Can Alan Greenspan move the American economy smoothly towards higher interest rates?
THE chairman of the Federal Reserve may no longer have the aura of infallibility that he enjoyed in the go-go years of the 1990s, but he is still credited by many with a magic touch when it comes to monetary policy. Alan Greenspan’s most recent wizardry—a willingness to slash short-term interest rates to 1% and keep them there—helped America stave off a sharp recession and bolstered a shaky recovery. Soon he must pull off another, possibly tougher, trick: raising interest rates back to more normal levels without either undercutting the recovery (by moving too soon or fast) or letting inflation or asset bubbles get out of hand (by waiting too long).
Listen to Wall Street, and Gandalf is about to swing into action. Over the past couple of weeks a slew of strong economic statistics (especially the creation of 308,000 new jobs in March) followed by news that inflation jumped unexpectedly, has sent financial markets into a frenzy of speculation that the central bank will tighten soon—and aggressively.
Only weeks ago, it was conventional wisdom that the Federal Reserve would keep short-term interest rates unchanged until next year. After the inflation and jobs numbers were published, futures markets began to price in the near certainty of a rate hike in August. Some economists even expect the Fed to move in June, with more raises possible before Americans go the polls in November. By the end of next year many in the markets expect short-term rates to be at 3.5%.
This week the magician himself spoke, in two testimonies to Congress. Not surprisingly, his message was both more balanced and nuanced than the thunder from Wall Street. Mr Greenspan was clearly preparing the ground for tighter policy but without suggesting that a move was imminent. He noted—as he has done before—that interest rates “must rise at some point” to prevent inflation from taking off, but suggested that “as yet” the long period of low rates had not “fostered an environment in which broad-based inflation pressures appear to be building”.
Nonetheless, compared to the Fed’s last official statement on interest rates in March, Mr Greenspan was noticeably more upbeat. In March, the central bank still saw the risks of lower inflation as slightly higher than those of inflation. This week, Mr Greenspan suggested that the disinflation trend had “come to an end” and that the threats of deflation were “no longer an issue”. He described the outlook for America’s economy as “good”. Significantly, he did not use the word “patient” when discussing how long central bank could keep rates low. Though much of the testimony dwelt on why there was scant risk of inflation getting out of control, Mr Greenspan was clear that the Fed would “act, as necessary” to maintain price stability.
While Wall Street is fretting about out-of-control inflation, Mr Greenspan and his colleagues in Washington, DC, are relieved that inflation has stopped falling. Despite its recent acceleration, America’s inflation rate is extremely low. Excluding the volatile categories of food and energy, the consumer-price index rose 1.6% over the past year. Other measures preferred by the Fed are hardly thrusting skywards. Given the worries about deflation, many central bankers see a small acceleration in consumer prices as a sign of success.
One question looms: is the inflation uptick due largely to one-off factors, such as higher commodity prices, or is it the beginning of a pernicious wage-price spiral? Many Fed governors play down the risk of the latter, pointing out that the labour market is still relatively slack. Despite the March employment figures, the current recovery looks anaemic in terms of job creation; until that changes, they argue, there is scant risk of price pressure being translated into higher wages.
But the central bankers’ view of the job market seems to be changing—at least a little. A few weeks ago, when the March jobs figures came out, Roger Ferguson, the Fed’s vice-chairman, played down their significance: it would, he said, take “some time” to see whether the improvement in the labour market was “fundamental and durable”. By contrast, Mr Greenspan’s tone this week was much more upbeat. He expects the pace of hiring to stay strong.
Yet even with faster job growth, Mr Greenspan seems sanguine about inflationary pressure. There is still, he points out, a “sizeable margin” of slack in the economy; productivity growth remains strong. Fat profits also give firms room to absorb higher wages without raising prices. All those factors allow the central bank wiggle-room before rates must rise.
This analysis is not shared by all of Mr Greenspan’s colleagues on the Fed’s interest-rate-setting committee. The presidents of district central banks, in particular, tend to be more hawkish about inflation. For instance, Bill Poole, president of the St Louis Fed, is concerned about falling behind the inflation curve. He reckons that the Fed must act “aggressively” when inflation risks change. Bob McTeer, president of the Dallas Fed, said this week that the March rise in consumer prices was “disturbing”.
In practice, however, it is Mr Greenspan’s views that count most—and his goals seem to be to prepare the markets for higher rates, but not necessarily to rush to action. The reason is partly tactical: if you spend enough time preparing Wall Street for higher rates, the eventual move may not roil the highly leveraged markets.
America’s rock-bottom interest rates have not just supported spending; they have also coaxed investors into gambling on borrowed money. Raise rates unexpectedly, or too quickly, and the unwinding of these investment bets could cause chaos in financial markets. Given consumers’ dependence on housing wealth, a meltdown in the mortgage market alone could be enough to snuff out the recovery. Memories of 1994, when the Fed began a sharp tightening cycle, are still fresh. Then bond markets collapsed as investors appeared surprised by the central bank’s moves. It is an experience Mr Greenspan will not want to repeat.
In all likelihood, the Fed will send a bevy of signals before it actually raises rates. This week’s testimony is best seen as the opening salvo. But signalling is not a simple business. In June 2003, Mr Greenspan’s efforts to convey his concern about deflation backfired when the central bank failed to cut interest rates by as much as the market expected. And investors can often refuse to take the hint. Fed officials reckon that they sent clear signals about tighter policy in 1993: Wall Street ignored them.
Judging by Wall Street’s jitters, that looks unlikely to happen this time around. After Mr Greenspan’s comments this week, no one can be surprised if rates rise later this year. But there are still enormous uncertainties about how to get from today’s rock-bottom interest rates to more neutral levels. It is not just a question of when the central bank starts to raise rates, but how far they are raised and how fast. If he is to pull off his monetary magic once again, Mr Greenspan will have to become clearer on both counts.

