10/26/12 – Cracks in the Great Wall

Posted by Brad McMillan, CFA, CAIA, MAI

This entry was posted on Oct 26, 2012 9:17:22 AM

and tagged Debt Crisis

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I am old enough to remember the last time an Asian economic superpower was going to take over the U.S. Back in the day, we heard a lot about how Japan was inevitably going to overtake the U.S. because of its superior work ethic, economic efficiency, and availability of low-cost capital because of high savings rates—and particularly how its government was so much better at managing its economy through agencies like MITI. Loud cries were heard that the U.S. needed to heed the lessons of Asia and become more like the Japanese. Does this sound familiar today?

Unfortunately, in many respects, we have become more like the Japanese. But that is the subject of another post. What I want to talk about right now are the similarities between China and Japan, especially about how Japan never looked as invincible as it did just before its two lost decades started.

The evolution of the debate on China has been interesting to watch. Many in the West have claimed that China was on an unstoppable growth path, and they have been right. More recently, though, that claim has run into a slowing Chinese economy and has changed slightly. Rather than claiming China will continue to grow at double-digit rates based on export growth, the argument now goes that the Chinese government will manage a transition to internally driven growth at high single-digit levels.

The new argument may be right, but to me it sounds like the arguments for Japanese government expertise 25 years ago. I would say that a government that can succeed under one set of circumstances—both Japan’s and China’s export-driven growth to growing consumer economies in the U.S. and Europe, with the explicit support of the U.S. government—does not necessarily have the skill set to make the transition. Japan did not, and it remains to be seen whether China can.

Conditions have changed. Japan started to come undone with the crash of the late 1980s and early 1990s and with the rise of Japan-bashing politicians that reversed the prior U.S. support for, or at least indifference to, Japanese growth. When the export model broke, Japan was never able to convince its population to start spending like Americans. And, in Japan’s case, it had a fairly transparent democratic government structure, which was nevertheless hamstrung by the dominance of a single party.

In China’s case, we have a financial crash that is much worse than the 1980–1990s. We have a much less developed domestic economy, compared to Japan, with much less developed economic management tools. China’s political structure is, to say the least, opaque. The New York Times (NYT) has a front-page article today on the billions in wealth accrued by the exiting premier’s family, “Billions Amassed in the Shadows by the Family of China’s Premier.” Unsurprisingly, the NYT’s website has been blocked in China.

To argue that China can make a successful transition and continue growth rates above those seen in almost any economy is to say that the Chinese government can find new ways to drive growth beyond exports and government-led construction and stimulus. It is to say that the political legitimacy that has held so far in an era of prosperity will continue to hold during that transition. It is to say that this growth can continue despite the growing hostility of the U.S. toward Chinese growth, both economic and military.

Maybe so. I would argue though that, at best, the case is not proven. Twenty-five years later, Japan is still struggling with the legacy of its success and may be moving into a crisis over its debt burden. I would have to say that China still has some work to do.

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