A long post from Quint Tatro in relation to China which will crash at some point.

I recently returned from one of the most memorable trips I have ever taken, spending over one week in China with the Lexington Chamber of Commerce. From start to finish, this Chinese Government subsidized visit was jam packed with adventure, as we toured four cities, multiple-industries and countless historic locations. The ancient history alone is enough to impress anyone however I returned home with a slightly variant view of my travels and a fascinating outlook on where this communist country may be headed into the future.

As interesting as the trip may have been, and as informing, just how much access did you really get? Communist governments are not exactly known for being transparent. So if your eyes were opened by this, in reality, how much worse might it actually be?

Unless you’ve been living under a rock you are well aware of the strength the Chinese economy has shown over the last several decades primarily due to America’s insatiable demand for cheap goods produced in China and exported to the US.

Also to Europe and Eastern Europe and Australia/NZ. The US however would be a major market for sure, simply look at US Treasury paper held by the Chinese.

Of course this is a result of countless US companies relocating their manufacturing plants to a country where the minimum wage has recently been raised to approximately $200 a month, a pale comparison to the $1,256.67* monthly minimum wage in the United States.

The relocation of capital has in part been driven by wages, but also by environmental costs. Chinese pollution is a disaster, largely due to their production processes having no costs attached to them. The result? Environmental destruction on a huge scale.

The economic life-cycle of all of this has really been quite simple. Over the last several years competition for profits have increased in the United States substantially, as consumer appetites for goods have risen considerably. With much higher employment costs due to such things as pension obligations, health care, insurance and a deteriorating work ethic, US companies have had to look elsewhere to increase margins.

Regulation, as detailed, will always raise ‘costs’. In this manner a ‘regulatory’ economy will lower productivity, thus lowering wealth creation. When capital can be invested in low regulation areas, the costs are reduced, allowing higher productivity, with increased employment.

Furthermore, as our ‘want it all now’ attitude has exploded, no longer are we a society that possesses one family car but rather two or three. Each room in the American house possesses a flat screen television and the gadget demand has reached an unbelievable level.

It is the nature of the human condition to wish to substitute perceived ‘better’ conditions for less favorable ones. Values change. Up to this point the three cars, large house and gadgets were valued [as present value goods] more highly than future value goods/services. That could well, and in point of fact may be in a transition phase to the opposite.

Of course there are two sides of every story and we cannot forget that over the years due to this manufacturing transition, product prices have come down considerably allowing most Americans to improve their standard of living while saving money.

Which, unfortunately, has been reduced through the constant money creation by government resulting in an inflationary loss of real wealth creation.

Rarely does a family experiencing hard times venture to the local thrift store when they can buy similar priced, new products at their local WalMart.

And why would they?

Of course this has come at the expense of US jobs, and foreign substandard labor practices but the lower prices have been enjoyed by most, whether they realize it or not.

Of course it has. The damage from the ‘cheapness’ to the environment has also been exported. It has also driven an innovation cycle that is now regaining US competitiveness. Some of the newer areas, energy, are still nascent, but they are coming on. Allocation of capital to these industries has been damaged via the mis-allocation of capital by the banking system and government intervention within the markets. It remains to be seen whether government will pull-back and admit defeat in their impotence with regard to employment issues in the US.

This economic phenomenon is not isolated to the United States but has spread to other countries all throughout the world. Despite what we would view as a considerable low wage, it has also served to create a middle class in China that never existed before in this massively populated, incredibly poor country.

True.

Once the economic wheels began spinning due to foreign involvement, the engine started to roar as Chinese families who previously had no means of earning money outside of local farming, now earn a much higher wage for their time and effort. This too created a Chinese demand for goods and services in their own country resulting in what would rival our US Industrial Revolution among the 1.3 Billion people of China.

True.

For most of you, this economic history lesson is understood, however there are a few nuances still worth noting. First and most importantly is that China remains a communist country. This must not be forgotten as the economic growth has not come due to a democratic dream but rather a well concocted plan, executed with finite precision from a small minority of Communist leaders.

There is little to no difference between Communism and Democracy. Once you have ‘government’ you have a problem. The difference is in one of control. Communism has a much closer to 100% control of power than democracies.

Most major corporations or profit centers in China are government owned and are therefore the largest employer by far. While this new boom has allowed many to prosper in China, we cannot forget that the majority of gains have been captured by the Communist leadership, with a vested interest in keeping the machine running at full speed.

The closer you come to 100% ownership of the productive assets, the closer you come to the inability to apply economic calculation. Add to that an inflation, and massive losses will eventually accrue.

