My Blog

August 15, 2008

Today is an anniversary of sorts.  Thirty-seven years ago, in 1971, President Nixon stunned the US by announcing the imposition of extensive wage and price controls in an effort to reverse rising inflation in the US.  In retrospect it is pretty clear that the price and wage controls were unlikely to reverse several years of booming money creation, and even the WIN buttons (“Whip Inflation Now”) distributed by President Ford a few years later weren’t enough to do the trick

The EconReview gives a short, potted history of the time:

In a move widely applauded by the public and a fair number of (but by no means all) economists, President Nixon imposed wage and price controls.  The 90 day freeze was unprecedented in peacetime, but such drastic measures were thought necessary.  Inflation had been raging, exceeding 6% briefly in 1970 and persisting above 4% in 1971.  By the prevailing historical standards, such inflation rates were thought to be completely intolerable.  The 90 day freeze turned into nearly 1,000 days of measures known as Phases One, Two, Three, and Four.  The initial attempt to dampen inflation by calming inflationary expectations was a monumental failure. 

…The wage and price controls were mostly dismantled by April, 1974.  By that time, the U.S. inflation rate had reached double digits.  While there were skeptics in August, 1971, there were a great many who thought "temporary" wage and price controls could cure inflation.  By 1974, this notion was thoroughly discredited, and attention gradually turned toward a monetary approach to inflation.  In a complete reversal, the policy to curb inflation in now thought to be an increase in interest rates rather than an attempt to hold them down.

A quick look at inflation rates in the US show that inflation had reached a temporary peak of 6.19% in 1971 Q1, and had been declining when Nixon imposed the controls in the middle of Q3 (5.46% and 4.26% over Q2 and Q3).  It continued to decline thereafter for several more months, reaching a low of 2.18% in 1972 Q2, before reversing course and marching upwards over the next two years to hit a second temporary peak of 12.38% during the third quarter of 1974.

After another period of improvement over the next two years (inflation declined to 4.21% by the second quarter of 1976), prices began another surge, which took inflation up over four years to a high of 10.36% in the fourth quarter of 1980 (it actually peaked in March at nearly 15%), after which time the very sharp and brutal economic contraction engineered by Paul Volcker of the Fed brought inflation back down again.

One has to be careful about drawing lessons.  What happened to the US in the 1970s tells us nothing about what must happen to China today, but it is worth remembering a couple of important points.  First, following a period of rapid monetary growth, which at first was able to deliver rapid economic and productivity growth, booming stock, real estate and art markets, and low inflation, the consequences of excess money creation only later led inexorably to higher prices.  Although a number of economists proposed higher interest rates and tighter money to combat the rising prices, the first instinct of Nixon’s economic advisors was to protect economic growth by using administrative measures to rein in inflation.  This didn’t work.

The second important point is that the process of rising inflation is rarely a straight line.  The US saw several fairly long-term reversals of the upward inflation path, but these reversals were temporary as long as the root cause of inflation – excessive growth in money – was not addressed.  In the end, however, the overall trend was upward and the cost of reversing it was significant – and it probably lost the election for Jimmy Carter.

One of the things we are wrestling with here in China is the extent to which the US experience is relevant.  In many ways it is not.  For example, today the National Bureau of Statistics released a report that had total investment in fixed assets for the first seven months of 2008 at RMB 7.2 trillion.  This represents 27.3% increase over the same period last year.  For the six months before July, FAI grew by 26.8%, and most analysts were expecting July’s number to be a little below that.  FAI is clearly very high.

I have been discussing the implication of these recent figures, including PPI and CPI inflation numbers, with several of my friends.  One of the questions that is always raised is about the transmission mechanism from high PPI inflation to rising CPI inflation.  On the face of it the surge in FAI suggests a future surge in industrial production that, especially given faltering global demand, is likely to create an oversupply of manufactured goods in China, which should make it more difficult for producers to pass rising costs onto consumers.  In that sense, it seems that the reduction in CPI inflation may be sustainable, even with last months’ unexpected jump in PPI inflation.

