Wednesday, May 23, 2007

An Imminent Protectionist Depression?

When credit expands investment becomes easy because there are loans to invest. As with any resource, care declines as the resource becomes abundant. As credit expands, banks and entrepreneurs make less careful investments. These can be into businesses that don't succeed, such as websites seven years ago, or they can be into real estate. Once the borrower spends the credit as money, the money circulates through the economy. As the amount of money increases because of the easy credit, prices begin to rise, and there is inflation. The inflation occurs in part because the investments for which the credit was used may not have been good ones. Back in the 1960s investment was made in bowling alleys, which failed, for example. The use of the credit for failed bowling alleys amounted to giving entrepreneurs and business people "food stamps" for which they did not produce anything. They used up resources to build failed bowling alleys. Demand for resources around the economy expanded. Prices rose unevenly because the money was distributed unevenly, being spent first on the bowling alleys for which the bank gave credit. For example, since, more recently, there has been stimulation of demand for house construction, construction-related commodities may have been the first to increase in price.

In the last cycle, China has modified the inflationary pattern. China has purchased a surplus of treasury bonds denominated in dollars. By purchasing dollars, China has reduced the number of dollars in circulation. This has reduced the price inflation that otherwise would have occurred. Why has China purchased the bonds? The reason is that it sees an advantage in reducing the value of its own currency, i.e., causing inflation in China. The advantage is that it wishes to redirect the way Chinese farmers work. Previously they had worked in small-scale agriculture. The Chinese government would like to see them working in manufacturing. By causing inflation, i.e., reducing the value of the Chinese yuan, demand for manufacturing output is increased. Because of the inexpensive yuan, it is inexpensive to purchase land relative to the demand, so extra factories can open.

The problems with stimulating the extra demand for land are two. First, the Chinese government must hold depreciating dollars. If (more accurately "when") the US stimulates its economy further, the number of treasury bonds that the Chinese must hold will increase as well. This is a risky strategy. Would you invest your entire investment portfolio in a currency investment where the economic forces suggest future depreciation? That is China's strategy. So it is borrowing from Peter (the Chinese taxpayer) to pay Paul (the Chinese farmer turned factory worker). Second, the stimulation of the Chinese economy will cause prices to rise. The January 4th Economist carries an article "Go West, Young Man" describing rapid wage increases in the Pearl River/Hong Kong and Shanghai regions where most of the development has occurred. Firms are increasingly locating factories in countries other than China because of costs or to inland China, further west. The problem with inland China is transportation costs and likely inadequate roads, which will require significant investment. With major infrastructure investments needed, will China be able to keep buying US treasury bonds?

There is no reason to assume that China will continue this policy indefinitely. Nor is there any reason to assume that China does this because it is charitable. China does this as long as the US and the west buys Chinese goods. If the US initiates a round of protectionism, what would stop China from selling the bonds? What motive would it have to continue holding the bonds? reminds us that the Great Depression was in large part a banking and monetary phenomenon and that Milton Friedman in his Monetary History of the United States speculated that religious bias against the president of the Bank of the United States, who was Jewish, led to the Fed's refusal to assist that bank run leading to its failure. In other words, biases can have economic consequences.

Dinocrat mentions that the current anti-protectionist movement is reminiscent of this very kind of trivial bias that can mushroom into larger-scale economic catastrophe. Let us hope the current protectionist saber-rattling by the knucklehead left is not to be taken seriously. There is a strategic inflationary risk that would exacerbate the always harmful consequences of trade barriers.

No comments: