Free Trade, 'Yes' - Mercantilism, 'No' - Why China Should be Shut Out

I have had several comments on the subject of free trade and protectionism, and thought the best way to answer this would be to dedicate a post to the subject. Much of the discussion revolved around some of the points that I made around the subject of China in the world trading system in recent posts, such as the notes at the end of my post on 'UK Bank Bailout - Round 2 Begins?'

The best way to start is to highlight my underlying principle, which is that free and fair trade is a good thing, and that such free and fair trade offers considerable benefits to all.

When I discuss fair trade, I would like to highlight that this is not the fair trade of 'fair trade coffee' and other such causes. I actually believe that such so called fair trade is grossly unfair and serves to create market distortion.

In the case of the coffee market, the reason for the fair trade movement was the collapse in coffee prices that was resultant from the decision by the government of Vietnam to expand the coffee business (yes another government distortion in the free market causing problems - see post here for an argument for free markets). The resultant glut in the coffee market caused considerable difficulties for other producers:

Apart from oversupply, there are two types of paradigm shifts underlying the current situation:

1. A structural change in the nature of supply, particularly increases in both the quantity and quality of Brazil and Vietnamese coffees.
2. Structural changes in demand, comprising increasing demand for high-end, differentiated products, new technology allowing greater flexibility in blending, and geographic-generational shifts in the appeal of different types of coffee products.

There are dramatic changes in the nature of this new supply. Of particular note is that global supply has become more concentrated. During the previous period of low prices in 1992, USDA data shows Colombia, Brazil, and Vietnam produced 44 percent of world production. In 2002-2003, 60 percent of world supply came from these three producers, and this figure is likely to increase unless production in other countries significantly reverses its decline. For some roasters, these three suppliers can provide almost everything they need, leaving them to buy only small amounts of coffee from other countries. (1)

The response to this shift in supply was to create the 'fair trade' coffee movement. At the heart of the movement were arguments about the immorality of the high prices charged for coffee in the West (Starbucks would often figure in these discussions), and the low prices achieved by farmers. This was apparently 'unfair'.

The result was that the fair trade movement instigated a system of guaranteed minimum wages for coffee farmers in particular regions, on a selective basis. In doing so, they offered prices for coffee that the market would not otherwise stand. This has created one central problem. If there is a glut in supply, and you guarantee prices, guarantee a living wage, you create a situation where a) you encourage otherwise inefficient producers to remain in the coffee market b) encourage new entrants into the market. In doing so, you are just prolonging the problem of oversupply in the market. Furthermore, on what basis do you award the guarantee to whom? Is it fair that farmer x gains a guarantee, even if he is an inefficient producer, but deny the same to farmer y, an efficient producer? What would be a fair basis to offer this guarantee? If farmer y is very hard working, very efficient, why would it be fair that he must compete in a market in which an artificial glut is maintained through price support for inefficient producers?

In this respect it is unfair trade. On the other hand, if we view it as a marketing tool, it is perfectly fair trade. If a company can persuade people to buy coffee on the basis of benefits to their sense of moral righteousness, then that is a good marketing ploy, and conveys a competitive advantage. They are no longer just selling coffee but a 'feel good', emotional benefit. However, that this is a genuinely moral activity is at the very least dubious. It is fair trade in the sense that a point of differentiation is created, but it is certainly not fair trade in the sense conveyed by the supporters of the fair trade movement.

The case of coffee illustrates my point of real fair trade perfectly. Real fair trade is about removing distortions from the market, but the coffee market has seen considerable distortions, including international agreements on quotas and all kinds of interventions (from the same report as above):

At the domestic level, state-managed governing bodies, such as the coffee boards, were often inefficient,and, under the ICO programs, their management of the export quotas gave them opportunities for rent seeking (Bohman and Jarvis 1999). When this rent seeking was combined with the inefficiencies, the marketing boards induced in their markets, it served to divert a significant share of the export value of these crops away from the producer toward either governments, the marketing boards themselves, or the export sector. even if they managed to smooth market signals and responses which most likely contributed to lower domestic volatility (Giovannucci, et al. 2002a). It was not surprising that, in many cases, the end of the ICO quota schemes led to both a dismantling of the coffee boards and a rise in the producers share of the export price.

Or:

Stabilization funds suffer from a number of structural weaknesses. As discussed above, the tendency of commodity prices to have short spikes and long troughs means that stabilization funds have a tendency to run out of money before a recovery can occur. In the case of Papua New Guinea, this led to the fund having to borrow from the government—loans that later had to be forgiven. There is also an assumption that the stabilization fund managers can better invest the levies received during periods of high prices than can individuals, and producer support for stabilization funds may, therefore, be indicative of a problem of lack of access to financial services.

I can not reproduce the entire paper here, but what you see is not a market of free and fair trade, but a market in which there are endless interventions both internationally and at national government level. If we just take the example of Papua New Guinea, the intervention meant that their coffee producers were given an unfair advantage in the market of a subsidy. Someone, somewhere, will lose from this subsidy because they will be faced with less efficient producers than themselves who are still in the market place due to subsidy. It is a classic case of 'beggar-thy-neighbour' policy. The end result of such policies is that everyone tries to manipulate the market, the gluts continue, and the problem of excess supply never goes away.

The end result of such distortions is that there is a lot of land devoted to producing a commodity that nobody really wants, and that means that potentially productive resource is actually not producing anything of value. At the local level, it is easy to make a case for intervention, but each intervention ripples through the market eventually hurting someone else.

As such, if you want true fair trade, then you need to make the markets as free and as fair as possible, which means that the most efficient producers survive, and the inefficient get out of the business. The problem with such a solution is that it meets with resistance in each of the countries that are unable to compete.

The coffee market is world trade writ large as, for some reason, farmers appear to have greater emotive appeal than, for example, a worker in a widget factory. For some reason a farmer going bust has greater emotive appeal than a widget factory worker being made redundant. In both cases they might be thrown into poverty, but for some reason the farmer's poverty counts for more. As such the distorting effects of intervention are particularly more apparent in markets such as coffee.

It is at this point it is worthwhile opening up the discussion of free trade to a broader frame of reference. No doubt, all of the readers will be aware of the bailout of the US automotive industry, and that similar bailouts are being proposed elsewhere (e.g. the UK). Even before the contraction of the world economy that we are now seeing, there has long been a glut in the supply capacity of cars, and the current contraction should have seen the end of the US automotive industry (or at least the end of one of the big three, possible two). Just as with the coffee market, we have a situation in which a government subsidy will create the same beggar-thy-neighbour effect as the intervention of Papua New Gunea in the coffee market. Someone else somewhere will pay the price of this intervention.

In the meantime, there is another problem. In intervening to prop up inefficient industry, it may appear that this is a good thing for the intervening country, but in some respects it will only cause them long term harm. In this case, the money for the car industry is being provided by central government, and that (one way or another) will be paid for elsewhere in the economy. There are several ways that this might cause hurt.

One is that, if it is funded out of borrowing, that money will need to be repaid, and that means that the efficient parts of the economy will have to pay for the inefficient parts of the economy, thereby removing capital from those efficient parts, and therefore constraining their growth potential. If the bailout is paid for by printing money, then it is paid for by a general tax on the economy as a whole, as the value of the existing money is transferred onto the printed money (the tax), and then transferred to the inefficient industry. In both cases, the efficient parts of the economy will be taxed to pay for the inefficient.

