naked capitalism

Submitted by Edward Harrison of Credit Writedowns

I have to admit to hyping the debate now swirling about protectionism. I believe that tariffs are not a very good solution to a trade problem as they are likely to result in retaliation and/or escalation. Moreover, they end up protecting small groups at the expense of higher prices for everyone else.  That is why I wrote the provocatively-titled “Murder-Suicide in Chimerica.”

But taking a step back from the rhetoric for a second, I want to highlight two recent articles and make a few comments.

Is the protectionist bogeyman really coming?

First, while a protectionist backlash is a distinct possibility which I see as the main threat to sustained recovery, I recognize that countries like China and the United States are co-dependent and loath to permanently altering the status quo unilaterally. So while I condemn the recent tariffs imposed on Chinese tires, I recognize that the tariffs were imposed in the calculus that this issue would not or could not escalate.

This is what James fallows argues in a post yesterday:

I keep putting this off, so before it finally disappears into the mists of time, here is a bullet-point summary of what I would have said at greater length when the Chinese tire tariff first arose.

1) There is not now, and there never was, a serious possibility that this would escalate into some sweeping, self-intensifying, global-recovery-threatening “trade war.”  The many publications and commentators who raised their hands in “Oh no! It’s Smoot Hawley again!” horror need to calm down — and to have their tendency toward over-reaction noted for the record. Yes, I’m talking about you, Economist magazine cover-designers (last week’s cover image, below), but you had tons of company.

There is too much going on, on too many other fronts, involving affairs of incomparably greater consequence between China and America, for this to have been more than a contained, specific dispute — contained in both duration and sweep. This was clear at the time and should have buffered the shock-horror tone of the stories. Why this matters: because of the  boy-who-cried-wolf principle. There are issues between China and the outside world in which a small disagreement could spiral into a very dangerous confrontation. Many of these involve Taiwan, for reasons to be spelled out another time. But tire tariffs, agree with them or not, were never going to set off a global economic confrontation.

In effect, Fallows is saying that it undermines ones argument to scream, “Smoot-Hawley, Smoot-Hawley” every time there is some issue that deviates from the idealized world of free trade. Eventually people will block this out, especially in an environment like this, in which populist sentiment is running high. Fair enough.

Protectionism is more than just tariffs

So with those thoughts in mind, I read Edmund Conway’s article “We are entering a new age of protectionism” in the Telegraph. Conway says:

Some are “traditional” measures, familiar from the Depression and elsewhere – subsidies for domestic producers or tariffs on imports, President Obama’s move to slap a 35 per cent charge on Chinese tyres being a prime example. Such measures are provoking fury, and with good reason: the protectionist spiral into which the world plunged in the 1930s almost certainly contributed to the war at the end of the decade.

However, such visible signs of protectionism tell a fraction of the story. For the shocking truth is this: over the past year, the costs and obstacles faced by exporters have, according to a study by economists David Jacks, Christopher Meissner and Dennis Novy, increased by almost the same scale as in the early 1930s when the US and others were imposing a range of protectionist laws, including the infamous Smoot-Hawley Act.

Partly this is one of the perverse consequences of the financial crisis, which crippled the system of trade credit that underpinned the international flow of goods, making it impossible for some companies to ship products from one part of the world to another. But, far more worryingly, it is also a product of explicitly protectionist measures imposed by countries such as the UK in an effort to save their domestic banking systems from collapse. Most egregiously, these included so-called financial mercantilism, whereby governments, having rescued a bank, insisted that it had to lend far more to domestic customers than business or individuals overseas businesses.

This new protectionism is a different beast from that of the early 20th century, but the result is the same. According to the Bank for International Settlements, the amount of money flowing across national borders has collapsed in a way never before witnessed. Put simply, financial globalisation, which helped power economic growth in recent years, has gone into reverse over the past year. All the more worrying is that it has done so without people noticing.

If I read Conway correctly, he is rightly pointing out that all the bailouts and subsidies we have seen – especially in the financial sector – are the economic equivalent of tariffs.  Protectionism is not just about tariffs. We are moving to a world in which domestic jobs are ‘protected’ via non-tariff remedies.

Extending Conway’s argument to the auto industry, it should be patently clear that this is what is happening. Here are a few posts I wrote on the issue.  The titles should give you the gist.

