Western socialism and Eastern capitalism

 By Alasdair Macleod

There has been a significant shift in geopolitics in recent months, with the US consciously deciding to withdraw from Asian conflicts, notably in Afghanistan. 

But the diplomatic war against Iran also appears to have been downgraded and the US presence in Iraq is to be wound down. 

Furthermore, President Biden has downplayed his objections to the Nord Stream 2 pipeline between Russia and Germany.

In this, the greatest of Great Games, America has seen the strategic advantage move to the China—Russia partnership, which probably explains why the US is backing off from Asia. 

Meanwhile, China’s production-based economy is strong while that of the US remains weak, a weakness only disguised by monetary inflation.

China will accelerate her policy of encouraging domestic consumption and trans-Asian trade expansion to become increasingly independent from US markets, which are likely to be hampered by a renewed bout of trade protectionism.

This article examines these and related issues, concluding that China and her close allies will be positioned to survive the worst of a developing monetary and economic crisis about to engulf the West.


At the root of the political conflict between the West and China is economics and the global distribution of capital.

To understand it, we must sweep away the fog of disinformation, and analyse it dispassionately, devoid of all nationalist instincts.

As soon as the state takes over economic functions from the private sector they get lost and replaced by political objectives. 

The West’s move from free markets towards greater state control in recent decades while China moved in the opposite direction is behind current geopolitical tensions. 

Since the days of Deng, China’s authoritarian leadership has prioritised free trade to create national wealth for its people. 

Meanwhile the objectives of social fairness, to redistribute wealth from the haves to the have-nots, have become a destructive obsession for Western-style democracies.

The only way the tide of socialism is ever reversed is when the accumulated destruction of the economy that results from the drift away from free markets ends in a crisis — proved again and again, most recently in Asia. 

This is why following the failure of communism China has embraced free markets. 

The Chinese have certainly learned the lesson and are not about to be lectured by, in their view, a decadent West about how they should run their affairs.

An economic crisis, such as that undoubtedly faced by Western democracies, is initially blamed by the establishment on the intransigence of private sector actors. 

But so long as a few statesmen in the political arena understand that the increasing unaffordability of the socialist drift is responsible, the reversion to common sense can occur. 

Think Margaret Thatcher, Ronald Reagan. 

And before that think Germany’s Ludwig Erhard in the post-war forties. 

There is no such saviour for the West in sight today.

Having lost all sense of its economic bearing, the West needs new free market heroes to give it a post-crisis sense of direction. 

It should look no further for a laboratory experiment confirming the stark differences that arise from socialism and free markets than post-war Hong Kong, which contrasted with Mainland China; the former becoming without any natural resources arguably the most successful economy in the world and the latter the most oppressive and one of the most impoverished as well.

With the death of Mao, that changed because China embraced capitalist reform. 

After a while, autonomous Hong Kong became the medium through which America attacked China. 

Geopolitics, the pursuit of war by other means, rather than socialism became the nemesis for Hong Kong.

Led by the Americans, Western disinformation, the handmaiden to geopolitics, became the threat to China. 

In this article, I assess the current and future state of geopolitics between America and China, effectively that of the world, from an economic point of view.

The financial war intensified under Trump

Under President Trump, America commenced a trade war against China under the slogan “Make America great again”. 

Trump’s proposition was that China unfairly drove US production offshore, and that was the reason for America’s enormous trade deficit, to be corrected by imposing trade tariffs. 

As subsequent events proved (tariffs did not reduce the trade deficit, which roughly doubled under Trump) the analysis was a surface argument by a politician following a populist agenda. 

But when tariffs failed, other attempts to destabilise China emerged. 

Indeed, even from Obama’s time, the Chinese detected American involvement in the Occupy Central movement aimed at Hong Kong in 2014, so under Trump trade was part of a continuing conflict. 

The Americans then attacked China’s Made in China 2025 economic plan, openly concerned that China would challenge America’s technological supremacy.

America escalated the trade war on a basis of unfairness, the theft of international property and on suspicion of spying embedded in China’s technology. 

Huawei, which was the leader in global 5G mobile technology suffered its founder’s daughter being detained on US instructions in Canada, and America’s five-eyes security partners made to revisit and revoke all Huawei 5G contracts. 

In effect, the US forced its allies to back off from trading with China’s technology, or risk their relationship with the US being downgraded. 

Politicians in the five-eyes partnership had no option but to comply.

Separately, the US stepped up its financial war against China by extending trade sanctions against Hong Kong and by supporting student demonstrations, creating civil disorder. 

The financial angle existed because China was using the Shanghai Connect route through Hong Kong for inward investment to support its infrastructure investment plans and the wider demand for capital. 

Global investment flows, predominantly from EU member nations, would otherwise have gone to the US, and the US was reluctant to see its global hegemonic rival benefit from them.

