China Will Eat Our Lunch

Most economists attribute the recent spike in Chinese inflation (6.5 percent in October) as an inevitable consequence of rapid growth. Few question why a country that has made tremendous gains in productivity, and that is responsible for lowering prices around the world, cannot deliver lower prices at home. In contrast, similarly rapid industrialization in the United States in the 19th century produced sustained price declines for more than 100 years.

The truth is that high prices in China, and the rest of the world for that matter, are a direct result of low prices in America. When the Chinese government, and their counterparts in the Middle East and Latin America, finally move to snuff out local inflation, a massive realignment of global purchasing power will ensue, with Americans on the losing end.

Despite economists' efforts to obscure the obvious, prices are a function of money supply. More money chasing a constant supply of goods pushes prices higher. More goods introduced into a constant supply of money pushes prices lower.

To sustain its currency peg to the U.S. dollar, China must expand its supply of yuan to purchase the hundreds of billions of excess dollars that it earns annually by selling products to Americans. With few American products to buy, many of these dollars are held by China as currency reserves. This action lowers inflation in the United States by making Chinese goods cheaper for Americans and restricting the supply of dollars globally. Conversely, the supply of yuan expands rapidly and overwhelms the downward price pressures made possible by increased productivity.

However, as China's inflation problems make the maintenance of the peg increasingly untenable, the day will surely come when the Chinese allow the dollar to fall and their own currency to rise. Most economists fear this will kill American consumption, leading to global recession. My view: while it would sound the death knell for the golden age of American consumption, it would in fact be a boon for China.

The absurdity of an economic model that credits Americans' insatiable willingness to consume as a prerequisite for global prosperity can easily be understood when boiled down to its basic elements. Suppose five Asians and one American were shipwrecked on an island. To maximize efficiency the castaways devise a plan where one Asian fishes, another hunts, the third gathers fruit, the fourth gathers firewood and the fifth cooks. The American is assigned the job of eating. In the eyes of the modern economist, the American is clearly the engine of this microeconomy; without his heroic consumption, the economy would stagnate.

The truth is that consumption is a movable feast. Americans overconsume because the world props up the purchasing-power of our currency. As the dollar declines, so too will our ability to overconsume. But the purchasing power lost by America will be gained by countries whose currencies rise in relative terms. Factories around the world won't shut down if Americans stopped spending. Without the American to feed, the Asians would simply have more to eat themselves.

With a per capita GDP of $43,000 the International Monetary Fund currently ranks the United States fourth among all nations in economic output per person. At $7,600 per year, China ranks 86th. However, due to its massive population of 1.3 billion, China already ranks third in total economic output. Most forecasters assume the total size of the Chinese economy will eclipse that of the United States by the middle of this century. But by factoring in the weakening dollar and the inevitable slowdown that drop will inflict on the United States, the changing of the guard will occur much sooner, perhaps in the next five years. In short order, currency realignment could push the United States out of the list of the top 20 nations in terms of per capita GDP, behind such countries as Greece and Singapore.

My forecast is that as foreigners continue to walk away from dollar assets, the greenback will lose an additional 40 to 50 percent against the U.S. Dollar Index. Given that the yuan has been artificially restrained by the Chinese government for decades, its rise will likely be much steeper, perhaps twice as much as the index itself. Such revaluations would result in China's GDP quadrupling in dollar terms. At current levels, this puts the Chinese economy at nearly $12 trillion and the U.S. at $13.2 trillion. Based on this assumption, it would only take a year or two of oversize expansion in China and modest contraction in the United States for the economic crown to move across the Pacific.

In the current status quo, America plays the role of one of its cultural icons, Tom Sawyer, who convinced his companions that the satisfaction of whitewashing fences (or in this case providing goods on credit) was reward in itself. The day will soon come when China and the other emerging economies decide to tend to their own fences. When that happens, Americans will have to paint for themselves, and perhaps even make their own brushes.