• Volkswagen: if the American carmakers can get bailout funds, so can we – Dec 208
• Sweden: competitive auto bailouts begin with Saab and Volvo – Dec 2008
• Germans reject Chinese offer for Opel – Jul 2009
• Cash for Clunkers will put GDP over the top in Q3 – Aug 2009

Every car company has its hands out for a subsidy or bail out and most of them are receiving it. Certainly, the U.S. has led the way, but the Germans have been as bad as anyone here.  The deal that the German government struck to save Opel with Magna, a Canadian-Austrian auto parts manufacturer, is widely perceived as having been slanted in favor of German jobs over Spanish, Belgian or British.  All of these countries are complaining bitterly to the EU that the deal represents a subsidy and is anti-competitive.

This is why you see the Germans talking up regulatory reform in finance and the Americans and the British are talking up re-balancing:  The U.S. and the U.K. have strong financial services industries and Germany has a strong export sector. Of course the Americans are opposed to financial reform.  Of course the Germans don’t want global rebalancing.

Politics is domestic

In a prior life I was a foreign policy guy.  In my time living and breathing foreign policy it became evident to me that politics is always domestic first.  If you want to know why a foreign leader is acting a certain way or taking a specific position, take a look at the domestic political environment.

Do you think the Chinese cared what Americans think, when they threatened to retaliate to the tire tariffs? Do you think Angela Merkel cares what happens to workers at Vauxhall plants in the U.K. when she arranged the Magna deal? Do you think the Americans care about what happens to Frankfurt as a financial center when they bailed out BofA and Citgroup? Of course not.

What matters is placating domestic concerns and consolidating power domestically. So while I talk about the “cozy” relationship between China and the U.S. as a marriage, I am under no illusion that this is anything more than a business relationship. When push comes to shove domestic concerns will win out. And if that means placating rioting workers in fear of losing jobs, so be it.

Expect more, not less protectionism

So I am not optimistic this protectionist wave is going to go away. My baseline sees more not less protectionism.  What would be wonderful is if the recovery taking hold were robust enough so that nations came together and worked out a workable forward-looking global solution to some of the more intractable macro problems. However, for the time being most people are retreating to their corners, making protectionism a continued threat.

This post has been deleted temporarily because it appears to be corrupting the RSS feed. It will be restored once we have isolated the problem.

It would be better if we were not proven correct on this one, but when the US imposed stiff tariffs on imported tires from China late on Friday, we noted, “This could get interesting in a bad way.” The Chinese responded quickly over the weekend to announce they were investigating US auto parts and chicken, which together account for roughly as much as the disputed tires ($1.2 billion versus $1.3 billion for tires).

It is if nothing else getting interesting fast, and it certainly does not look good. The Financial Times branded the harsh reaction from China as elevating the US action to “a full-blown trade row.”

When trade volumes plunged late last year, most commentators expected a rise in protectionism. There hasn’t been much in the way of overt action, yet, perhaps in the hope that government intervention would work and the crisis would pass quickly.

But protectionism is driven by the desire to protect jobs. Unemployment has not peaked in the US, and some analysts suggest that China’s job losses are far worse than the 20 million often bandied about, more on the order of 30 to 50 million. So political pressure is set to intensify.

The New York Times treats the Chinese reaction as a surprise. But the tire tariffs relied upon a special provision in the WTO agreement for China’s entry that set a lower bar for trade violations than the normal anti-dumping sort. This is the first time that rule has been used as the basis for an action against China, and China may feel it important to fight that precedent.

From the New York Times:

China unexpectedly increased pressure Sunday on the United States in a widening trade dispute, taking the first steps toward imposing tariffs on American exports of automotive products and chicken meat in retaliation for President Obama’s decision late Friday to levy tariffs on tires from China….

Eswar Prasad, a former China division chief at the International Monetary Fund, said that rising trade tensions between the United States and China could become hard to control…

“This spat about tires and chickens could turn ugly very quickly,” Mr. Prasad said.

China exported $1.3 billion in tires to the United States in the first seven months of this year, while the United States shipped about $800 million in automotive products and $376 million in chicken meat to China, according to data from Global Trade Information Services in Columbia, S.C.

For many years, American politicians have been able to take credit domestically for standing up to China by taking largely symbolic measures against Chinese exports in narrowly defined categories…For the most part, Chinese officials have grumbled but done little…Now, the delicate equilibrium is being disturbed….