But I have to confess that I have a problem – perhaps instinctual – with this line of reasoning.  It is true that an excess of manufactured goods should put downward pressure on prices of those goods – or at least limit the ability of producers to raise prices – but is this enough to eliminate inflation?

The way I see it, excess money growth creates excess demand for goods and services at current prices.  This excess demand isn’t necessarily uniform, but it exists, and it should result in rising prices on average.  During the past year in China, the excess demand coincided (perhaps) with problems in the food supply, so that food prices soared.  There was a lot of talk a few months ago about food hoarding, and this talk has all but disappeared, so it may very well be that rising food prices were at first exacerbated by speculative hoarding, but at some point this behavior in turn put downward pressure on food prices as speculators sell off stocks (I am only guessing that this might have happened but have no real proof).

At any rate rising food prices absorbed all or most of the excess demand, so that there was little upward price pressure on the non-food sector.  In fact, there should have been significant downward price pressure on the non-food sector given the huge run-up in food prices, but we actually saw non-food inflation low but rising. This, by the way, is why I believed and still believe that inflation in China was caused by monetary conditions, and not by a food-supply problem.

What happens if rising FAI and surging industrial production now put downward pressure on the prices of manufactured goods or, at the very least, make it hard for companies to pass on price increases?  One obvious thing is that profits will sag, bankruptcies will rise, and companies will eventually be forced to cut back sharply on investment and production (exports might also surge).

But what happened to the excess demand caused by excessively rapid money growth?  It still has to have an impact on the average price level.  One possibility may be that we will once again see food consumption surge and, with it, the price of food.  Another possibility is that price increases will show up in the service sector.  A third is that they show up also in the price of manufactured goods that are not in oversupply, where there will be bottlenecks.  Inflation, in other words, won’t disappear.

There is also another, perhaps even less benign, scenario.  It is possible for there to be no inflation because there is a sudden collapse in the money supply.  

How could that happen?  In a worst case scenario rising bankruptcies could put so much pressure on the banking system that Chinese banks would be forced to cut back on lending and Chinese banks and businesses would begin to hoard liquidity.  This would result, I believe, in a sharp reduction in money supply (via a collapse in velocity perhaps?) that would cause China to exchange the risk of inflation for the risk of deflation.  

I think this is what happened in the US in the 1930s.  Following a period of rising inflation in the 1920s – and for many of the same reasons: a rapid expansion in the US money supply caused by massive reserve accumulation in the 1920s – the overextended banking system was unable to survive the economic downturn, and a previously inflationary period was suddenly converted into a period of sharp deflation.  There was even a 2-year period at the end of the inflationary period (1927-29) in which the US was absolutely swamped with speculative inflows. 

There are lots of different periods in US economic history to look at to get a sense of some of the issues that China needs to deal with.  Unfortunately none of this makes prediction easy, but I think there is one prediction I can safely make: so many years of wild money growth must result in an adjustment and this adjustment is not going to be easy.  Whether the adjustment results in inflation or deflation depends crucially, I think, on the state of the banking system and the reaction by banks to an economic downturn.

On another note, the stock market had its first good day in a while.  It closed at 2461, up 0.9%.  Most of China is still focused on the medal count, although I should mention that we’ve had our first day of really beautiful weather in Beijing today.

Comments (16) for "Anniversary of Nixon’s price...

I wonder if the recent surge in fixed asset investment has something to do with the reconstruction in quake zones. About 1 trillion RMB will be spent in the next 2 years. That gonna add 1 or 2 points. By fatbrick - 8/14/2008 9:21 PM

I hadn't thought of this way of looking at it. At the time August 15th 1971 was the day Richard Nixon's Treasury Secretary Texan John Connally took the dollar off gold. That move set off a major international controversy on monetary arrangements which lasted down to the Rambouillet Conference of 78 or 79. The dollar became a petro-dollar and overseas holdings of dollars really began to climb into the 100's of billions. Seems kind of chump change by now! By Chris - 8/15/2008 11:06 AM

