Be Very Afraid of The China Bubble

What's the most important economic question in the world today? One contender is whether the euro will collapse. Another is whether the U.S. will plunge into a double-dip recession. But a third, and possibly the most important over the long term, is whether China can save the world--or whether the entire country is a $6 trillion bubble that's ready to pop.

That's the size of the Chinese economy, now the second largest in the world, after the U.S.'s. China contributed 19% of global economic growth in 2010, and that's expected to increase to 24% this year. China's strength is essential to the recoveries of both the U.S. and Europe; if Beijing crashes, the reverberations will be felt from Boise to Brussels.

And plenty of smart people are worried that it will. It may seem strange to Americans who hear so much about the rise of Asia and the pressure of Chinese competitiveness, but there are big questions about China's future. For more than 30 years, the Chinese miracle has been built on cheap labor, cheap land and cheap capital. But the model is starting to break down. China's banks, which have doled out too many bad loans, are perhaps as troubled as those in the West. The frothiness of the real estate market in major Chinese cities makes the U.S. housing peaks of 2007 look positively staid. Inflation is growing, as are unemployment--particularly among the middle classes, for whom, as in the U.S., there aren't enough high-level jobs--and social unrest. China's own Premier, Wen Jiabao, calls his nation's economy "unbalanced, uncoordinated and unsustainable."

Nowhere are the problems more evident than in the real estate sector, which has been at the core of the country's growth and development. Like Republicans in the U.S. who try to "starve the beast" by cutting government spending, the Chinese Communist Party has been attempting to put a damper on the nation's debt-fueled real estate boom. This is part of a deliberate attempt to rejigger the economy into one that relies more on domestic consumer spending and less on manufacturing and exports. To ensure its future growth, China must move from being the world's factory to being one of its largest consumers. If, however, the party's efforts to take the country in that direction result in a precipitous drop in real estate values, the entire economy could crash. Multinational corporations whose revenue and earnings growth are tied to China could be hit hard. And the U.S. could be thrown back into recession.

While very few economists doubt that China's growth is going to slow eventually, it's a question of how much and how soon. Will the landing be hard or soft? So far, the signs are mixed. GDP growth has moderated slowly in the past few quarters rather than falling off a cliff (though it's worth noting that Chinese economic figures, as released by the government, are a notorious black box). Yet in many parts of the economy, the bubble continues to expand. Local-government debt grew about 30% in 2010 from the previous year. In the first six months of this year, Chinese investment in real estate was up 33% from the same period in 2010.