The changing debate over China’s economy

Once again I apologize for taking so long to repair my blog, but it hasn’t been easy. We are slowly fixing up the mess on my website. There will be a link on the site directing interested readers to the old site if anyone wants to read older blog entries. I will do this because I have been advised that there might be infected code buried in my site that creates a backdoor that allows the hackers to break into my site regularly. By not transferring anything from the old site to this one, presumably, I lower the likelihood of accidentally importing the virus.

A lot of very kind people have privately and publicly expressed their concerns that my site has been hacked for political reasons, perhaps because I am saying things that they think might anger important people in China. Although I have certainly been the target of sometimes hysterical attacks – more so in the past, when my analysis of the Chinese economy seemed more unlikely than it does now – I have no reason at all to think that my blog was hacked for anything other than commercial reasons having to do with the sale of excitable pharmaceuticals.

Part of the reason for the concerns that my blog has been hacked for political reasons may be the wide-spread belief abroad that no debate is permitted within China about the urgent need for economic reform. In fact this isn’t true. The discussion within China is quite vigorous, and the misperception is probably fueled by the belief – spread often enough, it seems, by China bulls – that the debate about the weaknesses in the Chinese economy is largely a debate between foreigners and Chinese, with some bulls even arguing that it is a debate between those who wish China ill and those who wish it well. The implication, of course, is that only someone who is incapable of understanding China – i.e. a foreigner – could possibly believe that China has problems.

But this is just silly. I will ignore the irony involved in a foreigner’s claiming that it is precisely because they are foreign that it is impossible for the foreign skeptics correctly to understand the Chinese economy, Chinese culture, and the thinking of the Chinese people (those inscrutable orientals!). I suspect the reason they find China so different and alien is because they have little experience of other developing countries, and know almost nothing either about developing countries outside East Asia or about economic history.

The Chinese growth model, as I have pointed out many times before, is not radically new. It is based primarily on the growth model developed by Japan in the 20th Century. It involves policies that can be traced at least as far back as the “American System” of the early 19th Century, and it has been implemented in various forms by many different countries around the world during the past 100 or even 200 years. There is, in other words, actually quite a lot that we know and understand about the model, even if many of us seem to have forgotten much of it – including its typical weaknesses, one of the most obvious of which is the tendency for over-investment in the late stages of the miracle-growth period leading to an unsustainable increase in debt.

More importantly, the claim that “foreign” skepticism lacks credibility precisely because it is foreign has very little historical support. There have been many cases in which foreigners were able, perhaps because they tend to be more objective, to identify risks earlier than locals. The real estate boom in the US before the 2007-08 crisis, for example, was widely discussed by worried European economists for years, and Paul Krugman, a foreigner, was famously skeptical about the Japanese and Asia miracles at a time when most analysts, local or foreign, regarded such skepticism as evidence of either ignorance or ulterior motives (his work was based at least in part on earlier work by Alwyn Young, another foreigner).

Dismissing the credibility of skepticism about the Chinese miracle because it is foreign, in other words, has little in the history of economic analysis to support it. But the real reason why it is completely nonsensical is that it is simply not true. Among China economists living and working in China there is a great deal of worry about the sustainability of the growth model, and this has been the case for many years – so much so that former Premier Wen groused publicly about these issues long before most foreign analysts had doubts about the sustainability of the growth model, and he did so based on Chinese analysis, not foreign. Just as clearly, Premier Li has made it obvious that he sees the need for reform as urgent, and it is hard to believe that he would consider this to be such an urgent need if Chinese economists as a group were as oblivious to the risks and as optimistic as the traditional China bulls claim they are.

In fact I think until the recent shift in sentiment abroad, there was even more skepticism about the long-term functioning of the growth model within China than abroad, and one has only to read magazines like Caixin, and even the occasional article in the People’s Daily, to see how vigorous the debate is. It is true that sentiment abroad has shifted remarkably in the last year or two, but this reflects, in my opinion, the fact that foreign observers are not as close to events on the ground as are locals. Until about 2009-10, it was widely believed abroad that China’s growth model was functioning well – brilliantly, in fact – and that China would continue to grow at 9-10% a year for the next decade or longer.

Within China, however, most economists that I speak to were far more pessimistic. I remember meetings as far back as 2008, for example involving senior US or European government officials looking to be debriefed on the Chinese economy, in which the foreign (and some Chinese) analysts present spoke jauntily about the great success of China’s growth policies and the brilliant future ahead, while many of the Chinese economists present were much more cautious and even gloomy as they discussed the sheer intractability of China’s economic distortions. In those days, I would argue, skepticism was disproportionately to be found among Chinese economists, and not foreign economists.

The real difference in opinion

This is a good thing, of course. If Chinese economists were nearly as oblivious to China’s problems as the China bulls claim they are, we would have reason to be truly worried about the country’s prospects. In the last two years as the bull argument has been pummeled into reality by the surge in debt, the persistent failure of consumption growth to close the gap with GDP growth, and the sharp slowdown in overall growth, the mood abroad has turned increasingly bearish, to the point that many people are speaking about a China collapse and the horrible implications this will have for the rest of the world.

It is important to note however that nothing has really changed substantially in the past few years. The problems China is facing today should have all been expected, but we shouldn’t be so quick either to expect an imminent collapse in the Chinese economy or, even as China continues to slow sharply, an awful impact on the rest of the world.

The former bulls are using this shift in global sentiment to shift the goalposts somewhat. They now claim that the fundamental disagreement between China bulls and China skeptics is that the skeptics have been predicting an imminent collapse in the Chinese economy for several years – which of course has not happened – and that they are demanding that Beijing take policy steps which will force an adjustment in the Chinese economy such that consumption will immediately surge and investment immediately drop to “acceptable “ levels.

But the serious debate has not been about whether or not China’s collapse is imminent. The disagreement was whether or not investment misallocation and the repression of household income growth were fundamental to the Chinese growth model. The bulls argued that they were not, and that while poor investment decisions and low consumption growth could indeed exist, these could be addressed administratively within the model and did not require radical reforms that would essentially result in an abandoning of the growth model. 

The skeptics argued that these were indeed fundamental to the model, and that worsening imbalances and an unsustainable rise in debt would be the inevitable and automatic outcome of maintaining current policies. For the bulls, although only after it became clear that debt was indeed growing too fast, debt problems are specific and localized problems created by irresponsible behavior on the part of individual actors, and they can be addressed by administrative measures on the part of the regulators. The skeptics, however, disagree. It doesn’t matter how strongly the regulators clamp down on one sector or the other, high growth rates – the skeptics argue – necessarily mean that debt is rising at an unsustainable pace no matter how vigilant the regulators. Our conclusion was that unless the investment-driven growth model were abandoned, it would lead inexorably to a debt crisis.

The heart of the bull argument until one or two years ago was that a radical adjustment was not necessary. The skeptics argued that it was, and, against the fervent advice of the bulls, they warned that the longer it took to implement the necessary adjustments the more difficult it would be. It is precisely the disagreement over whether or not major structural adjustments were even necessary that separated the skeptics from the bulls.

I wish this were just about bragging rights, but it is not. The bulls have been forced to recognize the inevitable consequences of the existing growth model, although some have resisted longer than others, but many of them still don’t get it. They don’t seem to understand that what is needed is not implementation of the “right” administrative strategies to fix the problems of debt, investment and consumption, and they mistakenly believe that China has plenty of time to implement these strategies.

Most dangerously of all, the bulls think that China can fix its problems while growing at 7% or 7.5% – which is better than the 8% they used to think is the minimum acceptable, although worse then the 6% they will undoubtedly cite next year as the minimal acceptable growth rate. But these growth rates, the skeptics argue, are impossible. In order that Beijing get its arms around credit growth and reduce the extent of wasted investment, GDP growth rates – the skeptics argue – must drop considerably, although since rebalancing means that household income must grow faster than GDP, it will not be nearly as painful as the bulls think it will be.

The issue about how much China’s GDP growth must slow in order to accommodate the necessary adjustment is probably the key difference between the bulls and the skeptics. Contrary to the new argument put forward by the old bulls, the problems of debt, investment and consumption in China are not new and unexpected, they are not just the normal growing pains associated with rapid growth in an otherwise healthy developing economy, they are not simply individual problems caused by irresponsible behavior, and they cannot be addressed except with far more radical changes than the bulls acknowledge.

Radical change versus administrative change

What’s more, and the various skeptics’ analyses have explained why, the changes China needs will necessarily create strong political opposition within the system. Arguments by former bulls that the real debate between the bulls and the skeptics is all just about whether China collapses in the next few months or not, weaken the case for reform and will, I suspect, make it harder for Li and the reformers to force through the necessary changes. These changes – and I don’t know if the bulls understand this or not – must come primarily at the expense of the political and economic elite, and I don’t just mean that there must be less corruption, as New York Times columnist Tom Friedman, another former bull, and among the most excitable of the lot, is now arguing

Anyone who understands the fundamental problem with the growth model that China has pursued, which has many historical precedents, and why its great success in the 1980s and 1990s could not be sustained once certain parameters were breached, as they inevitably must be, also knows that until those parameters were breached, the interests of the elite and of overall growth for the economy were more or less aligned. Since then, they are in opposite directions. This is why the period of adjustment after rapid growth has always been the most difficult stage for a developing country, and one that very, very few countries have successfully managed, and why it will be particularly difficult for China, and this is why corruption – although perhaps of enormous social and political consequence – is not the fundamental problem. 

The debate about China continues to rage, although it has taken a strange twist. No one doubts anymore that China’s imbalances threaten the success of the growth model and some are even insisting – very prematurely, in my opinion – that China has clearly failed and will face a collapse (whatever that means). I think the key division now, however, is over debt and over the recognition of previous losses. The bulls have retreated from many of their more fantastic predictions but they mistakenly think that the problem of debt is localized, and not systemic, and can be administratively resolved by the regulators. They also seem to ignore the possibility that there is an enormous amount of mispriced assets on the balance sheets of the banks and that these losses have to be assigned to some sector of the economy or the other, and that this assignation is at heart a political process.

The skeptics believe that an unsustainable rise in debt is key to continued growth in the economy and do not believe that it can be resolved administratively. High growth means, by definition, that debt is rising unsustainably. The bulls say that growth has bottomed out at 7% or 7.5% and that China can restructure the economy, rebalance towards consumption, and arrest the credit expansion while keeping growth rates above 7% or close to 7%. The skeptics argue that this is impossible, and to the extent that Beijing takes steps to keep growth rates high, it simply increases the risk of a debt crisis and economic collapse.

Last year in one of my blog posts I argued that although I remained very skeptical about the sustainability of the China growth model I nonetheless believed that China bulls could make a plausible argument but were failing to do so largely because they did not address the three questions that were fundamental to the debate on the sustainability of the Chinese growth model. These questions are:

  • How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
  • What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
  • What mechanism can be implemented to increase the growth rate of household consumption?

I think these continue to remain the key questions if the bulls are going to be credible.

No more stopped clocks, please

Before closing allow me – perhaps a little foolishly – to display a little peeve. For many years before 2007-9 a few analysts have warned that rising consumer credit in the US and peripheral Europe was unsustainable. They warned that rising debt to support misallocated investment in China was also unsustainable. They warned that soaring US mortgages backed by little more than the hope that land prices could only rise would lead to a real estate crisis. They warned that commodity-exporting countries that did not hedge their bets would find themselves in serious trouble when commodity prices collapsed.

Of course you could not have had a bubble unless the majority of analysts disagreed with these warnings, and most analysts did indeed disagree. So what happened when the warnings turned out to be right? Obviously enough the mistaken bulls publicly acknowledged that their models were incorrect and promised to hit the economic history books so that they never again would be so foolish.

Just kidding. What actually happened is that the former bulls immediately trotted out the stopped-clock analogy. The reason the worriers turned out to be right, they earnestly explained, is that they are perma-bears, and as everyone knows a stopped clock will always be right twice a day. This doesn’t mean, however, that models used by the worriers were right and the models used by the bulls were wrong, so of course there is no need for the bulls to change their models.

As China’s growth continues to slow and as its debt problems become obvious to even the most bullish, the stopped clock analogy is working overtime. How does it work? First, we must assume that there are only two possible positions one can take on China’s economy. The “bull” position is that China is in very good shape and is more or less doing everything right, even though (the remaining bulls have been adding lately) its economic growth must slow down a little. The “bear” position is that China must collapse within six months.

Second, we then point out that China hasn’t collapsed yet, and so the fundamental analysis was wrong. Of course China is slowing, as even the most fervent bulls acknowledge, and just as the bears said it would, but this, the bulls claim, had to happen eventually and has nothing to do with the analysis.