posted by iambrianfu [ 10:29 PM ] <$BlogItemComments$>

Rational expectations

From Wikipedia, the free encyclopedia.

Rational expectations is a theory in economics used to model expectations of future events, proposed by John F. Muth (1961). Modelling expectations is of central importance in economic models. For example, a firm's decision on the level of wages to set in the coming year will be influenced by the expected level of inflation, and the value of a stock is dependent on the expected future income from that stock.

Under rational expectations, it is assumed that actual outcomes do not differ systematically or predictably from what was expected. That is, it assumes that people do not make systematic errors when predicting the future. In an economic model, this is typically modelled by assuming that the expected value of a variable is equal to the value predicted by the model, plus a random error term.

Rational expectations theories were developed in response to perceived flaws in theories based on adaptive expectations. Under adaptive expectations, expectations of the future value of an economic variable are based on past values. For example, people would be assumed to predict inflation by looking at inflation last year and in previous years. This means that if the government were to choose a policy that led to constantly rising inflation, under adaptive expectations people would be assumed to always underestimate inflation. This may be regarded as unrealistic - surely rational individuals would sooner or later realise the government's policy and take it into account in forming their expectations?

The hypothesis of rational expectations addresses this criticism by assuming that individuals take all available information into account in forming expectations. Though expectations may turn out incorrect, the deviations will not deviate systematically from the expected values.

The rational expectations hypothesis has been used to support some controversial conclusions for economic policymaking. The hypothesis is often critised as an unrealistic model of how expectations are formed.

posted by iambrianfu [ 10:05 PM ] <$BlogItemComments$>

NAIRU

NON-ACCELERATING RATE OF UNEMPLOYMENT

From Wikipedia, the free encyclopedia.

The term NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment. It is a concept in economic theory significant in the interplay of macroeconomics and microeconomics.

The concept arose in the wake of the study of the Phillips curve which demonstrated an observed negative correlation between the rate of unemployment and the rate of inflation (measured as annual nominal wage growth of employees) for a number of industrialised countries with more or less mixed economies. This correlation persuaded some analysts that it was impossible for govenments simulaneously to target both arbitrarily low unemployment and price stability, and that, therefore, it was government's role to seek a trade off between unemployment and inflation which matched a local social consensus.

Critics of this analysis argued that the Phillips curve could not be a fundamental of economic equilibrium because it showed a correlation between a real economic variable and a nominal economic variable. Their counter analysis was that government macroeconomic policy (primarily monetary policy) was being driven by an unemployment target and that this caused expectations to shift so that steadily accelerating inflation rather than reduced unemployment was the result. The resulting prescription was that government economic policy (or at least monetary policy) should not be influenced by any level of unemployment below a critical level - the NAIRU.

