The China Vortex

While there has been much heated discussion in recent days about what Apple plans to announce on January 27, almost all of the comments, some of which are very good and offer intelligent insightful analysis, focus on what Apple is famous for, the front-end user experience.

In this article, I would like to focus on what I think is just as important but talked about much less, the business angle for the Apple Tablet. Beginning with the iPod, while Apple focused on changing the consumer digital experience, it has worked just as hard on changing broken business models, starting with the music industry. In 2001, when the iPod was first launched, many people listened to their music on recordable CDs and CD players. The music industry’s major labels had fought and won against Napster, but the digitally savvy were distributing songs and music for free on the Internet.

Then Apple updated iTunes, and continuously added more power and features, first on the Macintosh platform for its loyal user base, then when it had reached a degree of stability, pushing out to the dominant Windows platform. At the same time, Steve Jobs negotiated with the music labels to get them to accept music sales for .99 per single song. There was strong initial resistance to this because the labels were used to selling CDs, and even though CD sales were falling, they stubbornly stuck to this model. That is, until reality stepped in, and someone had to point out the obvious, after which one broke rank and reached a deal with Apple. Then the others fell in line.

Before the iPhone, there was the same problem with applications on mobile phones. Except in this industry, the role of the music labels was replaced by the carriers. As Steve Jobs himself said (paraphrasing him here); they found an industry which was broken and didn’t make sense, and Apple’s engineers came up with a new solution combining a phone, a computer, and gaming device all into one elegant solution based on OS X technology with the Apple interface. The result has been the iPhone which has become popular, breaking sales records worldwide.

It would be all too easy to say that the success of the iPhone is based on device and user experience alone. That would take an oversimplified view of what Apple has been doing since the iPod: it creates new devices which at the same time, create new business ecosystems which increase and diversify the revenue streams for Apple, while making things easier for publishers. The design sexiness means that the new device can sell for a premium price which Steve Jobs (and his shareholders) love, while the backend store and ecosystem builds out, becoming an important distribution point for Apple services and locking in publishers.

I accurately predicted this with the launch of the AppStore for the apps which users can download/buy for their iPhones, giving them the power to customize their phones with their own selection of application software. For developers, the model, while not perfect, is simple to understand: developers set the sales price, and Apple takes 30% for hosting and billing while the developers keep the remaining 70%. The result has been outstanding sales success, even beyond what Apple predicted.

Looking at the book publishing industry today, it is a broken business model. From the author’s point of view, while writing a book is hard enough, the business side is even worse. First of all, in the US, one must find an agent and complete a draft and book proposal. The agent then shops the book to publishers, and then negotiates a deal with the book publisher, which usually involves the agent taking 10-20%. The publisher then may pay an advance (becoming increasingly rare), and then the author is paid a portion based on royalties for the books sold, which is usually 5-10%. The book publisher makes sure that the book is edited and makes its way into the book distribution system (dominated by 2-3 players) which gets it into book stores. However, the author is largely responsible for promotion. To make things even worse, bookstores in the US don’t really buy books; they sell on consignment. This means that they can return unsold books to the publisher, and get a refund, which cuts back even more on how much the author gets.

When you figure all this in, it’s amazing that there are any authors who make money at all! Now, let’s say that you are writing a book on a fast-changing field. In my case, my main subject is China and technology, both of which are fast-changing fields. By the time you go through the whole book publishing process and your book hits the shelves, everything has changed! Information which was current 18 months ago has been completely superseded by changes in Chinese government policy, changes in business conditions and changes in technology.

Please tell me: “How can an industry get more broken that that?” No wonder smart people are choosing to get their information from the Internet in preference to books!

If I were Steve Jobs, I would look at this and say: “If I have a good device which offers superb user experience, leverages off the current Mac user base (which now includes iPhone users), and ties in on the back end with a new business ecosystem which gradually sweeps aside the current broken publishing ecosystem, we might have something.”

Now, in order to make the Apple Tablet a real success, it has to have certain functionality which will not cannibalize iPhone and Mac notebook sales. This is why it’s point of attack will have to be on books, magazines and the publishing industry. It will offer developer tools for Apple’s digital publishing solution. Already there is talk about Apple’s new SDK for this new platform.

My prediction is that this new SDK will make it apparent why Apple has not been friendly about offering Adobe’s Flash access to the iPhone, since Apple’s solution will offer much of the same feature set as Adobe Flash, but will be more tightly bundled in on the front and back ends to the device and to the store. (Steve Jobs likes closed ecosystems where he controls the whole experience.) Tough times for Adobe’s Flash and Microsoft’s Silverlight: all dressed up and nowhere to go.

So what about Amazon’s Kindle, which have already outsold print books in distribution this past Christmas? Ironically, the Kindle will help Tablet sales since many Mac users have held back on buying a non-Apple device, waiting for Apple to come up with their solution. When they see the Apple Tablet, this pent-up demand will be released, because the Apple UI design and interface will offer something to them which the Kindle, in its current iteration lacks. Amazon will get a new competitor for online electronic distribution, which will cut into their Kindle sales and profits.

Speaking to a few book publishers (yes, they still exist), I have heard complaints that they are not able to make money on their Kindle editions; print distribution is still more profitable with them, even though sales are tracking down. Apple and Steve Jobs don’t have to do much to bring them aboard. My prediction is that the business model will be like the App Store offering for developers: “You set the final sales prices, we take a percentage on each sale.”

As for Google, they seem to be focusing most of their efforts on the Google Android platform, which will make inroads this year. This year, Google won’t be able to do much in the publishing field, and if and when Google does enter this field to compete with Apple, they need to undo much of the bad feeling with authors and publishers over copyright which started with Google Books to the point where a Chinese author has sued Google! (Hmmm… What’s wrong with this picture?) This will give Apple at least a two-year lead over Google in this field and Google will have to fight a tough uphill battle when it comes in.

About this time, Apple will be getting into the advertising field. I mean, who is still impressed with small text box ads on their web page, and doesn’t find them at least a little annoying, even though they may be relevant? My guess is that Steve Jobs is thinking about applying some magic sauce to make them better, sexier both for advertisers and content syndicators, and in the process, getting more revenue, and a new revenue stream, for Apple. I find it hard to believe that Apple is investing so much in a new data center without new revenue streams. My guess is that it will include advertising, and if correct, then Google will be on the defensive. It may take the form of a free service Apple TV with ads, and subscription form without ads.

No wonder Steve Jobs is feeling extremely happy, life just keeps getting better and better.

If you look at the prevailing wisdom in business magazines, the view is that through the Chinese govt’s massive pumping of solvency into the economy beginning in November 2008, China has acted as a responsible global citizen, saving the world from a massive global meltdown which, left uncontrolled, would have forced the global economy back into the Stone Age. Without this massive stimulus package, Chinese factories would have had to lay off many more workers leading to more social problems, and maybe even social instability. And social instability is a no-no in China, especially when the stated policy goal is a harmonious society.

In order to maintain this top-down version of the harmonious society, the Chinese government, especially the media, has taken an active role in heading off issues which would be taken up by consumer rights organizations in other countries. Instead of trying to put a lid on dissent, reporters have acted more as investigators, giving lead coverage to stories such as lead poisoning by a government-owned smelter.

The thinking behind this new government pro-activism is that if government ministries can act pro-actively to head off issues before they become explosive social issues, then Chinese society can head off the kind of activism which is led by grassroots consumer organizations in other societies. At the same time, the Chinese government can clean itself up, shutting down companies which do heavy damage to environment and society, and replacing old-school bureaucrats with more modern technocrats who really know what they are doing.

The government’s job is helped and hindered by the Internet, which it has a love/hate relationship with. With more than 338M Chinese users on the Internet now, it has become the place where many bored and under-employed Chinese find entertainment and gossip. It helps the government keep an eye on local officials, since people will complain anonymously on the Internet. At the same time, rumors can spread very actively on the Internet, as was the case of Uighur women in Shaoguan being attacked in a Guangdong factory, which led directly to the deadly riots in Urumqi in early July.

The fundamental underpinning for China’s growth into a major locomotive of economic growth has been globalization, which until last year, was led by the US consumer sector. The problem now is that, for all practical purposes, the US consumer does not exist anymore. Basically, the US consumer had hocked its own future to the banks. Then the future arrived, and the banks put the screws to the consumer. Now, Americans are (re)learning the virtue of frugality.

Frugality and savings were a virtue which the Chinese have been well-acquainted with for a long time. Since China was dirt-poor only 30 years ago, most Chinese still know what it feels like to be poor and have squirelled away savings for a rainy day. However, more savings was not what the economy needed when the global economy tanked last year.

So, in order to keep the economy sailing smoothly, the Chinese government pumped liquidity into the economy. I have had my own doubts about the effectiveness of such a policy since much of the money has found its way into the Chinese stock markets and real estate, both of which continue to rise in defiance of their underlying business economic fundamentals, which are not that attractive. In a recent conversation with the partner of a private equity firm, I voiced my doubts. He said that in China, most of the money was going to companies, mostly state-owned, which were cash-rich. These companies really did not need more cash, but almost had it forced on them from the state-owned banks. Lacking a place to put this money which from their perspective, fell from the sky, they re-invested it in the stock market and real estate. Anyone with any investment experience in these markets is aware that the general rule for these two markets are “early in, early out”. Sure you can play, just don’t be the guy without a chair when the music stops.

The trouble with this policy is that it turns companies whose growth is based on cash flow into speculators. These companies got a windfall, and in order to protect their windfall, are encouraged to make short-term moves which basically speculative.

At the same time, this money is not going to companies and individuals who have poor credit or no credit, even though in all fairness to the government, there are smaller government policies in place to help people exchange their cars or buy electronics if they live in the countryside. The net result is that the rich/poor gap in China, which is already wide, will widen even more in the future. A society which has too wide an income differential between the rich and poor is not good for social stability in the long-term.

So, if you want to figure out who are going to be the winners and losers, all you have to do is figure out who is going to be left standing without a chair when the music stops?

It has been a long time since I last posted, for which I apologize. I won’t insult your intelligence by offering some excuses, but I will try to get back on a more regular schedule. I thank you for your understanding. If you would like to follow an unadulterated distilled real-time version of my thoughts, then I’d encourage you to follow me at twitter.com/pdenlinger

Today is the first year anniversary of the May 12 earthquake which killed an estimated 100,000, mostly in Sichuan, and causing untold damage and suffering. It also awakened the Chinese government and people to the suffering of ordinary Chinese in a way which did not happen before. I don’t have anything to add which I have not already said in the previous year, so I will offer a few links which I wrote last year.

Warning: If you are easily frightened, upset and can get depressed, please do not read this article. The content is strong not in its language, but in its implications.

On Twitter I have acquired a reputation for my “Tweets of Doom”. For the most part, I do not consider myself to be a pessimist but a realist. My main area of interest in the unfolding financial crisis is how economics, history, demographics and politics come together and give us hints about future trends and show us where we are heading to.

Recently, I have read a fine article by Michael Lewis in the April Vanity Fair, Wall Street on the Tundra (also called “How Iceland Went Splat”), about how the crisis unfolded in Iceland, first transforming it from an economy based on fishing, to a country based on investment banking at the peak of the boom, then when the economy collapsed, back to fishing again.

Three paragraphs in particular stuck in my mind:

Back in 2001, as the Internet boom turned into a bust, M.I.T.’s Quarterly Journal of Economics published an intriguing paper called “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment.” The authors, Brad Barber and Terrance Odean, gained access to the trading activity in over 35,000 households, and used it to compare the habits of men and women. What they found, in a nutshell, is that men not only trade more often than women but do so from a false faith in their own financial judgment. Single men traded less sensibly than married men, and married men traded less sensibly than single women: the less the female presence, the less rational the approach to trading in the markets.

One of the distinctive traits about Iceland’s disaster, and Wall Street’s, is how little women had to do with it. Women worked in the banks, but not in the risktaking jobs. As far as I can tell, during Iceland’s boom, there was just one woman in a senior position inside an Icelandic bank. Her name is Kristin Petursdottir, and by 2005 she had risen to become deputy C.E.O. for Kaupthing in London. “The financial culture is very male-dominated,” she says. “The culture is quite extreme. It is a pool of sharks. Women just despise the culture.” Petursdottir still enjoyed finance. She just didn’t like the way Icelandic men did it, and so, in 2006, she quit her job. “People said I was crazy,” she says, but she wanted to create a financial-services business run entirely by women. To bring, as she puts it, “more feminine values to the world of finance.”

Today her firm is, among other things, one of the very few profitable financial businesses left in Iceland. After the stock exchange collapsed, the money flooded in. A few days before we met, for instance, she heard banging on the front door early one morning and opened it to discover a little old man. “I’m so fed up with this whole system,” he said. “I just want some women to take care of my money.”

This made me ask myself a question: Maybe it was not enough to look at how economics, history, demographics and politics come together in this unfolding crisis? Maybe I should also take a look at human psychology and the role it played in the financial services industry? Were there certain personality traits which made it to the top of the financial services industry, making individuals with these personality traits captains of industry?

Armed with this question, I went to Wikipedia and looked up the term psychopathy and found this definition:

The psychopath is defined by a psychological gratification in criminal, sexual, or aggressive impulses and the inability to learn from past mistakes. Individuals with this disorder gain satisfaction through their antisocial behavior and lack remorse for their actions.