The other item worth noting and in my opinion by far the most important is the fact that the Chinese currency, the Yuan (pronounced “UN” spoken rapidly and meshed together unlike all media correspondents who pronounce it “YOUWAN”) is fixed or ‘pegged’ to the US Dollar.

Which means as a base, Chinese inflation mirrors US inflation.

You see most currencies in the world move up or down against other currencies in relation to their earnings strength against whatever country it is measured against. Commonly referred to as ‘floating’ a currency will always be quoted against another currency, for example the US Dollar vs. the Euro or US Dollar vs. the Yen. Unfortunately, we have a vastly misinformed American population when it comes to fiat currencies (another fancy name for paper money) which mandates I head down this road for just a moment.

It’s not limited to the man in the street. The confusion permeates through all strata of society and intellectual levels. The vast ‘profession’ of economists are hopelessly confused on the issue of ‘money’.

To better explain let me use an example that has always been helpful for me. A country’s currency can be equated with a company’s stock price,

And of course this is incorrect. A ‘stock price’ is quoted in money terms, but represents a ‘share’ of ownership of the productive assets in the business. A ‘share’ of fiat currency represents ‘purchasing power’ or a medium of exchange for goods and services. One [money] is present value goods, one [productive assets] is future value goods. The two are very, very different.

with the difference being that a currency is not measured on its own, like we would view a stock quote. For example, while I may say that Apple stock is currently trading at $369.80 or maybe IBM is trading for $182.39, we cannot do the same for currencies. Stating a stock quote gives us the amount of money it would take to purchase one share of company stock. Currency however is always quoted against another currency.

The individual is weighing the value of ‘present value’ against the value of ‘future value when looking at ‘money’ relative to ‘stock’. When comparing money to money, we are trying to value ‘present value’ against ‘present value’.

So for example, it drives me absolutely nuts when I hear a major media pundit talk about the significant decline in the US Dollar. These rants are typically used to bash the US Government with a nostalgic view of the fact that a dollar today just doesn’t go as far as it used to. While I understand the basis of the argument, the question that always must be asked after a dollar bashing statement is “against what currency?” For example, is the Dollar in a death spiral against the Zimbabwe Dollar or Mexican Peso? Of course not. More often than not, the dollar is most commonly quoted against the Euro which has in fact been on a multi-year decline until recently.

Clearly the author is confused. When major media ‘rant’ against the loss in purchasing power of the US dollar, they are ‘ranting’ against its loss of purchasing power against real goods and services, not against another fiat currency. All fiat currencies are money monopolies of their respective governments, save the Euro, which is an interesting experiment going horribly wrong very, very quickly. As such, all governments have inflated. Thus all fiat currencies have lost purchasing power vis-a-vis goods and services.

The reason for this common quote or ‘pair’ as it is known in the investing world is because the United States has the largest Gross Domestic Product in the world, followed by the Euro Zone or Euro, which is a combination of countries such as Germany, Italy, Spain and Greece, all making headlines recently for their growing debt issues.

But you can get a quote in any ‘pair’ that you wish. Of course in small currencies, the ‘spread’ will likely be significant.

Another topic for another day is the question of which would you prefer to own for the next several years knowing what is happening in Europe; the Euro or the US Dollar?

You have to own the one that operates in the geographical location in which you live. To have ownership for several years in a speculative sense implies that you are ‘investing’. In that case you want to sell your present value goods for future value goods, assuming that the discount to the future value returns a value that exceeds the present value + inflation.

Again, we’ll revisit this later so file it away for another time. Unlike a stock quote that can be reviewed against a company’s historical trading level to determine the general health of the company, for example Eastman Kodak trading at $1.39 after reaching a 1997 high of $92.31 would be viewed as a very ill company,

While this is true on one level, it is so wrong on many other levels. Using the Eastman Kodak example: the $92.31 to $1.39 price plotted against time is an empirical study that tells where Kodak was. It does not necessarily predict where Kodak will be in a future time/price series.

a currency quoted in relation to another currency can be used as a general way to determine the health of one country verse another. If one country’s currency has been rising against another, we could surmise that the economic health of the former is growing in relation to the other and vice versa.

Simply a superficial analysis. The purchasing power of a fiat currency vis-a-vis another fiat currency reflects the exchange value of one fiat currency against another. That may, or may not, have anything to do with the health on a relative basis of the two economies. The example of China vis-a-vis the dollar is case in point; where the Yuan is pegged to the dollar, there is no ‘free floating exchange’ of fiat currencies. Further currency flows are many times a function of interest rates. The current ‘carry trade’ is an ongoing example of this, and has seriously distorted the value of fiat vs fiat analysis with regard to economic health.

