THE Most Important Chart of the CENTURY

The latest U.S. Treasury Z1 Flow of Funds report was released on March 11, 2010, bringing the data current through the end of 2009. What follows is the most important chart of your lifetime. It relegates almost all modern economists and economic theory to the dustbin of history. Any economic theory, formula, or relationship that does not consider this non-linear relationship of DEBT and phase transition is destined to fail.

It explains the "jobless" recoveries of the past and how each recent economic cycle produces higher money figures, yet lower employment. It explains why we are seeing debt driven events that circle the globe. It explains the psychological uneasiness that underpins this point in history, the elephant in the room that nobody sees or can describe.



This is a very simple chart. It takes the change in GDP and divides it by the change in Debt. What it shows is how much productivity is gained by infusing $1 of debt into our debt backed money system.

Back in the early 1960s a dollar of new debt added almost a dollar to the nation’s output of goods and services. As more debt enters the system the productivity gained by new debt diminishes. This produced a path that was following a diminishing line targeting ZERO in the year 2015. This meant that we could expect that each new dollar of debt added in the year 2015 would add NOTHING to our productivity.

Then a funny thing happened along the way. Macroeconomic DEBT SATURATION occurred causing a phase transition with our debt relationship. This is because total income can no longer support total debt. In the third quarter of 2009 each dollar of debt added produced NEGATIVE 15 cents of productivity, and at the end of 2009, each dollar of new debt now SUBTRACTS 45 cents from GDP!

This is mathematical PROOF that debt saturation has occurred. Continuing to add debt into a saturated system, where all money is debt, leads only to future defaults and to higher unemployment.

This is the dilemma created by our top down debt backed money structure. Because all money is backed by a liability, and carries interest, it guarantees mathematically that there will be losers and that the system will eventually reach the natural limits, the ability of incomes to service debt.

The data for the diminishing productivity of debt chart comes from the U.S. Treasury’s latest Z1 data.

On page two of that report is the following table showing the Growth of Non Financial Debt:



I included Financial debt onto the end of the table, that data comes from page 14 of the Z1 report.

This table makes clear what is happening. Business, household, and financial debt is trying to cleanse itself, to bring the level of debt back within the ability of incomes to support it. Our governments, armed with people who cannot explain the common sense behind debt saturation, are attempting to compensate by producing prolific amounts of Governmental debt.

They feel they must do this because if they do not, then debt and money – since debt backs our money – would both decrease and that would cause the economy to slow. But by adding money, and debt, they have created a sovereign issue where our nation’s income cannot possibly service our nation’s debt. In just the month of February, for example, our nation took in $107 billion, but spent $328 billion, a $221 billion shortfall. That one month shortfall exceeds all the combined shortfalls of the entire Nixon Administration – one month.

This is like an individual earning $5,000 but spending $15,000 a month. Would you lend your money to such an individual?

Last year we spent just under $400 billion on interest on our current debt, plus we spend another $1.5 Trillion buying down rates via Freddie, Fannie, and Quantitative Easing. That’s $1.9 Trillion spent on interest, most of which wound up in the hands of the central banks and their surrogates. Compared to our $2.2 Trillion in income, interest expense last year nearly took it all. That means that nearly all your productive effort used to pay Federal taxes last year were transferred to the central banks.

Modern monetary theory does not understand, nor does it correctly describe the debt backed money world in which we live. Velocity, for example, slows as debt saturation occurs. This is only common sense, and yet the formulas do not account for the bad math of debt, nor its non linear function. Velocity is blamed partially on the psychology of “consumers.” What nonsense. It is as mechanical as the engine in your car, it was designed that way. Once people, businesses, and governments become saturated with debt, new money/ debt when introduced can only be used to service prior existing debt.

Thus money creation at the saturation point stops adding to productive efforts and becomes a roll-over affair with only the financial services industry profiting via interest and fees. In other words, money goes out and circles right back around to the banks instead of rippling through a healthy non saturated economy. If you cannot follow that most simple logic, then going to Harvard will not help you.

Below is a chart of the Gross Federal Debt, it is now $12.6 Trillion dollars and headed straight up, a classic parabolic rise:



Below is a chart of the Gross Federal Debt expressed in year-over-year change in billions of dollars. The same phase transition of debt saturation is clear as a bell.



Below is a chart of Federal Net Outlays, parabolic and again headed straight up:



Clearly this is not sustainable and that means that change to our monetary system is rapidly approaching. No, it will not be left to your children or your grandchildren. It is an immediate problem.

That chart of diminishing returns is the window to understanding why humankind is trapped in a central banker debt backed money box. No money for NASA manned space flight – NASA’s total budget a puny $18 billion in comparison to the $1.9 Trillion that went to service the bankers last year. One half the schools closing in Kansas City, states whose debts and budget deficits seem insurmountable all pale in comparison to how much money went to service the use of our own money system.

It doesn’t have to be like that, in fact it’s a ridiculous notion that the people of the United States, or any country, should pay private individuals for the use of their money system. Ridiculous!

It’s difficult to see this from inside the box, so let’s look at what happened to Iceland to illustrate. The central banks of the world created financial engineered products and brought them to the banks of Iceland. These products created a boom in the amount of credit. Prices of everything rose, and the people of Iceland then had no choice but to go along for the bubble ride. Then with incomes no longer able to service the bubble debt, the bubble collapsed.

