China’s massive stimulus program is being fuelled by an unprecedented increase in bank lending. More credit has been extended in the first quarter of 2009 than for all of 2007, and bank lending is growing by nearly 30 percent on an annual basis compared to about 15 percent in October 2008. That lending spree reflects an ultra-easy monetary policy with both the monetary base (currency plus bank reserves) and broad money (M2) growing at more than 25 percent a year.
The excessive growth of money and credit relative to real gross domestic product growth of slightly more than 6 percent poses a significant inflationary risk if the People’s Bank of China (PBOC) does not put on the brakes later this year. Once the inflationary genie is out of the bottle, it will be difficult to put him back in.
More significant, most of the new loans are flowing from state-owned banks to state-owned enterprises. Those loans and investments are heavily influenced by political decisions rather than by sound cost-benefit analysis based on market prices. Consequently, China’s stimulus plan is affecting the structure of its economy, with state-led development gaining ground and the dynamic private sector losing ground. If that trend were to continue, there would be a negative impact on China’s highly successful marketization process and an increase in the power of government over economic life.
It is ironic that, after celebrating 30 years of China’s economic liberalization and opening to the outside world, Beijing is now reverting to the old model of state-led development. Stimulating the economy through monetary expansion may work in the short term, but the risks to long-term price stability, prosperity and freedom are significant. Monetary mischief and artificially low interest rates could lead to a large misallocation of credit and an increase in non-performing loans. The PBOC’s easy money policy risks repeating the same boom-bust cycles of 1985, 1988 and 1993-95, when the central bank allowed the money supply to far outpace real economic growth.
At present, China is experiencing deflation, not inflation. But no country - including China - has ever escaped inflation when its central bank persists in creating an excess supply of money. In a careful study of China’s monetary policy, Gregory Chow of Princeton University found that when the central bank has controlled the growth of the monetary base, inflation has been tamed, as when then-premier Zhu Rongji brought inflation down from 22 per cent in 1994 to less than 1 per cent in 1997.
Today, the PBOC is putting less emphasis on controlling inflation and more on stimulating the economy. But there are limits to monetary policy: printing money cannot take the place of institutional changes that promote economic freedom and prosperity. Zimbabwe was once a rich country but is now impoverished because it destroyed sound money, imposed price controls, undermined private property rights and abandoned the rule of law. Rather than stimulating the economy, excessive money creation erodes the value of the currency, distorts market prices, slows economic growth, and reduces both economic and personal liberties.
Governments gain power when money is mismanaged. Inflation is a tax on real cash balances and, if inflation is suppressed by wage and price controls, governments resort to rationing and administrative means to determine the allocation of goods and services. The result is widespread shortages, corruption and an underground economy.
In August 1971, then US president Richard Nixon introduced wage and price controls when US inflation was less than 5 per cent. But the Federal Reserve continued to create excess money. When the controls were removed, inflation soared to double-digit rates until Paul Volcker’s Fed sharply tightened money growth, and the US suffered a recession.
If a democratic country like the US imposed price controls when inflation was relatively low, it is conceivable that China could revert to wage-price controls if inflation were to re-emerge.
China already controls interest rates, does not allow full convertibility of its currency, pegs its exchange rate at an artificially low level (as revealed in its accumulation of nearly US$2 trillion of foreign exchange reserves), and prohibits the private ownership of land. Those forms of “financial repression”, which limit the choices open to people, along with strict constraints on the free flow of information, mean that China’s quest to become a world-class financial centre will not be realized until those restrictions are relaxed.
With the demise of investment banking in the US, China has a golden opportunity to gain market share by further liberalizing its capital markets. Moreover, if China were to allow more flexibility in the yuan exchange rate, the PBOC could focus on maintaining long-term price stability, and China could move more quickly towards a fully convertible currency. The yuan might then evolve as the anchor for a strong regional currency bloc. Finally, state-owned banks should be privatized and market-determined interest rates should be used to guide credit allocation.
Market socialism and easy money are what got the US financial system into trouble. Fannie Mae and Freddie Mac were government-sponsored, not private, enterprises, and the Fed kept interest rates too low for too long. China should learn from those mistakes and recognize that future success will depend on increasing economic freedom and maintaining sound money, not on enshrining market socialism.