creative destruction

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Is War Coming Between China And Japan?

Last month, I looked at the legal implications of a conflict between China and Japan, concluding that the likelihood remains low, and that America would not be legally bound to defend Japan:

First of all, it is critical to note that the United States is not legally obligated under its with Japan treaty to intercede on Japan’s behalf. The treaty states that the United States is required to report any such event to the UN Security Council, instead:

Each Party recognizes that an armed attack against either Party in the territories under the administration of Japan would be dangerous to its own peace and safety and declares that it would act to meet the common danger in accordance with its constitutional provisions and processes. Any such armed attack and all measures taken as a result thereof shall be immediately reported to the Security Council of the United Nations in accordance with the provisions of Article 51 of the Charter. Such measures shall be terminated when the Security Council has taken the measures necessary to restore and maintain international peace and security.

Very simply, this means that China can attack Japan without fearing an inevitable American retaliation. That fact alone makes a small skirmish fairly likely.

So what if China successfully captured the islands — and perhaps even more Japanese territory — as we can perhaps assume given China’s overwhelming size and military-spending advantages? Well, the United States and presumably the international community other than China’s allies would seek to diplomatically pressure China to stand down and reach a peaceful arbitrated resolution via the UN.

If China refused to stand down and accept a diplomatic solution — that is, if China was absolutely set on staring down the United States — then the United States would be forced to choose between providing military support to Japan — and possibly ultimately escalating up to a global war between China and her allies and the United States and her allies — or facing a humiliating climbdown, and accepting both Chinese sovereignty over the islands, as well as any other Japanese territory that China might have captured, as well as face the possibility of further Chinese incursions and expansionism in the Pacific in the future.

In the last day it has been reported that Chinese forces have been mobilising.

Mobilising

A report out of China by NTDTV (in very broken English) notes:

February 3, Nan’an, Fujian Highway 308, artillery units practical exercise for several days.

February 3 to 6, Fujian, Xiamen, Zhangzhou, Huzhou, a large troop movements, nearly 100 vehicles of various types of military vehicles, armored vehicles, artillery filled the entire road, endless, Xiamen and even the scene of a traffic jam 10 kilometers.

In addition, on February 3 in Shiyan, Hubei, a large number of tanks, wheeled military base from Shiyan room counties is delivered to the coastal areas. Many local residents of the tense situation of some concern.

Prior to this allegation, January 15 and 30, the Chinese navy guided missile frigate, twice the fire control radar lock frigates and ship-borne helicopters of the Japanese Maritime Self-Defense Force, is also considered to enter a combat state.

According to mainland media quoted the “People’s Daily” front-page article claiming that China will not change in point of view on the issue of the Diaoyu Islands , and have to prepare to win the war.

The international media alleged that China has purchased from Russia 239 engine, used in the manufacture of the H-6K. Combat covering the Diaoyu Islands, in this model, the engine can also be used to manufacture transported -20 transport aircraft purchased.

If the engine assembled, will greatly enhance China’s military power.

This may turn out to be much ado about nothing, propaganda released to make a hullabaloo. With China gradually growing relatively stronger, and the United States and her allies growing relatively weaker, China on the surface may seem to have very little incentive to do much other than wait. But with global economic conditions worsening, and both China and Japan becoming more fierce in their rhetoric, it becomes likelier and likelier that China may choose to project its economic problems outward by starting a hot war. Most importantly, with the United States not committed to materially defend Japan, it appears to me like China may see this as a golden opportunity to impose itself on the region, to humiliate the already overstretched United States, and make a statement by pushing Japan out of the islands, or perhaps even by going postal and invading other Japanese islands or even Taiwan. With the world dependent on goods and components produced and assembled in China, China already has a lot of leverage to push the rest of the world into accepting a Chinese-dominated regional order.

Still I would say that by far the most rational course for China is to not start a war. But if China starts, it becomes increasingly likely that the United States will respond.

Governments around the globe are advised to remember that while war may increase GDP, and while it may lower unemployment, it destroys an unquantifiably larger amount of real wealth — lives, businesses, physical capital, social capital.

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Capitalism Explained For Angela Merkel

Europe’s new Führer (yes — I just went there) doesn’t seem to understand what capitalism is, or how markets work.

Stern-faced Teutonic Austerity

From Felix Salmon:

Ms Merkel agreed that private sector bondholders would not be asked to bear some of the losses in any future sovereign debt restructuring, as she had insisted this year in the case of Greece’s second bail-out. However, future eurozone bonds will still include collective action clauses providing for potential voluntary rescheduling of private debt.

Ms Merkel said it was imperative to show that Europe was a “safe place to invest”.

