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Bursting the Chinese Bubble

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In strict terms, inflation is not a rise in prices, but an increase in the supply of money. More money chasing the same quantity of goods leads to rising prices. And prices rise not entirely by the laws of supply and demand, but are influenced by speculation about where newly-printed money will flow. It’s a divergence between the real economy of goods and services and the financial economy of interest rates and currency exchange rates.

When the financial economy is out of alignment with the real economy, it’s a bubble. Money flows to where the money profits are instead of where the real value is created. The dotcom bubble and the housing bubble were both products of financial manipulations built atop some lesser amount genuine value.

Currently the global markets seem to be putting the excess money into commodities like gold, silver and copper. That makes the prices of those metals go up, but they’re really not getting any more valuable in real terms. Copper is perhaps the best example, since it isn’t used as a form of money these days.

Copper futures closed at a record high in New York after imports by China rebounded from the lowest level in a year.

Shipments of copper and products into China, the world’s largest user, rose 29 percent in November to 351,597 metric tons from October. Total imports in the 11 months ended Nov. 30 gained 0.7 percent to 3.95 million tons. Copper has jumped 43 percent since July 1, partly on demand from emerging markets.

Up 43% in price, but has it changed in usefulness? Given it is durable and stockpilable—more so than oil—there’s little real economic reason for the rise in prices. It’s mostly the financial economy chasing more imaginary money.

That’s the imaginary money which is inflation, which leads to rising prices.

Premier Wen Jiabao’s government has been creating about $US250 billion worth of yuan each year “out of thin air,” Duncan said. To keep its currency from appreciating, the People’s Bank of China has been printing yuan to offset the dollars flowing in from a trade surplus that expanded to $US27.2 billion in October, the most since July.

China’s gross domestic product will by expand by 9.2 per cent this year, according to the median estimate of 17 economists surveyed by Bloomberg News, poised to overtake Japan as the world’s second-largest economy.

China’s GDP is growing at 9.2%, but how much of that is real growth and how much is a product of rising prices? If China made one hundred teapots last year a a price of $1 each, the GDP would be $100. If they make 105 teapots next year, the real GDP would be $105. But if the new money lets people bid the price of teapots up to $2, the reported GDP would be $210. The financial economy would create $105 of non-real value. It would be a teapot bubble.

Getting back to copper, demand from China has been the real underlying reason for some of copper’s price rise. It is the law of supply and demand at work. They need more, so the price goes up. But what if the Chinese government realizes that they have already stockpiled more copper than they can use, because rising prices are making it hard to for ordinary Chinese to buy stuff made with copper?

in November alone, consumer prices rose 1.0% in cities and 1.3% in rural areas. That is not an annualized rate, but the rate of increase for one month. Food prices rose by 2% in just November.

Most of the financial value of copper would vanish. Without the speculative promise of even higher prices predicated on some genuine demand, money will flow out of copper and into something else. The copper commodity bubble would burst as prices adjust to reflect genuine value/usefulness of copper.

And anyone (or any institution) that was counting copper as an asset would see the value of their portfolio drop. When asset values fall, it is harder for anyone to borrow, because those asset values were usable as collateral against loans.

Less lending mean less real economic activity. Which is recession or depression.

I picked copper because it is something I follow a bit. But it seems like China is in a bubble in many sectors. Any single sector popping will likely lead to more bursts.

And if China pops, they will not be able to finance more U.S. debt. If the U.S. government has trouble borrowing, they cannot create new money. That’s because most of what we use as money these days is actually debt.

There is no new money created without an equal debt created somehwere. Without borrowers like China, there can be no more money. And by the strict definition, no more inflation. What happens to prices will depend on how much real economic activity shrinks compared to the supply of money. If the real shrinks faster than the financial, prices stay high. If the financial shrinks faster than the real, prices fall.

Given the bubblicious nature of the financial economy, my bet is that it shrinks much faster. I am betting on deflation and falling prices.

But as always, the problem is predicting when it will happen. The financial economy is well-practiced at shifting bubbles around and avoiding the ultimate reconciliation with the real economy.

Will China’s bubble bursting be the trigger? Or will it be one of the weak and insolvent economies of Europe?