Chinese Slowdown – Revenge of the Austrians?

On October 4, 2008 we wrote an article titled “Are The Wheels Coming Off Global growth? – Dubai and China”–dubai-and-china.aspx

Dubai and China represented the Promethean dream of unfettered global growth and we implied in our article that the economic gods were about to punish them just as the Greek gods punished Prometheus. This punishment seems to be meted out with alacrity and intensity.

Dubai is in trouble. Just ask James Chanos, a noted Hedge Fund Manager, who suggested recently that investors sell short the contractors, steel companies, commodity processors etc that depend on Dubai’s business. Dubai’s problems may create difficulties for companies that sell to Dubai but these are not of great consequence to the world.

China of course is an entirely different story. Chinese economy seems to be cascading down faster than most experts thought possible. The economic data released by China is bleak and getting bleaker. The NY Business press has now caught on to the scale of the problem. The Wall Street Journal wrote an article titled that “China’s 4% Fall in Electricity Output May portend Worse Economic Slump”.

The most disturbing article of all is the one in the New York Times titled “Factories Shut, Workers Are Suffering” ( ). This article is a must read if you want to understand the seriousness of China’s problems.

Just a week ago, China announced an enormous stimulus program to help the economy and its people. As a percentage of Chinese GDP, this $563 billion program is 4-5 times larger than the US stimulus program. The world’s markets rallied hard on this news and the US market rallied 200 points in the morning before selling off.

Perhaps after the initial euphoria, the markets asked, as we do here, whether the huge size of the stimulus is actually an indication that the scale of China’s problems is far greater than any one outside China understands.

Voracious and unrelenting Chinese demand created much of the global boom in capital spending and prompted rise in global equity markets in the last 5 years. Most people assumed that the great Chinese growth was due to the vast uniqueness of China.  They should have listened to the Austrians or more specifically to the Austrian Theory of Business Cycles. Though the Austrian theory has fallen in popularity, we should remember that Friedrich Hayek and Ludwig von Mises, the two founders of the Austrian School, correctly predicted the Great Depression in the USA.

Revenge of the Austrians

We have argued for about two years that the Chinese growth was directly due to the vast amounts of money pouring in to China from America and Europe. The money flow was so unprecedented that China fell into the classic liquidity bubble trap. Chinese property markets went sky high and China built factory after factory to create jobs for the millions of people who were migrating from rural and far flung areas. This was a textbook case of an overcapacity binge.  

The slowdown in America and Europe has crushed demand for Chinese goods. Consequently tens of thousands of small and mid-size factories in China have shut down.

This is exactly what the Austrian Business Cycle Theory predicts. In short, the theory argues that:

  • Low interest rates stimulate borrowing from the real and shadow banking systems;

  • This expansion of credit (borrowing) leads to an unsustainable monetary boom;

  • The monetary boom causes capital to be misallocated to areas that would ordinarily not receive such capital;

  • This misallocation leads to significant levels of overcapacity;

  • A credit crunch or a bust occurs when credit creation (excess borrowing) cannot be sustained;

  • The overcapacity gets rung out during the bust.
This is what has unfolded in the US Housing market and this is what we see unfolding in China. If the Austrians are right, the slowdown in China will be long and deep with serious consequences for the global economy and global peace.

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