Now some of the characteristic symptons are:

Factor1: Aggressive narcissism
Glibness/superficial charm
Grandiose sense of self-worth
Pathological lying
Cunning/manipulative
Lack of remorse or guilt
Shallow
Callous/lack of empathy
Failure to accept responsibility for own actions
Factor2: Socially deviant lifestyle
Need for stimulation/proneness to boredom
Parasitic lifestyle
Poor behavioral control
Promiscuous Sexual Behavior
Lack of realistic, long-term goals
Impulsivity
Irresponsibility
Juvenile delinquency
Early behavior problems
Revocation of conditional release
Traits not correlated with either factor
Many short-term marital relationships
Criminal versatility

This was getting interesting, so I went to a Time magazine article which listed the 25 people to blame for the financial crisis. The behavior of some of these individuals is, to say the least, very interesting.

Then I went back to the article and read more about the traits of psychopathic behavior. Where appropriate, I have added emphasis. They are:

In practice, mental health professionals rarely treat psychopathic personality disorders as they are considered untreatable and no interventions have proved to be effective.[18] In England and Wales the diagnosis of dissocial personality disorder is grounds for detention in secure psychiatric hospitals under the Mental Health Act if they have committed serious crimes, but since such individuals are disruptive for other patients and not responsive to treatment this alternative to prison is not often used.[19]
Because an individual’s scores may have important consequences for his or her future, the potential for harm if the test is used or administered incorrectly is considerable. The test should only be considered valid if administered by a suitably qualified and experienced clinician under controlled conditions. [20][21]
Hare wants the Diagnostic and Statistical Manual of Mental Disorders to list psychopathy as a unique disorder, saying psychopathy has no precise equivalent[20] in either the DSM-IV-TR, where it is most strongly correlated with the diagnosis of antisocial personality disorder, or the ICD-10, which has a partly similar condition called dissocial personality disorder. Both organisations view the terms as synonymous. But only a minority of what Hare and his followers would diagnose as psychopaths who are in institutions are violent offenders.[22][23] The manipulative skills of some of the others are valued for providing audacious leadership.[24] It is argued psychopathy is adaptive in a highly competitive environment, because it gets results for both the individual and the corporations[25][26][27] or, often small political sects they represent.[28] However, these individuals will often cause long-term harm, both to their co-workers and the organization as a whole, due to their manipulative, deceitful, abusive, and often fraudulent behaviour.[29]
Hare describes people he calls psychopaths as “intraspecies predators[30][31] who use charm, manipulation, intimidation, sex and violence[32][33][34] to control others and to satisfy their own selfish needs. Lacking in conscience and empathy, they take what they want and do as they please, violating social norms and expectations without guilt or remorse”.[21] “What is missing, in other words, are the very qualities that allow a human being to live in social harmony.”[35]

This was getting very interesting. I would encourage you to search through Google or your search engine of choice and make your own observation whether these individual/s showed any psychopathic personality characteristics.

Basically, what the American financial services industry created an industry where individuals with psychopathic traits could rise to the top to positions of power, making decisions about billions of dollars in investments and assets.

Intelligent psychopaths exist in every society, and many become actors, politicians and lawyers. The genius of the American system was that it put them in charge of large sums of money.

But this is only the beginning. In the name of industry deregulation, they were given, by the US government the power to create financial instruments. In plain English, they were given the power, through leveraging, to make money out of thin air, out of nothing.

Over the past twenty years, using their talents and creativity, they have leveraged approximately every single US dollar 35-40 times, inventing CDOs, CDSs and other financial instruments in the process, all of which were interlocked. As if that were not enough, some of these personalities co-opted the whole financial media, earning their trust and selling their investment ideas directly to the American people over leading TV stations and print media. At no time did any of the financial media say “Wait a moment. These guys are shysters and are cheating and lying to the American people.” Instead, the media went along and played the game with them, becoming actors in the play when they should have questioned what was going on.

The lines between advertisers, corporations and media became completely blurred, and dissenting voices were simply not heard. It became a vortex which benefited all the players, who hyped the same worldview about finance.

What was missing in the whole equation? In one word, trust. The quants had created formulas such as the Gaussian copula formula to provide a rough measure of risk, but banks had become completely separated from their clients through a complex ecosystem which also included mortgage brokers, who originated loans, even for individuals who did not have work and had no chance of being able to make the monthly payments for the homes they bought.

The house of cards began to collapse in 2007 with the subprime credit crisis, and is continuing to unwind. At this stage, we do not know where it will all end.