From this perspective, all seems very clear. Subsidy, it appears, hurts yourself. However, I have emphasised that it also has a beggar-thy-neighbour impact. The point here is that, if you subsidise an industry sufficiently, you have the potential to destroy the same industry in your neighbour. Having destroyed that industry, you remove the glut, and your inefficiently run industry can then achieve a position of profitability and market domination.

It is for this reason that governments intervene to support their industries. It is very rarely ever discussed in these terms, but the central idea behind subsidy is that of supporting an industry until it is the 'last man standing'. I do not mean this in the literal sense, as it is unlikely in most cases that it will be the last man standing, but rather if there are not many men left standing, then the industry can achieve profitability. I recently read an essay in a book (2) in which they discussed the 'rule of threes'. This is the idea that, over time, industries will whittle down to three major players, and that in an increasingly globalised system this is starting to apply internationally. Whilst not agreeing with their entire argument, the principle is roughly right. In such circumstances, whilst having some negative effects on your own economy, subsidy can pay.

From this starting point, we now come on to China. I have consistently argued that there are two fundamental problems with the rise of China. In particular the theft of intellectual property, and aggressive trading practices such as currency manipulation. I had the following to say in an earlier post on China (it is a little clearer in the original context, but the central point is clear enough);

I have suggested in a previous post that the world trading system needs to get tough with China. I did not have the time to dig up the articles that I had read, which caused me so much concern, so have previously not outlined this point of view. However, on reading the latest attempt by the Chinese government to manipulate trade, it seemed a good point in time to outline this problem. I am at heart a free trade advocate, but I also believe that trade should be free and use reciprocal rules should be binding and enforced. It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.

In another post I concluded the following:

China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).

And in yet another post:

One of the key elements in the rise of the Chinese economy has been their very lax attitude to Intellectual Property, which is stolen at a rate that is truly astounding. For example, it is nearly impossible in most Chinese cities to buy genuine computer software for individuals, excepting that which is preloaded on new computers. If we just took the example of Microsoft Windows, we can take a reasonable guess that, at least, 100 million computers are running on the software, and the majority of these are illegal copies. At something like $100 retail per unit for Windows, it is not difficult to grasp the scale of the theft. This is just one example. Multiply this across all of the software, and the numbers start to look truly shocking.

I later go on to say the following:

Another problem has been the exchange rate in China. It has been fixed, then moved to a basket with a partial floating rate. In a free trade situation, this is unacceptable. However, the West congratulated China on holding firm on its exchange rate during the Asian financial crisis, thereby hobbling the ability to complain about the problem of the exchange rate later. Had the exchange rate been free, the RMB would have strengthened, making Chinese exports more expensive, and thereby avoided the degree of imbalance that has occurred.

What I am therefore saying is that there was always going to be some pain for the Western economies, but the foolishness/weakness of Western leaders contributed to the scale of the current problems. China always had the potential to grow, but the rise was boosted by two practices which might be described as 'unfair' trade practices. These have accelerated the growth and have contributed mightily to the degree of imbalance that we now see.

As you will note, my stance on free trade has been pretty consistent, and in particular with regards to China. My argument has always been that China has enough advantage without any subsidy, whether that is through the export subsidy and protectionism implicit in exchange rates or through the theft of intellectual property. I believe that, as a result of the implicit subsidy in the exchange rate, in conjunction with intellectual property theft, China has been in a position where it has been effectively been allowed to destroy industries in its competitors. The worst part of this is that China has always had the potential for strong growth without such measures. I have always believed that China deserves its place in the sun, but only on free and fair trade terms.

I should qualify this slightly, as I think that all countries indulge in some unfair practices to some degree or another. This is not to condone any such practices, but at least they should be minimal. The difference with China is that it has practiced two policies which have such a massive impact on the trading position of the country.

The real question in all of this is why the world trading system has not responded, and this is a difficult question. One part of the equation was detailed in one of the posts I have already cited as follows:

On a related subject, in an article a while ago the Telegraph, it was reported that senior Chinese officials were willing to use dollar sales as a way of exerting power over the US. In short, the Chinese have the power to destroy the $US by selling the currency, and therefore have huge economic power over the US. The Chinese government later denied the policy, but those familiar with Chinese culture will know that using such methods of presenting a threat is not unusual.

Another factor which is somewhat harder to summarise has been a divide and conquer, carrot and stick approach, in which the two major trading partners of China, the US and Europe, have been played off, one against the other. It has appeared to me that the Chinese government have long played this game, but it is hard to support such an allegation. The carrot has always been the access for each country's companies to the lucrative engineering and infrastructure projects, ease of access to the Chinese market and so forth. The stick is getting unfavourable treatment within the Chinese market. All the time there will be pressure from business on governments to keep China 'sweet', in order to secure the access.

In other words, what has been lacking is a unified stand against the unfair trade practices of China. I believe that, as the severity of the impact of the speed of growth of China's impact on US manufacturing gathered pace, the US would have acted, were it not for threat that China could destroy the $US. By the time the US woke up to the impact of China, it was too late to act, as they had already ceded economic power to China by allowing the massive accumulation of $US reserves.

My argument has always been that it is better to take the risk of economic damage now (the damage to the $US), rather than later. The longer it is left, the greater the accumulation of $US reserves by China, the greater the numbers of industries permanently destroyed, and the greater the long term pain. In other words, the longer that the confrontation with China is delayed, the less able the rest of the world will be to withstand the consequences. When I first wrote about this, the full impact of the economic crisis was just in my imagination, was just a prediction. Now that it is here, the weakness of the economies of West is such that the leverage of China is that much greater. I have long predicted the collapse of the $US, and mainstream thinking such as Willem Buiter, are coming around to the idea. In the situation of an already vulnerable currency......

At the end of this post, I can only conclude that it is time to face up to the mercantilism of China, and finally address the problems that are being caused by such practices. I do not, and will not agree with protectionism, but I do believe that, where a country is systemically mercantalist, then action should be taken, including raising trade barriers and tariffs. I would even countenance a complete embargo on trade.

The trouble is that, as I pointed out in a previous post, China has now placed itself in a position where too large a proportion of the economy is geared towards export. It is destroying the very customers that are supporting its economic growth. If the West were now to act to discipline China, it is a very dangerous proposition. In particular it will wreak even greater damage on the Chinese economy, which is already suffering from the contraction of its major markets. Regardless of the rights and wrongs of the situation, China will cry 'foul', and will proceed to stir up nationalist fervour within China. This will see attacks and boycotts on Western and foreign owned businesses. It will see even greater unrest in China, which is already seeing unrest as a result of world economic contraction, and the situation will potentially become explosive. In letting the nationalist genie out of the bottle, with legitimacy of the Chinese government founded on economic growth and nationalism, we have the makings of a heady cocktail. Where such a heady cocktail might lead can only be a matter of supposition, but it will certainly not be a good direction.