China’s authoritarian response to riots in Hong Kong was to protect its interests by reneging on its 1997 agreement with the UK and to take it in under Beijing’s direct control. 

But in doing so, it politicised the financial and trade war with the US, and the agenda moved to condemning China for its treatment of Uighurs and its territorial claims over Taiwan. 

And the intervention by the coronavirus in human affairs has led to China being blamed for its creation, assumed by many to be from a state laboratory in Wuhan.

Whether this is true is beside the point. 

Covid appears to have been less damaging to China’s economy than it is to those of her Western trade counterparts. 

The proof is seen in the money. 

China has been restricting bank credit expansion for over a year, damping down the credit cycle, while the West is still pretending their economies are okay, covering the evidence of financial and economic destruction by government spending financed by monetary inflation.

The trade wars, Act 2

This brings us back to the trade wars, because in the absence of an increase in total savings the massive and still increasing government budget deficits in America are being mirrored in higher trade deficits. 

For those who are unfamiliar with it, the explanation is in the box below.

The link between the twin deficits

The reason the twin budget and trade deficits are linked is because of the following accounting identity:

Net imports ≡ (Investment - Savings) + Budget deficit.

Assuming the budget deficit increases and there is no increase in savings (investment trends with savings anyway), then net imports will increase pari-passu. 

This is most noticeable in consumption driven economies, such as the US and UK.

In savings-driven economies a larger portion of the deficit is financed by savings and a similar portion of subsequent government spending is also saved as opposed to being spent by private sector beneficiaries. 

This causes private sector investment to increase, which tends to reduce production costs. 

What is not bought by relatively depleted consumption becomes competitively exported.

Between two trading nations it is the balance between their budget outcomes and the spending and savings characteristics of the two populations. 

It explains why Japan, which runs a substantial budget deficit maintains an export surplus. 

It also explains why consumer price increases are more subdued in Japan than in consumption driven economies. 

And it is the driving force behind China’s export surpluses, because the Chinese are the biggest savers on the planet.

Evidence of the benefits to China’s economy is seen in the boom in China’s net exports, which in 2020 contributed 28% to the growth in China’s GDP, the highest since 2000 on a far smaller GDP base. 

Much of this took place in the second half and has continued into this year, as US and other nations’ consumer spending increased when covid restrictions began to be eased. 

Consequently, China’s economy is genuinely booming while Western economies are being artificially supported by monetary expansion.

The increase in costs for US imported goods is effectively being suppressed relative to that of domestic manufactured production because they are not being fully reflected by changes in the yuan/dollar exchange rate. 

Since the Fed reduced its funds rate to zero and increased QE to $120bn monthly, the yuan has gained only 6.75% annualised against the dollar, not enough to reflect the dollar’s internal loss of purchasing power measured in yuan terms. 

This is because the goal-sought 2% CPI target is a myth.

Anyone who seriously believes that the US CPI numbers are a true reflection of the loss the dollar’s internal purchasing power might think China is a net loser in its US export trade because they might argue that the rise of the yuan relative to the dollar is greater than that of the US CPI. 

But we know that the CPI is heavily doped by American statisticians and that a true rate of annual price increases is now over ten per cent.[i] 

That being the case, there is an artificial boost to China’s export profitability from its US trade due to an overvalued dollar not yet reflecting its declining domestic purchasing power.

In common with all exporters into American markets, China’s are now benefitting materially from an overvalued dollar. 

The question that arises is what, if anything, will the Americans do about it. 

With an accumulated total of $31 trillion already invested by foreigners in US financial assets and dollar cash, would the Biden administration dare to encourage a lower dollar to reduce the profitability of China’s export trade?

It seems unlikely. 

Of course, markets might lead to this outcome anyway, but the combined focus of America’s geopolitical strategists and the political class is likely to lead to even greater tariffs instead, predominantly aimed at restricting Chinese imports, and probably taking in the EU as well, acting as an excuse against the EU’s restrictive trade practices and improving EU-Russian relations.

Meanwhile, for some time China has planned to reduce its economic dependence on America and her close allies anyway.

Playing into Chinese hands

While trade tariffs are politically popular with a jingoist media and the public, they create self-inflicted economic damage. 

Tariffs are a tax penalty on a country’s own population, affecting everything from production to consumption. 

And when the central bank is already debauching the currency, the overall effect on higher domestic prices tends to be greater than the tariff rates would imply on their own.

The last time the American public suffered discriminatory tariffs book-ended the 1920s, with the Fordney-McCumber Tariff Act of 1922 and the Smoot-Hawley Tariff Act of 1930. 

It was Congress passing the Smoot-Hawley Act in late October 1929 for President Hoover to sign in June 1930 that coincided with the Wall Street crash. 

And the subsequent market decline that lasted for two years from May 1930 to July 1932 followed the Act being signed into law.