The NAIRU theory mainly intended as an argument against active Keynesian demand management and in favor of free markets. There is for instance no theoretical basis for predicting the NAIRU. Monetarists instead support the generalized assertion that the correct approach to unemployment is through microeconomic measures (to lower the NAIRU whatever its exact level), rather than macroeconomic activity based on an estimate of the NAIRU in relation to the actual level of unemployment.

posted by iambrianfu [ 9:59 PM ] <$BlogItemComments$>

ROBERT LUCAS AND RATIONAL EXPECTATIONS



An even bigger attack on Keynesianism came from Robert Lucas, the founder of a theory called rational expectations. (1) This highly mathematical theory dominated all economic thought in the 70s and early 80s, so much so that Lucas attracted a broad following of disciples who raised to him to cult-leader status. By 1982, Lucas' views were so entrenched that Edward Prescott of Carnegie-Mellon University would boast that his students had never heard Keynes' name.

Lucas won the Nobel Prize in 1995 for the core aspect of his theory, that rational businessmen adjust their behavior to the government's announced economic policies. However, history has not been kind to the rest of his theory. Lucas himself has abandoned work on rational expectations, devoting himself nowadays to other problems, like economic growth. His once broad following has dissipated. And Lucas himself would admit upon receiving his Nobel prize: "The Keynesian orthodoxy hasn't been replaced by anything yet." (2)

There are two main parts to rational expectations. First, Lucas began with the old assumption that recessions are self-correcting. Once people start hoarding money, it may take several quarters before everyone notices that a recession is occurring. That's because people recognize their own hardships first, but it may take awhile to realize that the same thing is happening to everyone else. Once they do recognize a general recession, however, their confusion clears, and the market quickly takes steps to recover. Producers will cut their prices to attract business, and workers will cut their wage demands to attract work. As prices deflate, the purchasing power of the dollar is strengthened, which has the same effect as increasing the money supply. Therefore, government should do nothing but wait the correction out.

Second, government intervention can only range from ineffectualness to harm. Suppose the Fed, looking at the leading economic indicators, learns that a recession has hit. But this information is also available to any businessman who reads a newspaper. Therefore, any government attempt to expand the money supply cannot happen before a businessman's decision to cut prices anyway. Keynesians are therefore robbed of the argument that perhaps the Fed might be useful in hastening a recovery, since Lucas showed that the Fed is not much faster than the market in discovering the problem.

Lucas then gave a fuller and more supported version of Milton Friedman's argument. Suppose the Fed established a predictable anti-recession policy: every time the unemployment rate climbs one percent, the Fed increases the money supply one percent. Rational businessmen would only come to expect these increases -- hence the term, rational expectations -- and would simply build automatic responses to monetary policy in their pricing systems. So in order to be effective, then, monetary policy would have to surprise businesses with random increases. But true randomness would make the economy less stable, not more so. The only logical conclusion is that the government's efforts to control the economy can be actually harmful.

Rational expectations borrowed heavily from earlier conservative theories, but Lucas supported these arguments mathematically, and in far greater detail and nuance. In fact, rational expectations spawned many new mathematical and statistical techniques, and allowed a generation of economists to specialize in these techniques. In a typical rational expectations model, the public adjusts its behavior to announced monetary policy. This is supposed to result in a more realistic description of the economy.

But despite its technical brilliance, today we know there are several major flaws in the theory.

First, it is not reasonable to believe that business owners generally determine their prices by following macroeconomic trends. Can you cite the Federal Reserve's rates and policies at the moment? The inflation and unemployment rates? The nation's GDP growth? Even more improbably, do you set your budget, prices and wage demands by these indicators? Only an economist (who knows all these statistics anyway) would think this is natural behavior.

