China Rising?

So much ink has been spilled–especially over the last several years–about the rise of China that I wanted to devote a blog to the subject.

I won’t bury the lead: I believe China is more likely another Japan than another United States on the rise.  My goal is not so much to tell the future–I don’t know what will happen–as much as it is to cast doubt on the overwhelming consensus of China’s inevitable rise to supremacy.

What consensus you might ask?  That China’s economy will inevitably surpass the U.S.’s in the next 10, 20, or 30 years; that China will surpass the U.S. in technological superiority; that China will surpass the U.S. militarily; that China will surpass the U.S. in every way possible, it seems.

All of these things very well may come to pass.  But, it is not written in the stars, and the consensus view is almost entirely built on an extrapolation of current trends–a technique of forecasting which is almost never accurate.

As an interesting illustration of forecasting difficulty, I’d like exhibit #1 to be Paul Kennedy’s excellent book, The Rise and Fall of the Great Powers.  Now, granted, this book came out in 1987, when Japan’s ascendancy was widely accepted as given, but it’s a wonderful example of how someone extremely knowledgeable in a specific field can suffer from the biases of extrapolation. 

In his book, he speaks of the 5 centers of power at the time: the U.S., the U.S.S.R., Japan, China and the European Economic Community.  He spells out how clearly Japan is surpassing or going to surpass the U.S. in computers, robotics, telecommunications, automobiles, trucks, ships, biotechnology and aerospace. 

Please understand, he was writing in 1987, when Japan Inc. was thought to be unbeatable, buying up property all over the world, technologically unstoppable.  He didn’t know Japan would fall into an economic funk a mere two years later where Japan’s economy wouldn’t grow for the next 22 years (nor did he see the fall of the U.S.S.R. coming, and even seems to poo-poo the idea).  So much for Japan Inc. and extrapolation of the past.

But, really, how could anyone really think that Japan would surpass the U.S. in computers and software?  Or biotechnology and aerospace?  Yes, Japan has definitely done better in robotics, automobiles and ships, but to provide such a long and overwhelming list as a historian?  A bit naive, I think.

The consensus view on China reminds me in many ways of the view 20 years ago of Japan.  Don’t get me wrong, Japan and China are very different stories, but people’s perception seems to be similar. 

Just as China’s centrally planned economy and “state capitalism” (an oxymoron if there ever was one) is seen as the wave of the future and a better way to govern, so Japan’s Ministry for International Trade and Industry (MITI) and it’s coordination of economic activity was seen as a huge advantage over the U.S.’s capitalism. 

Just as China’s production of engineers and scientists is seen as an unstoppable force, so was Japan’s.  Just as China’s high research and development budget is seen as superior, so was Japan’s.

Just as China’s high national savings rate is seen as an advantage over the U.S.’s consumption, so was Japan’s.  Just as China’s superiority in aptitude tests is seen as intellectually over-powering the U.S.’s poor scores, so was Japan’s.

I believe people make these extrapolations because they don’t really understand the sources of growth.  They simply expect the recent past to keep going, but it almost never does.

Just as Japan’s extraordinary growth came from adopting western technology and industry and having huge western markets to sell to, so does China’s.  If either Japan or China had had to create these industries from scratch, as the U.K. and U.S. had done, the growth would never have materialized.  And, just as Japan’s economy has demonstrated over the last 20 years, if China ever has to rely on it’s own consumers and businessmen for innovation and growth, you’ll see growth fall off a cliff.

Neither Japan nor China invented the Bessemer process, or assembly lines, or transistors, or binary computer logic, or almost any of the other major innovations which allowed them to grow.  They got it all from the west. 

And, this brings me back to my blog of two weeks ago, where I said that return on capital is the most important concept in finance.  You see, neither Japan nor China view return on capital as a primary concept.  Japanese businessmen are frequently on record saying that the U.S.’s focus on shareholder returns is ridiculous.  China is a communist state that sees returns on investment as a mere means to other ends.

The U.S. and U.K., at least during periods of innovation, let returns on capital as determined by individuals allocate resources, instead of some central planning bureaucracy.  The U.S. and U.K., thanks to intellectual greats like Adam Smith (a moral philosopher, not economist), recognized that human potential was unlocked when individuals were able to pursue their self-interest, as long as there was a rule of law and, specifically, protection of property rights.