The real answer is that the question of the rise of China should have been dealt with long ago. However, the situation as it stands does need to be confronted. Saying that it should have been dealt with long ago is not very helpful. The trouble is that, because it was not dealt with, a situation has arisen in which the costs of dealing with China have exploded. One commentator mentioned that it seemed that the world trading system appears to be fragile, if China's rise can have so much impact. It is only fragile because the impact was not addressed earlier, at a time when the impact of China could have been the emergence of a strong economy in a (in very loose terms) free trade world.

In short, we have a very, very serious problem at the heart of the world trade system. Not only that, but it is a problem whose resolution can only be painful. However, the problem must be resolved, one way or another.


(1) Lewin, Bryan, Giovannucci, Daniele and Varangis, Panos,Coffee Markets: New Paradigms in Global Supply and Demand(March 2004). World Bank Agriculture and Rural Development Discussion Paper No. 3 .

(2) Sheth, Uslay C, and Sisodia, R, (2008) The Globalisation of Markets and the Rule of Three, in Marketing Metaphors and Metamorphosis, ed Kitchen, P

The Crisis of 2009 - the Fault of Markets or Governments?

This post started out as an attempt to address the many interesting and often enlightening comments that have been made against the posts. However, in attempting to address two comments in particular I found that the responses led me onto a completely different track. This is one of the benefits of having having so many intelligent and incisive commentators on the blog. They spur new ideas and considerations.

In this case, I found that my rather meandering answers to their questions somehow morphed into something entirely new, a defence of free market economics. There are ever more calls for interventions in every market, more regulation, more controls, and all this adds up to is ever more government interventions. However, as I wrote my answers, it seems that everything that has gone wrong in the world economy can be directly, or indirectly, traced to government interventions. Despite this, the blame for this crisis is being laid at the door of the free market?

A good place to start is actually to look at the root cause of the problems, which I have detailed throughout this blog (e.g. here). This is the massive input of labour into the world economy, which has happened as a result of both India and China entering into world markets. This has led to the effective doubling of the available global labour force in a period of about ten years. It can not be emphasised enough here, that the massive dumping of labour into the market is not the fault of free markets, but is the result of a correction of government intervention in China and India. Both of these countries were artificially holding their labour back from the market until recent times. It is the sudden reversal of a government managed market distortion that has caused the shock to the world system. Governments in countries like China held back their labour force in a way analogous to a dam, only to let the dam open as a flood. Thus we have a massive imbalance in the available labour as a sudden shock to the global economy.

The real surprise in this distortion is that the free market system has managed to integrate such a massive input of labour as effectively as it has. However, the free market system is quite simply incapable of adjusting quickly enough to absorb this level of input flooding in. Whilst the system is flexible, it is simply not able to adapt quickly enough.

Another element at the root of the curren crisis is also the result of government intervention. In conjunction with dropping a massive labour supply into the world market, there has been an ongoing distortion in the world market.

As is pointed out by Lord Keynes (a commentator - not the original Keynes), we do not live in the perfect world of free trade, of genuine open competition. Lord Keynes points to the myriad ways in which competition is distorted, and quotes the quasi-mercantilist approach of China as detailed by Clyde Prestowitz:

Today, China is already the largest market in the world for steel, mobile phones, cement, aluminum, and electronic components. Within 20 years, it will likely be the largest market in the world for just about everything. If you are a manufacturer, you will pretty much have to succeed in the China market to have a chance of surviving anywhere else. In theory, you can serve the China market by exporting, but there are some good reasons why you might not. Because Chinese labor is inexpensive, production processes that are capital-intensive in the advanced countries can be “dumbed down” and made much less capital-intensive in China. As a manufacturer, you cut both your wage and your investment costs. On top of that, the Chinese government at local, provincial, and national levels will offer substantial investment incentives -- such as long tax holidays, capital grants, free land, low utility rates, worker training, and other benefits -- to companies willing to put plants and research-and-development facilities in China.

These investment incentives confound free-trade theory. They are, in fact, distortions of the market, and therefore of questionable legitimacy under the rules of the World Trade Organization. This has never been challenged because other countries have investment subsidies, too. (American states offer tax deals to induce companies to invest.) China, however, subsidizes investment strategically to capture new industries at higher levels than anyone else.

Prestowitz goes on to say the following:

Nor are there government policies to maintain U.S. advantage; it is assumed that American genius and free markets will automatically result in U.S. leadership.

Prestowitz is making a perfectly valid argument that China is following a beggar-thy-neighbour approach, and that the approach is nothing to do with free and fair trade. However, he also makes the point that the West has used its own variants of such policies, just with less aggressive mercantilist intentions. As Pretowitz points out, there is a belief that US brilliance will suffice.

I have long argued that China has been using unfair trade to gain unfair advantage, and that the US should have long ago confronted this problem. The posts can be found here and here, and I detail many of the unfair trade practices, as well as a threat by the Chinese government to destroy the $US.

However, the picture painted by Prestowitz, whilst perfectly valid, does not emphasise enough one of the real keys to the success of China. That key is the drive and determination to succeed at every level of Chinese society. I have lived in China for several years, and I was trying to think of an illustration of that drive. I then remembered a little street food restaurant that I used to use for my breakfast. It was open seven days a week from six in the morning until 11 at night, and every day, every hour, it was manned by the married couple who owned the business, with their daughter occasionally helping out.

Not all Chinese people are so hard working, but it is hard to see many cases of such complete single minded dedication to work in the Western world. The business was small, not very well run, but they were going to succeed, whatever it took from them. Knowing Chinese culture, their motivation was almost certainly to secure their daughter's future. Can anyone in the Western world deny that people such as these deserve their place in the sun, deserve the opportunity to secure the future of their daughter? We hear so much about the poor wages of Chinese workers, but we do not hear of these hard working people working to secure the future of their family.

There is generally considerable talk of 'slave wages' making the difference in China. However, low wages are only one part of the equation. I have seen a side by side comparison for an identical product made in a French factory and in a Chinese factory. The wage differential made the difference of a few percent, but it was in all of the other elements of the cost that the real differential lay. It is for this reason that I have emphasised that the solution is about restructuring of the Western economies. Whilst, for high labour input goods, labour cost will be a significant factor in competitive advantage, it is not the case for many products.

So where does this leave China in the world trade system?

On the one hand, they have an economic structure that is highly supportive of a competitive position, and where there is a strong argument for their success being deserved. On the other hand we have aggressive mercantilist policy, such as the control and fixing of the currency, no enforcement of intellectual property, and so forth. I have long argued that the US in particular should confront China over the latter problems, but have also recognised that the US is in no position to confront China, as China has the ability to destroy the $US (read the posts I linked to earlier for details of this). However, the lack of action, under the Chinese threat to the $US is just allowing China to build ever more leverage and exacerbates the problem. Better to face the pain for the $US now than later, when there is even less left of the manufacturing base.

What we are seeing is a world trade system that is anything but free, open and fair, and where the strong advantages of China are being rammed home with unfair trade practices. However, as has been pointed out, the problem is that to different degrees other countries are using unfair practices. It is the fact that these practices are entrenched to different degrees that makes it so difficult to deal with the particularly effective form of quasi-mercantilism practiced by China. For example, during the Asian financial crisis, there was universal acclaim for China for not devaluing its currency in line with the fall of other Asian currencies. It was apparently right to fix their currency at that time, when it suited Western interests, but not now that it no longer suits Western interests.

