China – my fear is a ”secondary deflation”

China has certainly moved to the very top of the agenda in the financial markets this week and a lot of what is playing out in the Chinese markets is eerily similar to what happened in the US and European markets in 2008.

As in 2008 there is a lot of focus on a bubble being deflated both among commentators and among central bankers. This in my view could lead to very unfortunate policy conclusions. I am particularly afraid that the People Bank of China’s fear of reflating the bubble will lead it to take too long to ease monetary policy – as clearly was the case in the US and Europe in 2008.

China – an “ideal” Hayekian boom-bust?

Market Monetarists are in general very sceptical about the Austrian story of the Great Recession and sceptical about a bubble explanation for the crisis. That, however, do not mean that Market Monetarists outright denies that there can be bubbles. In fact I certainly think that there was many examples of “bubbles” in 2008. However, the real reason for the bust was not overly easy monetary policy, but rather that monetary policy became insanely tight both in the US and the euro zone in 2008.

But how do that compare to the Chinese situation today? I have earlier argued that I don’t believe that easy monetary policy on its own it enough to create a major bubble. We need something more – and that is the existence of moral hazard or rather the implicit or explicit socialization of the cost of risk taking. One can certainty argue that Too-Big-To-Fail has been and still is a major problem in the Western world, but that is even more the case in China, where the banking sector remains under tight government control and where the banks are mostly government owned. Furthermore, the investment decisions in many industries remain under strict government control.

In that sense one can argue that China over the past 4-5 years have had the “ideal” environment – easing money and massive moral hazard problems – for creating a bubble. The result has most likely also been the creation of a bubble. I have no clue have big this bubble is, but I feel pretty certain that the Chinese government run banking system has created serious misallocation of capital and labour in the last 4-5 years. In that sense we have probably been through a Hayekian boom-bust in the Chinese economy.

Fear the secondary deflation rather than a new bubble

The Chinese authorities have been extremely focused on how to deflate what they consider to be a bubble and as a result Chinese monetary and credit policies have been tightened significantly since early 2010 when the PBoC the first time in the post-crisis recovery tightened reserve requirements.

Hence, since 2010 the PBoC has basically tried to “deflate the bubble” by tightening monetary conditions and as a result the Chinese economy has slowed dramatically.

The PBoC obviously has been right to tighten monetary policy, but I have for some time though that the PBoC was overdoing it (see for example my post on “dangerous bubble fears” from last year) and in that regard it is important to remind ourselves of Hayek’s advice on conduct of monetary policy in the “bust” phase of the business cycle.

When Hayek formulated his version of the Austrian business cycle theory in Prices and Production from 1931 he stressed that the monetary authority should let the bubble deflate with out any intervention. However, he later came to regret that he in the 1930s had not been more clear about the risk of what he called the “secondary deflation”. The secondary deflation is a “shock” that can follow the necessary correction of the “bubble” and send the economy into depression.

If we formulate this in Market Monetarist lingo we can say that the central bank should allow nominal GDP to fall back to the targeted level if there has been a “bubble” (NGDP has accelerated above the targeted level). This will ensure an orderly correction in the economy, but if the central bank allows NGDP to drop significantly below the “targeted” level then that will could trigger financial distress and banking crisis. This unfortunately seem to be exactly what we have seen some signs of in the Chinese markets lately.

The graph below shows two alternative hypothetical scenarios. The red line is what I call the “perfect landing” where the NGDP level is brought back on trend gradually and orderly, while the green line is the disorderly collapse in NGDP – the secondary deflation. The PBoC obviously should avoid the later scenario. This is what the ECB and fed failed to do in 2008.


Reasons why the PBoC might fail

I must admit that my fears of monetary policy failure in China have increased a lot this week, but luckily a secondary deflation can still be avoided if the PBoC moves swiftly to ease monetary conditions. However, I see a number of reasons why the PBoC might fail to do this.

First, there is no doubt that the PBoC is preoccupied with the risk of reflating the bubble rather than with avoiding secondary deflation. This I believe is the key reason why the PBoC has allowed things to get out of hand of the past weeks.

Second, significant monetary easing will necessitate that the PBoC should allow the renminbi to weaken. There might, however, be a number of reasons why the PBoC will be very reluctant to allow that. The primary reason would probably be that the Chinese do not want to be accused of engineering a “competitive deflation”. In that regard it should be noted that it would be catastrophic if the international community – particularly the Americans – opposed renminbi devaluation in a situation where the crisis escalates.

Third, the PBoC might feel uncomfortable with using certain instruments at its disposal for monetary easing. One thing is cut banks’ reserve requirements another thing is to conduct to do outright quantitative easing. We know from other central bank how there is a strong “mental” resentment to do QE.

I strongly hope that the PBoC will avoid remarking the ECB and fed’s mistakes of 2008, but the events of the past week certainly makes me nervous. Monetary policy failure can still be avoid it – how things develop from here on it up to the PBoC to decide.

Leave a comment


  1. At least they are far enough away from the zero bound that David Glasner’s point about the Fisher Effect under deflationary expectations probably won’t bite them (and us).

  2. nickikt

     /  June 22, 2013

    Lars, I have a question. So I would agree that montary policy that is done nicly would not creat bubbles or misalocation. Take a example of a free banking system with a gold base. If a gold flows into the system, the broad money expands, the diffrent banks spend this new money on whatever investment the think is best, witch probebly mean its spread threw the economy broadly.