But the timing of the announcement — on a weekend and just after the tire decision in Washington — sent an unmistakable message of retaliation. The official Xinhua news agency Web site prominently linked its reports on the tire dispute and the Chinese investigations…

The bigger risk for China, economists and corporate executives have periodically warned, is that trade frictions could cause multinationals to rethink their heavy reliance on Chinese factories in their supply chains. The Chinese targeting of autos and chickens affects two industries that may have the political muscle in the United States to dissuade the Obama administration from aggressively challenging China’s policies.

DoctoRx gives a Pangloss watch update from Bloomberg: Obama’s China Tariffs May Be Prelude to Opening Trade

The US tonight imposed steep tariffs on tires, a move directed against Chinese imports. From the Wall Street Journal:

The Obama administration will put steep import duties on Chinese passenger and light truck tires, responding to what the U.S. International Trade Commission determined to be a surge of Chinese tire exports that has rocked the domestic U.S. tire industry and displaced thousands of jobs, U.S. Trade Representative Ron Kirk announced Friday night.

The announcement of 35% import tariffs, which would decline to 30% in the second year and 25% in the third, comes at a sensitive time. The heads of state of the 20 largest economies arrive in Pittsburgh in less than two weeks for a summit of the Group of 20, amid rising trade tensions and looming economic disputes. The United States needs China to help float a U.S. deficit expected to reach $1.56 trillion this year. President Barack Obama is also likely to seek new sanctions against Iran to combat its nuclear program, and China’s vote on the United Nations Security Council is pivotal….

Between 2004 and 2008, China’s tire production capacity surged by 152% and is projected to jump an additional 16% by 2010. At 235.2 million tires, China’s production capacity in 2008 was more than three times greater than its shipments to its home market. U.S. imports of tires from 2004 to 2008 jumped from 14.6 million to 46 million. China’s share of the U.S. tire market surged 255% in that time, to 16.7% from 4.7%.

Meanwhile, four U.S. tire plants closed in 2006 and 2007. Three more are planned for closure this year. There were 5,168 fewer workers in the U.S. tire industry in 2008 than there were in 2004.

The New York Times stresses that this is the first time the US has invoked a specific safeguard included as a condition of China’s entry to the WTO:

Under that safeguard provision, American companies or workers harmed by imports from China can ask the government for protection simply by demonstrating that American producers have suffered a “market disruption” or a “surge” in imports from China.

Readers are welcome to correct me, but it looks as if Team Obama has chosen to take a stand on a pretty narrow matter. Given this Administration’s history of brave talk combined with cautious to no real action, this is more likely to be meant to be a concession to labor than a shot across China’s bow.

But it is easy to see that the Chinese may view this differently, particularly since given the precedent set by relying on a heretofore unused mechanism.

And it is hard to know what the Chinese will do. On the one hand, China is clearly wedded to mercantilist trade policies and it is hard to see them making serious changes when their economy is flagging. So they could see this as a frontal challenge at a time not of their choosing. The rhetoric from the Chinese, at least as reported in China Daily, says the Chinese regard this move as an affront, but the Chinese so frequently go into high dudgeon mode, it is hard to tell when they are merely posturing and when they are quite serious:

Experts have called the proposal “unreasonable and unfair” and said that Chinese tire manufactures “largely do not compete against their American counterparts in the US.

Chinese tires have been “targeting the budget and no-brand replacement tire market for US consumers with severe budget constraints,” a sector that the US tire makers
gave up long ago and are unwilling to enter again, said China Chamber of Commerce of Metals, Minerals & Chemicals Importers & Exporters in a letter to President Obama….

But the Chinese government will not turn away from issues that will harm the interests of Chinese industries. Officials from the Bureau of Fair Trade for Imports & Exports with the Ministry of Commerce said China has prepared an assortment of plans for countering different possible results from the Obama administration.

“We will surely protect local tire manufacturers from being hurt when needed,” they said.

China will likely take retaliatory measures against the US industries. The Tire Industry Association has petitioned China to launch restrictive measures.

Moreover, experts suggested the Chinese government clamp down on US auto imports. During the first half, China imported more than $1 billion worth of automobiles from the US, up by 9.1 percent year-on-year.

“It’s unfair for Chinese laborers, after we made the American automakers happy, if the US launches sanctions against Chinese tire imports,” said He Weiwen, a council member of the China Society for American Economy Studies.

Stay tuned. This could get interesting in a bad way.

