Lessons To Learn From China's Failed Stimulus Program

by: Shaun Connell

When confronted with the awkward fact that the Great Depression lasted a decade under FDR and didn't disappear until the United States was able to help rebuild the world which destroyed by World War II, most Keynesians simply explain that FDR didn't spend enough. A common argument is that the economy was improving, but stopped improving when he began cutting back.

When confronted with the fact that under Obama the economy is arguably structurally weaker than it was when he took office, most Keynesians simply argue that we haven't had enough spending, or that state and local governments stopped spending, and that ruined everything.

Fine. I think Keynesian economics is hogwash, but we have already seen the greatest experiment in the theory of John Maynard Keynes, essentially to the point of digging holes to fill back up.

And it's failed, as China's economy continually shows more and more signs of a "hard landing".

China: The Deficit-Spending Disaster

While many people, even myself, believe that unless an all-out economic meltdown occurs, China is set to become the world's largest economy in the 21st Century.

Back in 2008, they had a huge stimulus package, even bigger than the US stimulus spending when you account for different sizes in GDP.

It also failed. Inflation skyrocketed, incomes barely grew at all, most of the people didn't benefit on any level from the spending, and huge malinvestment became logged in the system. As the folks at Heritage explain:

Though Chinese GDP picked up after the stimulus, the life of the average person grew more difficult. In the years after the stimulus, true inflation was high and incomes grew slowly. Housing prices soared due to diversion of bank loans into the property market. In major cities in China, housing prices reached 30 times the average annual income.

The majority of the fiscal stimulus went to infrastructure development, such as building airports and reconstruction in the Sichuan earthquake zone. These government-selected projects did not deliver benefits for most people. For example, the trillion-yuan high-speed railway had a 30 percent occupancy rate on some lines after completion. The world's longest sea bridge, built in Qingdao, has few users, making it the Chinese version of the "Bridge to Nowhere."

And now they're at it again, with talks of a new round of stimulus spending for railroad infastructure.

Why Stimulus Spending Fails

It fails because government stimulus spending is essentially, by definition, malinvestment. It ignores the invisible hand when it comes to directing resources, and is far, far less efficient than market pricing.

I've written before that ignoring prices is the real problem with economic troubles. The student loan bubble, the housing bubble, the financial crisis, growth of the financial sector -- these are all malinvestment consequences of government trying to "fix" the economy through monetary and fiscal manipulation.

Just look at the bubbles in China. The stimulus spending created their own version of the housing bubble which has really begun to burst in the last year, and now untold millions of people connected to the industry are finding their incomes grinding to a halt.

Brother, we've been here before.

SF Gate interviewed some people who are experiencing economic hell first-hand:

"A lot of building projects are half-finished and forced to stop. I think it is even worse than 2008," said a manager for Hangzhou Yuanlong Construction Co. in the eastern city of Hangzhou. She would give only her surname, An.

The company, with 20 employees and four teams of independent construction contractors, is owed 2 million yuan ($300,000) by cash-strapped customers and is having trouble collecting, An said. "Our boss is looking for new opportunities," she said. "Otherwise we are not going to survive."

Stimulus spending always misallocates resources and gives "false" signals to investors. It messes up prices so that bad choices are suddenly "good" in the micro-sense for the short-term, leading to the economy becoming unstable and needing a new recession to "clean out" the bad investments.

We absolutely must accept the fact that the government can't fix the economy through spending and monetary policy. Only by getting out of the way and letting the market correct can we help an economy.

Will the government get out of the way? No, not at all. They'll continually come up with new excuses as to why their government spending just created bubbles that then burst, and they'll keep up the printing and the increase in government.

That's probably the single best reason to buy gold and hold onto it -- because when it comes to gold investing, right now you'd think that politicians are on the payrolls of the gold bullion dealers, creating demand for doomsday asset. ETFs like GLD and SLV will likely get a boost if the Chinese government continues its own money-printing debt-creation binge. No matter what, however, nothing beats the physical.

The Economy And The Investor
Don't, however, confuse investment markets with the actual economy. The economy, at least in the short run, can fare poorly while the capital markets grow. Just look at the US economy -- the two simply aren't linked in the short run, though in the long-run the correlation is far greater.

Market indexes investing in China like FXI still pay great dividends almost at 5%, meaning unless we have a full-on economic collapse in a manner that destroys dividends, it can still be a nice income source for investors.

Personally, I'd rather just put my money in a savings account and eat the inflation loss before I'd ever invest directly in China. Investing for Chinese growth is better done indirectly.

In my last article on China, I wrote:

A few companies to watch for would be Freeport-McMoRan (NYSE:FCX), Cliffs Natural Resources (NYSE:CLF) , Molex (NASDAQ:MOLX) and Rio Tinto (NYSE:RIO), all of which have strong exposure to the Chinese economy, either by mining or manufacturing electronic devices high in demand for the growing economy.

Over the next few years, we should learn the lesson of China. But I wouldn't bet on that happening. Instead, I'll bet on good companies and commodities that can survive the decisions of the political class.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I own physical gold and silver and am adding to my position regularly.