"slouching dollar, hidden inflation" c
Slouching Dollar, Hidden Inflation
By DAVID RANSON
March 29, 2007; Page A17
After a year and a half of more than 100% rates of appreciation, China's stock market abruptly tumbled nearly 9% on Feb. 27, bringing down world-wide markets in its train. Coupled with bearish stories in the U.S media and elsewhere, this has fed stock-market turbulence as investors everywhere began rearranging their portfolios to reflect heightened perceptions of risk.
But where is the supposed new risk coming from? One precipitating factor is a flurry of announcements from Chinese officials of measures to clamp down on their soaring equity and real-estate boom.
Central bankers express intolerance of inflation and are downright hostile to fast-rising property and stock-market prices. It appears that they cannot distinguish between symptoms of prosperity and symptoms of currency debasement -- certainly they act as if they can't. What makes them really go to town is a situation where accelerating inflation coincides with a boom in equities and/or real estate.
Until now the People's Bank of China has shown admirable restraint in the face of protectionist demands from the U.S. that it float its currency. But now it has succumbed to the same anti-growth doctrine that hamstrings the private economies of North America, Europe and Japan -- and is far along on a well-traveled path.
Throughout the world equity prices have a history of vulnerability to official fears of "irrational exuberance" that prompt actions aimed at restraining bull markets. This is what former Fed Chairmen William McChesney Martin and Paul Volcker meant by "taking the punchbowl away from the party." But as the Japanese learned in 1989, puncturing so-called capital-market "bubbles" is one of the riskiest economic policy actions that a government can take.
The pre-existing conditions for a stock-market plunge in China can be traced back to the U.S. The Chinese authorities have repeatedly expressed discomfort with recent signs that inflation is returning. At the same time the central bank has defied pressure from U.S. economic diplomats and permitted only minor adjustments in the exchange rate of its currency with the dollar. This would have been a happy state of affairs for the Chinese if the dollar itself had been stable. But as the dollar depreciated, the yuan was carried down with it. In pegging their currency to the dollar, the Chinese also pegged their inflation to U.S. inflation and their short-term interest rate to the U.S. short-term rate.
The inflationary consequences of a currency decline are not widely recognized, but they are revealed much more clearly when currencies are measured in terms of gold rather than consumer goods or foreign exchange. Just between the middle of 2005 and the end of 2006 the dollar price of gold rose to $632 from $437 per ounce, or about 45%. The price of gold in Chinese currency rose to 4,945 CNY from 3,622 per ounce, an increase of 37%.
In effect, inflationary pressures have spread from the U.S. to the many countries (including China) whose currencies are linked to the dollar. The official rate of inflation in China is not yet high, but it has been accelerating recently. The Ministry of Commerce forecasts that China's consumer price index will rise by 2.5% in 2007, up from 1.5% in 2006.
A central bank's perennial response to an inflationary boom is to blame private speculation and pursue various measures that block investors' access to credit. Before and after the turbulence hit, the Chinese government has been tightening bank reserve requirements and raising interest rates. According to some, the economic risk to China lies in asset prices that are "unsustainably high," and the economic consequences of government efforts to push them down is merely collateral damage. For example, the Economist welcomed China's stock-market plunge as "a reassuring thing." It reported rumors "that some fund managers might be fingered for insider trading and that the dealing records of their families would have to be scrutinized."
According to other reports, the Chinese government is also planning a hike in the "land appreciation tax" on sales of real estate that could take it as high as 60%. But Chinese stocks staged a partial recovery on official denials of a new capital gains tax on stock transactions.
Central banks are a source of turbulence rather than stability. In a sense, the ultimate cause of the Chinese stock-market debacle is the failure of governments world-wide to keep inflation low now that the gold standard no longer does the job for them. Simply stated, it is impossible to maintain price stability and float the price of gold at the same time. As the table shows, country by country throughout the emerging world, inflation has been directly proportionate to currency depreciation relative to gold.
This relationship was well known to economists as far back as the early 19th century, but new economic doctrine since World War II has led today's economists down a different path. It was the assassination of classical economics by John Maynard Keynes and his followers that led over time to the ejection of gold from the international exchange-rate system, a process that was complete by the time President Richard Nixon repudiated U.S. obligations under Bretton Woods.
Since that time U.S. policy makers have largely attributed the inflationary roller coaster that followed to either excessive demand (too much economic growth), or excessive credit (too much financial freedom). Their own pivotal role in fostering inflation -- the separation of currencies from gold -- has been left unacknowledged. With many of the old truths of classical economics forgotten, currencies fluctuate, and the idea of combating inflation by restoring and stabilizing currency values is almost taboo.
As a result virtually all policy measures that receive official support these days are variations on the theme of killing off economic vitality -- in some ways gentle, some violent -- in order to restrain inflation. This very harsh approach addresses the wrong target. Instead of sponsoring currency stability and facilitating economic success, central banks facilitate currency weakness (and thus inflation) and intervene in the credit markets to curb wealth creation. While excessive access to credit is not the cause of inflation, deliberate hampering of access to credit can be the cause of recession and even depression.
Capitalism is not the only intellectual gift that our government has exported to China. China has joined the central bankers' club. Western officials have exported their misplaced economic moralizing, which has managed to make the Chinese fearful of their own prosperity. Their boom was always fragile. Yet the Chinese government has now adopted an economic policy that could compromise the ability of their private sector to catch up with the West.
Mr. Ranson is principal of H. C. Wainwright & Co., Economics, an investment-strategy research firm.
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