In those days, the dollar was freely convertible into gold. 

Combined with the rapid mechanisation of farming and factory production, rising unemployment reduced demand for an overproduction of food and consumer goods with a dramatic downward impact on prices. 

Today, price outcomes of an intensified tariff war would be fuelled less by production volumes and more by the monetary inflation of recent years. 

And the increase in time preference that comes with unsound money, sooner or later, results in rising nominal interest rates with predictable effects on financial asset values. 

A stock market crash, mirroring that of 1929-32 in scale now appears to be inevitable. 

But instead of being against a background of falling prices and low nominal rates, it will be accompanied by rapidly escalating prices for goods, rising nominal interest rates and collapsing asset values.

China is less exposed to this outcome, presumably still influenced by its earlier military intelligence analysis. 

In 2015, Qiao Liang, a People’s Liberation Army (PLA) Major-General and geopolitical analyst gave a speech at the Chinese Communist Party’s (CCP’s) Central Committee. 

In his speech, Qiao explained that he has been studying finance theories and established that the U.S. enforces the dollar as the global currency to preserve its hegemony over the world. 

He concluded that the U.S. tries everything, including war, to maintain the dollar’s dominance in global trading.

Qiao described how America pumped and dumped Latin America in the 1970s, and then repeated the trick on South-East Asia in the 1990s. 

The strategy was to direct cheapened dollar credit flows at a victim nation or region with a declining dollar, and then by reversing monetary policy to create a stronger dollar, collapse the target economy through debt deflation, allowing US corporations to take control of national assets on the cheap. 

In China’s case, presumably the objective would be to only undermine its economy, thereby removing a potential hegemonic rival.

To explain China’s thinking, this is a translated excerpt from Qiao’s 2012 analysis:

“If we acknowledge that there is a U.S. dollar index cycle and the Americans use this cycle to harvest from other countries, then we can conclude that it was time for the Americans to harvest China. 


Because China had obtained the largest amount of investment from the world. 

The size of China’s economy was no longer the size of a single county; it was even bigger than the whole of Latin America and about the same size as East Asia’s economy.

Since the Diaoyu Islands conflict (the Senkaku Islands) and the Huangyan Island conflict (the Scarborough Shoal), incidents have kept popping up around China, including the confrontation over China’s 981 oil rigs with Vietnam and Hong Kong’s “Occupy Central” event. 

Can they still be viewed as simply accidental?

I accompanied General Liu Yazhou, the Political Commissar of the National Defence University, to visit Hong Kong in May 2014. 

At that time, we heard that the ‘Occupy Central’ (Hong Kong) movement was being planned and could take place by end of the month.”

According to Qiao, Occupy Central was delayed to that October to coincide with the Fed’s tapering, which drove the dollar higher, encouraging the accumulation of inward investment into China through Hong Kong to reverse itself out of yuan and collapse Chinese financial assets.

Apart from a brief bull market that ended the following May, the Shanghai Composite Index is at similar levels today to January 2010 having risen by less than 20% since then. 

Meanwhile, the US’s S&P 500 Index has risen fourfold. 

Clearly, China has discouraged the sort of asset speculation on its own patch that creates dangerous bubbles. 

This is illustrated in Figure 1.

If we take the Shanghai Composite as a rough proxy for investment returns in China as a whole, then compared with the US and other Western markets, with a gently rising yuan it must continue to be an attractive option for international investment flows, especially when the US bubble pops. 

We should conclude from this information that China is still suppressing financial speculation and even private sector financial services as well to prevent a build-up of destabilising speculation.

In other words, America’s use of dollar hegemony, which according to Qiao Liang first ramps regional markets before collapsing them has not only failed against China, but with the high level of Chinese investment in US financial assets can be turned against America. 

On this analysis, China now holds the hegemonic cards.

China also appears to be employing American tactics against emerging nations around the world, not, at least yet, to call in debts and create conditions for Chinese corporations to just walk in and buy assets on the cheap, but simply to guarantee material supplies and keep political control over foreign regimes while trading freely with them.

Protection from the fall-out

A credible conclusion from the state of the financial war between America and China is that America can no longer afford to pursue dollar hegemony against China. 

Not only has China rumbled America’s game, but America’s own economy has become destabilised. 

US markets are clearly in an extreme bubble. 

And it cannot afford to raise dollar interest rates to undermine other national economies, because it would end up collapsing its own bubble and those of its allies. 

Without raising interest rates the US now faces the prospect of a dollar weakening beyond its control and the prospect of rising interest rates then being imposed upon it by market forces.

A collapse in financial asset prices would be devastating for the US economy, and there is little doubt that the US authorities will work hard to prevent it. 

The only weapon at their disposal is the further expansion of money and credit to support assets by buying them. 

It is a policy that ends with the destruction of the dollar itself.

The increasing inevitability of this outcome must inform the Chinese with respect to their geopolitical strategy. 