To “save the day,” the IMF and central bankers around the world rushed in to “rescue” the people, banks, and government of Iceland. They did this by offering loans... documents that create money simply by signing a contract of debt servitude. That contract demanded ownership of Iceland’s infrastructure such as their geothermal electrical generating plants. It also demanded the future productivity of the people of Iceland in that they should work and pay high taxes for decades to pay back this “debt.” Debt that they did not create or agree to service in the first place!

Tipping Point: Near-Term Systemic Implications of Peak Oil

The credit crisis exemplifies society's difficulties in the timely management of risks outside our experience or immediate concerns, even when such risks are well signposted. We have passed or are close to passing the peak of global oil production. Our civilisation is structurally unstable to an energy withdrawal. There is a high probability that our integrated and globalised civilisation is on the cusp of a fast and near-term collapse.

As individuals, and as a social species we put up huge psychological defences to protect the status quo. We've heard this doom prophesied for decades, all is still well! What about technology? Rising energy prices will bring more oil! We need a Green New Deal! We still have time! We’re busy with a financial crisis! This is depressing! If this were important, everybody would be talking about it!

Yet the evidence for such a scenario is as close to cast iron as any upon which policy is built: Oil production must peak; there is a growing probability that it has or will soon peak; energy flows and a functioning economy are by necessity highly correlated; our basic local needs have become dependent upon a hyper-complex, integrated, tightly-coupled global fabric of exchange; our primary infrastructure is dependent upon the operation of this fabric and global economies of scale; credit is the integral part of the fabric of our monetary, economic and trade systems; a credit market must collapse in a contracting economy, and so on.

We are living within dynamic processes. It matters little what technologies are in the pipeline, the potential of wind power in some choice location, or that the European Commission has a target; if a severe economic and structural collapse occurs before their enactment, then they may never be enacted.

Our primary question is what happens if there is a net decrease in energy flow through our civilisation? For it is absolutely dependent upon increasing flows of concentrated energy to evolve and grow, and to form and maintain its complex structures. The rules governing energy and its transformation, the laws of thermodynamics, are the inviolate framework through which all things happen- the evolution of the universe, the direction of time, life on earth, human development, the evolution of civilisation, and economic processes. This point is not rhetorical, access to increasing flows of concentrated energy, which can be transformed into work and dispersed energy, is the foundation upon which our civilisation stands. Yet we are at a point where these flows are, with high probability, about to begin decreasing. We should intuit that an energy withdrawal should have major systemic implications, for without energy flows nothing happens.

The key to understanding the implications of peak oil is to see it not just directly through its effect on transport, petrochemicals, or food say, but its systemic effects. A globalising, integrated and co-dependant economy has evolved with particular dynamics and embedded structures that have made our basic welfare dependent upon delocalised 'local' economies. It has locked us into hyper-complex economic and social processes that are increasing our vulnerability, but which we are unable to alter without risking a collapse in those same welfare supporting structures. And without increasing energy flows, those embedded structures, which include our expectations, institutions and infrastructure that evolved and adapted in the expectation of further economic growth cannot be maintained.

In order to address these questions, the following paper considers the nature and evolution of this complex integrated globalised civilisation from which energy is being withdrawn. Some broad issues in thermodynamics, the energy-economy relationship, peak oil, and the limits of mitigation are reviewed. It is argued that assumptions about future oil production as held by some peak oil aware commentators are misleading. We draw on some concepts in systems dynamics and critical transitions to frame our discussion.

The economics of peak oil are explicated using three indicative models: linear decline; oscillating decline; and systemic collapse. While these models are not to be considered as mutually exclusive, a case is made that our civilisation is close to a critical transition, or collapse. A series of integrated collapse mechanisms are described and are argued to be necessary. The principle driving mechanisms are re-enforcing (positive) feedbacks:

• A decline in energy flows will reduce global economic production; reduced global production will undermine our ability to produce, trade, and use energy; which will further decrease economic production.

• Credit forms the basis of our monetary system, and is the unifying embedded structure of the global economy. In a growing economy debt and interest can be repaid, in a declining economy not even the principle can be paid back. In other words, reduced energy flows cannot maintain the economic production to service debt. Real debt outstanding in the world is not repayable, new credit will almost vanish.

• Our localized needs and welfare have become ever-more dependent upon hyper-integrated globalised supply-chains. One pillar of their system-wide functioning is monetary confidence and bank intermediation. Money in our economies is backed by debt and holds no intrinsic value; deflation and hyper-inflation risks will make monetary stability impossible to maintain. In addition, the banking system as a whole must become insolvent as their assets (loans) cannot be realised, they are also at risk from failing infrastructure.

• A failure of this pillar will collapse world trade. Our 'local' globalised economies will fracture for there is virtually nothing produced in developed countries that can be considered truly indigenous. The more complex the systems and inputs we rely upon, the more globalised they are, and the more we are at risk from a complete systemic collapse.

