Monday, November 22, 2010

Woes in the Orient

Remember back when the world was in the depths of the global financial crisis, and Bush and Obama had just begun playing modern day Hoover and Roosevelt? Back when news stories weren't even talking about QEI, because it was inconceivable that a multi-trillion dollar stimulus would be insufficient to turn the economy around and require a second round?

At that time, the whole world went on a bailout and government stimulus binge, virtually none excepted. However, there were some fairly great differences in degree, and one of the most eye-popping was the massive stimulus plan proposed by the Chinese government that positively dwarfed any other proposal out there.

Remember that?

I do. I also remember listening to idiotic AM radio show hosts talking about how the Chinese and Indians had managed to get their economies back into strong growth while the American economy still lay mired in high unemployment and recession, as if they had gotten something right and we hadn't. And I remember thinking “You'll be eating those words someday.”

That day looks as though it may soon be here.

China is fast heading for a large-scale economic fiasco. The central bank has raised reserve requirements multiple times as well as the targeted interest rate in an attempt to head off a mushrooming monetary expansion that is rapidly driving up prices and making a mockery of their “recovery.” Furthermore, as Austrian aficionados well know, once the tightening takes effect, the massive malinvestments will be revealed and the economy will be headed for a crash. Actually, “re-revealed” might be a better description, because the 2008 crunch revealed them the first time, and the supposed recovery has only been a papering over.

Of course, the People's Bank of China (PBoC), may just be playing games with us, as our own FED does. Outside observers can't actually check on the Chinese monetary base, so a rate hike doesn't necessarily say that the PBoC is stabilizing the money supply. Raising reserve requirements limits the creation of new deposits (M1 and M2 money aggregates) through lending, but only once the bank reaches its reserve limits, and only if the central bank stops increasing the monetary base. So long as those two conditions aren't satisfied, the banks can still lend away, and raising reserve requirements is effectively rendered toothless.

For those who watch the PBoC on anything approaching a regular basis, this kind of activity is pretty standard. The bankers don't actually like to tighten. They usually spend several months issuing stern sounding edicts in an attempt to jaw down markets before actually taking decisive action. Which means that in the early stages, everybody ignores them, which is probably the best response to meddlesome bureaucrats. In any event, the jawing is usually ineffectual. It is pretty clear to me that even now the PBoC is loath to take any decisive action, as increasing the reserve ratio has little meaningful effect on actual interest rates, and the rate hike itself was a paltry .25 percent, an inconsequential amount in an economy growing in excess of 8%.

However, there is real data that suggests that things are rapidly getting out of hand. Commodity prices have gone through the roof. Here in the US, we sometimes forget that there are other kids on the block playing fast and lose with their financial systems. Most of the commodity price increases of late are probably due to China's profligacy, not ours.

But for me, the far more convincing indicator that China is in real trouble is the fact that the government is once again buying US Treasuries. Supposedly, China was transforming its economy to focus on domestic consumption rather than export led mercantilism. It had stayed out of the Treasury market for close to a year. The fact that it is buying again suggests that the plan has blown up in its face (as, you'll recall, I said that it would) and the government is desperately trying to prop up employment. Either that, or it suddenly has newfound confidence in the value of the dollar and America's willingness to cut her massive deficits and service the crushing debt load.


There is an important reason that the course of events in China is running a bit different from ours. If you'll recall, China's stimulus was not only larger than ours, it also had some components that ours did not. It was not merely a difference of degree, but of kind. China's government used its power over state-run enterprises to force large amounts of lending, often irrational lending that was merely done to meet government imposed quotas. This action jump started the fractional reserve process, creating new deposits and touching off new commodity and housing market bubbles and pushing the reported price inflation rate up to 4.4% (it is probably higher.) Now the Chinese government is even looking at instituting price controls. In the US, by contrast, bank lending has been voluntary – and stagnant. As a result, this kind of inflationary mayhem has been muted.

In a way, in observing China's woes we are probably looking into our own futures. Once lending takes off here, we will face similar problems – a long bout of heady price inflation. In both cases, monetary tightening will be necessary, and a drastic correction will ensue. As China heads into the tightening phase it will be instructive to observe exactly what happens there.

In summary, once again China proves that it isn't magical.  It follows the same economic laws as everybody else.  Because China took a more aggressive/destructive approach to dealing with the financial crisis through stimulus and basic economic manhandling, it got its little blip sooner and is now in the process of re-derailing, harder and faster than before.  If the US had tried an approach that drastic, it would be going through the same processes.  When China tightens 'for real,' expect another major global correction.

Stimulus doesn't work.  Neither does 'quantitative easing.'

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