When trade volumes tanked in the later part of 2008, quite a few observers expected a rise in protectionism. We haven’t seen a Smoot-Hawley analogue, a wide ranging measure that elicits retaliation. But that does not prevent policy makers from more targeted forms of gamesmanship.

Trade has retreated from front-burner coverage due to the modest recovery in activity. However, what is noteworthy is that most other surplus countries have seen a much greater fall in their surpluses than China. Moreover, some argue that the stabilization and improvement in trade activity is due to government stimulus, and as those programs tail off (and some are even now), trade volumes could give up their recent improvement.

So the situation is more fraught than it might appear. It should therefore not be a surprise that there is a fair bit of jousting on the trade front. One is a proposal is a de facto ban on Chinese tires. I would be surprised if this gets done, but then again, the Bush administration backed steel quotas. From ChinaDaily (hat tip reader Michael):

The proposal by a United States workers union to ban Chinese-made tires has US President Barack Obama bouncing between two very precarious positions.

The high-level tariffs, which would effectively impose a ban, will keep Chinese tire imports off US roads, strip 100,000 local laborers of their jobs and potentially spark a series of special taxes by other nations and regions.

On the one hand, Obama threatens to sour China-US relations…But on the other hand, Obama is wary of enraging the unions who support the case…

The proposed tariffs arose out of a petition brought by the United Steelworkers Union, which represents half of American tire makers. The International Trade Commission in April announced that tire imports from China had disrupted the US industry and proposed a three-year program of import relief, with a 55-percent-tariff on Chinese-made tires in the first year, 45 percent in the second and 35 percent in the third. Last Thursday, the US Trade Representative sent the recommendations to Obama…

Chinese tires have been “targeting the budget and no-brand replacement tire market for US consumers with severe budget constraints,” a sector that the US tire makers gave up long ago and are unwilling to enter again, said China Chamber of Commerce of Metals, Minerals & Chemicals Importers & Exporters in a letter to President Obama…

But the Chinese government will not turn away from issues that will harm the interests of Chinese industries. Officials from the Bureau of Fair Trade for Imports & Exports with the Ministry of Commerce said China has prepared an assortment of plans for countering different possible results from the Obama administration.

“We will surely protect local tire manufacturers from being hurt when needed,” they said.

China will likely take retaliatory measures against the US industries. The Tire Industry Association has petitioned China to launch restrictive measures.

The US had narrower anti dumping case about eighteen months ago, involving coated paper, where the facts seemed pretty clear cut, yet it came to naught.

More from Bloomberg:

The pipe case, the largest so-called countervailing duty complaint filed against Chinese-made products, was brought by the United Steelworkers union; U.S. Steel, the largest U.S.- based steelmaker; U.S. operations of Evraz Group SA, Russia’s second-largest mill; and Pennsylvania-based Wheatland Tube Co.

After the ruling is published in the Federal Register, importers of the product — known as oil country tubular goods — will have to deposit duties of the assigned amount, pending a final ruling later this year by the Commerce Department and a separate decision by the U.S. International Trade Commission.

Chinese officials have spent the past months trying to head off tariffs for the steel pipes and the separate case brought by the United Steelworkers union against Chinese auto tires.

“If there is really such a decision, China’s Commerce Ministry will have a formal response,” Wang Baodong, a spokesman for the embassy in Washington, said in a telephone interview. “On these anti-dumping charges, the Chinese government has been very clear.”

The EU is not happy with how China is behaving and the UK would like to turn up the heat a bit too, as reported in the Telegraph:

The Business Secretary, on a visit to Beijing to boost UK-China trade links, also warned on Tuesday that future “tension and disagreement” between China and the EU was inevitable as the trade deficit between China and Europe continues to grow….

Trade relations between Europe and China are under increasing strain, with a series of opinion polls showing that the European public is growing steadily more intolerant of China’s unfair trade practices.

Last week, the European Union Chamber of Commerce in China released a report containing 600 pages of complaints by European businesses which had fallen victim to China’s myriad hidden way of discriminating against foreign businesses..

Lord Mandelson said that while such trade was vital to reinvigorating Britain’s economy, there needed to be “constant dialogue” to keep up “legitimate pressure” on China’s government to open its markets more fully.

However, he said he did not agree with growing calls from some quarters of the EU for the need to take a tougher stance with Beijing, saying that constructive – as opposed to “conditional” – engagement was in the bests interests of both parties.

“China would say ‘we are a big, complex, fast-growing economy and you have to be patient, give us time’. I understand this, but equally China must understand when we in Europe feel we are being too hard done by.