• Another pillar is the operation of critical infrastructure (IT-telecoms/ electricity generation/ financial system/ transport/ water & sewage) which has become increasingly co-dependent where a systemic failure in one may cause cascading failure in the others. This infrastructure depends upon continual re-supply; embodies short lifetime components; complex highly resource intensive and specialized supply-chains; and large economies of scale. They also depend upon the operation of the monetary and financial system. These dependencies are likely to induce rapid growth in the risk of systemic failure.

• The high dependence of food on fossil fuel inputs, the delocalisation of food sourcing, and lean just-in-time inventories could lead to quickly evolving food insecurity risks even in the most developed countries. At issue is not just food production, but the ability to link surpluses to deficits, collapsed purchasing power, and the ability to monetize transactions.

• Peak oil is likely to force peak energy in general. The ability to bring on new energy production and maintain existing energy infrastructure is likely to be severely compromised. We may see massive demand and supply collapses with limited ability to re-boot.

• The above mechanisms are non-linear, mutually re-enforcing, and not exclusive.

• We argue that one of the principle initial drivers of the collapse process will be growing visible action about peak oil. It is expected that investors will attempt to extract themselves from ‘virtual assets’ such as bond, equities, and cash and convert them into ‘real’ assets before the system collapses. But the nominal value of virtual assets vastly exceeds the real assets likely to be available. Confirmation of the peak oil idea (by official action), fear, and market decline will drive a positive feedback in financial markets.

• We outline the implications for climate change. A major collapse in greenhouse gas is expected, though may be impossible to quantitatively model. This may reduce the risks of severe climate change impacts. However the relative ability to cope with the impacts of climate change will be much greater as we will be much poorer with much reduced resilience.

This will evolve as a systemic crisis; as the integrated infrastructure of our civilisation breaks down. It will give rise to a multi-front predicament that will swamp governments’ ability to manage. It is likely to lead to widespread disorientation, anxiety, severe welfare risks, and possible social breakdown. The report argues that a managed ‘de-growth’ is impossible.

We are at the cusp of rapid and severely disruptive changes. From now on the risk of entering a collapse must be considered significant and rising. The challenge is not about how we introduce energy infrastructure to maintain the viability of the systems we depend upon, rather it is how we deal with the consequences of not having the energy and other resources to maintain those same systems. Appeals towards localism, transition initiatives, organic food and renewable energy production, however laudable and necessary, are totally out of scale to what is approaching.

There is no solution, though there are some paths that are better and wiser than others. This is a societal issue, there is no ‘other’ to blame, but the responsibility belongs to us all. What we require is rapid emergency planning coupled with a plan for longer-term adaptation.

New Baghdad and the Collapse of Capitalism

Forty years ago, it was a small town on the Persian Gulf, merely one of seven sheikdoms joined in federation in 1971 to create the United Arab Emirates. Basically, there was nothing there but sand. Yes, oil had been discovered under that sand, and the city/state was enjoying its first economic boomlet. From about 60,000 in 1968, population tripled by 1975, doubled in the next ten years, and nearly doubled again by 1995.

Problem is, especially compared with many of its Gulf neighbors, it didn’t have all that much oil to begin with, and its reserves were falling fast. What it did have was Sheikh Mohammed bin Rashid Al Maktoum, the most influential member of the family that had ruled for more than a century and a half. And the sheikh had a vision.

Sheikh Mohammed believed that the Muslim world needed a New Baghdad, a center of commerce and learning and culture that would shine like the hub of the old caliphate, which had dominated the civilized world a thousand years earlier. He was determined to erect a dazzling, ultra-modern new metropolis, starting from scratch.

On the sands of Dubai.

The rest of the story is pretty well known. The crown prince, and later ruler, of Dubai had his way. His emirate became one of the richest and gaudiest places on the planet. Population shot to almost 1½ million, about 90% of them immigrants – from unskilled Bangladeshi laborers to software engineers from the U.S. – all lured by the promise of better-paying jobs than they could find at home.

Even more striking was the explosion of construction projects. Up went mansions, office skyscrapers, artificial islands, stadiums, a speedy Metro, a busy international airport, and the world’s only 7-star hotel, among other things. And the capstone was, of course, the Burj Khalifa, formally opened on January 4.

The Burj Khalifa is the tallest manmade structure on earth. Not by a little, mind you; halfway is not a word in Sheikh Mohammed’s vocabulary. Tallest by so much that it boggles the mind. It’s 2,717 feet high. That’s more than half a mile. For comparison purposes, take New York’s late Twin Towers. Stack them one atop the other. Now you’ve got the Burj Khalifa.

Begun in late 2004, the building was originally budgeted at US$869 million. Final tally as we entered 2010 was something north of a billion and a half. That bought the first luxury hotel to bear the Armani name, four swimming pools, a 158th-floor mosque, 57 elevators, and an observation deck at 1,450 feet, along with 52,490 square meters of office space and 288,000 square meters divided among 900 apartments.

Its coming-out party, with 10,000 fireworks and synchronized fountains shooting jets of water 150 feet into the air, was a spectacular light show, worth watching if you haven’t yet seen it, here http://www.youtube.com/watch?v=yRxxv6AZ_xg&feature=fvw . Hard to believe that you’re looking at a bone-dry desert.