What is even more interesting is that the personalities and personality traits which got us into the mess are still there, negotiating with US Secretary of Treasury Geithner in the belief that they should receive money from the government for their bad assets, which they believe will recover some value after the economy bottoms out. Others believe that these assets have no value, and the sooner the government recognizes this fact, the sooner recovery can begin.

American society had become one where competition and competitiveness were rewarded without regard to the implications for the society as a whole. The society was always looking for the next big thing, the instant hit without caring about the cost. Now it is paying the price for a screwed up values system. Now we know that there are no quick fixes, and none of the choices are good.

In the meantime, we are helpless in this world they have created for us.

If you haven’t poured yourself one already, maybe it’s time for a whiskey. A strong whiskey. Neat.

@GregoryLent on Twitter just pointed me to this article, A User’s Guide to 21st Century Economics, by Umair Haque which I recommend highly.

After reading this article, some questions which came to mind:

• Chinese companies traditionally have not been good at adding value. How well can they adjust to the new 21st century economic situation?
• Chinese companies have been spending much on acquiring steady supplies of raw commodities. How much are they thinking of what is needed for the 21st century? Will they continue to build a twentieth century economy modeled on the American model, which is going defunct rapidly, or will they build a new development model for the 21st century?
• The 21st century development model is reliant on individual human talent and creativity, and making it possible for them to succeed. How is China going to attract the best minds in the world to China in the 21st century?

On this blog, I have been a frequent critic of the view that China is a threat to the rest of the world as a rising superpower. Most of the time, these critics have a clear agenda to sell with regard to fear of China, or are journalists who have very little understanding of China. If the latter group, their articles are really rehashes of “If China were a rising superpower like US/Britain etc. this is what China would be plotting to do.” For someone who has never been to China and does not understand the country and people, the argument makes sense. But for someone who has been in China for some time, it’s ridiculous.

The reason for this is very simple. Running a country of 1.3 billion people is a very tough job, and this is something these China newby articles invariably overlook. In simple terms, the daily challenges are huge and are much bigger than the rulers of the US and UK have to deal with. For the most part, Chinese are not nearly as docile as Americans and Britons, and are much more “creative” about the ways they express their unhappiness. The knife hiding behind the smile or 笑裏藏刀 is a useful phrase to be aware of in business and politics in China.

In recent days a new theme has popped up, and that is the government incentives from the Chinese government are beginning to show positive results in the Chinese economy. Some of the articles are:

• Differences Between Chinese and US Economic Recoveries
• China’s Stimulus Plan Ignites Economy

The Chinese government has acted forcefully, much more so than western governments, in fighting the effects of this recession which has turned into a depression. Compared to the west, the Chinese government has been the model of efficiency.

Sources in Beijing have told me that the Chinese government has offered companies full salary subsidies for company positions. That is, they have offered to reimburse companies full salary for positions in companies, especially positions for new university graduates. I am not sure if this applies to SOEs or if it also extends to the private sector. I am not aware of the full details of how it is implemented, but it does have the ring of truth. This has created a favorable market for employers, as many companies routinely lay off 80-90% of students following the three-month probation period.

Coming back to the rising superpower theme, this serves as an excellent illustration of a major point of mine: to become a superpower, you really don’t need to have a plan for world domination. You only need to be the last man standing when everyone else has already collapsed.

It will be very interesting to find out how long China will stand? The Chinese government is running the distinct risk of using all its bullets too early, and not having any left if the depression continues over a prolonged period. If that happens, the only thing China can do is inflate its way out. Another article point out the risk of this approach:

• Is China Pulling An Alan Greenspan?

If the depression is long and this scenario plays out, then China will become a very short-lived superpower, and will only be standing a very short time before it collapses on top of the heap with the other former superpowers.

You only win when you can walk away after the battle. Otherwise it is just a pyhrric victory.

(Trouble is, pyhrric victory is a western term which does not an equivalent in Chinese.)

UPDATE Feb. 20, 2009: Knowledge@Wharton has an article about the possible ramifications of the surge in lending by Chinese banks.

My apologies for not having written for so long. I have been “otherwise pre-occupied” and have also been watching the first weeks of the Obama presidency and the accelerating unwinding of the financial markets.

The situation looks increasingly bleak. I hope you are prepared.

Readers know that I have been a critic of globalization in its present form. In this article, I will lay out for you how badly Americans have been fleeced by their own politicians, losing their own jobs, factories and any hope of a better future for themselves and their children. And all this has happened in a country with a supposedly free media, and where people can exercise greater free will than in China, where I am writing from now.

