Commentary

The Inflation Threat

This article appeared in Caijing on September 27, 2007.

When the 17th National Congress of the Communist Party of China convenes in October, President Hu Jintao will be confronted with some serious challenges. Foremost among those will be to ensure steady economic growth and price stability. Inflation is now at a 10-year high, reaching 6.5 percent (year-over-year) in August as measured by the consumer price index.

Actual inflation is probably much higher given the defects of the CPI, which does not accurately reflect the consumption pattern of the present market-oriented system. Housing prices and other asset prices are increasing at double-digit rates, but housing is under-weighted in constructing the CPI (it only accounts for 13 percent of the index compared with more than 40 percent in the United States). Moreover, some consumer goods are still subject to price controls.

Yi Xianrong, an economist with the Institute of Finance and Banking at the Chinese Academy of Social Sciences, is correct to argue that “a CPI that is unable to accurately mirror people’s consumption offers an inaccurate interpretation of the country’s economic life and is also prone to leading the government, enterprises and ordinary households to erroneous decisions.”

Inflation is a sustainable increase in the average level of money prices and occurs when too much money chases too few goods. Governments often try to suppress inflation by imposing price controls. Such controls distort market prices, interfere with economic freedom, and increase government power.

Some people blame the current increase in inflation on rising pork and other food prices. But such price increases primarily reflect changes in market demand and supply, and only have a temporary effect on the price level.

The National Development and Reform Commission warned local governments not to interfere with market price determination unless “there is remarkable price growth due to emergencies or natural disasters.” But it is precisely at those times that the free market best performs its role of allocating scarce goods to their highest valued uses. Placing caps on prices of food and supplies when they become more limited will simply exacerbate shortages and corrupt markets. The poor will not be helped, but those administering the controls will gain in power. Just look at Zimbabwe.

If inflation is due to an excess supply of money, then the responsibility for inflation must rest with the People’s Bank of China, not with the price of pork. China’s earlier bouts of double-digit inflation were clearly the result of irresponsible monetary policy, not the result of market forces.

In the second quarter of 1986, for example, there was a sharp increase in the money supply and inflation began to accelerate by the fourth quarter of 1987. At the time agricultural prices were rising and, according to noted reformer Wu Jinglian, officials contended, “There was no macroeconomic problem … only a local problem of agricultural production.” By mid-1988, monetary aggregates were growing at annual rates of 33 percent for M1 and 29 percent for M2. Inflation skyrocketed to more than 18 percent in 1988–89.

The high inflation of 1993–95 was also the direct result of excessive monetary growth. Moreover, given the first episode of inflation in 1988–89, people’s expectations of further price increases in the second episode helped increase monetary velocity and further fueled inflation. Clearly, the PBOC needed to control the money supply to control inflation.

The high inflation in the late 1980s led to price controls and shortages. Today, the PBOC is more disciplined and authorities generally recognize the futility of price controls as a means of containing inflation. As the China Daily reported, the recent decision of the NDRC to allow some intervention in the free formation of prices “does not mean the invisible hand of the market should be replaced by the administrative hand.”

Is the current increase in the CPI a monetary phenomenon or simply a short-term increase in the price level due to the food component of the CPI? The answer is that the food component of the CPI is causing an increase in recorded inflation, but the monetary base is currently growing at 15 percent, and M2 growth of 18 percent exceeds the PBOC’s target of 16 percent.

Excess monetary growth is being driven by China’s record current account surplus and foreign direct investment. Foreign exchange reserves could reach $1.6 trillion by year-end. The PBOC must buy dollars to peg the nominal exchange rate. The monetary base expands unless the newly printed renminbi are withdrawn by sterilization—that is, by the PBOC selling bills to commercial banks. The PBOC is also increasing the required reserve ratio to limit credit growth. But loans are still growing by nearly 17 percent, and urban fixed asset investment is growing by about 27.

If the CPI understates true inflation, then real growth is overstated. With velocity of money increasing, due to low real interest rates and inflationary expectations, the present monetary growth rate is too high to bring about long-run price stability. The real inflation rate is better indicated by sharply rising housing and asset prices than by the CPI.

It is time for the PBOC to stop interfering with the nominal exchange rate and let market forces set that relative price. Capital controls need to be further relaxed, interest rates need to reflect market supply and demand, and the PBOB needs to focus on what central banks do best: control the supply of base money and provide for long-run price stability.

If inflation is tamed and if people are free to choose without price, exchange, or capital controls, markets will better be able to create the harmonious society and all-round development that China’s leaders are calling for.

James A. Dorn is a China specialist at the Cato Institute and coeditor of China’s Future: Constructive Partner or Emerging Threat?