Good luck finding that intellectual framework in Japan or China. 

In forecasting the future, this return on capital concept is vital to accuracy. 

If the U.S. abandons its focus on return on capital (as the U.K. has in most ways done), good-bye growth and innovation, good-bye technological and military superiority, good-bye world leadership. 

If Japan adopts a focus on return on capital at the individual level, which I believe is possible over time (perhaps in the next decade) welcome back growth and innovation. 

If China adopts a focus on return on capital at the level of the individual–an unlikely route, in my opinion–it can become a leading state.  Without that focus, growth will eventually crash and burn as it did in Japan (China is witnessing a boom in real estate, just as Japan did before its crash–coincidence?).

Forecasting China or U.S. over the next 30 years seems a bit silly without a focus on return on capital, but the consensus opinion is that it’s a done deal–China will be supreme. 

I beg to differ because I don’t believe large population, numbers of engineers, test scores or central planning are the lifeblood of growth, but the innovation of individuals who produce high returns on capital for their own benefit.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

China Rising?

Beggar thy neighbor

I was surprised this week to read several reports that Europe announced improving production and business confidence, particularly out of Germany.  Several European companies announced better than expected earnings, too. 

After all, weren’t financial commentators the world over (including yours truly) prattling on a couple of months ago that Europe was coming apart at the seams?

And then I remembered the phrase “beggar thy neighbor.”  It refers to the political policy of devaluing one’s currency and/or erecting trade barriers to boost one country’s economy at the expense of other economies. 

It’s called beggar thy neighbor because it only works as long as your neighboring countries don’t react (hence the begging).  If they erect their own trade barriers or devalue their currency, then the game is up and everyone ends up worse off.  Like most boondoggles, it only seems to work as long as you focus on the surface and not the aggregate.

Because I have a sarcastic sense of humor, I couldn’t help but be amused by all the Germans who were coldly saying, a few short months ago, that the Club Med countries should be dumped from the euro currency and even the European Union.  Now that the Club Meds have caused the euro to drop, Germany seems to be making out like a bandit. 

The main reason is that Germany is mostly an export economy (like China and Japan).  In fact, China overtook Germany only last year as the world’s largest exporter.  Germany’s economy would grind to a halt if it weren’t selling to others.  Not surprisingly, the euro dropping benefited them most.

But, it won’t last too long.  Even now, U.S., Japanese and Chinese politicians are most likely forming policies that will lead to our own devalued currencies or new trade barriers that will eliminate the euro advantage.  The effort will succeed in kicking Europe–particularly German–in the shins, but it won’t make anyone better off.

In the long run, people adjust to currency changes.  Over time, a burger in Asia, Europe and America will cost about the same in real value.  Buyers and sellers adjust the prices they are willing to pay and receive until things are back to the way they were.  Currency depreciations don’t work for long, and trade barriers just reduce everyone’s standard of living. 

Beggar thy neighbor doesn’t work, unless of course your goal is to get elected in the short run.  It may be the only thing less productive than re-arranging deck chairs on the Titanic.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Beggar thy neighbor

Is Greek Tragedy Contagious?

I’ve written several blogs touching on Greece’s problems over the last 5 months (please see: Sovereign Subprime, Bonds and Cash Just Aren’t That Safe, Going Greek, Return of the Bond Market Vigilantes). But, as one of my long time readers noted, given recent events, it’s time for an update.

First, a review. Greece’s fiscal deficit is hitting double digits. When deficits get this large, countries find it difficult to issue debt and keep their currency from sliding in value. Greece, however, is in a unique position as a member of the European Union (EU) that also utilizes the euro as its currency. Greece’s fiscal and debt problems are not just their own, but an issue for the entire EU. This means more fiscally responsible countries like Germany and France are feeling compelled to bail out Greece. If they don’t, their economies will suffer, too, and the political/economic experiment that is the EU will go into the dustbin of history (as have all other pseudo-unions of this sort).

As I’ve remarked elsewhere, Greece’s tragic movie is coming to theaters near you, because Greece’s issues are and will be repeated the world over. This includes western Europe’s sick brothers: Portugal, Italy, Ireland, and Spain; several eastern European countries; several South American countries; and will soon feature such first world countries as the United Kingdom, Japan, and the United States.

