The New Robber Barons Read online

  From the perspective of the derivatives markets, this is earth shattering. What would have happened if AIG had done the same thing? (Hey, Goldman, UBS, and others…you want your collateral? Well…Stuff It!)

  At the end of August 2009, China signaled that state owned oil consumers: Air China, COSCO, and China Eastern could default on money-losing commodities derivatives contracts.

  The U.S. should have done everything in its power to correct our mistakes, clean up the mess in our financial system—instead of sweeping it under the carpet—and turned our efforts to maintaining the credibility of the capital markets and the credibility of the dollar.

  Clear and Present Danger

  October 31, 2011

  The United States is the largest debtor nation in the history of the world, and our borrowing is increasing. In 1950 spending for social programs was only one percent of the total Federal Budget. As the economy grew, social programs expanded to include Social Security, Medicare, Medicaid, Food Stamps, Unemployment Compensation, Supplemental Security for the Disabled, and educational programs. In 1983 as the United States pulled out of an ugly recession and brought inflation under control, social programs consumed 26% of the budget. In fiscal year 2012, they'll eat up an estimated 57% of the budget.

  The original idea was that if everyone agreed to chip in a small percentage of ever growing income, the percentage of social spending would never have to change even if the programs grew. The percentage for social programs could stay constant because if income doubled every twelve years or so, the amounts available for welfare would also double. Military budgets soared, the U.S. waged unfunded wars, the banking system was bailed out of the consequences of unwise lending more than once, and government bureaucracy grew rapaciously. All of this would likewise be covered by taxes assessed on growing income, or so the theory went. Like many academic economic theories, it was a convenient but misguided story. No country has ever managed to create a perpetual growth machine for its economy.

  Time and again U.S. growth was brought to a standstill by (among other things) oil shocks of the kind the U.S. experienced in 1973 and 1979, monetary shocks of the kind the U.S. experienced in 1981, and systemic financial crises of the kind the U.S. experienced in 2008 and will likely experience again in the not too distant future.

  Growth in the U.S. has been hobbled by moving many of our smokestack industries and soft manufacturing industries offshore. Traditionally weakening the dollar relative to stronger currencies like the Chinese yuan (the renminbi) stimulated growth as relative labor costs sank in the U.S. Today, much of the benefit of this strategy leaks to offshore manufacturing facilities.

  Periods of anemic growth meant the U.S. had to raise taxes, but there is a limit to how much the economic engine and the population will tolerate. Hiking tax rates invites inflation, and artificially low interest rates are a hidden tax that punishes savers while food, energy, and medical care costs have soared. The U.S. can impose consumption taxes on liquor and other discretionary items, impose higher taxes on the rich, and possibly impose a confiscatory wealth tax, but eventually the U.S. will reach a point where this will be counterproductive.

  U.S. debt now approaches 100% of GDP. In the long run the U.S. will have to cut social programs and increase taxes, but in the short run the U.S. cannot adjust quickly enough. If the U.S. has to pay its debts and it can't tax more, then it must borrow more. In fact, we are borrowing more, and how we borrow matters.

  High rates of debt to GDP are the chief danger to any country's economic future, and any method of borrowing holds its special brand of danger. There are only three ways to fund a government deficit: foreign borrowing, domestic borrowing with monetary expansion, and domestic borrowing without monetary expansion. The U.S. has chosen a combination of the first two. Of the three, the way to get into big trouble very fast is to become dependent upon foreign borrowing. Treasury note and T-bill issuance as of second quarter 2011 was around $14.4 trillion, and the total bond market size estimate by SIFMA (less intergovernmental debt held by the Federal Reserve and Social Security Trust) was around $9.2 trillion. Total foreign holdings of $4.5 trillion represented around 31% of total Treasury issuance or around 48% of SIFMA's estimated government bond market. China's and Japan's combined holdings represent around 14% of total issuance or around 22% of SIFMA's estimated traded government bond market. As of June 2011, Japan held $911 billion or around 20% of U.S. foreign U.S. Treasury holdings, and China held around $1.16 trillion or approximately 26% of foreign U.S. Treasury holdings.

