Chinese Geopolitics

Whither Japan?

He used to seem pretty scary.

Do you remember the big Japan scare in the 1980's?  When it seemed like Japan was poised to take over the entire world?  It was once said that the Imperial Palace of Japan was worth more than all of the real estate in California. Americans were scared.

Fast forward 30 years -- how does Japan look now?  Answer: Fine, still certainly impressive, but not exactly world-dominating.  It has a sluggish economy.  Its Generation-X equivalents have spurned the "salary man" lifestyle (as they call it), and its iron-clad work ethic.

As an aside, it was just reported last week that China overtook Japan as the second largest economy in the world.  Most Americans, the same ones freaking out over Japan in the 1980's, failed to notice.

From what I hear, in the 1960's, even Japan was considered decidedly second-rate.   The Soviet Union was the big concern, in the world-domination department.  As we all know, by the early 90's, this once-biggest fear collapsed under its own weight.   That was before my time, though (I was born in 1972).

Today's Worry:  Made in China

Worry D'Jour

So who are we fretting these days?  China, of course.  Listen to any financial talk show, and it seems China will be taking over the world any day now. 

Let me put your mind at ease:  Don't worry about China.  China has bigger issues of its own.

Within 30 years, China's trajectory may not have fallen as severely as the Soviet Union's between 1960 and 1990 -- but neither will it have fared as well as Japan.  Meanwhile, the United States will remain strong, despite the ever-present doom-and-gloomers.

How can I make such a prediction?  Geopolitics.


Geopolitics 101
Last year, George Friedman, president of the foreign intelligence firm STRATFOR, published his prediction for the next century, aptly titled The Next 100 Years.  STRATFOR produces situational reports on various countries, conducting analysis on who's stable, and who's not.

In this book, he lays out the clearest argument I've observed for why China's star can't continue shining so brightly.

First off, "geopolitics" isn't just a fancy way of saying "international affairs."  It is the study of how geography impacts politics.  Geopolitics explains why Great Britain and Japan amassed empires (and remain two of the most influential countries in the world), despite their small sizes.  It also explains seemingly-strange issues, like why Russia is so obsessed over keeping Chechnya.

To understand why China will have difficulty remaining a world power for very long, we must first examine the dynamics between internal (land-locked) and coastal areas.  For a variety of reasons (lavishly described in Friedman's book) these areas radically differ from military, economic and cultural perspectives:

It sure helps to live on the coasts...

Geopolitics in Action: Red States vs. Blue States

Still a bit skeptical about how geography can impact politics?  Consider the Red State vs. Blue State issue through the lens of geopolitics.

Can't we all just get along?

 If we consider the states bordering the Great Lakes to be Coastal, then virtually every Blue State was coastal, and almost every Red States was Internal.

Alaska is quite coastal, but given its remote location, it acts more like an Internal state.  (Siberia, its sole neighbor across the Bearing Strait, isn't exactly a great trading partner.)   States bordering the Gulf of Mexico act similarly, given that they receive a disproportionately small share of international trade.

These geopolitical dynamics between provincial Internal areas and cosmopolitan Coastal areas have existed throughout history.  You might have read comparisons between provincial, warlike Sparta vs. cosmopolitan, educated Athens.  Sparta was a land-locked Internal city-state; Athens was Coastal.

Geopolitical Analysis:  China vs. the United States

So, let's compare China and the United States from a geopolitical perspective, and see what it tells us.

In the illustrations below, I annotated each country's richest cities, to show you where the money (and hence influence) is.  For the United Sates, I show every city in the top 25 highest GDP cities in the world (as reported by Wikipedia).  For China, I show every city in the top 100 highest GDP cities in the world. 

American Geopolitics

The United States has two coasts, which (as we saw above) share similar values, and contain almost all of the richest cities.  Because both coasts share such similar values, it's much easier to keep the country unified.  

But the Internal states have their own advantage: central location.  If you're going to distribute goods throughout the country, it helps to be centrally located.  It should come as no surprise that Wal-Mart and Target are headquartered in Arkansas and Minnesota, respectively.   

Plus, the Internal states benefit from direct access to international trade with Mexico and Canada (our two biggest trading partners).

Summary:  The Internal and Coastal states make excellent trading partners -- each benefiting from the other's strengths.   So, while they might see the world differently, they get along, and the country stays strong.

Chinese Geopolitics

China's geopolitical landscape is completely different.  Here, there is a single coast, and it controls almost all of the wealth.  When people say that China is booming, what they mean is that Coastal China is booming.

Internal China is not centrally located, and has a dreadful array of neighbors -- mostly impoverished nations with shaky diplomatic relations.  Instead of trading partners like Mexico and Canada, the Internal Chinese provinces get North Korea, Burma, Mongolia, and a handful of other economic disasters. 

The citizens of Internal provinces of China face a terrible choice: 

• Stay impoverished, in the middle of nowhere.
• Move to the coastal cities, which can neither employ nor support them. 