I’m going to keep this simple, but there are some numbers involved. Keep in mind that I’m not an accountant, but I do understand business. To make my illustration, I’m going to create a simplified fictional scenario.

OK, let’s suppose that there is a factory in Pennsylvania which employs 500 people to make widgets. This factory has been making widgets since 1955 and employs 500 people, who make an average income of $2,000 a month. This means that the monthly payroll is US$1 million a month, or US$12 million annually. Of course the factory owners and employees all pay taxes which go to the city, state and federal government.

Now, the owner goes to China and finds that he can go to China, and instead of paying his workers an average of US$2,000 every month, he can get Chinese workers at an average salary of US$200 a month. Their productivity is just as good as the American workers, but they cost only 1/10 the wages. His monthly payroll expenses fall from US$1 million a month to US$100,000 a month, and his annual China payroll becomes only $1.2 million. This means that he can afford to lower the price of his widgets, thus selling more widgets.

Moreover, in order to attract the investment, the local Chinese government is willing to give him cheap land and a tax holiday for several years. This means that his upfront investment costs are lowered drastically to only US$500,000 for land and factory. The business owner would be a fool to turn down such an opportunity, right?

So he goes back to Pennsylvania and begins transferring production to China, gradually laying off his Pennsylvania workers along the way. Now this is where things start getting wacky. As he lays off his workers, they go to the state government to collect unemployment, which for the sake of simplicity, we will say, runs about $400 per worker per week for six months. This cost is carried by the state government. Eventually all are laid off, and the state pays out a total of $5.2 million (400 * 26 * 500) for all the laid-off workers.

Now, our factory widget owner is happy, because thanks to globalization and WTO, not only has he lowered his costs drastically, but he can export all over the world duty-free, since WTO has regulations against import tariffs and barriers. He has more markets, and more market access. His investors are happy because they are making more because of lower costs and higher profit margins.

But what has happened in the US? More and more unskilled, then skilled, workers are losing their jobs. The state governments need to pay unemployment, and they need to tax the employers who remain in the state for corporate taxes to sustain the system. Meanwhile the tax base of factories which remain in the state shrinks while the number of unemployed grows. At the same time, there is a very large group of politicians who rail against taxes, so the states cannot raise taxes even though their tax base is shrinking and the number of unemployed is growing. Meanwhile, the number of people accessing free state services continues to grow.

Basically, this is what has been happening in the US over the past 15 years with globalization. If you think about it, it is amazing the US economy, with all the deficit spending over the past eight years, has not collapsed sooner! And mind you, we have not even talked about subprime mortgages and derivatives yet!

Now before WTO and globalization, there would have been import tariffs. If Chinese costs were so low (which they are), the US would at least have been able to impose some tariffs to bring costs closer to what they would cost in the US and thereby mitigating some of the difference, and bringing money into the US Treasury. China’s growth would have been slower, and probably healthier for China and the rest of the world.

Now there is talk in the US of a “Buy America” campaign. Too late folks! If the US raised tariffs now, it would trigger a protectionist trade war, one which the US is very poorly prepared to win, since it now has to look to China to bail it out of its current mess. In times like these, cash is king, and China has the cash.

Now, is this the fault of the Chinese? I would say no. The Chinese just took maximum advantage of a system which was given to them, and the Chinese government wanted to maximize exports to the US so that it could earn foreign exchange to fund China’s economic development.

Different American politicians and pundits have pedaled globalization to Americans as the panacea to all their ills. But what has happened in reality? Americans have lost their jobs, lost their homes because of the growing subprime and now prime mortgage crisis, and they do not have the skills which are needed for this new period we are entering. The companies are optimized for a world which no longer exists. Americans have lost their own future, and the futures of their children and maybe grandchildren. And most are completely unprepared for this new kind of globalization, which looks like it may very well bring the US standard of living to something more closely resembling the Chinese standard of living.

For your information, until very recently, the Chinese were dirt poor. They remember what it’s like, and even though they do not want to live that way again, they can roll back expenses to the minimum if it needed. Give you an example: there is now a movement among Chinese university students to spend 100 yuan (about US$15) a week. How many Americans can do that?

These are the times we are in for.

Saying that Americans were fleeced by charlatans and politicians on both sides of the aisle does not even begin to describe the situation. Just about the only thing they have left is their own internal organs. Already there are young women who are selling their eggs to make a living. And it will just get worse and worse.

Now does China export jobs? No, China exports Chinese. The country has too many people, and the government is encouraging them to go to Africa where many Chinese companies are investing in hard assets, otherwise known as commodities. Anyone who has lived in China can tell you that Chinese are great believers in hard assets.

