There is an excellent interview about China in the latest edition of Barrons magazine. The interviewee is Anne Stevenson-Yang, who, having spent the bulk of her professional life in China since first arriving in 1985, is extremely well-informed on the topic. She is fluent in Mandarin and is currently the research director of J Capital, a company that works for foreign investors in China doing fundamental research on local companies and tracking macroeconomic developments. Anyone interested in finding out what’s really going on in China should click the above link and read the full interview, but here are some excerpts:

“People are crazy if they believe any government statistics [such as the 7%+ GDP growth figures], which, of course, are largely fabricated. In China, the Heisenberg uncertainty principle of physics holds sway, whereby the mere observation of economic numbers changes their behavior. For a time we started to look at numbers like electric-power production and freight traffic to get a line on actual economic growth because no one believed the gross- domestic-product figures. It didn’t take long for Beijing to figure this out and start doctoring those numbers, too.

I put much stock in estimates by various economists, including some at the Conference Board, that actual Chinese GDP is probably a third lower than is officially reported. And as for the recent International Monetary Fund report calling China the world’s biggest economy on a purchasing-power-parity basis, how silly was that? China is a cheap place to live if one is willing to eat rice, cabbage, and pork, but it’s expensive as all get out once you factor in the cost of decent housing, a car, and health care.

I’d be shocked if China is currently growing at a rate above, say, 4%, and any growth at all is coming from financial services, which ultimately depend on sustained growth in the rest of the economy. Think about it: Property sales are in decline, steel production is falling, commercial long-and short-haul vehicle sales are continuing to implode, and much of the growth in GDP is coming from huge rises in inventories across the economy. We track the 400 Chinese consumer companies listed on the Shanghai and Shenzhen stock markets, and in the third quarter, their gross revenues fell 4% from a year ago. This is hardly a vibrant economy.”

And:

“The giant government economic-stimulus programs since 2008 are rapidly losing their effectiveness. The reason is simple. Much of the money has been squandered in money-losing industrial projects and vanity infrastructure spending that make no economic sense beyond supplying temporary bump-ups in GDP growth. China is riding an involuntary credit treadmill where much new money has to be hosed into the economy just to sustain ever-mounting bad-debt totals. Capital efficiency, or the amount of capital it takes to generate a unit of GDP growth, has soared as a result.”

And:

“The Chinese home real estate market, mostly units in high-rise buildings, is truly bizarre. Many Chinese regard apartments as capital-gains machines rather than sources of shelter. In fact, there are 50 million units in China that are owned but vacant. The owners won’t rent them because used apartments suffer an immediate haircut in value.

It’s as if the government created a new asset class that no one lives in. This fact gives lie to the commonly held myth that the buildout of all these empty towers and ghost cities is a Chinese urbanization play. The only city folk who don’t own housing are the millions of migrant laborers continuously flocking to Chinese cities. Yet, they can’t afford the new housing.”

And:

“All of China’s major corporations are speculating on residential real estate with either cash reserves or borrowed money. Who wants to build, say, a shipbuilding plant when a company thinks it can make a lot more speculating in the housing market?”

And:

“…liquidity seems to be a growing problem in China. Chinese corporations have taken on $1.5 trillion in foreign debt in the past year or so, where previously they had none. A lot of it is short term. If defaults start to cascade through the economy, it will be more difficult for China to hide its debt problems now that foreign investors are involved. It’s here that a credit crisis could start.”

And:

“As for Xi’s much-ballyhooed anticorruption campaign inside China, it offends me that international media depict it as a good-governance effort. What’s really going on is an old-style party purge reminiscent of the 1950s and 1960s with quota-driven arrests, summary trials, mysterious disappearances, and suicides, which has already entrapped, by our calculations, 100,000 party operatives and others. The intent is not moral purification by the Xi administration but instead the elimination of political enemies and other claimants to the economy’s spoils.”

China is an economic disaster happening in slow motion, but it is not a good idea to be short the country’s stock market.

