innovation, second and third generation automation, innovations safeguarded by a far more robust protection of American intellectual property. [I note here that the Chinese have appropriated without compensation an entire range of US and Western intellectual property.]

Government at all levels has run out of money and is on the brink of running out of credit.  Dumping gobs more of fiat money on the problem of stagnant growth is counterproductive because of the risks attendant hyperinflation.

This leaves private money.  Trillions of privately owed and controlled dollars (or their equivalent) are poised to invest in the US economy – or somewhere else.  Fortunately their owners are rational in the sense that they want their investments to be productive.  The USA is still one of the safest places to invest in a new business, but not necessarily the most long-term profitable one.

What needs to happen? The current political load on commerce, the red tape, the petty approvals, the irrational bureaucracies that threaten to suffocate any new economic venture need to be carefully, rationally and rapidly peeled away.

This is the only play we have left.

In the current situation, Americans and their servant politicians need to open the doors wide to private investment from anywhere in the world so long as the resulting enterprise and its backers remain subject to the three core rules of business development in the contemporary American setting:

(1) When you risk you money here, you will not be bailed out if you fail, and you will not be punished – or bled – when you succeed.

(2) Your capitalization needs to be sufficient to ensure accountability for fraud, misrepresentation and contractual compliance.

(3) You and your backers need to respect American intellectual property rights.

Implementation of such a vision of an open door, return to private-investment-driven capitalism, with a strong emphasis on creative innovation, requires a set of leaders that has not yet clearly emerged on scene.   Among the lessons that all too many of our political leaders have not learned is this: Bureaucrats are to creativity as water boarding is to breathing.

[My more detailed proposals and the background analysis are in a series of my articles, linked*** below.]

JBG

LINKS

* http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2011/03/05/BUVN1I3MCD.DTL

Pull quote –

“Dong Tao [is the] chief regional economist for non-Japan Asia at Credit Suisse in Hong Kong.

Tao says China is fast approaching the so-called Lewis turning point, named after Arthur Lewis, the Nobel Prize-winning economist whose work described that critical moment in a developing economy’s rise when its surplus labor supply dries up, and increases in wages, prices and inflation ensue. In China’s case, demand for workers will outstrip supply by 2014, Tao’s team calculated in a January report.”
** http://finance.fortune.cnn.com/2011/03/02/gross-warns-qe2s-end-could-sink-markets/

Pull quote A

“…if QE2 ends on schedule at the end of June, that bid will disappear – and the government will presumably have to offer somewhat higher interest rates to appeal to purchasers who are increasingly concerned about the prospect of inflation down the road.”

http://www.cnbc.com/id/41392090/Fed_to_Start_Tightening_as_QE2_Runs_Out_LaVorgna

Pull quote B

“With the second leg of the Fed’s QE program to run out in June, after it purchases another $600 billion of Treasurys to expand its balance sheet to nearly $3 trillion, it will then be faced with a tough choice of how to proceed.

“Investors will be watching the move closely.”

[No kidding…. JBG]

“Nomura Securities’ Bob Janjua estimated earlier this week that QE2 has been responsible for 250 points of the S&P 500 rally since late August 2010. Pimco’s Bill Gross also attributes a chunk of the stock market gain to the Fed, putting the impact at 4,000 Dow points since it started intervening.”

“LaVorgna, Deutsche’s chief US economist, lays out his expected timeline:

“As QE2 runs its course in June, the Fed at its June 21-22 meeting will announce that it will let its mortgage-backed securities run off its balance sheet and will not reinvest the proceeds in Treasurys, as it has been doing.”

*** Background Articles by JBG:

ON the nature of the crisis and the failure of conventional wisdom:

http://jaygaskill.com/KeynsianCollapse.pdf

http://jaygaskill.com/FiscalEarthquake.htm

http://jaygaskill.com/DelusionalEconomics.htm

http://jaygaskill.com/ChinaKrugmanGreatAdjustment.htm

ON the challenges of sparking creative solutions

“Creativity & Survival” http://jaygaskill.com/CreativityAndSurvival.htm

Getting Practical:

http://jaygaskill.com/ChinaInc.htm

http://jaygaskill.com/ChinaInc2.htm

http://jaygaskill.com/China3.htm

Walking the Walk:

http://jaygaskill.com/Breakout1.0.htm

http://jaygaskill.com/Breakout2.0.htm

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