Economic Forecast: 100% Probability of Deflation Until Currency Cracks

Balding: Deflationary Prospects for China

Businesses are fighting to stay alive and how they do this is by lowering the price of their products. I think one of the absolute clearest economic events currently is that Chinese industry is experiencing very low capacity utilization. Numerous IB’s have produced charts on the relationship between the output gap and deflation and it is very clear.

...Due to the deflationary pressures, it is quite clear what is happening in the Chinese economy is that loose money is being used to both continue to expand capacity (furthering deflationary pressures) and keep struggling firms alive (even further adding to the deflationary pressures).

...if you take an even longer term view and assume that China works through these deflationary pressures by 2020, at that point, China will be facing even greater population pressures. Working age population has been falling since about 2012 maybe even 2011, so let’s say by 2020 the capacity issues are resolved, at that point China will have ten years of falling population furthering deflationary pressure.

Much more at the link as he runs through 6 points.

There's a sustainable level of consumption and investment, a relatively stable allocation of resources when a total free market exists. There's going to be a lot of changes due to fads, fashions, demographic changes, new technologies, etc., but outside of a major shocks, the economy will be relatively stable. People are able to satisfy their wants and needs freely and prices reflect the aggregate desires of the public. In this free market, simply adding too much debt via the banking system can upset this balance and create an unsustainable condition because those with access to credit are able to bid beyond their natural demand. They could terminate credit growth at a sustainable level and resume a normal growth rate, benefiting from a short-term boost in credit, or they can keep borrowing beyond their ability to repay to support ever rising demand. Eventually, the credit stops and this demand is destroyed. There is a recession.

In China, not only was debt funneled into politically connected businesses, which by itself distorted the economy, but the government also centrally planned the economy. It changed the public's consumption habits. Did Chinese people want homes to the degree seen in the past decade, or were they coaxed into buying in part because the local governments were determined to raise GDP through infrastructure development, which created conditions favorable to housing demand? There is some X value of natural Chinese housing demand, but how far beyond X did the nation go? Everything is working together, including monetary policy and peer pressure. Your friend is buying a nice new house, so you want to buy one more than you otherwise would. High import taxes makes autos, cosmetics and other consumer goods more expensive. All of the tertiary industries fed into the housing and infrastructure boom: steel, cement, copper, glass, etc.

Even if China could wave away all the debt tomorrow, there's a massive amount of misallocated labor and capital than needs to be "rebalanced." China is slowing the rebalancing by preserving the debt. It needs the misallocated assets in the steel sector in order to service the existing steel debt. This works if the rest of the economy grows fast enough. The misallocated assets don't get rebalanced, but the economy creates new assets around it. The steel sector, as an example, is starved for credit (just enough to keep the zombies moving) and slowly shrinks as a size of the economy. All the while, there's a persistent threat of a deflationary panic, which will most likely be solved with currency creation.