Friday, March 30, 2012

Greater freedom has made China more stable

by Richard J. Grant

BEIJING – If China’s government were a monolith, then reading its intentions from its actions would be much easier. There is never a guarantee that the words of a government reflect its true intentions. But there is no certainty that its actions do either.

There seems to be the recognition within the Chinese government that they must move away from protection of state-owned enterprises (SOEs) and away from state ownership. SOEs tend to be inefficient and to be disruptive of natural market activity. According to Professor Wen Hai, an economist and Vice President of Peking University, as well as Dean of the HSBC School of Business, SOEs appear profitable only because the government controls their prices. We happen to be meeting the day after the government increased gasoline and diesel prices by between 6.5 and 7 percent. That brings the gasoline price up to about $4.80 per gallon.

But special-interest groups have grown up around the SOEs. These groups profit from their relationship with the SOEs and don’t want it to end. As do interest groups everywhere, they will continue to work at preventing any reform that threatens that relationship. Result: Either nothing happens or reform comes more slowly than intended.

That society-changing reform has already come is unmistakable. The Communist Party of today is not the Communist Party of 40 years ago. Neither is China the same. Change has come much faster than in the West, so rapidly that generations are shortening culturally, which is another way of saying that generation gaps are widening. Those born in one decade experience a very different world from those born in the previous decade. Yet there is continuity.

Chinese history did not begin with Chairman Mao Zedong, nor did it end. Mao’s time in history is remembered and publicly respected. But it is not to be relived. Those who lived through the Cultural Revolution seem intent to guard against that.

Zhu Yinghuang, Editor-in-Chief Emeritus of China Daily, remarked that those of his generation (those now in their 70s) had accepted that whoever had the strength to seize control of the country “had the right to rule.” In his time that was the Communists. They seized control soon after helping to drive out the Japanese. He asks rhetorically whether leaders of future generations will think differently. Perhaps they will.

Different lessons are learned from shared experience. The experience of communism, as actually attempted, was “profitable” for only a few. For those who traveled or could see outside, the contrast with the West was unmistakable. So was the lesson: Reform must happen.

When speaking with high government officials, a word that recurs too frequently to be an accident is “stability.” Reform does not go ahead unless it is believed to solve a problem and not to threaten stability.

The high growth and rising incomes since the reforms began would certainly help the re-election chances of a Western government. While some Chinese might be politically emboldened by their experience of greater freedom and higher incomes, there might be as many who see no reason to risk derailing what seems to be working. This balance serves to help preserve stability in the governance structure.

It is one more example of where greater market freedom has helped to support stability of government and of society. Perhaps that was the intention.

Richard J. Grant is a Professor of Finance and Economics at Lipscomb University and a Senior Fellow at the Beacon Center of Tennessee. His column appears on Sundays.

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Copyright © Richard J Grant 2012

A Sound Currency Standard Keeps Inflation Quiet

by Richard J. Grant

In 2010, China had more than one reason to unpeg its currency from the US dollar. Certainly the Chinese were under pressure from US officials to allow the yuan to appreciate. The Americans had all but officially accused the Chinese of currency manipulation, of keeping the yuan undervalued. But even without this pressure, Chinese officials had reason to question their choice of standard to which to peg their currency.

The Chinese were in a position similar to that of the Germans 50 years earlier. In 1960 the German mark had a fixed exchange rate with the US dollar which, in turn, was officially fixed to gold. But as the US began the inflation that would ultimately lead to its break with gold, it transmitted that inflation to all those currencies, such as the mark, that were fixed to the dollar.

During 2010, the Chinese consumer-price inflation rate was rising. It peaked out at 6.5 percent in mid-2011. That was a year after the Chinese released the yuan from its dollar peg in June 2010 when its managed appreciation began. With this, and higher bank reserve requirements, inflation has dropped to 3.2 percent year-on-year for February.

