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China: a less shiny, but more drastic, version of debt-riddled Dubai? Gordon’s shameful “Brown Bottom” and the petty nanny state mentality, Plus, Bill Bonner on the American emerging class divide, the migrant worker solution and plenty more... The Daily Reckoning | Wednesday, March 31, 2010 Barbarous Relic vs. Brown Bottoms How Britain's bloated nanny state managed to sell off half the nation's most precious metal and shackle a great-grandmother for peddling goldfish. Joel Bowman Joel Bowman, reporting from Taipei, Taiwan... Markets were a snooze yesterday. On the back of some ambiguous housing data and a much ballyhooed, though ultimately underwhelming, consumer confidence report, major U.S. indexes barely managed to budge a fraction of a percent. Gold was rallying this morning, up $12 to $1,115 an ounce last we checked. Crude was lately nudging $83 per barrel. And here’s some news: A great-grandmother in England was slapped with a £1,000 fine and forced to wear an electronic tag for seven weeks after it was revealed she had sold a goldfish to a person under the age of 16. The case was part of a trading standards ‘sting’ conducted by local authorities in the woman’s hometown of Trafford. The prosecution of the “culprit” (and her son, presumably for “aiding and abetting” the offender) is estimated to have cost taxpayers £20,000 and has left the 66-year old woman with a criminal record. It must be lovely for a nation to be in a position to burn through public cash with such little regard for budgetary responsibility, and where its law enforcement agencies have nothing better to do than conduct sting operations targeting local goldfish peddlers. But wait, according to data published by National Statistics today, the U.K.’s Maastricht Treaty Deficit, its general government net borrowing, amounted to £159.2 billion in 2009, some 11.4% of GDP. Meanwhile, private sector employment in Ol’ Blighty has fallen 4% since the start of 2008, amounting to over half a million jobs lost...and counting... More on England’s welfare woes, and the growth of the fetid, developed world nanny state below. First, we’re here to discuss the inaugural Daily Reckoning Group Research Project. We’ll start at the beginning... “Long suffering” readers, as Bill jokingly calls them, will remember when our Reckoner-in-Chief issued his first Trade of the Decade, some ten years ago. With the benefit of hindsight, the trade seems simple enough: Buy gold on dips; sell stocks on rallies. The trade proved to be a superb market call, but it also provided a sound philosophical footing on which Bill and his DR co-editors erected many of the major editorial narratives of the past decade. As Eric Fry reflected in Monday’s edition of The Daily Reckoning: “This Trade of the Decade provided a great thematic backdrop for everything we would write about during the ensuing 10 years. We would write about the coming housing bust, about runaway government deficits and about lots of other things that provided absolutely no reason whatsoever to buy stocks, but plenty of reasons to buy gold.” Of course, not everybody was so enthusiastic about the trade at the time. The majority of investors adored the stock market; “stocks for the long haul” was their collective mantra. Conversely, that “barbarous relic,” as British economist John Maynard Keynes famously dubbed gold, was viewed as the scourge of the investment world. Having passed away more than half a century earlier, Baron Keynes was not on hand to take the other side of Bill’s trade. Unfortunately, plenty of proponents of his philosophy were...and still are. One such man was Keynes’ fellow countryman, the then Chancellor of the Exchequer, Gordon Brown. From 1999 to 2002, Brown took advantage of a 20-year bear market bottom in gold to unload approximately half of his nation’s total reserves. During the three-year selloff, carefully spread over 17 separate auctions, Brown dumped 395 tons of the U.K.’s yellow metal...for an average price of $275 per ounce. The proceeds, again under Brown’s sage stewardship, were then reinvested in foreign currency deposits, most notably in the euro. By the time gold hit its to-date record of $1,214 in late 2009, the estimated loss to the British taxpayer was somewhere in the vicinity of £5 billion. The fiasco was to go down in history as the “Brown Bottom.” Readers who wish to put a face to the metal component of Bill’s Trade of the Decade, therefore, might like to think of it as, “Buy Bonner; Sell Brown.” To kick off the next ten years, Bill offered dear readers a “Trade of the New Decade” – Buy Japanese equities; Sell U.S. Treasurys. More recently still, your editorial director, Eric Fry, offered his own version – Sell everything...except uranium. While we’ve got plenty of time to flesh these and other “in-house” forecasts out, we thought it might