  Why are foreign borrowings such a huge risk for the United States? The funds are currently kept in dollars a lot of which is with American banks. That money is yankable and that can cause a run on the dollar. Military leadership addresses the threat of attacks, and administrative leadership must address the clear and present danger of financial withdrawals. The dollar is still the world's reserve currency, but that advantage doesn't make the dollar bullet proof. U.S. dollars can be converted to yen or to euros. On October 17, China took a key step to internationalizing the yuan and making it an alternative to petrodollars if not an alternative reserve currency; Hong Kong's Chinese Gold & Silver Exchange Society now offers gold quoted in yuan.

  This might have been worth the risk if foreign borrowing had been invested for roads, high speed railroads, new industries, cheap energy, airports, and to fund scientific research. The debt would self-liquidate. Instead, some of the debt has been used for transfer payments to fuel current consumption or for items like farm subsidies. It's as if you mortgaged your house to buy groceries. Eventually you'll have no house and no food either. Moreover, a very large chunk of the debt has been monetized through Federal Reserve Bank purchases and used to fill gaping holes in bank balance sheets. Unrepentant banks resist reform and dilute attempts at regulation while soaking up ongoing subsidies. All of this is dead-end financing at the expense of citizens that saved their money and pay taxes.

  Greece's distress is an extreme example of what happens when debt service is high but investment in the economy is insufficient. According the Wall Street Journal, "Parliament member Panagiotis Kouroumplis...supported the first bailout, but, he says, 'every single euro we got went for debt. We haven't spent a single euro on development.'" The U.S. has a bigger and broader economy, but our bailouts--and the financial malfeasance that preceded and follow them--have nonetheless given our producing economy a body blow while chiefly benefiting fee-seeking dead-end financiers that eat up an outsized percentage of the nation's GDP.

  In 1978, we averted a near-crash of our financial system after Kuwait refused to renew a more than $1 billion deposit with J.P. Morgan (then Morgan Guaranty). The Federal Reserve intervened to stabilize the dollar and averted a "19th Century financial panic" that would have triggered a "genuine depression."[1] In 1979 as tensions escalated with Iran, the U.S. sequestered Iranian assets to prevent a repeat of the near-crash in 1978. In the first years after these events, the U.S. seemed to have learned its lesson and reduced foreign borrowings--including borrowings from the Saudi's and Kuwait--to around 7% of total borrowings. Decades of bad policies, unfunded wars, and uncontrolled chaos in the financial system ballooned our debts and our foreign borrowings. Today's foreign borrowings are 31% of total issuance or 48% of the estimated government bond market. The U.S. is in hock to foreigners again, particularly to Asia.

  How does the U.S. try to counter the danger represented by foreign borrowings? After exporting our profligate spending to China with no intention of reform, we wield the implied threat that if China doesn't continue to lend to us, it will go down with us. The Chinese may not see it that way as they feel the pinch of inflation, experience inevitable cyclical growth slowdowns, and develop new trading partners.

  Foreign borrowings of the United States represent a clear and present danger to the U.S. dollar and to the U.S. financial system. Potential dumping of U.S. dollars would start a run on the currency and a financial panic that would tip our already precariou
s economy into a deep depression. No matter how much currency central banks use to try to manipulate exchange rates, the market always has more. The U.S. needs contingency plans against a large scale withdrawal of funds from the U.S. and from U.S. financial institutions. In the gravest extreme to avoid a run on the U.S. currency and a collapse of the U.S. economy, the U.S. requires a standby plan to sequester a foreign nation's funds, just as we have done in the past.

  1 Janssen, Richard F., and Levine, Richard J., "A Threat to Economy Was Factor in Pressing U.S. to Defend Dollar," Wall Street Journal (Front Page), November 6, 1978.