In the past year, the yuan has appreciated about 4.4 percent against the dollar and 9 percent against the euro. Not surprisingly, Chinese trade surpluses have diminished. In February, their trade balance with the rest of the world went into deficit.

Last week, Chinese Premier Wen Jiabao announced his government's 2012 “growth target” of 7.5 percent, down from 8 percent. Such projections usually understate their true expectations, but the reduced target is consistent with deliberate currency strengthening. The pegged exchange rate required the regular purchase of a large quantity of dollars and the issue of a commensurately large quantity of newly created yuan. The reduction of such monetary inflation generally results in a slowdown and the temptation to reflate.

The premier's justification of the diminished growth target seemed to recognize that the continuation of such inflationary stimulus might possibly result in a worse slowdown. He said a reduction would help improve the quality of growth and better facilitate a needed economic restructuring. The implicit hint is that inflation and fiscal stimulus can yield a low-quality growth that is unsustainable.

Just as the economic gains of the past 30 years were made possible by a relaxation of the communist chokehold, future gains will depend increasingly on further deregulation and extension of property rights. Premier Wen spoke of the need to improve the security of rural land rights and the need to deregulate the financial sector by finding a way to legalize what is now an underground finance market.

The extension and clarification of land rights would enable more productive use of that land and make it available as collateral to attract financing. Deregulation of the financial sector would open up opportunities currently ignored in a marketplace dominated by large state-owned banks.

A less-regulated economy always adjusts more quickly to the after effects of inflation. As in any economy, the real limits to growth and adjustment are legal, not physical. The economy will continue to grow as long as the state continues its evolution from a restrictor of private action to a protector of private property rights.

Any hesitation in this evolution will make the prospect of any “hard landing” that much harder to take.

Richard J. Grant is a Professor of Finance and Economics at Lipscomb University and a Senior Fellow at the Beacon Center of Tennessee. His column appears on Sundays.

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Copyright © Richard J Grant 2012

Sunday, March 11, 2012

Is Fed Policy Twisted Or Merely Sterile?

Published in The Tennessean, Sunday, March 11, 2012

and Forbes with archives.

by Richard J. Grant

Federal Reserve officials continue their search for new and improved methods to invigorate our underperforming economy. According to Jon Hilsenrath in the Wall Street Journal, the Fed's latest idea is to “print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates.”

Such a program would change the composition of assets and liabilities held by the Fed. It would also increase the demand for long-term bonds, thereby holding down long-term interest rates a little longer. But the short-term borrowing that finances it would also bid up short-term interest rates. In this regard, it would have the same effect as the recently implemented version of “Operation Twist” in which the Fed has sold short-term securities and used the cash to buy long-term securities.

But why doesn't the Fed just create money to buy whatever it wants? Fed officials are as aware as anyone else that monetary inflation pushes prices higher than they would have been “all else equal.” That is why they won't let all else be equal.

As years of malinvestment – bad or inappropriate investments – began to unwind during 2008, the Fed had to decide quickly whether and how to respond. It purchased unprecedented quantities of mortgage-backed securities and other low-quality assets that threatened the solvency of many financial institutions. Those financial institutions received cash while the “toxic assets” moved onto the Fed's balance sheet.

When the Fed created the cash to purchase those assets, it created it out of nothing. Central banks do that. But when analysts saw the quantity of base money double during the last quarter of 2008, they were justifiably concerned about the increased likelihood of future price inflation.

All else equal, such a rapid increase in the quantity of base money would soon after result in a rapid and general increase in prices throughout the economy. The first symptoms would be dollar weakness and rising commodity prices. This would eventually show up as rising consumer prices once we had worked our way through the recessionary adjustments and economic activity began to pick up. The size of the increase would, of course, hasten the symptoms of inflation.

But no such rapid increase in consumer prices has yet occurred. During 2008, the Consumer Price Index rose almost 5 percent and then fell back by the same amount. Since then, although some commodity prices have been strong, the CPI has not risen by much more than 3 percent per year. Clearly, all else is not equal.