To understand just how stupid this is, all you need to do is go back and read Michael Lewis’s Ireland article. The fateful decision in Ireland was to take the insolvent banks and give them a blanket bailout, with the banks’ creditors all getting 100 cents on the euro. That only served to put a positively evil debt burden onto the Irish people, forcing a massive austerity program and causing untold billions of euros in foregone growth, while bailing out lenders who deserved no such thing.

Are we really going to repeat — on a much larger scale — the very same mistake that Ireland made? Does no one in Europe realize that this is the single worst thing they can do?

Salmon is correct, but there is a bigger issue at play here — this kind of nonsensical rubbish is exactly what has turned first Japan, and now America into zombie economies.

Showing that Europe is a “safe place to invest” effectively means rigging the market to eliminate sovereign default, or any kind of behaviour that threatens “systemic stability”. Of course, as the last few years have shown, the system is too interconnected for large entities fail. The reactionary perspective on this is to bail out everything again and again and again. The realistic perspective is that no such system is sustainable. Worse, no such system allows for any kind of capitalism.

Capitalism means both successes and failures. It is a fundamentally experimental system, with a continuous feedback mechanism — the market, and ultimately profit and loss. Ideas that work are rewarded with financial success, and ideas that don’t are punished with failure. With capitalism, systems, ideas and firms that fail to produce what the market wants fail. They go bankrupt. Their assets, and their debt is liquidated.

When that mechanism is suspended by a government or central bank that thinks it knows best — and that a system that is too interconnected to fail is worth saving at any cost — the result is almost always stagnation. This is for a number of reasons — most obviously that bailouts sustain crippling debt levels, and are paid for through contractionary austerity, which is what Salmon was getting at. But it is larger than just that.

In nature, ideas and schemes that work are rewarded — and ideas and schemes that don’t work are punished. Our ancestors who correctly judged the climate, soil and rainfall and planted crops that flourished were rewarded with a bumper harvest. Those who planted the wrong crops did not get a bailout — they got a lean harvest, and were forced to either learn from their mistakes, or perish.

These bailouts have tried to turn nature on its head — bailed out bankers and institutions have not been forced by failure to learn from their mistakes, because governments and regulators protected them from failure.

The darkest side to this zombification is that it takes resources from the productive, the young, the creative, and the needy and channels them to the zombies. Vast sums spent on rescue packages to keep the zombie system alive might have been available to increase the intellectual capabilities of the youth, or to support basic research and development, or to build better physical infrastructure, or to create new and innovative companies and products.

Zombification kills competition, too: when companies fail, it leaves a gap in the market that has to be filled, either by an expanding competitor, or by a new business. With failures now being kept on life-support, gaps in the market are fewer.

Japan has experienced twenty hellish years of zombification, all because they suspended capitalism in favour of systemic stability and creditors getting their pound of flesh. America did virtually the same thing, and the result has been three years of stagnation. Now — if Merkel gets here way — Europe will face the same thing.

Without experimental capitalism societies stagnate. That is the lesson policy makers — especially Europe’s new Führer — need to learn.

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Empiricism in Economics

It has long been held that there are two kinds of economics:

  1. Rationalist economics: starting out with theses about philosophy, money and reality (etc) and using logic and reason to reach conclusions about the present and predictions about the future.
  2. Empiricist economics: starting out with data and creating mathematical models representing these data, and using these models to reach conclusions about the present, and predictions about the future.

In traditional circles, the first class tends to include the various schools of Austrian and Marxian economics, and the second class tends to include the various schools of Keynesian and Monetarist economics.

Today, I want to put an entirely new spin on empiricism in economics, by focussing away from modelling. The process of mathematical modelling is just as rationalist as using logic and reason.

Why?

Economies are nonlinear systems.

From Wikipedia:

In mathematics, a nonlinear system is a system which is not linear, that is, a system which does not satisfy the superposition principle, or whose output is not directly proportional to its input. 

Effectively, a nonlinear system is one in which mathematical modelling mostly does not work. This, in a nutshell, is the reason why professional economists within the academic system, at the Federal Reserve, and within the IMF and the World Bank are often so desperately incorrect with their predictions, as we have seen so many times in the last few years. 

This is because nonlinearity is a direct result of incomplete information. Any map or model built will not be an exact replica of reality, and as Benoit Mandelbrot showed tiny divergences in an unmodelled (or unknown) variable can result in a humungous variation in the output of the system (i.e., the economy).