What you have here is a situation of 'pick 'n' mix' on the question of free and fair trade. Everyone can agree with everything, as long as it protects their own interests. This pick n mix approach offers legitimacy to Chinese unfair trade practice, and leaves complaints struggling to reach the moral high ground.

So where has this led us?

At its most basic, when a Western manufacturer tries to sell into the Chinese market they will often struggle to sell their product, as the Chinese government has held their currency at an artificially low level, and provided subsidy and incentives for manufacturers within their borders. In fact the Western company has trouble selling into any market in which they compete with any China based company. The Chinese government in following this policy has developed what can only be described as a powerful form of investment. In holding down the currency, the Chinese government makes every individual in China poorer in the short term (the investment - foregone income), as they do not have access to the same amount of goods as if they had a stronger currency, but the upside is that this relative poverty now is an investment that destroys the competitors who are unable to compete on these unfair terms (the return). It is a policy for long term success at the cost of short term wealth. It is a very effective investment, but one which is completely unfair in an open trading system and a system that creates imbalances in the world economy.

In the traditional definition of mercantilism the aim is the accumulation of bullion but, in this modern form, it is the accumulation of foreign exchange reserves. As has already been pointed out, the accumulation of such reserves has seen a transfer of power into China, which now has the power to run a steam-roller over currency markets. With that threat, they are in a position where they can face down demands for fair trade, and all the while their supply of foreign currency grows strengthening their ability to destroy currencies at whim.

In the picture painted by Prestowitz, the implication is that China has won through following this policy. It is now increasingly evident that they may have actually set in motion their own catastrophe.

The simple truth is that, as countries like China use unfair trade measures to gain advantage, imbalances build up as a result, and the world system goes out of kilter, requiring ever more government interventions to stave off disaster, but creating the foundations of the next round of disaster. China has built up a massive trade imbalance, but in doing so has sowed the seeds of their own downfall, because they have quite literally destroyed the wealth of the market on which their own growth in wealth was dependent.

Instead of allowing their currency to float, they hold it down, and hope to support their own economy by exporting into the west, thereby pushing the West further into the ground. All the time, they are destroying their customers, and doing so at the cost of holding their own people in relative poverty. As a simple example, allowing the RMB to float freely and rise would dramatically pull down the cost of Western medical equipment, and allow for cheaper and better health care. One of the key reasons for Chinese people saving so much is the cost of health care as this is largely provided on a cash payment basis. That very high savings rate holds back the growth of their internal consumption of their own production, as well as the products from other countries. The result of the RMB rate is an artificially high cost of medical equipment and medicine. This in turn feeds into the cost of medical care, and this feeds into higher savings rates, and this feeds into less domestic consumption. In other words we can find just one small impact of the artificial currency level and see that it is just one of the many small distortions that ripple through markets as the result of government interventions, leading to its own problems, its own imbalances.

The implication of writers like Prestowitz is that China is winning in this great game of beggar-thy-neighbour. However, as we view the slide of the Chinese economy, it does not look much like a winner. It will not be long before the trade barriers start to go up in retaliation, or the collapse of their export markets sucks them down. In either case, they can not win in the long term, and the cost for China may be very high indeed. It might be that they see the kind of instability that leads to bloody war and revolution. Returning to the little ripple caused by health care costs, the switch to internal consumption in the Chinese market is, in part, held up by the very distortions that have led to the rapid economic expansion. As their exports collapse, they need that switch to the internal market, but one of the reasons for consumers keeping their wallets closed is the cost of health care, and that is partly the result of the mercantilist policy on currency.

I have just chosen one example of the problems that the Chinese government intervention in the exchange rate creates, the cost of health care. However, it is if we imagine a full float of their currency that we see the extent of their difficulties. If they float the RMB, China will likely collapse. With so much accumulation of foreign reserves, such a strong balance of trade they are in a position where any float would see the RMB soar to astronomic levels. The result of such a change would be to wreak destruction on their export machine, and create a massive inrush of imports. Whilst they might retain a strong balance of payments position, they would see large sectors of their export industry wiped out overnight, as well as seeing foreign companies suddenly emerging as effective competitors within their own markets. Quite simply, the artificial exchange rate has insulated their business from tough competition.

In short, they have accumulated this massive reserve of power and wealth, the massive accumulation of foreign reserves, at the cost of trapping themselves. They must keep exporting as a large part of their economy is structured towards this goal but, in doing so, they are impoverishing and destroying their customers. The only way they can save their customers is through a move to fair trade, but the destruction to their economy of such a move would see their country likely collapse into chaos. If they keep going as they are, their customers will go bust, and they will eventually collapse with them, and if they abandon the policy that is destroying their customers, they will also collapse. If their customers call time on their unfair trade, they threaten to sink the $US, but in doing so China will destroy the massive reserves they have accumulated, along with their customers. They could try to manage the rise in their currency, but they would still need to make the rise in the RMB fast enough to prevent a trade war, and to prevent the destruction of their customer base. The shock would still be too great.

In other words, their quasi-mercantilist policy allowed them to grow at a rapid rate, but the rate of growth has turned out to be an illusion. One way or another, they sink or swim with those upon whom they directed their mercantilist policy. A balanced and fair trade policy might not have offered such astounding rates of growth, but the rate of growth might have been sustainable and solid.

In one of the posts on China that I linked to, I suggested that China was balanced on a knife edge, that as the Western economies crumbled, maybe China had the capability to soak up the losses with growth in internal consumption. However, their mercantilist export policy meant that this was never going to be possible. They could have allowed their reserves, for example, to be used to pay for the building of a system of health insurance, or a basic social security net. Such a move would have allowed for their people to have the confidence to spend some of their huge reserve of savings. They need not have followed the expensive and overly complex state models of the West, but come up with at least some form of security for their people. Now it is too late. They can not change the savings culture of their people overnight, and can not therefore stimulate internal demand. They can not overnight structure their economy from their reliance on exports to the West.

Had their currency been free floating, they might not now have their reserves, but there might also have been a better balance of growth between export and internal growth. The massive growth in their industry might have still been export oriented, but not so fatally so. Furthermore, with a free floating exchange rate, their rise would have been more measured, and not led to the destruction of the customers that provided for that growth.

As it is they now own the massive reserves of currency, but the question arises as to how those reserves might be deployed without destroying the value of those reserves. In order to utilise those reserves, they need to start buying things from the US, with most of their reserves held in $US. However, their mercantilist policy has left the US in a position where they have less and less to sell to the East. What does China want from the US, that is does not now manufacture at home? Yes, there will be some things, but they will be relatively expensive because they have trapped themselves in their own currency game. The only way that China will be able to use those reserves will be to sell large amounts of the reserves and, in doing so, destroy the value of those reserves. Their massive reserves are, in other words, valueless paper.

I hope that this is becoming clear. Whatever China does now, the imbalances that it created have left it with no options for riding out this crisis. If they float their currency they fall into chaos. If they fix the rate at which they maintain their exports, they will suffer retaliation, or simply proceed to economically destroy their customers. Yes, they will accumulate yet more reserves of yet more useless paper...but to what end?