“These things will even out over time, but in the meanwhile this is going to spark some tension and disagreement, but all of this must be managed because it is in all our interests to see China growing. We would all pay a colossal economic price if China was to fail economically.”

Whether these disputes continue to simmer or escalate into something worse depends on domestic employment in major economies. Were it to worse much, the pressure to Do Something would become intense.

While the G-20 agreement to move forward with a coordinated approach to bank capital rules and employee incentive payments is progress, it is important to recognize that what took place was effectively an apple pie and motherhood statement. The one stake in the ground was the commitment to make Tier 1 Capital a key metric.
However, the devil lies in the details of arrangements like these, and we are a long long way from having them.

From the Wall Street Journal:

Finance officials from the Group of 20 largest economies agreed Saturday to a global framework for bank capital rules under which banks will face higher capital requirements.

The framework will include leverage limits once the global economy moves out of recession, as well as a stricter definition of Tier 1 capital that will force banks to hold higher quality capital to cushion themselves against possible losses.

The framework represents a victory for U.S. Treasury Secretary Timothy Geithner, who earlier this week called for more stringent capital rules for all large banks.

In another compromise, finance ministers and central bank heads also agreed on guidelines for the payment of bonuses to bankers, but those don’t include a cap on the amount that can be paid to an individual.

However, the G20 asked the Financial Stability Board — a group of international regulators — to consider whether bonus limits are needed….

The FSB was also charged with coming up with more detailed proposals on new capital rules….

The G20 nations also agreed to impose sanctions on tax havens from March 2010. Jurisdictions that don’t meet international standards for sharing tax information may be deprived of funds from international financial institutions like the International Monetary Fund and the World Bank, and they may also be deprived of aid from G20 governments.

Earlier this week, on the eve of a G-20 meeting, some European ministers were not only threatening to implement tough restrictions on the financial services industry, but they also asserted that the G20 was largely in alignment. That did not seem credible, particularly given the US propensity to talk tough and do very little on this front.

Predictably, fissures are already emerging in this supposedly united front. Two days later, the officials are already bickering. The US, backed by the UK and Canada, is pushing for new rules that call for more stringent capital requirements for banks. The EU ministers are not keen, arguing that first Basel II needs to be put into effect, then additional reforms can be implemented.

And why the focus on Basel II? European countries adopted it, and the US has not (yet). As Reuters noted:

France and Germany were cool as they pushed for more countries to adopt the Basel II rules in full, something which the United States has resisted.

Geithner wants the new framework to be broader and tougher, requiring banks to hold more capital and be in place by the end of 2012 — an ambitious target as Basel II took a decade to thrash out.

This vignette illustrates why the banksters have nothing to fear. First, despite bold talk about coordination and harmonisation, national officials will look after their own institutions first.

And why are the EU officials so keen to defend Basel II? It isn’t as if compliance with Basel II meant European banks dodged the financial crisis bullet. In fact, the real reason for upholding the standard is that Eurobanks made an art form of gaming it, with the result that some of the large banks are believed to have even weaker capital bases than US banks (given the widespread regulatory forebearance, it’s harder to be certain where many banks stand).

Second is that it takes a very long time to reach agreements of this sort. Geithner knows that full well, which is why he can take what looks to be a bold stance without worrying about needing to climb down for his original stance without it being too obvious that he has done so.

From derivatives expert Satyajit Das of Traders, Guns & Money fame:

In the 1980s, the Japanese were taking over the world. In the 1990s, it was going to be an ‘Asian’ century. These days the pundits are betting on the ‘Chinese Age’. Like all such glib predictions, despite their superficial appeal, they mask complex undercurrents and issues that require careful study.
Michael Schuman, a business journalist, in ‘The Miracle: The Epic Story of Asia’s Quest for Wealth’ tries to describe the transformation that has taken place in Asia over the last 30 years. Schuman covers the post-war reconstruction built on electronics and heavy industry through to the age of outsourcing. The story is personalised and ‘The Miracle’ is at its best when recounting rich anecdotes about the politicians, such as Deng Xiaoping and Park Chung Hee, and business leaders, such as Sony’s Akio Morita and Wipro’ Azim Premji. Schuman’s snappy journalistic style adds colour and insight to the stories.