So what can President Obama do? It doesn’t look like he can do very much. Collapsing sales and profits reports keep on coming down the pike, and have acquired a momentum all their own. It would be nice if we could take globalization out back and shoot it in the back of the head, but it’s too late. The cat’s out of the bag, and it’s not going back in.

That’s why I’m in China.

Now, why is it the US with its free press, tell the people what was really happening? Or were they just distracted by left-wing/right-wing pseudopolitics and red/blue arguments so much that they did not notice what was happening to them?

If you want another angle on this bleak picture, I’d recommend that you read Clusterfuck Nation.

In previous articles, I have voiced some of my criticisms and predictions re globalization here, here, here, and here. Unfortunately, it is becoming clearer by the day that globalization was largely a fraud where Americans could endlessly consume and Chinese factories could endlessly manufacture without any adherence to economic fundamentals and creating a false and bloated version of prosperity and rising living standards. The brilliant minds of Wall Street came up with “risk management strategies” (irony alert) so that derivatives could endlessly build a never-ending Ponzi scheme which would go on forever and ever.

We are now entering a very painful period of unwinding of what economist Niall Ferguson called “Chimerica”. Now, China and America are entering a dangerous period of deglobalization, where they have come to the realization that after the bubble pops and the deleveraging begins, their interests are really quite different. Instead of China and America being two sides of the same economic coin, they need to play or pander to their own constituencies. The blame game will begin.

And their native constituencies are confused, hurt and angry. But they are not nearly as angry now as they will be in the near future when they have figured out what has happened to their wealth. When that happens, there will be hell to pay, and there will be blood in the streets.

The reason for this is because the leveraging which occurred is simply too big and too complicated. Taking all the bad leveraging out of the system and replacing it with cash and credit liquidity is like trying to rebuild the engines of an aircraft in flight. It cannot be done. This means that there can only be a crash.

The bright side is that crashes can be managed. You can go into a death spiral which is impossible to pull out of, but a smart pilot will look for a stretch of land and try to glide in for a crash landing. So far, the political leadership worldwide is pursuing policies which more closely follow the former path of the death spiral. This is because everyone is acting in what they perceive in their own interests, instead of keeping their heads and thinking through what needs to be done. It is a deadly panic move.

The problem is that we are now entering a phase where the crisis has spread from subprime mortgages, to derivatives, and then on to currencies. In the beginning the patient suffered from a lack of credit liquidity (constipation), so the central banks are going to provide liquidity (the enema). This did not work, and the patient has become bloated. There is the very real chance that this will eventually cause runaway inflation (dysentery) and the patient will then die of dehydration. When this happens, the currency becomes worthless and society falls apart until a new dictator imposes his will on the society, as Hitler did at the end of the Weimar Republic in Germany. In China’s case, runaway inflation led to the Kuomintang and Chiang Kai-shek’s loss of support in the cities, and directly contributed to the establishment of the People’s Republic.

Sounds really really really bad, doesn’t it? That’s because it is.

But there are survival and prosperity strategies. I will talk about them in 2009. But you will have to be really really tough.

Gladiator movie poster

At the end of my previous post, where I painted a generally pessimistic picture of the near future, I mentioned that I would write about the businesses which would do well in this downturn.

In my opinion, they are bread and circuses.

During the decline of the Roman empire, the Roman emperors realized that in order to prevent uprisings, they needed to feed the people (bread), and to entertain them (circuses). Life was grim, ugly and short. People lived for the day. People were reduced to their most basic needs, food, sex and entertainment. Everything else was unnecessary, and most likely, did not do well as a business.

The most popular entertainment of the time in Rome were massively staged gladitorial spectacles which were fights to the death for the gladiators. When people were this miserable, they wanted to have power, if only for a moment, to see others fight to live. People were not happy, and they got pleasure and enjoyment out of what some would call sadistic entertainment (in happier times).

The Roman emperors provided a huge spectacle as an outlet for this frustration in the form of gladiator fights at the coliseum. Instead of trying to resist this angry urge, they saw that the only way out for them was to channel the urge away from them. The state rode this wave, and brought Hollywood production values and state funding to this entertainment to keep the sheeple happy. That is how they were able to extend the period of decline in the Roman Empire to 400 years instead of being overthrown much earlier.

Bread and circuses.

The times we live in will be very similar.

In China, where entertainment is already a large part of what makes up the Internet, there is already a very large entertainment component.