You may also be looking at a gargantuan white elephant. Although every unit in the Burj Khalifa has supposedly been sold, some unknown percentage of buyers (likely very large) was speculators who opted in during the height of the world real estate boom. Properties were flipped like it was Southern California. At the market peak, modest flats were fetching more than $2,700/sq. ft. No wonder Emaar Properties, developer of the project, claims it has already recouped its capital outlay from these suck--, er, investors.

Those prices have now plummeted by up to 50%. Of the folks left holding the bag, how many of the 25,000 slated to live in the building will actually do so? We don’t know, and no one who does will talk vacancy rates. In terms of transparency, Dubai makes the Bush administration look like an ad for Window World.

What we do know is that at the moment the structure is the Big Empty. Western critics have limbered up their keyboard fingers in order to pound out expressions of disdain, everything from “The Final Monument to Excess” to “Bling City Is Dead” to “The End of Capitalism.” The first may be apt, as we’ll probably not see the likes of the Burj Khalifa again, but the last? That’s something we want to look at more closely. There is a lesson to be learned.

The truth of the matter is that there were two key, and contradictory, elements to the Dubai miracle, and when the world recession hit in 2007, one overrode the other and the whole thing came tumbling down.

First: As noted, Sheikh Mohammed didn’t have a river of oil money to rely on. So how did he manage to build his gleaming city by the sea? On the surface, it was simple. Turn Dubai into one of the world’s premier places to do business. Make it essentially tax free. Create investment incentives. Attract entrepreneurs from all over. Enlarge and capitalize on the city’s status as a deep water port. Replace traditional smuggling with legit import/export operations. Become a world financial center.

In short, install the best aspects of free-market capitalism, then send an Open for Business letter to the world.

It worked. Capital, resources, and personnel flooded in. By 2005, oil and gas were responsible for only 6% of the emirate’s GDP. Property and construction was the biggest contributor at 22.6%, followed by trade at 16%, entrepôt (duty-free import/export business) at 15%, and financial services at 11%.

No one, apparently, thought it ominous that nearly a quarter of GDP was generated by the construction and trading of properties, nor paused to consider what would happen when the music stopped and supply exceeded demand. Dubai was riding high, a model for other resource-poor, developing nations, showing them how to get rich.

Today, the hot desert wind blows through half-buildings that will never be finished. Immigrants, their work visas rescinded, are rounded up and sent home. Mercedes Benzes and Jaguars have For Sale signs taped to their windows or are just abandoned at the airport. Real estate prices tanked by 50% in 2009 and are projected to suffer another 30% haircut this year. The stock market has plunged 70%. Unmaintained, the artificial islands designed as millionaires’ playpens have begun to sink beneath the sea.

The glorious ride is over. But just in case there was any doubt, the point was hammered home last November, when Dubai World – one of the country’s leading development conglomerates – told creditors it was declaring a six-month moratorium on repayments it could no longer make.

That sent shock waves through financial markets the world over. Everyone, it seems, had invested in Dubai during the boom times. Now they’re staring at a very unfavorable restructuring at best and flat-out default at worst.

Dubai’s debt, or at least as much of it as its rulers will reveal, is about US$80 billion, or 140% of GDP. Bad enough, but it may well be significantly understated. One local investment banker puts the real number in the $120-150 billion range; with no balance sheets to pore over, we can’t know. Dubai will ask oil-rich fellow emirate Abu Dhabi for help, but there are no guarantees help will be forthcoming. Abu Dhabi has always cast a disapproving eye on Dubai’s helter skelter expansionism, and if it does step in, it will probably demand a whole lot of collateral.

Critics of a certain bent have pounced. History’s grandest experiment in unfettered free-market capitalism ran aground, they cry. Therefore the system doesn’t really work.

Which brings us to the second element in the Dubai miracle. It was built on a mountain of debt that couldn’t survive an economic downturn. And who supported that debt? The government. All of those go-go corporations, like Dubai World, are essentially government owned. Sheikh Mohammed wanted his New Baghdad, no matter the cost.

Granted, private enterprise businesses are imperfect. When in trouble, they will lie and cheat like anyone else. But in the end, they have a bottom line that they have to reveal at some point. Accounting tricks are eventually exposed. Capitalism, like a computer, is strictly binary. A company with sound finances prospers; a company that fails in the marketplace simply disappears.

Government-sponsored entities have no such limitations. They’re actively encouraged to overreach, to take risks that no sane CFO would approve. Because if they bleed red ink, the government is there to step in and prop them up. All of Dubai’s corporations were “too big to fail.” But fail they did, and in the process pushed the government into insolvency as well.

The takeaway from this story is simple. Dubai was no more free-market capitalist than Soviet Russia. Or the U.S., for that matter. If the government is the guarantor of last resort or just perceived as the ultimate reliable source of bailout money, a business has no incentive to be well run. When government (with taxpayer funding) takes a stake in even that most American of corporations, GM, capitalism truly has collapsed. Not, however, because of its shortcomings. Because government has not allowed it to function properly.

Though we lack a symbolic last gasp like the Burj Khalifa, make no mistake about it: we’re all fellow travelers with Dubai now. Washington would do well to study what happened there and hopefully learn a thing or two. Because we’re speeding toward the same crack-up.

