Mao Tse-tung in 1956 called the United States an empire. He called it a paper tiger.

In appearance it is very powerful but in reality it is nothing to be afraid of; it is a paper tiger. Outwardly a tiger, it is made of paper, unable to withstand the wind and the rain. I believe the United States is nothing but a paper tiger.

It is now half a century later. The United States is bogged down in a war that has lasted longer than its participation in World War II. The government’s on-budget debt is in the $9 trillion range. Its off-budget debt is in the $70 trillion range. Here was Mao’s assessment in 1956.

The United States owes debts everywhere. It owes debts not only to the countries of Latin America, Asia and Africa, but also to the countries of Europe and Oceania. The whole world, Britain included, dislikes the United States. The masses of the people dislike it. Japan dislikes the United States because it oppresses her. None of the countries in the East is free from U.S. aggression. The United States has invaded our Taiwan Province. Japan, Korea, the Philippines, Vietnam and Pakistan all suffer from U.S. aggression, although some of them are allies of the United States. The people are dissatisfied and in some countries so are the authorities.

All oppressed nations want independence.

Everything is subject to change. The big decadent forces will give way to the small new-born forces. The small forces will change into big forces because the majority of the people demand this change. The U.S. imperialist forces will change from big to small because the American people, too, are dissatisfied with their government.

Mao has been dead for three decades, yet his words seem strangely prophetic. He understood what the United States was facing. Yet he had no clue about what China was facing. He was completely wrong about China’s role in the world economy in the decades that followed his death.

China remains officially Marxist politically, yet in fact has become the fastest growing large capitalist economy in history. This began in 1979 under Deng Xiao-ping, the man Mao failed to execute. (Deng was saved by the personal intervention of Col. von Trapp’s son-in-law, but that’s another story for another day.)

THE OTHER TIGER

Economist F. A. Hayek in 1969 offered his version of having a tiger by the tail: monetary inflation.

Now we have an inflation-borne prosperity which depends for its continuation on continued inflation. If prices rise less than expected, then a depressing effect is exerted on the economy. I expected that ten years would suffice to produce increasing difficulty; however, it has taken 25 years to reach the stage where to slow down inflation produces a recession. We now have a tiger by the tail: how long can this inflation continue? If the tiger (of inflation) is freed he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished! I’m glad won’t be here to see the final outcome. (Hayek, A Tiger by the Tail, Institute for Economic Affairs, 1972, p. 112.)

As he spoke, a recession in the United States was about to hit. There was another in 1975. The United States went off the international gold standard in 1971. Price inflation soared in the decade. Then the Federal Reserve stabilized money in 1979. The result was a pair of recessions, 1981 and 1982. Price inflation slowed, but then an international monetary crisis hit in August, 1982, when Mexico threatened to default. To avoid a disaster, the FED pumped in money. Price inflation continued, though at a slower pace.

Hayek died in 1992. He lived long enough to see the Soviet Union fall. He did not see the end of inflation.

So far, the West has not gotten off the tiger’s back. But the tiger has not yet eaten us.

Now it is China’s turn to ride the monetary tiger.

CHINA’S MONETARY POLICY

At the beginning of 2007, the Chinese central bank announced its monetary goals for the year. As it does every year, it announced that the policy would be prudent.

It said it will continue to implement a prudent monetary policy and improve its foresight on the country’s economy and financial sector.

Here is what prudence is in today’s China. This was the target for M-2.

China aims to keep the annual growth of its broad money supply this year to within 16 percent, nearly 1 percentage point down from that of 2006, the central bank announced on Sunday.

The target was set on the basis of an expected 8 percent growth in gross domestic product (GDP) and a less than 3 percent rise in consumer prices year-on-year, the central bank said at its annual work conference that concluded yesterday.

Consider 8% growth. This means a doubling of the economy every nine years. As for price inflation, the bankers expected 3%. This means that they expected real economic growth of 5%, which is very high for a nation of 1.3 billion people.

