I did a spot on CNBC Squawk Box this morning to discuss the impact of the recent unrest in China. Much of the news surrounds stories about migrant worker protests. As I wrote yesterday, the drivers for the protests making the news is not ideology–it is practical life issues like pay, jobs, work practices, discrimination, and corrupt local government officials. Wen Jiabao recently said that corrupt officials is China’s greatest crisis. Last year more than 146,000 corrupt officials were arrested in China; 97% of them were at the county, city, or village level.

Our discussion this morning turned on the impact on the US. The biggest US risk is supply chain interruptions, much like the Japanese earthquake. Just under half the manufacturing capacity in the world is in China. Much of it is in southern China, especially Guangdong, where the factories are operated by migrant workers from Sichuan, Hunan, and Xinjiang. Recent job losses in Guangdong caused by “hollowing out,” (businesses moving to cheaper locations in Vietnam and other Asian countries) are a real problem. Migrant workers are often the only source of income for their families in poor villages in western provinces. Rising food prices has also put the squeeze on migrant worker incomes, even though the incomes are rising at 10% per year.

All this is interesting, but what I care about are the people. It is easy to lump groups of people together and call them “migrant workers” if you have never met them. Not so easy when you know their names.

I thought I would just take a minute to inject a little humanity into the story by posting a few pictures of the kids I work with in the migrant worker schools in China. For several years, my partner Fred and I have organized teams of university students to work in primary schools in poor villages, often migrant worker schools. We have done projects in Tibet, Yunnan, northern China, and tried to do one in North Korea that failed to happen. In each case, we supply the students with books and materials to build libraries and kitchens, plant gardens, pay student fees, and give the children pencils and paper. The students spend a month or more in the schools teaching and working with the children.

Here are a few pictures from one of our recent projects in a migrant worker school in northern China.

The photo above is our team for a migrant worker school project. Fred (white t-shirt just in front of me) is my partner in all the projects we do. Ethan (black Rutledge capital shirt in front of me) was team leader for this project. The other team members are students at China Agriculture University.

Below are a few of the children, including an unforgettable kindergarten student showing me her very beautiful graduation dress.

This is a migrant worker school classroom. The classrooms have no doors and no heat in the winter–the students weal heavy coats in class to stay warm.

Finally, the picture below is a very special one for me. We were able to arrange for 15 of the students graduating from the migrant worker school to go to the official public school nearby, which will allow them to later go to university. They needed clothes, school supplies, and the like to fir into the new school. This is a picture we took on their first day of class. I keep this photo on my desk.

I hope you get to meet some of these wonderful children one day for yourself.

JR

My friend John Tamny, who runs the Op-Ed operation at Forbes, emailed last week asking me to fire up my Forbes column again, I couldn’t be more pleased. My first column is below. Hope you enjoy. You can view it on the Forbes.com website by clicking here, or at RealClearMarkets by clicking here.

China Inflation: The Canary In the Coalmine
The real inflation story is here in the United States.

Rising inflation in China has investors running scared, fearing that Chinese central bank tightening will end global growth. They are worrying about the wrong problem. China’s inflation problem is transitory and will not interrupt China’s growth. But it is a canary in the coal mine that should warn us of a serious, long-term, inflation problem building up in the U.S.

China’s most recent inflation figure, 5.3%, is a very big deal in China. In Chinese history, periods of high inflation are associated with social, economic, and political unrest, something China’s leaders do not want. In spite of their extraordinary growth record since Deng Xiao Ping opened China in 1978, China’s per-capita GDP is just $4,399 ($7,481 purchasing power adjusted), less than one-tenth of the $48,157 U.S. level. They need 30 to 50 years of uninterrupted high growth to bring Chinese living standards up to current developed country levels. That’s why their central bank, the People’s Bank of China, has raised reserve requirements for Chinese banks five times so far this year to more than 20% today and adopted a number of other policies to curb price increases, such as selling food from government stockpiles.

China’s inflation is not high across the board–it has been driven by two factors: rising food prices and rising energy and industrial commodity prices. So-called “core” inflation, excluding food and energy, is still quite low, productivity is growing 10-12% per year, and there is widespread excess capacity in Chinese industry that is keeping finished goods prices in check.

