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Greatest Show On EarthYou probably haven't heard about this one. It's one of those things that you have to look for or belong to the "right" circles "that know" in order to find out. It so happens that the Chinese economy is in troubles and this fact has consequences. Take a look at the picture below.

In this picture you can see the wild variations of the %CPI over time. The CPI is the Consumer Price Index, commonly known as the Inflation Index. What is interesting of this graph is that while the %GDP (Gross Domestic Product) seems to have stagnated, the %CPI seems to have skyrocketed. Of course, we can't know for sure exactly how much because the Chinese government routinely dis-informs all international organizations and does not provide any information as to how their economic measurements are made. The data in the graph are estimates believe to be accurate, but, in all likelihood the %GDP is probably currently overestimated and the %CPI underestimated in a typical communist propaganda fashion.

China GDP Inflation

 

According to Monetarist and Mercantilist principles (the current economic pseudo-theories that the Chinese follow), if an economy begins to tank the government must print. This accomplishes two things:

  • The internal economy reactivates
  • The currency depreciates and therefore it is easy to export because goods and services become cheaper

This is exactly what the Chinese government is doing. Of course, they won't tell you that that's what is going on. According to their official excuses it is "lesson" for currency speculators for bidding up the CNY(Yuan) and also to stop the inflow of "hot money" (i.e. speculative money) into China. Whatever.

Furthermore according to Western economists, China is facing the horror of deflation. As such, they must print, print, print and then print some more. This effectively lowers the exchange rate of the CNY hence making their exports more viable.

The problem is that any export operation requires two parties; one buying and one selling. If China is selling, who is buying? The rest of the world. This means that if this works, China will reactivate while the buying party (rest of the world) will de-activate. And so China is indeed exporting its deflation.

Furthermore, the higher the currency exchange rate against the CNY, the higher the incentive to import Chinese goods and services. And which currency is relatively high against the CNY? The EUR. Just one problem: the EU is broken.

If China is indeed successful in exporting its economic troubles to EU, what will happen with EU? It will face another 2008 economic catastrophe, but this time much worse. And so, what is the classic solution? Print, print, print, and then print some more in EU. What will this accomplish? To devaluate the EUR against the CNY and therefore make Chinese goods and services "adequately" expensive again. This will "protect" the EU.

In a twisted and irrational manner, this is correct. The problem is that it triggers an acceleration of the race to the bottom; this is, whoever devaluates the faster sort-of wins… until the whole economy collapses under hyperinflation or hyper-stagflation or hyper-depression. This race is sort of a nuclear economic war; there may be a winner, but it won't be worth living with the consequences.

But there is a sunny side to all of this, just not for you; for Central Bankers, Bank owners and politicians. To understand how it works, we need to look at how the European Central Bank (ECB) works. The ECB can print money, but outright buying government bonds is strictly verboten (i.e. forbidden). The reason for this is because outright purchases of government bonds is the same as budget-printing and this is what's called high-powered money. Once it gets into markets it is automatically multiplied by 10 and then inflation gets out of control rapidly.

The way the ECB prints is by asking government to issue bonds, which are purchased by "private" (ejem…) banks and then re-sold to the ECB for freshly printed electronic EUR.

Theoretically speaking, this would deter countries from issuing bonds since the market would act as a bunch of vigilantes watching critically the worthiness of bond. If the issuing country seems less than worthy they will demand higher interest rates or will simply refuse to buy. This should force governments to live within their means… the operational word being "should".

Of course, we have seen that this does not work. The free market is infinitely cleverer than any bunch of bureaucrats and Central Bankers. All kinds of processes where found around this "pesky" process that enable governments to borrow like drunken sailors.

However, since Mario Draghi became ECB's czar in a bloodless coup in November 2011, ECB's "outlook" (i.e. marching orders) have changed remarkably. They went from "guarding the stability of the EUR" to supporting collapsing EU governments with the excuse to "guard the stability of the EUR". In July 2012 Draghi issued a similar statement to Bernake's "helicopter money"; Drahi said "whatever it takes" followed by a "and believe me it will be enough".

Ever since then, all kinds of new-and-improved methods to "support" governments have been developed by the ECB and its Crony Central Banks, some of them of dubious legality (at least according to the old rules). These methods would include turning the blind eye to National Central Banks in EU directly financing government deficits through convoluted deals such as the one in Ireland with the Irish Central Bank. The ECB has only stopped short of outright buying country bonds… for now.

This new found willingness to do "whatever it takes" was described as the "Draghi Put" in parallel to the "Greenspan Put"; this put is what is driving the EU bond market into a frenzy.

