China: Time to Admit To, Then Douse, Our Inflation Fire

I don’t buy into the core inflation number that the press or Federal Reserve use. Today’s Wall Street Journal has an article on the front page entitled “Inflation at 44-Year Low.” When you read further, you realize they are using the bogus core inflation number that strips out food and energy costs to get a 0.9% y/y number. Nowhere does the article mention actual consumer price inflation number of 2.2% y/y.

Everyone is manipulating their figures of course—especially the Chinese. The stimulus the government provided in China to prevent disaster in 2008 has created an enormous inflation problem which the official numbers completely obscure. All prices are running up and out of control. But the government has capped prices to prevent the official numbers from reflecting the actual levels of inflation. An article in Caixin tells the story.

Inflation can be described in many ways, but it’s difficult to define. Still, inflation is easily perceived when rising prices reduce purchasing power and, hence, distort resource allocation.

Inflation in a narrow sense means that prices for consumer goods rise, increasing day-to-day living costs. However, inflation in a broader sense also includes property prices, especially in economies with low home ownership rates and a big need for urbanization, such as China’s. In these economies, property price hikes inevitably reduce purchasing power.

Moreover, in economies where prices are entirely or partially controlled by the government, inflation may not be perceivable by simply looking at consumer prices. Instead, inflation may become evident when there is a shortage of goods, or after enterprises chalk up losses because their product prices are controlled by the government. This so-called hidden inflation leads to imbalances in resource allocations. And when hidden inflation is superimposed on dominant inflation, the result is so-called true inflation.

How does hidden inflation work? In one example, a cap on electricity prices can encourage energy-intensive enterprises to expand blindly, eventually overburdening power suppliers or prompting the government to subsidize energy consumption.

The official consumer price index was up only 2.2% in the first quarter and 2.4% in March. But, its easy to achieve those numbers when the government is artificially suppressing prices. And price controls simply don’t work as we learned in 1971 when Richard Nixon attempted it in the U.S.

In August of 1971, Nixon, with an eye firmly placed on re-election, announced a ‘temporary’ 90 day freeze on wages and prices because inflation was spiraling out of control. The 90 day freeze turned into nearly 1,000 days.  As inflation took hold anyway, the Nixon Shock ended as a monumental failure.

We shouldn’t expect the Chinese to fare any better. Moreover, low interest rates and easy money encourage leverage and speculation. To the degree that consumer prices do not rise, asset prices do. Even more worrying, resource allocation is distorted by these policies as unprofitable businesses and poor stewards of capital receive more than their fair share of investment money. The result over the longer-term is economic underperformance. This is what we are witnessing in China. Caixin writes:

Property prices increased 22.4 percent last year and 14.5 percent in the first quarter, far above official personal income growth rates of 8.8 percent and 9.8 percent for the corresponding periods. More than half of all Chinese people have not bought a house, though, and property price hikes have hurt their purchasing power. Their intentions to save money for future home purchases have also reduced their purchasing power.

Meanwhile, electric power producers have been posting colossal losses due to a conflict between sky-high coal prices and regulated electricity prices. Their combined losses were as high as 40 billion yuan in 2004. At the same time, the nation’s energy consumption rate is rising faster than GDP growth – a clear sign of a distorted resource allocation.

Why is China experiencing inflation? For starters, the country has too much currency: Growth in the broad money supply M2 is far outpacing GDP growth.

M2 rose 17.8 percent in 2008 and 27.7 percent last year. And it’s expected to grow 19 percent in 2010. That means the cumulative increase in M2 over the past three years could be as high as 80 percent. But cumulative economic growth for the same three-year period is expected to reach just 30 percent. This could set the stage for a 50 percent increase in consumer prices if all that currency remains in circulation.

But, it won’t happen this way. Instead, the Chinese authorities will slam on the brakes, precipitating a hard landing.  And when that hard landing materializes, there will be bailouts and subsidies all around. That is how Sir Alan Greenspan did it. That’s how Ben Bernanke has done it too. Why should we expect anything different in China?


Nixon Tries Price Controls – Excerpt from The Commanding Heights by Daniel Yergin and Joseph Stanislaw, 1997 ed., pp. 60-64. – PBS

Time to Admit, then Douse, Our Inflation Fire – Caixin

Originally published at Credit Writedowns and reproduced here with the author’s permission.