We can see that they have avoided the asset inflation that would make their own economy vulnerable to a dollar crisis. 

For the moment, escalating US budget deficits are leading to substantial increases in China’s exports, but as we have concluded above, this is likely to result in even higher tariffs against Chinese goods. 

If anything, China’s strategic planning must be to accelerate the move towards domestic consumption to make her economy as independent as possible from economic and political events unfolding in North America.

Domestic considerations support such a course as well. 

China’s leadership has got away with its restricted form of electoral accountability by promising its population a mixture of political stability and economic progress. 

Encouraging less saving and more consumption would reduce the structural trade surplus with the US, and therefore national dependency upon that trade. 

The improvement in living standards would continue to ensure political stability. 

This has, in fact, been China’s economic objective for some time.

There are two other legs to this strategy, the first being with Russia to exploit the wider Eurasian economy through partnerships with any nation on the super-continent which cares to join in on a free-trade basis. 

And the second is to take the lead in creating Eurasian markets for itself by expanding continent-wide communications. 

Enough has been written about the new silk roads to not require further elaboration, but communication projects also include electrification and telecommunications.

The Shanghai Cooperation Organisation (SCO) is central to this strategy. 

It is less followed in the West than it deserves to be, but now has as its members and those who are working with it almost half the world’s population — a population that is rapidly industrialising. 

Furthermore, the EU is finding it hard to resist the siren calls for trade with the nations to its east, not least because rail shipments from China to Europe are about the only post-pandemic global logistics that are reliably delivering goods into the heart of Europe.

Furthermore, America is giving up on its military interventions in Asia. 

It is backing down from earlier belligerence against Iran, and withdrawing from Iraq, giving China and the SCO a clear run to the Gulf. 

Importantly, Afghanistan is entering the SCO’s sphere of influence now that the US has withdrawn. 

Agreements between the nations to the north of Afghanistan, which are all members of the SCO, and the Taliban are setting the scene for fully incorporating Afghanistan into the SCO. 

Already an observer state, agreements with an Afghani government with or without the Taliban offer the promise of unexploited natural resources and control over Islamist terror groups which would otherwise use Afghanistan as a base.

China’s future strategy

Strategically, China appears to be moving in the right direction. 

It is implementing policies to reduce trade imbalances with the non-Asian world by encouraging the expansion of her middle classes, likely to increase the nation’s propensity to spend at the expense of a phenomenally high savings rate. 

Despite the increase in exports to the US, she is turning her back on America, realising long ago that her own contribution to trade imbalances must change. 

The scale of US imports is now being set by US fiscal policy and its citizens paltry savings rate, over which China has no control.

As has been her intention since the SCO morphed from a central-Asian security arrangement into a trading bloc, China sees her future being mainly in trade with Asia, from which US influences are now receding. 

Her relationship with non-Asian nations is principally to secure supplies of commodities and raw materials for her Asian ambitions. 

And now that the UK has left the EU, US influence over the other end of the super-continent is also waning. 

Over the next decade trade between the EU and Russa is set to increase, with the productive powerhouse that is Germany leading the way, together with other Central European nations.

US interests in Ukraine and the Middle East are declining because the days when the US could count on European support for its policies are ending. 

The lure of free trade without political intervention will promise a better outcome for these war-torn nations than US interventionism and hegemonic control. 

Furthermore, western social-democrat policies are of no interest to Asian nations, nor to China — that is a political model alien to them.

Meanwhile, the US is showing signs that she realises that she has lost ground to China in the financial version of The Great Game. 

The evidence is in her withdrawal from Afghanistan and her de-escalation of threats against Iran. 

And the way is clearing for China’s reconstruction of Syria and Lebanon, and eventually Iraq as well.

The role of gold in China’s geostrategy

There can be little doubt that China has acquired for herself substantial quantities of gold. 

Between 1983 and 2002, before the Chinese people were permitted to own gold and the Shanghai Gold Exchange opened, based on capital flows I estimate the state acquired at least 20,000 tonnes not declared as reserves. 

Since then, China has invested heavily in mine production and for some time has been the largest gold producing nation. 

It has consistently imported gold and silver doré for refining, and almost no gold has left the country. 

On its own and in conjunction with an associated network of Asian trading centres, the SGE dominates global physical trade.

The desire to sell some of her stockpile of dollars for gold informs us that there has always been an element of mistrust in western currencies, particularly the dollar. 

It must be remembered that back in the 1980s it was widely regarded as sensible for an exporting nation to diversify some of its foreign exchange earnings, typically between 10%-15% in physical gold. 

We saw Germany do this in the post-war years, and the Arabs partially with their oil revenue.

At some stage China’s motives over gold changed, principally in response to American foreign policy. 