Their mercantilist policy once looked to be a very clever road to success, and has given them economic power. The trouble is that the economic power they have gained as a result is as illusory as the apparent economic success in the West over the last ten years. It is the economic power, to borrow a phrase from the cold war, of Mutually Assured Destruction. They can not escape the fact that their economic fate is entwined with the West, and they are now locked into a morbid lover's embrace with the West, even as the west plunges over the cliff edge.

Is this a case of free market failure? I think that it would be hard to pin the blame on the free market under such circumstances. One of the great balances of trade, the rate of exchange of currency, was allowed to be manipulated. This manipulation caused imbalances that a floating currency would long ago resolved.

However, there is another guilty party in all of this, and that is the US. In this respect, I agree with the analysis of Prestowitz. The US has issued useless paper on a scale that is quite simply astounding. As Prestwitz says, the attitude has been:

If the Chinese are foolish enough to exchange low-priced consumer goods for cheap U.S. paper, let the party continue.

So the Chinese exchanged their hard earned currency for what is now evidently useless paper. And the exchange was one in which the Chinese exchanged their hard earned labour by lending to the consumers who would then buy their goods, and would repay that debt with ever more paper with ever less value.

The US has used its position in the world currency system, has abused its position, to pour ever more paper into the world markets to fund their own boom in consumption. The same argument, to a lesser degree, can be made of many other Western countries, such as the UK. However, whilst they followed a similar route, none could manage the scale of the US, where the strength of their status as a reserve currency gives them so much more potential to get away with it over such a long period of time. I have said it before, and will say it again, the $US is the biggest bubble that the world has ever known.

However, the issuance of the useless paper is not a great money for nothing scheme that will hurt the Chinese. The US may have got huge amount of product in exchange for useless paper, but it will eventually hurt the US too, as it will eventually bounce back to the US as a horrendous devaluation of the currency which will destroy the wealth of the American people.

Once again, the bubble is not the result of a free market failure, but is the result of government central banks being able to issue fiat currency. If they were constrained by ensuring that the money had some underlying contractual value, such issuance of money would never have been possible.

Once again, this is not the failure of markets, but the manipulation of markets, of debasing the value of the very thing upon which markets are built - money. In one sense, yes, there has been a market failure. The US should have been punished for the irresponsibility of its actions a long time ago. However, once again, the markets have been distorted, with governments around the world, again with China as a good example, following mercantilist approach such that they have followed policy of actively seeking to accumulate $US reserves. This is not demand to support trade between countries, but a modern misguided attempt at the accumulation of 'bullion'. The market did not create demand for this bullion, but government policy. If there were just the purchase of $US for trade between countries, then the bubble would never have grown as it has done. If it were trade alone that determined the value of the $US, it would have sunk long ago, as the $US just does not produce enough that others want to buy. Quite simply, there is relatively very little demand for the $US to allow trading with the US.

So we have a debased $US.....

.....and if you thought that the manipulation of money already detailed were not enought, Jeremy, a commentor, posted a link to a Youtube clip in which experts on gold discuss the interventions of central banks in the gold markets. One of the most important points of the discussion (I believe) was the consideration that gold is a competitor to fiat currency. In particular, there has been a significant move of individuals into private holdings of gold. I have discussed at some length that fiat currency is built entirely on confidence, and the move into gold is indicative of the erosion of that confidence. Again, I recomend this clip, as it is very illuminating. One of the points that is raised is that central banks have been shown to be regularly intervening in the gold markets. The interviewees debate why on earth central banks, issuing fiat currency, might have any interest in the gold market. As is identified at the start, gold is still a competitor to fiat money, so the only explanation for the interventions that makes sense is to hold the value of gold down, to make it unattractive in relation to the fiat money. Again, there is government intervention in markets, and in this case in support of their own increasingly debased fiat currencies.

Then we come to the other market distortions that have allowed the US to continue to borrow and issue useless money. One of the greatest distortions can be found in the Basel accords, in particular Basel I. As I have detailed in my previous post on the banking system, the accords actively encouraged banks to buy up issuances of government debt. OECD sovereign debt is a key constituent of the capital adequacy ratios of banks. It is quite extraordinary that banks have been actively encouraged to lend to governments. The idea that governments should borrow at all is in any case quite absurd, but that rules for the financial system should be implemented to actively encourage lending into governments just heightens the absurdity. As I pointed out a long, long time ago, such lending pulls money away from the private sector and only serves to increase the cost of capital for the private sector, which has to compete with the ever growing government deficits by attracting higher interest rates.

For the sake of convenience, I will quote my post on Government borrowing:

Another reason why government borrowing is influential is best illustrated by a simplification. I am an individual investor and wish (for whatever reason) to make an investment in £GB. I will be faced with a range of choices for where I might to wish to put my money. For example, I may wish to lend into the consumer markets (e.g. putting my money into a building society account where it will be used to provide mortgages), or invest in companies (e.g. stock market), or I can lend to the government (e.g. bonds) and so forth. In each case I must make an assessment of risk and reward. If we take the example of lending of money to the government through the purchase of bonds, these kinds of bonds are considered to be 'no-risk' (a misnomer - as they do have risk) and therefore are highly competitive in the respect that they are relatively very safe investments (in some cases they even allow for inflation). By comparison non-government lending looks pretty risky.

In this situation, my investment decision would, if all investments were offering the same yield, be to go for the government bonds. Why take a risk on putting my money into unsafe instruments such as consumer lending. As such, non-government competitors must offer me a premium over lending to the government in order to give me an incentive to invest my money in their asset. As such the government becomes a formidable competitor in the market for where I invest my money, and set a benchmark on the minimum yield I will accept. In doing so, they are distorting the markets, and setting an effective minimum interest rate in the market.

And this is just the start of the negative effects of government borrowing. For more detail, you may wish to visit the original post. Once again, we have a massive distortion in the market, a distortion in which governments can set the baseline on the accepted level of return on investments, can draw money away from investment into productive private business, and all on the basis that they have a legal entitlement to extract cash from their populations at some point in the future to pay for their borrowing.

I do not intend to reproduce my post on the banking system here, but the encouragement of lending into governments is not the only distortion that has been caused by banking regulation and the interference of governments into the banking market. What I will do is answer another of the comments that I have received. Chas H offers this point on my proposed reform of banking, which I will quote in full:

Thankyou for another well argued post. I would welcome the kind of explicit presentation of risk that you propose, but I see two obstacles to making it work.

1) We live in a culture which does not understand risk. Thus many people buy lottery tickets with a real belief that that they stand a good chance of winning the jackpot. At the same time many people become neurotically anxious about the miniscule risks to health presented by eating certain types of food.

2) We live in a risk-averse society which is burdened down by absurd legislation and precautions to remove risk.

It is for this reason that there must be bank failures on an ongoing basis, and the regulation of banks to make them 'safe' need to be abolished. There needs to be a regular reminder that risk in investment is real, and this will create caution. Such failures will help prevent systemic risk of the kind that we are witnessing. Yes, individuals will be hurt in such bank failures, but it is a discipline on the business of banking, and reminds us all that risk is real and exists. As for point 2, this is exactly the problem. Individuals are currently in a position where they can take huge risks with their money, and then, if that risk goes bad, they suffer no consequence, as the loss is absorbed by everyone else. That is the nature of the previously implicit/explicit (and now just explicit) government guarantee of the banking system. If we remove the consequences of risk, greater risk can be taken with a sense of impunity, encouraging systemic risk taking.