The Chinese government is working desperately to channel money from the rich coasts to the poor internal states.  So far, they have been able to redistribute the wealth quickly enough to keep the peace.   Most of this redistribution has been in the form of widespread financing Internal public works, which has resulted in massive levels of off-the-books bad debt (i.e., loans that will never be paid back).

So far, the Chinese government has kept the music playing.  But it can hardly maintain this pace, much less maintain it with an economic slowdown.  What happens next is anybody's guess.

How Bad Could It Really Get?

You might be thinking that every country goes through downturns.  The Internal provinces will just have to deal with it, right?   What's the worst that could happen?

China's history is fraught with this exact problem -- the dissonance caused by rich coastal areas and stagnant internal areas leading to upheaval and massive, forced economic redistribution.   When was the last time it happened?  A scant sixty years ago.   Search online for "The Great Leap Forward", and you can read all about it.  Here is a quick summary:

• Coastal wealth forcibly redistributed
• Intellectuals killed or deported
• 20-30M deaths by starvation, due to enormous resource mis-allocations
• Greatest destruction of real estate in history (more than all damage from WW2)
• 2.5M beaten/tortured to death; 1-3M committed suicide

Summary:  Yet again, China faces intractable geopolitical problems, as it struggles to balance its overheated Coastal provinces and its stagnant Internal ones.  Nobody (with a decent sense of history) wants to see what will happen if its government can no longer maintain this balance.  ...But, at some point, we probably will.

Conclusion

People have been predicting that the United States' best days are over since July 5, 1776.  And, to be sure, we have no shortage of challenges -- first and foremost, our massive debt.  De-leveraging will be a painful process, and there's really no way around it.

Yet, we have some permanent geopolitical advantages that will be here long after we've resolved our debt: We have two coasts; we border peaceful, developed trading partners; and we're located between eastern Asia and western Europe.   Plus we remain far and away the most technologically innovative country on the planet.  (More on that later.)

So, should the United States be worried?  Sure, a little worry is a good thing.  But I don't think the Chinese dragon will devour the US any time soon.

US Real Estate Will Never "Recover"

These days, most people believe that the current real estate downturn is due to rampant speculation.  At some point it will recover from this excess of speculation, and will resume its upward trend.   How realistic is this expectation?

Well, consider the following:

• Real estate hasn't always appreciated. Indeed, from 1890 to 1970, while being equally volatile, real estate appreciated at almost exactly the rate of inflation -- making it a paltry investment, indeed.
• Baby Boomers went into hock, too. Ask any Baby Boomer about their home-buying experience in the 1970s, and it sounds just like what Generation X'ers are going through today:  Both groups bought as much as they could afford, and fretted over making the payments.
• Economics 101:  For an asset's value to appreciate, someone else has to be both willing and able to pay more for that asset.

So, given that every generation spends as much as it can on home prices:

How does the 2010 home buyer afford so much more than the 1970 home buyer?

When we can answer this question, we can assess whether the 2050 home buyer will afford proportionately more than the 2010 home buyer.

It turns out that are four reasons why real estate has appreciated so much since 1970.  All have abruptly ended.

1. Family income greatly increased.

This is likely the largest reason why real estate has appreciated.  Women entered the workforce in the 1970s in great numbers -- first in lower-paying jobs, but over the past 30 years their salaries have been steadily increasing.  
Can family income continue to increase?  Barring selling our children into slavery, the US family will not experience any additional income earners.   Moreover, any residual increases in second-earner income (as the gender salary gap further declines) are more than offset by increasing childcare and education costs.

2. The cost of borrowing declined.

In 1982, the 30 year mortgage rate hit 21.50%.  Over the past 30 years, it has coasted down to the mid-4%s.  This allowed people to borrow more money while leaving their monthly payments unchanged, and implicitly increased the amount they could spend on their homes.
Can the cost of borrowing substantially decline further?  Highly unlikely, interest rates are already at 60 year lows.  All indications is that the US is flirting with losing its triple-A debt rating over the next few years, which would cause interest rates to skyrocket.
 

3. People borrowed more money.

In the 1950s and 60s, mortgage debt was seen as a temporary evil.   You could not purchase a house with less than a 20% down payment -- and the goal was to pay it off quickly.  Since then, people have progressively financed larger percentages of the home price, and are far more comfortable holding long-term debt.   This has allowed people to spend more money on their homes.
Can people borrow even greater sums of money?   People already often put 0% down, and routinely upgrade their homes once they get enough equity in their current homes (i.e., keep themselves constantly leveraged to the hilt).  I don't see how people could borrow more than they do today.

4. People borrowed on more risky terms.

In 1982, Congress deregulated savings and loan associations and allowed banks to provide adjustable-rate mortgage loans (via the Garn St. Germain Depository Act).  This act was cited as a major factor in the savings and loan crisis of the late 1980s.  Nevertheless, it stuck around, and even more risky terms have appeared: No Disclosure Loans, Option Arms, Interest Only Loans, to name a few.
Can people borrow on even riskier terms?  The market has already dabbled with insanely risky loans, and only backed off because they're wholly impractical.  There is no room to lower payments (and consequently increase home prices) by incurring more risk.