Historically, Chinese rulers have been experienced at putting down rebellions and uprisings, but when it came to entertainment for the masses, they could not hold a candle to the Roman emperors. On the other hand, they did not produce characters quite as twisted as Caligula and Nero either. The Roman emperors were in a league of their own.

Now, how to get state funding and production values for huge epic productions which recreate the smell, blood, excitement and drama of a real gladitorial spectacle as was captured in the movie Gladiator? Whoever can answer that question and can figure out how to bridge online games and the real world drama of life and death gladiator fights, creating a whole new experience, is in the money, not only in China, but globally.

Plus ca change, plus c’est la meme chose.

One of the big problems with the present economic crisis is that we really do not know how big the problem is. We know that our problems have been caused by the creation, then over-leveraging of debt. But we don’t know how much debt was created, then sliced into derivatives multiple times which were then sold on to financial institutions all over the world.

But no one knows how much debt, then derivatives, were created by this whole process. That is the big elephant in the room which no one wants to talk about.

That makes it a good reason for me to talk about it.

We now know that a great deal of what passed for growth in the US over the past 20 years, starting with the Reagan administration, was financed by the creation of debt. Debt, by itself, is not a bad thing. In fact, it is needed for healthy growth. Companies, and countries, frequently reach stages in their growth when they need to borrow in order to reach another level of growth. When they get return from this new level of growth, they pay back and retire the debt. That is the way debt is supposed to be used.

Now, the problem which started in the US is that there was no intention to retire the debt. This was why the US Republican party pushed “deregulation” to get votes. Without deregulation, and a necessary amount of fraud, this debt mountain would not have grown as fast as they needed it to grow. Instead, the debt was sliced to ever finer parts, and sold into the global economy. Wall Street, especially its investment banks, became a mechanism for the creation, processing and sale of ever newer varieties of debt into the global economy. As long as there was growth, the system worked fine. And this is where the problem comes in: any system which can only survive when there is “growth” and cannot withstand changes and reverses in market conditions is effectively a Ponzi scheme. “Growth” becomes a means to its own ends, and becomes a necessity. When the “growth” conditions end, the system collapses.

Which is what we are going through now.

What we are going through right now is the great unwinding or deleveraging of what has happened over the past 25 years. In simple terms, the investment bank firms, and now hedge funds, and so much of the US financial industry became addicted to leveraging. Now they cannot leverage anymore, and their business model no longer works.

This raises a very interesting question which I have not seen others ask yet. That is “If debt financing and leveraging did not happen in the US, then how big would the US and global economy be?” In dollar numbers, it would be much smaller, and financial services and outsourcing would be much less important features of the US economy. There would be more manufacturing, and China would not have grown as quickly because it would not have had such a huge US export market to sell its products to. Without such fast economic growth, it is likely that the Chinese government would have had to look at social and political reforms sooner rather than later. Faster growth would have been replaced by slower more solid and more balanced growth.

China has made this problem bigger because it insisted on keeping the yuan at a lower exchange rate in order to protect its main export market, the US, addicted to Chinese exports. As I have said earlier on this blog, China and the US are two sides of the same coin. But right now, the two sides do not enjoy the same interests. The Ponzi scheme which served both sides so well no longer exists. This means that there will be recrimination and anger as each side seeks to pin the blame on the other side.

If we are ruthlessly honest about unwinding the overleveraging, I suspect that much of the world’s growth (60-75% + compounding) since the late 70s would not exist. Obviously, that is an outcome none of the world’s governments would have an interest in.

The main problem in economics is: “What is productivity, and how do we measure it?” I do not pretend to have an answer to that very challenging question, but I suspect that most of the improvements in production over the past 30 years come from improvements in information technology. These improvements in productivity mean that it is possible to create more with less people.

The real problem now is there are too many people, and most of them are not very productive in terms of adding value to an economy.

My guess is that as the unwinding continues, people will get angrier as their standards of living fall. When this happens, governments will have to choose which is worst, deflation (caused by unwinding) or inflation. Inflation has the advantage in that it can hide the real fall in living standards by gradually debasing and eroding the value the currency, but making the general populace think that they are making more money. The downside is that inflation is notoriously difficult to control. In a worst case scenario, it turns a country into an Argentinian or Brazilian basket case, where inflation becomes a routine tool for controlling the masses. More darkly, it drives the entrepreneurial class to other countries where they can make a better living for themselves and for their children.

When it does go out of control, it becomes the most powerful and deadly destroyer of wealth there is.

And that is the current situation where we are…

In my next article, I will talk about the businesses which will do well during The Great Unwinding.