When Money Is Limited, So Is Government

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In a case of what is being presented as a clear contradiction, the Purchasing Managers Index for China dropped to a seven-month low of 48.3 in February, below the purported "contraction" level of 50. In an economy devoted to manufacturing goods, contraction, or even the hint of it, is cause for serious concern. Astride that, however, credit growth in January "surprised" analysts on the upside. Total Social Financing, a government measure of broad liquidity, far surpassed expectations of 1.9 trillion yuan, totaling 2.58 trillion yuan ($425 billion).

As with so many other monetarist systems, the latter takes precedence over the former in fomenting expectations of future economic trajectories. If credit growth in any form is advancing, the expectation is that the economy will eventually follow; money flows, then the economy, at least according to the ideology.

There is more than a few cautionary notes to accompany the revelry, though, as January was complicated by the Chinese New Year which often makes for difficult comparisons, and thus analysis. There is also the fact that we are dealing with Chinese figures and they are notorious for often being downright fabrications. There is very little in terms of transparency, so there is a higher degree of faith warranted than their US or European counterparts (which also require more than a little element of faith).

Setting those concerns aside, this mainstream embrace of credit growth has it, unsurprisingly, exactly backward. You can understand the impulse to see such credit expansion in the most positive light, as monetarism posits essentially some form of the quantity theory of money driving "aggregate demand." In China, that is doubly so since most credit expansion finds itself in the hands of state-owned enterprises doing the governments' (both central and provincial) bidding. It is the near-seamless blend of blatant monetarism coupled directly to fiscalism, or the exact prescription offered by American and European orthodoxy for every economic ill.

There is a growing disconnect between the Chinese economy, as measured by GDP, and credit growth. In both 2012 and 2013, GDP growth measured 7.7% both years. That was the slowest pace since 1999 - the fact that it was repeated across two years should be far more concerning in the context of that credit growth. Bloomberg estimates that each additional $1 of credit generated $0.83 of GDP in 2007. By 2012, that rate had dropped to $0.29. By the first quarter of 2013, it had fallen again to $0.17. All of this stimulus, driven by "money" growth, is exhibiting a marginal utility stall.

Changing the terms, total credit, defined as non-financial, non-government debt, fell to about 140% of GDP by December 2008. That was down significantly since the start of the terminal phase of the US housing bubble, about 170% through most of 2003 and 2004. It's not as if credit growth had been restrained during that period, but rather GDP growth accelerated as bubble-euphoria gripped the end user export markets in both the US and Europe. Chinese GDP accelerated from 8.3% in 2001 to 14.2% by 2007.

Even while its primary export markets were enthralled within crisis in 2008 and 2009, the Chinese managed 9.6% and 9.2% GDP growth, respectively. After rebounding some in 2010, GDP has been slowing since (matching both the US and Europe). Meanwhile, credit growth has surged as government authorities enacted textbook "stimulus" to try to manage the economic situation. After reaching 180% debt-to-GDP in 2011, credit growth spiked in 2012 and 2013. Current estimates place the ratio at about 210%.

That itself is not necessarily alarming, particularly in comparison to "developed" economies. But that may not be an apt standard in the case of China. The current level is almost exactly that of Japan's in 1988 (though, on a per capita basis it is much smaller). Further, like Japan, this credit growth has been exceedingly condensed.

In 2008, the Chinese banking sector was estimated to be about $10 trillion in total size. That made it already one of the largest on the planet, certainly befitting, on the surface, an economy that was near second largest. But by 2013, the banking sector is thought to be somewhere around $25 trillion. That kind of growth is unprecedented in such an abbreviated period - it is growth of nearly the size of the US banking system itself. In other words, in the space of five years under direct government orders for monetary/fiscal stimulus, the Chinese have added an entire US banking system to their financial economy.

This growth has also been far from monolithic, pointing to even deeper complications as the country comes to grip with its much more obvious inefficiency. Like any "modern" banking system, it is replete with "innovation", particularly shadow banking. Since 2010, there has been a rapid tide of credit production outside the "normal" bank system. It was very reminiscent of the US and European eurodollar engorgement of the 1990's and 2000's.

There is no single form of shadow banking, either. In fact, some conduits have evolved so quickly that neither regulators nor market participants are aware of all the particulars despite their seemingly easy funding. And, as usual, the development of these off-balance sheet conduits is directly attributable in good part to attempts at slowing credit growth.

In 2012, deposit rate regulations were adjusted, widening the deposit rate "band" meaning banks would have to compete for deposit balances. That led to rising deposit rates, as the People's Bank of China hoped that rising interest rates would filter through to the shadows and perhaps curtail sensational growth. Instead, it added to it as banks began to reduce their own loan growth as higher deposit rates instead reduced spreads on loan production. Shadow banking simply took up the slack.

In the first quarter of 2012, regulated lending totaled about two-thirds of total credit growth - a proportion that had been pretty constant throughout the "recovery" period. By the end of 2012, regulated lending had fallen to less than 40% of new credit growth. Instead of regulated banks, credit was flowing in the form of entrusted loans, trust loans, off-balance sheet "wealth management products" (WMP), securities firms offerings of WMP's, and particularly undiscounted bankers' acceptances.