Since China’s currency is, effectively, pegged to the dollar, soaring global food, oil and commodity prices, expressed in dollars, are the culprit. Both can be traced to U.S. policy mistakes. The Fed tsunami that increased bank reserves by 17x since 2008 is driving global energy and industrial commodity inflation. And Fed policy, along with our misguided ethanol policy that has diverted 40% of U.S. corn production into ethanol, have more than doubled corn prices in the past year.

The impact on China will be short term. Rising productivity and excess capacity will return inflation to lower numbers. And their monetary tightening won’t derail growth for the simple reason that monetary tightening in China isn’t as effective as it is in the U.S. Growth in China is largely driven by small, private companies that do not get their working capital from banks. China’s banks are not nearly loaned-up. And Chinese companies are enjoying strong cash flow, driven by roughly 15% average sales growth (10% real GDP growth plus 5% price growth).

The real inflation story is here in the U.S. For us, China’s inflation is the canary in the coalmine. The Fed has increased the stock of bank reserves by more than 17x since they turned on the printing presses in 2008. That’s enough money to more than double the U.S. price level in the next decade.

The weak dollar and soaring gold, oil, commodity, and food prices are warning signs of what is to come. I do not believe the Fed will have the political will to shrink bank reserves back to levels that will keep inflation in check. Financial reform legislation has undermined the political independence of the Fed. Inflation hawks at regional Fed banks are resigning. Inflation doves are firmly in control. And monetizing our ever-expanding government debt in the coming years will be politically easier than shrinking bloated entitlement programs.

Ironically, this story will ultimately force China to abandon their fixed exchange rate with the dollar, not in response to pressure from our government, but when China’s leaders decide that U.S. policy has become too unstable and too inflationary to serve as a useful anchor for their price level. When that day comes, it will not be a good day for the U.S.

JR

I wrote an op-ed for the Christian Science Monitor a few days ago on US/China relations. You can read it by clicking here. It deals with the question of when China’s GDP will exceed US GDP. My point is that the answer depends on us.
Can we stay ahead of China? Yes!
But it will depend on America’s political will to fix its own problems, rather than blaming them on China.

I was approached by a man at the supermarket who penetrated my Southern California disguise of baggy shorts, T-shirt, and deck shoes with no socks and asked if I was me? (Yes); the one who talked about China on CNBC? (Yes); then the question I hear all the time, “Are the Chinese going to let us to stay rich?”

He is onto something. Whether we stay rich and powerful is hugely important. Economic, political, technology, and military power go hand in hand. But whether we stay rich is not up to China; it is up to us – determined by how fast we grow. We didn’t need China to get rich; we don’t need them to stay rich. But we do need to get our economic growth act together.

While the United States is the biggest, richest economy in the history of the world, it’s about to get passed by. China’s gross domestic product will exceed US GDP within the next decade – of this there is no question. At recent relative growth rates – 10 percent for China, 2 percent for the US – China’s GDP will exceed US GDP in 12 years. Adjusted for purchasing power, China’s GDP will exceed US GDP in just five years.

Being the second richest guy in the room, of course, isn’t the end of the world. But it’s not as good as being No. 1. Just ask the Europeans or the Japanese how they feel about US dominance in recent decades.

Of course, China has more than four times the number of people as America does. So in terms of annual income per person, Americans remain far ahead: $48,157 versus $4,399 (or $7,481, if measured in terms of purchasing power). At present rates of growth, it would take 30 years for the average Chinese to exceed American standards (25 years, if adjusted for purchasing power). This assumes that Chinese growth can keep outpacing America’s growth by the same rate, which becomes harder to do as China’s economy becomes larger and runs into more resource constraints on the availability of energy, commodities, and other resources.

So Americans have an opportunity to stay ahead in terms of income per person – and that won’t depend on China. China’s high growth rates are not the result of manipulating its currency or restricting trade: Manufacturing employment in China is falling, too. Instead, they are the result of huge saving and investment levels and intensely competitive Chinese markets. Private companies account for more than 70 percent of Chinese economic activity now and for essentially all new growth, jobs, and tax revenues.

Which brings us to the real question behind my supermarket pal’s query. Do we have the political will to stay No. 1?