The Asian crisis in the late-1990s, referred to above, would have been closely observed and analysed, as would the attempt to punish Putin’s Russia by threatening disconnection from the interbank settlement system, SWIFT, and actual SWIFT disconnections subsequently deployed against Iran. 

Even before the Lehman crisis, US intentions about using the dollar’s hegemony as a foreign policy weapon would have concerned China’s leadership.

China’s gold is just sitting there, for the moment as an undeclared insurance policy. 

But if the financial war evolves into a military conflict, an announcement of her true reserves would torpedo the dollar, making the US’s financing of a conflict difficult. 

We should also remember that her population owns a further 17,000 tonnes and stands to benefit from such a declaration.

But events beyond China’s control are now likely to determine the future role of China’s gold. 

America has flooded her economy with dollars, partly through QE aimed at maintaining financial asset values and suppressing the government’s borrowing cost. 

And funded mostly by monetary expansion, the US Government is estimated to be overspending its revenues by 75% during fiscal 2020 and 2021, according to the Congressional Budget Office. 

Consumer prices are now rising remorselessly, and there is little doubt the dollar’s future existence is now under threat.

If the dollar does face a severe crisis, being the world’s reserve currency, it will undermine the entire global fiat complex, including China’s yuan. 

The premium placed on national gold stocks will rise accordingly, and China’s economic and geopolitical strategies will prove to have been very wise.

What is the right analogy for what the Fed is doing?

Robert Armstrong

The Federal Reserve, it seems, wanted to use its meeting yesterday to do almost nothing. 

It appears to have succeeded. 

In the written statement, the phrase “the economy has made progress toward these goals” was just about the only novelty. 

This tiny droplet of hawkishness sent a most delicate ripple through markets, in the form of a slight flattening of the yield curve and a little fall in Tips yields. 

We are in a holding pattern until Jackson Hole.

James McCann, deputy chief economist at Aberdeen Standard Investments, described the delicacy of the Fed’s movements like this: “[Jay] Powell’s job at the moment is like trying to turn a cruise ship in a bath tub.” 

Meaning he has limited choices and that a small wrong move could create big waves.

I think the analogy is not extreme enough.

I think of the Fed as the family in the film A Quiet Place, who are stalked by vicious monsters that are incredibly sensitive to sound. 

So far, the Fed has managed to do its job while tiptoeing in stocking feet and communicating with hand gestures. 

But the audience knows that eventually someone is going to knock over some crockery.

Real rates redux

Reader mail on real rates had two common themes. 

One was that I was naive. 

Of course QE is distorting real rates, several readers said; that’s the whole point. 

In an era of fiscal profligacy, suppressing the real rate of interest is the only way to make national debt burdens bearable. 

This view is not confined to muttering conspiracy theorists. 

One reader pointed out this comment form Deutsche Bank’s Jim Reid: 

With debt so high real yields are likely to stay negative for the rest of my career as the authorities have to control funding [of] this rising leverage. 

I’m even more convinced of this post-pandemic . . . positive US real yields for any length of time would likely set off debt crises around the world so we are probably stuck with the regime. 

However you can still have negative real yields and higher nominal yields. 

Most of the big debt reductions seen through history have seen such a wide gap via higher inflation. 

In some ways we are seeing that now.

Thomas Mayer of the Flossbach von Storch Research Institute expressed a similar statement via email:

I suggest that we go back to the financial repression of the pre-1980s. 

Reinhart and Sbrancia [in The Liquidation of Government Debt] produced excellent research on this. 

They explain: “One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail. 

This effect, other things equal, reduces the governments’ interest expenses for a given stock of debt and contributes to deficit reduction. 

However, when financial repression combined with inflation produces negative real interest rates, this also reduces or liquidates existing debts. 

It is a transfer from creditors to borrowers.” 

In a free market, no sensible creditor would volunteer for such a transfer. 

Hence, if we observe it, the market must be manipulated by a very big borrower who has the power to do this.

The second group of correspondents argued that real yields are not so much a gauge of growth as of risk, whether of inflation or financial stress. 

Here is Jack Edmondson of OU Endowment Management:

Sometimes it’s useful to see the depth of negative real yield as the price some market participants are willing to pay to hedge against inflation outcomes, not just to reflect the central expectation of inflation . . . 

For example, it’s rational to pay a significant negative real yield to own an inflation-linked bond if you think inflation could run very high, or, in fact, even if you thought there was even a small chance of very high inflation.

Explained another way, the real yield can be seen as an insurance premium for a distribution of outcomes over and above the implied break-even rate.

My colleague Martin Sandbu (whose economics newsletter, Free Lunch, you should subscribe to) made a related point:

We should think about whether changes in risk attitudes are a good explanation of Tips price behaviour. 

Here’s how I think about it: investors/“markets” have some view of the overall (real) growth prospects of the economy and hence the real returns they can hope to achieve in various investments. 