Note: a "put" is an option where a seller guarantees to sell a good at a future date at a given price for a fee. The simplest use for a put is as insurance (hedge) against a share dropping in price. For a fee, the put purchaser can guarantee that he won't lose money should the price of a good drops below certain price. In terms of international economy, a put simply means that the Central Bank will step-in to prevent banks or countries that are "too big to fall" from falling.

And so, the Draghi put is fueling the new appetite for Greek and French and Italian bonds that are essentially junk bonds. Private banks can now purchase these bonds paying juicy interest rates because the ECB is ready to step-in and support any country from failing. Essentially, there is no risk for banks. The excuse is that this prevents the ECB from outright buying country debt by ensuring that such debt is purchased by private banks. The ECB will, most likely, back this "put" by allowing national EU Central Banks to do the "dirty" job themselves instead the Central ECB directly. However, in the end, it does not matter if the process takes one step or thirty. It is still highly unorthodox if not illegal. But does it matter? Certainly not. Politicians will do whatever politicians want to do when politicians want to do it. Only people still believing in the system will be surprised by this.

The end result of all these processes is that the ECB is, in fact, printing, printing and then printing some more to support failing EU countries. And so we come full circle, since the Great Chinese Deflation Threat suddenly becomes a god-sent excuse for doing what they were determined to do anyways: to print.

But the story does not end here. For this to work the ECB must continue printing in order to keep interest rates low in order to create economic "reactivation". But the EU economy is busted and debt is rampant. No entrepreneur in their right mind would ever go deep into debt just because interest rates are low. Which means that the ECB can only keep lowering them in the hope they will work. Well… they won't. Welcome to ZIRP (Zero Interest Rate Policy). At this point in the near future, the EU will find itself in the same conditions in which Japan and USA are stuck. Then, the only possible so-called "solution" will be Quantitative Easing (QE), which implies purchasing long term bonds to lower their interest rates with the intention of luring business to borrow cheap for investing in the long term. The only problem with this is that it is outright purchase of government bonds and it is… verboten (and against the German Constitution).

And then what?

Interesting question. It will be an issue of South EU countries (France, Greece, Italy) against North EU countries (primarily Germany) with the ECB trapped in the middle. Who will prevail? At that point, a singularity will be reached in EU and all economic rules will be tossed out of the window. Maybe the Germans will change their constitution or will find a way around it. This is possible but unlikely since it will be a political non-starter (German people are fed-up). Maybe Germany will exit the ECB and re-float Deutsche Marks. But will this destroy the EU? In its current form yes, but the EU market is simply too big to be shut-down by politician and Central Bank stupidity.

And China? China will crash. Hard. This much is unavoidable. The debt they have is monstrous. The inflation large. Their economic stagnation critical. Their political instability, legendary. Where do we go from there is anybody's guess but it will all depend of the Chinese government. Will the communists retain power post-debacle? Our bet is yes because in ultimate analysis they control all police, security and military forces. Communists won't doubt a second to massacre as many Chinese people as necessary to maintain their jobs. The excuse will be, of course, to prevent "civil unrest" when daily necessities disappear due to a collapsed economy. Party "discipline" will be called to action and the repression will be brutal. Trying to control 1.4 billion pissed-off, near-starving people without absolute terror is quite difficult. But where do we go from there? Economically speaking it is a 50/50 toss. Will communist bosses prefer an iron grip on people to retain their jobs or will they push ahead with the Chinese agenda to become a superpower (in which case they will need capitalism). Right now, the answer is the latter; but one thing is certain, a near-death experience by mob lynching has the tendency to alter perceptions in people.

Mentally and economically speaking, China is in the same position as Japan was before the crash of the 80s. Both governments "discovered" a new way of "manage" the economy which was an "improvement" from capitalism, communism and anything in between. They were arrogant, they were powerful and they were dead wrong.

And where do we go from there? Cascading cross defaults. Crashes. Depressions. Hyper-inflations or hyper-stagnations. In a word, a world-wide series of economic catastrophes, most likely of unheard-of proportions. And what happens then? Politicians will do more of the same; this is, all the pseudo-remedies that are incorrect and do not work. And what happens then? People will begin to evolve politically, one disappointment at the time. Only when things get really, really bad, people begin to think things through. And then? Well, by then people may begin to flex their political muscles by… ignoring governments, and things may finally! begin to improve. But by then, the computer singularity will probably already be here and a completely new paradigm will appear in the world. It is anybody's guess what the consequences will be.

CONCLUSION

And there you have it, dear reader. The greatest show on earth is about to begin, but you don't need to rush to buy tickets; you have front seat reservations for the next few decades right there, in your very own country. We only hope you are prepared. Or not, your choice.

Note: please see the Glossary if you are unfamiliar with certain words.

 

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