I have not written articles in a few months, except for the one I wrote for the July issue of Institutional Investor magazine, on Japan (I’ll post a link once the magazine comes out).. I am sure Freud, after spending a few minutes in my subconscious, would provide some disturbing explanations. But as Freud said, sometimes a cigar is just a cigar. I’ve just been enjoying summer with my family.
My nine-year-old son Jonah and I have been playing chess a few hours a day. I never thought I’d enjoy playing chess as much, but I do. In fact, over the past year I’ve probably played more chess than in my whole life. I win every game! When I win, I win. When I lose I win – seeing your son (your student) beat you gives you an enormous satisfaction as a teacher. In fact, I never thought I’d enjoy losing so much. Jonah has this quality that I need to nurture in him – he never gives up. Even a game that is a clear loser for him, he plays till the end. What a great quality to have in life!
I am also enjoying seeing my four-year-old daughter Hannah grow up. We have yet to find an activity we both enjoy doing together (other than hugging to death), but we’ll get there. She has almost learned how to ride a bike without training wheels; maybe we’ll do cycling together. They’ve been going to a summer camp that is half a mile from my work and six miles from our house. A few times a week, while I tug Hannah in a bike-stroller, Jonah and I ride our bikes 30 minutes to the summer camp, through the park.
I envy my kids; they have the pleasure of spending time with their grandparents. My grandparents lived thousands of miles away from me – I saw them once a year for a few weeks and that was it. My wife’s and my own parents live just a few miles from us. My father’s house is a block away from my office; I stop by a few times a week for breakfast before I go to work.
My father gave Jonah a 50-state quarter collection for his birthday. Now, every day before Jonah goes to sleep, he and his grandfather spend half an hour on Skype learning about each state; and once they are done with a state, Jonah puts the coin at the proper place in the board. They also play a game of chess on Skype chat.
I gave a presentation last week at the Value Investment Seminar in Trani, Italy (here is a link to the PDF). I strongly suggest you visit their website in a few weeks, as it will have presentations and videos. It was a terrific event; I learned a lot.
I spoke about China, Japan, and our favorite stock idea: eBay. I changed the title of the China presentation to “China, the Mother of all Grey Swans” (instead of “Black Swans”). A while back, when I shared this presentation with my readers, I was corrected: China is not a black swan, because a black swan is a rare, significant, and unpredictable event. However, the consequences of what is transpiring in China and Japan are for the most part predictable (especially if I am writing about it). We don’t know when they will play out, but they are predictable.
Nassim Taleb, one of my favorite thinkers, who brought the black Swan to life in his books Fooled by Randomness and The Black Swan (I like both books, but Fooled by Randomness is my favorite, plus, it is by far an easier read than Black Swan), solved my dilemma with China by creating a new swan: “grey”– a rare, significant, but predictable event (though the timing is still unknown, or perfectly known only with the benefit of hindsight.)
I spent a few days at the seminar discussing and debating China with some very smart folks, who stirred up some random thoughts.
What really amazes me is how people who would not trust the US or European governments to do their laundry, have unconditional faith in Chinese government involvement in its very complex economy.
The Chinese government brainwashes its people the same way the Russians and Soviets brainwashed theirs: by controlling and censuring media. So I understand when Chinese people who live in China speak highly of their leaders – they are brainwashed (I have experienced this first-hand). However, I am amazed that the Chinese government has been able to brainwash people who reside outside of China.
No, an economy in large part controlled by the state is not superior to ours. Greater control over their economy allows the Chinese government to pull the economy out of recession a lot faster than in the democratic countries, but there is no free lunch. Their actions will just lead to greater excesses and imbalances down the road.
It seems that as Westerners we have an inferiority complex when it comes to Asian cultures. Chinese uniqueness is praised today the same way Japanese superiority was in the 1980s. I even remember reading Russian newspapers in Russia, in 1989, praising the Japanese work ethic and their unique culture and spouting predictions of the continuance of Japanese dominance. I can only imagine how the mainstream press in the US was caressing Japanese uniqueness in the late ’80s, especially as the Japanese were invading (buying) Times Square and the State of California.
