Editor’s Note: Mr. Pierre A. Hanson is the author of The Truth behind Inflation (「通胀的真相」).
Nobel laureate U.S. economist Milton Friedman (1912-2006) once said: “Economics is a fascinating science. What fascinates people the most is its basic principles being so simple. You can write them on a piece of paper and anyone can understand them. However, the people who really understand them are rare!" Among the rare people, those who can express their understanding in simple terms and write a monograph that interests the general public and makes them understood are rarities of rarities. I am very pleased that just a few months after Mr. Pierre A. Hanson (韩和元) published in March this year the thought-provoking Chinese book, We Do Not Have Avatar: China's Soft Power Crisis (「我们没有阿凡达：中国软实力危机」), he is able to write another book The Truth behind Inflation (「通胀的真相」) with remarkable insights. I also feel much honored to be asked to write prefaces for these two books and to be able to engage in constructive exchanges of ideas with scholars and readers in this country.
Due to space limitations, my preface will focus on the subject of inflation in China, because in June 2011 the inflation rate of China was at its peak of 6.4% (this was the official consumer price index (CPI) inflation based on the officially “selected price indexes,” which is generally lower than the actual rate. The actual rate was estimated at more than 10%). This rate was much higher than the 3.6% in the United States, 2.4% in the euro area and 0.2% in Japan; the situation in China was more special and more serious. For the conditions in the United States and other countries, Mr. Hanson has made brilliant expositions in The Truth behind Inflation, I will not reiterate them here.
I. Inflation Wake-up Call for China
All recent commodity prices in China reached a record high. In renminbi (RMB) unit, the U.S. per capita disposable income (including non-income children and unemployed) is about 10,000 yuan per month, while for the Chinese people it is only about 2,000 yuan; but in the U.S., half a kilogram of lean pork costs about 32 yuan, while in China its costs 20 yuan; in the U.S., a McDonald's Big Mac costs about 25 yuan, in China, it costs 20 yuan; in the U.S., a movie ticket costs about 50 yuan, in China, it costs 80 yuan; in the U.S., a pair of Italian shoes costs about 300 yuan, in China, it costs 1,500 yuan; in big U.S. cities, a house of 250 square meters (about 2,750 square feet) costs about 3 million yuan, in major cities of China, it costs about 5 million yuan. Housing prices in China have comprehensively surpassed those in the U.S., the city median house prices in China are 14% higher than the U.S. average; the non-construction proportion of the housing cost in China (64%) has surpassed the U.S. housing indicator (51%) when the U.S. housing market was near its peak; during the past five years, property prices in China rose by 60% or even more. The high commodity prices caused by the inflation in China have come to an intolerable point! In addition to the difficulties of making ends meet suffered by people due to inflation, Chapter V of The Truth behind Inflation also lists many other sins of inflation. The Chinese government cannot avoid being vigilant and thinking deeply about the fundamental solution.
II. Where does the Recent High Inflation Rate Come from?
The proximate cause of high inflation and economic difficulties the world faces today originated from the U.S. subprime mortgage crisis and the collapse of financial derivatives in September/October 2008. In order to save the economy, the U.S. did not begin to solve the underlying structural problems, but took the line of “government intervention" of John Maynard Keynes, the most influential economist of the first half of the 20th century, to issue excess currency to stimulate economic growth. From November 25, 2008, to March 31, 2009, the U.S. launched the first quantitative easing worth 1.725 trillion U.S. dollars (about 13 trillion yuan), and from November 3, 2010, to June 30, 2011, launched the second quantitative easing worth 900 billion U.S. dollars (about 6 trillion yuan). After the U.S. subprime mortgage crisis, countries around the world also started to print money to stimulate economic growth. China, with a package of stimulus plan worth four trillion yuan to support its economy, was eager to promote domestic demand, make up for the decline of exports and maintain social stability.
Chapter I of The Truth behind Inflation tells us that "inflation only has to do with the government"; because "when there is no precious metal as a support, the person in charge of the printing machines can start printing money, and the only way to restrict him is to make him care about his credit; as soon as that care disappears, then the money supply can be ... arbitrary, and he can print whenever he feels like to print"; and if "the rate of currency increase goes much larger than the rate increase of physical products and services, prices will inevitably rise, and monetary value is bound to fall."
