Please read the fine post from immobilienblasen about price control in China. I want to dig a bit more into this topic.

Let start from the basics again. To simplify the things the world economy works as an entity that extracts natural resources from the Earth and process it into consumable goods. If you divide this entity into countries that are essentially sub-entities unified by some policy and other common properties of business units located in that country.

Each country has a particular competitive advantage in certain fields of processing natural resources and the logic of the world economy pushes those resources into this country. For example, Japan is very good in converting oil and silicon into flat panel televisions. So those countries who extract oil and silicon from Earth are sending them to Japan and then Japan sends those flat-panel TVs to the rest of the world. In case of Japan this advantage is in technology, patents and know-how.

In case of China the competitive advantage is the abundance of extremely cheap yet relatively qualified labor, concentrated along navigable rivers and backed up by business friendly government. There are many countries in the world with cheap labor but few of them are stable, qualified or accessible. The output from China is pretty much anything that is labor-intensive and can be easily outsourced from the West. Like plastic toys.

Now more about cheap labor. In the market economy there is a certain proportion between luxury, durable items and staples. For example, one day at ski resort will cost you the same as 10 bags of rice. The basket of consumable items will include the mix of staples and luxuries, both rice and ski resorts. The feedback loops between consumption of all those items creates this typical basket and the typical cost of labor in Western countries. Every kid in USA once in a while comes to Disneyland and this is a part of the basket.

Now very clever Chinese authorities came to a very clever idea (used in all Eastern European countries before) that they can subsidize the staples and change the proportion between various items. So the day at Disneyland (or ski resort) will cost not 10 bags of rice but 50 bags. So the typical consumption basket will include more rice and less Disney, overall supporting all the life necessities at cheaper price. The idea is that only a fraction of the country output is sufficient to be used for subsidies but overall it will make the labor artificially cheap and thus supporting the big trade surplus.

In the completely free market economy the China market would quickly adjust itself, the basket would be more expensive and include more luxury items and services, the price of labor would go up and the trade surplus shrink quickly. But this doesn’t happen.

So what is the conclusion? The world economy is in market equilibrium based on certain price of all goods. But the big player China is distorting the market mechanisms. First, they consume more natural resources than they would otherwise. Second, they produce more artificially cheap goods than they would otherwise. And this disproportion is widely based on subsidies that are coming from large trade surplus.

If anything in this artificial, non-market structure will start breaking the results may be disproportional the the cause because the market usually adjusts itself much better than any government structure. It looks to me like a big house of cards which is much more stable flat rather then tall