be fun to solicit some opinions from the greater Daily Reckoning brain trust. Specifically, we want to know what asset class you would sell, and which you would buy, to best capitalize on the unfolding trends of the coming decade. We’ll be featuring a selection of your responses in future issues but, for now, please continue to send your thoughts to this address: joel@dailyreckoning.com Judging by the first round of replies, many readers see the emergence of China as one of the forces set to shape the short-to-medium term future. Here to discuss the Chinese economic enigma in more detail is today’s guest columnist, Vitaliy N. Katsenelson. Please enjoy... The Daily Reckoning Presents The Bursting of a Super-Bubble Vitaliy N. Katsenelson The world looks at China with envy. China’s economy grew 8.7 percent last year, while the world economy contracted by 2.2 percent. It seems that Chinese “Confucian capitalism” – a market economy powered by 1.3 billion people and guided by an authoritarian regime that can pull levers at will – is superior to our touchy-feely, democratic capitalism. But the grass on China’s side of the fence is not as green as it appears. In fact, China’s defiance of the global recession is not a miracle – it’s a “super-bubble.” When it deflates, it will spell big trouble for all of us. To understand the Chinese economy, consider three distinct periods: “Late-stage growth obesity” (the decade prior to 2008); “You lie!” (the time of the financial crisis); and finally, “Steroids ’R’ Us” (from the end of the financial crisis to today). Late-stage growth obesity About a decade ago, the Chinese government chose a policy of growth at any cost. China’s leaders considered strong GDP growth essential for political survival and national stability. Because China lacks the social safety net of the developed world, unemployed people aren’t just inconvenienced by the loss of their jobs, they starve; and hungry people don’t complain, they riot and cause political unrest. Remember the 1994 movie “Speed?” A young cop (Keanu Reeves) had to save passengers on a bus that would explode if its speed dropped below 50 m.p.h. Well, China is like that bus with 1.3 billion people aboard. If the Communist Party can’t keep the economy growing at a fast clip, the result will be catastrophic. To achieve high growth, China has kept its currency, the renminbi, at artificially low levels against the dollar. The cheap renminbi makes Chinese-made even cheaper to buyers around the globe. Thus, China became a significant exporter to the developed economies. Normally, if free-market economic forces were at work, the renminbi would have appreciated and the US dollar would have declined. However, had China let this occur, demand for its products would have declined, and its economy wouldn’t have grown at roughly 10 percent a year, which it did during the past decade. The more China sold to the United States, the more dollars it accumulated, and thus the more US Treasuries it bought, driving our interest rates down. US consumers responded to these cheap goods and easy, inexpensive credit by going on a buying binge, further boosting Chinese economic growth. However, companies and countries that grow at very high rates for a long time will inevitably suffer from late-stage growth obesity. Consider Starbucks: In 1999, it had 2,000 stores and was adding 1.8 stores a day. In 2007, when it had 10,000 stores, it had to open 5.5 stores a day in a desperate bid to keep growth rates up. This resulted in poor decisions and poor quality – a recipe for disaster. In China, political pressure for full employment has led to similar late-stage growth obesity. In 2005, China built the largest shopping mall in the world, the New South China Mall: Today it’s 99 percent vacant. China also built up a lavish district in a city called Ordos: Today, it’s a ghost town. You lie! All good things come to an end, and great things come to an end with a bang…or a pop. When the financial meltdown erupted in 2008, US and global banks started dropping like flies. Economies everywhere suffered contraction. Even China’s. During the crisis, Chinese exports were down more than 25 percent, tonnage of goods shipped through railroads was down by double digits, and electricity use plummeted. Yet Beijing insisted that China had magically sustained 6 to 8 percent growth. In other words, China lies…or maybe it just doesn’t tell the truth. The country’s ruling elite go to great lengths to maintain appearances, including censoring media and jailing those who write anti-government articles. That’s why we have to rely on hard data instead. Steroids ‘R’ Us Today the global economy is stabilizing, thanks to Uncle Sam and other “uncles” around the world. But the consumers of Chinese-made goods are still in debt, unemployment is high, and banks aren’t lending. You might think the Chinese economy would be