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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 spiralling 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?

Sources

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

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

11 Comments

  1. Coldcall says:

    On a side note, though not completely off topic as this is connected to Spain’s woes re EMU; in 1999 the EMU entry inflation in Spain was massive. I’m not sure of the exact figures because the EU fudged all the inflation data over that period in order to cover up for the mass profiteering that took place by businesses overtly rounding up in eiuros.

    However word on the street was that a coffee which had previously cost 100 pesetas now cost 1 euro, similar with a bottle of water. Not sure what inflation rate that represents but surely 20-30% is a conservative estimate. In any case Spanish wages did NOT increase accordingly, so Spaniards actually got poorer after euro entry, however they were fooled into thinking otherwise because of the easy credit which flooded Spain after 2000.

    That easy credit allowed them to think they could afford the new car, appartment etc…but in reality the cost of living had increased far higher than their wages and means to pay for it.

    So when i hear Krugman and other classroom contemplators say that Spanish wages need to drop by 20% i can hardly believe what i am hearing. Its prices which need to decrease relative to Spanish wages, and not just the overpriced property market. Everything in Spain needs to deflate by a considerable amount if there is any hope of balancing that economy with the that of Norther Europeans.

    My view is the inflationary seed was planted during EMU in 1999, and consequently became a hard-wired flaw in EMU which would of course be exposed once the credit tap was turned off for the terribly imbalanced Spanish economy.

    This is why i am so bearish on EMU as a whole. No-one has looked back to 1999 for the real answer as to why southern european economies are so out of whack with the northern countries. No-one talks about the huge inflation in real terms suffered by Spain and probably other PIGS in 1999. Its been completely covered up and ignored.

    Such a system will collapse under its own contradiction no matter how much money you throw at it.

    • Fico says:

      Yep. I was in Amsterdam right during the Euro change over too. I felt like I was the only one who noticed that prices on EVERYTHING increased 100% in 24 hours. Either that or the entire continent can’t do basic math. No one seemed to notice. Strange indeed – I don’t even tell people that b/c I get weird looks…somebody stole much of the continent’s net worth me thinks, they just ain’t talking…

      • crocodilechuck says:

        Fico

        I echo your point; visited Italy just after the Euro changeover-prices SPIKED. But the cafes were full (not just tourists) and people were spending money. I wondered, where was it ($) coming from?

        • Coldcall says:

          Where was the money coming from? Easy credit.

          I can only speak of Spain as i have lived there on and off for many years; but sometime after 2000 Spain was flooded with easy money for anyone who asked their bank manager for it.

          I almost suspect there was a complicity between the architects of EMU and the banks. They had to make credit easy peasy in order for the Spanish not to notice that they had been totally scammed by entry into the euro.

          Im not saying there was a conspiracy but it sure feels like it looking back on it now.

  2. Scott says:

    A price index only matters if you are on a fixed income, social security, or you rely on COLA raises. For those of us trying to increase our earning power, we are still slaves to the market and we only care about more bread. Who cares if they lie? Go out there and call b*llsh*it and ask for more money and get the wage price spiral going full steam. When that happens we’ll know the retirees were screwed and we are worth less than we think we are.

  3. Hal Horvath says:

    “bogus core inflation” — I think this characterization is imprecise. Food and energy prices do fluctuate a lot during any 12 month period, resulting in y/y headline fluctuating randomly and widely.

    If you just knew one month’s y/y headline, you could not say with much confidence what the true average inflation rate is lately.

    Witness how wildly the summer 2008 oil spike ran the numbers up and down. The result is the simple summer 2009 y/y headline readings actually could be called “bogus” if someone was represented they told us all we needed to know.

    Now, if you want to take some average like a trailing 6 month y/y average, for instance, I could buy that as a superior measure. But, in the meanwhile, in terms of reported numbers that we can all refer to, the “core” is superior to the simple y/y headline.