Since coming into existence in 1913, the Federal Reserve has helped facilitate a massive decline in the purchasing power of the US dollar. However, the Fed is not the root of the US monetary problem, as evidenced by the fact that there were several US financial crises/panics during the half-century prior to the establishment of the Fed. As explained by Murray Rothbard (America’s greatest economics historian), these pre-Fed financial panics “were a result of the arbitrary credit creation powers of the banking system.” In other words, the root of the problem is — and has always been — the legal ability of banks to create credit ‘out of thin air’, commonly referred to as fractional reserve banking. With or without a central bank, fractional reserve banking will tend to bring about a boom/bust cycle and thus reduce the long-term rate of economic progress.

Central banking is perhaps history’s best example of government attempting to fix a problem — in this case, the instability resulting from the practice of fractional reserve banking — and making things much worse in the process. The fact that fractional reserve banking leads to periodic crises suggests the following solution: banks should not be allowed to create new money out of nothing, that is, banks should be subject to the same laws as everyone else. However, the big banks tend to be politically influential, and imposing proper restrictions on the banking industry’s ability to expand its collective balance sheet would also restrict the government’s ability to grow, so rather than address the underlying problem the government put in place a system that would enable arbitrary credit creation to continue for much longer and to a much greater extreme without a ‘cleansing’ crisis. In the US, this “system” is called the Federal Reserve. Since the advent of the Federal Reserve there have been longer periods of apparent stability followed by much greater financial crises and economic downturns (the three most severe peace-time economic downturns in the US (the downturns of the 1930s, the 1970s and the 2000s) occurred since the birth of the Fed). There has also been a dramatic increase in the size of the US federal government, with its adverse consequences for freedom.

So, fractional reserve banking caused financial panics and boom-bust economic cycles in the US prior to the creation of the Fed, but crises and recessions in the pre-Fed era were relatively short and the economy tended to recover far more quickly. How, then, do I explain the “great depression” of 1873-1896, which some commentators cite in an effort to ‘prove’ that the Gold Standard doesn’t work and that central banking can be beneficial? 

The short answer is that there was no “great depression” during 1873-1896. Thanks to excessive deposit creation (fractional reserve banking) there were three financial panics during this period (in 1873, 1884 and 1893), but the overall economy achieved very strong real growth. 

For a longer answer I turn to the following excerpts from Murray Rothbard’s “A History of Money and Banking in the United States”:

“Orthodox economic historians have long complained about the “great depression” that is supposed to have struck the United States in the panic of 1873 and lasted for an unprecedented six years, until 1879. Much of this stagnation is supposed to have been caused by a monetary contraction leading to the resumption of specie payments in 1879. Yet what sort of “depression” is it which saw an extraordinarily large expansion of industry, of railroads, of physical output, of net national product, of real per capita income? As Friedman and Schwartz admit, the decade from 1869 to 1879 saw a 3-percent-perannum increase in money national product, an outstanding real national product growth of 6.8 percent per year in this period, and a phenomenal rise of 4.5 percent per year in real product per capita. Even the alleged “monetary contraction” never took place, the money supply increasing by 2.7 percent per year in this period. From 1873 through 1878, before another spurt of monetary expansion, the total supply of bank money rose from $1.964 billion to $2.221 billion — a rise of 13.1 percent or 2.6 percent per year. In short, a modest but definite rise, and scarcely a contraction.

It should be clear, then, that the “great depression” of the 1870s is merely a myth — a myth brought about by misinterpretation of the fact that prices in general fell sharply during the entire period. Indeed, they fell from the end of the Civil War until 1879.

Friedman and Schwartz estimated that prices in general fell from 1869 to 1879 by 3.8 percent per annum. Unfortunately, most historians and economists are conditioned to believe that steadily and sharply falling prices must result in depression: hence their amazement at the obvious prosperity and economic growth during this era. For they have overlooked the fact that in the natural course of events, when government and the banking system do not increase the money supply very rapidly, freemarket capitalism will result in an increase of production and economic growth so great as to swamp the increase of money supply. Prices will fall, and the consequences will be not depression or stagnation, but prosperity (since costs are falling, too), economic growth, and the spread of the increased living standard to all the consumers.”

…”It might well be that the major effect of the panic of 1873 was not to initiate a great depression, but to cause bankruptcies in overinflated banks and in railroads riding on the tide of vast government subsidy and bank speculation.”

