In China, It's 1928

I know I have been warning about a Chinese recession/depression for a while, but it takes a while (and still will take some time) for this disaster to play out.  But the warning signs are all there.  This article today in the WSJ is a great example.  

A little over a year ago, a Chinese credit agency downgraded a government-owned financing company in this dusty industrial city. Default—nearly unheard-of in China on government bonds—was a possibility, it said.

But during discussions with lenders, city officials made sure Wuhan Urban Construction Investment & Development Corp. could keep borrowing, officials with knowledge of the matter say. The city during those discussions said it backed the finance firm, essentially guaranteeing the debt, and helped the company restructure its assets to entice investors to lend more.

Borrowing by firms like Wuhan Urban is a big reason China’s debt load is expanding. The International Monetary Fund says China’s debt is growing more rapidly than debt in Japan, South Korea and the U.S. did before they tumbled into deep recessions. Local-government borrowing is responsible for one-fourth of the buildup in China’s overall domestic debt since 2008....

Even before its latest step, Beijing had put forward plans to slow local-borrowing growth. But China’s local governments have a surprising ability to resist policies. Another central-government priority—reducing excess production in steel, cement and other industries—has foundered due to local opposition.

“The guys running local government financing operations won’t roll over and die,” says Fraser Howie, co-author of “Red Capitalism,” a study of China’s financial system. “These companies take on a life of their own.”

Perhaps we should call this the looming Thomas Friedman recession, as China goes bankrupt doing exactly what Friedman admires - building more and more infrastructure and then taking out debt and building even more.

There is absolutely no reason to believe, as folks like Friedman do, that this investment in infrastructure automatically has a positive return, and in fact there are a lot of reasons to think it does not (ie gluts of housing and basic materials).  As I have written before, like light rail spending in the US, these infrastructure investments pay their benefits mostly in prestige to local government officials and rents for politically connected contractors and government workers and not in real returns to future economic growth.

I tend to accept the Austrian theory of recessions, which I would simplify (perhaps inaccurately) as mis-allocation of capital and labor investments leading to economic downturns as the economy restructures.  The longer the reckoning is put off, the worse the recession.   These mis-allocations can sometimes be due to private causes (e.g. over-euphoric investments in early Internet companies in the late 1990's) but they often have public causes (e.g. artificially low interest rates or government programs to promote investment in a single industry like, say, housing).

I am convinced this is what brought down Japan -- after years of admiration for Japan, inc. and MITI economic management, it turns out the government had directed all capital into a few export manufacturing industries, while continuing to protect retail and agriculture locally from any real change or competition.  Which is why 25 years of government directed deficit spending has not fixed the recession -- it just doubles down on the original cause.  For those of you too young to remember, the Friedman-types of the world were all praising Japan to the hilt in the late 80's as the model we should all be following.  People like this don't admit error, they simply shut up about Japan and started praising the same behaviors in China.

The same reckoning is coming to China.  Probably not this year or the next, but within the next 5 years almost for sure.  It is 1928 in China.

Postscript:  By 1928, I mean a year of apparent prosperity before the Great Depression in 1929.  I am not referring to the nominal reunification of China or start of the "republic" under Chiang Kai-shek.


  1. Onlooker from Troy:

    Yep, the denouement is drawing near. How they deal with that is the next key. Let it wash out? Or another Japan-like (or USA Great Depression-like) stagnation?

  2. LoneSnark:

    I disagree. The Chinese worker is still incredibly underpaid for their productivity. Therefore, when the correction comes, labor markets will be able to recover. Debt financed growth will crash, everyone will lose their shirts in debt and stock markets, but self financed firms would continue to grow quickly without the need to wait for labor to reprice itself.

  3. Ward Chartier:

    For my friends and former colleagues in China, I worry. Nearly all are of an age that they have no memory of the crash in 1929 and the economic upheavals that have occurred in China since then. They are psychologically unprepared for a major recession. I hope my friends and former colleagues will get through this coming storm.

  4. Matthew Slyfield:

    What productivity? China is building numerous modern urban centers with zero population. If you add in the real value of the massive real-estate and infrastructure projects to build and support entire cities no one wants to live in, it's likely that aggregate worker productivity in China would be near zero if not negative.

  5. Mike Powers:

    I remember, growing up, how Totally Obvious it was that the Japanese were just going to own everything in the future.

  6. HenryBowman419:

    Friedman is sufficiently predictable that at least one fellow has written a Thomas Friedman Op-Ed Generator.