III. Money Supply in China
The formula in Chapter IV of The Truth behind Inflation is helpful to our understanding of the money supply in China. It is determined by two aspects:
B = D + F
M = m × B = m × D + m × F
Here B represents the monetary base, D represents the domestic credit provided by the central bank (including central bank’s re-lending to the financial institutions, the state fiscal overdraft and loans, as well as some financial loans and other monetary deliveries in the forms of loans, securities investments, etc.); F represents the net foreign assets of the central bank, which we call the foreign exchange reserves (foreign investments, hot money, the trade surplus, etc.); M represents the money supply; m represents the money multiplier. m × D is the domestic money supply, m × F is the money supply caused by the fluctuations of the foreign reserves (U.S. dollar is the dominant currency; the U.S. also has foreign exchange reserves, but their size is very small, accounting for 0.59 months’ worth of imports; Germany, France, Britain, Canada and other developed countries have foreign exchange reserves worth about 1.1 to 1.9 months of imports, so the foreign exchange reserves have little effect on the money supplies in these countries).
Although the stimulus package of four trillion yuan has maintained Chinese economy growth at nearly double-digit levels (2008, 9.6%; 2009, 9.2%; 2010, 10.3%; 2011, an estimated 9.6%), it caused an increase of the domestic credit D of the central bank and made individual banks carry a large number of loans that may be difficult to recover (an estimated total of 10 trillion yuan). It also ignited inflation.
China's foreign exchange reserves F are extremely abundant (3.2 trillion U.S. dollars of foreign exchange reserves, ranking first in the world). Therefore, the supply of RMB corresponding to the increase of the foreign exchange reserves is not small; there is even the pressure of being too much. Due to the yuan funds obtained from the acquisition of foreign exchanges by the central bank (through the payment of RMB to individuals and business units in exchange for their income in foreign exchanges), the inflation in China is also much impacted by foreign investments, trade surplus and hot money (the U.S. quantitative easing, the expected appreciation of the yuan and the domestic deposit rates being higher than those in the U.S. result in large inflows of hot money).
IV. Inflation Measures of China
In order to curb inflation China has exhausted all measures, including:
1. Making the Foreign Exchange Reserves F Smaller
Due to the economic boom, the strong exports of the mainland have led to an expanded trade surplus of the country and encountered the dissatisfaction and pressure of European countries and the U.S. In particular, the U.S. has repeatedly called for the yuan to appreciate to an appropriate level to facilitate U.S. exports to the mainland. In fact, since July 2005, the yuan has already undergone about 30% of appreciation. The process by which domestic economic growth relies heavily on exports of low-end products in the global production chain for foreign exchanges has been challenged. In order to maintain growth, the mainland officials decided to turn an "export oriented" economy into a "domestic consumption-expanded" economy and made it the focus of the 12th Five-Year Plan (2011-2015). The 2008 trade surplus of China reached nearly 300 billion U.S. dollars, but dropped to less than 200 billion in 2009, and further declined to 180 billion in 2010; the 2011 trade surplus is expected to decline further. In addition to the domestic initiative to change the mode of growth, the main reason for the decline was foreign trade enterprises facing enormous domestic and foreign pressures such as shrinking foreign demand (the impact of European debts has gradually manifested itself), rising costs, tightening corporate cash positions, rising RMB exchange rates, etc.; particularly severe is the current serious and comprehensive European and American trade protectionism that has affected many businesses; the mainland exports have entered a "trough." In terms of the relative amount, the trade surplus of the mainland in 2008 accounted for 6.7% of the mainland gross domestic product (GDP). It dropped to 2.2% during the first half of 2010, while the first half of 2011 compared to the same period of last year also fell 0.7 percentage points, accounting for 1.44% of the GDP. In general, the trade surplus figures for countries accounting for 3% of their GDPs are more reasonable.
