China and Business Cycles
I’m a fan of Bloomberg’s Odd Lots podcast1 thanks to my friend Saul who got me hooked on it during Covid. Recently I listened to their episode2 with Hugh Hendry, a very non-conventional hedge fund manager who is also a surfer, podcaster and investor. Hugh made a few points that were really insightful and one of the hosts made a comment I hear a lot and grated my nerves. So, their show pushed me over the edge on a topic I’ve been mulling over for months: China and Business Cycles.
The Comment
First, the comment which I’ve heard in one form or another over and over on the financial news for the last few months. It’s something like this: “So, where is China in its business cycle?” The question arises because China has had a hard time lately and people wonder when they’ll recover. That’s fine, but I have an issue with the way people discuss business cycles as if they are known, understood and consistent objects. They are not.
The Business Cycle
The idea behind business cycles is that “economies boom and bust”. That’s true enough for market-based economies. They grow, they have a recession, they grow again. That pattern is a business cycle.
But, there’s nothing normal or predictable about business cycles. In the United States the National Bureau of Economic Research (NBER) officially records our business cycles. The following graph from the NBER’s website3 has a blue line for unemployment and the grey bars for recessions. The important point here is that there is nothing normal, regular or predictable about the recessions in terms of either their lengths or their timing/frequency.
Business cycles are not natural phenomena like a wave or something in the physical sciences. There is no law of gravity in economics so that what goes up must come down. They don’t come at regular intervals and you can see in the graph that the grey bars vary a lot in thickness (i.e., how long the recession lasted).
The NBER records recessions all the way back to 1857 and tracks the length of each from peak (before recession) to trough (bottom of recession) which tells us how long the economic contraction was. They also record the time from trough to peak which tells us how long the economic expansion was. The data is free, see footnote4.
Contractions since 1857 vary from a minimum of 2 months to 65 months (the October 1873 to March 1879 recession) and the statistical average is 17 months in length (standard deviation is 12 months, for the more technical readers).
Expansions have been as short as 10 months and as long as 128 months (the post 2020 expansion), averaging 41 months in length (with std. dev. of 30 months). This is all to say that they vary widely in their length.
And they vary in their timing or frequency. The NBER gives us two measures of “length between cycles”: from trough to trough and from peak to peak. The shortest time between troughs is 28 months and the longest 130 months while the shortest time between peaks is 17 months and the longest 146 months both measures with averages around 58-59 months (and standard deviations around 30 months). Again… wide variation.
My point: The word “cycle” is almost misleading because you immediately imagine some consistent pattern. There’s not one. At least not in the terms usually used in discussing them. They vary widely in timing and duration.
Capitalist versus non-Capitalist Business Cycles
There’s additionally a misconception - at least in the way stated - that business cycles are the product of the “capitalist system”. The implication is that non-capitalist systems don’t have business cycles. There is some truth to this in my opinion, but not in the way people stating this mean. Non-capitalist systems don’t usually recover. They often just decline into squalor assuming they managed to grow enough in the first place to provide more than subsistence level life.
Capitalist systems grow and, as long as they remain relatively free and solidly founded with good political institutions, they recover because the incentives and freedoms in place allow people to adapt in a valuable way. So, yes, “capitalist systems” produce business cycles and that’s a wonderful thing. The alternative is just decline without recovery.
About 2 years ago the Sri Lankan economy crashed and burned. The Argentinian economy crashed some years ago as well and their new political leaders are trying to get them out of their malaise. Venezuela fell apart and lies in ruins. Cuba fell apart decades ago and remains in ruins. North Korea… the same. Those aren’t business cycles. Those are how non-market-based economies handle shocks. They just fall apart. They crash and burn. It’s sad. It’s horrible. Those people could all have much better lives under a better system that has business cycles instead of crash and burn patterns.
As a side note, I don’t know what a “capitalist system” is. I prefer market-based or some similar terminology to indicate that the primary organizing mechanism is private individuals making choices for themselves versus non-market-based systems where that’s not the case. My friend Les (who writes here 5) uses “command economies” versus “demand economies” which I find clever. But that’s a longer conversation for another time.
Back to China’s Business Cycle
Now we can return to China and the question of where they are in their business cycle. Now you hopefully realize that I think the question itself is a bad one. It implies the presumption that there’s some “normal” phases of a business cycle and one can know where one is in the cycle.
You hear this a lot today, however. China has indeed had a property crisis that rocked it recently. People seem to think “oh, we had a property crisis in 2008 in the US and Europe and therefore known the phases of the business cycles that follow such a crisis”.
Firstly, no. Recessions, like unhappy Tolstoy’s families, are unique in their unhappiness. Go see my comments above on business cycles generally.
Secondly, a shock to the Chinese economy is not like a shock to the American or another market-based economy. More precisely, the shock itself can conceptually be the same, but the system being shocked is radically different. And our Scottish surfer hedge fund investor, Hugh Hendry, made this point beautifully.
“China Produces GDP but Not Wealth” - Hugh Hendry
Throughout the Odd Lots episode Hugh made the point that “emerging markets” are capable of producing GDP but not real, meaningful wealth. And, he made this point repeatedly about China, reminding us that while it went a long way from a purely communist government and centrally-controlled economy to a pseudo-centrally-controlled-marketish economy, it’s still not a truly market-based economy and doesn’t behave as such. His point about GDP versus wealth was extremely insightful, in my opinion. I hadn’t heard it put that way before.
His explanation highlights the key point. GDP is just a number. Any government can just buy machine guns and that would drive up GDP. But that rise in GDP would not be a sign that the economy is vibrant, healthy or any of the other things we’d like to see from an economy.
Below are some excerpts from the podcast. I’ve edited the transcript hopefully making it clearer. You can find the whole podcast and unedited transcript here.