  7. LoneSnark:

    Owners go bankrupt, bonds are worthless, everyone goes back to work making things people actually want to buy for the vast majority of employers which have self financed all their growth because they were not politically connected and therefore could not get financing from state owned banks.

  8. Matthew Slyfield:

    All the real wealth destroyed by those pointless infrastructure projects won't be magically recovered and those self financed enterprises you mention employ only a small percentage of the people employed in the government sponsored enterprises that are at risk of collapse. Those private enterprises won't be able to expand fast enough into the vacuum to avoid a recession.

  9. ErikTheRed:

    It'll be different this time, as the world is now run on pure fiat currency. I don't think it will be better (and I suspect much worse), but I don't think the song will be quite the same. My best guess is that the run-up to the crash will be much slower. People like Peter Schiff who are constantly screaming "ZOMG THE WORLD WILL END NEXT YEAR" every year don't do us any favors. He will be right eventually, but Austrian economic theory frowns on trying to predict timing.

    To me the most interesting thing is that back then the only widely-accepted alternative store of value was gold, which the US government clamped down on hard. These days we also have cryptocurrencies, which are quite difficult to control (but also have severe downsides like device security). We also do most of our day-to-day purchases with credit cards, which aren't tied to a specific currency. From a credit card perspective, cryptocurrencies are Just Another Currency - so if Visa / MasterCard / AmEx or whomever decides to support them, then the transition is fairly seamless for a huge chunk of transactions. It's easy to suspect that there would be extreme resistance to cryptocurrencies by The Powers That Be, but at the same time politicians are nothing if not shortsighted. I think it's reasonable to assume they'll take the quick fix to get things back on track even though it means trading away 90% of their long-term power base (currency control).

  10. Sam L.:

    Friedman, with a couple shots of Paullie "The Beard" Krugman.

  11. Nehemiah:

    Let me see. Their one child policy created an imbalance in population whereby males outnumber females by over 100,000,000. They have aspirations to expand their influence and everyone knows a good war can create economic activity. I don't think they'll suffer economic collapse peacefully.

  12. Scottvan949:

    To avoid the recession of 2008, the central government pushed a building frenzy on the local party leaders by their demands for GNP growth.The local party officials were only too happy to oblige as it allowed them to enrich themselves and fill the local governments’ coffers with land sale proceeds and transaction fees. The banks dutifully followed orders and loaned out money to the politically connected with little regard to business plans and underwriting standards. Developers received loans with interest rates below inflation. Spectaculars especially the very inefficient and opaque State Owned Enterprises have flooded the market. Everybody won.

    As a result they have overbuilt the luxury housing market (64 million unoccupied apartments), office space (there's 25 square feet of office space for every man woman and child in the country!), airports, steel mills, railroads,shopping malls and whole cities. Few of these projects have any chance of making a positive return on investment. China has avoided a contraction because most Chinese have never experienced a downturn before and believe the central government will bail everyone out if needed. Also, their leadership keeps the flooding the country with debt every time the economy slows. Plus fraudulently books help mask problems. When the banks run out of money to lend or investors realize that they can not sell or rent their properties, investment will stop. And when investment makes up 60-70% of your GNP, that's not a problem, it is a catastrophe. China is facing a depression level contraction which its social fabric is unlikely to withstand.

  13. Forrest Waller:

    I remember a facetious prediction based on 1990 trends in Japanese economic expansion, population contraction, US balance of payments deficits to Japan, and Japanese longevity: In 2150 every dollar of US GDP would go to Japan to service US debt to Japan and the recipient would be the last surviving Japanese, a 135 year-old woman.

  14. teapartydoc:

    What I want to know is why we don't see more articles like this from conservative economists.

  15. Da John:

    Maybe the muslims in Africa will piss them off, and thus solve the the global islamic cancer that's been plaguing the West. Win-Win!

  16. CruisingTroll:

    While yours is an interesting scenario, here's the question:

    How many of these "self financed firms" are there? Are there enough to make a difference? Consider this analogy: You have a neighborhood of nice homes. 5% of the homes have tanks of gasoline around the property, in order to run the generators. The other 95% have pools of water and hydrogeneration. A fire breaks out in one of the gasoline homes, and spreads. Briefly. The hydro guys pump water, first onto their own homes and then onto their neighbors, fire is extinguished.

    Now reverse the percentages, 95% gasoline, 5% hydro. Result: The entire neighborhood is toast.