The Death of Money (15 page)

There is also no mystery about who is to blame for the dysfunction of overinvestment.
The IMF study points directly at the state-controlled banks and SOEs, the corrupt
system of crony lending and malinvestment that is visible all over China: “State-owned
enterprises (SOEs) tend to be consistently implicated . . . because their implied
cost of capital is artificially low. . . . China’s banking system continues to be
biased toward them in terms of capital allocation.” State-controlled banks are funneling
cheap money to state-owned enterprises that are wasting the money on overcapacity
and the construction of ghost cities.

Even more disturbing is the fact that this infrastructure investment is not only wasteful,
it is unsustainable. Each dollar of investment in China produces less in economic
output than the dollar before, a case of diminishing marginal returns. If China wants
to maintain its GDP growth rates in the years ahead, investment will eventually be
well in excess of 60 percent of GDP. This trend is not a mere trade-off between consumption
and investment. Households deferring consumption to support investment so that they
may consume more later is a classic development model. But China’s current investment
program is a dysfunctional version of the healthy investment model. The malinvestment
in China is a deadweight loss to the economy, so there will be no consumption payoff
down the road. China is destroying wealth with this model.

Households bear the cost of this malinvestment, since savers receive a below-market
interest rate on their bank deposits so that SOEs can pay a below-market interest
rate on their loans. The result is a wealth transfer from households to big business,
estimated by the IMF to be 4 percent of GDP, equal to $300 billion per year. This
is one reason for the extreme income inequality in China. So the Chinese economy is
caught in a feedback loop. Elites insist on further investment, which produces low
payoffs, while household income lags due to wealth transfers to those same elites.
If GDP were reduced by the amount of malinvestment, the Chinese growth miracle would
already be in a state of collapse.

Nevertheless, collapse is coming. Michael Pettis of Peking University has done an
interesting piece of arithmetic based on the IMF’s infrastructure research. In the
first instance, Pettis disputes the IMF estimate of 10 percent of GDP as the amount
of Chinese overinvestment. He points out that the peer group of countries used by
the IMF to gauge the correct level of investment may have overinvested themselves,
so actual malinvestment by China is greater than 10 percent of GDP. Still, accepting
the IMF conclusion that China needs to reduce investment by 10 percent of GDP, he
writes:

Let us . . . give China five years to bring investment down to 40% of GDP from its
current level of 50%. Chinese investment must grow at a much lower rate than GDP for
this to happen. How much lower? . . . Investment has to grow by roughly 4.5 percentage
points or more below the GDP growth rate for this condition to be met.

If Chinese GDP grows at 7%, in other words, Chinese investment must grow at 2.3%.
If China grows at 5%, investment must grow at 0.4%. And if China grows at 3% . . .
investment growth must actually contract by 1.5%. . . .

The conclusion should be obvious. . . . Any meaningful rebalancing in China’s extraordinary
rate of overinvestment is only consistent with a very sharp reduction in the growth
rate of investment, and perhaps even a contraction in investment growth.

The suggestion that China needs to rebalance its economy away from investment toward
consumption is hardly news; both U.S. and Chinese policy makers have discussed this
for years. The implication is that rebalancing means a slowdown in Chinese growth
from the 7 percent annual rate it has experienced in recent years. But it may already
be too late to accomplish the adjustment smoothly; China’s “rebalancing moment” may
have come and gone.

Rebalancing requires a combination of higher household income and a lower savings
rate. The resulting disposable income can then go into spending on goods and services.
The contributors to higher income include higher interest rates to reward savers and
higher wages for workers. But the flip side of higher interest rates and higher wages
is lower corporate profits, which negatively impacts the Chinese oligarchs. These
oligarchs apply political pressure to keep wages and interest rates low. In the past
decade, the share of Chinese GDP attributable to wages has fallen from over 50 percent
to 40 percent. This compares to a relatively constant rate in the United States of
55 percent. The consumption situation is even worse than the averages imply, because
Chinese wages are skewed to high earners with a lower propensity to spend.

