The Spreading Chinese Inflation

China has been printing a lot of money for a long time in order to keep the yuan low which befitted their export sector. As a result of their policy they accumulated massive foreign exchange reserves, and had giant trade surplus. Since China has over one billion people and since most of them where farmers up until the 1990's the money printing didn't cause wages to rise dramatically. (Money flows to places where supply is tight and China had abundant labor.) So the money went into commodities, real estate, and stock prices in China. But now something totally different is happening. China's trade surplus is gone, food prices are rising and wages too. This combined with weak exports and a weak euro is killing China corporations' margins and we have a classic wage and price spiral. – Israel Financial Expert Blog

Dominant Social Theme: China is just fine. Let the yuan float.

Free-Market Analysis: This is a treat. We were scrolling through the 'Net and came on this June China analysis laid out in an Israeli blog that bills itself as one that offers "a Libertarian and Austrian View on Economic, Financial and Geopolitical Issues." Since we have been writing about Chinese inflation for well over a year, long before it was fashionable (and received considerable reader push-back for our troubles), we were gratified to read an analysis that not only conforms to our sense of what is occurring in China but expands on it.

The analysis itself, within a blog-setting, obviously does not represent a mainstream dominant social theme. But it is quite relevant to our mission as it rebuts an increasingly important one: "China is a healthy economy with nearly 1.5 billion people and its continued economic vibrancy will salvage sad Western economies."

In fact, real estate is in a bubble in China, and now the inexorable process of inflation is beginning to show up elsewhere in that vastly populated land, most notably in commodities and food prices. What this article tells us and what we have regularly maintained is that the old men running the vast Chinese economy from behind the scenes are in no position to "manage" the Chinese economy into a Keyensian "soft landing."

A soft landing is probably the last thing the Chinese leaders want. (They don't want a "landing" at all.)  Leading China into a glorious future of ever-expanding wealth and prosperity is a way to cling to power in a country where the alternative to maintaining power at such high levels is pretty awful. Incarceration or even death, we would suggest. Here's a little more from the article:

The price/wage spiral represents a vicious circle process in which different sides of the wage bargain try to keep up with inflation to protect real incomes. Thus, this process is one possible result of inflation. It can start either due to high aggregate demand combined with near full employment combined with an increase in the credit and money supply. As the spiral evolves, business owners raise prices to protect profit margins from rising costs, including nominal wage costs, and to keep the real value of profit margins from falling. At the same time wage earners try to push their nominal after-tax wages upward to catch up with rising prices, to prevent real wages from falling. So "wages chase prices and prices chase wages," persisting even in the face of a recession. The spiral is also limited if labor productivity rises at a quick rate. Rising labor productivity compensates employers for higher wage costs while allowing employees to receive rising real wages, and allowing the company's margin to stay the same.

Of course if the money supply does not expand, then the "price wage spiral" would not occur. Business, after all, does not attempt to "protect profit margins" ... it tries to maximize profits. The reason that high economic growth and inflation are often observed together is that when the government creates inflation by printing fiat money, the inflation tricks capitalists into increasing production, which creates the illusion of an economic boom. The "spiral" of increasing prices and wages, however, can only continue as long as the government continues to intervene in the economy by inflating the money supply.

And so the Chinese central bank does what all such banks do. It prints money. While the overprinting of money begins by affecting one sector of the economy, inexorably, over time, it begins to spread. There is nothing mysterious about the process. The Israeli article does not make clear distinctions between inflation (the overprinting of money) and price-inflation, the result of an over-printing of money, but both are part of the process. The inflation in China has already taken place, and is ongoing. The government no doubt continually overprints money. But from a citizen's standpoint, it is price inflation that does the damage.

The wage-price spiral analysis is pretty much dead-on from our point of view. It is yet another aspect of Chinese economic reality that is not being reported by the mainstream media which has focused of late on the rising Chinese stock market. Of course as we have pointed out numerous times, Chinese equity market are even more manipulated than Western ones. And elsewhere we read that the reason for Chinese equity progress has more to do with yuan manipulations and hot money flowing back into the Chinese markets from overseas – temporarily anyway – than any other issue. Rising markets, in other words, are not a testimony to the management skills of Chinese leadership.

And why should they be? The Chinese communist leadership lost most of its credibility during Mao's anti-intellectual "great leap forward" which ended up costing the lives of millions of Chinese due to hunger and violence. The second time the bell tolled came when the government decided to use violence to put down the Tiananmen Square uprising. Regardless of the reasons for the social protests (and they were apparently pro-socialist ones) the reactions of the government made the social contract clear. The government would provide prosperity if the larger mass of Chinese would cease to question authority. And that is the uneasy peace that holds today.

The Chinese leadership has two strikes against. But the merciless gunning of the Chinese economic engine through money printing has gone on far too long. Inflation is dispersed throughout the system and the chances of "sterilizing" the money are nearly zero, even were the leadership willing to do so.

Inflation has psychological consequences. People begin to expect rising prices and change their purchasing habits accordingly. They begin to buy more and borrow more, anticipating less purchasing power tomorrow. The velocity of money increases throughout the system, with attendant credit increases as well. Workers demand higher salaries (which Keynes called "wage push) and this in turns feeds the price appreciation.

Conclusion: Once entered into, this sort of upwards spiral is not easily broken. In fact we would argue it is the inevitable outcome of China's aggressive monetary policies. The old communist men of China, were delighted years ago to rediscover the almost magic benefits of the printing press – no doubt at the behest of certain elite Westerners. What wasn't explained at the time was that printing money in great gobs has a downside. Those that expect China to provide the engine that pulls the rest of the West out of the current slump may want to rethink this perspective. Inflationary processes such as the one on which China is embarked rarely (or never) end well.

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