Second, it is not reasonable to believe that humans are perfectly rational or perfectly informed. Much of Lucas' theory "worked" only after making such idealistic assumptions. Interestingly, Lucas and his followers have usually defended these assumptions by attacking their opposite. Early Keynesians had "overlooked" the fact that people would adjust their behavior to national economic policy. Here are some typical criticisms of this oversight by Lucas and others:
"The implicit presumption in these Keynesian models was that people could be fooled over and over again." -- Robert Lucas (3)

"The problem with the old models was that they assumed people were as dumb as dirt and could be fooled by the government into changing their behavior." -- Paul Romer (4)

"The essence of rational expectations could be summarized as 'people aren't as dense as policy makers used to think they were.'" -- Ron Ross (5)
The black and white universe of the Lucas school is rather amusing: if human beings are not walking calculators or walking statistics manuals, then, by God, Keynesians must think they are complete idiots. The truth is a bit more prosaic. Keynesians have primarily based their theories on historical evidence, not assumptions of citizen ignorance. Money has never deflated easily, for whatever reason, and Keynesian policies seem to work best in smoothing out the business cycle. The failure to deflate may spring from many sources: not just citizen ignorance of monetary policy, but certainly price rigidities as well. For example, during the severe recession of 1982, the Fed's proposal to expand the money supply was widely debated in the press. When the Fed did move, it was well announced. But rational and expectant businessmen did not raise their prices and create inflation. On the contrary, 1983 actually saw lower inflation, as well as a job-creation boom that would last seven years.

And this leads to the third flaw: Lucas's theory just doesn't explain reality very well. In an article entitled "Great Theory… As Far as it Goes," economist Michael Mandel writes: "Unfortunately, models built on rational expectations do not reflect the real world as well as the old Keynesian models they were supposed to replace… Most economic forecasting models still have a Keynesian core." (6)

To wit, the recessions of 80-82 and 90-92 behaved very differently from what Lucas's models predicted. Keep in mind their key assertion that recessions only happen because individuals are temporarily confused about the situation. Once workers realize they are in a general recession, they will cut their wage demands, which will restore full employment. But after the unemployment rate hit 10.7 percent in the winter of 1982, it took until 1987 for it to recover to 1979 levels (about 5-6 percent). Did it really take workers eight years to figure out they were in a recession before cutting their wage demands by the necessary amount? Of course not.

The main obstacle to Lucas's theory is that that recessions last far too long to attribute them to temporary public confusion about the situation. Jimmy Carter was voted out of office for a "misery index" (inflation plus unemployment) that crested 20 percent. Yet it wasn't until the second year of Reagan's term that a recovery started. The same with George Bush -- a recession struck in 1990, and his 90 percent approval rating took a free fall in the election campaign that followed. That campaign was defined by James Carville's slogan, "It's the economy, stupid." The economy did not truly start recovering until 1992, and employment took even longer to recover. If the public's awareness of recessions is great enough to drive presidents out of office after extended campaigns, it's clear that people understand their plight. But then why do recessions last so long?

Lucas and his followers searched everywhere for a model that would keep businessmen aware of leading economic indicators and yet ignorant of the fact that they were in a recession. Needless to say, they did not find one.

Life after Lucas

Around the mid-80s, economists became aware of the theory's shortcomings. One of these was probably Lucas himself, who never really bothered to defend it when journals began seriously questioning it. As Lucas moved on to other projects, conservatives economists found themselves back at the drawing board, asking themselves such basic questions as: what is a recession?

The existence of recessions has always been an embarrassment to economists on the right. Recessions suggest that markets are not magical, that they often result in hardship and suffering. One far-right tack, as exemplified by the Austrian School of Economics, is to blame them on government. But depressions were exclusively a feature of laissez-faire economies; since the rise of modern welfare states, nations have seen greatly reduced recessions and unprecedented economic growth. So much for the government scapegoat.

The opposite tack, as exemplified by "real business cycle theory," has been to claim that recessions are actually beneficial self-cleansing rituals of the market. Thanks to recessions, the market adapts to change. This idea has been satirized in such Keynesian articles as Willem Buiter's "The Economics of Doctor Pangloss," after Voltaire's fictional philosopher who believes everything is for the best. As Paul Krugman remarked: "If recessions are a rational response to temporary setbacks in productivity, was the Great Depression really just an extended, voluntary holiday?" (7)

Real business cycle theory was presented as a replacement to rational expectations, but it ended up imploding under self-criticism and ideological infighting. Unlike monetarism or rational expectations, it never became a serious movement.

Instead, economics has seen the revival of Keynes, with the emergence of New Keynesianism. Many people thought that Lucas had refuted Keynesianism as a matter of principle. Any businessman with a newspaper would learn of a recession as quickly as the Fed, and would nullify the Fed's actions with the appropriate counteractions. However, economist George Akerlof would undermine this "refutation" with his own seminal article, "The Market for Lemons." Akerlof made two crucial observations, one of them obvious, one of them not-so-obvious.