So in dealing with nonlinearity the model always fails — sometimes by a fraction, and sometimes by a huge amount.  The notion of accurate modelling was famously taken to a logical conclusion by the writer Jorge Luis Borges in On Exactitude in Science:

In that Empire, the Art of Cartography attained such Perfection that the map of a single Province occupied the entirety of a City, and the map of the Empire, the entirety of a Province. In time, those Unconscionable Maps no longer satisfied, and the Cartographers Guilds struck a Map of the Empire whose size was that of the Empire, and which coin- cided point for point with it. The following Generations, who were not so fond of the Study of Cartography as their Forebears had been, saw that that vast Map was Useless, and not without some Pitilessness was it, that they delivered it up to the Inclemencies of Sun and Winters. In the Deserts of the West, still today, there are Tattered Ruins of that Map, inhabited by Animals and Beggars; in all the Land there is no other Relic of the Disciplines of Geography.

So if accurate modelling in complex dynamical systems such as economies is effectively impossible without mapping every input what hope can there be for empiricism in economics?

We have to approach it from another angle: if it is impossible to model economies in a laboratory, through equations, or in a supercomputer, the real world must be the testing-ground for ideas.

Actors in economies should be free to experiment. Good ideas should be free to succeed, and bad ones to fail. The role of the government should be to provide a level playing field for experimentalism (and enough of a safety net for when experiments go wrong) — not pick winners or “manage the economy”. People with ideas must be able to access capital so that those ideas can be tested in the market place. If experiments go badly, that is no bad thing: it just means that another idea, or system, or structure needs to be tested. People should be free to go bankrupt and start all over again with a different mindset and different idea.

The corporatist model that most nations around the world have adopted, or fallen into (i.e. “capitalism” led by governments and large corporations) is nothing like this. Small businesses struggle to access capital. Young men and women are thrown onto the scrapheap of unemployment without a chance to develop skills, or entrepreneurial ideas, or even sell their labour, and pushed into leeching off the wealth of the nation through welfare. Large banks and corporations whose business models have failed are routinely declared “infrastructurally important” or “too big to fail” and bailed out to leech off the nation.

This is not empiricism. This is a disaster. To restore society, we must restore empiricism into economies.

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Hemingway on Krugman

Paul Krugman — surely the most (deliberately) provocative economist in the world — thinks we need more inflation.

Why?

From Paul Krugman:

Inflation hawks, including Paul Volcker in today’s NYT, often invoke the supposed lessons of history, to the effect that inflation is always harmful and always gets out of control.

But that’s a selective reading of history, and it skips the most relevant examples.

Early on in this crisis, I began wondering why the US didn’t relapse into the Great Depression after World War II. And there’s a good case that this had something to do with it:

The big rise in prices during and after WWII arguably did a lot to eliminate the debt overhang, making it possible for the economy to enter a sustained, non-inflationary boom.

So his reasoning is that inflation is necessary for debt elimination. And when it comes to debt elimination, (for once) I agree with him. But should that be done through inflation?

Absolutely not. If a debtor cannot afford its debts, there are two paths to debt-elimination:

  1. Admitting that the mountain of debt is immovable, and giving negotiated haircuts to creditors
  2. Inflating away the debt with money printing

The second option — which is effectively what Krugman is advocating — is incredibly risky. From the perspective of the consumer, inflation coupled with stagnant wages would be painful — and the potential for a hyper-inflationary spiral is downright dangerous. A far better option is giving consumers more options to default on or renegotiate their debts, including mortgages.

But from the perspective of the US Treasury, inflation would be far worse still. Why? Money printing is increasingly seen as a sign that foreign creditors need to get out of the dollar, and into harder assets. This would result in many foreign-held dollars flooding back to America, worsening the inflationary spiral.

From alt-market:

The private Federal Reserve has been quite careful in maintaining a veil of secrecy over the full extent of dollar saturation in foreign markets in order to hide the sheer volume of greenback devaluation and inflation they have created. If for some reason the reserves of dollars held overseas by investors and creditors were to come flooding back into the U.S., we would see a hyperinflationary spiral more destructive than any in recorded history.

Conversely, a straight-forward haircut would be painful in the short term, but would do far less than money printing to undermine the dollar in the medium term — and cause far less of a flood of dollars back into America. Creditors, particularly China, would be happier to see a short-term default stopping the printing presses and safeguarding the long-term purchasing power of the dollar than they would see the dollar constantly undermined.

So, in conclusion, default achieves debt elimination in a clean and relatively one-dimensional manner, while safeguarding the value of the currency. Inflating away the debt achieves the same thing in a more dangerous fashion, because it endangers the quality of the currency. The international ramifications of such a policy are unpredictable, especially given the fact that so much of America’s economic might is built on its ability to acquire resources and energy with dollars.

As Ernest Hemingway put it:

The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.

No — we don’t need more inflation. We need to pay down our debts in a timely and honest fashion, and if we can’t do that we need to default.

Of course, there is another aspect to this:

Krugman thinks weak demand is eating the American economy, and that money printing and a little inflation will provide enough of a boost to juice the economy into a stronger position. But weak demand is not the problem. The biggest problem is imperial overstretch.