So, at this point one may ask then what is the relationship of the US Dollar and the Chinese Yuan? Well, interestingly enough, several years ago the Chinese made the incredible and brilliant decision to fix or ‘peg’ their currency to the US dollar. One US dollar currently buys 6.3 Yuan however it is a ratio that has remained relatively fixed for quite some time as they will move in relation to one another. Should the US dollar decline against other currencies such as the Euro, so to will the Yuan. Its hard not to believe the Chinese saw the writing on the wall with where the US was headed and decided that rather than allow their currency to gradually appreciate as their economy improved, they could hop a ride down with the US Dollar. But isn’t a declining currency a bad thing?

Also known as ‘Mercantilism’, and now, as in the past, doomed to failure. Mercantilism in the past emphasised tariffs as the barrier to imports, making them less competitive. Currency manipulation serves exactly the same purpose, making imports relatively expensive against the home currency.

It’s at this point currency movements can get very confusing so I am going to use some brush strokes on why currency values are so important, outside the normal ‘scorecard’ of health. Currency fluctuation boils down to imports and exports and can be summarized through two arguments. If a country’s currency is stronger than another it makes the first country’s goods more competitive within the second country. For example if the United States Dollar strengthened against the Yuan (remember this is not possible at present due to being pegged) then US Goods would become more affordable to the Chinese in their country. The other side of this is that foreign goods in our country would become more costly for us. In addition should the US dollar rise, US corporate profits would decline as money is brought back into the US from foreign countries. Again, this can be very confusing so at this point don’t get caught up in the details here and focus on the big picture. The thing to remember is that as the US Dollar increases in value against another country, it makes our products cheaper in that country, while making that country’s products more expensive in the US.

The point of importance that has been overlooked is that in an economy with high specialization and technology, that typically involves longer production processes, this loss of purchasing power actually equates with capital consumption over time. This is highly damaging to an economy over time.

This is precisely President Obama’s argument and what I believe to be the most important piece of news going on at this very moment as the US Congress makes a decision on whether or not to pressure the Chinese to unpeg their Yuan. The President’s argument is that by keeping the Yuan artificially low, it is hindering our US manufacturing and international sales.

Obama and Congress are clueless. Capital is the most important factor in productivity. Productivity results in increased supply. Increased supply lowers the unit selling price, making the product more competitive. Congress, through enabling massive money creation has destroyed the efficient allocation of capital, and thus destroyed productivity. China with its lack of pricing for pollution, other regulatory impairments and taxes, thus has become increasingly competitive in the low technology/innovation industries, where America should be trying to exit. Due to the endless interventions into the free market American government has made itself the biggest handicap to American competitiveness.

The Presidents political opposition makes the argument that if the President is successful in urging the unpeg Yuan, Chinese goods would be more expensive and thus hurt our economy even further.

Fiat currencies distort all economic decisions. The key is to return to a commodity money [gold] and remove the money monopoly from government entirely. Reduce their ability to intervene in the free market on an absolute basis.

Based on what each side believes would happen to the Chinese Yuan if it were unpegged from the US Dollar, the economic principals make complete sense however after spending time in the country and studying the situation, I believe them both to be wrong in their assumption as to the direct of the Yuan should it no longer be fixed to the Yuan. Let me explain.

Ok.

China has economic problems and when you visit the country, these problems can be seen by the naked eye. Everywhere you look, in every major city the casual spectator will notice miles of construction skyline. The buildings are amazing as high-rise after high-rise is being built however the interesting thing is, they are all empty. Everywhere you look there is incredible construction which sits vacant, dark and downright creepy. In certain parts it is not just empty buildings but entire cities dubbed ‘Ghost Cities” which go heavily unoccupied. Despite this strange phenomenon builders keep building and high-rises keep rising. But why? If the demand is not there, why would a country continue to build and build. Well, its really quite simple. The primary construction companies which are all communist government owned are building to keep people working. They’re keeping people working to keep people fed. They’re keeping people fed so they can stay in power. You see, it goes back to the original point which we must not forget about China. It remains a communist country and therefore has a central power source which has a vested interest in keeping its 1.3Billion people satisfied. One cannot forget that websites like Facebook are blocked by the government and everywhere we went as American business tourists, we were treated with unbelievable courtesy seeing all the best China has to offer. Yet under the surface a trained eye can still recognized a model that is simply unsustainable.

