How China Broke the World’s “Bubble Machine”

By Bill Bonner on November 3, 2015

POITOU, France – U.S. stocks still going up…

What does Mr. Market know that we don’t know?

Plenty. He knows everything. Millions of facts. Millions of opinions. Millions of guesses. A damned know-it-all.

Mr. Market is always right; there is no higher authority except God Himself.

So, if Mr. Market says stocks should go up, who are we to argue?

“Don’t fight the tape,” is another old-timer expression on Wall Street. When stocks are going up, you don’t want to be short. When they are going down, you don’t want to be long.

Magical Money System

As simple as that sounds, it doesn’t help you much. Because you never know which side the tape is on.

Mr. Market is a cunning, wily, and tricky fellow. He’s perfectly capable of leading investors up and up… only to knock them down from a higher place.

Also, he’s known to give out the word that it’s “all clear” in the stock market… while brewing up the storm of a century.

Or you may hear him singing the blues about how awful everything is… and then discover that he’s been buying the entire time.

So, even though the Dow has been trending upward… we’d be careful about drawing any conclusions. Mr. Market could be up to his old tricks; the tape could reverse at any time.

And we kinda think it will.

Friend and economist Richard Duncan points out that the booms and bubbles of the last 35 years had a particular cause. They weren’t the product of Mr. Market’s caprice or of investors’ shrewd judgments. Instead, an almost magical money system drove consumption, production, and asset prices to new highs all over the world.

What a hoot! Wages rose 10 times in China. Stocks rose 16 times in the U.S.

But now the party is over…

Wheels A’Turning

Here’s how it worked: Once the world’s money lost its golden anchor in 1971, things got a little funny.

Americans spent money they never earned and never saved – dollars created “out of nothing” with nothing more than keystrokes on a computer.

Much of this new money went overseas, where foreign nations – notably China – had to print their own currency to keep up with it.

But you’ve heard this story before. China makes. The U.S. takes. In the process, a glut of dollars ends up in the hands of the Chinese feds as foreign exchange reserves.

The buildup of these reserves is both the cause and the measure of the globalized boom the world has enjoyed since the early 1980s.

As Americans bought more goods from China than they sold to China, they sent more dollars to the Middle Kingdom. These dollars boosted the world’s money supply… and set heads a’spinning, wheels a’turning, and chimneys a’smokin’.

China (and other countries) filled the orders and banked the dollar sales. Of course, you can’t easily spend dollars in China. So the Chinese central bank, the People’s Bank of China (PBoC) exchanged merchants’ and manufacturers’ dollars for renminbi at a fixed rate. (Otherwise, the demand for renminbi would push up its exchange value – something the Chinese have been keen to avoid.)

This left the PBoC with lots of dollars. What could it do with its stash?

Buy U.S. Treasury bonds!

As China recycled its export dollars into U.S. government debt, it lowered U.S. interest rates and increased the amount of money bidding for U.S. financial assets.

That – roughly – is how we got to where we are today. China’s supply of foreign currency reserves rose from zero in 1979 to $4 trillion in 2014.

Worldwide, reserves grew by $12 trillion.

Broken Bubble Machine

Here, you can easily see the difference between this new credit-based system and the gold-backed system it replaced.

You could never add $12 trillion to the world’s money supply in the same way if it was linked to gold. All the gold ever mined has a present value of only about $6 trillion.

This big increase in the global money supply was what set off the booms and bubbles of the last 35 years.

But now, what’s this? The bubble machine is broken?

The PBoC is no longer adding to its dollar reserves. Instead, it is offloading them. About $400 billion has been clipped from China’s foreign exchange reserves since 2014.

This drop is a big change for China… and for the world’s financial system. Imports into China – mostly raw materials – are dropping at a double-digit rate. Exports are rolling over, too.

There is nothing like easy money to cause people to make mistakes. Americans overspent. China overproduced. Now, Americans can’t step up their buying (they owe too much already)… and China has too much capacity.

China’s growth, by the way, has been heavily concentrated on building factories and infrastructure – capital investment.

