This article was published by The McAlvany Intelligence Advisor on Friday, May 26, 2017:  

Perhaps without knowing it, Moody’s downgrade of one full notch on Wednesday exposed the fallacy of managed economies: that government bureaucrats with fancy degrees from the University of Chicago, Harvard, or Yale know what they’re doing. One of those fallacies that have been promoted for years came from Yale grad Arthur Laffer as far back as the Reagan administration. On the surface it sounds eminently logical: cut and the will grow. The fallacy is knowing just how much to cut, whose to cut, when to cut, and how long to cut.

The Laffer Curve undergirds the whole idea of “supply side economics” – the idea that by stimulating production the government encourages consumers to spend. Again: what bureaucrat knows which industries to stimulate and by how much? And if, as is usually the case, such stimulation involves borrowed funds, how does one know if the profits gained will be enough to pay back the loan?

In a thousand years of trying, no government on earth could have developed Apple’s iPhone, and the expressed by those who think they can is monumental, bordering on insanity.

Moody’s moved the world’s second-largest economy from Aa3 (“high quality [with] very low risk”) to A1 (Upper-medium grade [with] low ”). It explained why:

The downgrade reflects Moody’s expectations that China’s financial strength will erode somewhat over the coming years, with economy-wide debt continuing to grow as potential slows.

That “potential growth” has been slowing since at least 2010. In that year Chinese government agencies reported growth in excess of 10 percent. By 2014 it had slowed to 7.3 percent, to 6.9 percent in 2015, and now at a reported 6.7 percent.

Moody’s is late to the game. It has maintained China’s Aa3 rating since 1989. Fitch Ratings dropped its rating on China a full notch seven years ago. Standard & Poor’s has had China on negative outlook since February last year.

China’s so-called “economic miracle” began in 1978 when the government introduced free market principles into the moribund third-world economy. Applied initially to agriculture in the form of privatization and allowing peasants to keep their profits, the economy responded smartly when the party allowed foreign investors to build factories to take advantage of China’s cheap labor. Then came investments in power plants to serve the growing economy. This was followed by enormous investments in cities, as well as in basic industries such as steel and cement.

Nothing grows to the sky, and when the economy began to slow, new Five Year Plans were implemented along with government to keep the economy growing. During the 2008 financial crisis those government loans were expanded, with proceeds flowing through government to state-owned enterprises (SOE).

Since a directed economy has no ability to project prices accurately, the loans were based upon assumptions rather than reality. What Moody’s has come to learn, albeit lately, is that the conflict between reality and those Five Year Plans is likely to set off “contagion” where the failure of one bank could lead, like dominoes, to the failure of others. This would put more pressure on the central government to bail them out – after all, they’re part of the government apparatus – expanding debt just at a time when the ability to service it is declining.

Aside from the problem of making loans that aren’t likely to be paid back is the fact that new loans simply don’t work as well as previous ones did. Early on, government money infused into an industry is often confused with real capital, fooling entrepreneurs into thinking that there’s real opportunity there. But over time the fallacy is revealed. Keith Bradshear, writing (surprisingly) in the New York Times, got it exactly right:

With its economy maturing, China has to pile on ever more debt to keep its growth going at a pace that could prove unsustainable. And the money is increasingly flowing through opaque channels that operate outside the regulated banking system [“shadow” banking], leaving China vulnerable to blowups.

 

But debt no longer packs the same economic punch for China. An aging workforce, smaller productivity gains, and the sheer math of diminishing returns mean [the government] must borrow more money to achieve less growth.

Moody’s at least sees what the problem is: a politically-managed economy that tries to impose a Five Year Plan with little idea or ability to know where the best prospects for growth really are. Only entrepreneurs, through trial and error, are able to do that.

Here’s Moody’s justification for its downgrade from its announcement:

The importance the authorities attach to maintaining robust growth will result in sustained policy stimulus … such stimulus will contribute to rising debt across the economy as a whole….

 

China’s … potential growth is likely to fall in the coming years … rendering the economy increasingly reliant on policy stimulus. Over the near term … the burden of supporting growth will fall largely on fiscal policy, with by government and government-related entities – including policy banks and state-owned enterprises – rising.

Falling productivity and aging demographics in China are only hastening the day about which Moody’s is warning: the day when local debt will not be serviced, failing banks are bailed out with more borrowed money, reaching the point when government debt itself is incapable of being serviced.

A cynic would point out the unnerving similarities between China and the United States. After all, it’s been almost seven years since Standard & Poor’s downgraded its rating on the federal government, which has only expanded its national debt since.


Sources:

Bio of Arthur Laffer

Laffer Curve

CNBC: Moody’s downgrades China rating to A1 from Aa3, citing concerns over a slowing economy and growing debt

The New York Times: China Can’t Sustain Its Debt-Fueled Binge, Moody’s Says

Reuters: Moody’s downgrades China, warns of fading financial strength as debt mounts

Rating Action: Moody’s downgrades China’s rating to A1 from Aa3 and changes outlook to stable from negative

China’s economy

China’s national debt

Background on Moody’s

What is Supply Side economics?

BBC: China’s Economic Miracle

Fitch Ratings

U.S. government downgrade in 2011

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