When the quantity of base money grew rapidly (it has tripled since mid-2008), its growth in dollars was almost matched by bank reserves. Banks now hold 18 times the amount of reserves that they held in mid-2008. Not coincidentally, in late 2008 the Fed began paying interest to banks for holding their reserves. Currently, banks receive one-quarter percent interest for making a risk-free loan to the Fed.

This sounds rather similar to the new and improved program being considered by Fed officials. It also sounds similar to “Operation Twist.” All three programs are structured to increase demand for some long-term asset by sending a flood of money in one direction while “sterilizing” it against inflation by retaining or pulling back an equivalent amount of money at the same time.

The Fed continues to bury its talents.

Richard J. Grant is a Professor of Finance and Economics at Lipscomb University and a Senior Fellow at the Beacon Center of Tennessee. His column appears on Sundays.

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Copyright © Richard J Grant 2012

Sunday, March 04, 2012

The Fed and The Power To Redirect and Redistribute Wealth

by Richard J. Grant

A butterfly flapping its wings in a rain forest is nothing compared to a central banker flapping his lips.

Federal Reserve Chairman Ben Bernanke recently told a congressional committee that, although he wouldn't rule out another round of quantitative easing, he did not foresee another round in the near future. With this statement, the dollar rose compared to other assets, as reflected in a sudden 5 percent drop in the price of gold. The silver price also plunged, as did stock prices and Treasury securities.

Other than the good news – that the Fed won't be inflating the money supply as much as it has been recently – it highlights the economic impact of one of many government-created agencies. The Federal Reserve Board, through its statutory power to create currency, does not create wealth but has the power to redirect and redistribute wealth.

When it inflates the money supply to hold down interest rates, it ensures that those who sell bonds get a higher price (at the expense of buyers) and that those who buy and hold bonds receive lower income streams than they would have. Investment choices and patterns are different than they would have been under a different monetary regime. Interest rates no longer reflect the preferences and decentralized market knowledge of millions of market participants. Instead, interest rates are manipulated by a small group of government-appointed individuals according to their much narrower judgment and preferences.

The exercise of such powers usually results in some kind of seemingly unconnected crisis or reversal. This is why periods of deliberately low interest rates are eventually followed by periods of deliberate and systematic increases in the Fed's targeted interest rates. During the period of artificially low interest rates and expanding money supply, credit seems cheap and resources are directed into investments and uses where they might not otherwise have gone. It looks and feels like a boom of prosperity, but it is also a time when businesses are misled by low interest rates to invest as though capital is less scarce than it really is.

What can't go on forever must stop. Expansion of the money supply eventually causes prices to be higher than they would have been. When inflation goes above the Fed's preferred level, as it is now, they must slow or stop the expansion of money supply. Interest rates will rise commensurately. Families and businesses that can't handle the higher rates might have to postpone future plans or reverse previous decisions.

If such reversals are widespread, we call that a recession. We recognize that something is wrong; we change our plans; and while we reorganize, people and resources are often unemployed. All this unfolds because some central planners thought that they could improve on the market.

Other government agencies, such as Fannie Mae and Freddie Mac, use their power to shift risk onto taxpayers through government guarantees of mortgage-backed securities. This lowers the perceived costs of homeownership. They don't really create new wealth; they merely change the patterns of mortgage lending and property ownership. Resources that would have gone into more-productive uses are enticed toward apparently less-risky mortgages.

Still other government agencies interfere in banks’ decisions about creditworthiness and which markets they will serve. Any one of these can create problems for someone, but all of them together multiply the likelihood of financial crises and industrial fluctuations.

Richard J. Grant is a Professor of Finance and Economics at Lipscomb University and a Senior Fellow at the Beacon Center of Tennessee. His column appears on Sundays.

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Copyright © Richard J Grant 2012