It has been the trust loans that have captured the most attention recently, particularly as several are scheduled for default in the coming months - a first for China. Such trust conduits are very much like junk bonds and leveraged loans in the US. These are high-risk borrowers that so easily work around the squeeze of traditional bank lending, finding nearly unlimited financing potential in "high yield" products. Such products are attractive only in a world where the price of risk is suppressed so uniformly and moral hazard is the primary rule.

Two such trusts were scheduled to "default" recently, and though technically that did occur both were eventually "bailed out" by traditional bank loans. China Development Bank lent 2 billion yuan to Shanxi Liangsheng, a coal company, to help repay trust investors, alongside a 50% sale of company interests, after the default.

The modern monetarist doctrine is that failure is never to be countenanced as it can stand starkly against the tide of credit flow. Since the monetarist view so heavily relies on such credit production, no failure can interrupt its course. And so the answer in every economic situation is more credit, more debt, more monetarism in a circular feedback loop that can only produce larger credit-driven bubbles - previous failures have to be bailed out and absorbed into the new debasement cycle. Once unleashed, they take on a direction or scale all their own, abetted by the originating theory that such a credit scaling is always beneficial.

While on the surface what has happened in China may seem heartening in that the Chinese appear increasingly enthralled by market mechanisms, particularly citing the wish for market-based structures in widening the deposit band, what has occurred is no more capitalism than the series of asset bubbles here. The Chinese have learned, directly from their US and European counterparts, that expropriation of "markets" is actually a more fitting tool in the centralized planning regime. By intervening and cajoling throughout the financial chain of credit production, such "markets" become vital tools in the drive toward economic utopia.

It is seemingly so simple in its original concept - unleash the torrent of finance in order to "generate" some GDP. In almost every case that "works." Inevitably, though, results are nothing like what a truly free market, capitalist system would produce. The incentives are all re-arranged to the primary benefit of finance rather than sustainable economy. Profitability is left behind as liquidity becomes the moving factor in all economic affairs - and liquidity, as I mentioned above, is only a one-way setting and can never be allowed pause as it becomes itself an all-or-none proposition (thus, moral hazard is the "only answer").

The end of this "cycle" (which is ironic because monetarism in this manner always assumes a linearity) is both predictable and completely inevitable, just as Minsky predicted. The cycle of debt, as it becomes increasingly inefficient, strains the ability of borrowers to maintain the forward debt momentum. At some point, new debt is issued solely to maintain old debt. That usually becomes apparent when certain indications, like the amount of GDP produced by marginal increases in debt, begin to fall precipitously. Eventually, this narrowing focus into only finance ripples into the rest of the system as more and more are ensnared by the reductionism.

In 1972, Karl Popper, the famous philosopher and professor of the London School of Economics, asserted that, "Whenever a theory appears to you as the only possible one, take this as a sign that you have neither understood the theory nor the problem which it was intended to solve." Unfortunately, he also noted that, "no rational argument will have a rational effect on a man who does not want to adopt a rational attitude."

Professor Popper also spent a great deal of time expounding on exactly the nature of science itself. He was influenced by the brevity of Einstein's own genius, not necessarily in formulating special relativity itself, but in doing so in a way that could be "proven." Einstein had devised three formal tests that would empirically overturn two centuries of "settled science." Of the last he said, "If it were proved that this effect does not exist in nature then the whole theory would have to be abandoned."

Of that exact scientific nature, Popper proclaimed that, "good tests kill flawed theories; we remain alive to guess again." The nature of monetarism is, in direct contrast to Einstein and Popper's "rules" on science, unfalsifiable. The destruction released by the asset bubbles are those "good tests", and conclusive in that regard. Yet, there is only one theory still allowed, and it has spread throughout the world regardless of nominal political systems and boundaries. The reason for that is blindingly simple - a shared ideology. Ideology overrides rational thought, including any empiricism derived from such "good tests."

What does it say about the current state of monetary affairs in the US when the system developed since the end of the gold standard is so readily adopted by Communist China and the oligarchy of Russia, among others? Proponents will argue that it is the successful demonstration of the advancement of freedom, but nothing described here or of the bubble decades in the US and Europe can properly be classified as such. This is so far from the ideals of a free society that its easy adoption and incorporation in totalitarianism is itself falsification of the theory. Under only such autocratic regimes and ideology would there be allowed only one answer to every question and problem.

This gets back to the most basic monetary factor, that "money" without anchor is despotic. The true gold standard (or any form of hard money or rule) is the power of the people to exercise true authority over not just banks, but governments. When money is limited so is government. The excesses of these global bubbles are exactly the pathology of a monetary system directed toward centralization and for governments' own ends. It is an amendation to Ben Franklin's starkest warning, that those who would trade economic freedom for economic security will have neither. In the end, what you "get" are bubbles and the inevitable consequences of them, and eventually none of the freedom to stop it.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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