They also have some sense of the uncertainty of those prospects. 

The more uncertain, the more of a (real) risk premium they will demand between safe and risky assets, even given completely constant inflation expectations. 

How would you test this? 

By looking at some measure of the risky real rate of return and then comparing it with Tips yields for a measure of the (real) risk premium. 

If my hunch makes sense, we should have seen this rise.

And, voila, here is a chart of just this from a few days ago, showing the spread between equity earnings yields (risky expected returns) and (risk free) real yields widening in recent months (see the little red arrow):

 No alt provided

Fixing the Treasuries market

The Group of 30 is a group of very serious finance people — from Timothy Geithner to Mervyn King — with a very pretentious name. 

Yesterday they came out with a set of recommendations for making the US Treasury market work better. 

That reform is necessary, the group says, was demonstrated by the events of March 2020, when everyone at once wanted to sell their Treasuries for cash, liquidity disappeared, bid-ask spreads blew out, the moon turned blood red, and so on. 

The group’s primary recommendation is that the Fed stand ready at all times to swap Treasuries for cash with a wide range of market participants, not just banks and broker-dealers. 

Centralised clearing would be a good idea, too. 

This all makes sense to me, but two things in the report struck me as funny. 

The group says that having a standing repo facility is preferable to having the Fed simply come in and buy tons of Treasuries whenever there is trouble, because

if market functioning can be sustained only by frequent, large-scale purchases of Treasuries by the Federal Reserve, market participants could come to believe that fiscal concerns rather than macroeconomic objectives are motivating the purchases.

Ahh, guys? There’s a lot of smart people who think that already (see the discussion of real yields, above).

Second funny thing. 

The authors write that,

the root cause of the increasing frequency of episodes of Treasury market dysfunction under stress is that the aggregate amount of capital allocated to market-making by bank-affiliated dealers has not kept pace with the very rapid growth of marketable Treasury debt outstanding, in part because leverage requirements that were introduced as part of the post-global financial crisis bank regulatory regime. 

I’ve never really bought this line of thinking, maybe because I’ve heard so many bankers bang on about it over the years, but also because market maker liquidity has historically been the umbrella that you only use when it isn’t raining. 

That’s just me though. 

What is funny is that the group turns out not to agree with it, either, at least not in the cases that really matter: 

Even if far more capital had been allocated to market-making, the Treasury market could not have functioned effectively in March 2020 . . . The underlying economic uncertainty created by the pandemic and the associated massive and widespread “dash for cash” by holders of Treasury securities was so extreme that no market structure could have provided the capacity to absorb the widespread selling pressures.

I don’t care about little liquidity crises. 

They work themselves out, and probably are a good reminder for everyone to be prudent. 

I care about big ones, and in the big ones, market-maker capital is not much help.

Reading the report also made me wonder about a larger issue. 

Several biggish market players have said to me in recent weeks that they are not worried that Fed tapering and tightening will lead to a market “accident”, for the simple reason that there is masses of liquidity around now, and as long as cash is abundant, you can’t have big chain-reaction market crack-ups. 

That is, in a way, the animating notion of the Group of 30 report (though they are careful to point out that there are sorts of crisis that even a broad Fed repo facility can’t prevent). 

Is this right? 

We may find out in the coming months. 


Chris Vermeullen

Continuing our research into shifting Consumer Sentiment and other economic data recently posted. 

Part II of our research article will focus on the components of US GDP and how shifting consumer sentiment and activities may result in lower GDP data for a period of time.

GDP is one of the biggest measures of total economic activity and the health of the US economy.  Rising GDP suggests overall strength in the economy while falling GDP suggests one, or more, of the GDP components are weakening.  If the current downturn in Consumer Sentiments and NY Manufacturing activity is any real indication of a shift in how consumers are engaging in economic activity, then we’ll likely see a continued downward shift in these economic data points for a period of time.


As we suggested in the first part of this research article, we’ve seen very few major declines in US consumer sentiment over the past 15+ years.  

The only time we’ve seen a big decline in consumer sentiment over the past 10 years was near the bottom of the COVID-19 economic collapse.  

On April 9, 2020 (-20.31%) and April 24, 2020 (-19.42%), the Consumer Sentiment levels collapsed by nearly -20%.  

These broad collapse levels came after the COVID peak in late February 2020 and were preceded by more moderate downward trends in Consumer Sentiment; March 13, 2020 (-5.05%), and March 27, 2020 (-7.09%).

The current collapse in Consumer Sentiment represents a -13.55% decline preceded by July 16, 2021 (-5.50%), and July 30, 2021 (-5.03%).  

Overall, the current weakening of Consumer Sentiment is somewhat similar to the March/April 2020 collapse.  

Although, this time we are seeing a downward swing in Consumer Sentiment while the US economy is still moderately active, and not entering another extended shutdown period related to the COVID virus.

