China is following in the footsteps of Japan. Deflation happens when you have an aging work force coupled with an asset bubble that bursts spectacularly.

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Image courtesy of Trading Economics.

China Deflation Fears Deepen, With Good Reason

The Wall Street Journal reports While Everyone Else Fights Inflation, China Deflation Fears Deepen.

The article gets some ideas correct but is nauseating for what it gets wrong. Here are some snips and my comments,

WSJ: While the rest of the world tussles with inflation, China is at risk of experiencing a prolonged spell of falling prices that—if it takes root—could eat into corporate profits, sap consumer spending and push more people out of work. Its effects would ripple across the globe, easing prices for some products that countries like the U.S. buy from China, but would also deprive the world of important Chinese demand for raw materials and consumer goods, while also creating other problems.

Mish: Falling prices is a benefit. The problem is excessive debt. I will expound on this point below.

WSJ: Some economists see alarming parallels between China’s current predicament and the experience of Japan, which struggled for years with deflation and stagnant growth.

Mish: The parallels are easy to spot and they were easy to predict in advance.

WSJ: In the 1990s, a collapse in stock markets and real-estate values in Japan pushed companies and households to drastically cut back spending to service burdensome debts—a so-called balance-sheet recession that some see taking shape in China today.

Mish: Correct! The key words are balance-sheet recession.

WSJ: In Japan, deflation first appeared in 1995. Excluding a few respites, it more or less stuck around until the 2008-09 financial crisis. Even today, Japan is battling to sustain higher rates of price growth with ultraloose central bank policies.

Mish: The solution is to write down the debt. Japan refused to do so, and China is following Japan.

WSJ: One textbook response is a massive monetary expansion, lowering interest rates and printing money to spur borrowing and spending, which in theory should trigger more inflation. 

Mish: The textbook theory is total nonsense. Look at round after round of QE in Japan and by multiple Fed chairs in the US. QE tends not to create consumer inflation, it creates asset bubbles. It is galling that no central banks understand this key point. Of course, mainstream media and academia all parrots proven falsehoods. Inflation expectation theory is disproved nonsense, yet all of the central bankers believe in it.

WSJ: Data show Chinese companies are reluctant to take on new debt to expand production, while droves of homeowners are choosing to repay mortgages early. Both are signs of weak demand for loans, muffling the effectiveness of interest-rate cuts. A major reason is that many companies and households already have such large debts that they don’t want to add more. Household debt has surged to 1.5 times that of income, far above the level of most developed countries, including the U.S., according to calculations by Jens Presthus, associate director of Global Counsel, an advisory firm. 

Mish: Correct! Importantly, it is a massive mistake by central bankers everywhere to keep attempting to jam more debt into a system flooded with it. The Fed has done so too, but not to the same extent as China’s housing bubbles.

WSJ:  “Deflation is particularly dangerous when there’s a lot of debt,” said Arthur Budaghyan, chief emerging markets economist at BCA Research. 

Mish: Correction, deflation is only dangerous when there is a lot of debt.

Historical Perspective on CPI Deflations: How Damaging are They?

Hello Fed, Bank of Japan, ECB, and Bank of China. It’s not consumer inflation that matters, it’s inflation that matters, specifically debt induced bubbles.

I have been making that case ever since 2006, to no avail. To become a decision maker at the Fed you have to believe total silliness instead of reality.

I have referred to this article before but now is a great time for a refresher course.

Please consider Historical Perspective on CPI Deflations: How Damaging are They?

Of all the widely believed but patently false economic beliefs is the absurd notion that falling consumer prices are bad for the economy and something must be done about them.

The Bank of International Settlements (BIS) took a look at the Costs of Deflations: A Historical Perspective. Here are the key findings.

Concerns about deflation – falling prices of goods and services – are rooted in the view that it is very costly. We test the historical link between output growth and deflation in a sample covering 140 years for up to 38 economies. The evidence suggests that this link is weak and derives largely from the Great Depression. But we find a stronger link between output growth and asset price deflations, particularly during postwar property price deflations. We fail to uncover evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations. The most damaging interaction appears to be between property price deflations and private debt.

Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive.

