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Thursday, April 17, 2008

Revised Musings on China

In an earlier post I suggested that it was theoretically possible that China's rapid price inflation wasn't the result of a loose monetary policy, but instead its efforts to curb the appreciation of the yuan. However, at the time I hadn't quite worked out the mechanics of how this would be possible; it was just a hunch based on the obvious fact that an appreciating currency would have a deflationary tendency.

After thinking about it some more, I think I've come up with a mechanism whereby this could occur. However, in order to get it to work, I have to assume things that I'm pretty sure aren't true. Hence, when all is said and done I think my friend (the "Chinaman") was right when he thought they had sown an unsustainable boom, and we might have big trouble in big China.

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THE THEORY

OK so if China were a capitalist country, here's how it could work: We're trying to show that consumer goods prices could go up, even if the government doesn't run the printing press. Absent any changes in the demand for yuan, the only way is to have prices of other things (which aren't included in the CPI basket) go down. So for example, if the Chinese government raised taxes and then spent all of its revenue on grain and milk, this might cause a spike in the Chinese CPI. The citizens before the tax hike would've spent their money on a wide range of things, and so the government in effect concentrates a fraction of that money in goods whose prices indicate "inflation" in the official measures.

OK let's make it a little closer to home. Suppose that instead of buying the consumer goods itself, the Chinese government buys assets from foreigners, and then they use the yuan to buy finished goods from China. So the Chinese government is basically stealing purchasing power from its people and handing it over to profligate Americans, who then pump it into consumer goods.

Now this actually could be part of what is happening. Suppose that for whatever reason, it just made economic sense for higher order (in the Austrian sense) goods, such as tractors, supercomputers, drill presses, etc., to be produced abroad, whereas it made sense for lower order goods such as peanut butter and TVs to be produced in China. Then when the Chinese government forced its people to save a ridiculous 40% of its GDP (I think that's the figure), they would invest it in foreign assets. Thus, the giant Chinese factory wouldn't be converted into churning out those higher-order goods--it would still crank out consumer goods. And as the process intensified, you would see the prices of those goods go up, thus boosting measured inflation.

If you had the whole world on a gold standard, it would be clearer what was happening. There wouldn't really be price inflation in Chinese consumption goods, just like there wouldn't be deflation in the Western countries. But with regional currencies I think you could get false snapshots as I've described above.

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THE REAL WORLD

As I said, I think the above process is in fact part of what's going on. But in order to get an absolute--not just relative--rise in yuan-prices for consumer goods in China, you would need a fall in Chinese asset prices. And that's clearly not happening. In fact, foreigners want to buy not only Chinese exports, but also Chinese assets. This is why the yuan needs to appreciate even more.

So in conclusion, although I think it is theoretically possible for a country to experience high domestic price inflation even though it isn't running the printing press, in this case I don't think that's what is happening. Especially when you consider how high China's real GDP growth has been, I have to believe they've been expanding their money supply. It's hard for me to go "look and see," because (a) my initial google attempts literally landed me on Chinese webpages and (b) I don't know anything about their institutional arrangements so the official numbers could be quite meaningless.

My final observation is this: Up until mid-2005 China had a pretty stable peg against the USD. Some have said that it was this peg that allowed China to weather the Asian financial crisis fairly well back in the day. Remember, it wasn't until the last couple of years that people really started questioning the solvency of the dollar.

So, in that context, I think the Chinese could have been quite comfortable expanding their monetary supply, so long as it wasn't putting downward pressure on the yuan vis-a-vis the "solid" dollar. It's as if they had a gold standard, and kept accumulating tons and tons of gold reserves every year. They would think they were doing a great job, being perfectly responsible.

Where does this leave us? Unfortunately it could mean that China is sitting on a bigger pile of malinvestments than the U.S.

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