growing at a lower rate. But no, it is growing again at nearly 10 percent, as though the financial crisis never occurred. Though this growth appears to be authentic – electricity consumption is back up – it is not sustainable growth, because it is based on an unprecedented stimulus package and extraordinary government involvement in the economy. In the midst of the financial crisis, in late 2008, Beijing fire-hosed $568 billion stimulus program into the Chinese economy. That’s enormous! As a percentage of GDP, it would be like a $2 trillion stimulus in America, nearly triple the size of the one Congress passed last year. This story gets even more interesting. Unlike Western democracies, whose central banks can pump a lot of money into the financial system but can’t force banks to lend or consumers and corporations to spend, China can achieve both at lightning speed. The government controls the banks, so it can force them to lend, and it can also force state-owned enterprises (one-third of the economy) to borrow and to spend. But government’s are notoriously inept at allocating capital in the private sector. And the Chinese government is no exception. Political decisions (driven by the goal of full employment) are often uneconomical, while instances of corruption and cronyism result in “stimulus projects” that squander wealth, rather than create it. To maintain high employment, for example, China has poured money into infrastructure and real estate projects. This massive effort explains why the Chinese keep building new skyscrapers even though existing ones are still vacant. The enormous stimulus has exacerbated problems that already existed, threatening to turn China into a less shiny, but more drastic, version of debt-riddled Dubai. Ominously for the rest of us, what happens in China doesn’t stay in China. A meltdown there – or even a slowdown – would have severe consequences for the rest of the world. A sever Chinese slowdown would tank the commodity markets, for examkple. While demand for industrial goods would fall off a cliff. At the same time, China’s appetite for dollars would likely drop – putting pressure on the greenback’s value and driving US interest rates higher. No more 5 percent mortgages and 6 percent car loans. No more shortcuts to prosperity...for either China or the U.S. We look at China and are mesmerized by its 1.3 billion people, its achievements of the past decade, its recent economic resiliency, and its ability to achieve spectacular results on the fly. But we have to remember that economic bubbles are usually just a good thing taken too far. The Chinese economy is no exception. Its long-term future may be bright, but in the short run, we’ve got a bubble on our hands. Everyone wants a shortcut to prosperity, but there isn’t one. China has been trying to bend the laws of economics for a while, and with the control it exerts over its economy it may seem that it has succeeded. But China’s recent success is partly a mirage, which will dissipate into a painful reality. No, there is no shortcut to prosperity – not for individuals and not for nations. Vitaliy Katsenelson for The Daily Reckoning Ed. Note: Mr. Katsenelson is a portfolio manager/director of research at Investment Management Associates in Denver. He is the author of “Active Value Investing: Making Money in Range-Bound Markets.” Bill Bonner The Great Correction Bill Bonner “Wow...it’s amazing how many Spanish-speaking people there are in this area...” The one that we find most striking – after being away from the US for 15 years – is how the Hispanic population has taken over. The woman who cleans our office speaks Spanish and little English. So does the woman who cleans our house. And the gardener. And the fellow who shovels out the driveway when it snows. And the busboy in the restaurant where we have lunch. And the maintenance man. Our landlord explained: “Eusebio came here from Peru. He lived at Macho Pichu. He walked here. But he’s been here 10 years. And he’s great. Always ready to work. Smart. Figures things out. And always nice to work with. He charges $150 a day. Not bad really.” On our drive to work, we put on Spanish-language radio: CNN en Espagnol. We can only understand about half of what is said. But we’re learning... Jules, 22, rode along with us in the car... “It’s amazing. Those people are everywhere. And you know something, they give me hope for the future. They come here. They work hard. And as long as they stay outside of the official status...that is, as long as they’re illegal immigrants, everything works well. Because they can’t go on welfare, I guess. And they can’t vote themselves special programs and benefits. They have to work for a living. And they work hard. “There’s some movement in Congress, I think, to change the immigration laws so that these illegal immigrants would be treated a full citizens. What a mistake that would