…”The record of 1879-1896 was very similar to the first stage of the alleged great depression from 1873 to 1879. Once again, we had a phenomenal expansion of American industry, production, and real output per head. Real reproducible, tangible wealth per capita rose at the decadal peak in American history in the 1880s, at 3.8 percent per annum. Real net national product rose at the rate of 3.7 percent per year from 1879 to 1897, while per-capita net national product increased by 1.5 percent per year.

Once again, orthodox economic historians are bewildered, for there should have been a great depression since prices fell at a rate of over 1 percent per year in this period. Just as in the previous period, the money supply grew, but not fast enough to overcome the great increases in productivity and the supply of products. The major difference in the two periods is that money supply rose more rapidly from 1879 to 1897, by 6 percent per year, compared with the 2.7 percent per year in the earlier era. As a result, prices fell by less, by over 1 percent per annum as contrasted to 3.8 percent. Total bank money, notes, and deposits rose from $2.45 billion to $6.06 billion in this period, a rise of 10.45 percent per annum — surely enough to satisfy all but the most ardent inflationists.”

“The financial panics throughout the late nineteenth century were a result of the arbitrary credit creation powers of the banking system. While not as harmful as today’s inflation mechanism, it was still a storm in an otherwise fairly healthy economic climate.”

In summary, a 23-year period in which the US economy achieved the strongest real growth in its history is strangely characterised in some quarters as a “great depression”, quite likely because so many economists and historians do not understand that real economic progress puts DOWNWARD pressure on prices. Unfortunately, there is no chance that the next 10 years will be anything like the so-called “great depression” of late 19th Century. We won’t be so lucky.

This blog post is a slightly modified excerpt from a recent TSI commentary.

Back in July of last year I pointed out that in a world where official short-term interest rates are close to zero, some short-term market interest rates are also going to be very close to zero, and that, in such cases, interest-rate dips below zero could occur as a result of insignificant price fluctuations. A topical example at the time was “gold backwardation”, meaning the price of gold for immediate delivery moving above the price of gold for future delivery. Gold backwardation is still a topical example and, thanks to the persistence of near-zero official US$ interest rates, is still not significant. What I mean is that the “backwardation” has almost everything to do with the near-zero official short-term interest rate and almost nothing to do with gold supply/demand. So please, gold analysts, stop pretending otherwise!

When the gold market is in backwardation, something called the Gold Forward Offered Rate (GOFO) will be negative. A negative GOFO effectively just means that it costs more for a major bank to borrow gold than to borrow US dollars for a short period. In a situation where the relevant short-term US$ interest rate (LIBOR) is close to zero, why would this be important or in any way strange?

The answer is that it wouldn’t be. What’s strange is an official US$ interest rate pegged near zero. Given this US$ interest rate situation, it is not at all surprising or meaningful that the GOFO periodically dips into negative territory and the gold market slips into “backwardation”.

The charts displayed below illustrate the point I’m attempting to make. The first chart shows the 1-month GOFO and the second chart shows the 1-month LIBOR. Notice that apart from a couple of spikes in one that don’t appear in the other, these charts are essentially identical. The message is that GOFO generally tracks LIBOR, so with the Fed having effectively pegged LIBOR near zero since late-2008 it would be normal for GOFO to fluctuate around zero and to sometimes be negative.

The upshot is that a negative GOFO (and, therefore, a “backwardated” gold market) would be a meaningful signal if LIBOR were at a more normal level (say, 3%), but with LIBOR near zero it should be expected that GOFO will periodically move below zero. In other words, there won’t be a useful signal from GOFO until official US$ interest rates move up to more normal — or at least up to less abnormal — levels.

Before ending this post, here are two related points on gold-linked interest rates:

First, the Gold Lease Rate (GLR) that you see quoted in various places is equal to LIBOR minus GOFO. It is a derived quantity and not the actual amount that is paid to borrow gold. The actual amount that any gold borrower pays in interest will be negotiated on a case-by-case basis with the gold lender and will NEVER be negative. In other words, although the derived GLR will sometimes go into negative territory, this doesn’t mean that people are being paid to borrow gold.

Second, a lower GOFO implies a higher (not lower) cost to borrow gold. GOFO’s recent dip into negative territory therefore implies that the cost to borrow gold has risen, although the percentage changes have been tiny and, as noted above, the lease rate paid by a specific borrower will generally not be the same as the GLR published by the LBMA and charted at web sites such as Kitco.com.