As for M-1, the narrow money supply, the bank issued no target figure.

China’s bankers underestimate money growth, year after year.

Last year, the central bank set its macro-control targets at a 16 percent annual growth for M2, a 14 percent rise for M1, and 2.5 trillion yuan (US$312.5 billion) of newly added loans in Renminbi.

Data from the bank show the country’s M2 last year rose 16.94 percent year on year to 34.56 trillion yuan, with M1 up 17.48 percent to 12.6 trillion yuan and new credit surging to 3.18 trillion yuan, or 27 percent beyond target.

This discrepancy was easily explained: “The money supply and credit targets are not missions it must meet but only a policy guide, the bank has said.” How will the bank achieve its goals in 2007? By winging it. “The central bank pledged to adopt multiple tools for monetary macro-control and to advocate flexibility in interest rate adjustments to address excessive currency liquidity.”

The money supply in China has risen in the 15% to 18% range, year after year. By April, the increase in M-2 was around 17%, year to year, slightly higher than the announced rate.

But what of official growth figures? The government claimed 10.7% growth in 2006, meaning a doubling every 6.7 years. It claimed price inflation of 1.3%, meaning that China in 2006 had real growth of 9.2%. This is astronomical. There is no historical precedent for anything like this. I think we should employ skepticism regarding these figures. Statisticians in Marxist countries must toe the line.

POPULATION MOVEMENT

Jim Jubak has offered an explanation of how these high economic growth rates are possible. I have mine. They agree. It is due to a freeing up of labor and capital. The labor market is outside the compulsory welfare system of the Chinese government. He thinks this is bad. I think it is good. He writes:

It works like this. A peasant looking for a better life can move to a city or an industrial zone and get a job. But they can’t get a “hukou,” the certificate of residence required to access public services such as schools, health care and unemployment benefits. These migrant workers live crammed in company dormitories, usually earning far below the official minimum wage and sometimes as little as $1 for a 12-hour day, doing the dirtiest and most dangerous work that no worker with a certificate of residence wants. And quite often, the company refuses to pay the migrant worker even those wages. Official Chinese government figures say that more than 70% of the country’s migrant workers were owed pay by their employers last December.

This is a free labor market involving huge numbers of people. Jubak writes: “Estimates of the number of migrant workers in China range from 110 million to 120 million.” He estimates that 3.7 million migrants live in Guangzhou, which has 7.5 million people. “Migrants make up 80% of all urban construction workers and 68% of workers in electronics manufacturing, according to UNESCO (the United Nations Educational, Scientific and Cultural Organization).”

Consider some implications of these numbers. In China, Inc. (2005), author Ted Fishman offers these tidbits of information.

“Every month, China must build enough urban infrastructure to accommodate a city the size of Houston in order to absorb the 300 million rural Chinese who will move to cities in the next 15 years.”

“China has 450 cities with a population of at least 250,000, compared to 68 cities in the United States with at least a quarter of a million people.”

“China has over 100 cities with a population of at least 1 million people — the United States has 9.”

“Half of China’s 1.3 billion people are under age 24. Over 300 million, more than the population of the US, are under the age of 14.”

We begin to see the nature of the tiger that China is riding. China has the highest rate of monetary inflation of any large industrial nation. It is experiencing the largest migration of population in recorded history. In less than one generation, well over a hundred million people have moved from farms to cities. It may be closer to 200 million people.

Monetary inflation is not the main source of China’s economic boom. This kind of increased economic productivity does not arise out of increases in the money supply. Fiat money does not create new wealth. Economic growth has arisen out of a freeing up of capital and labor in what had been a Communist economy.

Monetary inflation does affect the allocation of capital and labor at the margin. Companies that get access to the newly created money can buy goods and services at yesterday’s prices. They can fund new plants and new projects more inexpensively than companies that get access to the fiat money later in the flow of funds.

