Prepare for the next phase of the credit crisis: inflation
The refresh, the first four phases were:
1. A US household debt crisis (2000-2006), spilling over into banks' balance sheets
2. A global bank balance sheet crisis (2007-2008), shutting the economy from lending
3. A global near-debt-deflation recession (2009), where governments socialized private debts
4. A sovereign debt crisis (2009-now), which unhinges the international financial system
As said, the next phase wil be inflation (probably, stagflation) and China has been leading the way.
As in the run up to the credit crisis (the 1980s-2007 Great Moderation) and the aftermath (with lots of quantitative easing, or QE), we need to examine how effective the policies are.
QE has not been so far, and with 'QE2' expiring this month (june 2010), prepare for QE3.
Inflation fears in China are being battled with increased bank reserves, and other ecoom,ies may well follow this. Like QE, we need ot ask does it work?
The first piece in this disucssion says it won't. A next one explains why QE did not work.
China Is Not Locking Up Its Cash
Last month the People's Bank of China, the central bank, raised the amount of money that large commercial banks must hold in reserve to 20.5 percent, effective from April 21. The aim of the measure it is to mop up excessive liquidity and control inflation. Commentators estimate it will take about 376.4 billion yuan ($57.66 billion) out of the market and affect lending of about 1.71 trillion yuan.
Will it work? The track record is not good: this is the tenth increase since the beginning of 2010 and inflation is rising to 5.4 % in March. That is unsurprising, for it has been tried before - and failed. The People's Bank people may not realize it, but their policy is a copycat of the British ‘special deposits’ and ‘supplementary special deposits’ measures, which decreed British banks hold more cash with the Bank of England. While this policy ran from 1960 to 1980, inflation in Britain rose steadily in the 1960s and exploded into double digit territory in most years in the 1970s.
Then as now, the policy is based on a misunderstanding of what banks do. Banks are not firms facing a cash constraint so that taking away cash from what they can spend will limit their spending, and all we need to do is replace ‘spending’ with ‘lending’. It is better to think through what will happen than to follow intuitions based on a vague analogy of banks with firms. The reasoning is in fact fairly obvious. Here is the problem.
A Chinese bank is going to be forced to sell some of its investments and hold the cash in its deposit with the People's Bank. What will the People's Bank do with it? Like any bank, it has to balance its books and put the money somewhere. Central banks do not have all that many options for putting money somewhere. They either lend directly to government, buy treasury paper - which also amounts to lending to government - or buy paper from non-government parties (e.g. bills of exchange or repos). In short, Chinese banks sell investments to the markets to increase their cash deposits at the People's Bank, which uses it to buy investment in the same market. No money has been ‘taken out’ of the economy. All that happened is that money has been shifted around, from one investor to another.
Just like the British special deposits policy, the Chinese measures are really a zero-sum game at best. There are two ways in which they might actually backfire. By increasing the number of transactions in the markets, they might push up demand for money, and thereby prices and inflation. And banks which are forced to hold low-interest cash deposits at the People's Bank will seek to raise interest on other deposits, so increasing inflation through the cost channel.
The results may seem counter-intuitive, but only if you started with the wrong analogy. The larger lesson – for the Chinese as for others - is that money is not a liquid mass to be mopped up at will by the authorities. The money supply is the total amount of liquidity contracted in private and public creditor-debtor relations. That total amount is not changed by requiring that banks hold 20.5 percent (or any other figure) in deposit with the central bank. The central bank will invest it back into the economy - somehow, somewhere. It must balance its books, too. Effective monetary policy requires a realistic look at the accounting relationships that make up our financial system.
Dirk Bezemer is an associate professor at the economics and business department of the University of Groningen in the Netherlands.