The U.S. economy is like an out-of-control sports car in search of a tree, and the government is not “here to help you.”

Matthew Simmons' Awesome Presentation On The Coming Oil & Water Shortage

Oil industry analyst Matthew Simmons is one of the most influential proponents of the idea the notion that oil is growing increasingly scarce, and that our future will be characterized by shortages and price spikes.

At a recent, he recently delivered an excellent presentation on the coming oil and water shortage.

It's a great presentation, and though it would probably be somewhat better hearing him deliver it, it actually holds up very well on its own.

Flipping through it will give you a great base of understanding >

Is China broke?

Is China broke?

It seems like a silly question, right? China's foreign-exchange reserves stood at $2.4 trillion at the end of 2009. Yes, China announced that its proposed annual budget for 2010 would produce a record deficit, but the deficit is just $154 billion, or 2.8% of China's gross domestic product. In contrast, the Congressional Budget Office projects the U.S. budget deficit for fiscal 2010 at $1.3 trillion. That's equal to 9.2% of GDP.But remember the theme of my column earlier this week: All governments lie about their finances. At worst, as in Greece and the United States, the lies are bold and transparent. Everybody knows the emperor has no clothes, but no one want to say so. At best, as in Canada and China, the lies are more subtle -- more like a magician's misdirection than a viking raider's ax. Look at these great numbers, the lie goes, but don't look at those up my sleeve.

There's a good argument to be made that if you look at all the numbers, instead of just the ones the budget magicians want you to see, China is indeed broke.


More debt than meets the eye

Want to see how that could be?

If you look only at the current position of China's national government, the country is in great shape. Not only is the current budget deficit at that tiny 2.8% of GDP, but the International Monetary Fund projects the country's accumulated gross debt at just 22% of 2010 GDP. U.S gross debt, by comparison, is projected at 94% of GDP in 2010. The lowest gross-debt-to-GDP figure for any of the Group of Seven developed economies is Canada's 79%.

But China has a history of taking debt off its books and burying it, which should prompt us to poke and prod its numbers. If we go back to the last time China cooked the national books big time, during the Asian currency crisis of 1997, we can get an idea of where its debt might be hidden now.

The currency crisis started in 1997 with the collapse of the Thai baht -- and then, like dominoes, the currencies of Indonesia, South Korea, Malaysia and the Philippines collapsed.

In each case, the country had built up an export-led economy financed by foreign debt. When the hot money that had been flowing in instead flowed out, that sent currencies, stock markets and economies into a nose dive.

China escaped the first stage of the crisis because the country's tightly controlled currency and stock markets, and its economy, had kept out hot money from overseas. China had built its export-led economy on domestic bank loans instead. The majority of bank loans, then as now, went to state-owned companies -- about 70% of the total, the Congressional Research Service estimated in a 1999 examination of the period.

• Check today's currency exchange rates

Those loans were all that kept the doors open at many of China's biggest state-owned companies. In its review, the Congressional Research Service estimated that about 75% of China's 100,000 largest state-owned companies lost money and needed bank loans to continue operating.

That became a problem when, in the aftermath of the currency crisis, China's exports fell. That sent revenue plunging at state-owned companies that were already losing money. Suddenly, China's banks were sitting on billions and billions of debts that anybody who'd taken Bookkeeping 1 in high school could tell were never going to be paid. This was especially a problem for China's biggest banks, all of which had ambitions to raise more capital -- and their international profile -- by going public in Hong Kong and New York. But no bank could go public with this much bad debt on its books.

What to do? Why not bury the bad debt?

The Beijing government created special-purpose asset management companies for the four largest state-owned banks, the Industrial and Commercial Bank of China (IDCBY, news, msgs), the Agricultural Bank of China, the Bank of China (BACHY, news, msgs) and China Construction Bank (CICHY, news, msgs). These asset management companies -- China Cinda, China Huarong, China Orient and China Great Wall -- would ultimately wind up buying $287 billion in bad loans from state-owned banks. The majority of those purchases were at book value.

So how did the asset management companies pay for the purchase of that $287 billion in bad loans? They certainly didn't pay cash. Instead, they issued bonds to the banks in exchange for the bad loans. The bonds, of course, were backed by the promise that the asset management companies would gradually sell off or collect on the bad loans in time to redeem the bonds. And in the meantime, they'd pay the banks interest on those bonds.

Neat, huh? In one swell foop, the state-owned banks got $287 billion in bad loans off their books and turned deadbeat loans that would never pay off into streams of income from these bonds. To read more on this neat bit of financial engineering, check out this research paper (.pdf file).

Of course, that still left the little issue of where the asset management companies were going to get the approximately $30 billion in annual interest they had promised to pay the state-owned banks. There was also the small matter of how they were going to pay off these bonds when they came due in 10 years, especially since the cash recovery rate on these bad loans would run at just 20.3% in the first five years.

Fast-forward financing

But who really cared? The Beijing government and the state-owned banks had kicked the problem 10 years down the road. (A favorite tactic of politicians, Republicans, Democrats and Communists alike, is to punt, so that today's problem becomes somebody else's problem in the future.) The bonds issued by the asset management companies didn't have an explicit government guarantee, but everybody assumed that at some future date the government would either pay up or punt again.