  Chanos Crash: Timing China’s Financial Meltdown

  December 6, 2011

  At an October seminar of the Chicago Council on Global Affairs (CCGA), carnival economist Niall Ferguson promoted his new book, Civilization: The West and the Rest. He revealed the blindingly obvious as if it were a divine revelation: the U.S. has serious problems. He preached that the U.S. corrupted its six Ferguson-defined “killer apps”: competition, science, rule of law, medicine, the consumer society, and a strong work ethic.

  Ferguson claims India and China have downloaded these killer apps and compares the West with a virus infected PC and the East with a fast Mac. Never mind that competition, science, medicine, trade, and industrious workers have been in evidence in India and China for centuries. The West didn’t invent these ideas, so perhaps there’s more to the story than Ferguson’s pat explanation. As for rule of law, that killer app seems as corrupted in the East as it is in the West. Ferguson’s crowd-pleasing presentation didn’t mention other “killer” apps that are prevalent in China: fraud, high debt levels, and privatizing gains while socializing risks and losses.

  Ferguson claims that in 1978 citizens of the U.S. were on average 20 times richer than the citizens of China. Today, U.S. citizens are only five times richer. He apparently defines wealth as acquisition of material goods. That is important, to be sure, and the West should pay careful attention to the material economy. But Ferguson’s China supremacy presentation didn’t mention the negative human wealth effects of China’s one-child policy on the shortage of female mates, the general disregard of public safety, and shortage of essentials like agricultural water and arable land.

  Ferguson projects that China will have closed the material goods gap by 2016. This fits right in with popular group-think that China is an unstoppable growth machine. But it is this type of group-think that warned no one about the pending financial crisis in the U.S. in 2008 and now ignores serious potential problems in China.

  Bailouts, Railroading, Cover-ups, and the Chinese “Miracle”

  China is becoming a version of the U.S., but it’s the version that builds lots of Penn Centrals in record time to connect slapped together empty cities before going bankrupt.

  When Ferguson claimed China downloaded killer apps from the West, he left out one that is literally a killer in the form of reckless disregard for public safety. China’s Ministry of Railroads, an entity with rapidly growing debt of 2.1 trillion yuan ($330 billion), was bailed out when the National Development and Reform Commission announced it had “government support.” (See Gordon G. Chang’s October 23 article in Forbes.)

  The bigger problem is the shoddy construction of China’s high speed railroad system, and cover-ups by railroad management. It turns out that railway bridges were constructed by untrained unskilled migrant workers and rocks and gravel were tossed into pier foundations instead of concrete. Unqualified workers also built tunnels. When tunnel problems manifest themselves, they usually involve suffocation of passengers. If you ever wondered how the Chinese can slap together an infrastructure so fast, here’s your answer. It literally slaps it together. Fixing the construction problem may ultimately be more costly than having done it properly in the first place. But the social issues are an even bigger disaster for Chinese government.

  In July 2011, two bullet trains on the Wenzhou Line crashed. Officials claimed a lightning strike caused the accident, and tried to suppress reports.

  After officials claimed everyone was removed from the carriages, bulldozers buried the rubble and onlookers screamed as bodies fell out of the windows of the about-to-be-buried carriages. Then after it was formally announced that all of the bodies in the carriages had been removed, a four-year-old girl was found alive in the wreckage. A spokesman for China’s Railway ministry told the reporters shouting at him that it was a “miracle.”

  Tens of Millions of Mate-less Men

  China’s population comprises more than 1.3 billion people. According to Unnatural Selection, China has 121 male births for every 100 females, whereas the highest natural ratio is around 106 males per every 100 females. Wikipedia’s 2008 figures show that in the under 15 age group, there were already 113 males for every 100 females. I’m sure young men and women have given this ratio at least a passing thought, and it’s getting much worse.

  Putting aside the issues of selective abortion of female fetuses, female infanticide, and the implications of household formation, this means a growth in the tens of millions of frustrated men dispersed throughout China.

