05/26/2007 12:58 pm ET Updated May 25, 2011

The China Blackstone Deal -- Bubble, Bubble, Sterilization and Trouble

So China is thinking of investing some of its 1.2 trillion dollar reserve in the US.

Early this year, the Chinese government announced it was looking for a place to invest a portion of its $1.2 trillion of foreign-exchange reserves. Not long after, private-equity firm Blackstone Group launched plans to raise money in an initial public offering.

The sides found each other in dramatic fashion yesterday when China said it would invest $3 billion in Blackstone. The landmark deal signals China's determination to earn higher returns on its reserves and gives Blackstone a potential advantage in doing deals in China.

Continued investment in U.S. entities could help restore some equilibrium to China's accounts with the U.S., and thus alleviate one of the biggest sore points between Washington and Beijing. The deal came just before this week's U.S.-China economic talks in Washington led by U.S. Treasury Secretary Henry Paulson and Chinese Vice Premier Wu Yi; the run-up has been dominated by U.S. complaints that China's currency is kept artificially low to give Chinese exports an edge.

Let's examine this. Blackstone buys and manages companies. It is, essentially, the head company in a conglomerate, though that word isn't used much these days. $3 billion invested in Blackstone will mean $3 billion used to buy companies (actually, with leverage, quite a bit more than $3 billion).

This is, actually, the way borrowing money is supposed to work.

The US, by the way, is the party borrowing money. The US runs deficits -- the government deficit (not just the Feds, but at almost all levels); a balance of trade deficit, and a balance of payments deficit. When you spend more than you're bringing in, you have to borrow the money.

Well, sort of.

If you're a government, you can print money. And that's essentially what the US has done -- it has had a massive expansion in the money supply. To a large extent this expansion has been sterilized -- in the 90s it went into the stock market bubble and then much of it was destroyed when the bubble burst; in the 2000s one place it went into the real estate bubble (and is being destroyed, slow-mo, as we speak). Another place it went was into foreign reserves -- the $1.2 trillion China holds, among others. China wanted to keep the Yuan down in value, so they bought dollars. If they hadn't bought those dollars either US interest rates would have had to go up a lot more than they did, or the dollar would have had to go down against the Yuan. That would make Chinese exports to the US much less competitive. China doesn't want that. Neither does the US (because that would mean inflation.)

But let's step back a second to the word "sterilization". In the real world that means getting rid of germs, but in this context it means something different -- it means getting rid of the effect of printing lots of money.

Printing money is necessary to the economy. We need it, and it makes a modern economy possible. However if you increase the money supply faster than the actual economy is growing you (generally) wind up with inflation. Inflation, as every central banker in the world had pounded into them back in the 70s and 80s, is bad (if you aren't old enough to remember serious inflation ask some older folks what it was like).

Specifically, inflation that gets into the general economy and effects everyone is considered bad.

So if you're going to say, double, the amount of money in circulation before the economy doubles, you need to find something to do with that money, or it'll just increase prices and no one will be better off.

You need to sterilize it.

Money in the stock market, as in the 90s, is largely sterilized. It won't set off general increases in wages. It doesn't increase the cost of oil. It doesn't increase the cost of bread. It doesn't increase the cost of toasters. Oh sure, some people get rich (mostly people in the casino, er, Wall Street, who take their cut from the suckers) and those people bid up the prices of Manhattan condos, buy yachts, $10,000 bottles of wine and fancy vacation homes -- but, basically, that money stays in amongst a limited number of people and doesn't make it into the economy in general. So you can print money without causing a bout of general inflation.

Of course, eventually people realize that it's a bubble and *poof*, stock market crash. Some money remains, but a lot of money is, effectively, destroyed. That has some problems, but large amounts of the money have been permanently sterilized, all right (and should have stayed that way, but George and the Republicans decided to bail out the rich with their tax cuts. However that's mostly another story.)

When the stock market went down, the Fed cut interest rates to the bone. That was part of the bail out of the rich and corporations, for all that it was sold as being good for the economy (which, in fact, it was, sort of.) When you can borrow at less than the rate of inflation it's not hard to make money (no, no, you can't borrow for that little. Those rates are only for people who matter.) In any case, dropping rates so low also had the effect of creating the real estate bubble. Real estate is a good place to sterilize money (though not nearly as good as stocks) because real-estate is relatively illiquid. Sure people's house prices soared, but most of them still didn't sell. It was all paper money -- unless, of course, the person was stupid enough, or strapped enough, to borrow against it. To refi, or to take out consumer loans based on the new value of their real-estate. But that wasn't entirely a bad thing - that ability to borrow against the bubble allowed consumers to go into debt so they could keep spending, which is what has kept the US' economy on life support for the past 6 odd years.