This leads me to a question from a regular commentator, Lemming, who asks whether capitalism and Fractional Reserve Banking can only survive in a situation of growth. The answer to this is that FRB is a matter of risk. In times of growth, the risk is on the upside, and in times of contraction it is on the downside. Even during these bad times, some investments will continue to make money. The trouble is that people just don't like losing their money or accepting that they are risking their money. It all comes down to explicit acceptance of risk. During contractions, there will be more bank runs and bank failures. As some institutions find that they have utilised their depositors funds unwisely, they will find that depositors will lose confidence in their ability to manage their money and secure returns on their investment. In all such cases they will then be subject to the risk of a bank run, in which their available cash reserves are insufficient to meet depositor demand for cash. This will just serve to ensure that people scrutinise their decisions more carefully.

It can best be summarised this way. If we think of the average person opening a deposit account in a bank, how much care do they ever take over that process? They simply look for the highest rate of interest....without any acknowledgement that their higher rate might come with a greater risk to the capital. Such is the government regulated and implicitly and increasingly explicitly backed banking system.

This is not capitalism. This is a dream of a one way bet. Risk free investment.....It is the heart of the problem that I identified in my banking reform post.

Once again, we are very far from failures caused by the free market, and can see that the root of the problems is in the regulation of markets. I give an example in my post on the banking system that directly links developments in the financial crisis to responses to the Basel Accords, and the example that is given by no less than the Bank of England. They spotlight how growth in securities was directly encouraged as a result of Basel I. Again, this is detailed in the banking post. If you read the post in full, it is evident that market failure was not the cause of the financial crisis, but rather it is the endless interventions of government.

I have given some examples here of some of the root causes of the current financial crisis, and none of them are the result of market failure, and all of them are the direct result of government interference and manipulation in markets. As hard as I look, whenever I look to the roots of the problem, I find not market failure, but rather problems that are the direct or indirect result of government interference, manipulations, and regulation of markets.

A long time ago, I listened to a recorded lecture from the von Mises Institute. I can not reference it here, as I forget the details of where I found it or who the speaker was (apologies). One of the key elements of the lecture was that Marx got it fundamentally wrong when he said that he was describing the capitalist system. He was, in fact, describing a mercantilist system, and the reason why Marx's analysis was so wrong was that he thought he was analysing something that was in fact something else.

As I have written this post, this observation came to mind. People are readily describing the economic crisis of today as a failure of free markets. It is nothing of the kind, but represents the distorting effects of governments on markets. There has been no free market, but rather a series of market interventions. What we are seeing are ripples of chaos that emerge from the many distortions in the markets created from those interventions.

One distortion is the withholding of labour from the market, followed by the sudden release of that labour into the market. Another distortion that followed is the artificial currency exhchange rates that allowed the accumulation of worthless paper, issued because government has been allowed and encouraged to borrow, and allowed to run a policy of endless expansion of money. Meanwhile, the banking system has been regulated into ever more distorted activity, and the regulation offered guarantees of the system, encouraging horrendous risk taking through a promise of an unlimited guarantee of the system.

Mercantilism, government intervention, regulation and distortion of markets. If we wish to find a culprit for all that has happened, it is not the fault of free markets, but it is the fault of the endless interventions in the markets. Quite simply, blame for the mess we are in is being put in the wrong places.

Note 1: My apologies for not answering the many comments but, as you can see, I became somewhat distracted.

Note 2: Mercantilist is not a very good term, but it does appear in the dictionary, and seems more convenient than discussing the subject as an 'ism'.

China Propping up the $US

I have discussed the position of China in the world currency system previously. I have made the point that China needs to be challenged to open up the RMB to be being a completely free currency, as this is one of the absolute necessities for rebalancing the world economy. The simple fact of the matter is that, as long as the RMB does not trade freely, the Chinese economy can use the currency to subsidise exports. I do not believe in any forms of currency controls, but even for apologists for such a system I can see little justification on the RMB.

Bearing all of this in mind, I was fascinated to read an article in the Telegraph newspaper, which had the following to say:

'China has resorted to stealth intervention in the currency markets to amass US dollars, using indirect means to hold down the yuan and ease the pain for its struggling exporters as the global slowdown engulfs the economy...'

And...

'Beijing has raised the reserve requirement for banks five times since March, quickening the pace with two half-point rises in late June.This is having major spill-over effects into the currency markets because banks in China have been required over the last year to hold extra reserves in dollars rather than yuan. The latest moves have lifted the mandatory deposit from 15pc to 17.5pc of total lending since March'

There are many motivations that could be given to justify this action, some of which are more forgiving than others. It might be argued by apologists for China that they are doing this to protect the value of the $trillion+ reserves of $US. However, such a move can only delay the day of reckoning for the $US, so I do not believe that this would be why the policy is being enacted. Furthermore, it is just multiplying the problem of increasing the holdings of a currency that is structurally weak, meaning that the problem that it is trying to solve would just be getting more acute. However, I agree with the article that China is using unfair means to subsidise exports.

I have also pointed out in previous posts that China has sustained an implicit policy of allowing wholesale intellectual property theft (a generous interpretation of China's policy can be found in an article here). However, there is more to the story of Chinese economic aggression than currency manipulation and intellectual property theft. Last year, whilst living in China, I came up with a rather startling thought about China and the way in which it is managing trade and the economy. It occurred to me that China was waging and economic war against the US, Japan and Europe. Having come up with the idea, I explained this to some friends who lived in China. As you would expect, they were initially aghast at the idea and were disbelieving. However, after I showed them some recent articles, added to the RMB policy and intellectual property policy, they agreed that there was merit in what I had to say.

At the time I had read several articles in the Economist magazine that, in isolation, were not too worrying. However, taken together they showed a pattern of Chinese government anti-foreign business policy. For example one article showed how the Chinese press were campaigning against Western companies through the use of slanderous stories about Western companies. Such campaigns could only be undertaken in China with at least tacit support of the Chinese government, and they appeared to be coordinated. The campaigns were clearly intended to undermine the perception that Western brands provided quality and safety. In other words, they sought to undermine the potential for foreign economic success within China. In another article it was demonstrated that there were counterfeits being made of cars in China. The extraordinary thing is that the cars were being sold below any reasonable cost of manufacture. This is what the Economist had to say:

'The great mystery about these copycat cars is their price. Chinese counterfeiters obviously save on research and development costs, but they still have to buy steel and other materials at market prices. Most of them make cars in very small volumes, so there are no economies of scale. That they can sell these cars for half the price of the originals suggests that something odd is going on. They either do not know their own costs (a distinct possibility), have revolutionised carmaking (highly unlikely) or are being subsidised in some way. For the time being, no one knows.'

The only conclusion that can be drawn here is that the government has been subsidising the manufacture of these cars. They are actively trying to destroy the foreign car business in China.