Another force, more powerful than financial warlords, is standing in the way of consumer
spending. This drag on growth is demographic. Both younger workers and older retirees
have a higher propensity to spend. It is workers in their middle years who maintain
the highest savings rate in order to afford additional consumption later in life.
The Chinese workforce is now dominated by that midcareer demographic. In effect, China
is stuck with a high savings rate until 2030 or later for demographic reasons, independent
of policy and the greed of the oligarchs.

Based on these demographics, the ideal moment for China to shift to a consumption-led
growth model was the period 2002 to 2005. This was precisely the time when the productive
stage of the investment-led model began to run out of steam, and a younger demographic
favored higher spending. A combination of higher interest rates to reward savers,
a higher exchange rate to encourage imports, and higher wages for factory workers
to increase spending might have jump-started consumption and shifted resources away
from wasted investment. Instead, oligarchs prevailed to press interest rates, exchange
rates, and wages below their optimal levels. A natural demographic boost to consumption
was thereby suppressed and squandered.

Even if China were to reverse policy today, which is highly doubtful, it faces an
uphill climb because the population, on average, is now at an age that favors savings.
No policy can change these demographics in the short run, so China’s weak consumption
crisis is now locked in place.

Taking into account the components of GDP, China is seen to be nearing collapse on
many fronts. Consumption suffers from low wages and high savings due to demographics.
Exports suffer from a stronger Chinese yuan and from external efforts to weaken the
dollar and the Japanese yen. Investment suffers from malinvestment and diminishing
marginal returns. To the extent that the economy is temporarily propped up by high
investment, this is a mirage built on shifting sands of bad debt. The value of much
investment in China is as empty as the buildings it produces. Even the beneficiaries
of this dysfunction—the financial warlords—are like rats abandoning a sinking ship
through the medium of capital flight.

China could respond to these dilemmas by raising interest rates and wages to boost
household income, but these policies, while helping the people, would bankrupt many
SOEs, and the financial warlords would steadfastly oppose them. The only other efficacious
solution would be large-scale privatization, designed to unleash entrepreneurial energy
and creativity. But this solution would be opposed not only by the warlords but by
the Communist Party itself. Opposition to privatization is where the self-interest
of the warlords and the Communists’ survival instincts converge.

Four percent growth may be the best that China can hope for going
forward, and if the financial warlords have their way, the results will be much worse.
Continued subsidies for malinvestment and wage suppression will exacerbate the twin
crises of bad debt and income inequality, possibly igniting a financial panic leading
to social unrest, even revolution. China’s reserves may not be enough to douse the
flames of financial panic, since most of those reserves are in dollars and the Fed
is determined to devalue the dollar through inflation. China’s reserves are being
hollowed out by the Fed even as its economy is being hollowed out by the warlords.
It is unclear if the Chinese growth miracle will end with a bang or with a whimper,
but it will end nonetheless.

China is not the first civilization to ignore its own history. Centralization engenders
complexity, and a densely connected web of reciprocal adaptations are the essence
of complex systems. A small failure in any part quickly propagates through the whole,
and there are no firebreaks or high peaks to stop the conflagration. While the Communist
Party views centralization as a source of strength, it is the most pernicious form
of weakness, because it blinds one to the coming collapse.

China has fallen prey to the new financial warlords, who loot savings with one hand
and send the loot abroad with the other. The China growth story is not over, but it
is heading for a fall. Worse yet, the ramifications will not be confined to China
but will ripple around the world. This will come at a time when growth in the United
States, Japan, and Europe is already anemic or in decline. As in the 1930s, the depression
will go global, and there will be nowhere to hide.

THE NEW GERMAN REICH

But there is another message I want to tell you. . . . The ECB is ready to do whatever
it takes to preserve the euro. And believe me, it will be enough.