The obvious one was that human beings are nearly rational, not perfectly rational. The not-so-obvious one is that nearly rational people may make decisions that approximate those of perfectly rational people, yet still obtain completely different economic results. Two examples best illustrate this point:

Suppose a farmer is selling wheat on the market, and notices that demand drops. Every other farmer is selling wheat for five cents a bushel less than he is. Now, wheat is a homogenous product, meaning that one farmer's wheat is virtually identical to another farmer's wheat. There is no advantage for a buyer to buy wheat at a higher price, so it would be foolish for the farmer to stay a nickel above the competition. The farmer may not want to lower his prices, but the market's supply and demand will force him to. So although the farmer is only nearly rational, he can come to perfectly rational decisions when the product is a homogenous one.

But what if the product is not homegenous? What if you're selling artwork? Artwork can range from a first-grader's finger-painting to "Ambroise Vollard" by Picasso. You might have a general idea of what's it worth, but to figure it to the penny, like wheat, is impossible. Too many variables affect the final price. One art collector might want the Picasso more than another collector, and be willing to pay more for it during an auction. A movie or book about Picasso might spur unusual interest in his paintings over those of Monet. A rich idiot might come along who has no idea what it's really worth. Therefore, an art seller is not being irrational by refusing to sell it to someone in the hopes of gaining a higher price. In other words, there is a range of acceptable prices, and most people hold out for higher prices out of self-interest.

The vast majority of goods on the market are not homogenous: examples include cars, homes, even workers on the labor market. People may be fully aware of a recession when they are in one, but they do not know how much they should reduce their prices. To know the exact percentage would require an astronomical amount of information and calculating ability. The cost of arriving at such a calculation would surely outweigh its benefits. Therefore, people should -- as a matter of principle -- try to make best guesses. Unfortunately, this often results in the sort of price stickiness that prevents recessions from curing themselves. Keynesian policies therefore remain a useful tool in cutting recessions short. We have long known that this is so in practice; it's heartening to know that this is so in theory now as well.

Next Section: Ronald Coase and the Coase Theorem
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Endnotes:

1. Unless otherwise noted, this essay is primarily based on Paul Krugman, Peddling Prosperity (New York: W.W. Norton & Company, 1994), pp. 47-53, 197-205.

2. Steven Pearlstein, "Chicago Economist Wins Nobel Prize: Lucas has Focused on Theoretical Issues," San Jose Mercury News, Wednesday, October 11, 1995, p. 4A.

3. "Economics dynasty continues: Robert Lucas wins Nobel Prize," Chicago Journal, The University of Chicago Magazine, December, 1995.

4. Quoted in Steven Pearlstein, "Chicago Economist Wins Nobel Prize: Lucas has Focused on Theoretical Issues," San Jose Mercury News, Wednesday, October 11, 1995, p. 4A.

5. Ron Ross, "Anticipation," The North Coast Journal, December, 1995.

6. Michael Mandel, "Great Theory… As Far as it Goes," Business Week, October 23, 1995, p. 32.

7. Krugman, p. 204.

posted by iambrianfu [ 7:58 PM ] <$BlogItemComments$>

In the first of a series of articles on the Copenhagen Consensus project*, we look at financial instability


THE severity and frequency of financial crises, especially the combined currency and banking collapses of the past decade, have made financial instability a scourge of our times, one that bears comparison with damage inflicted by famine and war. In a new paper for the Copenhagen Consensus, Barry Eichengreen, from the University of California, Berkeley, has reviewed the literature, attempted to count these costs, and to weigh them against the costs of a particular proposal for remedial action.

The costs can be reckoned in stalled growth and stunted lives. The typical financial crisis claims 9% of GDP, and the worst crises, such as those recently afflicting Argentina and Indonesia, wiped out over 20% of GDP, a loss greater even than those endured as a result of the Great Depression. According to one authoritative study, the Asian financial crisis of 1997 pushed 22m people in the region into poverty. For developing countries, currency crises are an important subset of financial crises. Mr Eichengreen, while cautioning against taking the precision of such estimates too seriously, reckons that the benefit which emerging-market countries would reap if such crises could be avoided altogether would be some $107 billion a year.