Of course this is just dumb. There are other far more likely alternatives for China that involve neither perpetual double-digit growth nor collapse. For example, I have been skeptical about the sustainability of the Chinese growth model since at least 2006-7 but I have never argued that China would collapse, let alone collapse within six months. My argument is that China’s growth model, which is not at all unique and for which there are many historical precedents, is usually wealth enhancing in its early stages, and then becomes wealth destroying once capital is systematically misallocated. When that happens, debt rises at an unsustainable pace until we reach debt capacity limits, in which case the country will have a debt crisis. I have usually estimated that it would reach debt capacity limits around 2016-18 but now I think it is likely to happen earlier.

However I never believed China would hit those limits, or have a debt crisis, because I was fairly sure that Beijing would begin adjusting earlier. It is during the adjustment period that I expected growth to drop sharply, to 3-4% as the upper limit.

Regular readers of my blog know how often I gripe about the superficiality of those analysts who don’t see why describing a growth model that is generating an unsustainable increase in debt is not the same thing as predicting a collapse in six months. Debt can rise unsustainably for many years before the debt burden itself becomes unsustainable – after all it is not true that those who worried about the rise of consumer credit in the US in the mid 2000s were “wrong” until the stopped clock eventually was right.

This strikes me as an incredibly superficial analysis, explained only by the fact that many of us expect economic analysis merely to predict whether the stock market will rise or fall this week. Those who worried about rising consumer credit in the US were not wrong every single year until 2007-8, when they accidentally became right. They were right every single year, and were proven right in 2007. Those who have been arguing that China is experiencing an unsustainable increase in debt have not been wrong every quarter that China has not collapsed. They are almost certainly right and it is hard even for the most foolish of bulls any longer to deny it.

An analysis that points to an unsustainable trend is always right if the trend turned out indeed to be unsustainable. The fact that it may have taken many years before the limits were reached is not an indication that the model was wrong. It is simply how the economy works.

This is why I get very annoyed with people who were obviously wrong when they dismiss people who were obviously right by referring to the stopped clock that is always right twice a day. Whenever a bull defends himself with the stopped-clock analogy, it suggests to me that he is likely to be an economic illiterate – and completely wrong to boot.


 Add your comment
  1. what do you think about the fact that Li Keqiang has claimed that 7.5% is the minimum acceptable growth rate

    • I think he is focusing on the wrong growth rate. 7.5% is an acceptable growth rate for household income, and may even be possible, but I think there is no way China’s GDP can grow by 7.5% for more than a couple of years without creating for China a huge debt problem.

      • I mean do you think Li Keqiang has the determination to push through reform? I think not. Li Keqiang also claim urbanization will be the engine that will drive chinese economic growth for the next 20 years, I think he’s delusional. Increasing food price may even reverse urbanization.

      • another danger facing china is it becoming the world’s top oil importer and high oil price. The US housing bubble was probably burst by oil price shock. A oil price shock caused by say iraq disintegration or terrorist attack on the suez canal may burst the chinese housing bubble. CHina has water shortage so it does not even have the option of fracking.

  2. “Those who worried about rising consumer credit in the US were not wrong every single year until 2007-8, when they accidentally became right. They were right every single year, and were proven right in 2007.”

    Quite right.

  3. There is no such thing as a “soft landing”, is there?

    • One thing Michael has said before is historically speaking the rebalancing has always turned out to be a lot worse than even the most pessimistic people expected. No one expected the USSR to disintegrate in 1991, no one expected the Japanese economy to stagnate for 20+ years and no one expected the Latin American Lost Decade of hyperinflations and negative growth. One problem with credit and/or debt bubbles is when they burst they can have unpredictable consequences above and beyond what you would expect.

  4. Sorry to use big words, but this may be some of the best you have ever written, putting your views in a contextual battle. Was the hacking perhaps a blessing in disguise, sharpening the mind? Could the Chinese sign for crisis really be the same as opportunity…?

    • Thanks, Eric. After reading so much nonsense by China bulls claiming that they were actually right all along I thought it might be useful to try to separate the respective positions of the bulls and the skeptics.

  5. The youth in china have all their life experienced continued economic growth and improving standard of living, a sudden economic stagnation or recession will be quite a shock i believe.

    • Only if a slowdown in GDP growth is fully matched by a slowdown in household income growth which, depending on the political infighting, doesn’t have to be the case.

      • See, this is why I have long argued to colleagues that you are a closet “China bull”, after all. Welcome back.

        • I don’t consider myself either a bull or a bear, Jacob, just a skeptic who happens to know something about developing countries and something about economic history, and who knows that bubbles cannot exist unless people believe in them very strongly and are willing to justify every new price rise. I think the best we can do is work out logically the functioning of the system and limit our predictions to potential outcomes that are internally consistent. A slowdown in GDP growth can be consistent with both rising household income and declining household income, and so neither should really be ruled out, but it is worth noting that it is very rare for rebalancing to occur with rapidly rising household income.

  6. Welcome back Michael.

    I think the biggest problem the bulls have is that they fail to really appreciate the devastating effects that credit bubbles have, especially in developing countries.

    • I think you are absolutely right, illumined, although I didn’t really bring out this point in my entry. There is a sense that if only Beijing were to stop mis-investing every thing would be fine and we can start from zero, but isn’t there a cost to all of the pervious mis-investment, and doesn’t this cost have to be absorbed at some point? If not, why bother changing the strategy?

      • Misallocated investments are a sunk cost, however losses on bad debts, or poor investments, hit incomes when they are recognised – when there is no alternative.

        Many investments turned out in 2008 to have been unproductive. But realising losses is extremely unpopular, so asset prices have been inflated until the problem disappears. The assets are no more or less productive than they were, but by enforcing low rates of return we maintain poor investments at the cost of more productive future investments.

        The preference for maintaining asset values with low personal incomes – socialising the losses – rather than writing down bad assets, investing in productive assets and earning higher incomes, is political commonplace.

        If asset holders won’t accept losses, the state can support asset prices. QE demonstrates one approach. Supporting the prices of unproductive assets does nothing for household incomes, and the economic adjustment is slow.

        Alternatively the assets could be written off quickly, distorting subsidies cut, unemployment jumps as firms close, and then fresh unsubsidised investment and government spending kick-start a recovery with eventually rising household incomes. Since nobody likes this process, it’s usually a consequence of external rather than domestic factors.

        Perhaps China will be different but if a crisis arises I cannot imagine that the latter course would be chosen voluntarily.

        So it’s a race between rebalancing and crisis, and to the extent that rebalancing – diminishing funding for under-performing assets – causes problems, the process is a slippery slope that ends with a crisis.

        I wonder why it wouldn’t?

  7. Michael, I don’t understand how you can expect a soft landing, when apparently the trajectories that need adjusting have not been reversed yet?

    The debt-to-GDP ratios are as high as any where when non-official debt is factored in. There has been no sustained deflation of China’s housing bubble yet.

    For the elite within the Communist Party to give up wealth to the masses, seems to be the antithesis of what makes the Communist Party exist. They will only do this when they are losing more money by holding on to the old, than they could make by privatizing.

    Michael if the western world collapses in a sovereign debt collapse where aggregate global demand is reduced by 30 – 50%, are you claiming China could have a soft landing?

    If I am correct about such a global implosion starting 2016, then the process of the elite adjusting will occur with a depression in China.

    The Pi model says the center of the global empire moves period round-robin from Europe, Americas, Asia, and that the USA had its depression in 1929 as the handoff from Europe to USA of the global empire. 78 years later in the Pi model (78 = 26 x 3.159, 26 = 8.6 x 3.1459, 8.6 = 1000 x 3.1459), China will have its 1929 starting in 2016/7 as the handoff from USA to Asia of the global empire enters the next phase.

    • Shelby, on what basis do assume the US is going to handoff to Asia in this decade? When the US essentially took over we were by far the largest economy in the world, we had world class inventors and we had a genuine free market to allow inventions to be capitalized on very quickly. The Asian nations have none of these.

      • The USA didn’t fully take over and become the #1 middle class in the world until after WW2 in the 1950s, 26 years after the handoff depression that started 1929. The current downturn started 2007 even for China (export growth peaked 2007, and the deadcat bounce was just global stimulus and then back on trend down). So thus I am not expecting China’s middle class to be #1 (in aggregate, not per capita) until 2033, i.e. 26 years after 2007.

        I am looking at this from Armstrong’s model of international capital flows, which says the USA took over not because of better technology, but because capital was fleeing the sovereign debts of Europe. There was no other place for capital to go, because the rest of the world was bankrupt from socialism (i.e. government share of GDP too high). The Heritage Foundation data shows that (except for Switzerland) all developed nations have government shares of GDP over 50% (actually much greater than that when off book liabilities are factored in, not to mention costs of regulation and Obamacare). So in my model, Asia becomes #1 after a depression to bleed off this bad debt they’ve racked due to cheap dollar loans that poured in because western capital had to go to emerging markets to find yield due to ZIRP.

        Technology doesn’t fund an economy, because it employs very few people people. It is the use of technology that employs the broad population, and Asia is ripe to adopt technology because they are young. The western demographics is old and hanging on for a few more good years of life, not bursting with energy to adapt. The USA’s technology will be applied to Asia, as that is where the growth will be (after the depression starting 2016 to wipeout the misallocation of capital and reset).

        • Shelby, the US was the dominant technological and economic power both overall and on a per capita basis by the 1870s, and the US had the highest wages in the world for nearly all of the 19th Century. By the end of the Civil War German officers watching the war already saw the US as the dominant military power. I am not sure why you do not think this happened until the 1950s.

          • New York did not become the financial capital of the world until after WW2. As you know, this was because Europe imploded and capital fled to the new frontier. The Florida land bubbles were caused by gold fleeing Europe into the USA. The same is about to happen to the USA going to Asia circa 2033, but first we have one last hurrah for the dollar as the emerging markets are short the dollar (either bond issues or China’s dependence on exports) and capital will rush back to the core economy as global socialism implodes (again, which is what caused prior world wars).

            Although Asia is not #1 per capita, they have several times more population. And if valued on a PPP basis including TRUE health care and social services costs NOT SHIFTED INTO THE FUTURE BY BEING OFF BALANCE ENTRIES, then Asia is already ahead of the West in aggregate (perhaps not per capita but we really don’t know until the write-downs come). One can argue that Asia will have to pay for their elderly one day, but that is not a significant balance sheet item now or anytime in next few decades. The Japanese throw their 50+ off the job bus.

            The USA was importing immigrant labor so labor was not in oversupply as is the case in Asia. So we shouldn’t be comparing wages, rather social balance sheets (c.f. Michael’s astute blog about “social capital”).

            Again my theme has been that socialism’s peak also corresponds to some massive technologically induced unemployment in the former dominant economies (this corresponds every 78 years to the collapse of real estate in the dominant economies), e.g. the factories disrupting cottage industry going into the 20th century and now computers and internet with outsourcing, robotics, automation (even accounting and POS system integration, etc).

          • Note the Asian crisis at the turn of the 21st century was caused by capital rushing back to Europe for the launch of Euro (and we see how that speculative capital flow into PIIGS ended up now).

          • I read that Societe Generale says Germany, France, UK, and USA have the highest net government liabilities-to-GDP ratios including the off-book/off-balance sheet items, higher than the PIIGS.

        • In addition to what Michael said I’ll also point out that this type of “America is in decline” rhetoric is nothing new. In the 1970’s and during much of the 80’s it was commonplace. Supposedly we were to hand off to the USSR and then Japan respectively. Granted when I grew up in the 90’s this had largely subsided (although we were still taught to hate ourselves), but I do know some people who grew up in the 80’s during the previous declinist wave. Their teachers were actually telling them Japan will become dominant and there was nothing they could do because those Japanese guided by their far sighted ancient wisdom (massively paraphrased of course) were just too smart.

          I think a lot of this declinism is just wishful thinking on the part of the left and foreign nationals. The US does have some big challenges and problems that really do need addressing but the “pretenders to the throne” (the BRICS) have much bigger challenges and will far more likely to just try papering it over.

          Brazil is still quite dependent on resource exports, and we all know what happened to them at the end of the last commodity supercycle.

          Russia is pretty much a resource export economy, in order to balance their federal budget they need oil prices to be over $115 a barrel. Besides exporting military hardware they really don’t to have much else in the way of internationally competitive industry.

          India is a mess. It never really did get its act together in a variety of ways and has far more red tape than even China. I don’t know enough to comment on the specifics, but the potential just isn’t there.