Mario Draghi

President of the European Central Bank

July 2012

If there is no crisis, Europe doesn’t move.

Wolfgang Schäuble

German minister of finance

December 2012

■
The First Reich

Those blithely predicting the breakup of Europe and the euro would do well to understand
that we are witnessing the apotheosis of a project first begun twelve hundred years
ago. A long view of history repeating itself reveals why the euro is the strongest
currency in the world. Today the euro waits in the wings, one more threat to the hegemony
of the dollar.

Europe has been united before: not all of it in the geographic sense, but enough to
constitute a distinct European polity in contrast to a mere city, kingdom, or country
in the area called Europe. That unity arose in Charlemagne’s Frankish Empire, the
Frankenreich,
near the turn of the ninth century. The similarities of Charlemagne’s empire to twenty-first-century
Europe are striking and instructive to those, especially in the United States, who
struggle to understand European dynamics today.

While many focus on the divisions, nationalities, and distinct cultures
within Europe, a small group of leaders, supported by their citizens, continue the
work of European unification begun in the ashes of the Second World War. “United in
diversity” is the European Union’s official motto, and the word
united
is the theme most often overlooked by the critics and skeptics of a political project
now in its eighth decade. Markets are powerful, but politics are more so, and this
truth is slowly becoming more apparent on trading floors in London, New York, and
Tokyo. Europe and its currency, the euro, despite their flaws and crises, are set
to endure.

Charlemagne, a late eighth- and early ninth-century Christian successor to the Roman
emperors, was the first emperor in the West following the fall of the Western Roman
Empire in
A.D.
476. The Roman Empire was not a true European empire but a Mediterranean one, although
it extended from the Roman heartland to provinces in present-day Spain, France, and
even England. Charlemagne was the first emperor to include parts of present-day Germany,
the Netherlands, and the Czech Republic with the former Roman provinces and Italy,
to form a unified entity along geographic lines that resemble modern western Europe.
Charlemagne is called, by popes and laymen alike,
pater Europae,
the Father of Europe.

Charlemagne was more than a king and conqueror, although he was both. He prized literacy
and scholarship as well as the arts, and he created a court at Aachen comprised of
the finest minds of the early Middle Ages such as Saint Alcuin of York, considered
“
the most learned man anywhere” by Charlemagne’s contemporary and biographer, Einhard.
The achievements of Charlemagne and his court in education, art, and architecture
gave rise to what historians call the Carolingian Renaissance, a burst of light to
end an extended dark age. Importantly, Charlemagne understood the significance of
uniformity throughout his empire for ease of administration, communication, and commerce.
He sponsored a Carolingian minuscule script that supplanted numerous forms of writing
that had evolved in different parts of Europe, and he instituted administrative and
military reforms designed to bind the diverse cultures he had conquered into a cohesive
realm.

Charlemagne did not pursue his penchant for uniformity past the point necessary for
stability. He advocated diversity if it aided his larger goals pertaining to education
and religion. He promoted the use of vernacular
Romance and German languages by priests, a practice later abandoned by the Catholic
Church (and belatedly revived in 1965 by the Second Vatican Council). He accepted
vassalage from conquered foes in lieu of destroying their cultures and institutions.
In these respects, he embraced a policy the European Union today calls
subsidiarity
: the idea that uniform regulation should be applied only in areas where it is necessary
to achieve efficiencies for the greater good; otherwise local custom and practice
should prevail.

Charlemagne’s monetary reforms should seem quite familiar to the European Central
Bank. The European monetary standard prior to Charlemagne was a gold
sou,
derived from
solidus,
a Byzantine Roman coin introduced by Emperor Constantine I in
A.D.
312. Gold had been supplied to the Roman Empire since ancient times from sources
near the Upper Nile and Anatolia. However, Islam’s rise in the seventh century, and
losses in Italy to the Byzantine Empire, cut off trade routes between East and West.
This resulted in a gold shortage and tight monetary conditions in Charlemagne’s western
empire. He engaged in an early form of quantitative easing by switching to a silver
standard, since silver was far more plentiful than gold in the West. He also created
a single currency, the
livre carolinienne,
equal to a pound of silver, as a measure of weight and money, and the coin of the
realm was the
denire,
equal to one-twentieth of a
sou
. With the increased money supply and standardized coinage, along with other reforms,
trade and commerce thrived in the
Frankish Empire.