The 10-year punt of 1999 came to earth in 2009, and, lo and behold, there was more magic.

In some cases -- China Huarong, for example -- the asset management companies simply declared that they'd done disposing of bad debts, that profits were soaring and that they were seeking strategic partners in preparation for a public offering.

In others cases, the magic was more complex. In October 2009, for example, China Cinda said it had secured government approval for a restructuring plan that would create a company to dispose of the $30 billion in bad loans still on Cinda's books. The company said it would then look for strategic partners in preparation for a public offering.

Who in their right minds would be a strategic partner and investor in one of these asset management companies? Well, how about one of the original state-owned banks, China Construction Bank, that Cinda had bought the bad loans from in the first place. "The hardest thing," China Construction Bank Chairman Guo Shuqing said in an Oct. 17, 2009, interview, "is evaluation."

Really? When the government runs the books, does all the accounting and decides what assets to send where, I think evaluation would be very easy. Any wonder, then, that today's huge run-up in loans -- and bad loans -- by China's banks is making some critics nervous?

The bigger problem, though, isn't so much China's big banks but the country's local governments.

Thinking globally, hiding (debt) locally

By now, everyone who has a nickel in China, or a dime itching to get into China, knows that the country's banks went on a lending spree in 2009. On top of official government stimulus spending of $585 billion, banks, encouraged by the government, doubled their lending in 2009 to $1.4 trillion from the previous year.

(Please remember when judging these figures that China's economy was an estimated $4.8 trillion in GDP in 2009, according to the CIA World Factbook. Estimated U.S. GDP was about three times larger, at $14.3 trillion. So China's 2009 bank lending of $1.4 trillion would be equal to lending of $4.2 trillion in the United States, and China's $585 billion government stimulus package would equal a $1.7 trillion U.S. package, more than twice the $787 billion size of the U.S. stimulus package of February 2009.)

China's banks hit the ground running even harder in 2010, lending out an additional $309 billion in January and February. If the banks had continued at that rate, they would have passed the official lending ceiling of $1.1 trillion by August. (See my Jan. 14 column for more on the lending boom and its results.)

So China's banking regulators, spooked by the increase in bank lending, tightened the reins. For 2010, they set a lending target 20% lower than 2009 lending levels. They raised reserve requirements so banks would have less capital to lend. And they told banks to hit the capital markets to raise an estimated $90 billion through 2011. (See this blog post for more.)

It's not clear that those steps will be enough to balance the huge number of bad loans that China's banks made during the lending boom. But China's regulators have clearly learned a lot about how to address a bad loan problem in the banking system since the 1997 currency crisis.

But as our own Federal Reserve has so amply demonstrated over the past decade, regulators tend to gear up to fight the last war. That leaves them vulnerable to the next crisis precisely to the degree by which it differs from the last one.

China's new debt problem is the thousands of investment companies set up by local governments to borrow money from banks and then lend it to local companies.

By law, China's local governments can't borrow directly. But the incentives for local governments to set up investment companies were huge.

By making loans to local companies, local governments could produce thousands of jobs and drive up the value of local enterprises. And by funding commercial and residential construction, they could drive up the price of land. Those results were important to local officials who often profited personally, but they were also essential to the survival of local governments. By law, those units also aren't allowed to raise their own taxes for local expenditures. To meet local demands -- and to fulfill the directives issued by Beijing -- local governments are dependent on frequently inadequate revenue transfers from Beijing and what they can collect from such transactions as local real-estate sales.

So how much did these investment companies borrow and then lend?

Local-government investment companies had a total of $1.7 trillion in outstanding debt at the end of 2009, estimates Victor Shih, an economist at Northwestern University and the author of "Factions and Finance in China." That's equal to about 35% of China's GDP in 2009.

In addition, banks have agreed to an additional $1.9 trillion in credit lines for local investment companies that the companies haven't yet drawn down, Shih says.

Together the debt plus the credit lines come to $3.8 trillion. That's roughly equal to 75% of China's GDP.

None of this, Shih points out, is included in the IMF calculation of China's gross-debt-to-GDP figure of 22%. If it were, the number would be closer to 100%.

Savings aplenty, but for whom?

Exactly how important is this number?

It depends on how many of those loans at local investment companies will go bad. Shih estimates that about 25% of current outstanding loans -- totaling $439 billion -- will go bad. (For comparison, remember that in the aftermath of the 1997 currency crisis, the newly established asset management companies swallowed $287 billion in bad loans.)

It also depends on how much of China's huge reserves and huge base of personal savings are available to offset the debt. So far, I've been talking about gross debt. But China, like Japan, has a huge domestic pool of savings it can use to buy debt. Economists point out that Japan has carried what looks like a crippling gross-debt-to-GDP ratio for years -- 188% in 2007, 197% in 2008, 219% (estimated) in 2009, and 227% (projected) in 2010 -- without disaster, because the country funds its debt internally from savings.

China, the argument goes, could easily do the same, so what's the problem?

A looming retirement crisis

The problem for both China and Japan is that it's not clear exactly how much of their huge pools of domestic savings are actually available in the long run to buy debt. Japan has a woefully underfunded retirement system, and it's by no means clear how the population of the world's most rapidly aging country is going to pay for retirement.