What is very interesting about it is that today all those Japanese cultural advantages are looked upon as disadvantages. For instance, “saving face” did not allow Japan to deal sufficiently with failed companies; their economy was full of semi-dead, zombie companies, which did not allow the healthy ones to prosper. Their employment-for-life system that was praised to the heavens during the Japanese golden age is now killing productivity of the economy. I recently read that 12-17 million people in Japan are employed who should not be employed (for an economy of 120 million people, these are huge numbers). In other words 12-17 million Japanese show up for work every day and receive a paycheck, but add little or no value to their employers.
Back to China. Even if the Chinese are harder-working and more entrepreneurial than Americans and Europeans, that doesn’t mean the laws of economics are somehow suspended in China – they are not. The Chinese economy was geared for high global growth, while now much lower growth is in the cards. The excesses created by 14% of GDP being “stimulated” into the economy through a fire hose have led to significant overcapacity. It will take time for these excesses to be dealt with, even in a country full of super-hard-working people.
A friend asked, “But what about Singapore; its government plays a significant role in the economy, and Singapore is thriving.” The clear answer: government can only succeed in running very small and relatively simple economies. Let me give you this example. I have a game on my iPad called Flight Controller – my kids love it. The point of the game is simple: you are an air-traffic controller and your job is to land planes. Planes come in three colors, red, yellow, and blue, and each plane has to be landed on the runway matching its color. The objective is not to have mid-air collisions. I can land ten planes no problem, twenty gets more difficult, and forty I cannot handle (Okay, I played the game a few times). The same is true for economies: the more complex the economy the more difficult it is to be centrally planned.
Government is not and never will be an efficient allocator of capital. It empowers bureaucrats, which in turn leads to corruption, which further misallocates capital. The size of the bribe or strength of the personal relationship decides the flows of capital instead of the invisible hand that funnels capital from low to high uses. (A side point: Singapore is one of the most uncorrupt countries in the world; this may explain in part the government’s success. China is not Singapore; it is infested with corruption).
I often hear that you have to go to China to understand it. But tourists who go to China don’t see the real China, the same way that tourists who go to Moscow don’t see the real Moscow. I was in Moscow a few years ago, and I was impressed by how clean and beautiful it looked; in fact it didn’t look much different from the center of Brussels. Of course, I was only in the center of the city, where you see fancy restaurants, gift shops, museums, theaters, etc.
I went to see my college friend who lives in the real Moscow – I saw a very different picture. The second you veer off the main road, it turns into pothole hell, and the streets are anything but clean. My friend lives in a nine-story apartment building that has not been painted in decades; paint is peeling both inside and outside. Interestingly, most of the sides of the buildings that face large streets in Moscow and in Murmansk (the city where I spent all my Russian life) are usually painted, but the sides that face small streets have not been painted in generations.
My friend – a lawyer – and his wife and kid have to live with his mother, as they cannot afford to live on their own. But you won’t see this Russia if you are a tourist visiting Moscow. People who visit China even multiple times harbor an illusion that they understand it – they don’t. In fact they so overwhelmed by its grandness that they stop being rational in their analysis.
I keep thinking about the possible consequences of the Chinese overcapacity bubble pop. It is relatively easy to understand what will happen in Japan: deflation will quickly turn into hyperinflation as government is forced to print money to service its debt and social obligations. They’ll announce and may even execute austerity measures, but those will be a decade or two too late. The Japanese yen will likely decline, though maybe not right away, as Japan owns a lot of US dollars and may be forced to sell them.
The Chinese situation is far more complex. China has tremendous overcapacity, but overcapacity is deflationary. It will drive prices for commodities down, and prices of Chinese-made goods will likely decline as well. Demand for industrial goods will collapse, pushing their prices down. But China will also have to deal with a lot of bad debt and will likely have to print money to do so – which is inflationary.
The popping of both the Chinese and Japanese bubble economies will lead to higher US, and likely global, interest rates.
Japan, as the title of my presentation suggests, is past the point of no return. Internal consumption of its debt will likely turn negative very soon. Its post office, which includes a postal savings system that was historically one of the largest buyers of government debt) announced recently that it will be a net seller this year. The situation is out of the Japanese government’s hands. It will probably not be able to intervene in the economy for much longer, so rates will rise and there will be little they will be able to do about it.
China is different from Japan. Its government is trying to slow down lending, but at the same time we have started seeing news of possibly another multi-hundred-billion-dollar stimulus over the next few months. The Chinese government’s actions are the wild card that will determine the duration and the magnitude of the bubble pop – the longer they intervene, the more dire the consequences will be.
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).