World’s Largest Fraud: China.

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China is not a communist country. Communism in China died with Deng Xiaoping’s agricultural reforms in the late 1970s. The legacy of Mao Zedong is kept around merely as a nationalist tool. Nobody in China believes in Marxism or Maoism anymore. The government openly spurns Maoism, in fact. There is almost nothing communist about modern China.

In China, communism has been replaced by another ideology, albeit unspoken: Crony Capitalism. The ruling Communist Party (in name only, of course) has long abandoned orthodox socialism in favor of hardcore cronyism. The Chinese Government does not directly plan most of the Chinese economy, but it uses a wide swath of regulation to pick and choose favored corporations and firms to dominate certain industries.

By now, most people have read about the Chinese property boom, which is a huge bubble. In fact, it is possibly the largest bubble in history. We’ve all read the stories from China about the construction of gigantic cities that sit empty, enormous shopping malls that never open a store, and the relentless construction of zany resorts and landmarks that never reach a mass clientele. All of this is being built, and most of it is never put to profitable use. In a pure Capitalist market, whoever is building these would have gone out of business long ago. But that isn’t happening. The major firms in China that undertake these projects are keeping their heads above water. How is this possible? How can a real estate development firm build a city’s worth of perpetually-empty condominiums and not go totally bankrupt? You know that the Chinese government has to be involved somehow.

David Stockman, former fund manager and ex-director of the Congressional Office of Management and Budget, has written a marvelous article examining the Chinese property bubble. As Stockman writes in an article posted to Lewrockwell.com:

As the 21st century dawned, China had about $1 trillion of credit market debt outstanding, but after a blistering pace of “borrow and build” for 14 years it now carries nearly $25 trillion. But here’s the thing: this stupendous 25X growth of debt occurred in the context of an economic system designed and run by elderly party apparatchiks who had learned their economics from Mao’s Little Red Book!

That means there was no legitimate banking system in China–just giant state bureaus which were run by party operatives and a modus operandi of parceling out quotas for national credit growth from the top, and then water-falling them down a vast chain of command to the counties, townships and villages. There have never been any legitimate financial prices in China–all interest rates and FX rates have been pegged and regulated to the decimal point; nor has there ever been any honest accounting either—loans have been perpetual options to extend and pretend.

The main idea of the article is this: The Communist Party of China has been using it’s power to hide negative market consequences from the Chinese public and create the illusion of a functioning economy. The bureaucrats that run the Chinese government have been able to use their control over the banking system via the Central Bank to paper-over negative market consequences and prevent the unsound truth of the Chinese economy from becoming manifest in a major economic bust.

The key factors at play are interest rates. The Chinese government totally distorts domestic interest rates to generate demand. Interest rates are a vital signal in a market economy; interest rates reveal relationships between perceived present and future values, and thereby dictate the terms under which investors borrow, loan, and spend money. Central Banks worldwide distort interest rates, but the Chinese People’s Bank takes the cake. They have distorted interest rates beyond recognition for 30 years. Domestic interest rates in China are practically meaningless now, because they are dictated by the People’s Bank and not by the market and consumers.

Without a clear perception of the real rates of interest, Chinese investors and businesses do not know how to properly allocate resources. Knowing the proper interest rate helps an investor or businessman know how to allocate present goods against future goods. Because interest rates in China are so heavily distorted, investors and businessmen have practically no idea how to properly allocate resources. Furthermore, the Chinese government flat-out suppresses negative economic data through dishonest accounting. It is nearly impossible for Chinese investors to know anything concrete about the real state of the economy. How are they supposed to make any informed and wise decisions on how to allocate resources? This is why we are seeing the construction of entire cities that sit empty, and shopping centers that never host a single sale: economic signals are totally out of whack, and this leads Chinese builders to make wildly foolish decisions.

The second key point: Not only does the Chinese government suppress and distort economic data, but it also is committed to bailing-out any potential major busts in the markets. Major busts, like bankruptcies, are vitally important economic signals; such events let investors know when resources have been misallocated. These losses then find their way into the pockets of other investors, who put their newfound capital to more productive and efficient use. This is how the Free Market operates. However, the Free Market has not operated in China for over 30 years. The Chinese Government has been distorting economic signals and attempting to manipulate market signals since the late 1970s. This has created the illusion of explosive prosperity in China. There are people that genuinely believe the Chinese government has found a way to beat the Free Market, and that China is marching upward and onward into the light.

At some point, this whole charade will come crashing down. The bubble will pop; Chinese real estate will collapse, Chinese Stocks will collapse, some financial institutions will go under, and a lot of Chinese are going to lose a lot of money. However, I cannot tell you exactly when this will occur. The Chinese government is committed to preventing this scenario at all costs. They will not be able to prevent it, but they can delay it. Maybe for a long time. But I do not think it will be too much longer of a time.

When the real estate bubble pops in China, I think it’s possible that the Communist Party might be overthrown. Ye olde mandate of heaven, rearing it’s head once again. Millions upon millions of Chinese who have invested in the property bubble and now consider themselves to be middle class will riot and protest. The Communist Party has zero credibility in China, but it has great legitimacy. As long as the populace is sheltered by the government from negative economic sanctions, the Chinese public is content to let things continue as they are. After the property collapse, the Communist Party will lose legitimacy as well. No government can survive without legitimacy. The Communist Party will basically have to fight for it’s own life at that time. I foresee revolution.

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