China has, for all intents and purposes, no public retirement system. As a result of its one-child policy, the country has also begun to age quickly, and by 2030 its population will be as old as that of the United States.

In the U.S., the national accounts may lie about the effect of the problem by putting Social Security and Medicare off-budget on the argument that, since these programs have their own dedicated revenue streams, they don't count as part of the national debt. But that lie aside, because the benefits of these programs are defined, it is possible to put a dollar figure on the government's future liabilities in this area (with all the uncertainty that comes with forecasting inflation, of course).

China isn't hiding any future liability for pensions or retiree health care off the books. The government hasn't promised future payments. In an accounting sense, then, there is no future liability that ought to be on the nation's books.

But that doesn't mean China won't have to consume some portion of its accumulated savings to pay for its post-65 population in 2030. The country, either through the government or through private citizens, will have to cover the costs of old age, however it defines that cost. And any savings it will use to pay for those costs really aren't available now to pay current debts.

I think the Chinese leadership is profoundly aware of the need today to not waste money that the country will need tomorrow. That's one reason Beijing has taken steps recently to rein in local investment companies. On March 8, the Ministry of Finance announced plans to nullify all guarantees by local governments for loans taken out by their investment company vehicles. And the national government plans to sell $29 billion in bonds for local governments this year, giving those governments an alternative to setting up local investment companies.

But the big job -- the reform of China's tax system so that local governments don't have to rely on real-estate and stock-market bubbles for funding -- didn't make it on the to-do list announced by the National People's Congress this week and last. And I don't think it's likely to with Communist Party leaders jockeying for position to replace President Hu Jintao and Premier Wen Jiabao in 2012. (For more on the effect of politics on economics in China, see this blog post.)

By the time China's leadership team has sorted itself out in 2013, China's finances will certainly look different. There's little chance they'll look better.

Industry's Parting Gifts

We are going to need some widgets made. They do not have to be as sophisticated or as complicated as the widgets we have today. For instance, once it is no longer possible to launch satellites, we will no longer have satellite navigation systems such as the Pentagon-run GPS or the joint Russian/Indian GLONASS. To compensate, we will have to go back to using radio beacons, so that boats can find harbor entrances in the fog. Another example: once laser printer and ink-jet technology no longer exists, we will need to bring back the humble old teletype. Add to that all of the other humble adaptations that will be needed once the electric grid and municipal services first become unaffordable, then cease to exist.

Countless items will have to be manufactured, one way or another, using local means, because imports are also going to first become unaffordable, then cease to exist. These items will have to be far more robust, longer-lasting and maintainable than the consumer products of today. A population reduced to a permanent state of camping out shares certain characteristics with astronauts and deep-sea divers and others who live and work on the edge: their reliance on their equipment is absolute. In such situations, an unreliable or unmaintainable product is worse than no product at all, because it gives a false sense of security. Making such high-quality items is by no means technically impossible; things can be made so well that they will last a lifetime and even become heirlooms. This, then, should be the new main thrust of industrial activity: to manufacture and distribute products with the understanding that this process will run out of resources and stop. These products must be designed to outlive the process by which they are made, by as long as possible.

How would one organize such a production scheme on an industrial scale? Is it even possible? If it is not, then the only recourse is to have this done by garage, basement and backyard tinkerers, using plans shared over the internet. In fact, this seems to be what is happening, and it very well may be all that ever happens. If that is the case, then production volumes will be much lower than what can be attained with mass production techniques, leaving a huge unmet demand, and a far more precipitous drop in living standards than is really necessary. But let us imagine for a moment that we can do better. How would we go about organizing such an effort? Here are some thought experiments—projections, if you will—based on what I've observed over the years. I present three scenarios—not a complete list, I hope, but these are all the scenarios I can think of without straining my imagination. I hope that you can do better.

Suppose you have a company that sets out to make a widget. Let's call it Company A. Its founders are all engineers, of an uncompromising sort, and the widget they design and manufacture is of tremendous longevity, durability and overall quality. Taking full advantage of economies of scale, they design a single, universal model that uses the maximum possible number of interchangeable, off-the-shelf commodity components, optimize it for mass production, and stockpile a gigantic inventory, including all the custom spare parts that they feel would ever be needed. To make sure that their product is sufficiently idiot-proof, they even test it on selected members of their own families. The engineers concentrate on what they feel is important, neglecting questions of marketability and competitive pricing, and the result is that Company A's widget cost double of functionally comparable widgets sold by the competition.

When consumers refuse to pay so much more than they feel they have to, Company A's widget fails in the marketplace, and the company is liquidated. Its remaining stock of widgets is eventually sold at a large discount, while Company A's investors get almost nothing. Those who are lucky and clever enough to buy one of these widgets go on to use them for the rest of their lives, never needing to buy another one, because, being grossly overdesigned and overbuilt, they simply never fail or wear out. In spite of Company A's failure as a business, the reputations of the engineers do not suffer at all, because, after all, their product is a tremendous technical success. Furthermore, since the installed base of their widgets never goes down, the engineers remain in demand as consultants, called in whenever issues do arise. Some of them form a small company that maintains an inventory of spare parts, and uses it to recondition and service their widgets far into the future. Eventually, long after the names of Company A's competitors are all forgotten, its name enters the language as the generic term for the widget it once made.

