on china and lehman

not our kind of crisis, but possibly theirs

I’ve been noticing a particular market call going round and round for the last few weeks, suggesting that China is about to (real soon now) have a “Lehman moment”.  In the sense that it’s clearly had something of a real estate bubble, its financial system appears to be an over-leveraged mess of shadow banks, and in general that it looks very crashy, from a Western point of view.

Never say never, but this shouldn’t happen.  The Chinese system is fundamentally different in terms of its cybernetics.  And that ought to mean that it has different pathologies.  A “Lehman moment” for China isn’t a literal impossibility, or even something that you can rule out for practical purposes (always remember, Russia shouldn’t have needed to default on domestic currency debt, but it did).  But it’s not the natural way for things to happen.

What I’m talking about here is the simple fact that it’s a totalitarian society.  (Joris Luyendijk, in his excellent book “People Like Us”, semi-satirically argued that when you’re writing about a totalitarian society, every single report should start with the words “This Is A Totalitarian Society”, because it’s always the most important thing to know).  It’s not a rule-of-law country, so it doesn’t have the same cybernetic control structure as a democracy.

That ought to be important.  The “Lehman Moment” was entirely a control failure.  What caused the damage was that the information processing system was hit with something it couldn’t handle, and so it stopped being able to do its job.  Consequently, since a lot of the economic system was built in such a way as to require the particular mix of control, information and accounting co-ordination that is provided by the financial system (for brevity, let’s call this “money”), the real economic damage was wildly out of proportion to the actual losses suffered by Lehman Brothers.

The specific thing that the system couldn’t handle was a very rapid increase in the uncertainty attached to the value of financial assets, which had the effect of making every element of the system less sure that it could meet its own obligations, in a cascading manner.  Basically, the system was built on the assumption that certain kinds of interbank obligations could be treated as completely risk free.  As we’ve noted before, an item treated as if it has zero risk has no constraint on its ability to grow, so these claims multiplied up in huge volume.  Which meant that if you relaxed the assumption of zero risk even a little bit, the bandwidth needed to manage the system increased hugely.

What’s needed in that sort of situation is for some deus ex machina to step in and restore certainty – either the certainty that the asset is good, or the certainty that your money’s gone.  Which is what happened with central bank and government action, eventually.  But it was very difficult, because the system wasn’t set up for this kind of centralised action.  Lots of the legal powers didn’t exist, and because the US-centred financial system is based on democracies, that mattered.

China is a totalitarian society.  As I joked on Twitter, the government is capable of just stepping in and telling people “your money’s gone, tough, could be worse, you’re not in prison, yet”, and nobody will stop it.  Conversely, if they step in and guarantee assets, nobody’s going to step up talking about the burden on taxpayers (or even if they do, they’re not going to win an election or defeat legislation).  It is fundamentally much easier for China to manage this kind of crisis, because it has many fewer scruples about rewriting the rules; the system is in an important sense much less complicated because you don’t have to respect so many people’s rights.

There’s a catch, of course.  One might draw an analogy to the work of Sen and Drèze on famines.  As Amartya Sen famously noted, democracies don’t have famines; they have functional communication systems and accountability at the centre, which mean that their control systems respond to this particular kind of crisis. (And this is true for a very attenuated concept of “democracy” indeed – Sen’s examples in “Development as Freedom” included Zimbabwe).  But as Jean Drèze also pointed out, between Independence and the 1980s, democratic India managed to deliver more excess deaths from malnutrition and preventable disease than China had in the 1958-61 famine, every eight years.  The control system of democracies responds to immediate crises of mass deaths from starvation, but it doesn’t respond in the same way to kinds of poverty which don’t generate the same signals.

Similarly, a totalitarian financial system ought not to have Lehman Moments.  But that doesn’t mean it can’t have financial disasters of any kind.  The lack of rule-of-law makes the system less complicated in one dimension, but it also reduces the amount of external variety and information that it can absorb.  I don’t know enough about the specifics of the Chinese financial system to make predictions, but it seems to me that rather than Lehman Moments, we ought to be looking for financial disaster with Chinese characteristics.