Charlemagne’s empire lasted only seventy-four years beyond his death in
A.D.
814. The empire was initially divided into three parts, each granted to one of Charlemagne’s
sons, but a combination of early deaths, illegitimate heirs, fraternal wars, and failed
diplomacy led to the empire’s long decline and final dissolution in 887. Still, the
political foundations for modern France and Germany had been laid. The
Frankenreich
’s legacy lived on until it took a new form with the creation of the Holy Roman Empire
and the coronation of Otto I as emperor in 962. That empire, the First Reich, lasted
over eight centuries, until it was dissolved by Napoleon in 1806. By reviving Roman
political unity and advancing arts and sciences, Charlemagne and his realm were the
most important bridge between ancient Rome and modern Europe.

Notwithstanding the institutions of the Holy Roman Empire, the millennium after Charlemagne
can be seen largely as a chronicle of looting, war, and conquest set against a background
of intermittent ethnic and religious slaughter. The centuries from 900 to 1100 were
punctuated by raids and invasions led by Vikings and their Norman descendants. The
period 1100 to 1300 was dominated by the Crusades abroad and knightly combat at home.
The fourteenth century saw the Black Death, which killed from one-third to one-half
the population of Europe. The epoch starting with the Counter-Reformation in 1545
was especially bloody. Doctrinal conflicts between Protestants and Catholics turned
violent in the French Wars of Religion from 1562 to 1598, then culminated in the Thirty
Years’ War from 1618 to 1648, a Europe-wide, early modern example of total war, in
which civilian populations and nonmilitary targets were destroyed along with armies.

The sheer suffering and inhumanity of these latter centuries is captured in this description
of the siege of Sancerre in 1572. Sancerre’s starving population successively ate
their donkeys, mules, horses, cats, and dogs. Then the
sancerrois
consumed leather, hides, and parchment documents. Lauro Martines, citing the contemporary
writer, Jean de Léry, describes what came next:

The final step was cannibalism. . . . Léry . . . then says the people of Sancerre
“saw this prodigious . . . crime committed within their walls. For on July 21st, it
was discovered and confirmed that a grape-grower named Simon Potard, Eugene his wife
and an old woman who lived with them . . . had eaten the head, brains, liver, and
innards of their daughter aged about three.”

These bloodbaths were followed by the wars of Louis XIV, waged continually from 1667
to 1714, in which the Sun King pursued an explicit policy of conquest aimed at reuniting
France with territory once ruled by Charlemagne.

The European major litany of carnage continued with the Seven Years’ War (1754–63),
the Napoleonic Wars (1803–15), the Franco-Prussian War (1870–71), the First World
War, the Second World War, and the Holocaust. By 1946, Europe was spiritually and
materially exhausted and
looked back with disgust and horror at the bitter fruits of nationalism, chauvinism,
religious division, and anti-Semitism.

France was involved in every one of these wars, and Franco-German conflict was at
the heart of the three most recent, in 1870, 1914, and 1939, all occurring within
a seventy-year span, a single lifetime. After the Second World War, while the U.K.
wrestled with the demise of its own empire and a U.S.-Soviet condominium descended
in the form of the Iron Curtain and the Cold War, Continental statesmen, economists,
and intellectuals confronted the central question of how to avoid yet another war
between France and Germany.

