The graph below in different variations have been making its rounds on social media in recent days.
It is somewhat odd that it took so long for the number to get the any attention as the numbers this relateds to have been out for a couple of weeks. But frankly speaking I didn’t notice it either at the time. But I surely did now.
At the time the economists at TS Lombard wrote “The sharp contraction in M1 and broader monetary aggregates points to nominal growth falling below zero, assuming past relationships hold.”
For somebody who has been reading my blog regularly this shouldn’t be all that surprising. This is simply the equation of exchange:
M*V=P*Y
The money supply (M) times money velocity (V) equals nominal GDP (or the price level P times real GDP Y).
So what the graph indicates is that money velocity in China is fairly stable and also that there is some 2-3 quarters lead from money to nominal GDP growth in China.
The interesting thing here is of course that nominal GDP growth now has turned significantly negative and this obviously should worry China policy makers deeply as this indicates that China likely already is in the midst of a rather sharp real GDP downturn and deflation is likely to deep further.
As the graph below shows Chinese inflation has already over the past year been very low and even negative for periods and given the development in money supply growth is very likely that China will relatively return to deflation.
Re-visiting Irving Fisher’s debt-deflation
Yesterday the British economist and fellow-monetarist Tim Congdon in a newsletter highlighted the risk of debt-deflation in the way Irving Fisher – the father of the equation of exchange – called debt-deflation.
I think Tim is right in highlighting the this risk. China’s debt debt problems and the housing crisis are level know and as Irving Fisher highlighted back in 1931 in his famous article The Debt-Deflation Theory of Great Depressions, the two dominant factors in causing great economic depressions are over-indebtedness and deflation. Fisher explained that these two factors interact in a vicious cycle, where efforts to liquidate debt lead to falling prices, which in turn increase the real burden of debt. This self-reinforcing cycle can lead to severe economic downturns, as seen in the Great Depression.
Fisher argued that without intervention to stabilize prices and manage debt levels, economies risk falling into prolonged periods of recession and deflation, exacerbating financial crises.
Or said in another way if China wants to avoid a negative debt-deflation spiral then the People’s Bank of China (PBoC) needs to act so to ensure China moves away from the deflation.
Currency depreciation is the only way out of deflation
Therefore, the PBoC clearly should take action to ease monetary policy significantly. This would cause nominal GDP growth to pick-up, which certainly would ease the pain from the housing crisis and significantly reduce the risk the banking problems in China worsens further.
However, as I noted in an interview back in May this would also imply that the PBoC would have to accept a significant weakening of the Chinese renminbi. Something both the PBoC and the Chinese Communist party (CCP) seem very reluctant to accept.
From a political perspective the CCP and the PBoC are politically stuck between a rock and a hard place. The reason for this is that both structurally (due the a very significant slowdown in potential real GDP) and because of the risk of debt-deflation we should expect a real depreciation of the renminbi.
However, note that I here write REAL depreciation. A real depreciation can happen in two ways. First the “easy” way – simply allowing the currency to depreciate in nominal terms. There is no real economic problem in this – particularly if most of the debt is domestic (as it is in China and has been in Japan that for 30 years have been struggling with similar problems).
The other way to get real depreciation is the way it was done in Japan for more than two decades – trying to get the currency more or less stable (or even ensuring a nominal appreciation) but then having low inflation – or even deflation – than the outside world.
This is of course what happened in Japan which has meant that there has never really been a resolution of Japan’s debt and housing problems.
I my view Chinese policy makers so fast has failed to recognize the real dangers of debt-deflation and to me it looks like the CCP and PBoC are too afraid to do the right thing – push for a NOMINAL depreciation of the renminbi – repeating the mistakes of the Japanese governments and the Bank of Japan over the past 30 years.
But why not do the right thing? The reason in my view is twofold.
First, is “buble regret”. The CCP and particularly president Xi likely have been somewhat disgusted by the fact that many Chinese have been hunting for wealth by investing the property market and they know that it essentially has been wrong to try to keep the economy growth faster than potential growth (which has been slowing fast) by re-inflating the housing bouble. This is exactly what was driving Japanese policy makers for years.
Second, and likely more important the Chinese Communist party fear the people’s reaction to a sharp depreciation of its currency. Since the early 1990s the CCP’s claim to fame – after the catastrophic Mao years – has been the the CCP has been able to through it’s economic reforms has been able to lift income levels of the Chinese population massively.
However, the free market reforms ways behind China’s growth miracle have clearly been scaled back over the past decade and at the same time the very significant negative demographic headwinds are slowing growth.
And the clearest way to see this is the beginning real depreciation of the renminbi. At least for economists. We understand the real depreciation reflect a gloomier growth outlook. However, to the average Chinese this problem is less visible – at least as long as the NOMINAL currency rate is more or less stable.
It might be the CCP seem to have full control over the Chinse public – China is massively authoritarian – but the CCP clearly fear that one day the Chinese public will rise up against the dictatorship. A nominal depreciation of the renminbi would – at least in the heads of people like President XI – would make such a uprising significantly more likely.
Consequently, the right policy would be currency depreciation, but that it not the preferred policy of the CCP.
Rather it is very clear that the CCP has long ago moved away from the path it took during the 1990s and 2000s where free market reforms and at least particial political liberalization created the Chinse growth miracle. Now the CCP is back to use the heavy hand of government – also to control the economy and in my view we are likely to see more of that going foreward and all indications are that President Xi fundamentally has no economic understand and the economic “understanding” he has is basically not much different from Mao’s Marxist teachings.
Renminbi should be weakening – it is strengthening
Hence, it is very clear that there is a disconnect between what is the right policy and what is being done and recently this seems to have gotten even worse. In fact since we go the very negative M1 numbers for July the Chinse Renminbi has strengthened significantly against the dollar.
This remind me a lot about what was happening to the Japanese yen during the 1990s and early 2000s. Domestic savings was increasing (because of deflation-fears and banking problems) and deflation was become ingrened. This caused the yen to appreciate in nominal terms, which both through lower import prices and increased debt problems and a contraction of the money-multiplier that cause money supply growth to slowing further just made the deflationary problems even bigger.
For years Japanese policy makers refused to do anything about it – it just got worse. A lot of economists for a long time thought that the BoJ would undertake bold steps to ease monetary policy and the Swedish economist Lars E. O. Svensson suggested what he called a fool-proof way out of deflation – simply intervening directly in the currency market to weaken the yen. But the Japanese government and the BoJ for years refused to do that even though it would have been the right thing to do.
Governments and central banks often make mistakes – and sometimes the continue to do so for years. Not because it is good policy but either because they are misguided (that was mostly the case in Japan) or because they have other incentives – like stating in power (that is the case in China).
In the above mentioned newsletter Tim Congdon argues that the Chinese authorities likely will be able to avoid a debt-deflation crisis. While I obviously agree with Tim on the economics of this – we are after monetarists both of us – I disagree on the politics. The Chinese Communist Party has unfortunately long ago reverted back to its Marxist thinking and in my view we are more likely to see a lot more state control of the Chinese and likely also a lot more political repression before the authorities will undertake the right policies to curb the debt-deflation spiral.
If you want to know more about my work on AI and data, then have a look at the website of PAICE — the AI and data consultancy I have co-founded.