If this sounds like hyperbole to you, I don’t blame you. But, let me explain.

Greece’s problems are not a product of bad luck or bad timing, but are self-imposed. Like Bernie Madoff’s Ponzi scheme, Greece’s government promised benefits it couldn’t possibly pay out. Greece’s economy is saddled with a huge public sector that has overly generous pay, benefits and pensions. Now that Greece needs to trim back those benefits to get its fiscal house in order, public sector employees are taking to the streets in violent protest. This is shutting down its economy. This may be hard to believe for Americans, but Greece’s Air Force protested by not coming to work this week! When the defense sector goes on strike, things are out of hand.

How can Greece solve its problems? It must cut public spending and grow the economy. Only then can it pay back its debt burden. This is no more complex than a family running up too much credit card debt–the solution is to spend less, make more money, and pay off debts. But, Greece’s family is refusing to cut spending while its public sector is preventing growth. Not a pretty picture.

Greece is not alone in having made such unfulfillable promises. Close on its heels are Portugal and Spain. What made news this week was what debt markets noted months ago: the credit worthiness of Greece, Spain and Portugal is degrading–the rating agencies snapped out of their stupor and finally downgraded Spain, Portugal and Greece. In fact, Greece was cut all the way to junk.

So now Greek tragedy is spreading to the weaker brothers of Europe. Who is next in line? Italy and Ireland, and then eastern Europe, and so on. The problem is that this could feed on itself. If the EU, primarily Germany and France, don’t nip this in the bud, the problem will grow over most of Europe. What turns this into a negative feedback loop is that when credit ratings are cut and interest rates soar, it becomes more difficult to cut spending and grow your way out of the problem.

How does this impact the U.K., Japan and the U.S.? All three have made promises they can’t keep; all three hope to grow beyond their obligations instead of cutting benefits; all three assume they can grow by selling products to places like Europe, China, etc. All three face Greece’s problems, but at an earlier stage. If they don’t reduce cut spending or grow strongly enough, they will before long find themselves in their own Greek tragedy.

If you don’t think the U.S. (or the U.K., or Japan) has such a problem with its public sector, check again. Our states and municipalities have made enormous promises to public sector employees–promises that almost any actuarial accountant will tell you are unfulfillable. How do you think teachers, policemen, fire-fighters, motor vehicle administrators, etc. will react when we say we need to cut their pay, benefits and pensions? Perhaps not with violent street protests, but certainly not with simple resignation.

Greece’s overwhelming problems will not visit us tomorrow, but they will come over time. Even if Greece’s problems are solved, which will probably cost the EU (and International Monetary Fund (IMF)) 180 billion euros over the next 3 years, the EU still has to deal with Portugal, Spain, Italy and Ireland. How many hundreds of billions of euros before France and Germany are pulled down, too?

Greece’s problems are turning into Spain and Portugal’s problems, which are turning into France and Germany’s problems, which will eventually hurt the U.K., Japan and U.S.

With all that, what are the investing implications?

1) Buying sovereign bonds or holding cash is more dangerous than it may seem. If you must hold bonds, hold corporate or inflation protected bonds. If you must hold cash, gold is the way to go.

2) The world economy is likely to continue growing despite these issues. Fiscal stimulus from Europe, Japan, the U.S. and China will not run out until later this year, and until that happens, sovereign subprime will be a side issue. But, markets are likely to be more volatile than they have been over the last year, so owning something that does well in more volatile markets will probably be beneficial.

3) For the long run, buy blue chip, franchise companies and lowest cost commodity producers. Great companies have pricing power and not much debt, so they will be able to grab market share, grow, and adapt to changing times. When longer term sovereign issues raise their head more significantly, interest rates will spike, currencies will tank, and commodities will thrive. Owning lowest cost producers will be very profitable.

4) The timing on these issues coming to a head will be almost impossible to get right. If Germany decides to be nationalistic and kicks Greece out of the EU, markets will react right away. If the EU bails out Greece, then Portugal, then Spain, then Italy, etc. this could drag out over a long time. If you can read minds and know how sovereign powers will react, you can get the timing right; for the rest of us mortals, trying to time the markets will prove to be a fool’s errand.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.