One ready way to secure those benefits, you might think, would be to stifle financial markets. In impoverished parts of Africa, for example, credit crunches are relatively rare, because credit is always hard to come by. But as a rule such a solution would be more costly than the problem. Wherever financial markets are absent or repressed, savings go unused, productive economic opportunities go unrealised and risks go undiversified. If India's banks and stockmarkets were as well developed as Singapore's, India would grow two percentage-points a year faster, according to one study.

To grow fast, and keep growing quickly, countries need deep financial markets—and the best way to deepen financial markets, most economists agree, is to liberalise them. Does this mean that countries must open their financial markets to foreign capital, thus exposing themselves to the risk of currency crises? Or should they impose capital controls, confining the perversity of financial markets to national borders, where the central bank retains the power to offset it? Foreign direct investment aside, China's capital markets are still largely closed to outsiders. Yet it has no shortage of credit. For other countries, though, the evidence is mixed. A fair reading of the studies, and there have been many, suggests that, for most countries, opening up to foreign capital will deliver faster growth in most years—punctuated by a damaging financial crisis about every ten years. Some economists argue that periodic credit crunches are the price emerging markets must pay for faster growth.

What might be done to make financial crises less common? The answer depends on the causes of financial meltdown. Governments bring some crises on themselves by pursuing fiscal and monetary policies that are inconsistent and unsustainable. Such self-defeating policies may be the symptom of deeper flaws in the body politic. If so, there is little outsiders can do. But some countries' financial fragility results simply from their need for foreign investment. In the most susceptible countries, firms and banks borrow heavily in dollars, while lending in local currencies. If the value of the local currency wobbles, this mismatch between domestic assets and foreign liabilities is cruelly exposed.

Why are the assets and liabilities of emerging markets so ill matched? Perhaps because poorly supervised and largely unaccountable managers have scant reason to be careful with other people's money. But Mr Eichengreen offers another reason. International investors are very choosy about currencies. Most consider only bonds denominated in dollars, yen, euros, pounds or Swiss francs. This select club of international currencies is locked in for deep historical and structural reasons. Thus, poor countries that want to borrow abroad must bear currency mismatches through no fault of their own.



Match-making
If this is the problem, possible solutions follow naturally: either create a common world currency, used by rich and poor alike, or invent a liquid, international market for bonds denominated in the pesos, bahts and rupiahs that emerging markets are obliged to use. The first solution, even if it were desirable, is politically impossible; the second is merely very difficult. Mr Eichengreen spells out in his study an ingenious plan to make it a little easier. Briefly, he proposes the creation of a market for lending and borrowing in a synthetic unit of account, a weighted basket of emerging-market currencies. Such bonds would be popular with investors, since the currency would be more stable than the sum of its parts and, at first at least, carry attractive yields. Importantly, such a market, if it could be established, would eventually let emerging-market economies tap foreign capital without currency mismatches. This is because those, such as the World Bank, that issued such bonds would be keen to reduce their exposure to the basket by lending to the countries in that basket in their own currencies.

However, there is a cost: the extra yield that the Bank and others would need to offer to attract buyers of the new instruments. Mr Eichengreen estimates that this initial cost would be no more than $545m a year—a small sum compared with the $107 billion that would be saved if currency crises could be avoided.

posted by iambrianfu [ 8:10 PM ] <$BlogItemComments$>

“HOW high are Chinese interest rates?” your correspondent enquired. Unsure of the answer, and a bit embarrassed, the man flicked through a fat statistical report. This was surprising in one way, since the man in question was a senior official of the People’s Bank of China, the country’s central bank. But it was, perhaps, less surprising in another way, for interest rates play little role in an economy in which credit is allocated with scant regard to its price. And this anecdote demonstrates how hard it will be to cool China’s red-hot economy by the means traditional in capitalist economies: charging more for borrowing money.

If China’s economy is overheating, that will be hugely important for economic prospects worldwide, because the country has accounted for a quarter of global GDP growth (measured at purchasing power parity) over the past five years. The People’s Bank is desperate to slow growth in the money supply and in bank lending. To bring down the latter, on Sunday April 11th it announced that it was raising banks’ reserve requirements (the deposits they have to hold at the central bank) from 7% to 7.5%—the third increase in eight months


Official statistics released a few days later explain the central bank’s concern. Real GDP growth continued at a breakneck pace of 9.7% in the year to the first quarter of 2004, and consumer-price inflation rose to 3% in the 12 months to March, up from 0.9% a year ago.