'The way I see it, excess money growth creates excess demand for goods and services at current prices.' 'What happens if rising FAI and surging industrial production now put downward pressure on the prices of manufactured goods or, at the very least, make it hard for companies to pass on price increases?' 'But what happened to the excess demand caused by excessively rapid money growth? It still has to have an impact on the average price level.' Is the answer not right there in front of you? FAI (unless mostly real estate) will increase industrial output, presumably by 27,3% or more. What seems like excess money today will be matched with produced goods tomorrow. In simplified logic, there should not be much actual 'excess' money at all, and CPI inflation should be lower than expected, unless velocity turns up high until the increased output comes to market? By AustrianStalker - 8/15/2008 4:59 PM

Dear Prof, the last paragraph of the FAI report states: "In terms of volume of positioned funds, investment in urban areas hit 8,205.7 billion yuan, a year-on-year rise of 24.1 percent. Of which, domestic loans, foreign investment, and self-rising funds rising 15.3, 3.3 and 31.7 percent respectively, year-on-year." Does self rising funds cover the informal banking system? Does it mean that the main driver behind investment groth now are underground banks? By Gabor - 8/15/2008 5:28 PM

AustrianStalker's post sounds like a monetary version of Say's Law: money supply will create its own money demand. Shouldn't there be some relation between growth in income and non-inflationary growth in money? After all, substantially less than 100% of income is spent on buying industrial goods, and anyway we shouldn't assume that 27.3% growth in FAI (and it was much lower in previous months) accomodates just about any level of money growth. By Jack Zhang - 8/15/2008 5:31 PM

Fatbrick, I think you may be right, although I don't yet know the timing of the FAI disbursements in Sichuan. It might also be worth considering that to the extent that a portion of FAI is simply replacing facilities destroyed by the earthquake, it does not add to total supply of industrial goods. Chris, yes, the date is more often remembered as the day the US went off gold. It is worth remembering the futile fight against inflation, however. AustrianStalker, I agree with Jack Zhang's point. It is true that the increase in production will accomodate some money growth, but a sharp rise in production does not justify every and any increase in money supply. Gabor, I think "self-rising funds" are retained earnings. To tell you the truth I am not sure where informal bank loans come up in these numbers (perhaps someone who knows might comment), although with short terms and very high interest rates, probably little of the informal bank loans go to fund investment. Anecdotal evidence suggests a lot of it goes to fund short-term liquidity needs. By Michael Pettis - 8/15/2008 5:48 PM

Mr Pettis leveraging your investment, eg using informal bank loans to invest, is potentially fatal isn't it? even in relatively calm waters, you've got to be sure of ultimate returns giving you a rate higher than the loan rate at the very least. if informal bank loans are going in any significant % to investment, that'll be homegrown hot money, not something the government would like, that, in fact may pull down the house of cards, there needn't be even the usual head for the exits stampede, just lots of companies closing down and people losing money. By Judy Yeo - 8/15/2008 9:01 PM

Don't forget assets Michael. There is no reason why money should not bid up the price of assets just as easily as goods and services. In fact, since China seems to have quite succesfully sterilised the effect of its currency interventions on base money, money growth has occurred largely in deposit money, and such balances may well be seen more as substitutes for other financial assets, especially if they pay a little interest, than as a means of payment for goods and services. Your point about velocity is a good one; if other assets are a bad prospect, perhaps investors are just happy to hold deposits. By RebelEconomist - 8/16/2008 1:49 AM

By the way, regarding your last sentence, I hope China does not make too much of their position in the medals table. I am old enough to remember when a main contender in that competition was East Germany. In fact, per capita, they were way ahead of any other nation. Where is East Germany now? Anyway, today, the interest-weighted medals table is being led by Jamaica. By RebelEconomist - 8/16/2008 2:06 AM

The 'misery index' of combined inflation and unemployment used by Mr. Reagan to defeat Mr. Carter in 1980 tells only a portion of the tale. Mr. Carter's breath-taking incompetence in protecting American citizens held hostage in Iran had much more to do with his defeat for re-election than the inflation numbers did. By a Duoist - 8/16/2008 3:48 AM

