Part III - Great Depression No. 2 coming ?? Prepare your Noah's Ark

No wonder the Chinese stock market has been booming and the Chinese real estate market is on fire. Just like the U.S. in the 20s, China finances today foreign countries, mostly the U.S., by buying U.S. government bonds with their trade surplus dollars. Just like the Fed’s failed attempts of moral suasion during the 20s, the Chinese government today similarly attempts in vain to curtail growth of credit by providing it only to those industries that need it, that is, only to industries that the government endorses for usually political reasons.

Also, for most of the current boom, Chinese consumer prices have been mostly tame and even falling, while prices for raw commodities have been skyrocketing, which perfectly fits the Austrian view that prices of higher-order goods, such as raw materials, should rise relative to prices of lower-order goods, such as consumer goods. This indeed confirms that credit expansion has already been in progress for a considerable time, and that inflation now is in an advanced stage, although it has not yet reached a runaway mode. Thus, economic conditions in China today are strikingly similar to those in America during the 1920s, and the multi-year credit expansion implies that a bust is inevitable.

There are also important parallels regarding currency and export policy. During the 1920s, the British Pound was overvalued and was used by smaller countries as a reserve currency. While Britain ran its inflationary policies during the 1920’s, it was losing gold to other countries, mainly the United States. Therefore, “if the United States government were to inflate American money, Great Britain would no longer lose gold to the United States” (p. 143). Exacerbating the problem further, the Americans artificially stimulated foreign lending, which further strengthened American farm exports, aggravated the net-export problem, and accelerated the gold flow imbalances. “It [foreign lending] also established American trade, not on a solid foundation of reciprocal and productive exchange, but on a feverish promotion of loans later revealed to be unsound” (p. 139). “[President] Hoover was so enthusiastic about subsidizing foreign loans that he commented later that even bad loans helped American exports and thus provided a cheap form of relief and employment—a cheap form that later brought expensive defaults and financial distress” (p.141) Thus, the preceding discussion makes it clear, that the fundamental reasons behind the American inflationary policy were (1) to check Great Britain’s drains of gold to the United States, (2) to stimulate foreign lending, and (3) to stimulate agricultural exports.

Similarly, today the dollar is overvalued and used as the reserve currency of the world. The U.S. runs its inflationary policy and is losing dollars to the rest of the world, mainly China (and Japan). Today, the currency and export policy of China is anchored around its peg to the dollar. The main reason for this is that by artificially undervaluing its own currency, and therefore overvaluing the dollar, China artificially stimulates its manufacturing exports. The second reason is that by buying the excess U.S. dollars and reinvesting them in U.S. government bonds, it acts as a foreign lender to the United States. The third reason is that this foreign lending stimulates American demand for Chinese manufacturing exports and allows the Chinese government to relieve its current unemployment problems. In other words, the motives behind the Chinese currency and export policy today are identical to the American ones during the 1920s: (1) to support the overvalued U.S. dollar, (2) to stimulate foreign lending, and (3) to stimulate its manufacturing exports.

Just like America in the 1920s, China establishes its trade today not on the solid foundation of reciprocal and productive exchange, but on the basis of foreign loans. No doubt, most of these loans will turn out to be very expensive because they will be repaid with greatly depreciated dollars, which in turn will exacerbate down the road the growing financial distress of the banking sector in China.