The Gathering Storm

As all the world's eyes are focused on America and its elections, a very frightening piece of news is developing in China:

In the initial weeks of the global financial crisis, Chinese officials resolutely declared that they were not significantly affected. But now, as factory closings, dire corporate earnings reports and stock market losses continue to mount, the Communist Party's confidence has changed to another feeling entirely: fear.

For the first time in the 30 years since China began its capitalist transformation, there is a perception that the economy is in real trouble.

And for the Communist Party, the crisis is not just an economic one, but a political one. The government's response offers a glimpse into its still ambiguous relationship with capitalism -- relatively hands-off in good times, but quick to intervene directly at the first signs of a downturn in order to prevent popular unrest.

Normally, you might think to take this in stride, but here's the problem: the American economic system, including our own governmental operations, are inexorably linked to the Chinese system, indeed, to the government itself.

Should the Chinese government fail to stem the economic tide within its own borders, should the absolute worst happen and the Chinese government itself go belly-up (like Iceland almost did) in financing a bailout of its banks, then the Chinese government will do one of two things:

The lesser of the two evils is to stop buying American bonds, you know, those things we've been financing the deficit with. This will create a hyperinflative environment with both skyrocketing prices AND skyrocketing itnerest rates, the economic perfect storm of stagflation I predicted three years ago.

The worse of the two evils is that China will liquidate its outstanding investments, meaning they will dump our T-bills and notes and bonds onto the open market. This will cause the value of the dollar to crash, and trigger a depression that will most definitely not be called "great". It will be nothing less than a catastrophe. War would be the most likely outcome of such a radical move, war on a global scale.

There's small comfort to be had here, and we should all be crossing our fingers or praying really hard right now. China is a relative rookie in free market capitalism, and the mistakes we made up to now have been pretty horrific.

And we continue to perfect our mistakes. China doesn't have the benefit of our past experience, even. It won't take much, just a minor panic attack and things could topple quickly.