- The three stages of the debt life cycle
- Interest eventually costs real money
- Where is China in the three stages of the debt life cycle?
No doubt you’ve noticed the sudden influx of news about China’s stumbling economy and financial markets. Deflation, bankruptcies and bizarre economic policies to try and counter the decline all feature.
We covered China’s struggles in last month’s edition of The Fleet Street Letter, including what to expect next for stocks. But in this three-part series for Fortune & Freedom, I want to focus on something different.
You can read part 1 here. It reveals the shape of China’s bubble economy – the same absurdities that we saw on a smaller scale in places like the US, Portugal, Ireland, Greece and Spain in 2006.
Today we focus on how this bubble came about – the debt cycle.
Just promise me one thing: if you read on, you’ll read the last few paragraphs of part three tomorrow, which will reveal a shocking twist about what you’re going to discover below.
If you agree to this, read on…
The life cycle of debt as it moves around the economy seems to be the crucial link between the economic debacles of the past few decades – from the Asian Financial Crisis to the 2008 debacle to the European Sovereign Debt Crisis. Understanding it will help put China’s bubble into context.
First, the private sector takes on debt, touting the enhanced returns possible by doing so. This creates an initial sugar high of prosperity, as economic growth jumps on increased investment in productive resources. At some point, however, a limit to productive borrowing is reached. To maintain the economic growth that has come to be expected, government begins to leverage up also.
By definition, government spending is not productive. Otherwise private investment would have stepped in already. So the borrowings of sovereign debt, unlike those of private debt, are not invested in assets that produce a return to the borrower. That return is needed to justify the cost of interest on debt. Put differently, society at large may benefit from government borrowing and spending initially, but not more than it will cost in taxes and interest that will have to be paid eventually.
The global financial crisis hastened the move from stage one to stage two of the debt cycle by debuting epic government bailouts of the private sector and a collapse in government revenue. Debt was transferred in unprecedented proportions from the private sector to the public sector in a short amount of time and the revenue needed to pay for it all evaporated. This has put many nations well and truly over the line of unsustainable debt. Europe’s sovereign debt troubles was just another version of the same issue, with debt being transferred and taken on by governments.
The nature of the political process is to continue to borrow, leaving your political descendants to deal with the bill. Rarely, a politician with foresight might reduce the debt burden. But that is only politically popular during periods of prosperity, which are in turn often driven by increasing leverage in the private sector. So either way, growth is debt-fuelled growth.
As debt mounts, both in the private sector and public sector, the determining factor of prosperity becomes the cost of debt – interest rates. That’s why governments monopolise control over rates by creating central banks. Central bankers are given the mandate, express or implied, to maintain employment and growth. As debt levels reach the point where the benefits of borrowing no longer justify the costs, central bankers simply lower rates. Paradoxically, the lower rates go, the more leverage becomes viable.
As an aside, many economists point to low interest rates as evidence that an economy is maturing, or is developed. Instead, it is more likely a sign of heavy indebtedness.
The third stage in the lifecycle of debt, the previous two being private and public borrowing, is monetisation of debt. Without the economic growth that comes with investing borrowed funds into productive assets, the debt burden soon becomes overwhelming. And so both public and private borrowers and lenders turn to the central bankers and their printing press for relief.
Most of the world is edging towards this third stage, where public debt and private debt reach impossible extents. Simply lowering rates doesn’t create more borrowing by the private sector any longer. And the public sector begins to struggle to find lenders. It turns to central banks to finance the debt, which is why central banks around the world are holding ever more government debt today.
What this third stage of the debt lifecycle looks like when it gets out of hand is an open question. Many point to the likes of the Weimar Republic and Zimbabwe as evidence of hyperinflation being the mark of the end of a debt cycle. But a build-up of debt on a global scale to the extent we are seeing now has never occurred. Its results are difficult to foresee.
So where is China in the three-stage debt cycle? Well, it seems that policy makers skipped much of the first stage and went straight to the second. Private debt featured, but not to the same nefarious extent it did in Western economies.