          China, Michael has already said plenty on the challenges facing China and I am pessimistic for its chances, just because the extent to which the rebalancing needs to be done and the fact that historically rebalancing has proven to be much more economically devastating than anyone ever predicts.

          I’m not sure why South Africa was included with the rest of the BRIC countries. It’s got an out of control AIDS problem, out of control crime and a brain drain that is really going to suck the life out of their economy in the next 10 years.

          Credit bubbles are unpredictable mostly because the policy responses to their bursting often are counter-productive in unpredictable ways. That being said, I think it’s far more tempting for the BRICS to enact bad policies than it is for the US.

          • They key difference is the west is now trying to tax higher than Laffner limit, this is the signal of empire collapse. I have sent some private emails to Michael discussing how empires have declined historically and the key signal to look for is when the government begins repressing its own people to the point where they can’t survive and must abandon civilization. The youth are already experiencing this in the PIIGS.

          • the argument might sound simple. and i wasnt reading newspapers when the same was said about russia and japan.
            but those have each half and a third of the population of the US. China has 4-5 times the population of the US, and a much better funktioning governement compared to the US now than the UDSSR? back then.
            so… no, the comparison doesnt make me think that this time its the same like back then.
            especially when one sees the educated workforce produktion and development/research china already has by now.
            sure it will take quite a while longer for chinese culture and media to have a similiar influence in europe as the american one still has. but aside that….

          • Boomups, there is always something which explains why this time truly is unlike all the previous ones, but why should higher population be the key difference in this case? Leave aside that China’s one-sixth share of humanity will come with one-third of all its people over 65, and that India, its neighbor with whom it has terrible relations, will have not just a bigger population but a much bigger population of 15-34 year-olds, for many years Chinese would tell you that China’s biggest problem was its enormous population, especially when couple with its disproportionately low share of arable land. If a huge population can be a major problem, why would it necessarily resolve all the other problems the country faces?
            More importantly, where is the evidence in post-Industrial-Revolution history that it is the most populous countries who are the dominant powers in their region?
            I am not saying it cannot happen, but as a skeptic I don’t find any of the arguments especially compelling, and certainly no more so than the busted arguments that justified all the other cases. And by the way why do you think China’s government is much better functioning than that of the USSR and Japan during their “inevitable” days? This is certainly not what people would have believed back then. In fact every government seems brilliant during its “miracle” stage.

          • Booomups said: “sure it will take quite a while longer for chinese culture and media to have a similiar influence in europe as the american one still has. but aside that….”

            Huh? What? Do you really think that American culture and media’s impact is based on its economic power? Sure, it might be a contributing factor, but I don’t think a Brazilian teenager listens to Kanye West because of economic power. I would suggest the influence of American culture (perhaps better described as Anglo-American) and media in the world is more the result of freedom of expression, the global persuasion of the English language, multiculturalism that fuses inspiration from many cultures and last but not least, perhaps a genuine spark of creativity. Of course, global communications makes this all possible in a way never possible in our past.

            I don’t hesitate to say that if you are waiting for Chinese culture to have the same influence in Europe as America, you and all of us on this board will not live to see that day.

          • Korean sensation Psy was doing the Gangnam Style with “You Can’t Touch This” McHammer in Times Square, New York on New Years. I didn’t think McHammer still had the moves, he comes from my generation so he must be pushing 50. Enjoyable to watch that video to the end if you are an X-gen like me. Nice to see the camaraderie between Psy and McHammer.

            Asia is coming…

            I agree China is repressed, thus all the more pent up demand and talent waiting to be launched once the elite are subsumed by the coming implosion I expect. The middle class will tolerate the elite for as long as they keep the economy growing.

          • Shelby, that’s an interesting point about Korean sensation Psy. I think I read somewhere that he’s about to surpass The Rolling Stones in all-time sales. All this on one hit song. Isn’t that amazing? 😉

      • There is some confusion in the data as to whether property prices have already collapsed. Since confidence drives markets (not fundamentals), then confusion in a bullish trend can be equivalent to “the correction hasn’t occurred yet”.

      • Perhaps more importantly there has probably never been a “hand-off” in history, and certainly not in modern times, from a more open society to a more closed one. I don’t think this is a coincidence.

        • Didn’t verify so I will take your word for it. And indeed this is why I had been bearish on China, because I didn’t see how it could become more open without a complete change of political and philosophical culture. I even criticized their top-down educational culture, population-wide (cultural) disregard for intellectual properties rights, etc..

          Then Armstrong made some valid points that shocked me– points we all probably know but didn’t bring to our conscious mind yet (i.e. cognitive dissonance).

          1. The West is less open. Shocking but true. We have the illusion of free speech, but in the Wallstreet protests they just arrest you for stepping on the grass. A recent news story reveals anti-terrorism forces are showing up at individual homes 100 times per day, e.g. a husband did an internet search for “backpack” and the wife searched for “pressure cookers”. Consider the relative level of regulation and government share of GDP. Even California has made it a criminal offense not to comply with Obamacare.

          2. Some claims the Chinese don’t have true private land ownership (the man who blocked a highway disagrees), yet in the USA we don’t own our house.

          And I add my own point:

          3. Although we can view Asia as top-down managed, in reality there is massive choice and competition, but as a Westerner you might not see it because you expect it to take the same forms you know at home. Some claim that China doesn’t have private health care, but I bet they have ubiquity of private folk medicine– there is a “quack doctor” in every community in the Philippines. James White wrote about this w.r.t. to manufacturing diversity, and is evidence of that. In the Philippines I can choose from three (or five) nationwide PREPAID cell phone networks (so I need at least a dual-simm phone) meaning I can buy a new simm in 30 seconds have a new number. In the west, you nearly have to give a blood sample to get a phone number and USA has much slower internet because of telcom monopolies. The list goes on and on…

          Its depressing that the world is moving to a lower common denominator of liberty, with Asia’s top-down systems as the best we have to look forward to, but actually what appears to be happening from my perspective is we are moving to anarcho-capitalism where an alternative Bitcoin will make it nearly impossible for the nation-states to tax and spend. The frontier of freedom appears to be on the digital highway. There is actually technology for all of this, e.g. Chaum’s high-latency mix-net, dc-net, OTR, and the Socialist Millionaire algorithm.

          • 1.) I don’t know how you can say the west is less open when you spent the first paragraph criticizing it. What you say about China applies to some degree or another to almost everywhere else on the continent. The Philippines might be an exception, I’ve never been there and know little about it, but it would be a very small exception. the vast majority of East Asia either copied the Chinese culture (including its closed outlook) or already had cultures that were very closed, like India.

            2.) All land in China is explicitly owned by the government, there have been some attempts at land reform but as far as I know it went nowhere.

            3.) I can’t speak for Europe but in the US getting a cell phone is easy, and in fact it’s commonplace for the carrier to hugely subsidize the cost of the phone itself. It’s also possible to get prepaid burner phones, they are cheap and fairly easy. While it is true that the local telecoms do have monopolies on landlines, that really isn’t very important because they have competing technologies like cable internet.

            4.) Asia’s top down systems are not all we have to look forward to and in actuality are probably its biggest weakness.

          • 1) I’m talking about openness when it comes to actions that you can do. In this regard, the USA is growing worse on free speech and privacy, while Asia is growing more open over time. There are 1000s of riots and protests in China.

            More importantly on freedom, in the west you need a permit just to remodel your bathroom, whereas in Asia you pretty much do as you please as long as it doesn’t threaten the power elite.

            After 2016, you will see a hard-down turn for the west on freedom due to the contagion on the debt crisis that will force the west to tax and bail-in the middle class more aggressively, then this point will be clearer.

            The key point is trajectory, since we are talking about my alleged handoff 20 years from now.

            2) Tell that to the guy who blocked a highway to win higher price concession on his house. I think you didn’t read what I wrote. I didn’t argue that China has land ownership, rather I argued that the effect of taxation, mortgages pulling demand forward by 30 years driving prices astronomical then the debt bust coming (when the price of a house will fall to 5 to 10 times the gold price) the USA doesn’t either.

            3) Cable internet are also monopolies, and the internet access is slow compared to developed economies in Asia. You don’t obtain a new cell phone number in 30 seconds at a sidewalk vendor. And you don’t obtain a new cell phone number without providing complete identification and usually a credit check. Well there might still be some prepaid cell phones in USA, the government is determined to shut down any way of obtaining a cell phone number where they can’t track your identity and all your communications.

            4) Asia’s top-down systems may collapse and Asia can function with more freedom because the only hindrance are the elite, not the population. Whereas, the west can’t, because the underbelly who depend on the government will demand that the government increase its control and ability to tax and confiscate.

  8. Michael,

    As a China “bull” I’m happy to take up your challenge.

    First, I would largely agree with your characterisations around the debate. I have long said that in China, if I say something bad about the economy, I will invariably be told it’s actually worse. Similarly, in India, if I mention something bad, I was told it’s much better. But there you go. Either way I too find the debate difficult at times.

    Second, I have attempted to answer your three questions for bulls. The entries are actually quite dated, I undertook the project last year, but I am more than happy to stand by them.

    Third, I’m not sure we can agree that the debt is not concentrated in small pockets. The Goldman Sachs paper that has been quoted saying debt of 219% clearly shows some very important compositional skews. For instance, the local government debt is highest in rich provinces such as Beijing, Tianjin and Jiangsu. Or that there has been a large shift in corporate debt. The bottom 60% of companies by size have gone from debt equal to 3xEBITDA to -1xEBITDA while the largest firms have gone from 0.5xEBITDA to 1.5xEBITDA. This seems a very important compostional issue.

    Fourth, I am in the midst of writing a paper to show that there are too many contradictions in the Chinese model to make comparisons with Japan or Latin America valid. The US in the 19th C is very valuable. It is a time characterised by deflation and financial crisis but strong real economic growth. Pretty much where China is at.

    As I said at the start, the debate is fraught and accusations around motive are of little value. I would also add that as my blog discusses, I enjoyed our chat last year.


    • And my brief answers to the three questions:

      1. The economic value of the assets is higher than the debt based on total economic return which includes taxation and wages rather than just usage of the specific asset. Also, the wealth transfer flows in absolute terms from rich/middle class to poor. It’s the opposite of financial repression in the US.
      2. I shouldn’t have to identify projects, that’s not what macro people do. What I can say is that there is enormous productivity improvement required of China and its people. The political incentive drives this allocation decision.
      3. Investment is the principal mechanism that should be used to increase household consumption in China.

      As I said, brief answers to complicated questions.

      • If the Chinese middle class is allowed to invest throughout Asia to fully leverage Asia’s strength of youth demographics (the other countries balance some of China’s weaknesses), the export manufacturing and domestic real estate investment mono-conomy would thus be diversified. Your data says there will be focused losers, offset by winners if the diversity is allowed. You make a strong analogy to the low regulation, high liquidity, private banking, numerous booms and busts in the USA in the 19th century.

        But I think we all knew that. We all know what is standing in the way is the government propping up inefficient sectors of the economy primarily by entrapping the workers’ capital in low interest rates on savings and trapped domestically on investment.

        Your weakest point is arguing that the interests of the coddled elite are aligned with the middle class. Surely they are over the long-term, but when and how do they recognize that they have to unleash the capital controls that are forcing this mono-economy?

        Are you arguing they can continue the top-down control and shift to other domestic sectors? If yes, I strongly disagree. Top-down control is precisely what is trapping China at the middle income.

        My theory is the coming depression will be enough for the middle class to push for those capital controls to end. And I think the elite might suffer enough too to realize they have to change their model of wealth accumulation.

      • I read several of your blog articles and reduced your thesis to “zero-return fixed capital investment and exports” was the most efficient way to lift the society and employ the most people. Okay. But as I understand (and agree with) Michael’s point is that model has reached its limit. To get past middle-income, you have to accept a free-market where individuals maximize ROI, then you get consumers. This unbalanced (mono-economy, low capital return) model just can’t raise income levels any higher. No amount of infrastructure efficiency increases can raise productivity without this freedom to profit. This is why incremental increases in debt are no longer producing increases in real GDP. The model you are describing must change. If the leadership still think they can grow with tweaks without changing the top-down model, then they will have to learn the hard way.

        • In Michael’s article and in the comments I detect a number of assumptions which, taken together, might be addressed to open this debate a little wider.

          1. The Chinese economy is slowing. No, it’s growing faster than ever, adding $690 billion to GDP this year and more in 2014. Those are all-time records. The rate of acceleration is irrelevant; it’s the increase in gross dollar production per capita that feeds the bulldog.

