On China's 'Superficial' Bulls And 'Broken Clock' Bears

Authored by Michael Pettis, excerpted from ‘The Urbanization Fallacy’ via his blog,

No More Stopped Clocks – Please!

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 publically 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 not 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.

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, and it is during the adjustment period that I expected growth to drop sharply, to 3-4% as the upper limit, as I will explain in the next issue of this newsletter. In fact I did not believe the adjustment would start until 2013, but now I think it actually began in 2012 – earlier than I originally expected.

Regular readers of my newsletter 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.

But 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.


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