Dear Leader, Where are you now, Comrade Mao, when we need you? Pls come back to again take your long swim across the ChangJiang, and tell your fellow comrades if it is not true that the ChangJiang does not stink to high heaven. Look at the HuangHe, our chairman, oh holy one. Pls come back from your Tiananmen mausoleum to put these profligate capitalist economists in their place. As it has been said, by the Duoist, the misery index is always rising, even while the East is still Red. Comrade Mao, we pray for your resurrection, and your casting out of these profligates who are despoiling the land, and overturning your communist revolution, and destroying the pure environment of China, the motherland, which we all hold so dearly. Please Comrade Mao, rise up from your grave, so that the HuangHe can once again flow, every day, to the sea. Not just once in a while. By Ms. Nak Amichi - 8/16/2008 9:19 AM

Hey, JinTao, I know you are reading it. Just, pls tell us what it means to have a staggeringly high GDP growth rate, combined with a staggeringly high and unprecedented devastation of China's natural environment, rate. Do we need to put our books in order, Mr. Hu? Debits and Credits? No way. You totalitarians always hide from the truth, mostly under the nearest rock. You think slime is sublime, I guess. Skew you, Mr. Hu. For continuing to ever skew the truth! By Ms. Nak Amichi - 8/16/2008 9:45 AM

Let everyone keep in mind, while Mr. Phelps on his mission almost impossible, has been splashing around in the pool, and while he has been captured in so many striking images with water bouncing off his beautiful body, there is another side to the story. In Hebei, the poor farmers who had their water diverted to Beijing so that Mr Phelps and others could splash around: In truth, these farmers do not have much more than a drop to drink, nor water for their crops.. Does this story get covered as it should? Rise up! Do what is truly in your heart, Farmers of Hebei. Speak out. And cast out any government that you think does not adequately represent your best interests. They steal your water this time. Next time, what will they steal from you? Your manhood? By Ms. Deep-Dry Throat - 8/16/2008 10:11 AM

Whom among us has not heard it said that the rats are the first to flee a sinking ship? And whom among us does not know that the water table, and the water situation in Beijing, is sinking fast? Well, who are the rats that will flee first? Could it be the economists? Probably not. They will just stick around to find out if their models were correct, having no real stake in the society. They will eventually leave like flies, pouncing on the next carcass to lay their miraculous eggs on their next experimental subject. So, which rats will be the first to flee? From Beijing? We will see. Let us just hope that the first people to flee are not those whose heads were lopped off due to substandard products, taking bribes, or just doing basically not much wrong, in the least. This would be too scary, having all those Chinese relatively faultless Ichabods running around without heads. Or, if they had their heads, then there would probably be a small hole just behind the ear where they paid for their expert, instantaneous, drilling through the noggin. The rats will remain. The first sector of people to leave will be from the bottom up. Then, it will be wonderful to be able to find a huge Beijing apartment, cheap. But, who will the comers be, with no water, no swimming pools, and no greenery? Could it be the next generation who have adapted to live without water? And, will water become a liquid or fungible commodity, in Beijing? In the future, of course, no need to post signs. No need to tell anyone not to spit. As much as I like spitting, I just don't think Beijing will have enough water to waste on this lovely habit. Is it really true that Beijing could run out of water? This is not a state secret. Except in Beijing. The facts are very obvious. And have been for the past 20 years. It only need a 3rd Grader to do the arithmetic. Of course, all the old aquifers/springs that used to dot Beijing have long since dried up. Now, the only last bit of water available just might be to collect the sweat from the well meaning economists that still dot the land. By Ms. Goodlast Drop - 8/16/2008 3:29 PM

I don't understand why people don't care about the 60% decline in stock market. Ekonomix <a href="http://turkeconomy.blogspot.com/">http://turkeconomy.blogspot.com/</a> By Ekonomix - 8/19/2008 2:29 AM

"I don't understand why people don't care about the 60% decline in stock market. Ekonomix " The reason they do not care, is because you are reading a blog written by smart people who all sold their shares around October 2007. Either that or, as you know, these economists will never admit to a loss. They think they are HS gods. So, when they lose money in the market, like the good gamblers they are, they keep a stiff upper lip. This is why. But, be sure, some of those tight wads lost a grand amount of money. Does this make you feel better? By Mr. Duh - 8/19/2008 6:55 AM