Because of the sharp drop in exports, economic growth must rely on expanding domestic demand. However, since the reform and opening up, even though the GDP growth of China has been rapid and government revenue has significantly increased every year, people's wages have not risen with the same pace. The social security system has not been established and people lack a sense of security in life. They desperately want to save money, but dare not spend money. Chapter IV of The Truth behind Inflation suggests establishing a social security system for the domestic residents, supporting the development of small and medium private enterprises, creating more jobs, and generating growth in disposable income, etc. This will correct the past model of economic development led by heavy investment and export, which made the country wealthy, the people poor, and the consumption insufficient. However, it must be clear that the per capita revenues of the U.S. and Europe are more than ten times that of China’s. According to the current financial resources of the mainland, in the allocation and use of funds, the first consideration should be the needs and interests of the people in order to make choices and set priorities. If the fiscal revenue grows so fast, why are the public services and social security still at a low level? Where did so much money go?
A Chinese military website reported: for 18 years the domestic educational expenditure did not achieve the goal of 4% of the GDP; the public health spending accounts for 4.5% of the GDP, ranks 188 among 191 countries in the world (the fourth from the bottom); the rural population accounts for 70% of the total population, but health care spending is less than 20% of the total national expenditure; the educational and health care investments in China are less than in Uganda, one of the world’s poorest countries! However, the ratio of officials to public announced by the Chinese government has now reached 1:28 (some say 1:15), an absolute record in the world. From a historical perspective, the proportion of Chinese officials to people was 1:7948 in the Han Dynasty, 1:3927 in the Tang Dynasty, 1:2299 in the Ming Dynasty, 1:911 in the Qing Dynasty, 1:294 (some say 1:600) in 1949, and 1:30 (some say 1:28) today; some places even reach up to an unprecedented 1:9 (for example in Huanglong Xian of Shaanxi Province, every 9 peasants support one cadre). From an international perspective, the officials-to-public ratio in 1999 was 1:30 in China, 1:98 in Indonesia, 1:150 in Japan, 1:164 in France, and 1:187 in the U.S. The administrative costs and wage expenditures of the local grass-roots governments in the rural communities account for 80% to 90% of the local revenues, which is typical of the "free-meal fiscal policy." It is like placing heavy taxes on the common people. How can domestic demands then be expanded?
Referring again to the reduction of the hot money in the foreign exchange reserves F, the mainland has to continue the pace of internationalization of the RMB. It should not always maintain a RMB upward trend against the U.S. dollar. It must reduce the external expectations of RMB appreciation. Hot money flows into China in order to get higher interest earnings, to benefit from appreciation of the RMB and premiums of the asset prices. Hot money investments generally include bank deposits, stocks, real estate properties, industries, etc. Hot money engages in speculation of real estate, stocks, commodities and food prices, and also flows to private money lending markets and domestic commercial banks that lend hundreds of billions of funds in the coastal areas. Assuming that the appreciation of the RMB against the U.S. dollar is expected to be 3 to 5%, plus the one-year deposit rate 3.5%, then, the arbitrage profit of hot money each year in China is expected to be at 6.5 to 8.5%. In addition to strengthening the supervision of cross-border capital flows, China should also steadfastly refuse to raise a substantial one-time exchange rate. This can prevent hot money being quickly pulled out and escaping overnight once the RMB reaches its peak due to rapid appreciation, and avoids it seriously affecting the financial situation of China. What also needs to be guarded against is that, because of the domestic foreign exchange controls in the mainland, Hong Kong has become the pipeline to enter into the Chinese mainland market, which has greatly increased its importance in international finance. Chinese companies that are listed overseas or in Hong Kong have formed a network with the mainland A-shares and they are closely connected. The next round of international financial crisis initiated by the U.S.-led multinational financial institutions is most likely to begin by attacking share prices of the Chinese companies. Also, because of the gradually increased influence of China, attacking the Chinese capital can also drive the global crisis. The international financial center of Hong Kong will actually become a battlefield. The financial regulatory agencies of Hong Kong should make preparations for early prevention.
2. Making the Money Multiplier m Smaller
Since October 2010 the Chinese government has raised interest rates five times and the bank deposit reserve ratio nine times. It has also ordered banks to restrict lending within the mandatory upper limit; large financial institutions have practiced an unprecedented reserve rate ratio of 20.5%. The freezing of funds totaled about 3,000 billion yuan. This has naturally shrunk m and resulted in a decreased M. Given the rigid lending quotas, banks tend to lend to large state-owned enterprises and almost cut off lending to small and medium private enterprises. This has led private enterprises that provide 80% of the mainland jobs to close down or move abroad due to the shortage of funds. Against the backdrop of high inflation and negative interest rates (in several previous months the mainland CPI rose more than 6%, although in October it dropped to 5.5%, and in comparison with the one-year deposit rate of 3.5%, there is still a difference of 2 percentage points), people tend to transfer their savings to other investment channels. The increasingly popular private lending has become an important destination for deposits and results in an escalation of defaults on private lending.
