The Chinese haven’t figured out the answer to the chicken and the egg problem yet. But they sure have answered the economics version of the same question: What comes first, production or consumption?
You can’t consume without producing, but why produce if you’re not consuming?
The Chinese have decided that production is more important. They run the entire Chinese economy on the premise of keeping people employed, not buying stuff. The Americans are the opposite. They think the desire and ability to consume comes first.
Their answer to the chicken and egg problem is to eat both. That’s why, when the financial crisis hit, the Americans stimulated ‘demand’. While China’s economy built stuff, putting things into production.
The demand for Australian resources that resulted from China’s production is what kept us out of trouble during the financial crisis. Finding out who is right about production and consumption, China or America, could determine the source of the world’s future economic growth. And the demand for our resources.
Unfortunately, both sides are wrong. It’s all about producing and consuming at the same time. It’s pretty difficult to produce if you’re not consuming anything. And it’s pretty difficult to consume if you’re not producing anything. Unless you’re a lawyer.
The key is the proportion of the two. And to make sure you produce the right stuff.
Coconut Picking and Ladder Building
Here’s the catch. To enhance your production and consumption, you have to consume less at first. That’s because enhanced production first requires you to work on how efficiently you produce. You need to take the time to build a new tool, or machine. In other words, you need to invest. You can’t consume what you spend on investment. So you have to save it first.
Here’s a quick example to prove the point. You’re stuck on a desert island with a bunch of palm trees. To survive, you need to consume 20 coconuts each day. Any more than that and you’re living a life of luxury. You can pick 4 coconuts an hour (production), or you can produce wood (save) to build yourself a ladder (investment), which will take 5 hours.
With a ladder, you can double your production to 8 coconuts an hour. How do you apportion your time between coconut picking and ladder building without starving or dying of exhaustion?
The Chinese answer is to produce more ladders. The American answer is to consume more coconuts. Obviously, you want to do both. But just wanting more of one or the other isn’t going to achieve anything.
The real question you face is how to apportion your time between coconut production and ladder building.
What’s interesting is that every individual would answer the question differently. We have different preferences for how many coconuts we want and how hard we want to work. Not only that, but the amount of coconuts we need and are able to pick differs. So does our ladder building ability.
But when the government makes the decision on whether the economy needs more production or consumption, everyone is along for the ride.
That’s why hundreds of millions of Chinese are suffering in terms of not being able to consume very much. And millions of Americans are suffering in terms of not having a job.
Over in America, they’ve been so busy consuming coconuts, they haven’t even maintained their ladders, let alone increased them.
That’s why ‘American incomes declined more in the three-year expansion that started in June 2009 than during the longest recession since the Great Depression, according to an analysis of U.S. Census Bureau data by Sentier Research LLC.’ Oops.
Over in China, they’ve got multiple ladders up any given coconut palm. That’s another way of saying the Chinese have been building bridges to nowhere. In fact, reality is even more absurd than the metaphors.
‘Duan, the official in the west, is … in a hurry. Duan builds things, and he does so because he can. The sheep walk across Duan’s wonderful, multi-lane, freshly asphalted street, and they’re disruptive.’
The sheep probably don’t appreciate their new highway any more than the occasional drivers do. Der Spiegel visited one of China’s empty cities, built to create jobs:
‘It’s a gloomy day, and the wind is howling through the shells of buildings. According to the plans, there will be 300,000 people living here in 2015, 600,000 by the year 2020 and eventually as many as a million… Everything is already there: airports, railways and highways. Second, there is “unlimited electricity”. And third, the province has rich mineral resources, including coal, oil and nickel. Of course, he adds, it also has plenty of workers.’
Why there are Ghost Cities in China
The beautiful irony of China’s ghost cities is that America is facing a similar problem in its former industrial hubs. Just look at Detroit, the world’s former industrial miracle. You can now play golf from one side of the city to the next. Much of it is abandoned and crumbling.
The problem with overconsumption is obvious. You become unproductive because you didn’t invest in production. The problem with China’s overinvestment is less obvious.
In fact, most economists wouldn’t spot the problem if it was woolly and walked across the highway in front of their car. The term for this is malinvestment. And China is a textbook case. The Age reports on some examples:
‘China’s banks are coming after the country’s steel traders, hauling executives into court to chase down loans that some traders say they didn’t initially need and can’t now repay…
‘”After the financial crisis, when the government released its stimulus, banks begged us to borrow money we didn’t need,” Li Huanhan, the owner of Shanghai Shunze Steel Trading, told a judge at a recent hearing. “We had nothing to do with the money, so we turned to other investments, like real estate.”‘
Debt is one problem even a mainstream economist can spot. It is difficult to repay debt if you don’t earn an income from your investment. And one characteristic of a malinvestment is that it doesn’t earn enough of an income to justify it.
But economists don’t recognise many of the other problems, which are obvious to the rest of us. Producing things that nobody wants, like empty cities, is incredibly wasteful.
Eventually, China will experience an economic crisis. The debts they ran up to malinvest can’t be repaid. When the economy tries to shift towards a more stable balance of consumption, investment and production, it will be extremely disruptive.
Jobs and all the industries catering to construction will take a major hit. You can’t turn an investment and production focused economy into a balanced one overnight.
Unfortunately, all this means a collapse in demand for Australian resources. The mining boom will be over. The iron ore price will plunge. Treasurer Wayne Swan’s budget will be in tatters. As will the speedy half of Australia’s two speed economy.
Worst of all, many of those predictions have already come true. As for what to do about it, you can watch Greg Canavan’s presentation on the matter here.
Editor, Money Morning
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Written by Nick Hubble
Nick Hubble is feature Editor of The Daily Reckoning Australia – weekend edition. Nick has spent the last three years discovering lots of new, exciting and surprisingly simple ways to generate money for retirement. He’s put all these ideas into his investment publication The Money for Life Letter.
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