Besides increasing banks’ reserve requirements, the central bank and the government have also instructed banks to curb new lending to sectors which officials believe are growing too fast, namely steel, cars, cement, aluminium and property. In late March, the People’s Bank also raised the interest rate it charges banks. But the rates at which consumers or firms borrow from banks—the key interest rates in free-market economies—have remained fixed for more than two years.

The government line is that the economy is overheating only in this handful of sectors. Yet the figures suggest that it is an economy-wide problem. Bank lending rose by 21% in the year to March. And although the rates of increase in the money supply and bank credit started to slow from the middle of last year, they picked up again in March.

As always, analysis of China’s economy is clouded by dreadful statistics. Widely quoted figures show investment 50% higher than a year ago in the first quarter of this year. These figures almost certainly overstate the true pace of growth, and yet more reliable numbers suggest that investment is growing at the still-rapid rate of about 30%.

While that is unsustainable, some perspective is in order. The situation is nowhere near as severe as in 1993-94, when investment grew at an annual rate of over 60%, GDP growth peaked at over 15%, and inflation hit 28%. Nor is China’s condition now as fragile as East Asia’s economies were in the late 1990s, before the region’s economic crisis. Then, excess demand resulted in higher inflation, huge current-account deficits and rampant asset-price inflation. China’s inflation is still quite low and it has a current-account surplus, if a shrinking one. Although there may be a bubble in luxury housing, especially in Shanghai, house prices nationwide rose by only 4% on average last year. China’s stockmarket has been one of the world’s worst performers over the past year.

Although China may not be seriously overheating yet, there are signs that it could do so soon. The main risk of excessive growth is not a surge in inflation, but the inability of China’s financial system to allocate capital efficiently. Excessive borrowing is likely to lead to another wave of bad debts. On some estimates, these already amount to 40-50% of all bank loans.

In a developed economy, the obvious solution would be to raise interest rates. But it is a truism of economics that a country cannot control both its exchange rate and its interest rate simultaneously. While the yuan remains pegged to the dollar, the People’s Bank can do little about monetary conditions. Huge inflows of capital put upward pressure on the yuan. To hold it down, the central bank must buy foreign currency, which injects new liquidity into the banking system. As a result, banks have excess reserves, undermining the impact of a rise in reserve requirements.


The central bank has tried to mop up the extra liquidity by selling bonds. But such “sterilisation” is getting harder. The central bank has had difficulty selling its bonds in recent months because it needs to sell so many. China’s foreign-exchange reserves climbed by 39% in the year to March, to $440 billion, second only to Japan’s. Unless investors are offered higher interest rates, they will be reluctant to buy more bonds. But higher interest rates would attract yet more capital inflows.

Though economists hotly debate the question of whether the yuan is undervalued, China needs to adjust its currency, not because it may be too cheap, but to regain control of monetary policy. In the medium term China needs to allow its exchange rate to float. That cannot happen, however, until the banking system is in better shape.

Many foreign economists argue that in the meantime the government should revalue the yuan’s peg, widen its trading band or shift from a dollar peg to a basket of currencies. But a modest 5% revaluation of the yuan or a widening in the band within which it is allowed to trade could prove counter-productive. Recent strong capital inflows are driven by higher interest rates in China than in America and by an expected appreciation of the yuan. A small revaluation might thus attract still more capital in expectation of another rise. Any revaluation would need to be large enough—15-20% say—to dash such hopes. Since a rise of this magnitude would be unacceptable to the government, any move is unlikely this year.

Instead, the government may be considering tougher enforcement of capital controls, such as cracking down on the illegal ways in which banks connive with their customers to dodge restrictions on bringing in speculative capital. The China Economic Quarterly, an independent newsletter, points to a report published on the website of the State Administration of Foreign Exchange, which details such illegal techniques. This was, it thinks, intended as a warning shot to banks.

Tighter capital controls could allow the People’s Bank to raise interest rates. But it is unlikely to be allowed to do so by the government unless inflation goes above 5%. On the other hand, if capital inflows continue to accelerate, the China Economic Quarterly predicts that inflation could be double that by the end of the year. And then the question would not be whether China is growing too quickly, but how fast it will slow down

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