A smaller m naturally reduces the role of hot money, which according to the Chinese government means that hot money enters through a large hole into the reservoir of foreign exchange reserves, and flows out through a small hole limited by the raised bank deposit reserve ratio. However, an unprecedented 20.5% of the deposit reserve ratio cannot eliminate the effect of hot money, but almost cut off lending to small and medium private enterprises. The side effect is very serious.
3. Taking Administrative Interventions in Macroeconomic Control Policies
In addition to addressing monetary policy and fiscal policy, the article by the Central Party School’s Professor Zhou Tianyong expressed: "The mainland undertakes administrative interventions in macroeconomic control policies. These include setting administrative limits on some consumer goods like food and others, setting limits on the purchase price and number of units of real estate properties, constructing government-led low-cost housing, increasing the housing supply, as well as controlling the price adjustments to a number of resource products related to electricity, water, and gas that are relevant to people’s living. The lattest CPI showed that inflation in October 2011 dropped sharply to 5.5%, a five-month low, from 6.1% in the previous month. The rise of the industrial producers prices (PPI), an inflation leading indicator, narrowed to 5%; the rate of drop was more than expected. These indicate that the turning point of inflation has been established.
However, the banking system is saddled with a large number of loans and the banks may have difficulties to recover the funds. The private sector, especially the real estate market, conceals big trouble; the industry this year will have 3,000 business offices closed out and about 50,000 brokers unemployed. The housing prices in China are plummeting; the trend of price drops has spread to the second- and third-tier cities. Independent economist Andy Xie presented a sharp observation by saying: "The 2012 collapse will appear in the Chinese real estate sector, but the burst of the real estate bubble is a good thing for the Chinese economy. The Chinese government should not relax on its control of real estate", "The impact of the bursting of the real estate bubble is just like tax cuts; people become fearful that they will not be able to afford a house, then they are afraid to spend money; if house prices fall, the future impact on the economy is a good influence like tax cuts. So, as long as the government is willing to go through the difficult six months that is coming, the Chinese economy will have good days later. "
4. Walking on the Path of Innovation
When the low-end products of the Chinese enterprises lose their export price advantage (they also have been criticized for their severe pollution of the environment), three things must be done in order to continue exporting goods, earn foreign exchange and raise the growth rate: 1) produce high value-added products through innovation to attract new customers; 2) further improve product quality to stabilize the existing customers; and 3) go abroad or set up factories in lower-cost areas (the central and western areas of the mainland) in order to continue to have a base in the world market. More than 200 million young people were born in the 80s and 90s in the mainland, including the new generation of migrant workers and urban white-collar workers, who think that "they should not be hard on themselves in life." Because they have a strong desire for consumption, the foreign media regard them as the “savior” of the world economy. The future China does not lack great consumption groups. The problem is whether the Chinese real economy can have a healthy growth and build brands, and whether the service industry can provide diversified and quality services with increased range.
The well-known economic reformist Wu Jinglian once again called upon the government to promote economic, social and political reforms. The purpose is to eliminate the institutional barriers in the transformation of the economic development model to establish an environment conducive to innovation and an institutional environment conducive to entrepreneurship. He said: "We used to think that Chinese technology was rather poor and produced very few of the world's cutting-edge inventions. In fact, this is incorrect. The problem is that it is very difficult for these inventions to achieve industrialization", "The current financing and tax environment do not give enough support to the high-tech enterprises and service enterprises within the manufacturing industry. The industrial entities are still facing many lures to encourage them ‘to neglect their main jobs.’” He added: "Because of our money oversupply, excess liquidity and high leverage, the profits of the so-called virtual industry such as the securities industry are very high. Also, the land resources are in government hands. As long as the government gives you land at low price, you can immediately gain a fortune and become a billionaire. So the cutting-edge industries in our manufacturing industry feel the great temptation. You can check these out. Including the famous IT companies, how much profit does it come from the real estate? If this environment is not improved, I think that it is very difficult to upgrade our industry." Andy Xie also believes that many of the problems encountered by the Chinese economy in recent years were caused by real estate; China's industry being large but not strong is also due to this. The deformed real estate market has turned the entrepreneurs’ aim of becoming big industrial entities into a simple sentence: "later, to make money is to engage in real estate."