Such articles were just a couple of examples from a brief period when the idea of Chinese economic war was dawning upon me. There have been many more since. We can add to these examples the widespread use of commercial espionage, such as an article here which shows conventional industrial espionage, an article here which shows commercial espionage against the US government and here for commercial espionage in Europe.

As for the attacks on foreign owned businesses in China, these are still ongoing. For example, China has introduced new labour laws and, no surprise, they have actively targeted the laws at foreign multi-nationals, despite the fact that foreign companies are generally much better employers in every respect. An article on this can be found here. Another recent example of unfair trade (restricting car imports, and car part imports) can be found here.

On a related subject, in an article a while ago the Telegraph, it was reported that senior Chinese officials were willing to use dollar sales as a way of exerting power over the US. In short, the Chinese have the power to destroy the $US by selling the currency, and therefore have huge economic power over the US. The Chinese government later denied the policy, but those familiar with Chinese culture will know that using such methods of presenting a threat is not unusual.

Each of the stories above, taken in isolation, would not cause undue alarm. However, when considering them all together, then there is a worrying pattern emerging. It should also be remembered that all of the above are just examples. What is very clear is that China, and the Chinese government, are actively pursuing a policy of unfair trade at home and abroad. Quite simply, they are using economics as a tool of power rather than just enrichment.

I have suggested in a previous post that the world trading system needs to get tough with China. I did not have the time to dig up the articles that I had read, which caused me so much concern, so have previously not outlined this point of view. However, on reading the latest attempt by the Chinese government to manipulate trade, it seemed a good point in time to outline this problem. I am at heart a free trade advocate, but I also believe that trade should be free and use reciprocal rules should be binding and enforced. It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.

It is very worrying indeed.

Note: At the end of this post there is an always appreciated comment from a regular commentator on the blog, 'Lemming'. I just thought I would respond. He correctly identifies that I have said that there is no 'conspiracy' in a previous post, but the following post suggests otherwise. However, as Lemming correctly identifies, what I am referring to is that there is no conspiracy amongst bankers and the government of the UK, and Western governments. The point of this post is that China may actually really be conspiring. I hope that the intended meaning is clear in the first post, and believe that there is therefore no inherent conflict of opinion / contradiction in the two posts.
It is nice to know that people are paying such close attention to what I have written, which is very heartening, in particular as I had forgotten the details of the original post myself.

Note 2: A quick response to an anonymous comment (see below). If the Chinese government were to seek to destroy the US currency, it is difficult to guess where the US dollar would land. Let's just say at 50% of today's value against a basket of the major currencies, for the sake of argument. Some of the consequences would be as follows:

1. In so doing, the US currency would cease to have reserve status (loss of economic power)
2. There would be hyper inflation in the U.S.
3. The U.S, would not be able to borrow any more money (maybe a good thing)
4. The U.S. economy would collapse
5. The U.S. would be a much poorer country

In reality, the collapse of the U.S. currency would cause chaos, and it is difficult to predict the precise consequences. In a state of chaos it is impossible to say what situation would emerge. However, the one certainty is that the U.S. would be destroyed economically and would emerge from the chaos fatally weakened.

The revaluation would make the adjustment that I have talked about elsewhere in the blog, such that the U.S. would be a much poorer country. This is, in any event, going to happen. However, in this scenario, it would happen in a way in which it would be a dramatic shock. Instead of a gradual adjustment to a new equilibrium, the U.S. economy would plunge. As an analogy think of a person climbing down a ladder compared with falling from a height.

Yes, it would hurt China's exports, and throw the world economy into a tail spin. It would hurt China as well as the U.S. Eventually, the U.S. would recover with export growth, but it would almost certainly never regain the pre-eminent position in the world economy, which would go to China. China would risk social unrest during the adjustment that followed. However, the reward if they were to pull it off would be status as the new economic power.

As for the cost, $600 billion in devaluation of reserves would be a small price to destroy your greatest rival, and assure a pre-eminent position. The foundation of power is economics. If China destroys the U.S. economy, they destroy the power of the U.S.

The threat to sell the dollar I refer to in the blog, is an expression of China's new found power. Whether they are willing to take a gamble on the consequences of use of such power is a point of question. There are major risks to China if they were to carry it out. However, as things stand, the threat has rebalanced world power.

More on the UK

I have had several comments posted over the last couple of days, so I will try to address these briefly. The first post is provided by Anonymous, who asks:

'I would be interested to hear who you think the (few) winners will be in the UK business world. What do Asians want to buy from the West? Should business to consumer (B2C) companies look at getting their websites fully translated into Chinese/Hindu?etc.? Could they tap into that emerging market, selling collectibles or other specialist items?'

Dealing with the first question, it is actually very difficult.

The way to think about this is to ask the question of what consumers are likely to do next. In tough times, what will people spend their money on, and what will they give up? The first thing to go are luxuries such as taxis. Secondly, people will not have the money or inclination to spend as much money on home improvements, new furniture, or the latest gadget. Upgrading the car will happen less. Foreign holidays will be more expensive (a falling £GB) and are a luxury, so there may be a switch to domestic holidays, but overall less holidays away from home. For leisure, the evening in with a bottle of wine, a movie, and take-away food will replace the restaurant, cinema, theatre and bars. Designer labels will be less alluring, as people trade down the cost ladder. Where before a person might buy Gucci, they will buy Gap, where they typically buy Gap, they will buy M&S and so forth. Hobbies will come back centre stage in people's lives, replacing shopping as the number one leisure pursuit.

We can think about the kinds of companies that will benefit from such a change in consumer behaviour - those who provide for cheap entertainment. That means video games retailers, home delivery food companies and so on. The discount retailers will benefit. Think Lidl and Poundstretcher. Discount pubs and fast food restaurants will be fine, but up market restaurants will suffer a bloodbath. Retailers able to contain/lower their costs will survive, those that do not - will not.

In the wider economy, manufacturers who have a unique technology or process will improve profits as their costs fall, provided that they have export markets (where the drop in the £GB will help them). For any manufacturers who are primarily serving the UK market, they will struggle mightily. Exporters in general will benefit, and may see real growth, but the growth will be slow to start, whilst the world economy goes through turbulence.

On a more depressing note, debt collection will be a growth business, as will be the companies involved in liquidations, from the insolvency accountants through to the auction houses. Second hand stores and second hand car dealers will possibly do well, and eBay and Craigs list will do well.

What do Asians want from the West? Production machinery, high tech products, machine tools, process design, and designer goods. Pharmaceuticals, medical equipment, insurance, weapons. It is a difficult list to compile, as there are many goods and services that the West still excels at. The trouble is that, Asia is already fast climbing up the technological tree, and is already starting to compete in many of these areas. The only answer is a rebalancing of the cost base of the West to allow the continuation of the strengths in these areas, as well as starting to protect the intellectual property that is the foundation of such advantages.

As for selling through the Internet, there are some problems to overcome in this respect. If you look at China, for example, there is a problem with trust. There are some Chinese companies that are managing this, for example through Cash on Delivery systems. However, there are many challenges to overcome that require an in depth understanding of the Chinese market. You should also be aware that China already has an excellent Internet infrastructure, and already have excellent content and services. As for selling collectibles, I have no idea, but this could only be a small business.

