This week’s gyrations in world stock markets resembled a blizzard that comes up with little warning. Many of us relish a good blizzard once in a while: It gets the blood flowing and provides material for water-cooler discussions. Truth be told, economists similarly relish a good financial crisis: They get the blood flowing, pique student interest and foster pontificating on the global economy.
Storms and financial crises have something else in common. Both are inevitable outcomes of natural processes. In the face of both, governments and households can make prudent, self-protective decisions. But neither Midwestern storms nor global financial crises are subject to human control.
At this point, it is not clear what the week’s events portend for the U.S. economy. For China, the signs are clearer. Things got started Tuesday when Chinese share prices dropped 9 percent, reportedly as a result of Chinese government actions to cool off stock markets that have risen 100 percent in 12 months and are in a classic bubble mode. China’s economy has to slow eventually. That may be starting now.
China has grown almost uninterruptedly for 29 years. Physical investment in new factories and infrastructure is at levels unprecedented in human history. Its balance of payments accounts are unsustainably out of whack. Until this week, Chinese stock prices had soared. Urban land prices have risen similarly. Credit has expanded too rapidly.
The Chinese government, still autocratic, has no experience guiding a modern economy over a full business cycle. Moreover, its tools for controlling the money supply, banking activities and credit remain crude compared with those of the wealthy industrialized countries.
This does not mean that the Chinese economy is going to fall into an abyss, or that three decades of growth will be lost. It does mean, however, that China is overdue for some degree of recession that will bring Chinese business and household expectations back to realistic levels. Some Chinese companies will go bust. Some banks will prove insolvent. Some foreign investors will take a bath.
The Chinese government may then be forced to make some hard choices that it has been able to avoid so far.
Hidden in the Chinese boom are many unsustainable contradictions.
Despite the explosive growth of new companies, the old Stalinist industrial sector, unproductive and unreformable, still employs hundreds of millions of workers in China. Years of bad loans from state-owned banks to state-owned companies still hang over the economy. Disparities in incomes between the modernizing coastal areas and the interior grow apace. Unprotected by enforceable property rights, many farmers are shoved off their land by urban growth and become roving casual laborers.
Exports have boomed, in part because of a government-maintained weak currency. However, keeping the yuan cheap requires the government to print money to buy up hundreds of billions worth of dollars, yen and euros. This monetary expansion further stokes an overheated economy. And the purchased foreign currency must then be invested somewhere.
Ending this artificial depression of the yuan will reduce exports, business profitability and employment. But it will happen.
Rapid economic growth always induces economic distortions. We saw that in our own country in the 1990s. When an economy booms, everybody with a business plan or investment looks like a genius. Bankers and businesspeople get caught up in the whirl of things. They lose perspective. Inevitably loans are made, machinery is purchased and buildings are constructed that, in retrospect, don’t make sense. Real estate prices rise beyond levels that can be sustained in a normal economy.
Stock market corrections, land price busts and recessions are the natural way an economy corrects such misperceptions. They can be painful, but seldom interrupt growth of the underlying real economy for more than a few years. That has to happen in China, and if it is not starting now, it will eventually.
The $64,000 question is how that will affect the rest of the world. South America is doing well because prices of metals and farm commodities are boosted by Chinese demand. We have low interest rates and low inflation because imports from Asia are cheap and Asia is willing to lend us a lot of money.
A slowing Chinese economy would hurt Minnesota farm and mining products. The dollar might weaken and U.S. interest rates could rise if we are forced to fund our own household and government spending instead of borrowing from across the Pacific.
All these imbalances will work their way out. Just how fast and how painful that process will be is anyone’s guess. Offhand, China will face dramatic changes in the next 18 months. Our economy will slow. We may achieve the mythical “soft landing.” But don’t count on it.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.