To do that, we are going to have to tackle our real problems – the ones that put us in this spot. We are going to have to fix our schools so our kids can read, do math, and graduate. We are going to have to reform our tax system so people have incentives to work, save, and invest again. We are going to have to replace our so-called entitlement programs with ones we can afford so we can rein in unsustainable spending, runaway budget deficits, and the growth of government debt before it reaches the point where default or permanent 1970s inflation – with the attendant 20 percent interest rates – are inevitable. We have to restore the Fed’s political independence and commitment to price stability.

To do all these things we must talk with voters about our problems like adults, not blame our troubles on others. If we face up to these problems we can do more than stay rich, we can continue to lead the world.

But make no mistake about it. In that world, there are going to be two big elephants in the room, the US and China. There will be plenty of legitimate issues – energy supplies, environment, and terrorism – to solve. Playing the blame game runs the risk of bringing these two elephants into conflict, with unthinkable consequences.

I am convinced that the security and welfare of my children will depend more upon the quality of US-China relations than any other single issue. We simply must get to know each other to find common ground to work together for mutual security and prosperity. And the US must get back to the economic growth that allowed us to earn the No. 1 spot in the first place.

JR

(June 14, 2011) Last week I had the pleasure of participating in a public forum hosted by the Common Ground Committee in Darien CT. You can watch a  video of the forum at the Common Ground Committee’s website.

The thesis of the forum is to explore a controversial topic and look for common ground–areas where both sides can agree–to use as a basis for building a solution. Our topic was China: Threat or Opportunity?The forum was moderated by John Yemma, editor of the Christian Science Monitor, where I ran an op-ed on the subject ahead of the meeting. The combatants were Henry Tang, Alan Tonelson, Peter Ford, and myself, with Kraft Bell facilitating the event.

The answer, of course is yes; China is both a threat and an opportunity from the viewpoint of the US. People are finally realizing that China is big and growing fast. People here know very little about China because most Americans do not travel there and because we still have a cold war image of China in our heads–grey jackets, bicycles, red books. Trust me; that image is no longer true of China.

China will overtake the US in GDP within 5-10 years. China and the US will soon be the only two elephants left in the room. We simply must expend the energy to get to know each other because conflict between the two elephants would be unthinkable. I am convinced that the security and prosperity of my children’s and grandchildren’s lives depends more on the relationship between the US and China than any other question.

I hope you enjoy the video.

JR

I did a spot with Larry Kudlow tonight to discuss today’s retail sales reports that seems to have been a major impetus behind today’s huge stock market increase. Great to work with my old friend again. Not many know this, but Larry and I have been working together since 1976 when he was Chief Economist at Paine Webber and I was a professor at Claremont Men’s College (known as Claremont McKenna College today).

The US Advance Advance Monthly Sales for Retail and Food Services Report for was down -0.2% for May (+0.3% excluding motor vehicles), and +7.7% over year ago levels (+8.2% excluding motor vehicles.) Analysts focused on the numbers excluding motor vehicles because the supply chain interruptions caused by the Japan earthquake made a significant dent in assembly and sales. The stock market interpreted this number as “no double dip recession”. Nice.

The Chinese retail sales number was even better. May retail sales were +16.9% over year earlier levels and a big jump over April. This was important because US investors have been hyper-ventilating over the idea that China’s growth was about to end. (They did this about once every 6 months. I don’t know why.) The truth is retail sales in China are doing fine, signaling continued strong growth.

The interesting stuff, as usual, is in the details. Among the components of the retail sales index sales of oil products were +42% above year ago levels, jewelry sales were +43%, and grain and edible oil sales were +24%, revealing the effects of rising oil prices, gold prices, and food prices. But middle class luxury items were up big too including  cosmetics (+20%), personal care goods (23%) and garments (22%). Government policy is trying to increase the consumption share of GDP relative to the investment share, which should keep retail sales strong in coming years. (If you want to watch a company in this sector, Haier Group makes washing machines and water heaters and is a powerful brand in China. Haier’s revenues should grow 20% next year producing 25% earnings growth–the stock sells for 15x 1011 earnings and 8x 2011 EBITDA in the Hong Kong stock market.

Other supporting growth news this week include:

• +13.5% industrial production growth in May.
• +34.6% real estate investment growth January-May
• +33% Real estate sales growth January-May
• +25.8% fixed asset investment growth January-May.