The Miracle traces the importance of globalisation of trade and capital flows as well as the role of America in the development of Asia. It perhaps understates the less than benign role played by the state in fostering economic development. The Book also is very forgiving of the political repression, social in-equalities and environmental degradation that underpin Asian development.

The defence would probably be that there are always costs to dragging millions out of poverty. In truth, the average business book reader would not be particularly concerned about those issues.

Paul Midler’s ‘Poorly Made in China’ offers a different perspective that is loquaciously captured in the lengthy sub-title ‘An Insider’s Account of the Tactics Behind China’s Production Game’ (obviously a Twitter marketing ploy!). A businessman who has worked in numerous factories in China, Midler provides interesting and, at times, scarily funny insights into a system that produces products that fail basic safety and manufacturing standards.

Midler identifies the process by which buyer demand for cheap products and the Chinese manufacturers willingness to meet the requirements lead to what he characterises in the chilling anodyne term – ‘quality fade’. This is the process by which manufacturers take increasing liberties with quality to eke out profits from unprofitable contracts. This entails cheaper components, altering chemicals, lower hygiene standards and, in general, lower everything.

Midler describes the process whereby manufacturers compete to gain unprofitable contracts to make sought after products. The sole reason is that access enables Chinese manufacturers to gain access to intellectual property allowing the manufacture of lucrative ‘knock-offs’ in places where patents and trademarks cannot be enforced.

Midler acutely records the tensions between buyer and manufacturers and the entire flawed system where ultimately the only true product control and testing is by the final consumer, sometimes, as in the case of the melamine contaminated milk, with tragic consequences

‘Poorly Made in China’ provides an interesting alternative to the hagiographic view of globalisation and trade much favoured by the Thomas Friedman’s of the world.

Underlying both ‘The Miracle’ and ‘Poorly Made in China’ is a view of the emerging world best captured by the term ‘Orientalism’, associated with Edward Said. A Palestinian academic, Said’s writings on colonialism explored the caricatures, cliches and pre-conceptions that shaped Western perception and therefore relationships with Eastern nations. Said’s argument was that the West’s view of the East was shaped by political power and unequal commercial exchange.

Said’s work built on George Orwell’s criticism of colonialism. Writing in 1939, Orwell provided a vivid and stark view of the developing world that has rarely been equalled: “When you walk through a town like this – two hundred thousand inhabitants, of whom at least twenty thousand own literally nothing except the rags they stand up in – when you see how the people live, and still more, how easily they die, it is always difficult to believe that you are walking among human beings. All colonial empires are in reality founded upon the fact. The people have brown faces – besides they have so many of them. Are they really the same flesh as yourself? Do they even have names? Or are they merely a kind of undifferentiated brown stuff, about as individual as bees as coral insects? They arise out of the earth, they sweat and starve for a few years, and then they sink back into the nameless mounds of the graveyard and nobody notices that they are gone. And the graves themselves soon fade back into the soil.”

The unwritten sub-text is that the East is there as a resource for the West. Developments are read and interpreted through the cultural lens of Western literary and economic tradition. ‘The Miracle’ and ‘Poorly Made in China’ are books in the ‘Orientalist’ tradition, which sees Asia as little more that a vast market, a cheap manufacturing base, (recently) a source of money and an opportunity for developed nations. The books never quite see the world from the point of view of the nations and people that they describe.

‘Prisoner of the State’, the secret journal of former Chinese Premier Zhao Ziyang, provides something of an antidote to a Western view of East Asia.

Remembered now mostly for his disastrous role in the Tiananmen Square student protests and subsequent massacre, Zhao Ziyang was Premier of the People’s Republic of China from 1980-1987, and General Secretary of the Communist Party from 1987-1989. He was involved, with Deng Xiaopeng, in the economic reform of China. Produced from smuggled tapes during his house arrest after being removed from power as a result of his role and handling of the Tiananmen Square protests, Zhao produced a memoir covering details of the crackdown, the intricate manouverings of China’s leadership, and the economic reform program.

While the focus around the book has been on the sensational events around the protests and subsequent crackdown, ‘Prisoner of the State’ provides interesting insights into the rationale behind China’s economic reforms.

Anecdotes of Zhao’ overseas trips, where he begins to gain exposure to the glittering riches of overseas economies, provides a vivid backdrop to the changes in economic policy. The interest in reforms appears driven entirely by pragmatic rather than ideological concerns, such as declining living standards, concern about food security, observed inefficiencies in productivity and fear that economic failure would mean political ruination.

