The China de-couple theory

January 8, 2008

Whether China will emerge unphased from a significant slowdown in the American consumption machine is a debate that has been raging for well over a year. Many respected economists disagree on this important question.

On Bloomberg TV the author of Tomorrow’s Gold: Asia’s Age of Discovery and the Gloom, Boom and Doom report, Marc Faber, stated with convincing authority that de-coupling is a myth, and China will suffer from an American recession. He only elaborated very briefly, indicating that in a world where final products are produced with partial manufacturing in one region and assembly in another, there can be no de-coupling in the manufacturing process of many goods. Most importantly, however, he said there will be no financial de-coupling — and by that I assume he meant China will continue to be dependent on a constant flow of foreign capital.

What was lacking from his interview (possibly due to time constraints) is a figure specifying the percentage of total Chinese manufactured goods destined for overseas markets that are comprised of partially completed products — anyone who has ever shopped in China may be surprised to hear this argument. Even if they are producing a significant amount of unassembled products certainly the most difficult step in the entire process is what already occurs in their country. Given what they have accomplished in recent decades and the significant amount of capital that has already poured through their border, how difficult could it really be to create a few new assembly plants?

With regards to financial de-coupling, I would argue that if anything China has too many US dollars and would benefit from a slowdown. An American recession could accomplish quite effectively what repeated Chinese interest rate and bank reserve increases could not. My primary concern with the Chinese story has always been the massive scale of environmental destruction that has been the consequence of their extremely rapid expansion. The health of the economy suffers when the health of the nation declines. China could very easily have crossed a dangerous threshold with another few years of growth at current levels. A more reasonable rate of expansion could be exactly what the Chinese authorities need to complete energy, transportation, medical and other infrastructure projects required to continue their remarkable achievements in the longer term.

On the other side of this debate is the author of Crash Proof: How to Profit From the Coming Economic Collapse and President of Euro-Pacific Capital, Peter Schiff, who explains in great detail in his book and the video attached to last week’s article Peter Schiff and the global economy that de-coupling will occur once the rest of the world realizes that America adds very little value to the global economy. He argues that America is a dead weight and once Asia stops subsidizing American consumption with artificially low currency valuations all those goods that are now shipped overseas will instead be consumed at home.

He elaborates with a very compelling analogy — America post WW2. During the war, millions of jobs and a significant percentage of American GDP was tied to the military industrial complex, producing armaments, ammunition and other items required to supply the military. He claims that if today’s economists had been around at the time they would have argued the American economy would collapse without war, but instead America boomed.

He explains the phenomenon by pointing out that American standard of living was being artificially reduced during the war to support the military effort — the country was rationing important materials — and once this interference in the natural supply and demand relationship was eliminated, consumers were more than happy to snap up all the extra goods being produced by their remarkably efficient new industries. He argues that by artificially devaluing their currency, the Chinese are also effectively rationing their output because the goods are priced too high for their consumers to purchase. All around China people work around the clock to send goods abroad that they would happily consume given the opportunity.

This argument is very interesting and reminds me of Henry Ford’s successful $5/day policy. However, it also has some potential flaws — the most important of which is access to oil. In the 1950’s America was the Saudi Arabia of the world. Dealing with rising fuel costs, the massive loss of capital associated with buying oil from abroad, or the potential need to re-engineer an entire industrial base to use a different fuel, did not threaten the American experience.

I also wonder how the enormous Chinese black market affects the claim that current supply is not sufficient to satisfy the real Chinese consumer demand. Also missing from his explanation are figures to support his assertion that much of the military industrial complex was actually dismantled to re-focus investment on consumer products. I seem to remember President Eisenhower had something to say about that.

This is a question with no easy answer, the truth likely lies somewhere in between.