Which are these companies? Obviously, among the winners are companies that export to the West, whose importers can buy the Chinese yuan at a low price due to the increase in the supply of yuan. China is imitating the five Asian “tiger” economies that were built on exports to the West: Japan, Taiwan, Hong Kong, South Korea, and Singapore.

To subsidize the export sectors of the economy, the Chinese central bank has adopted monetary inflation. It has used its newly created currency units to buy foreign currencies, which it then uses to buy the debt certificates issued by Western governments, including the United States. This has helped keep interest rates lower in the United States than what would have prevailed, had the Chinese central bank not inflated or else had bought assets other than T-bills.

THE BOOM-BUST CYCLE

Hayek pointed out the nature of the tiger in 1969. He had learned this from Ludwig von Mises, who had discovered the nature of the boom-bust cycle in 1912. The cycle comes from monetary inflation, which stimulates economic growth. Then, when the rate of price inflation slows, the underlying forces of the economy reassert themselves. Interest rates rise as prices rise. Projects that had been launched because of the low interest rates that had been produced by the fiat-money-funded purchases of government debt, now face bankruptcy because of rising interest rates.

China has now moved into the industrial world. It is part of the world economy. It is experiencing huge population movements. People are moving off low-output farms and moving into huge cities. In cities, there is a much higher division of labor than in rural villages. There is much greater specialization of production. So, there will be much greater economic losses when a recession hits. On a farm, you can switch production to self-sufficiency when market demand declines. In a city, you get fired when market demand declines. Your income ceases. You must find different employment.

How do you do this if the urban economy takes the brunt of the economic losses? You lower your price. You work for less. To persuade workers to do this, companies must create incentives. They fire people. Until workers recognize the new conditions and adjust to them by lowering their wage demands, they remain unemployed.

This is a major threat to the Communist government. The tight controls imposed on the population by the political system were justified by guaranteed employment in state-owned companies. These have been steadily shut down by the government.

What happens to the political order when the tiger of inflation is replaced by the tiger of recession? This is the nature of the tiger that Hayek described.

The central bank has placed the entire society on the back of this tiger. It dares not stabilize the money supply. So, it continues to create new money, hoping that prices will not rise domestically because of the downward pressure on wages created by the flood of rural workers streaming into the cities.

So far, this policy has worked politically. Enormous economic growth has kept down domestic prices. But the threat of recession grows ever greater as people keep filling the cities. A fall in employment in a city where millions of newcomers are living is far more dangerous politically to a centralized political order than a dispersed, unorganized rural society is.

CONCLUSION

No society is riding a more dangerous tiger than China. China has combined an aging, centralized political hierarchy with a youthful market-driven population. To this risky brew the central bank has added monetary inflation, which has now become endemic. Participants in the economy have planned on this monetary inflation.

It is unexpected changes in the rate of monetary expansion that create serious losses. The central bank dares not reduce the rate of inflation.

So, the results are predictable: rising commodity prices, supply bottlenecks, real estate bubbles in fast-growing cities, a stock market bubble, and euphoria regarding the future.

The move from farms to cities by young men is the central factor in the deferral of production crises. Labor is a large component of any economy. China’s is no exception. The flood of immigrants from the farms is holding down production costs.

The bubble in China resembles the bubble 1995—2000 NASDAQ in the United States. The Chinese stock market is trading at a price/earnings ratio above 50. Some stocks are trading at 80. In a speech on June 12, Alan Greenspan commented, “Some of these price-earnings ratios are discounting Nirvana.” But let us not forget that the NASDAQ reached a p/e ratio of more than 200 in December, 1999.

China’s goods will continue to be cheap. In a recession, they will be even cheaper. The problem will be in the debt markets. When the Chinese central bank starts buying its own government’s debt in order to bail out the Chinese government directly, interest rates in the West will rise. China has exported price deflation: cheap goods. It has done this by purchasing western governments’ debt. When that strategy hits the iceberg of domestic recession and unemployment, the West’s days of low interest rates and economic boom will cease abruptly.

June27, 2007

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 19-volume series, An Economic Commentary on the Bible.

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