This isn't the only place the money went -- it also went into speculation, some of it very adverse to what the Fed wanted -- for example, commodity speculation, which increased the price of oil and other commodities even over what scarcity would have pushed them to. Lately that money is going into the private equity boom, as investors flush with money take public companies private.

And right now, all that extra money is causing problems in China. Because, you see, in order to buy up all that US money, China had to print money too -- Chinese money, which it exchanged for US money. It had to print a lot of it, and much of it has gotten back into China, where it's causing inflation much worse than the official numbers indicate (because China has two economies -- the coastal and the interior, and averaging them tells you very little about what inflation is like in either of them.) Not only is it causing inflation in China, it's also causing their own little stock market bubble, a bubble which is not likely to end well (when banks pay under 3% and housing inflation is running 18% or so, you might as well gamble. It's going to be worth half in only a few years anyway.)

But let's bring all of this back to China wanting to invest in the US. China has 1.2 trillion dollars of money. China wants to get something for it. Some American things. Like -- shares in companies and their growth. It wants to actually use that money.

When it does so the balance of payments numbers will start looking better (which is why Paulson is shoving them to do this) and a lot of people on Wall Street are going to get even more stinking rich than they are already.

But it also means that a lot of money is going to pour back into the US. And when a lot of money comes into the US and the economy proper hasn't increased by that much, what do you get?

Yes, you get inflation. The question is whether it's localized inflation, sterilized inflation, or general inflation.

Localized inflation -- we haven't talked about this yet. Localized inflation is what leads to the joke "one man's inflation is another man's pricing power." Health care costs have been going up far faster that wages over the last few years. That's localized inflation. It's also pricing power -- when you need your cancer tumor cut out, you pay, because you want to live. Same thing with gasoline prices -- there's no substitute for most people, and they need to drive to work and to get groceries, so they pay. Even housing inflation can be looked at this way. Imagine you don't own a house now -- how'd that housing bubble work out for you? Oh, made it less likely you'll ever own a house now, didn't it? (Well, until the bubble bursts fully, anyway.) When money moves unevenly through an economy some parts get pricing power and some don't. Who this is is based primarily on whether there's a substitute and that is based largely (right now) on whether that part of the economy is protected. That's an essay for another time, but for now -- protected means you can't do it outside the US, or there are significant barriers to doing it outside the US. Haircuts, houses, military spending and health care are all protected sectors -- so is agriculture, because of heavy subsidies.

Money pouring back into the US to buy up US companies and other specific assets (as opposed to the Chinese, say, buying collateralized debt obligations against mortgages) should, in principle, be mostly sterilized. It will go to a very few people, it will make them stinking rich, but it won't be spread around. A few shareholders will do very well out of it (yeah, I'm aware of pension plans, which amount to agglomerations of small shareholders) and a number of middlemen will do even better, and some people (like politicians) will get their share in bribes and spending money, and industries that cater to the really rich will be really happy -- but most of the money won't get into the economy that ordinary people live in.

Until, of course, the bubble bursts and people realize they've paid too much for all these things they've bought. And in order to make the returns they expected to make, they'll have to cut operating expenses (except executive salaries, of course); shut down companies, offshore and outsource, slash wages, get rid of pension obligations and downsize medical plans.

These days everyone thinks private equity is a great deal. Lots of the companies taken private are doing gangbusters and it seems like easy management arbitrage -- take'em private, improve management, make more profits. borrow money, give self money, take it public again.

Works -- until it doesn't. Works -- until the low hanging fruit, the companies that were basically healthy and badly managed in obvious and easy to fix ways -- are gone. Works, until the lenders realize that giving loans to companies to pay takeout artists might be that great a risk. The boys who have been doing private equity these last few years got the low lying fruit. Every month means there are less and less takeovers which are easy turnarounds.

But as with all bubbles, long past the time it makes sense, there'll be another buyer and another buyer and another buyer -- until one day, far after it should have happened, suddenly there are no buyers. Just a pile of companies which were bought for more than they're worth, with investors looking to squeeze every damn penny out of them no matter who it hurts.

So... China investing in the US and in private equity. Not going to end well for the US. But if I were China... well, might as well buy now, those dollars aren't going to be worth more in 10 years than they are now, and some assets are better than holding dollars when there's dollar/yuan parity.

And it'll sure help those balance-of-payment numbers look good.

But I don't think it's going to work out as being all that great for the US in the end. Still, you give people money and then they come to you and want to buy something with it, you can't really say no, or they may not accept that greenback next time.

Originally posted here.