Too Much Money, Not Enough Economy

Credit-Quality Problems in Asia

We spend a lot of time worrying about the economy in the United States, especially as it relates to politics and policy. We’re facing very slow growth, well below the long-term trend, and certainly below what we’re capable of. At the same time, inflation is running well above normal (we reached a 5% annual rate in June).

Europe faces similar problems, although their policy response has been different from ours. The EU’s economic managers prefer to control inflation even if it means reduced industrial output. Here, we do it the other way around.

But while we’ve been reducing interest rates and generally doing everything we can to spur new credit formation and business activity, the exact opposite has been happening in Asia.

For the better part of a year, China and India have been raising policy interest rates and required bank-reserve ratios in a mad attempt to cool off their blazing economies. Just yesterday, India’s central bank raised its benchmark discount rate from 8.5% to 9%. The most comparable American and European rates are 2% and 4%, respectively.

This activity is starting to have an effect, especially in China, which has very effectively popped a domestic stock market bubble that peaked late last year. But the cure is causing its own problems.

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High inflation has been one of the broad themes in financial and business news this year. Most Americans experience inflation as higher prices for gasoline and for products (like fresh food) that include motor transport as a factor-cost.

But if you’re a good Friedmanite as most of us RedStaters are, you tend to think of inflation as primarily a monetary phenomenon. Sure, changes in supply and demand will affect the prices of certain goods and services at different times. But price increases in one sector will generally displace consumption in a different sector. To get the phenomenon we’re seeing now, in which prices are increasing nearly everywhere for nearly everything except labor, someone has to be creating too much money.

Ah ha, you say! It’s the Federal Reserve’s fault, with all the excess liquidity they’ve been creating all year, with the Term Securities Lending Facility, and the Bear Stearns buyout, and the opening the discount window to the GSEs, etc, etc.

But if you watch the Fed very carefully, they’re not over-creating money. The crisis which is gripping the financial world is all about liquidity impairment and an unwillingness to take counterparty risk. The Fed is careful to make sure that credit-worthy institutions have the liquidity that they need to meet their obligations on a nightly basis, which is what’s required to keep the banking and payments system stable.

But none of that activity requires permanent additions to the money supply. And in fact, the Fed has engaged in significant sterilization activities to keep the permanent money supply reasonably stable during this year of crisis. The Treasury has played a part as well, with their regular refunding operations being calculated carefully to provide the most-demanded maturities and manage the shape of the yield curve. The monetary inflation isn’t coming from us.

Instead, it’s probably coming from Asia.

It’s almost certainly the case that the Asians have been overinvesting in productive capacity. It so happens that when you lend money to someone (thus forming credit), you’ve ipso facto done something nearly equivalent to creating new money.

And that works beautifully if the new factories and buildings you build with borrowed money actually pay out. You create a lot of new jobs, make a lot of new goods and services that people need and can pay for, your investors make a nice rate of interest on the money they lent you, the sun shines more brightly and you sleep better at night. It’s all good.

But what if you build too many factories, and the markets aren’t available to buy up all your production? Especially if, let’s say, many your customers are in North America or Europe, and they’re hurting so much from reduced home and stock-market values, that they’re not buying as much stuff as you expected them to?

Now your credits start going bad. People start defaulting on business loans, banks get in trouble and start pulling loans from healthy borrowers, people start getting laid off, and government officials start losing sleep at night.

Officials in China and India are deeply concerned about this possibility, which is why they have been so aggressive about raising interest rates and increasing the reserve-ratios that banks must maintain.

In China, the reserve ratio now stands at 17%, far above the 8% or 10% which is normal for Western banks, and high enough to make it close to impossible for Chinese banks even to make a profit.

China’s problems are exacerbated by their decade-old policy of deliberately underpricing their currency. This has had the effect of making their export industries competitive against cheaper competitors like Vietnam and Thailand, but has also flooded the country with foreign-exchange reserves (now well above $1.5 trillion) that must be carefully sterilized to avoid massive inflation.

Well, what happens when a country runs interest rates that are well above those in other countries? Same thing you do when you spot a bank that pays higher interest on savings: you try to put your money there.

This phenomenon (called “hot-money inflow”) is of great concern to the Indians, and deeply, deeply frightening to the Chinese. China in particular maintains very strict legal controls on who may bring money into the country, although there is evidence that these controls are being massively circumvented.

The problem with hot money is that it can leave just as quickly as it comes, because it’s only there for the high interest rates. This can crash a domestic economy, as Thailand found out in 1997 and Vietnam did earlier this year.

So the Chinese and Indians are walking on hot coals right now. They have far too much money and not enough domestic economy to soak it all up. And there’s a limit to the amount of foreign assets they can buy before US Senators start jumping up in front of TV cameras to howl about “those furriners that are buyin’ up th’ whole dam’ country!”

The outcome of all this depends greatly on what happens in the United States. I started by saying that we’re now in a period of very low growth. Unlike many recent recessions, this one is being led by lower consumer spending, which in turn is driven by pressure in the housing market.

Now the basic policy approach to the housing/mortgage crisis in the US has been to stretch it out as long as possible and hope everything stabilizes without a major (downward) readjustment in asset values. That’s the philosophy that’s embedded in the just-passed Housing and Economic Recovery Act of 2008. (Aka, the Dodd-Frank Moral Hazard and Bank-Bailout Act).

The thing is that, just like the New Deal programs that were based on the same idea, the housing bailout bill will dull the pain, at the cost of significantly prolonging it.

We may be able to stand a multiyear period of subpar growth in the United States. (And if Barack Obama becomes President and makes good on his high-tax and protectionist pledges, it will be even more subpar and even longer.)

But will Asia be able to stand the strain of reduced export markets for several more years without going into a significant banking crisis?

Many Americans strangely think that such an outcome would only be fair. These are the people who think that Asian manufacturers “stole” all our high-paying union jobs. Barack Obama is one of them.

But this is a grave mistake. A real return to high growth and better jobs in the US depends on markets in Asia. We need them as much as they need us. Fortunately, John McCain’s policies would seek to expand rather than limit foreign trade.

-Francis Cianfrocca

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