    Now if the central bank only buys mortgage backed securities, would this not drive up the price and creat a misallocation of resources into sector?

    It seams to me if the central bank wants to do montary policy correctly they should invest into a wide range of industries in order not to influence the price (resource allocation) of any one industry to much.

    So it seams to me that moral hazzard, bad montary transmission and collective delusion can create bubbels. We can avoid the first two.

    Am I missunderstanding something? Do you agree?

  3. Very reasonable

  4. James in London

     /  June 22, 2013

    I agree with what you say on monetary policy. But, I think you grossly underestimate how hard it is for a corrupt state to allow its state-owned banks to foreclose on bad loans made to loss-making state-owned industries. In a democratic state failed economic policies of one government are usually exposed by the next government. I don’t see how this can happen in China.

    While the governing party has recently changed it’s leaders, the party in power has not changed. I recognise there is some sort of “clean up” taking place, but the hidden loan losses at the big state-owned banks are widely assumed to be very large. The message from the ultra-low PE ratios (c.5x) and P/BV ratios (c.0.5x) of the banks is very clear on this. The market is right, and is extremely sceptical.

    There must be a huge temptation to use monetary policy to inflate away the bad debts, rather than recognise and recapitalize the banks. Essentially, the route followed by China in 1998 was this policy. A 35% bad loans to total loans was recognised back then; the bad assets were “sold” to quasi-asset managers at more or less face value in return for bonds issued by the quasi-asset managers; the banks carried on more or less as before; and NGDP growth over the next ten years has gradually reduced the relative size of the old bad loans to a relatively small fraction of total loans. But banks as a % of GDP were far smaller than today, the same trick will cost far more today.

    Maybe it will work again, but maybe it won’t. The last ten years has seen strong, catch-up, RGDP growth as well as the strong NGDP growth. If the next few years are mostly NGDP and not RGDP growth, then how will the one party state cope with Brazil or Turkey style protests? Brazil and Turkey have proper elections and democratic accountability these days, and hopefully stick with those processes. What does China have? We’ll have to wait and see.

    • James, I very much agree – Turkey-Brazil style demonstrations in China would send shock waves through the global financial markets and there is a major problem that most investors really don’t have a clue what is happening behind the scenes in China. It is easy to be bearish on the China outcome.

  5. Benjamin Cole

     /  June 23, 2013

    China? Who understands China? State-contolled banks. But the CCP also controls the PBoC. 1.5 billion people. I assume it is an impossible country to understand–especially since you have experts making opposite predictions as to that nation’s future.

    I wonder if central banker-itis is even stronger than ideology.

    But that, I mean if you ask a central banker anywhere what is a good policy, they will say “tighter money.” It is like asking a military man should the Army be bigger. In any nation, no matter socialist. communist of capitalistic, they will say “Yes.”

    Central bankers should not be allowed to work at central banks.

    • James in London

       /  June 23, 2013

      Benjamin. You are probably right. We’re doomed!

      The Chinese have actually had “easy money” for several years, in terms of negative real interest rates and high, probably too high, NGDP growth. The state control of banks then became even more necessary to ration credit growth attracted to the negative real interest rates via loan quotas and caps on deposit rates.

      However, the market response is to get round these constraints somehow. The consequence has been the explosive growth of “shadow banking”. I am now thinking that shadow banking in China is more of a “free-market/black market” response to excessive state control of official banking.

      It’s tolerated most of the time out of necessity, otherwise the overall economy won’t work. This has been the history of China since the end of Mao: small reforms through which the dynamism of the market then drives a bus right through. It’s not ideal, but it has clearly worked.

      The current vogue in China is to “teach these shadow banks” and the state banks that partly finance them, “a lesson”. The PBOC tigthening of liquidity is the result. Monetary policy has been abused once in staying too easy, resulting in huge banking sector distortions, and is now abused again.

      Freeing up state-owned banking from state-directed lending is the right thing to do, but politically very difficult, and economically painful for all those un-creditworthy state-owned enterprises, probably linked to senior politicians and their clans.

  6. Hi Lars,
    I have no intention to gloss over China’s problems, particularly not those related to moral hazard dynamics, or the inefficiencies and problems resulting from the command-economy type structure.

    Nevertheless, it is worth noting that China has had several similar credit crunches since 2010. These crunches all led to temporary surges in money market rates, and a somewhat elevated, and more volatile, level of interbank rates there.

    However, these occurrences were all defused at least in the sense that they did not cause much damage outside the Chinese markets and Hong Kong.

    Countries in possession of the entire monetary policy arsenal of tools should be able to offset tighter conditions in China, which are apparently desired by the authorities there, as long as China’s economy doesn’t completely crash (which I don’t expect).

    Today, however, the markets obviously share your shares about a “secondary deflation” in China.

    • Mikio,

      I certainly hope that your are right and I am aware that we have had a couple of hiccups in the Chinese money market since monetary tightening was initiated in early 2010. However, the recent “event” has been much worsen than the other hiccups and it is particularly concerning that what we saw last week was at least the outcome of a deliberate attempt on part of PBoC to punish a certain part of the financial sector.

  7. James in London

     /  June 24, 2013

    Just had a horrible thought: What if the PBOC actions and the Fed actions are a coordinated move to suppress “bubbles”?

  8. My latest blog post: “The Employment To Population Ratio (EMRATIO) is NOT a good indicator”

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