Now suppose you have another company, Company B, which makes a similar sort of widget. Its founders are all MBAs who are mainly interested in things like growth strategies, market penetration and continuous profitability. They are superficially interested in the widget itself, as consumers or from a sales and marketing perspective. The internal workings of the widget are, to them, best left up to the engineers. They do hire some smart engineers to start with, but don't give them much of a voice in making strategic decisions, and manage them by doling out bonuses and promotions for things like new features, shorter time to market, and lower production costs. They see to it that the widget they make is competitively priced, fashionably designed, and quickly obsolescent, so that consumers are ready to pay again and again just to get the latest features and designs. Durability and longevity are not a concern, since one or two years of semi-reliable service is all that's needed for Company B to come up with a new, improved version that consumers can be persuaded to buy given a sufficiently generous trade-in offer.

They work to boost revenue by offering an extended warranty or a service plan (made necessary by frequent breakdowns), charging for premium customer service (made necessary by their normal customer service, which consists of a robotic phone maze backed by a few trainees in India who just read aloud from Company B's public web site in a listless, stuttering monotone) and offering numerous enhancements and upgrades (made necessary by annoyances or missing functions within the base product). They also build a profit center out of selling spare parts. They see to it that their product does not contain any commodity parts, and that no parts are interchangeable between model years, so that every replacement part has to be purchased through a dealer. Company B does quite well, becoming profitable, doubling in size several times, and gains a commanding market share.

But then the troubles begin. First, given the short replacement cycle of its widget, it becomes harder and harder for Company B to contain costs while continuing to increase production. Costs of key inputs, such as certain metals, plastics, energy to run the plants, and shipping and distribution costs, all start going up, making their widgets more expensive to produce. At the same time, it becomes increasingly difficult to pass these higher costs on to the consumers. Concerted efforts at cost containment, championed by senior management, burn up more money than they find in savings. Second, turnover among the engineering staff starts to creep up, and after a while employee retention becomes a major problem. An effort is made to boost recruitment, but paradoxically this only increases the turnover rate, until the average tenure of an engineer is shorter than the time it takes to learn the product.

As development timelines slip and defect rates increase, management throws money at the problem by hiring high-priced consultants and engineering methodology snake oil salesmen, all to no avail. Lastly, although Company B manages to hold on to its market share, the overall size of the market starts to shrink as consumers run out of money and curtail their purchases, holding on to their outdated widgets until they fail, then learning to live without them. Eventually Company B is acquired by a foreign company, which crates up and ships off the few pieces of the operation it finds useful and auctions off the rest. As Company B's customers try to eke out a bit more life out of their half-broken widgets, the average resale price of Company A's widget soars well above its initial list price, and its proud owners go around looking insufferably smug.

Company C is not really a company but a consortium organized by a group of activists who correctly perceive the great need for this widget and decide to tackle the issue head-on through tireless community organizing. Their initial concept includes plans for the widget to carry a "100% Sustainable" label. A group of retired community college professors takes several months to define the technology selection criteria that would allow the project to meet the 100% sustainability requirement. In the end, they decide that the widget could be made out of hand-worked clay baked in a solar oven, but only if the oven itself is exempted from the 100% sustainability requirement. It could also be hand-woven out of wicker and bamboo, provided that these were subsequently composted and the compost returned to the soil where the wicker and bamboo were grown. However, the widget can't be made to work without the use of Nylon, Vinyl, Neoprene, epoxies and other fossil fuel-based synthetics, nor can it operate without components made with mined, increasingly scarce elements such as tantalum, gallium and lithium.

The organizers then move to drop the "100% sustainable" requirement and to shift their focus to "Serving community at every level." Production of the widget is to include hands-on job training programs at community colleges and vocational training centers, assembly tasks would be done by groups of mentally and/or physically challenged individuals, while testing, kitting-out and packing would be performed by religious groups (in conservative states) and groups of people with alternative sexual orientations (in liberal ones). From the outset, the consortium is plagued by scandal. The "Made with Pride in the USA" decals turn out to be made in China. The Visual Installation Guide is never printed in Braille. Worst of all, due to communication difficulties caused by static and noise on the line during conference calls, the lesbians (who were to lovingly pack completed widgets in wicker baskets hand-woven by Haitian orphans and filled with organically grown straw) turn out to be not lesbians at all, but eager out-of-work Thespians (of both genders, and barely half of them gay) and Fezbians (perfectly conventional males with convincing falsettos united by their predilection for wearing a fez). The consortium collapses in acrimony and mutual recriminations without shipping a single completed widget. Out of sheer frustration, one of the organizers, laboring alone, succeeds in assembling a single working widget, and donates it to the Smithsonian.

Based on the foregoing, it would appear that the choice is between failing at something and failing at everything. Company A makes excellent widgets but fails to pay back its investors. Company B makes money but its widgets quickly become useless trash. Company C entertains us with its feckless shenanigans but fails to produce any widgets. I really do hope that I am missing something. Is there a Company D out there? If so, please tell me, because I would really like to know.

- D. Orlov