The Limits of Monetary Policy

May 9, 2008 • Commentary
This article appeared in the South China Morning Post on May 9, 2008.

A central banker must know the limits of monetary policy. Pumping up the supply of fiat money cannot generate real economic growth, but it can ignite inflation. Just look at Zimbabwe, where Robert Mugabe’s policies have destroyed the currency, which even has an expiration date, and created economic chaos. Although China is thankfully not following Zimbabwe’s lead, creeping inflation and price controls are a threat to social harmony and stability.

In a world of mobile capital, using monetary policy to peg exchange rates makes it more difficult to control inflation. Real economic development requires stable money and economic freedom, which expands the range of choices open to individuals. China’s phenomenal rise since 1978 has resulted from economic liberalization, not monetary ease.

But China is still not a full‐​fledged market economy, and monetary policy is compromised by Beijing’s reluctance to let market forces determine the interest and exchange rates. Excessive monetary growth in 1985, 1988, and 1993–95 led to rapid inflation. Since that time, the People’s Bank of China has slowed the growth of the monetary base (currency in circulation plus bank reserves), and inflation has become less onerous.

Nevertheless, inflation is now at a 12‐​year high. The consumer price index increased by 8.7 percent in February, from a year ago, due primarily to higher food prices. But unless the PBC steps on the accelerator and allows much faster growth in money and credit, which is unlikely, China’s CPI inflation should return to about 3 percent by year end.

The real threat to China’s long‐​run price stability is not from the risk of higher food prices or other increases in relative prices but from excessive growth of money and credit—due to an undervalued exchange rate and artificially low real interest rates on loans at state‐​owned banks. Meanwhile, price controls designed to suppress inflation distort relative prices and breed corruption as shortages spread and black markets appear—just as in Zimbabwe.

Although China announced a major change in its exchange‐​rate regime in July 2005, and told the world it would henceforth manage its currency by pegging to a currency basket as opposed to the U.S. dollar, Congress has been impatient. Bipartisan legislation threatens to penalize China for “currency manipulation.” Presidential hopefuls Hillary Clinton and Barack Obama have joined the anti‐​China chorus and said they would co‐​sponsor a bill to treat the undervalued yuan as an actionable subsidy.

Congress should recognize that it is in China’s own interest to let the yuan appreciate at a faster rate in order to avoid inflation. When the yuan’s value in dollar terms increases, it means that the PBC does not have to create as much base money to buy dollars. In this way, money and credit growth can be tamed without administrative controls, and without risking further inflation.

Even though the yuan has been allowed to appreciate by 18 percent against the dollar since 2005, China’s foreign exchange reserves have more than doubled from $819 billion to $1.8 trillion today. The PBC has successfully “sterilized” capital inflows and kept the monetary base from explosive growth. In particular, the PBC has been able to restrict the growth of money and credit by selling bills to state‐​owned banks, increasing reserve requirements, rising loan rates, and enforcing credit quotas. Meanwhile, Beijing has supplemented those forms of financial repression with price controls on foodstuffs and energy.

Using sterilization and administrative measures to implement monetary policy is far from optimal. China’s reluctance to let the yuan float means that monetary policy cannot be devoted solely to the task of preventing domestic price inflation. Indeed, that task becomes even more difficult as capital controls are relaxed or evaded, and as China’s trade sector grows and financial innovation occurs.

China needs a more transparent monetary policy aimed at achieving long‐​run price stability. The stop‐​go monetary policy of the 1980s and 90s is less severe today because the PBC has been able to slow the growth of money and credit, but only by flooding the balance sheets of state‐​owned banks with PBC bills, crowding out alternative investments, and imposing credit quotas.

Financial repression and price controls are denying China the opportunity to increase economic freedom and prosperity. Interfering with market prices—whether in the form of undervaluing the exchange rate, capping interest rates, or controlling the relative prices of products, services, and resources—weakens property rights, politicizes economic decisions, and leads to corruption. Those in government who administer the controls gain power, while the people lose wealth and freedom.

The danger China faces from accelerating inflation is that the march toward the market will be reversed by the unintended consequences of state control over financial transactions and private exchanges. History has shown, and the current situation in Zimbabwe confirms, that whenever government fiat money is in excess supply and inflation results, those in power blame private entrepreneurs (“capitalists”) for the higher prices and attack them by imposing price and profit controls. If monetary stability is not restored, hyperinflation will destroy both economic and personal freedom.

Using capital and exchange controls, credit quotas, and price ceilings to substitute for a transparent monetary policy aimed at price stability is becoming more costly, as China’s economy grows and becomes more integrated with the global economy. The challenge for Chinese leaders will be to let go of the legacy of central planning and adhere to a market‐​based monetary policy that allows price flexibility while maintaining sound money and economic freedom.

About the Author
James A. Dorn

Vice President for Monetary Studies, Senior Fellow, and Editor of Cato Journal