Less positive news:

• +15% M@ growth in May is a little slower
• +5.5% CPI inflation in May is a big number

China’s central bank raised reserve requirements today again for the 6th time this year (after 6 times last year) to 21.5%. They are doing this to show the government’s concern about inflation, which means rising food and gasoline prices to the man on the street. These tightening moves are not as tough as they would be here in the US–banks are not nearly loaned up anyways. But if they keep beating on this horse long enough it will surely have an impact.

Larry made a point during the show that I think is worth remembering. From our perspective, a little slowing in China and a little lessening of inflation pressures are not necessarily bad things. Slower growth and lower inflation would be easier to maintain.

China’s stock market was up big today after being driven more than 12% lower since April by falling growth worries. I think that market is pretty cheap today, as are the stocks of US companies who sell retail products in China. That’s where I am putting my money.

JR

(June 14, 2011) Will do an early morning spot on CNBC Squawk Box tomorrow (Wed. 6/15/11) 8:40AM Eastern time (5:40AM hit for me here in California–argh!). Hope you can dial us in.

The topic will be the recent unrest in China that was the subject of the Wall Street Journal front page story today. There have been a series of public protests in recent weeks in Inner Mongolia, Lichuan, and Zengcheng, including bombs set off in Fuzhou and Tianjin a few days ago. Individually, the events are hard to connect: a Mongolian sheep herder accidentally killed by a Chinese truck driver; protests against corrupt local officials and property seizures; rough treatment of a migrant street vendor by police. Together, they reveal the stresses on a population struggling to deal with rapid change, corrupt local officials, rising food prices, and especially for migrant workers, uncertain paychecks.

As I have written many times before, every policy discussion with a Chinese leader focuses on a single goal–social, economic, political stability. Cynics say that is because the government wants to continue in power. Optimists say it is because the government knows they must keep China growing for a long time to catch up to the rest of the world’s living standards. China has grown by an incredible 10% per year since it was opened up 33 years ago. That growth has increased per capital GDP by a factor of 23 times from roughly $200 per year when Deng Xiao Ping opened China to market reforms in 1978 to roughly $4800 today ($8200 if measured adjusted for purchasing power.) But US per capital GDP is about ten times that high at roughly $50,000 per year. It will take decades for Chinese incomes to rise to US or European levels even if growth remains at 10%, which gets harder to do as incomes rise.

I don’t think the pressures than are making people angry are going to disappear overnight. That means we are going to see more protests, and more policy responses that are equal parts harsh security measures and accommodative economic policies designed to keep maintain high rates of steady economic growth. As an example, China’s huge stimulus program during the recent financial crisis was heavily weighted toward infrastructure and construction to keep the 100+ million migrant construction workers in China’s cities employed so they can continue to send money to their families in poor villages in western China.

The one think I can say about the protests in China is they are not ideological. They are often about very practical, local issues like food prices or a land grab by a city official. That means we should be careful not to make sweeping generalizations about them. In China, as in the US, the interesting stories are in the detail. These stories are heartbreaking. As you may know, I work with migrant workers’ children in China, building libraries and kitchens in grade schools and providing scholarships so kids can go to school. They don’t need life to be tougher than it already is.

Tune into our discussion on Squawk Box tomorrow. I will try to come up with something clever and insightful to say about all this by then but don’t recommend you hold your breath until I do.

JR

• Grassley amendment–make Obama, political appointments, members of Congress, Congr. staff enroll in Obamacare. http://bit.ly/aNDcIW #

China CPI – February 2010

(The charts below are courtesy of Andy Rothman at CLSA. Andy is by far the most knowledgeable person I know on Chinese inflation issues.)

The worry that rising inflation in China will provoke the government to tighten sharply, which would slow growth and push commodity prices lower is unfounded.

China’s February CPI was up +2.7% from a year earlier after showing deflation for most of 2009. As the chart below shows, however, it’s all food prices. 2.06% of the 2.7% headline number came from food. Another .44% came from residence expenses, which were pushed up by a one-time increase in utility costs last year. Other goods and services accounted for only 0.2% of the 2.7% increase–about one-fourteenth of the total increase in consumer prices.

