Tuesday, September 23, 2003

Chinese Growth - Who's afraid of the big bad wolf?

China has grown at 8.6% for over 20 years. Great for them, but I agree with James Kynge of the FT: hardly 'the most striking economic transformation in human history.' You might be concerned that they consistently grow output twice as fast as the US and 8 times as fast as Europe.

We all know that growth allows you to live as though you have more than you have. It makes otherwise unprofitable investments profitable and it makes otherwise unbearable expenditures bearable. Were it not for the historic clip of US growth, one can only imagine which projects wouldn't have been able to show a good enough IRR on paper to be carried through to a finished product: TV, cellphones, PCs, commercial websites, artificial hearts, Grisham novels, Spielberg films, Red Bull . . . often times, products upon which we have or will build even more advanced and productivity/growth enhancing products. A virtuous cycle for the economy.

Back when Economics was just a quaint European social science, the US was growing at a much more heady clip. To do this, we (gladly) paid the price in social and environmental terms as we inefficiently ravaged natural resources and exploited human resources like locust. China is at a similar point in their economic progression, and they are doing exactly the same thing.

But as their economies became richer, their middle classes larger, their governments more sophisticated, they began to attribute ever higher costs to these environmental and social exploitations. Eventually, they had to find other, more sustainable ways of growing. The real genius in the US is that we have been able to move to the highest standard of sustainable methods and yet maintain 4% growth. What makes the US different from other European or Asian economies?

Investment savvy.

Investment decisions always boil down to a risk-vs-return equation. However, imperfect information creates a margin of error in this equation which can easily be larger than the expected return. In other words, we might estimate that a project has a cost of $10 and an estimated return of $12-$15. Guaranteed return of 20 to 50 percent. Riskless, right? If your calculations are accurate enough and your estimates are realistic enough its is. The US continues to develop and refine powerfully accurate calculations whose variables are populated using tomes of stochastic data. The rest of the world has not spent an equivalent amount of scientific effort on investment strategy and thus uses simplified equations with variables populated using guesswork. Worse, their equations are often not economically rational because they include favoritism, prejudice (for example, they prefer invest in local projects even if they aren't as profitable as alternatives). As a result, the US investor can be highly confident in his conclusion He thus is supremely successful at rapidly throwing big dollars at certain investments and reaping the big rewards. The rest of the world's investors find that their calculations are 50% as accurate at predicting returns. Even though both groups of investors came up with the same $12-$15 range, the non-US group's margin of error means that (whether they recognize it or not) their real range expands to $6-22.5. Suddenly, the same investment becomes riskier for the non-US group. Time and again, the inaccuracies of their calculations lead them to make poorer investment decisions, and reap lower profits. As they recognize this, they lose the appetite for risk and their investment strategies drift toward safer, lower-yielding investments -- look at the percentage of Japan's money which sits in bank deposit accounts earning less than a percent a year -- whereas US investors' consistent success fuels their appetite for ever more (calculated) risk and are willing to put money into ever more germinal projects with longer delays before payouts. US investors are willing to make bigger R&D investments which often spawn other, more sophisicated and more profitable projects along the way. Thus, the returns compound into a virtuous cycle. On the other hand, non-US economies require immediate payouts, not just for the investors but for the laborers as well. Unsurprisingly, non-US economies end up with consistently lower growth figures than the US.

If China can do the same, they will increasingly be an economic force to fear. If not, they will be just another Japan.

The illusion of geopolitical borders

We can once again thank the quaint Europeans for this legacy! As they played Imperialist Edition Monopoly with planet Earth, they felt it only appropriate that no square foot go un-claimed. When they chickened out on colonialism, the borders of their global jigsaw puzzle largely became seamless national borders. They handed over responsibility and ownership to the fledgling national governments, bought themselves a round of beer, and called it a day.

These new national governments also inherited another gift from their previous bosses: a European-structured government, conceptually based on the rule of law and the supremacy of the state. Sometimes democracy, colonial robber-baronist economics, a military command structure, and/or human rights were thrown in as well, but I digress.

And for many many years the world has obligingly acted like these new countries are legitimate.

But let's face it: many of these malfunctioning governments have no more control over their own territory than your average American parents have over their brat kids. And they like it that way. They make 'national' laws which are to be enforced by a 'national' military/police/judiary complex. In fact, most often, that complex stretches no further than the capital city and is applied sparingly even then. The fun is in writing up the rules -- too much trouble and too little money to actually finish the job. Plus, think of all the Birthday presents you get when your citizens know every law is up for negotiation. Accidentally shoot your neighbor in the head? Well, that's nothing a few well-placed yaks and a bottle of Russkaya can't wash away.

Despite the fact that Sudan has laws calling for a national tax, post, police, army, and legal system, no one living in the desolate Northwestern Quarter gets a tax bill. When they do not pay, they are not visited by the tax man, the cops, or even those annoying collection agencies. On the flip side of the coin, why should they pay? Their homes and camels are not made safe from robbers and vandals by this reputed national police. Their mail is not collected and delivered by any national post office. The ownership of their intellectual property is not guaranteed by any legal system. If they decide to create a Sudanese branch of Bin Laden U, they are not stopped by any national army. Their national health system consists of crappy Medecins Sans Frontiers tents.

And yet G7 leaders "call on" these national governments to enact and enforce laws. They negotiate with them about trade and security as if the people they are talking to have any power to follow through. No, these 3rd world clowns are in the game for one reason: to look out for number one. To trade empty promises for dirty aid money (plus a free ride to Harvard for their kids, of course).

We should recognize that there are empty spaces between countries. Maybe not between Switzerland and Germany, but how about Ecuador and Peru? Even THEY can't agree on where to draw the line. This begs the question: if both slash neither country claims the contested territory, whose laws are the inhabitants subject to? The answer, of course, is neither. It's no-man's-land just like the Wild West of my great-great-grandparents. The only security you can count on is the Winchester above the fireplace. Jeez, maybe we should send the Freemen!