          Those 1.3 billion bulldogs are being better fed, clothed, housed, and transported every year. Given the stable population and controlled inflation, this represents a truly enormous improvement in the overall operating efficiency of the Civilization State. For all its faults, the government there is able to get the country moving in profitable directions, a feat which few Western governments will even attempt these days. The government has adequate political and financial capital to reach its 5- and 10-year goals and to make whatever adjustments necessary to stay on schedule.

          [Martin Jacques’ term ‘Civilization State’ is an accurate summation. My conversations with Chinese have convinced me that they’re the biggest critics/whiners on earth when it comes to governance (we Americans are meekly accepting by comparison) and at the same time they somehow know how to cooperate on a macro level that produces amazing results. They’ve been doing this for millennia under far worse governments than the current regime. And for decades now they’ve given 80+% trust and support to that government. Then they resume whining, presumably].

          2. That China is overspending on infrastructure. China will have overspent on infrastructure when its infrastructure is 20% better in all respects than Germany’s. Until that day, the Chinese people will continue to whine while congratulating themselves as they board the Beijing–Berlin Express.

          3. That economies cannot be managed and must experience the boom-bust cycles of Capitalism. Economies CAN be managed, as we’ve seen for the past 40 years. But, as the Chinese constantly point out, there’s no point in trying to implement a Chinese “model” without a Chinese civilization to implement it. Given that, we might profitably study aspects of Chinese governance, like only electing geniuses to their highest ranks. Then leaving them alone to make the best-informed decisions so that the country’s goals can be accomplished.

          4. That the Chinese Government should view ‘profit’ as our governments view it. (“No amount of infrastructure efficiency increases can raise productivity without this freedom to profit.”). They don’t. They’re Communists. They see profits as stemming from the entire nation and being a harvestable, macro-manageable crop which must benefit the entire nation. Oddly enough, a lot of Chinese capitalists agree.

          • 1.) China appears to grow because of PBoC credit expansions and additional spending on infrastructure, but in reality none of this growth is real. We’ve seen this before, with Japan in the late 1980’s and the US in the mid 2000’s. Bubbles always end abruptly, either until what stimulus caused them is removed (like the US in 2001) or until it “blows off” on its own (the US in 2007). It’s true that monetary authorities can intervene and either reinflate a bubble or prolong it which makes the inevitable fallout that much worse, and this is what we see in China today.

            The Chinese state might appear stable, but the economic transitions that have to be made have major political consequences as it means the Party will no longer be able to dole out nearly as much patronage. The vast majority of managers at SOEs are directly appointed by the Party, that’s no accident. Add to this the Chinese banking system is already insolvent and under tremendous pressure to continue financing the multitude of unproductive SOEs and wasteful infrastructure/construction projects. They’re only able to continue at this because of shadow banking and massive accounting fraud. I doubt they can continue this for 5 years, let alone 10 years.

            2.) I doubt the infrastructure is 20% better than Germany’s in quantity, let alone quality. So much of the infrastructure projects are riddled with massive corruption that greatly reduces the quality with a more extreme example being the Shanghai Garbage Railway Bridge. I’d be surprised if it lasted for 30 years before needing to be redone.

            3.) The idea that economies can be managed is a Keynesian mirage. There have been many. many, many attempts at “managing” the economies of the world in the past 80+ years and all of them either ended in prolonged depressions (US in the 30’s & Japan today), inflationary disasters (US & UK in the 70’s, Latin America in the 80’s) or outright collapse (the Soviet Bloc). That’s a pretty sour track record if I’ve ever seen one.

            The idea that somehow the Chinese model is “unique” and that the Chinese are so special and so unique is fiction. The Chinese model has a long history going back to post war Japan and was used extensively in Latin America and in the Asian Tigers. Your arguements smacks of what the bulls used to say about Japan in the 1980’s, that they were so smart, electing only well informed geniuses and so special and they have all the answers etc. Well, their genius leadership ran them right off a cliff and because of counter-productive policy responses they still haven’t found their way out of it and may soon be heading for a sovereign debt crisis of massive proportions. Central planners do not and cannot know everything.

            4.) The communist view of the world has been tried in many countries, at one point 1/3 of the world’s population lived under some communist regime or another. Today, how many are left? Maybe 5? If it was really so successful then how come so few are left?

          • “Given that, we might profitably study aspects of Chinese governance, like only electing geniuses to their highest ranks. Then leaving them alone to make the best-informed decisions so that the country’s goals can be accomplished.”

            During a boom, all the leaders look like geniuses, when the bust finally comes, they are revealed to be emperors with no clothes on.

          • China’s real population has been estimated to be anywhere between 1.5 to 2 billion. this 1.3 figure always bandied about by the media is happy horseradish, IMHO.

        • Thanks Shelby,

          I would argue that China is still a high return economy. The return flows to government in tax and labour in wages. Both are growing strongly. It’s just firms that are struggling. Also, as I mention lower down infrastructure is about supply, not demand. This raises living standards, and slows inflation, but is deflationary and so hurts companies. China has plus 10% wage growth but low inflation: they’re removing supply bottlenecks.

          I agree that the middle class is the big road block for China. I just don’t believe that we are at that point. There is still so much to do in an economy where true urbanisation rates are closer to 35% than 50%.

          Ultimately, the utilitarian model China pursues will run up against people who are interested in more satisfying things. I see evidence in places along the east coast that we are there already. But politically, the centre and west are more important. Indeed, China, historically has been inward looking. I think Xi’an may be ultimately more important than Guangzhou and Shanghai in time. The east is resisting this.

          My views, I thank Michael for posting them.


          • One of Michael’s points has been that if the capital stock is much higher than is appropriate for the wage-level, then it is misallocation of capital. I think I read somewhere the declining marginal-utility-of-debt in China seems to be evidence of that– might even be negative now.

            Wages increase but rents increase faster. Michael had an entire blog post about how bulls look at nominals and miss the offsetting factor.

            There is no utility in having everyone copy each other. It makes for a very low fitness and low valued added economy, i.e. stuck at middle income export mercantile model. A high value added economy is one where individuals innovate unprogrammed by some xerox formula.

            The laws of economics are not different for Asia, just because they have an abundant supply of labor. What makes an economy run efficiently is finely-grained adaption. What makes an economy inefficient is top-down non-adaption. The longer an economy goes in one top-down direction, the more (and more difficult to genuinely start) its adjustment due to Olsen political capture (precisely the model you cite, but you think it is a positive because you forget the offsets).

            I am even more pessimistic than Michael from 2016 to 2020 or so, because I believe (admittedly I don’t meticulously scour the data though) there has been no change to release top-down control, rather using volatility and misdirection to sow confusion so that the trend of confidence will remain alive until its back is fully broken by a deep, sustained collapse. When the marginal-utility-of-debt goes negative, then doing more of the same accelerates the drop in GDP, even if volatility is used to hide that the trajectory hasn’t really changed.

            I am very optimistic about Asia as after it writes down the private debt chaotically. Chaos tends to break up top-down structures.

            P.S. If comparing to the laissez-faire USA in the 19th century, if I am not mistake, the USA was importing cheap immigrant labor and didn’t have a central bank. And there were a few depressions along the way.

            Apologies I wrote too much.

      • 1. You are simply pointing out that investment projects can have positive (or negative, by the way) externalities and then you assume that China’s positive externalities must exceed the net cost of the investment. That there are externalities is pretty obvious and very widely known, but the existence of externalities does not imply that they must exceed the cost of the investment or else all investment would by definition be positive for wealth creation, and that is patently false. This argument, by the way, was very popular in late 1980s Japan among those who insisted that japan would not have a slowdown.
        2. You don’t have to name the projects, simply identify the sectors, and then show how the system is likely to channel investment into that sector. Most people agree, for example, that SMEs can benefit from additional investing, but they have never been able to take advantage because the financial system is unable to fund SMEs efficiently. In principle if Beijing were to dismantle and radically transform the banking system, it might begin to do so (“might” being the operative word, because very few countries, and most of them democracies, have been able to channel funding effciently into SMEs), but no country has even been able to manage such a fundamental reform to its banking system without terrific pain.
        3. Sorry but this is meaningless. For thirty years the household consumption share has declined precisely because of the need to subsidize investment.

        • Thanks for the response Michael,

          1. Not sure Japan in the 1980s was the same. At that time Japan was a stock market, private investment story, rather than a public sector investment story. But either way, I will investigate government revenues in Japan at the time.

          The externalities, a word associated with soft benefits, are measurable, as I am concerned, in one way only. Tax revenues and wages. Both are rising faster (taxes) and as fast (wages) than nominal GDP. That’s real benefit for the economy and the investor, the public sector. If growth in either taxes or wages ends persistently (greater than a year), I lose.

          2. I would argue it’s a convergence story. Investment, as I argue, must occur to ensure higher levels of equality. The IMF identified a lack of investment, seen in low urbanisation, lack of access to employment and education as principal drivers of the high inequality that persists in China.

          The GS report I quote shows SMEs have actually lowered their leverage over the last five years. Happy to share with you.

          3. Yes, investment has outstripped consumption as a share of GDP but consumption has risen and is contributing 50% of growth at the moment. It would seem difficult to argue that the Chinese aren’t consuming more than they ever have and this growth is faster than comparable Ems from India through developing ASEAN and Lat Am.

          Please feel free to tell me to piss off.

          • –On the Japanese bubble….. Your comments remind me of a banking course I took in the early 90s. We learned that the top ten banks in the world were all Japanese. But in the end, the devil was in the details. They were allowed to dabble in real estate, and they marked their assets to market. So they pumped money in, inflating values, marked up their balance sheets, and started the process over again. Today, I believe, only two large banks remain in Japan, and they are frankenstein compilations of failed banks from when it all went bust.

            Are Chinese banks allowed to own real estate? If yes, are their real estate assets marked to market or held at cost?

    • You misunderstand my point, James. The fact that debt is concentrated in localized sectors of the economy is not relevant in arguing whether or not an unsustainable rise in debt is fundamental to the system, especially in China where credit creation is highly localized anyway because it it is directed through the banking system. Surging debt is almost always localized in one or a few sectors because in a system dependent on credit expansion, that credit expansion must take place in whichever sector offers the least resistance. The point is whether economic growth is dependent on faster growth in credit. Looking at the numbers it is hard to say that it isn’t.

    • JamesWhite: I read your piece and frankly I don’t think it answers any of Pettis’s three questions at all, which makes it very hard to refute because there isn’t much upon which anyone can agree or disagree. Your first answer is just an assertion that there might be externalities, so don’t worry, and especially don’t worry about the debt, in spite of the fact that never in any country has devbt risen so quickly without fueling bubbles. Your second answer is that you can’t answer the question but don’t need to (I think you are wrong there because it might be the most important bull argument). And your third answer is also of the “don’t worry, everything is ok” variety. Investment has grown at the expense of consumption for thirty years but now, miraculously, it will cause consumption to grow even faster. What is the mechanism that justifies this? Pettis has explained very clearly the link between rapid growth and growing imbalances (low wage growth, undervalued currency, low interest rates), and you have neither refuted him nor explained why that link will be reversed.

      • Hi Jeremy,

        As I said, the externalities are real, taxes and wages, and if they stop growing persistently I worry about China. Indeed, I’m not sure where you get low wage growth from? Part of the bear case recently has been China losing competitiveness from high wage growth…

        You’re right, I was flippant. Across the board, living costs are high relative to income. To persistently lower these costs requires investment. Transport is a really important one that constrains consumption across vast sectors of the population. High energy costs, high environmental costs, high water costs, can be solved by investment, given that you don’t want to constrain low levels of consumption even more.

        As I said above, investment has grown at the expense of consumption only in the sense there’s been more. But consumption growth is strong both in statistics and in observation of people’s lives.

        What I don’t understand is the logic that thinks saving, using the capital to invest in productive capacity so as to increase future consumption is a bad thing. To consume now is to deny future generations consumption. In a society that’s long term ageing, investing now would seem the wise thing to do.

        Again, if I’ve out stayed my welcome, happy to depart. I appreciate the forum.

        • to persistently lower these costs requires investment.

          No it requires not funding unproductive activities, so that there is less waste, so that those who are truly productive aren’t competing for the same resources against those who are not truly productive. Excessive debt hides who is truly productive, because the unproductive can forestall by rolling over the debt with more debt. This is why the marginal-utility-of-debt declines (and eventually negative), because new debt is servicing old debt.

          If you have a fly to kill in your house, you can either use a fly swatter (i.e. only fund the truly productive) or blow up the entire house (i.e. fund everyone with debt).