Once we control for persistent asset price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services (CPI ) deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period. They are uniformly statistically insignificant except for the first post-peak year during the postwar era – where, however, deflation appears to usher in stronger output growth. By contrast, the link of both property and equity price deflations with output growth is always the expected one, and is consistently statistically significant.

The exception to the general rule was the Great Depression but, that was also an asset bubble deflation coupled with consumer price deflation.

Routine Consumer Price Deflation is a Benefit

I am sick of clueless central bankers all pushing for 2 percent inflation when not a one of them understands how to measure it.

For starters, falling prices are a great thing. Your money goes further. Standards of living rise because more people can afford more things. But no. Central bankers all hell bent on producing an outcome where hard earned dollars buy fewer and fewer things.

The Real Problem

The problem is not falling prices, the problem is central banks forcing more and more debt into the system looking for routine CPI inflation until the whole damn thing blows up. That is what happened in Japan and now in China.

Time and time again, the Central Bank of China kept turning to real estate and exports to meet preposterous GDP goals that it set. Every time China’s property bubbles started to lose steam, China went back to the same well.

The average consumer in China put most or all of their savings into property bubbles, typically on leveraged or borrowed money. Many of the buildings do not even exist and many that do are crumbling. But the Chinese leaders kept pushing and pushing and now the bubble appears to be unrevivable.

To top it off, China’s demographics have turned negative. This is the precise setup that hit Japan.

Fool’s Mission

In their foolish attempts to fight routine consumer price deflation, central bankers create very destructive asset bubbles that eventually collapse, setting off what they should fear – asset bubble deflations.

The US would be in the same boat, but US demographics, including net immigration, are in far better shape than China.

China Intervenes to Prop Up the Yuan

Recently, China intervened in the Forex markets selling US treasuries and buying yuan, hoping to prop up the yuan.

Musings of the Day

All talk about China dumping treasuries is nonsense. Instead of keeping treasuries on the main balance sheet, they are sitting in State Owned Enterprises.

Now China is “dumping” them to prop up the yuan. What a hoot.

What Does China Do With a Dollar That’s No Longer Risk Free?

Please consider my Pettis Q&A post What Does China Do With a Dollar That’s No Longer Risk Free? Buy Gold? 

Q&A With Michael Pettis

Mish: Will China now hold more commodities and fewer dollars despite the pro-cyclical nature of it? More Euros or Yen over dollars? More gold?

Michael Pettis (emphasis mine):

1: “Given that so much of China’s “reserves” are now indirect and held by state-owned banks (all the increase since 2017) it’s hard to say what the currency composition of China’s reserves are.

2: “Officially the US dollar is still by far the biggest component, but it is slowly declining.

3: “I expect that this will continue as far as the official reserves go but, as you know, the hard part of reducing the US dollar component of your reserves is figuring out what the alternative should be, and with such high and growing reserves (once you include the indirect reserves at the state-owned banks) that is a very difficult question to resolve.”

Gold-Backed BRIC Silliness

Pettis’ comment on the hard part is precisely why all the discussion on BRICs and a new currency backed by gold or some sort of weighted or commingled currency is hot air.

Launching a BRIC currency is, for now, somewhere between extremely difficult and impossible, in any meaningful sense.

I explain in detail in More Gold Backed BRIC Currency Silliness on Dethroning the Dollar

Thorsten Polleit, chief economist at Degussa, told Kitco, “For making the new currency as good as gold, a truly sound currency, it must be convertible into gold on demand. I am not sure whether this is what Brazil, Russia, India, China and South Africa have in mind.“

Marc Chandler, managing director of Bannockburn Global Forex, told Kitco: “Talk of BRICS gold backed currency seems like an echo chamber. They do not have the gold to back a currency meaningfully. Have we not learned anything from the EMU experience of monetary union without fiscal union. Color me profoundly skeptical.“

Importantly, there are no details to the BRIC announcement. The current discussion involves a “trading currency”.

A “trading currency” is a laughable construct because nations don’t trade, individuals and corporations do. It is the sum of individual and corporate actions that give rise to the concept of national trade deficits.

In essence, the proposed trading currency is a return to Bretton Woods, minus the gold, which surely will not be convertible on demand for the actual traders, individuals and corporations.

Details await. If you are honest about things, and understand trade at all, expect to be underwhelmed.

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