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January 17, 2008

Economist's View - 4 new articles

"Investing in China: Fool's Gold?"

Thomas Palley sends his latest:

Investing in China: Fool's Gold?, by Thomas I. Palley: Americans tend to disregard history. Henry Ford declared bluntly, "History is bunk," while Gore Vidal calls the U.S. "the United States of Amnesia." Usually, this disregard has few consequences, but sometimes not. That may be so with investing in China, where history suggests profits will be far below expectations, possibly making those investments fool's gold.

China's history is completely different from that of the United States and it has left deep imprints on China's politics. Therein lies the trap for investors and policymakers who ignore history and wishfully think market forces will inevitably make China just like the United States.

One critical factor is China's attitude to foreigners. That attitude is captured by the Great Wall of China, which provides a metaphor for China's long history of isolationism and xenophobia. A second critical factor is the legacy of China's humiliating defeats in the unjust 19th century opium wars with Great Britain. At the time, Britain was importing large amounts of tea and silks from China, and demanded the right to sell Indian opium in exchange. As the opium trade grew, not only did it cause massive addiction, it also caused a damaging monetary outflow of silver from China. That prompted China to stop the trade, and Britain then turned to military force to keep China's market open.

This historical experience has made China nationalistic and profoundly averse to foreign exploitation, which is why history is so relevant for investing in China. As a result, China will never allow itself to be exploited by foreigners. For investors, the trouble is that China views making profits from the Chinese market as a form of exploitation.

When foreign investments are for exports, China has viewed the profits as being earned abroad. Difficulties only arise when the goal is production for the domestic market. This explains why profitability on such investments has historically been so low, and why so-many joint-venture investments with Chinese partners have failed. It also helps explain China's persistent refusal to enforce foreign owned patents and copyrights that apply to medicines, movies, and music.

The lesson is that companies are likely to be disappointed regarding hopes of profiting from China's massive domestic market.

That has special relevance for American banks and insurance companies. China will allow these companies to invest and modernize its financial services infrastructure, but the profit pay-off is questionable. The same holds for auto companies, which China will allow to transfer technology and build modern plants. As long as the production is for export, those plants will be allowed to earn large profits. But once they start selling in the Chinese market, profits will likely shrivel under burdensome restrictions and theft of technology, ideas, and designs.

Stock market investors face a different case of fool's gold, with stock prices being artificially inflated by China's under-valued exchange rate and capital controls. That makes prices vulnerable to changes of policy.

The under-valued exchange rate has contributed to China's massive trade surpluses, and China has had to buy dollars and sell yuan to prevent its exchange rate appreciating. That has expanded China's money supply, and Chinese investors have bought stocks to earn higher returns and protect against inflation, which has driven up stock prices. Capital controls have also played a critical role by limiting investments available to Chinese citizens. Since money cannot leave the country, they have been forced to buy local stocks. Hence, the explosive appreciation of the Shanghai stock market, which has spilled into the Hong Kong market.

China's government has profited from this bubble, as it has been able to sell state-owned companies at high prices. Wall Street has also bought into the bubble, telling Main Street investors that the appreciation of Chinese stocks reflects China's growth prospects rather than its artificial market. However, come the day that China allows external investment by Chinese citizens, Chinese stock prices are likely to suffer as local investors move to diversify outside of China. That potentially makes long-term investing in China's stock market another case of fool's gold.

The bottom line is that when it comes to China, investors would be wise to remember all that glistens is not gold.

Alex Tabarrok: "Reason to be Highly Optimistic about the Future"

Don't worry, things are going to turn out great:

Dismal Science Sees Upbeat Future, Alexander Tabarrok, Forbes: Forget the talk of recession. The world is about to enter a new era in which miracle drugs will conquer cancer and other killer diseases and technological and scientific advances will trigger unprecedented economic growth and global prosperity.

Pie in the sky optimism? Perhaps. But there are reasons to be optimistic, and they rest ... within the badly misnamed "dismal science," economics.

To understand why economics triggers such optimism, imagine that there are two deadly diseases. One disease is relatively rare, the other common. ... If you don't want to die, it's much better to have the common disease. ... The cost of developing drugs for rare and common diseases are about the same, but the revenues aren't ... larger markets mean more profits.

As a result, there are more drugs to treat diseases with a lot of patients than to treat rare diseases, and more drugs means greater life expectancy. Patients diagnosed with rare diseases ... are 45% more likely to die before age 55 than are patients diagnosed with more common diseases. So imagine this: If China and India were as wealthy as the U.S., the market for cancer drugs would be eight times larger than it is today. ...

Like pharmaceuticals, new computer chips, software and chemicals also require large research and development (R&D) expenditures. As India, China and other countries become wealthier, companies will increase their worldwide R&D investments. Most importantly, as markets expand, companies and countries will put to work the greatest asset of all for the betterment of mankind: brain power.

Amazingly, there are only about 6 million scientists and engineers in the entire world, nearly a quarter of whom are in the U.S. ... But if the world as a whole were as wealthy as the U.S..., there would be more than five times as many scientists and engineers worldwide.

People used to think that more population was bad for growth. In this view, people are stomachs--they eat, leaving less for everyone else. But once we realize the importance of ideas in the economy, people become brains--they innovate, creating more for everyone else. New ideas mean more growth, and even small changes in economic growth rates produce large economic and social benefits. ...

In the 20th century, two world wars diverted the energy of two generations from production to destruction. ... Communism isolated much of the world, reducing trade in goods and ideas--to everyone's detriment. World poverty meant that the U.S. and a few other countries shouldered the burdens of advancing knowledge nearly alone.

The battles of the 20th century were not fought in vain. Trade, development and the free flow of people and ideas are uniting all of humanity, maximizing the incentives and the means to produce new ideas. This gives us reason to be highly optimistic about the future.

"A Tool to Stimulate the Economy"

Jared Bernstein writes to the editor of the NY Times about how to stimulate the economy:

A Tool to Stimulate the Economy: To the Editor:

Your Jan. 8 Business Day article about economic stimulus didn't mention one important tool that has particular currency right now: ratcheting up federal grants to states. States and localities depend on property taxes to finance much of their operations, but as foreclosures grow and home values fall, local revenues are taking a big hit, forcing towns and cities to cut back on needed projects at precisely the wrong time, economy-wise.

Tax collections are already down in 24 states because of the housing slump, and the 10 states hit the hardest, including California, will lose $6.6 billion in tax revenue this year. By increasing aid to states, the federal government can help offset this revenue crunch.

Moreover, economists have shown that this type of stimulus works quickly and effectively, with a large bang for the buck.

Here's a bit more on this point. This is the year-over-year growth rate for state tax revenues. The quarterly data are a bit noisy, so the data are smoothed by taking a three quarter centered moving average, e.g. the observation dated 2002:Q2 is the average from 2002:Q1 through 2002:Q3:

Year-over-Year Growth in State Tax Revenue (Three Quarter Centered Moving Average) Statetax [Data: Rockefeller Institute at SUNY State Revenue Report]

As you can see, state revenues are beginning to fall. States can amplify cycles when they are forced to cut spending as state revenues fall, so Jared's idea is a good one. Preventing layoffs by helping states avoid cutting back on projects is just as good, better even, than attempting to create new jobs after the workers have been laid off.

links for 2008-01-16

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