        • James, I am surprised you put so much emphasis on taxes. In China they are largely irrelevant because most fiscal expenditures are implemented through the banking system or, in the case of local governments, though the LGFVs. According to the IMF China, which I think runs a fiscal surplus or a very small deficit, has an “augmented” fiscal deficit, which doesn’t even include fiscal spending through the banks, only the hidden local government spending, of 10% of GDP. Other estimates put it as high as 25% of GDP, making a total mockery of th fiscal account. Unirule says that 70% of SOE profits consist of monopoly pricing, which is a hidden tax, and Michael has several times pointed out that the biggest taxes in China are the hidden taxes of financial repression, and undervalued currency, and pressures that keep wages from rising in line with productivity. I know a lot of people, including you, I think, argue that China is somehow different and special and cannot be judged on western standards (I think this is nonsense) and so it is very strange that in one of the real ways that Chinese practices differ from the Western practices, in the way it buries fiscal revenues and expenditures through its control of the banking system, you would assume that the fiscal account has the same meaning in China as it does in the West. Tax accounting in China tells us almost nothing.

          • Thanks very much for making this astute point.

            Unirule says that 70% of SOE profits consist of monopoly pricing, which is a hidden tax, and Michael has several times pointed out that the biggest taxes in China are the hidden taxes of financial repression, and undervalued currency, and pressures that keep wages from rising in line with productivity.

            Because this further’s my theory that Asia does not have the deeply ingrained socialism of the West, and thus Asia can grow much faster when the world economy bottoms after the write-down of the current massive global debt (warning: note as far I know, debt write-downs have not started yet, thus we haven’t seen anything yet w.r.t. to how severe the deflation is going to be!). These hidden taxes are not promises to a large constituency, such as is the case in the West. They are promise to a few elite. Much easier for a society to remove the elite, and than take an entire (50+% of the) population off of the social spending drug. It is important to understand how the Western socialism will end, from someone who has spent $100 million researching the relevant history.

        • Yes you’re right, consumption has grown strongly in the past few years — everybody knows this, by the way — but don’t you miss the point? The imbalance has nothing to do with the absolute speed of consumption or investment growth. It is all about the relative speed. China is unbalanced not because consumption hasn’t grown strongly but rather because it is only 35% of GDP. I don’t think there has ever been case in which consumption lagged GDP for thirty years, and so this is clearly a structural problem, and so far Michael has done the most convincing job of explaining why it is a structural problem. Frankly I thought nobody disagreed about this anymore.

    • “The US in the 19th C is very valuable. It is a time characterised by deflation and financial crisis but strong real economic growth. Pretty much where China is at.”
      Perhaps, but this strikes me as an extraordinary statement and certainly not something I, a total junkie when it comes to US economic history, would have thought, and, more importantly, it seems to me that you have already assumed your conclusions.

  9. Michael – I dabble in the financial blog world. In the past week I got hit by hackers and spammers. 21,000 spam messages in just a few days. It was a enough that Hostgator had to shut me down. A pain in the A to fix, and that means it cost money and time.

    So you’re not alone. I don’t think it’s the Chinese trying muck up our efforts. At least I hope not….

    Bruce Krasting

  10. Hi James,

    So just a clarifying question:
    The mechanism of “investment” is the one you have specificed on your website? Ei. investment leads to productivity growth which increases wages which again increases household income.
    Does it follow from this mechanism that increasing that the investment rate would have to be higher than the consumption rate (for example 12% growth in investment to create a 8% growth in consumption)? If so does this imply that you think investment could/should grow as a share of GDP in China over the coming years?

    Also regarding projects and sectors where this investment should happen, I was wondering, which specific political incentives are going to be driving investment towards productivity improving projects? Is it the “growth as an indicator for promotion for local politicians”?

    • Hi Tomas,

      The thing that strikes me about China is it’s a supply, not demand constrained economy. The investment is partly about boosting productivity, and it has. See wage growth. But the part that is as important is lowering costs in the economy: transport, living, health, education.

      I think investment can accelerate in China because so many key bottlenecks have been broken by investment.

      There is an imperative to invest in China. It creates political power both for officials but also the private sector.If you don’t want to invest, then you get the money out which is what many on the east coast are trying to do. The investment incentive is undoubtedly political and as long as the state runs a CAS then it can maintain such a system. This is also how China pursues convergence in a way other economies have failed because optimising the profits of an individual firm doesn’t always lead to optimal macro-economic outcomes.


    • Changing composition of expanding investment can require fewer workers who, even working at greater intensity, can not create sufficient labor value to perpetuate the expanding investment as capital — This can be transcyclic and lead in;to a period of over-accumulation of means of production and associated falling rate of economic profit even though there be ‘sufficient effective demand. Bank lending and/or State subsidies can [and have] provided what are in fact fictitious profit – all -seems- well but debt is accumulating.,leading, finally, into severe crisis which cannot be rectified via any additional credit [which itself is in ceisis].. The system winds down, often experiencing greater social-political ”incidents” which, if organized, provide f evidence of a pre-revolutionary condition, I do not see the outcome to be same as MP but more intensely transitional..

  11. What about the demographic issues China faces. From what I understand, China’s population maxes out either this year or next year. In around 15 years, the Chinese population demography literally falls off the cliff like no other nation we’ve ever seen before. Japan’s population demography is pretty bad, which has effectively turned their public debt issue into a Ponzi scheme, but in 15 years, China’s population demography will be much, much worse. When population growth goes from a positive to a negative like it will in China very shortly, how can even 5-6% growth rates be maintained.

  12. Once topic that you do not mention are China’s demographic issues. China’s population workforce is set to max out over the next 2-3 years while China’s population literally falls off a cliff in around 15 years. When you’re adding people to your workforce, it’s very easy to produce more and have higher growth rates(obviously). Once the Chinese population starts to fall, how can they even maintain 5-6% growth rates? On top of this, the Chinese economy has had increasing leverage which have added to GDP. Once the leverage stops increasing and the debt has to be financed, that will be another major drag on growth as the growth has to be paid back.

    Japan’s population demography has basically turned their public debt problem into a massive Ponzi scheme. In around 15 years, China’s population demography falls off a cliff; China’s population demography in that time will fall much faster and be much worse than Japan’s is right now. If you take into account the debts, the population demography, and the environmental consequences of such rapid growth, I don’t know how China doesn’t experience major, major issues over the next 20 years. In my opinion, it’ll be much, much worse than Japan today(and I think the Yen is going to crash in around 3-5 years because of Japan’s issues).

    • China may well have the worst demographics in the world, Suvy, but the problems they present tend to be long term and my focus is on the medium term because this is where China’s first great hurdle lies.

      • I’ve got kind of a different question, but I think it’s an important situation. What do you think will happen to the Chinese banking system? From the numbers I’ve looked at, the total assets of the Chinese banking system are in between 300-400% of GDP. Over the past few years, I think it’s been expanding at a rate of 50-75% of GDP the last couple of years, which is equivalent of the US pumping in $20 trillion through our banks in 3 years. If the banking system stops expanding at this rate, wouldn’t that be a massive demand hit? What tools do the Chinese have to get around this?

        I’m pretty sure the PBOC will have to print money, but we all know there is no free lunch. What are the possible impacts and negative ramifications of the PBOC resorting to money printing to solve all their problems? Is this what you think they’ll even do?

        I know that’s a lot of questions and some of them are kinda vague, but I’m just trying to figure this all out.

        Note: The numbers above are rough estimates from various sources of data that I’ve gathered. If there’s any mistake, please correct me.

        • Credit has expanded incredibly rapidly, and as far as I know there is no comparable case that did not end in some kind of debt crisis, but i do not expect a “collapse. As long as the implicit government guarantee is credible the banking system can survive, but it does mean many years of slow growth as debt is ground down.

  13. Perhaps those (myself included) who are worried about China have been wrong every single day, but it may just take years or even decades for them to be proven wrong. 🙂

  14. Great insights as always Michael. I want to come at the last issue you brought up from a different angle, regarding the unsustainability of economic models vs the timing of a change.

    While I enjoy thinking about economic models and history, many users of economics employ the dismal science to make predictions regarding business decisions. Particularly in the financial markets, analysis is usually binary in nature; buy or sell. It brings me to an oft quoted market saying, “Never confuse brains for a bull market”.

    I think most would agree that these trends can manifest for a long time before some sort of corrective action is observed – be it a pop in a credit bubble, a change in the feedback loop or something else. For this reason, as I think Michael likes to point out, analyzing economic models doesn’t always fit in a neat box or econometrics package and often relies more upon intuitive reasoning and understanding the fundamental relationships between economic variables, be it stock or flow accounts. Therefore you can have naive bulls who pound their chest and are proven right by the markets for a long time, only to have the folly of their reasoning undermined years later. But were the bulls really wrong?

    This line of thinking relates to a few similar arguments I heard regarding the US stock markets and the EU. Many bloggers and press today point to the high US unemployment rates, low GDP growth and soaring stock markets and conclude that the markets must be in a bubble, since economy is so ‘crap’. They are right that the economy is a slow growth on, but very much wrong on the stock market, which has been influenced by growing corporate profits and lax monetary policies.

    Similarly regarding the European Union there have been many who called the economic union a bad accident waiting to happen but who endured many years of insult before Greek default risk reared its head. And even now, when most realize the EU is a flawed design, can one really predict with confidence what will transpire?

    Businesses and financial markets need to make decisions about the future, with often incomplete information regarding future growth rates, returns and appropriate discount rates to account for risks. Flawed reasoning (perhaps related to the underlying economic growth model) can create feedback loops that influence these variables. But markets and people’s perceptions are whimsical things, and it is hard to predict the future course except under exception circumstances (ie the Nikkei or Nasdaq couldn’t keep up the growth rate forever) and even then, exact timing is impossible.
    So where does all this lead us, as I apologize for the lengthy comment. As Michael pointed out, analysis is not necessarily reality. But the great thing about this blog and I think Chinese leadership, is that people are willing to listen to new ideas, perhaps change their analysis and ultimately change reality. The more people realize the flaws in China’s growth model, the less likely it will prove disastrous as future decisions incorporate reduced expectations.

    PS: One last scatter brain thought. In the world of fiat currencies the bearish argument is easier to be made but harder to be realized.

    • “How is the stock market managing to levitate above a busted economy, where the sales growth of top companies can’t even keep up with nominal GDP? Part of the reason is leverage.

      The weighted average Return on Investment for the S&P 500 is slightly over 11%, and the cost of medium-term BBB borrowing (the average rating for the S&P 500) stands at just over 3%, thanks to the Fed’s quantitative easing program. In sectors where cash flows are annuity-like, e.g., consumers and utilities, it makes sense for companies to issue record amounts of bonds and buy back their own shares. That helps explain why earnings can continue to grow, at least modestly, even though revenues appear to have fallen by nearly 1% during the first quarter.

      Here’s a simple example. Suppose you and a partner jointly invested $100,000 in a business that earns $10,000 a year. You each have $50,000 in capital, and take out $5,000, for a return of 10% a year. If Ben Bernanke will lend you money at 3% to buy out your partner, you will now make $10,000 on your capital of $5,000, minus the interest expense (3% of $50,000, or $1,500). You earn $8,500 net on a $50,000 investment, or a 17% rate of return.

      You would do that trade all day if you could. Thanks to the Fed, large U.S. companies can, and do. The cost of BBB-rated bonds (the average credit rating of the S&P 500) is at an all-time low of 3%. And the average return on investment for the S&P 500 is around 11%. ”

    • “This line of thinking relates to a few similar arguments I heard regarding the US stock markets and the EU. Many bloggers and press today point to the high US unemployment rates, low GDP growth and soaring stock markets and conclude that the markets must be in a bubble, since economy is so ‘crap’. They are right that the economy is a slow growth on, but very much wrong on the stock market, which has been influenced by growing corporate profits and lax monetary policies.”

      Lax monetary policies CAUSE bubbles, especially asset inflation. We’ve seen this before, in mid to late 1980’s Japan, in late 1990’s US and again in the 2000’s around the world. Excess credit always looks for a home, a place where it can get a return.

    • That is why it probably makes sense to specify whether you are trying to understand the economy or predict the markets. These are two very different things and it doesn’t help when people misinterpret those who are doing the former as doing the latter.

      • Armstrong’s ECM model apparently does both (c.f. my comments downthread for supporting evidence), and makes the case that the two are inseparable.

