Last year, the world was stunned by an IMF report which found the Chinese economy larger and more productive than that of the United States, both in terms of raw GDP and purchasing power parity (PPP). The Chinese people created more goods and had more purchasing power with which to obtain them — a classic sign of prosperity. At the same time, the Shanghai Stock Exchange Composite more than doubled in value since October of 2014. This explosion in growth was accompanied by a post-recession construction boom that rivals anything the world has ever seen. In fact, in the three years from 2011 – 2013, the Chinese economy consumed more cement than the United States had in the entire twentieth century. Across the political spectrum, the narrative for the last fifteen years has been that of a rising Chinese hyperpower to rival American economic and cultural influence around the globe. China’s state-led “red capitalism” was a model to be admired and even emulated.
Yet, here we sit in 2015 watching the Chinese stock market fall apart despite the Chinese central bank’s desperate efforts to create liquidity through government-backed loans and bonds. Since mid-June, Chinese equities have fallen by more than 30 percent despite massive state purchases of small and mid-sized company shares by China’s Security Finance Corporation.
But this series of events should have surprised nobody. China’s colossal stock market boom was not the result of any increase in the real value or productivity of the underlying assets. Rather, the boom was fueled primarily by a cascade of debt pouring out of the Chinese central bank.
China’s Real Estate Bubble
Like the soaring Chinese stock exchange, the unprecedented construction boom was financed largely by artificially cheap credit offered by the Chinese central bank. New apartment buildings, roads, suburbs, irrigation and sewage systems, parks, and commercial centers were built not by private creditors and entrepreneurs marshaling limited resources in order to satisfy consumer demands. They were built by a cozy network of central bank officials, politicians, and well-connected private corporations.
Nearly seventy million luxury apartments remain empty. These projects created an epidemic of “ghost cities” in which cities built for millions are inhabited by a few thousand. At the turn of the century, the Chinese economy had outstanding debt of $1 trillion. Only fifteen years and several ghost cities later that debt has ballooned to an unbelievable $25 trillion. What we’re experiencing in the Chinese markets are the death throes of an economy that capital markets have realized is simply not productive enough to service that kind of debt.
GDP and Other Crude Economic Metrics are Misleading
GDP is meant to represent the collective value of all transactions within a certain boundary. This metric provides very little useful or accurate information about the actual quality of life in a country. GDP is artificially inflated by imputations such as the added “value” of a house owner not having to pay rent. GDP also includes government spending — such as when a government department purchases new computers. This transaction merely redirected labor and raw materials that would have otherwise been used to directly satisfy consumer demands with better or additional products. Government spending is not just “neutral,” it is actively destructive. Government purchases and sales do not operate with the same rules that other actors in the market are subject to. Thus when we look at GDP numbers from a country drunk on spending newly printed money on projects completely devoid of market signals, we should not place too much faith in them.
The IMF report and those who took it seriously relied heavily on GDP calculations when arriving at their astounding conclusions about China’s growth. To compare the Chinese and American economies using a crude metric like GDP is like trying to gauge the athleticism of an individual by how much sweat comes out of his pores. When one economy can produce companies like Google, Boeing, Costco, and General Electric while another builds empty homes, what meaningful information could an unsophisticated metric like GDP tell us? Much to the chagrin of Keynesians, not all spending is created equal.
Not long ago, we were haunted, not by the specter of this “red capitalism,” but by the communism of the Soviet Union. Some fifty years ago, mainstream economists blabbered tirelessly about the rising Soviet powerhouse. According to popular wisdom, the managed Soviet economy did not have the inefficiency and economic drag inherent in the “random” and “chaotic” American capitalist economy that sent some into mansions and others into bankruptcy. The widely-read Economics: An Introductory Analysis by Nobel-prize winning economist, Paul Samuelson predicted that Soviet GDP was nearly half that of the United States, but by 1984 (and surely by 1997), the strength of the Soviet economy would surpass that of the United States.
The Soviet Union crumbled. When experts rely on crude metrics we should not be surprised when experts are wrong.
The US Federal Reserve orchestrated an artificial boom from 2001 to 2007 through artificially low interest rates and has resumed doing so once again. Entrepreneurs operating under faulty market signals created by the Federal Reserve malinvested hundreds of billions of dollars into capital intensive projects primarily in the housing sector. We paid for our boom with millions of destroyed jobs, wasted labor, and wasted resources. The Chinese Central Bank learned nothing from the Fed’s catastrophic experiment. They will reap the same rewards.