On reading the above post, I am aware of the gloomy picture that I have painted in my other posts. However, the West does still have some outstanding businesses, and outstanding technologies. All is not lost, or at least not yet lost. There are solutions to the challenge of the East, but they require fundamental changes to the structure of our economies. As our currencies shrink (which means we get poorer), we will gain back some competitive advantage, and this will lead to an element of the rebalancing - things will get better eventually. The challenge will be to deal with our other cost disadvantages, such as over-regulation and taxation. On the plus side, we have strong legal systems and relatively little corruption, and a moderately well educated and healthy work force, as well as (variably) good infrastructure. The trouble is that, even if we get these elements right, we are shackled with bad debt, and a collapsing banking system, and that will (in any event) take time to work through the system. All of this will take time, and political will.

Dan, another poster, suggests the following:

'For the individual, asset liquidation should be embarked upon as quickly as you can. If you have got things lying around your home that you no longer need then sell them now. Toys, gadgets, antiques and all our detritus is going to be worth much less in the coming months. Sell them now, while there are still people with money to spend.'

Certainly, if you have assets you do not need, or of no value to you now, then there is no harm in selling them now if you would in any case sell them later. With regards to real estate, getting out now is better than later, if you own more than your home. However, you will be selling into a falling market so better to discount early to get the sale, rather than hang on until later, when the discount might be larger.

Anonymous2 also suggests investing into Asia. For this, I would advise caution, as Asia is fraught with political risk, as can be seen in my post on China. I have hesitated to suggest where to put money for the very reason that the world economy is now so turbulent. The interconnectedness of the world economy and trading system means that the problems of the West will have knock on effects in the East. Add to this the instability (e.g. Thailand and Cambodia are currently close to armed confrontation) - and the conclusion is that there is no safe haven.

Lemming (now a regular commentator on my posts) asks the following:

'So, would it be loosely correct to summarise that we have two trading blocks: China and the rest of the world? On paper, the rest of the world is heavily-indebted to China, but can show that China has benefitted from stolen intellectual property.

Does the rest of the world have to honour its debts to China?

Things seem so bad that the only way out of it might be some sort of drastic 'resetting' of the world economy. Or must we work through the consequences of all the millions of individual failed deals and transactions in order to preserve the purity of 'capitalism' for an eventual return to better days?'

The short answer to this question is 'yes', we must honour our debts to China. To not do so would see a complete closure of the world trading system. Without such a system, we would all suffer. The explanation for why open and fair trade works is beyond the scope of a short answer. The trouble is that the trade has not been open and fair, and this is part of the reason for the current problems. Trying to rectify previous failings by now refusing to honour debt obligations would not be a solution. The solution for the US and Europe is to give China a clear warning - fix the intellectual property problems by 'x' degree, by 'x' date, or face trade sanctions. Furthermore, give China a fixed period of time to enact a fully floating currency.

The trouble with such a scenario is that, as happened previously, China will just threaten to sell the $US that they hold onto the open market, thereby destroying the US economy (and probably other currencies too). The way that they did this previously was to use a Chinese 'think tank' to suggest that this was a possibility (I recall that it was during a period when the US was threatening action over faulty merchandise, but can not be sure I have remembered correctly), then the government denied that this was policy. This is quite a typical method in Chinese politics, as those who have studied China closely will be aware. Use a proxy to set up the scenario, rather than make a direct confrontation.

My own answer to this is that it is better to take the pain now, and face down China now, rather than later. It is to reshape the trading system such that it becomes fair. The price of such reshaping may well result in things getting much worse before they get better. It is a short term severe pain to offset longer term worse pain. My answer lies in reshaping of the structure of the Western economies to put them into shape to meet the challenges of Asia. I hope to post more on how to do that in the future.

As a note, I had the following comment on my post on the 'Economic Rise of China':

'..but shouldn't Europe be grateful that the Chinese Government are not suing us for the defects in the last intellectual property they acquired: Marxism?'

All I can say is, a very witty comment.......

The Economic Rise of China

I would like to briefly respond to a comment on my post 'What is Going on in the World Economy'.

The comment was as follows:

'One thing I don't quite understand is that you imply that China's debut in the world economy was always bound to make the West poorer. This makes me wonder why it was in our interests to trade with them in the first place. From what you say, if we had simply made a decision to ignore China we could have carried on living in the way to which we had become accustomed. I suppose this is basically protectionism, and I am sure there are sound reasons why it wouldn't work, but it is a reasonable conclusion to draw from your piece..?'

My post is not intended as an argument for protectionism. It is merely pointing out that, if you give the capital, technology and wherewithal to nearly a billion new workers, then it is inevitable that, for a while at least, there will be an excess of labour in the marketplace.

The question here becomes one of ethics. Is it right, or fair, for a large percentage of the population of the world to remain impoverished? Does national interest trump such ethical consideration? It is not the purpose of this blog to look into such questions, but rather to consider what is happening, why it is happening, and what will happen next.

I pointed out in my post a 'what if..' scenario, in which the transition in the world economy could have been significantly easier. There is more that could have been said on this issue, and I did mention one element that would have had great potential for ameliorating the effects. This is the question of intellectual property.

One of the key elements in the rise of the Chinese economy has been their very lax attitude to Intellectual Property, which is stolen at a rate that is truly astounding. For example, it is nearly impossible in most Chinese cities to buy genuine computer software for individuals, excepting that which is preloaded on new computers. If we just took the example of Microsoft Windows, we can take a reasonable guess that, at least, 100 million computers are running on the software, and the majority of these are illegal copies. At something like $100 retail per unit for Windows, it is not difficult to grasp the scale of the theft. This is just one example. Multiply this across all of the software, and the numbers start to look truly shocking.

Software is, of course, just one visible example of intellectual property theft. It is actually far more widespread, even to the degree where fake motorbikes are being built, and where industrial designs are being stolen and so forth.

As such, whilst not a protectionist, I do believe that China has broken the law on a massive scale. The Chinese government just made tiny gestures towards cleaning up this problem. As such, trade sanctions should have been threatened and, if need be, put in place until China took the problem seriously. One of the elements in the mix of the rise of China is that it has not paid for the intellectual property that supported its economic rise. This was a serious mistake by the West, which should have pressured China into compliance with the law. We have effectively subsidised their rise.

Another problem has been the exchange rate in China. It has been fixed, then moved to a basket with a partial floating rate. In a free trade situation, this is unacceptable. However, the West congratulated China on holding firm on its exchange rate during the Asian financial crisis, thereby hobbling the ability to complain about the problem of the exchange rate later. Had the exchange rate been free, the RMB would have strengthened, making Chinese exports more expensive, and thereby avoided the degree of imbalance that has occurred.

What I am therefore saying is that there was always going to be some pain for the Western economies, but the foolishness/weakness of Western leaders contributed to the scale of the current problems. China always had the potential to grow, but the rise was boosted by two practices which might be described as 'unfair' trade practices. These have accelerated the growth and have contributed mightily to the degree of imbalance that we now see.

In summary, free trade could have seen a slower rise in China, and a more gentle transition in the world economy, had the Western leaders insisted upon fair trade.