China's Lack of Trustworthiness: Iron Ore Edition

Garett Jones, guest blogging at econlog, has a post up on the value of trustworthiness in a society. 

I suspect that Adam Smith's pin factory prospered because the UK had found ways to create trustworthiness.  That's because without trustworthiness it's difficult to reap most of the rewards of the division of labor: if firms can't rationally trust each other, if workers and owners are rightly suspicious of each other's motives, if citizens can't trust the police, then everyone has to become a generalist.  In this world, everybody makes his own pins.  

This perspective makes what is happening in China even more interesting. China is a developing market that has moved away from full state control towards a more capitalistic structure. However, this structure is lacking in trustworthiness as highlighted by recent events in the iron ore market. 

The sequence is as follows: benchmark prices drop in the spot market; Chinese buyers walk away from contracts, often at the last minute; suppliers are forced to dump their defaulted-cargos in the spot market at knock down prices, further depressing the spot market; this triggers a fresh round of Chinese defaults. The spiral feeds itself, producing dramatic price corrections.

Even generalized, this lack of trustworthiness isn't going to crush China's economy. However, it does increase the chance that China will end up stuck in the middle income trap.