  The apparent euphoria of western pundits like Ferguson when discussing China makes me wonder if they downloaded an app for a peculiar kind of dementia. Everything we want or need in life comes to us through our relationships with other people. The quality of our relationships, or human wealth, defines the quality of our lives. Ignoring this is a socio-economic hand job. China is fundamentally impoverished in a way that is irreparable in the short run.

  China’s Housing Price Crash

  There’s a myth that low leverage makes a housing price crash immaterial. Many Chinese home buyers pay cash, but others make high down payments. Some reported down payments are as low as 30%; high by U.S. “standards,” but still painful when housing prices drop 30%. Some investors have bought multiple properties. Even if one pays upfront in full, a housing price decline has a huge impact on how wealthy investors feel.

  Here’s the most benign case. Suppose a buyer pays cash for an empty investment property. The buyer still has to maintain the property. If housing prices remain stagnant (or go down), and food prices and other prices escalate (as they have), will that buyer feel richer or poorer? Will he have a higher appetite for liquidity or a lower one? Will other potential investors observe this and want to buy real estate so they can enjoy the same delightful experience?

  The critical problem is that home prices in China are sliding fast. Some analysts say the “tipping point” started in September and they expect it to get much worse. Chinese newspapers reported riots in Shanghai after developers slashed prices to dump inventory. Contracted home buyers saw prices cut 25%. Some property developments in Beijing have had price cuts of 20-30 percent. China’s empty “ghost cities” are seeing price discounts of 30 percent for upfront cash payments. Mainstream U.S. financial media is now reporting possible housing price declines of 20-30 percent for major Chinese cities next year.

  China’s Debt and Coming Hard Landing

  Nothing creates a hard landing better than a housing collapse. Property construction accounts for more than 13% of China’s GDP up from around 3% of GDP in 1999 according to the China National Bureau of Statistics.

  Local Chinese governments have mounting debt to fund infrastructure projects of 10.7 trillion yuan ($1.7 trillion) and depend on land sales to fund payments. According to investment management company GMO debt in Local Government Funding Vehicles amounts to around 1/3 of China’s GDP. The projected slowdown in land sales will pose a huge problem, no matter whose numbers one uses.

  A huge problem in analyzing China’s debt problems are off-balance sheet obligations. No one knows the size of local government debt obscured by off-balance sheet vehicles. Hidden national government debt includes “support” such as for the railroad and a variety of other guarantees have ballooned China’s real debt.

  Then there are the obvious problems with undercapitalized banks. When most people think of “
Jim” and “China” they think of China advocate Jim Rogers or China skeptic Jim Chanos. Many people haven’t heard of Jim Antos, an analyst at Mizuho Securities in Asia. According to Antos, loan growth has slowed to 15% from 30%, but the unsustainable current level of bank loans stands at $6,500 per capita in 2010. Gross domestic product per capita is $4,400. [The CIA estimates 2010 GDP per capita at $7,600 adjusted for purchasing power parity. ] On a scale of one to ten, he rates China’s debt problem an eight and Greece’s debt problem a ten.

  GMO reports that Fitch estimates that 35% of bank loans are directly or indirectly tied to the Chinese property market, and UBS estimates it at 40-50% of outstanding loans. No matter which is correct, a pullback will be brutal. (“Between Errors of Optimism and Pessimism,” by Edward Chancellor, GMO, September 2011, and “China Real Estate—Final Destination,” UBS, August 25, 2011.)

  These loans don’t count active private lending frauds that fleece entire towns and enrich local bureaucrats, accomplices of “property developers” turned con artists.

  Swindles have become so commonplace that James Grant, of the Grant’s Interest Rate Observer, calls China “The People’s Republic of Madoff.” Research firm Muddy Waters gives foreign investors ample reasons to be wary. It’s been documenting suspicious numbers reported by a plethora of small cap Chinese reverse merger companies listed on foreign exchanges. Muddy Waters’ skepticism about a larger company, Sino Forest, caused its stock price to plummet.