We believe this current Consumer Sentiment decline is more related to the extended rally phase in the US stock market and other assets – which have been pushed well beyond the traditional supply/demand equilibrium by the US Federal Reserve and extended COVID-19 relief packages and policies.  

Price has been unable to engage in a proper “price exploration” process because the US Federal Reserve and US Government have been stomping on the easy money gas pedal while engaging in policy that distorts true valuation levels.

Consumers are not blind to these facts.  

In fact, Consumers are often keenly aware of opportunities and risks and have an innate skill of sensing and understanding when price levels reach well beyond upper or lower extremes.  

It may be that Consumers are starting to react to the reality of the situation before them and starting to pull away from these extremely hyper-inflated price levels of assets.


This leads us back to the question before all of us right now.  Are the consumers shifting away from growth expectations related to the post-COVID-19 recovery – and how could that shift reflect in future economic and GDP outputs?

We found this information related to the components of US GDP and how the GDP data is constructed.  

We thought it might be useful to share this data with you.

Notice how Consumers, Retail, and Services are the largest components of GDP.  

This suggests that a broad consumer shift away from chasing rising price levels may prompt a very big shift in how the US markets may react to what may become a contraction in the US and global economies.  

Remember, the US economy and stock market is the single largest economic driving component in the world.  

The US stock market consists of over $48 trillion in assets, whereas the next 8 largest global stock exchanges (China, Japan, Hong Kong, Euronext, London, Toronto, and India) consist of a total of $39.2T.

This means, where the US markets trend, foreign markets are likely to follow in some form simply because of the massive amount of assets allocated into the US equities markets.

(Source: https://www.thebalance.com/components-of-gdp-explanation-formula-and-chart-3306015#:~:text=Components%20of%20Real%20GDP%20%282019%29%20%20%20,%20%2016%25%20%2017%20more%20rows%20)

Production, Net Trade Balances, and Consumer & Services spending make up the core components of US GDP.  

Yet, Consumer Spending and Services make up nearly 70% of total GDP.

If the Dampening Sine Wave Process continues to unfold and shifts consumer sentiment away from chasing the rally trends, then it is very logical that we could see broad US and global trends decline over the next 6+ months and possibly lasting well beyond 2022.  

All it would take for this to happen would be some external world event to increase the Amplitude of the Dampening Sine Wave process – such as another new COVID variant, global wars, another global credit crisis, or broad consumer disengagement as asset prices fall.

(Source: https://www.thebalance.com/components-of-gdp-explanation-formula-and-chart-3306015#:~:text=Components%20of%20Real%20GDP%20%282019%29%20%20%20,%20%2016%25%20%2017%20more%20rows%20)


If the US Consumer continues to pull away from perceived risks associated with the hyper-inflated market and asset trends, then a bigger economic shift will continue to unfold.  

This process of “consumer protectionism” is a cycle that continued to strengthen until price levels revert away from hyper-inflated risk levels and fall to levels representative of under-inflated opportunity levels.  

Historically, this type of price reversion events has prompted new waves of growth and wealth for many as well as presented some real challenges for those that are unprepared for this type of event.

Once consumers start this process of pulling away from making big purchases and/or considering current price levels to be excessive. 

It is very likely this process will continue to build until one of two things happen; consumer confidence is restored (over time) and consumers believe a real opportunity exists in buying assets, or price levels actually move lower (creating the reversion process) where assets/stocks fall to levels where Consumers believe an opportunity exists to re-invest capital into the markets. 

We need to watch how the next Consumer Sentiment level shows either strengthening consumer belief in the economy or weakening belief that the economy is properly balanced at this time.  

On August 27, 2021, we’ll get the next Consumer Confidence report.  

Until then, we need to stay cautious of what the markets report to us related to these shifts in US consumer expectations.

In Part III of this research article, we’ll try to pull all of this together onto major index price charts to better illustrate how the markets are starting to react to this shift in how Consumers engage in the US economy.

More than ever, right now, traders need to move away from risk functions and start using common-sense.  

There will still be endless opportunities for profits from these extended price rotations, but the volatility and leverage factors will increase risk levels for traders that are not prepared or don’t have solid strategies.  

Don’t let yourself get caught in these next cycle phases unprepared.

China's Animal Spirits Deficit

The Chinese government has taken dead aim at its dynamic technology sector, the engine of consumption-led economic rebalancing. The authorities' recent actions are symptomatic of a deeper problem: the state’s battle to control the energy of animal spirits could sap the confidence of households and businesses.

Stephen S. Roach

NEW HAVEN – When it comes to the Chinese economy, I have been a congenital optimist for over 25 years. 

But now I have serious doubts. 

The Chinese government has taken dead aim at its dynamic technology sector, the engine of China’s New Economy. 

Its recent actions are symptomatic of a deeper problem: the state’s efforts to control the energy of animal spirits. 