Zhao’s notes were clearly predicated on ‘his’ version of history. His commentary on leadership struggles and the complex interplay of different individuals and camps are difficult to verify to those without a deep understanding of the inner workings of China. His views on the weaknesses of the system, especially the issue of corruption and the sheer difficult of political and economic management of vast complex country, are extremely relevant. They show the difficulties of making simple predictions about the evolution of China.

The book is illuminated by the hidden tragic sub-text that this is ultimately the story of a man who finds himself a victim of a system that he entirely understands and helped create. In the end, Zhao does not quite understand this irony.

Unlike other books on Asia, ‘Prisoner of the State’, despite its flaws, provides insights not found in traditional perspectives on emerging nations grounded in the simplistic world of ‘El-dollardo Economics’.

It must be lonely being a China bear….particularly for those dubious about its longer term prospects, as opposed to those who might simply think its stock market is a bit ahead of itself even after its recent correction.

Vitaliy Katsenelson, in an article at MorningStar, beings almost sounding a tad persecuted before he warms up to his theme. that there is more in common between Japan in the late 1980s, when it seemed poised to continue its inexorable rise and China today. And the differences for the most part favor Japan. Katsenelson first quotes Jim Grant at length, then offers his own comments.

From Morningstar (hat tip reader Michael):

China today is where Japan was in the late ’80s, except with the greater political instability that comes with a semi-controlled economy and the lack of a social safety net (read: jobless, hungry people don’t write angry letters, they riot)…Today China projects to the world a similar image as Japan did in the 1980s…

Lately, the Chinese economy has been impressing us with its growth…But Chinese economic structure is not is not superior to the West’s; the Chinese can just cook GDP numbers better and control their economy more effectively through forced lending and spending.

However, these short-term advantages come with long-term consequences – there will be a steep price to pay for them; there always is. I’ve written a lot about this (here and here). Instead I’ll quote James Grant, the publisher of Grant’s Interest Rate Observer. Jim is providing the latest issue of his newsletter free…Here are a few quotes …:

“A superb primer on the risks of China’s go-for-broke lending drive was published by Fitch Ratings on May 20. Is it not passing strange, the agency asks, that Chinese lending is accelerating even as Chinese corporate profits are shrinking? ‘Ordinarily, falling corporate earnings are met with tightened lending, but in China, precisely the reverse is evident. . . .’ You would expect—and Fitch does anticipate—that the borrowers of these trillions of renminbi are not so profitable as they were in the boom, and some will therefore struggle to service their debts.”

I think this chart, also excerpted from Grant’s Interest Rate Observer, tells the full story of the quality of China’s latest growth…

“Examining, first, the track of Chinese bank lending and, second, the trend in Chinese nonperforming loans, the seasoned reader will remember … Drexel Burnham Lambert. In the mid-to-late 1980s, the American junk bond market combined breakneck growth with muted default rates. The secret, fully revealed during the subsequent bear market, was that the default rates were a direct product of the issuance rates. Borrowers didn’t default because of—to adapt the Fitch formulation to that earlier time—the ‘pervasive rolling over and maturity extension of bonds as they fell due.’ Drexel failed when the junk market did.

Yves here. Hyman Minsky fans will recognize this as his Ponzi unit paradigm. Back to Grant via Morningstar:

“Since 2005, China has generated 73% of the global growth in oil consumption and 77% of the global growth in coal consumption.” [emphasis is mine]

Yves here, I know extended quotes in blog posts can be a bit confusing. We are now done with Jim Grant and are back to Katsenelson in a second of two linked articles:

Today, Chinese economic growth is the force pushing the global economy. The quality of this growth, however, is low as it is predicated on massive (forced) lending and thus unsustainable. As Chinese growth slows, China will turn from a wind into sails of global economy to its anchor. The impact will be felt in many, often unsuspected places.

It will tank the commodity markets, commodity producers and commodity exporting nations. Let’s take oil, for instance. As incremental demand from China collapses, oil prices will follow, taking the Russian economy with it, as Russia is for the most part a one-trick-petrochemical-pony. According to GavKal Research China accounts for 15% of Brazil’s exports (up from 1.5% a decade ago), significantly impacting the economy of that South American nation..

Demand for industrial goods will fall off the cliff. China consumed a lot of those goods – $550 billion worth annually (also according to GaveKal Research). So if Caterpillar expects to sell more of its yellow earthmovers to China, it will have put that thought on hold for awhile…..