Conclusion:

Appreciation between 1970 and 2010 didn't happen by magic.  Speculation played a role, but most appreciation was due to long-term trends of increased household income, cheaper borrowing, more leverage and more risk.


If these trends have halted, we can expect a reversion to the longer term trend:  real estate appreciation equal to the rate of inflation.  However, if these trends have reversed, we can expect appreciation even lower than that.

It this pleasant news?  No.  Is it realistic?  Probably.

The (American) Kids Are All Right

For the past 30 years, we've all heard how American kids are alarmingly behind in mathematics.  This  inevitably leads to economic disaster, as we fall technologically behind.  ...Or, so the argument goes.

Is it too late for the US to catch up?

Yet over that period, what has happened?  The United States has extended its lead in technology over the rest of the world, in every meaningful category.  Take a look at the (admittedly unofficial) leaders in the most influential high-technology areas.

So, if we're so bad at math, why are we utterly dominating in high technology?  ...And those countries with the superstar math students for the past 30 year -- where are they in this list? 


 Here's my theory, and it may sound crazy at first, but give me a chance to justify it:

Perhaps it's possible to be "good enough" in math, where any further obsessing hurts a country more than helping it.

Here's why:  Yes, we need math, but we don't need everybody to know the advanced stuff.  Hell, my friends are a pretty impressive economic-value-adding cross section: lawyers, salespeople, engineers, scientists, and financiers.  Do any of us use math more advanced than algebra and maybe basic trigonometry?

The answer:  Very few.  I have one friend who works at Lincoln Labs, doing defense work for the government, who has a Phd in Physics from Harvard.  He uses some pretty complex math.  That's about it.

My guess is that if a society has 5% of its population capable of performing advanced math , that's probably plenty.   This doesn't mean that a modern society doesn't use lots of it, but just that usually a hyper-specialist develops it, and the rest of us use it.  That's just how technology works:  I don't need to reinvent the wireless packet loss optimization algorithm every time I send a text message from my iPhone.  A small team of mathematicians did it once, and the rest of us just use it.

So I can foresee several counter arguments, allow me to address them:

"Maybe advanced mathematics isn't important, but basic mathematics is."  

I  agree to a point.  Most blue collar jobs likely require strong basic math (e.g. multiplication & division).  White collar jobs could benefit from a strong grounding in algebra.  Nevertheless, this doesn't appear to be a big technological bottleneck:  It didn't stop any of the aforementioned companies from dominating the technology world.

The concept of Contraint Theory tells us that if you improve an area that is not your the largest bottleneck, you'll receive subdued benefits.  Mathematics isn't the economic bottleneck any longer: Innovation is.

"Sure, we're leading now, but in [insert 5-30 years here] we'll feel the impact."

Oh puhleeze.  That's what they said 30 years ago.  The technology companies started above were founded by the students raised in this purportedly backwards mathematics educational system.  What's more, if you consider the attributes that led to their success, it wasn't the mathematics anyway.  No major companies are founded because someone somewhere was really good at integration.

"People don't need advanced mathematics very often, but when they do, they really need it. "

These days, most all advanced mathematics (that has any remotely practical use) can be done automatically.  

In fact, one of the few remaining pillars of mathematics academia just collapsed a few months ago, when Mathematica founder Stephen Wolfram released a free Calculus app for the iPhone.  You can put in any equation, and it charts its integral and differential.

And presto.  Just like that, all the mathematics that people struggled through in High School AP Math can now done automatically and for free.  Debates are now ongoing about whether students should be allowed to use this technology in schools, based upon the age-old arguments of using calculators in general.  But, until recently, calculus teachers everywhere could rally around the argument that "Sure, you can do some math on a calculator, but if you need to calculus, you have to do it yourself!"   For the first time in human history, that argument is now, permanently, dead.

"Even if we don't absolutely need to be #1 in mathematics, surely it doesn't hurt.  It can only help to be better in math."

One need look no farther than your typical IIT  (Indian Institute of Technology) graduate to see the flaw in this argument.   IIT is, by far, the most difficult school to gain admittance in the world -- dwarfing Harvard, Standford and MIT's admission percentages by a factor of ten (.6% vs. 6% admission).   Its focus upon math is off-the-chart: you have to be practically a savant to get in, and the math inside only gets harder.  Yet, as a result, their students are human calculators, not innovators.   (And yes, I am aware that Infosys was started by an IIT grad, but that's the exception, not the rule.)

I have worked with many IIT grads, and if you can fully constrain the boundaries of a problem on a mathematical level, they're awesome.  But unfortunately, in the real world, that virtually never happens.  Most business problems are at least partially obscure, and partially philosophical or strategic -- and, here, hyper-quant-jocks (like IIT grads) do NOT shine.

A national emphasis on math comes at a cost.  If a country's best and brightest spend years pounding complex calculations, as in India and China, they are not spending years learning how to make things that are beautiful (Apple), innovative (Google), social (Facebook) or economically-game-changing (eBay).   As a nation, The United States must not throw out what's really important, in pursuit of something that just seems important.