Double Bubble, Toil and Trouble

Guess where the biggest bubble in the world is, and what it has to do with the tiny fishing hamlet of Wukan.

1You won't believe what the biggest bubble in the world is. No, it isn't the Chinese real estate market, or European banks or even Facebook's valuation for its public offering. With all due respect to these potential bubbles, they don't reach the ankles of the biggest one of all, the quietest of the lot and certainly, the most unexpected. Or a least, the most unacknowledged.

When the American economy crashed in 2009 and Barack Obama came to the White House, gigantic bailout plans were cobbled together and tossed into the marketplace, and America's budget deficit and debt began to mushroom. The next phase of this process seemed all but inevitable: U.S. government bonds would lose their allure. Inevitably, they would drop in price and the interest investors would demand in exchange for kindly buying American government debt would rise to unprecedented heights. Prof. Kenneth Rogoff, a world-class expert on financial crises, even released a forecast: The yield on long-term U.S. government bonds would reach a huge 7%.

rebellion by villagers - Reuters - 10012012

Bill Gross, head of the world's biggest bonds fund, PIMCO, had no doubt either. He wouldn't touch U.S. T-bills, especially long-term bonds, with a ten-foot barge pole.

So much for the theory and huffing. What actually happened?

The U.S. budget deficits did explode, growing much faster than predicted. America's debt bloated to levels unthinkable just 10 years ago, growing 50% in three years. But American government bonds just kept rising in price.

In 2011, if anything the trend strengthened. America's debt grew to $1.3 trillion but interest on 10-year U.S. T-bills tumbled from 4% to less than 2%. Prices of these bonds jumped as much as 30%.

How did this miracle happen? The financial profile of the biggest borrower on the planet was deteriorating, so why were investors storming for its debt, driving up prices of its bonds and lowering the interest the bonds paid?

With hindsight, it's easy to understand. It is true that Washington's financial profile has deteriorated. But the state of the euro bloc has deteriorated much more. Investors feel that by and large, America's problems are a known quality. But in Europe, the process of exposing the rot has just begun. Despite its bloated, corrupt financial system, the U.S. still has a much more flexible, competitive and stronger economy. Also, the American private sector has sharply scaled back its borrowing because of the hard times, unemployment and fear of the future, which made more room for government bonds.

Lovely. Kudos. But as 2012 begins, a question is begged: What will happen when the trend reverses and investors start to flee U.S. government bonds? What happens when interest on them starts to climb?

Christina Romer, until a year ago chairperson of Obama's Council of Economic Advisers, warned in a New York Times column that the way America's deficit and debt are growing, it's just a matter of time before it defaults. In other words, it's just a matter of time before the biggest economy in the world goes bankrupt.

She isn't the only one warning about an American default. But the other warnings came to look pretty silly over the last three years. The more interest rates dropped, the more sentiment changed: The notion that the United States can sustain gargantuan deficits over time without paying a heavy financial price for it has won many believers in the markets.

Say the U.S. doesn't default but just prints money instead, creating inflation and eroding the value of its currency in order to evade its terrifyingly huge financial debt. What then? It would be enough for interest rates to return to their level of a year ago, or five years ago, to create a horrible crash in the bond market, wreaking havoc on investment portfolios of hundreds of millions of savers in America and elsewhere.

Stock markets are what make the headlines, but the American bond market is where the explosion could happen in 2012.


2 Forecasts and warnings, from us or any other source, should be taken with a grain of salt. Maybe not a grain - a whole sack. When the financial crisis erupted in the U.S., we wondered in this column when China would crash. The management practices there, the inflated figures and the wiggling in Beijing, and the dubious national accounts the government cooked up seemed like a recipe for disaster. Well, we were wrong. The Chinese economy rallied at lightning speed, helping the whole world recover from the financial crisis of 2008.

Yet, in our opinion, if anything the danger has grown even greater. If there's a bubble competing with that of American bonds, it's the Chinese real estate bubble. Behind the wonderful growth China presented in the last three years lies not the famous Chinese export sector, nor its widely-touted policy of spurring domestic consumption, but mainly the government's tremendous investment in infrastructure and construction.

The Chinese economy's reliance on investment in infrastructure and property is dangerous, not only because of the heavy borrowing from Chinese banks (which are controlled by government ) - but also because of the Chinese method. It is based on the government seizing land from residents for the projects it wants to build.

Last month the world heard briefly about a revolt in Wukan, a fishing and farming hamlet of some 20,000 in Guangdong, on China's eastern coast. The people rose up against local government officials, expelled them from the village and blocked the roads. Surprisingly, the regional governor decided to appease the villagers by acceding to their demands.

Yet the uprising in Wukan is merely an aberrant reaction to what is actually common practice in China: expropriation, appropriation, nationalization or theft - call it what you will - of land, without any real compensation for the impoverished residents. Behind a few dozen real estate tycoons worth billions who sprouted in the last 10 years stand hundreds of millions of displaced villagers.

China isn't only a vast export economy. It is also a vast pressure cooker, a terrifying bubbling cauldron from which revolt could erupt at any time. In that pressure cooker is a smoldering stew of hundreds of millions of poverty-stricken farmers and peasants - spiced with towering leverage.

America's mountain of debt is directly related to China, the biggest buyer of American bonds during the last 10 years.

Now, we wouldn't want to hazard a forecast, given the complexity of the financial markets and the feeble results of forecasting by the world's most prominent economists. But we feel the American bonds bubble and the investment at the expense of the poor in China look especially threatening.