The Chinese Dream, President Xi Jinping’s aspirational vision of a “great modern socialist country” by 2049, could now be at risk.

At first, it seemed as if the authorities were concerned about a one-off personnel problem when they sent a stern message to the irreverent Jack Ma, founder of Alibaba, the world’s largest e-commerce platform. 

Ma’s ill-timed comments at a Shanghai financial forum in late October 2020 about the “pawnshop” mentality of the bank-centric Chinese financial system crossed the line for China’s leaders. 

Early the following month, a record $34 billion initial public offering for Ant Group, the behemoth fintech spinoff of Alibaba, was canceled less than 48 hours before the scheduled listing. 

Five months later, Alibaba itself was fined a record $2.8 billion for alleged anti-monopoly violations.

And now it’s Didi Chuxing’s turn. 

Didi, the Uber-like Chinese ridesharing service, apparently had the audacity to raise $4.4 billion in US capital markets, despite rumored objections from Chinese officials. 

After forcing the removal of more than 25 of Didi’s apps from Chinese Internet platforms, talk of a fine that might exceed the earlier penalty imposed on Alibaba, or even a possible delisting, is rampant.

Moreover, there are signs of a clampdown on many other leading Chinese tech companies, including Tencent (Internet conglomerate), Meituan (food delivery), Pinduoduo (e-commerce), Full Truck Alliance (truck-hailing apps Huochebang and Yunmanman), Kanzhun’s Boss Zhipin (recruitment), and online private tutoring companies like TAL 

Education Group and Gaotu Techedu. 

And all of this follows China’s high-profile crackdown on cryptocurrencies.

It is not as if there were a lack of reasons – in some cases, like cryptocurrencies, perfectly legitimate reasons – for China’s anti-tech campaign. 

Data security is the most oft-cited justification. 

This is understandable in one sense, considering the high value the Chinese leadership places on its proprietary claims over Big Data, the high-octane fuel of its push into artificial intelligence. 

But it also smacks of hypocrisy in that much of the data has been gathered from the surreptitious gaze of the surveillance state.

The issue, however, is not justification. 

Actions can always be explained, or rationalized, after the fact. 

The point is that, for whatever reason, Chinese authorities are now using the full force of regulation to strangle the business models and financing capacity of the economy’s most dynamic sector.  

Nor is the assault on tech companies the only example of moves that restrain the private economy. 

Chinese consumers are also suffering. 

Rapid population aging and inadequate social safety nets for retirement income and health care have perpetuated households’ unwillingness to convert precautionary saving into discretionary spending on items like motor vehicles, furniture, appliances, leisure, entertainment, travel, and the other trappings of more mature consumer societies.

Yes, the absolute scale of these activities, like everything in China, is large. 

But as a share of its overall economy, household consumption is still less than 40% of GDP – by far the smallest share of any major economy.

The reason is that China has yet to create a culture of confidence in which its vast population is ready for a transformative shift in saving and consumption patterns. 

Only when households feel more secure about an uncertain future will they broaden their horizons and embrace aspirations of more expansive lifestyles. 

It will take nothing less than that for a consumer-led rebalancing of China’s economy finally to succeed.

Confidence among businesses and consumers alike is a critical underpinning of any economy. 

Nobel Prize winning economists George Akerlof and Robert Shiller view confidence as the cornerstone of a broader theory of “animal spirits.” 

This notion, widely popularized by John Maynard Keynes in the 1930s, is best thought of as a “spontaneous urge to action” that takes aggregate demand well beyond the underpinnings of personal income or corporate profit.

Keynes viewed animal spirits as the essence of capitalism. 

For China, with its mixed model of market-based socialism, animal spirits operate differently. 

The state plays a far more active role in guiding markets, businesses, and consumers than it does in other major economies. 

Yet the Chinese economy, no less than others, still requires a foundation of trust – trust in the consistency of leadership priorities, in transparent governance, and in wise regulatory oversight – to flourish.

Modern China lacks this foundation of trust that underpins animal spirits. 

But while this has long been an obstacle to Chinese consumerism, now distrust is creeping into the business sector, where the government’s assault on tech companies is antithetical to the creativity, energy, and sheer hard work they require to grow and flourish in an intensely competitive environment.

I have frequently raised concerns about the excesses of fear-driven precautionary saving as a major impediment to consumer-led Chinese rebalancing. 

But the authorities’ recent moves against the tech sector could be a tipping point. 

Without entrepreneurial energy, the creative juices of China’s New Economy will be sapped, along with hopes for a long-promised surge of indigenous innovation.

China’s mounting deficit of animal spirits could deal a severe, potentially lethal, blow to my own long-standing optimistic prognosis for the “Next China” – the title of a course that I have taught at Yale for the past 11 years. 

As I caution my students in the first class, the syllabus is a moving target.

Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China.