Tiger By The Tail

Well, well, well, the Chinese economy is experiencing inflation. Overall consumer prices rose by 3.6 percent in March 2012, year-over-year, including an upsurge in food prices of 7.5 percent. Even the prices of venerable Chinese herbal medicines took an upward leap of 8.3 percent. According to a CNNMoney report, inflation is “the price of prosperity.” The report goes on to fatuously instruct us, “While inflation poses challenges for consumers, it is the byproduct of one of the most robust economies in the world.” A comparison of China’s 9.2 percent real GDP growth in 2011 with the paltry 1.2 percent growth rate for U.S. real GDP in the same year is thrown in as supposed proof of this statement.

But this is utter nonsense and one of the most deeply entrenched myths in both academic economics and media commentary. Basic economic theory demonstrates that “economic growth,” which is nothing but  an increase in the supplies of various goods and services, is in and of itself deflationary. An increase in the supply of any good (or service), with the supply of money and all other factors fixed, results in a fall in its price and a growth in its sales, as the excess supply of the good drives the equilibrium price down and expands the quantity demanded. This irrefutable economic truth has been illustrated time and again since the late 1970s by sharp declines in the prices of items like personal computers, video game systems, HDTVs, digital cameras, and cell phones and of (uninsured) medical procedures like Lasik eye surgery and cosmetic surgery. Furthermore, this fall in prices has not caused stagnation in these industries but has instead coincided with their rapid expansion. I have explained this phenomenon of  “growth deflation” in more depth elsewhere.

What then is the cause of the accelerating Chinese inflation? We need look no further than the money supply. The broad measure of the Chinese money supply, M2, which includes currency in circulation and all bank deposits, increased by 13.6 percent in 2011, although the People’s Bank of China had targeted a 16 percent increase. The PBOC has announced that it will set the money supply growth rate at 14 percent for 2012. This inflation targeting policy, so beloved by contemporary macroeconomists, augurs more rapid price inflation for Chinese consumers for years to come. More important,  China’s long-standing super-loose monetary policy means that inflationary credit expansion has fueled a great part of the rapid growth of the Chinese economy, which is therefore unsustainable and doomed to collapse. Indeed, the pace of Chinese economic growth has already begun to falter in the last two quarters. In response, the PBOC has already cut reserve requirements twice in the last three months.

Having allowed the inflation tiger out of its cage, the Chinese government is now desperately hanging on to its tail. It must either cage the tiger forthwith  and confront the damage it has already wreaked in the form of a collapse in its economic growth rate; or it must inevitably lose its grip and permit its burgeoning market economy to be devoured by the beast in an inflationary breakdown and reimposition of direct controls.


  1. If the Chinese govenment no longer wishes to import U.S. inflation, all it needs to do is cut the peg and allow the RMB to apreciate to its purchasing power parity with the USD. This would quickly put an end to its huge current account deficit and concomitant capital account surplus. Yes, one of the costs of this would be that the value of its massive U.S. dollar reserves would fall, but the Chinese cannot use these reserves at their current value now anyway without precipitating a decline in their value. But their accumulation of dollar reserves cannot go on indefinitely and at some point the Chinese government must succumb to the economic pressure to appreciate and sustain even greater foreign exchange losses than they would by allowing their currency to float forthwith. But all this is beside the point. the Chinese are not caught on the horns of a “trilemma”; they love and want monetary inflation now more than ever to keep pumping up their growth rate, lest the Chinese “economic miracle” come to an end, which it will in any case.

    • This sounds like Ben Bernanke and Chuck Schumer. The Chinese should let their currency appreciate so that the US can win its monetary attack on the RMB with its weak dollar policy.

      If both the dollar and the RMB were linked to gold there would be no inflation and no windfall profits or losses. This is essentially what China is attempting to do with the dollar. By linking to the dollar there are no windfall profits or loses betweent the RMB and the dollar.

      The monetarists currency warriors in congress are doing all that they can to make China submit to US monetary hegemony.

      You are right that if the Chinese wanted to end deflation they could end their parity to the dollar this is just what the FOREX speculators like George Soros would love.

      China’s growth rate has been soaring for years but their inflation is a more recent phenomenon. The US has low inflation. How is that? Simply the economic conditions in the US are in the bust part of the ABCT. No amount of monetary “stimulation” will return us to the boom. The added money rushes into bank reserves unused. The US transmisssion mechanism to inflation is essentially broken. In China on the other hand they are still able to transmit their currency into the economy.

      If the Chinese do not learn that they must choose liberty and freedom to build their domestic economy you are correct their “economic miracle” will come to an end. Only if they understand that economic freedom has to be linked with individual freedom will they be able to generate the domestic economy that can sustain their prosperity.

      China’s primary problem is not monetary but political.

  2. The analysis is overly simplistic. The Chinese are caught on the horns of the trilemma. Their primary trading partner is the US and the US is very adept at using monetary manipulation to gain windfall monetary gains on the exchange rate. To counter this the Chinese significantly peg the RMB to the dollar. At the same time they exercise very severe capital controls. That means that essentially the Chinese have outsourced their monetary policy to the US FED. If the FED inflates then the Chinese import that inflation.

    In the US the FED has followed a policy of interest rate control via QE. This QE weakends the dollar in the FOREX markets. For the Chinese to maintain parity with the dollar they have to also expand their money supply.

    The Chinese are caught. They either surrender to US monetary manipulations and experience windfall loses from FX rates or they import inflaiton. The Chinese have determine that they it is better to target the dollar and then deal with inflation.

    Essentially the Chinese problem with inflation is created by the US weaking of the dollar. Will this lead to the consequences seen by Salerno? That is an open question, but if Chinese growth falls expect to see a change in the Chinese monetary policy possibly away from the dollar with the alternative being a gold anchor to the RMB.

  3. The symptoms of an inflationary boom are there to be seen:

    Hotel workers in Shanghai are now more likely to be Russian migrants than Chinese.

    Beer in bars frequented by local Chinese (no tourists to be seen) along the Bund (water front) in Shanghai was equivalent of £10 / pint one year ago.

    a friend who used to import cheap jewellery from China, now exports expensive jewellery to China.

    Construction projects throughout China are now so desperate for workers, that the chaos is obvious – wet concrete being shovelled onto the floor of a brand new, mirror lined elevator to take it to a higher floor.

    I’ve been introducing all of my Chinese friends to Rothbard’s work – I wish I’d known his work before the green striped “celtic tiger” fell over.

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