be. Pretty soon, they’d be as big a burden on the system as native-born citizens are. That’s the reason we can’t compete in the world... We have to carry too many retired people...and too many people on welfare...and too many chiselers getting a check from the government for not really doing anything... “The country feels old and worn out...at least compared to India. But these Hispanics are something else. They’re young. And they’re not yet ruined by the system. I mean, they’re not yet leeches...” Jules explains how to save the US from decline...below... But first, let’s turn to a related matter. (Bloomberg) – “Americans are down on the economy and the markets even as stocks and growth indicators are up. “By an almost 2-to-1 margin Americans believe the economy has worsened rather than improved during the past year, according to a Bloomberg National Poll conducted March 19-22. Among those who own stocks, bonds or mutual funds, only three of 10 people say the value of their portfolio has risen since a year ago. “During that period, a bull market has driven up the benchmark Standard & Poor’s 500 Index more than 73 percent since its low on March 9, 2009. The economy grew at a 5.9 percent annual pace during last year’s fourth quarter.” What’s going on? The economy is doing well (the last quarter showed a 5% + growth...). Investors are making money. Why all the long faces? That’s the problem with a zombie economy. It walks. It talks. But it still sucks the blood out of the living. People at the top are protected. They’ve got their sweetheart deals with the feds. They’ve got their bailouts...and their bonuses. Heck, we’re not complaining. Here at the Daily Reckoning, they pay us enough to keep the table set and the liquor cabinet full. What more could we ask for? But the poor man on the street is the one who feels the pain. The Great Correction is not just an economist’s abstraction. It’s everyday life. The Bloomberg report continues: “Barely one-in-three Americans say the country is on the right track. Fewer than one in 10 say they believe the economy will be strong again within a year. Just 4 percent of Americans who cut back on spending during the recession now say they are confident enough to open their wallets, according to the poll, which has a margin of error of plus or minus 3.1 percentage points. “Unemployment in February was 9.7 percent. Payrolls in the U.S. have dropped every month except one since December 2007. Economists expect job growth to turn around in March, with a median forecast that payrolls will rise by 192,000. “Poll respondents rate persistently high unemployment the greatest threat to the economy over the next two years, with 75 percent calling it a high threat. Chronically high budget deficits are cited as a high threat by 70 percent, followed by homeowners who can’t pay their mortgages, which is cited by 58 percent. Higher taxes are deemed a high threat by 57 percent. “Nine of 10 Americans believe that cutting the deficit, which is projected to reach a record $1.5 trillion this year, will require sacrifices from middle-class Americans. Still, when asked about a range of potential tax increases and spending cuts to address the problem, the large majorities of Americans favor tax increases that only affect the wealthy.” And more thoughts.... Yes, it does appear that a fault-line is widening in America. The upper classes are educated...smart...and they have money. They can compete with the elites of any country on earth. But the middle/lower classes have a problem. They’re used to getting paid the wages of a rich, developed country. But they don’t really have any more skills than people in India or Mexico or Russia. For thirty years the average hourly wage for an American working man has remained stagnant as more and more unskilled labor came on line. Much of it came as legal and illegal immigration from Latin America. And the rest came from labor outside the US. China mastered the business of making things to export into the US. India took the lead in service industries, where their English-language skills could be put to work. But there are still hundreds of millions of people who earn practically nothing; there are 500 million people in India who live on less than $3 a day, for example. As long as these people are still entering the global workforce, it’s hard to see how unskilled Americans can expect to earn more money. This is just part of the Great Correction that Americans must live through. They have to pay down (or default on) debt – as much as $20 trillion worth – while their incomes are under pressure from competition at home and abroad...and the US economy suffers a prolonged, Japan-like slump. Stephen Roach elaborates..and picks up our point (from Friday) about global trade: “The political pressures are grounded in the angst of American workers. After more than a decade of stagnant real compensation