Usustainable American Finances

Ah, there’s that word “unsustainable” again. While it is only a theory the world will punish the U.S. for its trade imbalance with even further devaluation — although the U.S. may be different, it has punished every other country in the same boat — it is a fact that a dysfunctional financial sector results in market crashes, institutional failures, massive consumer losses, and sometimes government failure. The prospect of such a development is a far more important problem for the world than the U.S. trade deficit.

If China were to fall into social and economic disarray because of market failures and the chaos paralyzed or brought down the government, the country would lack the legal and institutional backbone to recover quickly. China’s government management is monolithic and authoritarian. Like the U.S., China is too big to fail. It’s in everyone’s best interest to ensure that it does not. And we have abundant evidence the Chinese are acutely aware of the risk of failure in the process of transforming a communist dictatorship into a market economy with some elements of democracy.

After all, Russia rushed into both areas and fell flat on its face. The dislocation and disruption continues to this day, more than 20 years after perestroika. China is moving more slowly to avoid the same fate. In mid-2007 it’s already possible to identify a potential source of market failure — the Shanghai stock index, which goes up whether companies report earnings, the central banks raises interest rates, or any other event occurs that would cause a pullback under normal conditions. This is irrational exuberance, in spades.

And because for the most part the Chinese retail sector consists of people who are actually quite poor, a large failure on the scale of 1929 or 1987 could be socially and politically catastrophic. Unlike the U.S. trade deficit, the issue is urgent:
The Shanghai Composite Index rose 130 percent last year and is already up 56 percent in 2007 (Figure 3). It is widely believed the bubble in the Shanghai index was the real reason the People’s Bank raised interest rates, and that financial officials
are deeply worried.

More than 100 million individuals own investment accounts in China today — up from zero 15 years ago, when the Shanghai exchange was established. Private analysts say, rationally, that when bank deposits are yielding only a little more than 3 percent and inflation is 3 percent, the government is going to have a hard time luring savers away from stocks.