Considering the prospects for reform, Wu Jinglian expressed that "reform needs the government to play a leading role." He assured the "top-level design" concept in the 12th Five-Year Plan, which means that China is ready to restart in the next five years the same kind of reforms as in the 1980s and 1990s. The lesson Wu Jinglian drew from this is: to achieve the transformation of the economic development pattern, the key is reform, promoting market-oriented reforms, and supporting other social and political reforms of the market economy.
Concerning the U.S. quantitative easing, apart from the stock market rally that is to the benefit of Wall Street, the housing prices are still down, and the unemployment rate is hovering at around 9%. There is no significant improvement in the manufacturing sector, and the "Occupy Wall Street” movement spread like wild fire. A financial crisis seems to be evolving into a political crisis. Europe was affected by the United States, soaring domino effects have occurred such as bank failures in many countries, real estate declines in value, and the unemployment rate is rising. The five peripheral European countries (PIIGS: Portugal, Italy, Ireland, Greece, Spain) have difficulties increasing their government revenue, due to their weak economic growth. They cannot reduce the pressure of debts and get into trouble. This has made the euro fall and caused turmoil in the European Union. The U.S. CNBC published an article saying that maybe the worst would be the collapse of the Governments of Greece and Portugal; Greece may have to leave the European Union and develop social unrest, and the Italian banking system will have an intractable crisis. The possibility of a second round of the European financial crisis starting from Europe and sweeping through the world has risen to 65%. Internationally renowned investment guru, and "commodity king", Jim Rogers further pointed out on November 9, 2011, that in the environment of confusion in the European debt problem, the next crisis will be worse. For seven years, the European Union has been the largest trading partner of China. Once the European economy has problems, it will directly affect the economy of China. If life becomes difficult for the people of Europe, the foreign trade enterprises of China will not be better off. International Monetary Fund (IMF) President Christine Lagarde warned that the global economy is facing a crisis of a "lost decade."
As "curbing inflation" just begins to work, the pressure of “maintaining growth” is up again!
The manufacturing purchasing managers’ confidence index of China approaching the critical point, small and medium enterprises facing operational difficulties and the weakening of foreign demand all imply that China's economic growth rate will slow down further. Both the weak U.S. consumer demand and the shadow of the financial crisis have delayed the U.S. to step out of its quagmire of weak growth. The spread of the European debt crisis will undoubtedly add more obstacles to the economic growth. Based on the above considerations, the recent executive meeting of the Chinese State Council clearly proposed to sensitively and accurately grasp the changes of the economic trends in order to perform a "timely and moderate pre-set fine-tuning." The emphasis of "moderation" and "fine tuning" is on the effort of grasping the control policy. It is not a fundamental shift away from the "proactive fiscal policy and prudent monetary policy." Therefore, maintaining growth may again become the primary task of China or even the countries in the world. In the context of maintaining growth, the Chinese monetary policy tightening will be difficult, suggesting that monetary policy is expected to return to the "neutral" level, and fiscal policy will shift to a more active policy. As described in Chapter XI of The Truth behind Inflation, stabilizing the currency supply and returning to currency neutrality are the fundamental approaches to reducing inflation.
On the morning of November 12, 2011, Hu Jintao attended the Asia-Pacific Economic Corporation (APEC) CEO Summit held in Honolulu, the capital of Hawaii in the U.S. and delivered a keynote speech. When referring to China's economic and social development, he identified four major focal points, among them reducing government intervention in microeconomic activities and implementing a more proactive strategy of opening up. This will help to stabilize the confidence of foreign investors in the Chinese economy.
Mr. Hanson has produced a very complete and brilliant exposition to The Truth behind Inflation. The most fascinating point of his book is that it not only reconfirms Milton Friedman’s phrase that “Economics is a fascinating science," but it also enables the readers to quickly understand how the invisible hands of the economy can dominate personal and country's fates.
We are very grateful to The Truth behind Inflation for teaching us to comprehend and for helping China to move forward!