■
The New Europe

A first step toward a unified, federal Europe took place in 1948 with the Hague Congress,
which included public intellectuals, professionals, and politicians from both left
and right in a broad-based discussion of the potential for political and economic
union in Europe. Winston Churchill, Konrad Adenauer, and François Mitterrand, among
many others, took part. This was followed in 1949 by the founding of the College of
Europe, an elite postgraduate university dedicated to the promotion of solidarity
among western European nations and the training of experts to implement that mission.
Behind both the Hague Congress and the College of Europe were the statesmen Paul-Henri
Spaak, Robert Schuman, Jean Monnet, and Alcide De Gasperi.

The great insight of these leaders was that economic integration would lead to political
integration, thereby making war obsolete, if not impossible.

The first concrete step toward economic integration was the European Coal and Steel
Community (ECSC), launched in 1952. Its six original members were France, West Germany,
Italy, Belgium, Luxembourg, and the Netherlands. The ECSC was a common market for
coal and steel, two of the largest industries in Europe at the time. In 1957 it was
joined by the European Atomic Energy Community (Euratom), dedicated to developing
the nuclear energy industry in Europe, and also by the
European Economic Community (EEC), created by the Treaty of Rome and devoted to creating
a common market in Europe for goods and services beyond coal and steel.

In 1967 the Merger Treaty unified the ECSC, Euratom, and the EEC under the name of
the European Communities (EC). The 1992 Maastricht Treaty recognized the European
Communities as one of the “three pillars” of a new European Union (EU), along with
Police and Judicial Cooperation, and a Common Foreign and Security Policy (CFSP),
formed as the representative of the new EU to the rest of the world. Finally, in 2009,
the Lisbon Treaty merged the three pillars into the sole legal entity of the European
Union and named a European Council president to direct general objectives and policies.

Alongside this economic and political integration was an equally ambitious effort
at monetary integration. At the heart of monetary union is the European Central Bank
(ECB), envisioned in the 1992 Maastricht Treaty and legally formed in 1998 pursuant
to the Treaty of Amsterdam. The ECB issues the euro, which is a single currency for
the eighteen nations that are Eurozone members. The ECB conducts monetary policy with
a single mandate to maintain price stability in the Eurozone. It also trades in foreign
exchange markets as needed to affect the euro’s value relative to other currencies.
The ECB manages the foreign exchange reserves of the eighteen national central banks
in the Eurozone and operates a payments platform among those banks called TARGET2.

At present, Europe’s most tangible and visible symbol is the euro. It is literally
held, exchanged, earned, or saved by hundreds of millions of Europeans daily, and
it is the basis for trillions of euros in transactions conducted by many millions
more around the world. In late 2014 the ECB will occupy its new headquarters building,
almost six hundred feet high, located in a landscaped enclave in eastern Frankfurt.
The building is a monument to the permanence and prominence of the ECB and the euro.

Many market analysts, Americans in particular, approach Europe and the euro through
the lens of efficient-markets theory and standard financial models—but with a grossly
deficient sense of history. The structural problems in Europe are real enough, and
analysts are right to point them out. Glib solutions from the likes of Nobelists Paul
Krugman and Joseph Stiglitz—that nations like Spain and Greece should exit the Eurozone,
revert to their former local currencies, and devalue to improve export competitiveness—ignore
how these nations got to the euro in the first place. Italians and Greeks know all
too well that the continual local currency devaluations they had suffered in the past
were a form of state-sanctioned theft from savers and small businesses for the benefit
of banks and informed elites. Theft by devaluation is the technocratic equivalent
of theft by looting and war that Europeans set out to eradicate with the entire European
project. Europeans see that there are far better options to achieve competitiveness
than devaluation. The strength of this vision is confirmed by the fact that pro-euro
forces have ultimately prevailed in every democratic election or referendum, and pro-euro
opinion dominates poll and survey results.

Charlemagne’s enlightened policies of uniformity, in combination with the continuity
of local custom, exist today in the EU’s subsidiarity principle. The contemporary
EU motto, “United in diversity,” could as well have been Charlemagne’s.