China spent $4.3 trillion on fixed capital investment in 2013 – 10 times more than in 2000. But when you produce too much already, building more factories only makes the situation worse. Prices fall. (On a year-over-year basis, producer prices in China haven fallen every month for the last three and half years.)

Adding output capacity – often done with the connivance of local governments – was largely financed on credit.

Bank loans have risen threefold since 2007. These loans must now be going bad. Nonperforming loans should be shooting up. Recession should be coming. Instead of driving the world economy forward, China should become a drag on the whole world economy.

What does this mean?

China can’t allow its industrial economy to sink without a fight. It will have to devalue the renminbi to try to get more market share for its exports. It still has 80% of its workers earning less than $10 a day. A lower renminbi will reduce real wages further and make China’s exports cheaper than ever.

And then, what about the rest of the world?

As the renminbi goes down, the dollar, yen, and euro will have to go up. Commodities – priced in dollars – will stay down. U.S. corporate profits will fall. The stock market “tape” will go down. Consumer prices, too, will remain low… or go negative.

Deflation. Deflation. Deflation.

Regards,

Signature

Bill

Further Reading: Jim Rickards has a critical warning about China’s looming implosion. The collapse hasn’t even gone into full swing yet – as Bill just pointed out – but already global markets are being thrown into turmoil.

Now Jim is using his decades of Wall Street and Washington experience to profit from the drastic market moves caused by China. His brief video tells you what’s coming next for China and the world… and how you can use it to your investing advantage. Watch it here now.

 


 

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MarketInsight_header

“China’s steel demand evaporated at unprecedented speed.”

– Head of the China Iron & Steel Association

Steel production is a good indicator of economic growth because it’s in just about everything we use – buildings, cars, even electronics. So a decline in steel production is a bad sign.

As you can see in the chart below, steel production declined year-over-year for only the second time in the past 25 years.

110315 China Steel Production

The last time steel demand was negative, China’s stock market had just finished crashing 80%. Currently, the Chinese market is down 36% from its June high.


Mailbag

Your fellow readers are chiming in on last week’s special three-part Diary series with Jim Rickards – “The Death of Money.” Catch up here…

• A History of Currency Wars
• Collapse of the Dollar-Based System
• How to Protect Yourself in Today’s Currency War

After reading many economic predictions about our U.S. dollar collapsing, I’m scared to death.

As a hedge, I have purchased $3,000 Canadian. I would like to buy more foreign currency but am confused about which countries’ currency is safe. It seems that most countries are having financial difficulties, and may be getting into currency wars.

– David F.

I enjoy your writing on the end of money but perhaps you are aiming too low – maybe we are looking at the end of banking.

The move to virtual money means banks are becoming not simply functionally unnecessary but are economically very inefficient (greed/rent-seeking/corrupt) and present a very high risk of system failure. Money is, after all, the most fundamental public utility. The problem is that the state gave up control of its issuance to the banks centuries ago – maybe what you are seeing is a subtle shift back to state control.

The banks also benefit greatly from asset inflation – they need it to keep growing their business – and the Federal Reserve’s only tool for managing the volume of cash in circulation. The amount (and type) of debt being created actually encourages asset value inflation – it is perverse to have a bureaucracy determining the base price of debt, and it is even more perverse to enforce a higher price/return on a good (debt) than the “natural” value.

– Ciaran K.

Speaking about a currency war is inaccurate. It is not a war.

Via the BIS [Bank for International Settlements], the member central banks harmonize their efforts in communicating to the market how they would like to see things happen. We even learned it in university, in the course Money, Credit, and Banking.

– T.C.

It is quite obvious that all of our elected leaders are doing their best to sell the U.S. down the toilet to a one-world government.

I have asked the question for years: How can you have a one-world government with the U.S. as strong as it is militarily, financially, socially, educationally, religiously (Christian)?

You can’t.

The Lord called for this 3,500 years ago! Look up… your redemption draweth nigh!

– Richard W.


In Case You Missed It…

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