After mulling over the issue, I have arrived at the position that:
“Money, or what I prefer to call ‘leverage’, is created as a debt/credit relationship mediated by a bank. Once created, electronic money in particular must be lent and cannot be destroyed (other than by the originating central bank) or stored in large amounts, except by cancelling out a debt against a credit.”
The central problem is that the money supply depends on a process that is inherently unstable. Positive feedbacks can generate increased or decreased leverage (or lending) faster than any changes in underlying economic activity.
In response directly to increased lending (or leverage), or simply to increases in the money supply, asset prices, too, tend to increase and decrease faster than any changes in, say, the productivity of the economy one might naively suppose ultimately supports their price.
Now, in the description of the leveraging process, above, I’ve stressed that money is only normally destroyed when debts are cancelled against credits.
The foreign reserves of other countries are therefore a semi-permanent reservoir of a given currency that is extremely difficult to remove from the system.
It seems that China is determined to maintain its currency peg against the dollar, in order to maintain export-led growth, and as a buffer against capital flight in some future economic crisis. This suggests to me that we should ask ourselves two questions, which are really two perspectives on one question:
1. What would have happened had a credit crisis not begun in 2007, triggering the current recession?
2. What will happen if we simply make it more difficult for the banking system to fail, for example by requiring banks to build greater buffers in the good times against customer or counterparty defaults and/or a sudden withdrawal of liquidity from the money markets?
Let’s imagine that the policies to reinflate the bubble by encouraging banks to resume lending are successful – I don’t really see why they shouldn’t be, though inflation may start to appear relatively quickly. The following are likely to happen:
1. China (and other exporters) will resume their growth and continue to add to their vast foreign-currency reserves.
2. Property and other asset prices will recover from what will be seen as a “correction”.
3. Commodity prices will also resume their upward path. Oh, of course, it was just another “correction”.
There are a number of possible scenarios. First, a couple of possibilities if we don’t recognise the problem:
1. The bubble bursts in a similar way to the present situation – that is, with another banking crisis. But the problem is, we’ve made the banks stronger. Asset prices will therefore rise even higher and even more $trillions of capital will be lost before markets bottom out! I would anticipate that sovereign debt could be more of a problem next time round, for several reasons:
– countries such as the UK and the US may not have had time to clear the vast overhang of debt they’re taking on this time round.
– the huge investments by China and others in Treasuries will have kept their yields low, so governments will have been lured into becoming overextended. When the wind changes they will find themselves unable to roll over the debt.
– the banks will lose more money next time round.
2. The surplus moves either to resource exporters or new low-cost manufacturing countries. Manufacturing exporters such as China may start to find their surplus eroded (like India’s) by the cost of raw materials. Or, new entrants – perhaps in Africa – may emulate China’s strategy of export-led growth based on policies such as exchange controls to keep their currency low. Either way, the outcome is likely to be broadly the same: increasing trade imbalances and asset-price bubbles. Nothing much will have changed except for the distribution of surpluses and the height of towers in Dubai – 2 kilometres rather than 1, perhaps.
On the other hand, China (which, remember, I’m using as shorthand for a number of countries) may take some steps to alleviate the problem:
1. Most obviously they may diversify their reserves into other currencies, perhaps into the euro. This will simply move the problem – or, rather, spread it out. Asset bubbles will be more widely distributed, particularly in Europe. The crisis will again be worse, because it will take longer for the weak point to reveal itself. And when it does more asset prices will have further to fall.
2. Or perhaps they diversify their reserves into gold. This is very likely to happen, but since it will simply transfer a portion of reserves to prior holders of gold and resource countries (and likely create a gold price bubble), the outcome is likely to be similar.
3. Inflation corrects the situation. Now, what would actually be needed is inflation in China or deflation in US to equalise purchasing power (at the currency peg) in the two countries. Unfortunately, this is very unlikely to happen:
– in the short-term, the US is trying to inflate by, among other things, printing more money.
– the effect of the Crunch on output in China and other exporters is likely to be more than in the deficit countries. There’s a nasty aspect of the situation here: countries which need to revalue (Japan, China) to solve the long-term problem are more likely to be able to devalue during the downturn! With the currency peg, though (China having allegedly flirted with the idea of actually devaluing the currency!), costs in China (wages, raw materials, property) could conceivably fall more than in US. This is the complete opposite of what’s needed to prevent the trade imbalances causing new bubbles and a 2nd Great Crunch.
– because of the manufacturing dynamic, productivity in China is bound to grow faster than in more mature economies. This will have the effect of reducing costs in China relative to their trading partners – making the situation worse, not better. One relatively hopeful possibility is that technological innovation – green energy, perhaps – reduces production costs in developed countries at a faster rate than economies of learning and scale can in China. But most likely such technologies will be deployed in China as well. And for the sake of the planet, let’s hope they are!
– China develops a consumer economy. This would, perhaps, let us off the hook. But is China about to institute the mechanisms – such as trade unions or a much higher minimum wage – that would allow its people to raise their living standards? I doubt it – they still have 100 millions living in rural areas who will demand to be lifted out of poverty, so can’t simply lift the wages of the existing urban workforce.
4. The only real solution is for China to reduce its surplus by allowing the renminbi to rise as soon as the current financial crisis is over (ideally before, but that’s wholly unlikely). The trouble is, this will export jobs. Can China come to terms with this? Could the benefits in terms of faster global economic growth outweigh the disadvantage of slower relative growth in China?
As I said, I’m referring to China as shorthand for a number of countries, but its effect on the global economy is huge and likely to become even greater, so, scarily, the future course of the global economy could depend on a single set of decisions by a small group of people.
It therefore seems that if China is not able to come to terms with allowing the market to set the value of the renminbi, we are fated to see at least a repeat of the Great Crunch, and possibly an era of instability.
Worse, the global community may lose its resolve if we go round the same loop again in a decade or two, and the 2nd Great Crunch could result in a lurch into protectionism – and maybe wars.