Today’s note, “The Dude Abides: China in the Golden Age of Central Bankers“, looks at China through the Epsilon Theory lenses of history and game theory. It’s a long note, but I’ve got a lot to say. The grand political coalition forged by Deng Xiaoping in 1979, which forms the architecture of the modern Chinese State, is under assault from without and from within. Both the external threat (low-growth policies in developed export markets) and the internal threat (massive wealth concentration within a few hyper-privileged families) are perceived by China’s leaders as part of a system of global liberalism driven largely by Western monetary policy. China is already taking strong actions to challenge the “rules” of this system, but I believe this is just the start of a major shift in the tectonic plates of global economics.

“The Dude Abides: China in the Golden Age of Central Bankers”

A compassionate man once caught a turtle. He wanted to make it into soup, but unwilling to be accused of taking life, he boiled a pan full of water and, placing a narrow rod over the pan, said to the turtle, “If you can get across the pan, I will set you free.”

The turtle was in no doubt as to the intentions of the man. But he did not want to die. So, summoning up all his will, he accomplished the impossible.

“Well done!” said the man. “Now … please try it again.” – Cheng Shi (12th – 13th century AD)

It doesn’t matter whether the cat is black or white, as long as it catches mice. – Deng Xiaoping (1904 – 1997)

In approaching a problem a Marxist should see the whole as well as the parts. A frog in a well says, “The sky is no bigger than the mouth of the well.” – Mao Zedong (1893 – 1976)

What the caterpillar calls the end, the rest of the world calls a butterfly. – Lao Tzu (604 – 531 BC)

Everything ends badly. Otherwise it wouldn’t end. – Brian Flanagan (Tom Cruise), “Cocktail” (1988)

Jake Gittes: How much are you worth? Noah Cross

Noah Cross: I have no idea. How much do you want?

Jake Gittes: I just want to know what you’re worth. More than 10 million?

Noah Cross: Oh my, yes!

Jake Gittes: Why are you doing it? How much better can you eat? What could you buy that you can’t already afford?

Noah Cross: The future, Mr. Gittes! The future. …

You see, Mr. Gittes, most people never have to face the fact that at the right time and the right place, they’re capable of ANYTHING. – Robert Towne, “Chinatown” (1974)

China Deng XiaopingDeng Xiaoping was a survivor. That’s why I love this picture of the man, here 80-something years old, looking for all the world like Emperor Palpatine of Star Wars fame, still dying his hair jet-black and chain-smoking his Panda cigarettes. Purged not once but twice. Wife and daughter dead in childbirth. Friends mowed down by the Kuomintang. Eldest son tortured by Red Guards before being thrown out a 4th-story window. You think this veteran of the Long March, who lived in caves and ate rats … when the war was going well, wasn’t willing to do ANYTHING to set the future course of the modern Chinese State? You think that Tiananmen Square kept this guy up at night?

Deng Xiaoping and his ally/mentor, Zhou Enlai, are the architects of modern China, of China as a Great Power. For 30 years Zhou tempered the Maoist ideology of permanent revolution, preserving the kernel of a stable army and stable government bureaucracy, setting the stage for a pragmatic successor to Mao. But it was Deng who was able to out-maneuver the Gang of Four and seize control of the Army and the Party after Mao’s death (and Zhou’s) in 1976, replacing that Maoist ideology of permanent revolution with a market-driven ideology of modernization and economic growth. Deng wasn’t interested in political purity, but in economic results. It’s not the color of the cat, as he famously said, but its ability to catch mice.

Deng’s political genius – the core attribute that made him such a consummate survivor – was his ability to sell his vision of economic modernization and growth as an end in itself to other political and military leaders. Permanent revolution is … tiring … and doesn’t really pay that well. Deng offered a vision of stability and wealth, and by 1979 that vision proved to be enormously successful in uniting what Clausewitz called the iron triangle of a Great Power – Army, Government, and People, acting as one for a common goal. Economic growth was, to paraphrase “The Big Lebowski”, the rug that tied the whole room together.

Importantly, Deng’s unifying vision of economic growth and modernization was socialist and nationalist in nature, not liberal and individualistic. Deng was no petty oligarch, stashing away billions in foreign bank accounts during his tenure as Paramount Leader, and this was a big part of what made his transformation of the Chinese nation so successful. Deng was authentic. He was a survivor and he was a patriot. He was a Dude, enforcing at the highest levels of the Party and the Army an understanding that economic growth was (primarily) in the service of the nation rather than (primarily) in the service of personal aggrandizement. Sure, there might be the occasional provincial governor egregiously lining his family’s pockets rather than kicking up to the central authorities in Beijing, but this has only been a problem for the Chinese government for … oh, the past 3,000 years or so, and it’s nothing that a few show trials and public executions can’t bring back in line. No, the important thing was that China’s top political and military leaders shared Deng’s vision of market-oriented AND socialist/nationalist ideologies existing hand-in-hand. And for a while there, they did.

Today, however, the Chinese State faces two existential threats, each stemming from or accelerated by the Great Recession and Western policy responses to that crisis of market confidence.

First, QE and other “emergency” Western monetary policies of the past five years threaten the grand political unification of Deng Xiaoping from without.

Second, massive wealth inequality and concentration driven largely by those same monetary policies threaten it from within.

The external threat to Chinese political stability comes from the explicit purpose of recent monetary policy: to paper over anemic real economic growth with financial asset inflation. It’s a brilliant political solution to the political problem of low growth in the West, because our political stability does not depend on robust real economic growth. So long as we avoid outright negative growth (and even that’s okay so long as it can be explained away by “the weather” or some such rationale) and prop up the financial asset values that in turn support a levered system, we can very slowly grow or inflate our way out of debt. Or not. The debt can hang out there … forever, essentially … so long as there’s no exogenous shock. A low-growth zombie financial system where credit is treated as a government utility is a perfectly stable outcome in the West because our

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