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The American Illusion of Insulation from China

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The American Illusion of Insulation from China
Source: Reuters Source: Reuters

There is never a shortage of stories in the U.S. media about fears over China, or anxiety about what's going on in the world's second-largest economy located on the other side of the planet. Despite this widespread discourse about China, the rhetoric always falls back on essentially the same premise: We're protected from anything that happens overseas because of the size and strength of the U.S. economy.

This idea was brought up several times during the Greek debt crisis as observers wondered whether Europe's vulnerability would have a profound effect on the U.S. recovery. The truth was that, although the European Union (at times in the past, the world's single largest economic entity) undoubtedly influences the fate of our economy, Greece itself makes up such a small portion of the eurozone's total GDP that the notion of a "contagion" eventually lost its bite.

China, however, is not Greece. Far from it, in fact.

The Real Global Contagion

As we have already seen on the markets over the last few weeks, virtually every country's economy has an acute response to developments in China. It is now too well-integrated into the global economy and the international system for this not to be the case. Perhaps 20 years ago, events in China and its economy were ultimately of little consequence to the big players on the international scene; today, whether any of us like it or not, this is no longer true. When China sneezes, everyone in the proverbial room gets sick.

Source: pgm-blog.com Source: pgm-blog.com

The Shanghai Composite was down another 1.3% on Wednesday in overnight trading in what was a wildly volatile session, ranging from highs of 4% in the green to 4% in the red. The same volatility can be seen on stock exchanges around the world: while U.S. indices bounced back on Wednesday after two days of uneven up-and-down trading, European shares sank into the red after rallying in earnest on Tuesday.

A Legacy of Economic Shocks in China

There have increasingly been whispers that Chinese President Xi Jinping is losing support of some members of the Communist Party's Central Council and Politburo due to the sharp pullback for the country's economy. Although the Chinese premier has been consolidating his power under the banner of an anti-corruption campaign that has jailed many of his political enemies, it is also true that political support hinges upon the success of the regime's economic policies.

Ironically enough, the popping another financial bubble in China some 80 years ago is what paved the way for the Communists to come into power. History shows that blind belief in one's country remaining insulated from financial shocks overseas is an unwise presumption.

A Chinese silver coin from the early 20th century. A Chinese silver coin from the early 20th century.

China was one noteworthy country that was spared from the depths of the Great Depression—at least initially—thanks to being on an official silver standard, pegging its currency to the white metal when most of the world was on a gold standard. This shielded China from the worst of the global downturn, but as nation after nation abandoned the gold standard (the U.S. did so in 1933), the price of silver began to appreciate rapidly. Not only did this erode the positive account balance that the Chinese enjoyed up until the mid-1930s, but also led to the outflow of hundreds of millions of ounces of silver out of China.

For leaders in the U.S., the reasoning was that the increase in silver prices would help boost China's purchasing power, leading to more consumption of imported goods. Instead, China lost all of its competitive advantage in trade as its exports became too expensive.

china-stock

The outcome of all of this was the erosion of support for China's Nationalist regime. While the occupation by Japan during WWII certainly played a role in the ruling party's downfall, as well, the loss of credibility due to the economic crisis set in motion by the spike in silver prices is what shifted sentiment in favor of the opposition led by Mao Zedong and the Communists.

Depending on how far the Chinese markets fall (and for how long the suffering lasts for mainland investors and consumers), a similar scenario could potentially play out.

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