Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 21st October, 2010.

There is much gnashing of teeth by the realists and celebrating by the Keynesians over the possibility that the Fed will soon embark on another round of "quantitative easing". The anticipation of faster inflation of the US$ supply has put downward pressure on interest rates and caused the speculative juices to flow more freely in the commodity and equity markets. The Keynesians, who believe that economic depressions are caused by a mysterious decline in "animal spirits" and that everything would be just fine if we would simply return to borrowing, spending and partying as if it were 2006, are therefore getting their wish. The realists, however, understand that thanks to the excessive borrowing and misdirected spending of the boom years there are now huge imbalances in the economy that must be corrected before a genuine recovery can begin, and that artificially-stimulated borrowing and spending will only add to the imbalances by wasting more valuable resources; in other words, they understand that the problems are real and cannot be made to disappear by conjuring more money out of nothing or by using some other trick to foster more of a "devil may care" attitude within the collective mind of the public.

Strangely, though, many people who are realists when it comes to the US are anti-realists when it comes to China. Via the application of sound theory and logic they are able to see that almost all the actions being taken and proposed by US policy-makers will weaken the US economy, and yet they ignore the same theory and logic when forming opinions about China's economic prospects. China, they tell us, is going to go from strength to strength while the US morphs into a shadow of its former self.

A problem with the idea that China will continue its steep upward trend while the US economy shrinks or stagnates is that an important sector of China's economy is almost totally reliant on being able to sell products to the US. The irrepressible China bulls counter that if the US economy goes into an extended funk then domestic Chinese demand will take up the slack, but this makes no sense on a number of levels. For starters, if the Chinese manufacturers that currently export to the US could make a profit by selling their products locally then that's what they would already be doing (why go to the trouble and expense of shipping products across the Pacific Ocean if you can generate a reasonable return by selling them in your backyard?). For seconds, the US market for the sorts of consumer goods that are exported by China is many times larger than the market inside China. The relative sizes of the markets will change over the long term, but in the mean time a lot of manufacturing companies in China will find that they are geared up to make products that cannot be sold. This is an example of the classic "Austrian" mismatch between production and consumption that often arises in response to rapid monetary inflation and artificially low interest rates. It's not that there is insufficient aggregate demand (as the Keynesians like to claim in their misguided efforts to encourage even more inflation and an expanded role for the government); it's that long-term investments were based on consumer spending patterns that prove to be unsustainable because they are artifacts of a credit bubble.

Unfortunately, having a manufacturing sector propped-up by unsustainable consumption trends is not the only major problem facing China's economy. As discussed in previous commentaries and as documented by many other analysts, China is immersed in a fully-fledged real estate investment bubble. There are some interesting facts about China's real estate bubble and the associated mal-investment, including pictures of a completely empty Chinese city (Ordos) that was originally built to cater for 1.5M inhabitants, in the slide presentation delivered by Vitaliy Katsenelson at Casey's Gold and Resource Summit.

One of the indicators that China is an economic accident waiting to happen is the rapid rate at which the country's money supply has been rising. The monetary inflation rate was already at nosebleed levels prior to 2008, but was accelerated by China's monetary authorities in response to the global financial crisis. The total supply of Yuan is now more than 50% higher than it was just two years ago. With the effects of inflation spreading from the asset markets to the markets for basic consumer goods and labour, China's economic commandants became sufficiently concerned earlier this week to push interest rates upward for the first time in three years.

That China's economy continues to maintain the outward appearance of strength, despite a burgeoning inflation problem and mal-investment on an unprecedented scale, is testament to the extraordinary degree of control that China's government exerts over the banking system and the amount of borrowing/lending. Due to this control, insolvent banks continue to lend aggressively to insolvent State-owned companies, which use the borrowed funds to build impressive factories, office buildings and shopping centres, many of which are under-utilised and loss-making.

Eventually, the proverbial chickens will come home to roost (China's bubble will burst). Best to be positioned so as not to get hurt when that happens.

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