Government, the minority, must keep the majority pacified and compliant to retain power. This fact was observed by David Hume some 200yrs ago. It seems to be a lesson that keeps needing to be relearned, in large part due to the endless propaganda churned out via governmental technocrats and apologists.

The data points are mixed on Chinese growth however these are Chinese produced data points which I will view with a skeptic eye. Since we cannot determine their currency ‘score,’ the real measure of their health must be examined through the global price of raw materials they are in need of such as steel, copper and oil, all of which have plummeted in recent months. With such a slow down in raw material prices indicating a lack of significant true demand, how is it possible then for the government to continue this massive subsidized jobs program, the equivalent of an ongoing US stimulus package? Well, it is my opinion that the Chinese government is printing money at a far more rapid pace than even the United States or Europe. If printing Chinese money can go undetected due to their currency being fixed to the United States, why would they not just keep on printing, paying and building as long s they can? My view is that China is simply printing the money to pay what it needs to in order to keep the Chinese population satisfied. As long as they keep the population satisfied there will never be a hint of a any revolution as we have seen in other parts of the world within the last year. It my opinion as long as the Chinese youth can keep enjoying their quasi-western freedoms, there is no need for them to revolt however the minute this is put into question, they will take to the streets as they have in Libya, Egypt and Syria.

Agreed. China will, like the US in the late 1920’s hit that massive bust. It is inevitable. The question is of timing only.

So how is all of this possible? Well, it’s possible because the world cannot measure the real health of the Chinese due to their currency being fixed to the US Dollar. The Chinese could print as much currency as they so chose without it ever hitting the radar of the world.

You can take its temperature through the tracking of money and credit creation. It is a little more difficult with China, they definitely are not as transparent as the US who obfuscate their data somewhat.

The only way we will know this is if the Chinese Yuan is allowed to float on its own and receive a true grade from the world. If my assumptions are correct, the idea that the Yuan would strengthen against the US once unpegged is vastly incorrect and rather a floating Yuan would plummet thus revealing the true identity of the Communist agenda.

First let’s analyse exactly how the Chinese ‘peg’ against the dollar. An American firm, WalMart, purchases Chinese manufactured goods. WalMart exchanges dollars for the Yuan value of the goods purchased, and pays the suppliers. The supplying Chinese firms hold Yuan. In the currency markets the Yuan strengthens: WalMart sells dollars and buys Yuan.

The Chinese government sees the purchase by WalMart of Yuan totaling $1 billion US. China ‘prints’ the equivalent 6 billion Yuan and buys $1 billion US. The term for this is ‘sterilization’. The Yuan is pegged to the dollar. Thus if US imports of Chinese goods exceed the exports to China, the trade imbalance creates a necessity to ‘print’ Yuan. The ‘dollars’ that China buys are ‘stored’ or warehoused in US Treasury Bonds. This warehousing has the effect of lowering US interest rates across the maturities purchased.

If the Yuan were ‘un-pegged’ then the outcome would depend on trade flows. Trade flows would depend on ‘purchasing power’ or exchange ratios, a circular argument. Purchasing power would largely be decided by interest rates. As interest rates are being set by the Central Banks across all maturities currently, even the interest rate, which should reflect the aggregate demand for present goods against future goods, is distorted by government intervention. The only way to end the interventions is to end governments hold on the money monopoly.

The Chinese are printing at the expense of the United States and are holding us hostage with a fictitious belief they have a strong economy and the fear that a rising Yuan would cripple our already unstable domestic economy. We all know that China owns trillions of US debt. What if China simply printed money to buy this debt and thus has made exorbitant investments in the US under the guise of a strong economy when in reality it is simply a strong printing press? This would truly be the ultimate Trojan horse and the most incredible method to ‘capture’ our interests history has ever seen.

Which is exactly what has happened.

Late Friday night I enjoyed a beverage in Shanghai’s Bund 18, overlooking the amazingly well lit financial district. I watched young people of all walks of life enjoying a heavily westernized experience. They danced to American music,enjoyed their alcohol and sent text messages to their friends from their iPhones. The energy was alive and I could tell that this taste for real freedom was not going to go quietly into the night. I can’t help but wonder what will happen should the country not be able to keep the government employment going. These youth will not go back to the way it was decades before. The only question is how long can the ploy continue? If the US government doesn’t stand strong, pressuring the Chinese to unpeg their currency, it could go on for a very long time at the continued expense of US Jobs and US manufacturing.

There is no question the Chinese have increased their domination over the last several years however now I know just how strategic they’ve been and downright amazed we’ve let it go on for so long.

Like all booms fueled by fiat money and credit creation nonsense, it is doomed to end in a massive bust.

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