Food prices make up a much larger share of the CPI basket than they do in the U.S. or Europe. Food prices in February were +6.2% higher than a year earlier. Most of the increase was due to the 25.5% increase in fresh vegetable prices and +19% increase in fresh fruit prices, as shown in the chart below. Both were caused by severe weather and the New year holiday, which fell in February this year. Together, fruit and vegetable prices accounted for about one-third of the total CPI increase in February.

Rising incomes in China make the CPI increase negligible, as shown in the chart below. In fact, rising food prices drive higher income growth for China’s farmers. This is exactly the kind of relative price/wage pattern we expect in a country with fixed exchange rates and sharply rising productivity. Traded goods prices are constrained by global competition and rising productivity. But wages grow strongly to reflect rising output levels. It is important in this situation not to confuse rising wages with inflation when setting overall economic policy.

Internationally traded industrial input prices, however, are rising sharply to reflect the strong China growth and strong construction activity following last year’s stimulus program, as shown below. With input prices rising and end-user prices (CPI) constrained by intense competition and overcapacity the worry is not inflation, it is the profit margins of the industrial companies that make up a large part of China’s stock market.

Bottom line: China is not going to tighten policy aggressively to try to control cabbage prices. The exit from China’s stimulus program will continue in a gradual and orderly way over the next year.

JR

The vote is scheduled for Sunday, when most people are not watching the news–I wonder why? This weekend, House Speaker Pelosi is going to try to end-run the Constitution to pass the largest piece of legislation ever enacted–multi-trillion dollar healthcare reform–without a vote. My friend and constitutional law and health care scholar Betsy McCaughey  has written two books on the Constitution. Betsy says the Pelosi gambit won’t survive a constitutional challenge in the Supreme Court. You can read Betsy McCaughey’s analysis by clicking here.

A number of House Democrats do not want to go on record as having voted for the controversial and unpopular health care bill so Pelosi has crafted a way they can vote for the bill on Sunday and tell voters they “never voted for the health care bill” in November. The tactic is called “deemed as”. Members vote on an innocent-sounding budget reconciliation bill that “deems as passed” the Senate bill (i.e., assumes the Senate Bill has already passed by the house even though it has most definitely not been passed by the house). Members then only have to vote on a series of reconciliation amendments. They then send both the Senate bill and the House reconciliation package to the President for signing.

Confused yet? Good. That was the purpose of the maneuver. They hope voters in November are to be confused too.

Betsy says the Pelosi tactic won’t suvive a constitutional challenge. ” In recent years, the U.S. Supreme Court has twice struck down attempts to abbreviate the lawmaking process required by Article 1, Section 7 of the U.S. Constitution.” In both cases the Supreme  Court ruled that neither the President nor Congress may can depart from “finely wrought procedure commanded by the Constitution to make a law.” The language of the Constution is black and white on this issue.

Article 1 of the Constitution states: “The votes of both houses shall be determined by yeas and nays, and the names of the persons voting for and against the bill shall be entered on the Journal of each House respectively.”

“The Senate health bill raises $500 billion in new taxes over the next decade.” writes McCaughey. “…if Pelosi has her way, these taxes will be “deemed” enacted without any house vote at all.”

When Ben Franklin was asked after the Constitutional Convention what kind of government the founding fathers had created, he answered “a republic…if you can keep it.” That’s the question on the table this weekend in the House of Representatives.

JR

The Consumer Price Index for January 1020 was released today. On the surface, it showed momdest inflation of 2.1% over the past 12 months, as the table below shows. Beneath the surface, in its components, the CPI shows that the real situation is very different. There is a 45.2% difference between the highest annual inflation figure (36.8% for gasoline) and the lowest figure (-8.4% for gas utility costs). Five of the figures are above 10%. Six of them are below zero.

The job of the Fed is price stability–to keep prices stable so people will be able to predict their revenues and expenses and make long-term decisions. No rational person could look at these figures and make any long-term decision.

This is important to keep ttrack of because the direction of future inflation is the wild card for the economy and the stock market. The Fed’s bailout efforts have increased the stock of bank reserves by more than 1200% in the past 18 months, which screams future inflation. The Fed’s announcement this week represents that inflation is under control and they will be able to extract the reserves from the market before inflation shows up. I am skeptical of their qbility to do that.

JR