18:39 minutes:
But what China does, it's very good at creating GDP, but not wealth. So look at the [Chinese] stock market, … the stock market's flat, flat for twenty five years, and the currency is weakening. And that's the problem.
12:52 minutes:
… they laid down more concrete, they used more steal, et cetera in like ten years than the US economy did in the twentieth century. You know, it was big.
16:07 minutes:
They've done amazing things. Yeah, they've industrialized. Yeah, and the reward in economics is you get richer for doing so …. And they've not done that. …[they have gotten] amazing factories. The rise in productivity from taking someone off a field and putting them in a semiconductive fab is insane. Yeah. And so they're getting paid like ten X what their grandparents got paid. They're like, hey, you know, this feels good. The thing is they should be getting paid more.
37:50 minutes:
These countries are magnificent at creating GDP growth… But it's GDP growth at the expense of wealth…
Let's say we've got a bridge. It's going to cost us a billion dollars. We're going to link two communities. And let's say it's in America and … it's in the Bay Area, and the average per capital income of the two cities is one hundred and fifty thousand dollars, right, and … you're going to cut like fifteen [to] twenty minutes in the daily commute of all those people, people with that level of wealth cutting time is good, it's productive, it's going to add utility to their lives. [I]t's got … [positive] net present value. Okay. So the value of the billion that you spend … maybe it's two billion.
Okay. Now, if you join up two Chinese communities and the average per capita consumption is eight thousand dollars… But you spend [the same] billion and what happens is you've not created wealth. …[you actually lost] like half a billion, so you're in a half a billion deficit. That … half a billion deficit doesn't get measured in GDP. You measure the billion.
And so this is why the strategy doesn't work because sure you get GDP, but where's the stock market? Right? And where's the stock market in America? ... We're in it to win it, right, and so we get less GDP, but we get the best stocks and the best stock market. That's the fundamental flaw [in these non-market-based economies].
I’ll expand his insight. China and emerging economies are generating GDP but not as much real wealth and hence fall short of long-term sustained, quality economic growth because they are using non-market means to do it.
An economy dominated by free people choosing how to allocate their time according to their own, private, individual interests, leads to higher human well being, if we define human well being as letting people have what people themselves value, based on their own moral, religious or other views. But it may not lead to as much GDP. Maybe I want to work less and spend time with my family. That’s less GDP but more happiness.
Hugh’s point is more financial and notes that a market-system leaves an incentive to create value for people. If you do, you can make money. According to him, we can observe that China can generate GDP but not wealth because it’s stock market remains flat - or at least flatter than it’s GDP - and the currency continues to lose value (a long part of the rest of his discussion).
This will be a problem for any non-market-based action. Private individuals making private decisions would make the financial calculations and wouldn’t ever build the Chinese bridge in his example. Instead they would invest the billion dollars in something else that would return more than a billion dollars. Governments, however, do make that investment all the time.
Imagine connecting your hometown with the neighboring town. The first road connecting two cities might be worth it (i.e., generate more than a billion in value). But how about the second, third, fourth…or four hundredth road? Each time the billion is spent, GDP rises by a billion, but the deeper value isn’t really there and the four hundredth road was surely a waste of money.
Policy Implications
The policy implication should be clear. If we in the US and Europe are worried about China swallowing us up, the best policy is to keep our economies as free and as uninhibited as possible. We want people in our economies investing in opportunities they see as having long-term value.
The last thing we should do is use the government to conduct industrial policy to decide where to invest for the future. That takes things from a successful market-based policy to a “GDP without wealth” policy. We might choose to do that for some things like fighting climate change, social justice, or national defense, if those are things we believe in, but we do it in those cases regardless of whether it creates wealth. We do it for non-economic reasons.
When we want long-term growth and prosperity, we need to rely as much as possible on market mechanisms. We want to tap the wisdom of the crowds, accessing all that decentralized knowledge hidden deep in our society. We want those people no one knows about today but who are inventing the technologies, products and entire markets of the future. We want them to come forth and improve our lives. And when they do, they get to earn their financial reward which is wealth.
Conclusion
I don’t worry about China overtaking us economically. Not at any level.
Militarily? Yes. They have a huge navy, invest in military technology and are aggressive. We seem to be turning a blind eye to that challenge.
But, economically? No.
Sadly, China seems to have turned from the market-based path that brought so much improvement over the last 30-40 years. I don’t know why. Perhaps there are limits to how much you can allow markets to work when you don’t have a democracy.
Bloomberg recently wrote of the current situation: “To rescue the beleaguered Chinese property market, Xi Jinping’s government is relaxing mortgage rules and urging local governments to buy unsold homes as authorities become increasingly concerned about the sector’s drag on economic growth.” (link) That does not sound like a prescription for continued success. It’s chasing GDP instead of real wealth creation, once again.
My concern when I read reports from China about market problems, insufficient demand, ghost cities (i.e., buildings built but no one working/living in them), that they are subsidizing EV production, digging new coal mines, that they are having a property crisis and that their government is tightening it’s control and influence…my concern is that China’s past success is slowly crumbling and they are entering a long, slow decline back into squalor. I hope not. Sincerely. But I worry that these are signs of that decline.
But, you might wonder, what if they turned back to more market-based economic policies? Wouldn’t they threaten the US then? Wouldn’t you worry then? No. Not at all.
Market-based economies are based on cooperation, not conquering. In a truly market-based system, I can only get rich by serving my fellow citizen, selling them something they want, offering them services they value and so on. In a non-market-based system, I can get rich by getting into cahoots with the government, getting them to guarantee me some contracts, a protected market and so on. So… China becoming more market-based would be a wonderful thing for both the Chinese and the rest of the world.
Let’s hope they move in that direction and that we don’t move ourselves in the opposite one.
Thank you for reading.