Finally, Chinese appetite for our fine currency will diminish, driving the dollar lower against the renminbi and boosting our interest rates higher. No more 5% mortgages and 6% car loans.

Identifying bubbles is a lot easier than timing them. An astute observer could have seen the Japanese bubble developing in 1986, 1987 and 1988, but he would have been “wrong” until 1989….

Yves again. The other reason to take this gloomy appraisal seriously is that in the Great Depression, it was the big exporter (the US) that faced the most difficult adjustment. Overconsuming indebted countries in Europe simply defaulted.

Conspiracy theorists will have to wait until the article described in Inside Science is published to determine whether it delivers on its claims. It claims to analyze stock holding across 48 countries and alleges they are held in very few hands. But the work was done by physicists, which means they may not have understood the limits of the data they were working with.

I suspect this will wind up resembling a paper a friend studied in his graduate level statistical methods course over two decades ago (he has since gone on to a successful career in academia). Everyone in the seminar was assigned a single paper and told to analyze the techniques used and to present their findings to the class. This was the sole basis for the grade.

The paper my buddy got had already created a bit of a stir, although it had not yet been published. The author had looked at the prices at which the Fed did its daily operations (then the famed “noon buying rate”) and compared it to the results of Treasury auctions. The paper concluded the Treasury was doing a terrible job, as demonstrated in all sorts of analyses.

When my friend’s day to present came, he stood up and said, “I have only one comment to make. The Fed conducts its daily operations in transaction sizes ranging in the millions. Treasury auctions are in the billions. The Fed data is irrelevant to the Treasury analysis,” and sat down.

He received an A.

In this case, an obvious fly in ointment is many (most?) stocks are held in street name, meaning in the name of the brokerage firm or fund, not the ultimate owner. I presume it is impossible to segregate accounts where the broker has discretion to trade versus those where the clients simply trades through the securities firm.

But even if the analysis is flawed, it might stir up some interesting discussion.

From Inside Science (hat tip reader John D):

A recent analysis of the 2007 financial markets of 48 countries has revealed that the world’s finances are in the hands of just a few mutual funds, banks, and corporations. This is the first clear picture of the global concentration of financial power, and point out the worldwide financial system’s vulnerability as it stood on the brink of the current economic crisis.

A pair of physicists at the Swiss Federal Institute of Technology in Zurich did a physics-based analysis of the world economy as it looked in early 2007. Stefano Battiston and James Glattfelder extracted the information from the tangled yarn that links 24,877 stocks and 106,141 shareholding entities in 48 countries, revealing what they called the “backbone” of each country’s financial market. These backbones represented the owners of 80 percent of a country’s market capital, yet consisted of remarkably few shareholders.

“You start off with these huge national networks that are really big, quite dense,” Glattfelder said. “From that you’re able to … unveil the important structure in this original big network. You then realize most of the network isn’t at all important.”

The most pared-down backbones exist in Anglo-Saxon countries, including the U.S., Australia, and the U.K. Paradoxically; these same countries are considered by economists to have the most widely-held stocks in the world, with ownership of companies tending to be spread out among many investors. But while each American company may link to many owners, Glattfelder and Battiston’s analysis found that the owners varied little from stock to stock, meaning that comparatively few hands are holding the reins of the entire market.

“If you would look at this locally, it’s always distributed,” Glattfelder said. “If you then look at who is at the end of these links, you find that it’s the same guys, [which] is not something you’d expect from the local view.”

Matthew Jackson, an economist from Stanford University in Calif. who studies social and economic networks, said that Glattfelder and Battiston’s approach could be used to answer more pointed questions about corporate control and how companies interact….

Based on their analysis, Glattfelder and Battiston identified the ten investment entities who are “big fish” in the most countries. The biggest fish was the Capital Group Companies, with major stakes in 36 of the 48 countries studied. In identifying these major players, the physicists accounted for secondary ownership — owning stock in companies who then owned stock in another company — in an attempt to quantify the potential control a given agent might have in a market….

Glattfelder added that the internationalism of these powerful companies makes it difficult to gauge their economic influence. “[With] new company structures which are so big and spanning the globe, it’s hard to see what they’re up to and what they’re doing,” he said. Large, sparse networks dominated by a few major companies could also be more vulnerable, he said. “In network speak, if those nodes fail, that has a big effect on the network.”

The results will be published in an upcoming issue of the journal Physical Review E.