and, more recently, a sharp upsurge in unemployment, US labour is being squeezed as never before. Understandably, voters want answers. It is all because of the trade deficit, they are told – a visible manifestation of a major loss of production to foreign competition. With China and its so-called manipulated currency having accounted for fully 39 per cent of the US trade deficit in 2008-09, Washington maintains that American workers can only benefit if it gets tough with Beijing. “However appealing this argument may seem, it is premised on bad economics. In 2008-09, the US had trade deficits with more than 90 countries. That means it has a multilateral trade deficit. Yet aided and abetted by some of America’s most renowned economists, Washington now advocates a bilateral fix – either a sharp revaluation of the renminbi or broad-based tariffs on Chinese imports. “A bilateral remedy for a multilateral problem is like rearranging the deckchairs on the Titanic. Unless the problems that have given rise to the multilateral trade deficit are addressed, bilateral intervention would simply shift the Chinese portion of America’s international imbalance to someone else. That “someone” would most likely be a higher-cost producer – in effect, squeezing the purchasing power of hard-pressed US consumers. “The US would be far better served if it faced up to why it is confronted with a massive multilateral trade deficit. America’s core economic problem is saving, not China. In 2009, the broadest measure of domestic US saving – the net national saving rate – fell to a record low of -2.5 per cent of national income. That means America must import surplus saving from abroad to fund its future growth – and run current account and trade deficits to attract the foreign capital. Thus, for a savings-short economy, there is no escaping large multilateral trade imbalances. “Yes, China is the biggest piece of America’s multilateral trade deficit. But that is because high-cost US companies are turning to China as a low-cost offshore efficiency solution. It also reflects the preferences of US consumers for low-cost and increasingly high-quality goods made in China. In other words, savings-short America is actually quite fortunate to have China as a large trading partner. “Washington’s scapegoating of China could take the world to the brink of a very slippery slope. It would not be the first time that political denial was premised on bad economics. But the consequences of such a blunder – trade frictions and protectionism – would make the crisis of 2008-09 look like child’s play.” America is in decline. Or so it appears. Its population is aging (though not nearly as fast as China’s...or even Europe’s). Its industries are old. Its institutions are old. Its infrastructure...its government...and its economic theory (stimulate consumer spending at all cost!) are all old. It is now putting in place a health care system, a costly program based on a very old model for a social-welfare state. The anglo-saxon empire is long in the tooth too. It began in the 16th century, which makes it already longer-lived than most empires. The costs of running an empire are high. Typically, empires collect tribute to help pay for it. The US runs its empire at a huge loss...and depends on borrowing from the vassal states to stay in business. The arithmetic is bad. Domestically as well as internationally. Each year, more and more people vote for more and more benefits that they expect someone else to pay for. It doesn’t seem likely that this could go on much longer. But Jules had a solution: “The place needs new blood. These Hispanic immigrants have a lot of energy. In fact, there are probably millions of people who would like to come to the US and work. They should set up a special guest-worker program, like they have in Switzerland or Dubai. “They open the borders to these guest workers. They just have to register to get in. Then, they’re free to work...but they don’t get any Social Security...they aren’t covered by any welfare or minimum wage laws. They can’t vote. They’re just like illegal immigrants, but they can’t be deported. Oh, yes, they’d just have to pay a flat tax...10% of their wages. No complications. No deductions. “This would really fire up the economy. There wouldn’t be any need to outsource projects overseas because you could get cheap labor here. We oculd compete with China and India. And then, as these people earned money, they’d buy houses and cars and so forth, which would really help the US economy too. “The US would be a growth economy again... Of course, all our marginal native-born workers would lose their jobs...and the unions would got out of business...and we’d all have to learn Spanish... Pretty soon, I guess the country will be bilingual anyway...” Regards, Bill Bonner, for The Daily Reckoning Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com