China, fearing the spread of the global financial crisis, engineered a public borrowing campaign unlike any other. There are several possible explanations to why China didn’t follow the three-stage process. Perhaps China’s private debt markets were simply not yet at the bubble stage that others were. More likely is the fact that the distinction between private and public debt is blurred in China.
What’s wrong with too many houses?
One of the unique aspects to China’s debt trap, analysed below, is its political system. The one-party state has led to far less “separation of powers” – a political term for dividing the role of different levels of government and thereby holding each accountable to the others. Of course, political domination is the prime feature of the Chinese system, so the accountability is behind closed doors only. The paradox in this is that bureaucrats at the lower levels of government often have much freedom in how they achieve the directives required of them. Often the method of fulfilling the plans of their superiors compromise the intentions of those plans themselves.
This odd aspect of centrally planned economies has been studied by many economists. Ludwig von Mises explained why the centrally planned economy cannot succeed, nor last very long, in his book Socialism (1922). Put simply, the problem with a command economy is the measures it uses for success. By determining what will be produced based on one person’s perception of what should be produced, success and failure become detached from what is actually wanted and needed by all the individuals in society.
Production based on the mantra “from each according to his abilities, to each according to his need” ignores the fact that both ability and need are subjective, not objective. Ability and need are unique to each person and perceived differently by each person. Therefore, if one person, or a group of people, make production and consumption decisions for all others, all those decisions will be wrong to some extent. In a bad case scenario, these plans will cause mass starvation for people living amongst filled grain silos, as occurred in the Soviet Union. Slightly less bad is the construction of masses of houses without anyone to move in.
A capitalist system relies on individuals making individual decisions about what they would like to buy. Entrepreneurs seek to meet these demands. This relationship ensures produced goods are the ones wanted (or they stop being produced). Prices and profits are the signals – the means of communication – in this relationship. Profit is the signal that markets give when entrepreneurs find ways to serve others.
But when individuals’ demands are no longer the determining factor in what is produced, and that decision-making process becomes a centralised one, there is no guarantee that what is produced will be worth more than what was used to make it. An old joke about the Soviet Union illustrates this:
A nail factory manager was given the task of producing one ton of nails. He promptly went about doing so and arrived at his superiors office to make the delivery. On the back of the truck he brought with him was one giant nail, weighing one ton.
This joke is an exaggeration of true events. Nails produced in the Soviet Union were consistently too large, small, thick, thin or brittle. Because planners didn’t know what their customers wanted, they never got it right. And they didn’t care anyway, as long as their production quota was filled. The incentive to produce the right nail, which is missing in a centrally planned economy, is the widely known shortcoming of command and control economies. But the “calculation problem” of not being able to distinguish success from failure is far more of an obstacle for making centrally planned economies work.
Illustrating this amusingly is the fact that Soviet Planners would frequently smuggle Western catalogues to the motherland. And it wasn’t to stare at the pretty models. They were looking at prices. Because prices for items in the Soviet Union were either non-existent, or not based on any reflection of reality, the Soviet planners had no idea how much the items they produced were worth. Nor whether they were worth producing – whether the costs outweighed the benefit of the final product.
Without prices, profits and the freedom to rearrange capital and inputs, production becomes a guessing game. And the bureaucratically easiest route is taken by the manager of the production process.
Like the in Soviet Union, massive misallocations of capital have occurred in China as a result of the government-driven production decisions. What’s worth taking away from the Soviet lesson is that such misallocations of capital eventually correct.
Because of China’s limited capitalism, some of those misallocations are visible to the keen eye. The debt-fuelled stimulus of the past few years have laid them bear for all to see. China may have avoided much of the Global Financial Crisis, but it only managed to do so by replacing the bursting bubble of the West with its very own bubble.
To discover when and how China’s bubble bursts, check out tomorrow’s part 3 of the story. Or, if you’d like to find out where Nigel Farage expects China’s economic woes to lead us, you’ll have to become a member of The Fleet Street Letter today.
And don’t forget, you promised to read the very end of part 3, at least, to discover the twist hidden in my analysis…
Until next time,
Editor, Fortune & Freedom