Monday, February 15, 2010

Response to "I have to side with China on this one"

Marshall Auerback's response to China's (recent) actions on currency valuation (tied to this post).

There's another factor as well. There's been an enormous increase in money and credit in the past year. In fact, it seems to be as great as 5 years' growth in credit in the previous Chinese bubble. What happens is that the increase in money and credit is so great and so abrupt that you tend to get a high inflation quite quickly even if there are under utilised resources? Add to this the fact that you've got massive fiscal stimulus occurring today in China.

You have the makings of a very messy situation: if China seeks to sustain demand via fiscal policy, then you could get a big inflation problem, which could severely erode the tradeables sector. And you have all of these Chinese students all steeped in Chicago School monetary theory, coming home and taking over. So they might do a Paul Volcker to stop inflation.

But, what if the they don't? Inflation can take off and thereby begin to ERODE the competitiveness of Chinese exports. This might be the real reason why China is so reticent to revalue its currency. The Americans might go crazy if the Chinese devalue, but if the inflation is high enough, they might have to do it, as it will severely erode their terms of trade and cause their tradeables sector to collapse.

Or you get the hard-line monetarists triumphing by fighting inflation and you get riots as unemployment increases.

It could get very ugly.

This could be happening now in China. Everybody says no. The consensus is that inflation is a couple per cent and it is all pork prices because there was a lousy corn harvest.

However, economists such as those at Lombard Street in the UK, Jim Walker, Simon Hunt and the like try to figure out the changes quarter to quarter in Chinese nominal GDP which is reported only year on year. And they come up with giant double digit growth rates for the second half of last year.

Now this is complicated by the fact that the Chinese have revised up their GDP numbers and they throw the revisions all into the final quarter of the year. But when these guys try to adjust for that statistical screw up they still come up with giant nominal GDP increases. Lombard Street thinks it was twenty five per cent or so in the second half of last year. They think it was twenty per cent real and five per cent inflation.

Economies never grow at a twenty per cent real rate. And Simon Hunt says if you look at proxies like power output and rail traffic you don't get those kinds of numbers for real growth, which suggests that inflation must be higher than four or five per cent. Indeed, it could already be double digit. It is hard to say. But if it is double digit then the resultant inflation will cause a real revaluation of the trade weighted exchange rate.

And more so if the dollar rallies. That could well crush the volume of exports and the profitability of the industrial tradeables sector. Exports are the only area where China makes any kind of money because they can sell these products for about 10 times what they obtain for a comparable product in the domestic economy (where profits are virtually nil). The export sector is a big contributor to overall super excessive fixed investment in China. FDI will go to zero net.

There will be strong forces for a reduction in fixed investment in this large sector. Hence, there is a good chance that even without monetary tightening by the Chinese authorities, the overall fixed investment boom in China will turn down.

Nobody is thinking about this but it is a real possibility. And with fixed investment now at fifty per cent of gdp (which is unprecedented in any economy) and exports at more than thirty, we're looking at ratios that have never been reached before on a combined basis turning these two down could create a severe recession in China. China has gone too far this time. I think they are in a box that they and others don't recognize. The "Black Swan" event this year could well be a devaluation of the RMB.

by Marshall Auerback, posted by Rebecca


  1. Marshall/Rebecca - what do you think the consequences of a devaluation of the RMB would be in the developed economies...?

  2. Hi Stevie,

    In the medium term, export revenue - China's quickly becoming a driver of domestic demand it should be.

    There's something in the works here - and it has to do with a shift in domestic demand fueling world growth. Not US domestic demand, but perhaps China's or India's. A revaluation would simply transfer external demand flows to some of the developed economies. Theoretically.

    Brenda Rosser over at EconoSpeak has written some interesting pieces on China here ( and here (

  3. I am not to impressed with Marshall Auerback. For example, this post seems to ignore the possibility of balancing the budget by further increases in the corporate and individual top bracket income tax rates, which would reduce the deficit while creating jobs, with the added benefit of increasing equality.

  4. Unfortunately the United States (and others) are in such a spot that every decision China makes comes back to us. With its cut on lending rates and possible inflation drop, its relationship with the U.S. and especially with Japan is going to change.

  5. Hi James,

    My understanding of this article was not that deficits should be reined in, but that cutting the debt burden might actually reduce income generation and household disposable income.


  6. Hi Kyle,

    China's - along with India, Brazil, etc. - domestic demand is essentially driving world economic growth at this time. However, I do not see a reduction in inflation at this time - more likely that prices are rising (and very quickly as Marshall points out).