One part of the recent economic picture has been the too-cheap credit that has kept us all feeling really rich for the past decade. In the most famous story about this problem, cheap credit meant many people bought houses they couldn’t afford, and we all know what happened there. When the bad mortgage market collapsed – as it had to do, since it was built on fantasy demand – the housing market went with it, wiping out apparent wealth people had invested in their homes. Initially people here talked as if it was a problem specific to the USA, and that the Canadian real estate market and economy would be fine, since our banking and real estate sectors are significantly more conservative. The fundamentals of the Canadian economy were fine (whenever you hear that, you can assume the opposite).
The problem is that while our banking and mortgage systems might have been in better shape, the underlying demand for real estate is driven by the health of the overall economy. 30% of our GDP is generated by direct exports (not counting the significant spinoff economic activity that comes with those exports). 81% of our exports go to the ravenous USA. So, with a little bit of math you can conclude that if the US stops buying, Canada’s economy is up the creak.
And the problem is that the “cheap credit” problem was hardly confined to the real estate market. It’s in every bit of the economy. Credit was sloshing around everywhere, and that means spending everywhere: corporate mergers and acquisitions, new business, expansions, small business loans and student loans, car financing, luxury good purchases, lots of jobs for lawyers, accountants, and every kind of supplier to the big and little companies you can imagine, including web designers. Credit sloshing means we all feel rich, since there’s lots of cheap money to invest in new projects, lots of money and work to spread around.
But starting with the mortgage crisis, credit started drying up. All of a sudden the the rosy prospects for the whole economy contracted greatly. With credit expected to be no longer cheap, all the big spending ways of companies and governments and individuals, and all the VC money starts to tighten.
Imagine you have a platinum card, $100,000, and you spend accordingly, assuming you’ll be able to pay it off later. Then all of a sudden your card gets cut to a $1,000 limit. You’re going to spend less money: fewer trips, fewer gold necklaces, fewer iPhones. And each company that used to benefit from your largesse will feel the pinch too.
That’s why the stock markets have plunged. Because as each company’s credit has dried up, they are likely to buy less (services, materials etc). And since each company is likely to buy less, each supplier sees drops in their orders across the board. So everything is going down down down.
Since the stock market has long been a proxy for “health of the economy,” at least in the media, a shudder of terror went through just about everyone as the Dow, Footsie and TSX (and the rest of them) started to tank. But in some sense I get the feeling that people still think this is an abstract problem, with impacts on their RRSP statements, mutual fund holdings and stock portfolios, robbing them of significant paper wealth, but not quite linked to the day to day of life.
Of course it is: the result will be job losses across the board.
And then there is another problem: China.
While cheap credit was one reason we’ve all felt so rich the last decade or so, the other part of the equation is China’s manufacturing sector. Ever notice how cheap things are these days? You look at an item, say a BarBQ at Costco, and you just can’t figure out how something with so many components, materials, weighing tens of kilos, could have been assembled, built and shipped to you for such a low price. It often doesn’t make any sense, but we haven’t really bothered to care about that, we’ve just happily bought and bought more.
I worked for an environmental tech R&D company for a while, and one of our main products was a power inverter for alternative energy sources. A major part of the inverter was printed circuit boards. To get prototypes built here in Canada cost about $350 a piece, and took several weeks. To get the same thing from China too several days, including shipping, and cost $35 a piece.
That’s 10% of the Canadian price, and while I’m sure workers are paid poorly in China, I had trouble squaring such a price difference.
And the problem is that our whole economy is built on Chinese imports – of consumer goods sure, but just about everything now has Chinese components somewhere or other, especially anything in the hightech sector.
So if there is a problem in Chinese pricing, and if there is a real readjustment, then we’re all going to face the consequences. Here’s what Avner Mandelman has to say in today’s Globe:
You see, China, like Nortel and Japan and Soviet Russia, has been selling most things below true cost – which is the direct cost of production plus the cost of capital – and thus lost money on much of what it produced, and so destroyed much of its capital. A company that does so must eventually lay off workers and go bust. China, in my opinion, now faces similar risks, which Mr. Wen finally admitted.
Why does China sell below true cost? Because it is a dictatorship that wants to keep its restive people employed, and so, like (democratic) Japan before it, it keeps throwing good savings at bogus products. I say bogus because if you sell below true cost you create fictitious demand that otherwise wouldn’t be there had the product been priced realistically. Thus the large factory you built to satisfy the goosed-up demand cannot be rebuilt once it wears out because you didn’t include depreciation in the product’s price.