        Well I understand your point that economics determines efficiency and outcome, which drives where capital will flow. Yet humans don’t operate based only on economics, and rather overshoot on the uneconomic, thus CONFIDENCE and markets are the driving force, although the friction (inertia) is the uneconomic. Inertia is what causes waves, i.e. cycles.

    • “debt-driven buy-backs of corporate shares running at a $400bn annual rate. Leveraged buy-outs are back in vogue. Junk bond yields are near record lows. ”

  15. @Shelby: The tax rate in the US hasn’t gone up, it’s gone down. In the 1950’s the top end rate was 90% and the middle class had high tax rates too. And besides, Rome turned into an oppressive empire and still lasted for 400 years. I’m really not seeing much evidence to support your conclusion. Also like I said, declinist rhetoric is nothing new.

    • Sorry, you couldn’t have been more wrong.

      I was including Europe, which has insanely high rates of taxation.

      USA income and capital gains taxes are on the way back up (and that doesn’t include that caps on FICA do not adjust higher as fast as true inflation), the investment tax and regulation costs (hidden tax) in Obamacare starts next year, and Obama wants more. Property taxes so high, you can’t own your house (property taxes were minuscule in the 1950s). There are many hidden taxes due to regulation that did not exist in the 1950s. There has been a 1250% increase in taxation for a family of 4 since 1948.

      • I wasn’t including Europe because the discussion was about a potential handoff from the US. Everyone knows Europe is only a shell of its former self in a lot of ways (sorry Michael).

        1.) I don’t see how regulation can be considered more today than it used to be, in the 1950’s all of the excess regulation from the New Deal was still in place and would remain that way until the late 1970’s when the deregulation reforms were started. One of these was the AT&T telephone monopoly that charged a fortune for long distance.

        2.) Property taxes are not determined by the federal government, they are state and local. While it is true that some states do have high property taxes, others do not.

        3.) The capital gains tax is 15%, in the 50’s it was 25%. So again, taxes have gone down, not up.

        4.) Was that 1250% taxation increase adjusted for inflation? Did that include state and local, or just federal? Was it a family of 4 from the upper class or the middle class? You’ll need to do better than that.

        • 1) I provided a link upthread about telcom monopolies give us slow internet in the USA. Regulation has multiplied and now touches every small business, as explained in the link I provided. Indeed, the New Deal launched many of the programs we have today, but now the programs are pathological, e.g. you can’t build on your land because the federal government makes some environmental ruling about an insect or otherwise comes to steal your rural land. Google “sheriff stops federal government” and there is a lot more in that rabbit hole than I care to detail here.

          2) The low property tax percentages (you’ve got state + local schools, etc) are mostly if you live far from civilization where the opportunities for employment are much less. And either property taxes and/or sales taxes will be skyrocketing because the state and local governments are under severe financial stress which will get worse (the demographics of the USA are not improving any time soon, and many retirements to pay).

          3) In the 1950s, nearly no one paid capital gains, mostly only corporations. Now a significant percent of the population are investors, e.g. their 401k plan, etc.. I already provided a link in prior comment that capital gains is increasing from 15% to 18.8% under Obamacare, and dividends are no longer taxed as capital gains rather as income where the top rate is increasing from 33% to 35%. In 1950s, dividends were not taxed as income. Note capital gains on gold is taxed at 28% and you are going to need gold to maintain your net worth after 2016.

          4) You fail to assimilate that most Americans weren’t paying much tax back then. Did you just ignore the data in the link I provided as quoted below?

          Federal Tax Rates up 1,250% for Families of 4
          This chart compares the federal income tax rate for 1994 with that of 1948 for a family of 4 at median income level. (data: Family Research Council, reported October 1996 by presidential candidate Steve Forbes, Impris)

          The tax rate has jumped from 2% to 25% – – an increase in tax rates of 1,250%.

        • Nearly no one paid the top bracket income tax rates in the 1950s. There wasn’t an Alternative Minimum Tax as we have now at 20%, so used loopholes to avoid paying any tax. And the middle class was only paying 2%.

          Also the regressive sales taxes we have today were progressive back then, meaning again that most people didn’t pay them (or the top rate). And the highest rate I’ve found is 3% with most at 2% or less (and most weren’t even paying that) and some locales have over 10% now.

          Although it is true that we have a huge underbelly that pays no tax (used to support leftist arguments that taxes are low), that socialism is exactly what it going to tax the middle class into extinction over the next decade as the fiscal situation deteriorates as more boomers retire and interest rates rise.

          When Reagan lowered taxes, they also closed many of the loopholes and deductions that were available to the middle class.

          A google search for “Hauser’s law” brings up a relevant historical chart showing that those top tax brackets in the 1950s weren’t being paid.

    • Pottery records indicate that production continued to increase into 5th century, but then the rate of clearing and expedient farming methods to keep up with the tax and debt reached the point where soils collapsed, irrigation was polluted, and the economy collapsed. We will know the true condition of the USA when interest rates rise several percentage points (by 2016) and then eventually to double-digits. Don’t forget a $quadrillion in interest rate swap derivatives, and those have been moved in front of bond holders and depositors when bankruptcy hits. Note the Fed is privately telling banks there will be no more bailouts. Ditto Europe is preparing for bail-ins, over $100,000 is gone (and if you take it out now there will be clawbacks), and under $100,000 will be limited to 100-200 euros withdrawal per day. After that reduction in money velocity crashes Europe, they will have to make the capital controls even more severe.

  16. Great analysis! Michael – what about bad debts? If the economy slows, wouldn’t bad debts in the financial system become a big problem? Can the government recapitalize all the banks and fill the holes in local government finances?

  17. My wife is from Chengdu, and we’ve gone back to visit her family the last three years. The amount of wasted investment visible is incredible. There are new highspeed rail lines under construction; they are built on high viaducts, not at ground level (to save agricultural land?), so the construction cost is very high and future maintenance will also cost much much more. Because the tracks are well above ground the stations are all gargantuan multistory buildings. My stepson says the new highspeed suburban lines also charge less than busses, so the government is losing tax revenues from the busses while also losing money on highspeed rail. Tickets on the long distance highspeed trains will cost more than ordinary Chinese can afford.
    There is a new Hi-Tech Center on the south side of Chengdu, with an immense central building (in January it was surrounded by dozens of barracks for construction workers). This is at the same time that office buildings less than a year old near the center look to be less than half occupied. My stepson said that in the new apartment/condominium tower where he used to live a small company is renting an apartment to save money on office space. Commercial real estate must be a disaster.
    When I rode the train from Lhasa to Beijing (a wonderful train ride, highly recommended) they were replacing most of the line west of Xining, where it descends from the Tibetan plateau, with a new line with lots of tunnels and viaducts. Since the only visible freight traffic was coal, going downhill, and there wasn’t that much of it, it didn’t seem economically justified (or in an engineering sense either, as it looked to be shortening the line which would increase the gradient – the opposite of Horsehoe Curve or Tehachapi loop here in the U.S.). The strangest sight was at Nagqu, a boomtown literally in the middle of nowhere on the Tibetan plateau, with huge warehouses next to the railroad.
    It just doesn’t make any sense at all. Jim Chanos is absolutely right.

    • You know, I have to wonder about their high speed rail lines. Are any of them anywhere near breaking even, let alone making a profit?

    • a developer called Exhibition & Travel Group has just built the largest building in the world in Chendu. it’s called New Century Global Center. 1.7 million square meters of commercial space. it has the world’s largest indoor beach, a 500 meter long rafting river, an Imax cinema, hotels, shops, restaurants… it even has its own sun (no joke), based on Japanese technology. just the thing for that 10 month a year grey Chengdu smog. watch the Youtube promo video for this project and you will see something truly bizarre…

      there is quite a good correlation in various countries of impressive new buildings as being a leading indicator of future financial implosions…

      meanwhile Tianjin plans to build 10 million square meters of new office space… Sydney has about 5 million m2 of office space… Bangkok 8 million m2… it has taken 16 years for Bangkok to soak up the overbuilding from their pre-1997 skyscraper construction spree.

  18. I don’t know if China will ever get household spending up as long as they have a health care system like they have. How can you ask someone to buy a washing machine if their savings can literally be the difference between life and death?

  19. Michael,
    I find your analysis compelling, but I’m curious what specific policies you would recommend the Chinese government take to transition from the current growth model (and thereby avoid the inevitable debt crisis). It’s one thing to say that household income growth should eclipse GDP growth, but what would that actually look like?

    • I have discussed it many times, Juan, and it will be much further discussed in my new book coming out in September. In brief, the best thing to do economically (although the most difficult politically) is to transfer assets from the state sector to the household sector.

  20. Michael

    I have been following this space and other Chinese commentators for a while. I see what you mean by changing debate and these analysts just need to read their earlier articles to see what they had written. Most of them ‘change colors’ and continue to write as if they are the china experts.

    I don’t find much reason to be optimistic about change in Chinese growth model. The first step would have been to improve the quality of data, specially after the spectacular change in the trade data. On the data side too little is being done and too slow. There are too many frequent talks and quasi-commitment to maintain a minimum growth floor (which is being quoted as 7 – 7.5%) which is like cornering yourself.

    I think the efforts to transform the economy will get derailed. Every comment on fixing the economy is followed by a pledge to maintain a minimum growth rate. The resolve seems pretty weak to me.

    As for the debate, for a casual observer, bulls may still end up looking good/ok for next 2 years as they adjust their growth rate slowly and follow the party rather than economics.

  21. I’m pretty sure China is going down, and that it will prompt a major economic collapse in SE Asia too. SE Asia is currently in its biggest boom ever, from what I can see, from Singapore to Malaysia to Indonesia to Thailand to Cambodia to Laos etc. giant condo projects are announced every few days and sell out tp speculators in a weekend. Thai guys are buying shiny new pickup trucks at a rate that would make an Alabama redneck scratch his ears. New Range Rovers and Hummers almost outnumber the beggars in downtown Phnom Penh. All of SE Asia is on steroids. Most of the reason is China and central bank money-printing worldwide.

    Thailand had 91 finance companies before the crash in 97. a year later 56 of them were declared insolvent and shut down by the Thai authorities. across the Thai banking sector, NPLs were at least 45%. my guess is China will follow a similar path, but probably worse. the 10,000 LGFVs alone are a recipe for disaster.

    China has a $25 trillion credit bubble. there is not a hope in hell of this deflating gently. I don’t believe in fairy tales.

    • I was reading the Philippines Inquirer news section on some days earlier this year, and nearly every time I read about some bond issue by a corporation denominated in dollars (e.g. MegaWorld, Ayala Land, San Miquel, etc). My hypothesis is that QE sat at the Fed but it raised the reserves of the banks allowing them to loan out more money, but this doesn’t show up in Western credit increases rather somehow the loans are ending up in the developing world. Or it could just be investors seeking higher yield due ZIRP in the West. I read from Martin Armstrong that this was going on in Latin America too.

      But now the Great Rotation has started and capital is rushing back into the dollar, USA housing, USA equities, and as this drive USA interest rates higher, then it has a spiraling upwards feedback because potential home buyers rush to lock in the rates before the rise more, international investors (escaping coming capital controls in Europe and depreciating Yen due Abeconomics) rush to grab higher rates with an appreciating dollar, and domestic investors jump on the bandwagon (noticing that the recovery in equities since the 2008 crash is now more than just a recovery given new all-time highs).

      This rotation is also pushed by declining GDP in China, Europe, and thus rest of the developing world which feeds commodities and manufacturing inputs (notice a deadcat bounce in copper, gold, and stall in USA equities since China released better data past week).

      This rotation thus reveals the developing world is short the dollar (they owe dollars) while their currencies decline relative to the dollar due to this shift in capital flows. This will bring the developing world to its knees between now and the end of 2015, while the USA non-bond (except high yield) assets and dollar will be skyrocketing. Yet simultaneously this rise in USA interest rates and dollar will be choking the real economy (along with Obamacare tax rises coming 2014 and plans for more increases), thus in 2016 we will likely see the USA economy roll over, as Europe, Japan, and the developing world will likely already be sinking into the abyss by 2015 (c.f. my upthread post on the net liabilities of Germany, France, USA, and UK greater than the PIIGS although this is hidden in accounting gimmicks, also German and French banks are bankrupt, again hidden in accounting gymnastics).

      Michael offered his calculations on China in an email to Mish Shedlock. The problem is those calculations don’t factor in a 30 – 50% contraction (contagion) in global trade.

      Face it, the world is bankrupt financially (maybe not in human and real capital in the countries with much youth but the write-down can be chaotic). Fasten your seat belts. Giant Portobello ahead.

