In the 1979 movie, The China Syndrome, the implausible plot revolves around a nuclear plant’s core melting its way into the earth, supposedly not stopping until it reached China. While the the Hollywood version of the China Syndrome might be fantasy, the economic version might not be. In this case, the threat to the world comes not from an out of control nuclear plant, but an out of control Chinese economy. The direction of the threat in this case is reversed. It is China that could be poised to send its core of problems to the west.

The PMI index now shows China’s manufacturing sector is in negative territory. Not the first time this has happened, but it comes on the tale of other bad news. Namely, China has been going through a series of bank defaults. Unbeknown to many, China has had a massive credit bubble that dwarfs anyplace else on earth. Building cities with no occupants, financing businesses with no customers and giving money to those who have no hope of paying it back, official and shadow banks have put the country into a trap with no way out.

Deflation has reared its ugly head and could get much worse. Some of China’s paper giants could be on the edge of an implosive abyss. Bank of America, in a report aptly called “Deflation, Devaluation, and Default,” sees 2015 as the year China’s Pied Piper bill comes due. To put this in perspective, imagine the Sub-Prime Mortgage crisis, and now multiply several times over. China has managed to hide its underlying weakness by continuing the charade, but unfortunately this was a strategy that only made matters worse. Deciding to take the bull by the horns, China’s President Xi Jinping is trying to manage a controlled collapse of the credit bubble. The likelihood of Xi avoiding disaster is probably somewhere between zero and none. Still, credit must be given for attempting what so many others have tried to cover up. (Read also, Xi proposes Rule of Law for China)

The question becomes, what kind of contagion does China pose for the world’s other teetering economies. China imports will drop, possibly precipitously, effecting its main trading partners. Chinese investment abroad could, surprisingly, could take a jump, as the mainland rich seek sanctuary from the storm abroad. This fleeing capital only will make China’s matters worse. Japan, already in a Keynesian death spiral, will see its situation get more dire. Europe, on the verge of collapse politically, and facing its own deflationary fears, will be rocked as well. The United States is already facing its own economic demons. With bubbles in the stock, bond, and housing markets as well as expanding debt issues of its own, the shock could usher in a series of market corrections that would prove catastrophic.

There is no guarantee that this modern version of The China Syndrome will bore all the way through to the rest of the world, but there is no guarantee it won’t! Most predict a rocky road ahead but are optimistic things will somehow workout. Whether this is just wishful thinking time will tell. China can do things internally that most countries can’t, but miracle workers they are not.

The most basic of all the laws of economics is their must be balance. Just like in natural ecosystems, econosystems seek equilibrium. This balance can be delayed, but balance it must. The more successful the powers that be are at delaying this natural balancing act, the more catastrophic the rebalancing becomes.

The FED  has tried to outsmart the system by supplying cheap credit, much as the Chinese have done.  Ignoring the balance of risk and interest rates, encouraging investors to ignore value or even cost benefit by offering quick profits with little risk of pain. It created the problems facing America today. The European Central Bank and the Bank of Japan have engaged in the same behavior as well. Creating a great hole covered up by rotting planks, a hole that must be filled even as it has been dug ever so much deeper.

The world should of let the depression come, cleaning the slate of yesterday’s foolishness and letting things start anew. This was what was done before the advent of modern central banking, great downturns rarely lasted long and clearly never as long as they do now. Two to three years of hardship, at most, was the price paid for a return to prosperity and growth. Now the world is facing a cataclysm and unnecessarily so. China is poised to pay for its sins; the question is, will its troubles be the catalyst that makes the rest of the world pay for theirs? One thing is certain, payment will be rendered, with interest.

“The Conservative Mind”

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