We tuned in to Alan Kohler’s article over at the Eureka Report yesterday afternoon.

We liked the headline – “China playing with fire” – and we liked Kohler’s opening sentence:

“Chinese Premier Wen Jiabao is playing a dangerous game by upping the ante in the Cold War of words with the United States over exchange rates. And it’s a game in which Australia, and Eureka Report members, are more than interested spectators: we are on the field, in danger of being trampled by elephants blinded by rage.”

I’ll tell you why we liked it. Not because of the content of the article – which we don’t completely agree with – but rather the use of the term ‘Cold War’ to describe the stand-off between the US and China.

We liked it because it got us thinking. Are there more similarities between the Cold War and the ‘US and China War’ than we’ve dared think of?

We won’t carry the comparison too far, but let’s take a look…

There are many candidates who lay claim to having helped end the Cold War – Ronald Reagan, Maggie Thatcher, the Pope – but one of the most convincing is that the Soviet Union was beaten economically rather than militarily.

The Soviet Union didn’t ‘lose’ the Cold War because it had fewer aircraft carriers, or less nuclear warheads to threaten the West with. And it didn’t necessarily ‘lose’ because it spent more than it could afford on its military growth.

It ‘lost’ the Cold War because it insisted on pursuing a centrally planned economy. A planned economy that cost more than it produced.

It doesn’t matter whether the Soviets were spending millions and billions of dollars on military hardware, or whether it was spending millions and billions of dollars on factories. The point is, it was trying to support production for products that nobody wanted.

It was spending all this money but had no sustainable source of income. Think about it, there was hardly a massive demand for Soviet industrial output. Russians and Ukrainians could barely afford to buy what the empire produced, and as for the West, well, the West wasn’t in any hurry to choose Trabants over Volkswagens.

So, it’s arguable to say that the Cold War was ultimately an economic war. In effect, the West succeeded in producing and spending the East out of existence.

Whether it was military or non-military spending it doesn’t matter. According to a report in the New York Times from 1994:

“Sadly for admirers of Ronald Reagan, the study concludes that the increased Soviet defense spending provoked by Mr. Reagan’s policies was not the straw that broke the back of the Evil Empire. The Afghan war and the Soviet response to Mr. Reagan’s Star Wars program caused only a relatively small rise in defense costs. And the defense effort throughout the period from 1960 to 1987 contributed only marginally to economic decline.”

The article is referring to a study by William Easterly of the World Bank and Stanley Fischer from the Massachusetts Institute of Technology.

We’ll have to take their word for it on the amount of defence spending as a proportion of the entire Soviet economy. But as I say, in reality what the Soviets spent money on doesn’t matter. The more crucial point is that aside from revenues from natural resources – oil and gas – the economy didn’t produce anything else of value.

The simple reason for that is a centrally planned economy by its very nature puts the entire decision process making in the hands of bureaucrats, leaving no room for entrepreneurial activity and no incentives for individuals to improve their lot.

And of course, no ability or incentive for businesses to make profits.

Therefore, the lack of access to capital from external sources invariably meant, well, the Soviets ran out of money.

The West, by contrast had heaps of capital and so could invest the capital productively. The result was the Soviets couldn’t keep up. As the West progressed further it made it even less likely that Western investors would have anything to do with the Eastern Bloc, and even harder for the central planners to compete with freer markets in the West.

So, where are we going with this? Surely we can’t compare the US with the former Soviet Union.

Well, yes and no.

Yes, in that to some degree the fate of the US economy is out of its hands. The US no longer has ultimate control over its future.

But ‘no’, in that the US isn’t likely to suffer from a carbon copy collapse of the Soviet Union. The US may collapse, but probably in a different way. As I mentioned, I don’t want to carry the comparison too far as there are more differences than similarities.

But here’s where it is worth looking at the comparison. We’re thinking about where the capital for investment is located. Right now, China is holding all the cards. It’s holding billions and trillions of dollars worth of assets – much of it US paper assets of course.

However, it is in effect money in the bank. Compare that to the US which is loaded up on the other side of the ledger – debt, debt and more debt. While it still has a workable economy, and while it still produces products and services in demand by the rest of the world, the fact remains that like the Soviets, the US is spending more than it earns. Of that there is no doubt.