      • Armstrong’s ECM (Economic Confidence Model) is global (and based on time multiples of Pi, i.e. 224 yrs ≈ 78 yrs x 3.1459, 78 yrs ≈ 26 yrs x 3.1459, 26 yrs ≈ 8.6 yrs x 3.1459, 8.6 yrs ≈ 1000 x 3.1459 days) and it expected the turn downward and shift of exodus capital flows to accelerate Aug 7, 2013. Right on time on Aug 7, Europe decided that depositors will only be able to withdraw 100 Euros per day when a bank is bailed-in. Imagine the collapse in monetary velocity thus GDP upon widepread bail-ins. I’ve read that banks’ trading losses have priority in bankruptcy ahead of bank investors and depositors.

      • Armstrong arrived at this ECM model with the scientific method by back testing the hypothesis to all recorded history (even spending $100 million to obtain the data and build the computer model) and then to the future, and has been more accurate than any other forecaster. I have not been able to find one forecast from him since the 1980s that didn’t come true. Predicted the Sept 2000 market top, Nov 2002 market bottom, January 1st, 2005 yearly high for the NASDAQ to exact day in document that was published in 1997 which also predicted the 2007 market top and earlier had predicted the upturn in commodities in 1977. Predicted back in Jan. 2012 that gold would decline from $1600 to below $1200 before 2015 even while everyone was screaming he was nuts. This year he was writing a blog every few days shouting that gold was going to fall. The goldbugs hated him. He predicted the top in gold in 1980. He predicted the crash of 1987 (to the day!) and that bull market in Japan would continue until end 1989. His model predicted an event something like 9/11 would happen, etc, etc, etc..

      • Clif Droke wrote an article challenging the Great Rotation based on the Kondratieff wave, while explaining why the divergences in the USA equities are largely an exodus from low yield muni-bond funds. Thus the net capital ingress is much higher than he realizes as it is obscured by an egress which is funding the ingress. Kondratieff only used data from when the economy was primarily agarian and thus commodities. Unlike Armstrong who gathered data from 10,000 B.C. until now, the Kondratieff wave is only valid for commodities and thus yes gold won’t likely bottom until 2014 (under $1050). Yet the ECM model sees the DJIA doubling (after a dip now due to deadcat bounce in China) by 2015.75.

        I know this blog is not about speculation predictions, yet what I am writing about here is the model for the unraveling dominoes order of the coming global contagion, i.e. the international capital flows. Herbert Hoover wrote about the Great Depression, it was as if capital where chairs on the deck of the Titantic, rushing from side-to-side of the global economy unable to find a safe haven and real growth. This is what happens with ZIRP and sovereign debt end game all through out history. This pattern repeats as Michael wrote in his blog about “Globalization”. The ECM quantifies the timing of the (business, political, technology) cycles.

        Why does energy transfer in waves and why does human action occur in waves (i.e. cycles)? Michael possesses a physics background so he can readily appreciate inertia, acceleration and force. For example, if you push on a twig then you increase the force until it breaks. If you put too much force on a thick enough twig, you fall down as it breaks and your inertia pulls you forward. Then you recoil, i.e. a wave. Everything in the universe has an inertia, including every human and thus human action. My blog is linked on my name and I wrote more about this in The Universe.

    • China’s debt problem is probably greatly exaggerated. First of all, all the debt is domestic. It does not really matter that much to begin with. Second, China has $4 trillion plus domestic savings, as well as $3.4 trillion FX reserve, plus a couple thousand tons of gold the government has accumulated over the past couple of years. Third, Chinese economy still grows quite fast as a large economic entity when compared to other countries, which will relieve the debt problem. With SOE and financial reforms, plus the stimulus of relaxing the one child policy, China probably can grow relatively fast for at least one more decade. Finally, just by implementing a real estate tax nation wide in earnest, while reducing income, VAT, and other taxes, will eventually burst the real estate bubble, but secures government income at the same time.

      • seatrus, michael pettis has answered these questions so many times that i am sure i can answer them without problem.
        1, if the debt is domestic and not foreign just means that all the losses will be borne by chinese and not by foreigners. why is that better? to say it doesn’t mater is crazy. i guess because all the US debt in the 1920s, the russian debt in the 1960s, and the japanse debt in the 1980s, was domestic, it means to you that none of these countries had debt problems. can you really think this is true?
        2. the amount of domestic savings will not change the fact that the savings were wasted and that the losses have been hidden, and if you say that the people’s bank has $3.4 trillion in reserves why do you not also say that it has more than $3.4 trillion dollars in debt. is it only the assets that matter when thinking about debt, and not the debt? that is a very funny way of thinking about debt.
        3. if you want to argue that china will not slow down because of its debt problems you cannot do so just by predicting that it will grow fast. this is what pettis calls assuming your conclusion, and among logical people it is not an acceptable argument.
        4. of course raising taxes can pay the debt, but that is all any government can do to pay debt. this is nothing new. last time we had a debt crisis they paid for it by hidden taxes (keeping the real interest rate negative). but if we use high taxes to pay all of this enormous debt, then how can people spend money on other things? how can consumption grow enough to make the GDP grow?

        • 1. The debt can be monetized if it is all domestic. I know it’s a cost someone must bear. But it’s just part of the cost of a rapidly growing economy, like pollution. Some waste is unavoidable: no pain, no gain. It’s a problem, a big one maybe, but it is probably quite manageable, different from a crisis. Bad debt/overinvestment concentrate on some sectors, not a wide, cross-sectional phenomenon. Most areas of China still needs a lot of investment, the situation is totally different from Japan in 1990, which had been fully developed by that time. A few ghost cities among 700 Chinese cities, of which 450 have populations greater than 500,000, all of them needs maintenance and improvement, the cost is just a drop in a bucket.

          2. I do not say the government is $3.4 trillion in debt for the same reason as 1: it has been monetized. Relatively rapid growth in economy and slow to moderate increase in inflation will take care of things.

          3. China will slow down, from 9-10% to 7-8% growth, a number most economic institutions predict. Slower growth is of course possible. But it won’t last long, maybe over a couple of quarters.

          4. Increase in land and real estate value is a huge untapped reservoir of fortune. Since the government needs to pop the real estate bubble, adding real estate tax will be a win-win for both the debt and bubble problems. Note that after adding real estate tax, income tax, sales tax etc can all go down or even be eliminated altogether, which will definitely increase economic activity.

          • 1.) Yes the debt can be monetized if it domestic, but if you have a large amount the result is usually a hyperinflation. This is what Latin America did in the 80’s and what Argentina did again immediately after its default in 2001 when it couldn’t borrow from abroad anymore. Contrary to what Krugman and the like may have us believe, debt monetization carries some very real risks, especially with such large amounts.

            I’ll also point out that just because bad debt is concentrated in some sections doesn’t mean the overhang won’t spill over into the rest of the economy, 2007 should have proven that it does.

            A country doesn’t need to be fully developed to have a crisis like this. Latin America had an eerily similar experience in the 70’s.

            2.) As far as I can recall all the banks in China are state owned, and considering those infrastructure projects are financed with bank loans, I would say yes it is government debt. I also don’t see where this “rapid growth” is going to come from, exports reached their peak years ago and the Chinese consumer is still largely absent. Where the growth has been coming from now is more infrastructure spending, which means more debt. Since they won’t be able to lend like they have been, I really don’t see an easy way out, especially in the context of a poorly performing global economy that is also undergoing a major restructuring.

            3.) Most economic institutions did not predict the end of the dot com bubble and again did not predict the financial crisis in 2007. Most institutions have a proven track record of failing to recognize the existence of credit bubbles and then failing to recognize the effects the inevitable bursting might have. I’ve never heard of a major banking crisis that lead to growth being restored in just a couple of quarters. This time is not different.

            4.) The increase in property values is fictional, and will collapse. Just like it has to some degree in the US in recent years (and I would argue will go down further) and Japan after their bubble burst. In fact in Japan real estate is down by 75% or more. I don’t see any major growth coming out of China once it slows down for a very long time. How long depends on whether or not they adopt counter productive policies like Keynesian “interventions” (Japan) or Monetarist serial bubble making (US).

      • all the debt is domestic. It does not really matter that much

        Not paying people back still bankrupts them thus collapsing economic activity.

        Domestic only affords the ability to spread the losses around to all the population by the government, but default (due to negative marginal-utility-of-debt I mentioned upthread) still incurs the destruction of malinvestment that exists due to the negative marginal-utility-of-debt.

        You are arguing that wasting resources is free. Nonsense.

        China’s debt problem is probably greatly exaggerated.

        No the official figures understate by at least 60%, and the true ratio is approaching 200% of GDP.[1]

        Also apparently this doesn’t include the widespread practice of loans from (often elderly) relatives to buy a house in order to get married.

        $4 trillion plus domestic savings, as well as $3.4 trillion FX reserve

        GDP is $7 trillion, and so debt is over $14 trillion. The FX reserves it will need to use to transition to a consumer economy with a higher ratio of imports to exports.

        plus a couple thousand tons of gold

        32,150 troy ounces per tonne. Thus 64 million x $1300 = $0.08 trillion

        [1] Sober Look .com’s “PBoC’s cold turkey approach to China’s credit addiction”

        Chinese economy still grows quite fast as a large economic entity when compared to other countries

        See my link upthread to Michael’s calculations. Export growth has to stall or go negative to get rebalancing, and that is not even factoring a possible loss in global demand due to global sovereign debt contagion.

        secures government income at the same time

        Government income is not the problem, rather the opposite in that more of the income has to be shared with the broad population so they can consume more.

        stimulus of relaxing the one child policy, China probably can grow relatively fast for at least one more decade

        Children don’t stimulate the economy until they reach working age at least (and prime consuming years are in the 30s).

        • “You are arguing that wasting resources is free. Nonsense.”

          – No. I said the waste was unavoidable in a rapidly developing economy, and the burden is manageable/affordable.

          “No the official figures understate by at least 60%, and the true ratio is approaching 200% of GDP.[1]

          Also apparently this doesn’t include the widespread practice of loans from (often elderly) relatives to buy a house in order to get married.”

          – Numbers like these are not very useful. Some say Chinese GDP is a trillion short of the published number because of the understatement of inflation. Others say that the U.S. GDP is really only half of the stated number also because underestimating the inflation.

          “32,150 troy ounces per tonne. Thus 64 million x $1300 = $0.08 trillion”

          – The real number is probably 3x bigger because the real gold reserve in China now is probably >6,000 tons. $1,300/oz is low anyway. The thing is, China’s FX reserve remains at $3.4 trillions, not reduced by 250 billion.

          “See my link upthread to Michael’s calculations. Export growth has to stall or go negative to get rebalancing, and that is not even factoring a possible loss in global demand due to global sovereign debt contagion.”

          – Export is about 2.8% of China’s GDP in 2012. Negative growth alone does not mean trade deficit.

          “Government income is not the problem, rather the opposite in that more of the income has to be shared with the broad population so they can consume more.”

          – It will be a problem as economy slows down and debt increases. Income and sales tax will be reduced or even abolished completely once real estate tax is in place.

          “Children don’t stimulate the economy until they reach working age at least (and prime consuming years are in the 30s).”

          – Moderate short term effects will show up, while positive effects will be obvious on both the economy and demography long termly.

          • Seatrus et al,

            -On Real Estate taxes. There is no doubt that in the long run real estate taxes will help moderate any real estate bubble. Real estate taxes increase the cost of holding the asset for speculative purposes, forcing the owner to rent the property thus increases usable supply of housing. BUT…. imposing taxation of real estate at a level that would accomplish such a goal, on the Chinese middle class… would cause social stability problems. And low levels of real estate tax, that exist in places like Kuala Lumpur, do nothing to solve the “dark building” problem. Conclusion, this is a good solution for China in the long term, but will not help China in the next ten years.

            -There is a problem with statistics in China for sure. And we have variations in data from country to country. But some countries don’t consider the raw data a state secret. The statistics bureaus are kept honest by the thousands of grad students in economics doing their part to save the world. It’s difficult to accept your comparison to American statistics, when I can download the price of bananas from Albuquerque, New Mexico that was used to formulate US inflation. But… can I download the price of peaches in Dalian? Do we know if peaches are in the basket? (am I wrong?)

          • In the future, I suggest you use the <blockquote> and </blockquote> tags around your quotes, so they appear indented as I do.

            Some say Chinese GDP is a trillion short of the published number because of the understatement of inflation.

            Understating the deflator (inflation), makes the GDP appear higher than it is, not the vice versa as you erroneously assume. Basic math skills are required to even begin to understand economics. We can estimate the real GDP looking at electricity consumption, rail freight, etc.. Indications are that it is lower than the claim 7%.