What this means is that we’ve been rich based on two simultaneous fantasies: cheap credit and cheap goods from China. But cheap credit eventually dries up, and the cheap goods from China have essentially been sold at below cost, meaning China’s whole economy could come tumbling down.
It’s hard to figure out how all of this will play out. After all, China owns much of the US’s debt, and China can only keep it’s economy going if the US keeps buying. So everyone has an interest in keeping the fantasy going, but the laws of physics, I fear, are going to get in the way eventually.
All that to say, things might be much worse than we think they are. I hope not.
I think you’re on the money Hugh. And deflation doesn’t seem out of the question. The big ? in all this is the psychological component, will consumption lock up fast causing the banks to continue to hold back, or will well trained consumers rebound, despite credit constraint, enough for the banks to loosen those same constraints. Although we pride ourselves in being rational, we aren’t really, especially in large groups. We have our moments of clarity but I don’t think there is any logical, predicable course that things will follow. We have strayed into chaotic behaviour and small fluctuations will lead to big reactions until our confidence is rebuilt. For this to happen soon there will have to be a lot of pulling together, especially govt and business leaders, lets hope it brings us together because the alternative will be ugly.
@Ian Well, “consumer confidence & spending” is really just a band-aid solution, as is the recent lowering of interest rates to spur spending. The underlying problem is that we’ve had too much consumer confidence, spending for too long, and now it looks like the piper has not been paid. I don’ know, this stuff is in some sense so abstract – just keep spending and everything will be alright. But it sounds like perpetual motion to me, a house of cards. You are right tho: the alternative is ugly.
@Paul …are you spam? I guess not quite, but it’s borderline.
China is very often seen as dependant of US and western consumption. But I wonder if a country with such a strong culture and enormous population can ever be dependant of anyone.
My guess is that China is able to feed itself from its own market and will soon start to market “designed in China” products in every domains.
Westerners think too much that the world need them. It doesn’t. We became cash-cows because of our own greed, sacrificing our industry and our ability to have long term vision.
I don’t disagree with any of that, but I am not sure that it solves any of the problems. If China has built a huge manufacturing sector based on exporting goods to the US at below cost, then the whole foundation of their economy; which in a sense is the same foundation as ours, is teetering on the brink.
Whatever the cultural situations, the global economy is all linked together, and if there are big shifts in any direction (whether that is problems in US purchasing power, or problems in Chinese pricing schemas, or whatever else) it’s going to cause significant problems everywhere.
I’m not sure the global economy makes financial sense right now…and if it doesn’t, then it risks getting mighty uncomfortable across the board.
Then again, I am a bit of a pessimist on these things, maybe everythign will work out just fine.
Hugh, I don’t have any answers, it was just mere feelings. I just feel that the Chinese did not throw themselves into the globalized market without having thought twice. They have a different perception of society, individuals within the society, wealth, power, growth, machines, culture, etc. We are prompt to think they copy and adapt to the western standards, they don’t. They just move their own standards to new levels.
When I travel, I am always amazed to realize how the world is globalized only at the fringe, at a very superficial level. But at the core of cultures and people’s minds, things are still highly “local”. Which is good, I think.
I have no doubt that China will set new economical and social rules for the coming decades. Maybe not for the best, we’ll see… it’s a bit scary though.
I also think that it’s time for the West to think out of the “all economics” box that emprisoned us into a very tight perception of “wealth” and “growth”.
Nice analysis, Hugh.
In terms of China selling below cost, I’m not sure I quite buy that explanation. It looked to me like the way they boosted employment was to artificially strengthen the dollar and weakening the yuan by loaning us all that money. They did loosen the peg a while back, but not completely.
But this explanation has similar ramifications anyway, as this isn’t sustainable in the long term either. Eventually China’s central bank is holding too much of its assets in an overvalued dollar.
@guillaume: yes, i agree China will tend to be more careful than the western “freedom of the market” approach to things, but I still think we’re in for “interesting times.” My main premise is that western economies cannot afford the wealth they apparently have been generating for the past 15 years or so, and part of the reason for the fantasy has been cheap (underpriced?) goods from China. Even if China is stable, their growing economy/standard of living is eventually going to put the pinch on us – as manufacturing costs there rise. Then what? To Africa, perhaps.
In any case, I’m not really making any kind of prescriptive claims about what we ought to do (i have no idea), just a descriptive analysis of what seems to me built-in instability in our current economic structures, which is likely to eventually result in pain.
@felix: I don’t have any hard evidence about Chinese pricing, but it sounds feasible to me. I suspect China is doing everything it can to keep job creation healthy: infrastructure investment, below-value pricing, currencies manipulation. As Guillaume says above, they probably have their eye on on the long-term.
But how it’s all going to play out, who knows?