But let’s get back to China. China, despite being a centrally planned economy, has at least grown it’s economy by producing lots of things that people want at a cheaper rate than anyone else.

Western businesses and consumers have bought all those things, largely on credit. And, in return for selling things to the West, the Chinese receive some goods, but mostly it receives a bunch of depreciating paper currency.

As far as the Chinese are concerned, as long as the West is still buying, and as long as the paper currency retains some value then both sides are happy with the deal.

The problem occurs when neither side likes the deal anymore? And that’s the stage we’re at right now.

The West doesn’t like it because they’re spending more money than they earn, and they don’t like it that the Chinese are competing ‘unfairly’ due to a lower currency. And the Chinese don’t like it because the West is just giving the Chinese paper money in exchange for manufactured goods.

They don’t like the fact that all the paper currency they’ve got isn’t worth what it used to be. And now they’re worried that the US government is going to make things worse.

What are China’s options? The simple answer is they’ve got to get rid of those dollars – dump them. Wherever they can – Australia, Argentina, Africa, back to America… anywhere, it doesn’t matter.

The problem for the West is, dumping currency isn’t like dumping rubbish at the tip. You dump some stinky old lounge suite at the local tip and no-one cares.

You dump $50 billion of cash on the market and, well, everyone’s paying attention. But here’s the real problem for the West.

If the Chinese just dumped all their US dollars and bought Yuan, that would naturally weaken the US dollar, strengthen the Yuan and potentially have a negative impact on China’s exports. That’s exactly what the West is saying the Chinese should do.

So right now, just dumping dollars isn’t an option. Instead the Chinese want to get something in return. After all, they’ll argue they’ve earned it.

In effect the Chinese are looking to exchange their soon-to-be-worthless US dollars for things it hopes will retain or rise in value. That could be oil, iron ore, copper, and even entire companies if national regulators will let them.

But once it’s got all that stuff, what are they going to do with it?

The answer seems clear – use it. Hence the billions of dollars spent on constructing skyscrapers, freeways, shopping malls and power stations. So what if there isn’t the demand to use it yet.

Perhaps the Chinese are just making an investment decision on which is of most value. Is it USD$100 billion in US bonds or fifty skyscrapers with no one to fill them? At the moment the skyscrapers seem to be winning out.

If you’ve got cash in the bank and you can see that measures are being taken to devalue that cash, then why not build those fifty skyscrapers now? In a year’s time they may only be able to build forty skyscrapers for the same cost.

When you’ve got trillions of dollars worth of US dollar investments, each extra dollar you get is of less value to you.

Over the last few years that’s exactly what the Chinese have done. They’ve saved and now they’re spending.

The argument all along has been that China is growing because it’s a great new industrialised nation. It’s building and making stuff for the West, plus it’s building and making stuff for its own people.

Perhaps it’s doing that. But maybe there’s a chance it’s just building stuff in order to get rid of all those US dollars.

Is that so far-fetched?

And maybe an added bonus for the Chinese is that this plan will end up sending the US broke. Not by doing something fancy with US treasury bills or with exchange rates, but rather spending as much of its stash of US dollars as it can in return for other assets.

Take the recent numbers from the International Energy Agency, China’s oil demand increased 28% compared with last year.

Reading that news we’re just left scratching our heads trying to figure out how it’s going to use all that oil. Surely global economic demand isn’t going to pick up that much.

Or maybe with all those savings in US dollars the Chinese figure that oil makes a better investment than cash. Or that it will use the oil to make and build stuff no one needs. Whatever it is they end up with, it’s got to be better than holding US paper currency or bonds.

But perhaps all this is just crazy talk. Who knows? Right now China has the upper hand. It’s a net saver, it produces products that are in demand, and it’s able to buy as many foreign assets as it wants.

Which all seems rather similar to when the US was building its economic empire.

In contrast, the US is a net borrower, it produces some products that are in demand, but it isn’t able to buy foreign assets without going further into debt.

While that may not be painting the same picture as the former Soviet Union, it’s certainly painting the picture of an economy in decline.

Trying to figure out what that will mean for investors is the hard part. Get it right and it means a big pay day for investors. Get it wrong and the downside is big.

Either way, our guess is that the next ten years of investing will be just as volatile as the last ten years. But that’s why we’ve got Alex Cowie, the editor of Diggers & Drillers checking out what’s happening around town.

Cheers.
Kris.