            And GDP does not account for the waste due to debt. The effect is only see in collapsing GDP when the Minsky moment arrives.

            Export is about 2.8% of China’s GDP in 2012.

            I had a typo. Michael’s calculations refer to fixed capital investment, not just exports. It is currently roughly 50% of the GDP.

            It will be a problem as economy slows down and debt increases.

            You entirely missed the point, which is that marginal-utility-of-debt will be negative in China until the economy rebalances from fixed capital investment to consumption. The ONLY way to get there, is to share more of the income with the broad population. The government income is irrelevant to fundamental issue facing China.

            I know you don’t have clue about what I am saying, and you don’t even understand Michael’s basic thesis on China.

            demography long termly

            This has no bearing whatsoever on the fundamental issue facing China now until 2033. Ending the one-child policy immediately would be a good thing to do for results after 2033, and it would be a very astute political move although it might embolden the middle class to push for more (which is why I suspect they are going slow, also because there is a vested interest, i.e. inertia, in taking bribes and enforcing the regulation).

  22. Thanks Michael – bringing some sense into te debate as usual. Just wondering if you have a view on why steel production seems to be outpacing economic growth – and where is it all going?

  23. Understating the deflator (inflation), makes the GDP appear higher than it is, not the vice versa as you erroneously assume. Basic math skills are required to even begin to understand economics. We can estimate the real GDP looking at electricity consumption, rail freight, etc.. Indications are that it is lower than the claim 7%.

    What basic math? There is nothing wrong with what I said. Metrics? Service PMI > 50, car sales broke 10 millions for the first half of the year, CO2 emission at all time high, credit still expanding albeit at a lower rate, I just don’t see how you can be so sure that real growth is below 7%.

    You entirely missed the point, which is that marginal-utility-of-debt will be negative in China until the economy rebalances from fixed capital investment to consumption. The ONLY way to get there, is to share more of the income with the broad population. The government income is irrelevant to fundamental issue facing China.

    China will be balancing. But all investment doesn’t need to stop. Investment will be reduced, but may still remain relative high. That’s why China’s economic growth is slowing down from 9-10% to 7-8%. What do you mean the only way? Government can boost spending on healthcare, welfare, and education substantially, which in turn increase consumption. Breaking the SOE-bank complex and SOE monopolies, starting a new round of privatization, reforming the financial institutions so small and medium business can get sufficient capital to flourish, and abolishing the one-child policy, there are myriad ways to keep China’s economy growing.

    • Service PMI > 50, car sales broke 10 millions for the first half of the year, CO2 emission at all time high, credit still expanding albeit at a lower rate, I just don’t see how you can be so sure that real growth is below 7%.

      You need to look up the economics definition of real. All the examples you provided are nominals, not adjusted by the deflator.

      Investment will be reduced, but may still remain relative high.

      I guess you did not read the link to Michael’s calculations.

  24. Came across this People’s Daily article yesterday. Seems to illustrate your arguments re quick fix administrative measures:

    人民日报:新一轮投资与当年“4万亿”不同 不会浪费

    In any event, I continue to think that yours are the most convincing analyses of the Chinese economy and its relationship to the global economy as a whole, not least for their intellectual honesty in an environment where agendas and straw man arguments (e.g., the stopped clock) all too often seem to carry the day, among both so-called “bulls” and so-called “bears.” Hope the viagra problem is resolved!

  25. I’ve also been meaning to ask you if you could take a minute to respond to this, from John Ross’s (of Renda) blog:

    “The reason for such inaccurate predictions is that Michael Pettis makes, as shown in his book The Great Rebalancing, one of the oldest errors in economics – underconsumptionism, that is the confusion of demand (consumption plus investment) with consumption. He himself lists in the opening pages a whole series of underconsumptionist authors.”

    I’m not an economists, but it seems pretty bold to me. I figured that if you were really making “one of the oldest errors in economics,” I would have heard about it a long time ago…

    • I won’t presume to speak for the professor, but it seems really dumb to consider GDP growth something worth celebrating without caring about where the GDP growth comes from. Ross says the US should be thrilled to have Chinese levels of growth. Well, if they built 10,000 miles of new expressways every year, or 100m tons of new steel making capacity, I’m sure they could. Nevermind they might never be used, the GDP growth numbers will be awesome.

      Ross’s reasoning is so overly simple I feel like there’s got to be something else he’s asking us to assume. If China hits its “100% GDP growth” target but all the banks are bankrupt and there’s overcapacity in every sector, would Ross still be impressed?

    • When Pettis said China would be the last major economy to emerge from the crisis, he didn’t say its growth rate would necessarily drop below that of the US, and I think it is typical of Ross’s dishonesty that he claims that Pettis did. As I see it, the US has finally bottomed out and may be in the process of recovering from the crisis. China has postponed its adjustment by the massive investment boom, and we are now starting to see the first impact on China of the crisis. To say that the US is starting to merge from the crisis while China hasn’t yet, as Pettis argued would happen and which Ross strongly denied (he denied that there even would be an impact on China), sounds not only a good prediction, but I think it has already come to pass. I don’t think it is right for Ross to make up for getting it completely wrong by changing what Pettis said. Fair is fair, guys, and instead of trying to get out of it he should just recognize that he doesn’t really understand what is happening in China.

    • I think this is just typical Ross posturing in the hopes of getting someone to notice him. He had stopped chasing Pettis around in the hopes that someone would notice him after his extraordinary claim that the US was pressuring China to revalue the RMB not because of trade considerations but because of a “conspiracy” (as a former Trotskyite Ross is especially good as discovering ruling class conspiracies) to reduce the amount of money the US owned China. After Pettis showed how incredibly dumb that statement just from an arithmetical point of view was, he sort of disappeared for a while, but is starting to show up again in Pettis’ shadow.
      The truth is that at every point that I can remember in which Ross has insisted how wrong Pettis is, it turned out that he was right and Ross completely wrong. I participated in some of those debates many years ago and I remember how absurd his arguments turned out to be. The main difference between Ross and the other super-excited Chinese bulls of a few years ago is that as far as I can see even the bulls don’t take him seriously.
      To get back to his “”refutation”. where exactly does Pettis confuse consumption with consumption+investment? Most of what Pettis has written about China is all about the distinction between consumption and investment, and, more importantly, about what is and what isn’t sustainable demand.
      Ross is a bit of a joke, in my humble opinion, and just because he wants to be taken seriously doesn’t mean that anyone should pay attention. For that to happen IMHO he would first have to have gotten something right one or two times.

    • @J:

      As I see it, the US has finally bottomed out and may be in the process of recovering from the crisis.

      The jobs created are part-time and low-paid. I explained upthread that this is really just a cycle of speculative capital moving into the dollar and US assets to escape Europe, Japan, and the BRICs which have topped out already. At the endgame of this global sovereign debt crisis as it spiral the toilet bowl, capital comes back home to where it was created. On Exter’s Inverted Pyramid, the reserve currency sits right above gold. In every cycle of globalization, first the capital moves out to the periphery, then at the end it returns home before the big implosion.

      Note Europe is deadcat bouncing because I read the Fed deposited $1.3 trillion in European banks in July. If true, that is enough to explain the illogical rise of the Euro recently. Now watch this $1.3 trillion come rushing back home. 2014-5 is going to eventful 8-(


      IMHO he would first have to have gotten something right one or two times.

      A broken clock does better than that every day without fail.

  26. Michael ,

    I´m a big Latin American Fan, I red Your last 2 books and I loved them…. PLEASE : Release a Kindle version of your new work on time! For most people in Latin countries who can´t travel thats the only way to read your books!

  27. you are actually a just right webmaster.

    The website loading speed is incredible. It
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  28. Unfortunately, the “stopped clock” brigade are right, because the true test of a theory is its predictive power.

    Pettis: “An analysis that points to an unsustainable trend is always right if the trend turned out indeed to be unsustainable.”
    Not really, because literally every trend is unsustainable. The UK is exporting more to Europe? That’s unsustainable, otherwise it would go on until the UK’s exports went only to Europe. The dollar is rising against the yen? That’s unsustainable because the yen’s value isn’t going to diminish to zero. Etc., etc. Just pointing out that a trend is “unsustainable” means precisely nothing.

    A theory has power if it has predictive value. That means it has to give you some idea when (either in absolute time or relative to some other indicators) the trend is going to start causing problems.

    As a casual reader of your blog, I like your analyses, but it seems to me like your predictions are often wrong. I haven’t looked closely enough at them to really be able to tell, but I remember a number of instances where you made vague or specific projections of sharp slowdowns in growth, either overall or by sectors, and they seem to have been wrong so far. If your analysis is getting predictions wrong, then maybe it’s not such a good analysis. Sure, we can all agree with the headline: debt is going up, at some point it seems like that might well cause a problem. But greater precision than that is needed.

    To give a specific example: the projections for growth over the next few years. Your Economist bet is one thing, but Ross has made a much more striking projection that China will achieve its target of doubling the size of the economy in 2010-2020. I suspect Ross is closer to being right than you. Now it may be that after 2020 unsustainable debt causes a big crisis and recession. But if your models can’t accurately tell you what decade a major economic event is going to happen, then they’re pretty worthless.

    Or take Gordon Chang. If China does “collapse” in 2020, that wouldn’t make him right. Timing matters.

    • I assume you would prefer a reply from Michael. I do remember him predicting commodities would decline and if I remember correctly the timeline he gave was starting as early as 2013, or as late as 2015. Seems he is already correct on that point, although we get a slight bounce now as China restocks, before we resume another downwave as the BRICs and most NICs are falling over the cliff right now.

      I think Michael also said or implied that China would slow significantly now and need 10 years of very slow growth, else it would have Minsky moment by roughly about 2016 at the latest. Someone please correct me if I misinterpreted.

      My point to Michael is that if global contagion implodes aggregate global demand by 30 – 50% by 2016 or so (definitely before 2020), then China could not avoid a severe downturn.

      The predictive power of Michael’s work is in showing that why China could not grow further in the current model and that the adjustment had to begin about now, else it would come chaotically within another couple of years.

      If we could get accurate statistics on real GDP, I bet we would find the marginal-utility-of-new-debt in China is near or below 0, thus confirming Michael’s theory. At that point, only volatility (government stopping and restarting stimulus and increased liquidity) can mask and delay the crash spiral (Minksy moment) that comes when the public realizes the music has stopped playing in a game of musical chairs and everyone must fight for a few seats.

  29. I have enjoyed your articles over the years Michael. However I find two flaws in the analysis. First as we move from 2-3% world trade growth back to 5% plus which we will, China gets about a 1-1.5 % GDP lift largely from filling excess capacity with little incremental capital investment. This buys a lot of time for further adjustment to over investment. And it can be done even though the major real appreciation of the currency since 2005 has been achieved which is a prerequisite for moving to greater consumption led growth

    Secondly your analysis is OK as far as it goes on the mechanisms for transferring resources from households and to a lesser extent SME’s to corporates and Government for investment. However it seems to me that one of the real debates that is missing in China is the text book allocative effiency debate and dynamic effiency arguments about how/whether resources in the tradeables sector are moving to higher productivity activities. At the end of the day that is a decisive issue in the adjustment debate.

    As to household consumption growth? Well as data from the Rhodium group shows household consumption growth in China has been averaging around8.5% pa since 2003 and China is one of the nations where household consumption growth post the financial crisis is higher then per the financial crisis

    Bottom line. Exports will rise strongly providing more breathing space and offsetting part of the slowdown in investment that will occur over years. The real debate about allocative effiency and dynamic effiency will tell us whether productivity growth is strong enough to continue to support growth rates of 7% per annul for the remainder of the decade. I will leave my disagreements with you about urbanisation, capital stocks and capital output ratios for another day

    And greetings from Australia!!

  30. May I just say what a relief to discover someone who genuinely understands what they are discussing online. You certainly know how to bring an issue to light and make it important. More people ought to check this out and understand this side of your story. It’s surprising you aren’t more popular given that you most certainly have the gift.

  31. Does your site have a contact page? I’m having problems locating it but, I’d like to send you an email.
    I’ve got some ideas for your blog you might be interested in hearing.
    Either way, great site and I look forward to seeing it grow over time.

  32. Michael, 7 years of reading your blog and it just dawn on me that I should keep a copy of your blogs (for my kids if they show interest) , should there be another one of those Viagra attacks on your website. I can’t find the old archive back from 2007 and internet archiver doesn’t show up old blogs anymore. Is there anyway I can access full archive?

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