Saturday, April 18, 2009

China wants inflation

Following my previous post on China entering deflation zone, I look at recent history of money supply (M1) in China and how it precedes inflation (CPI). As famously said by Milton Friedman "inflation is everywhere a monetary phenomenon", China will be no exception.

I often wonder "unemployment" and "inflation", which is a bigger evil. Modern monetary theory points to the latter, and I agree. But given more than 20m migrant workers out of work due to manufacturing plants shut down in the coastal area, maybe inflation concern has to rest, for now.

(click to enlarge; source: author's own calculation and NBS)

If you look at the chart above carefully: in late 90s, China also had deflation and it was followed by a huge surge of money supply (at nearly 25% increase in the mid of 2000) , but inflation did not rise to a uncontrollable level, only about 2%. Then more money was pumped into the economy, and inflation finally rose to 5% level (not until 2004). This was in sharp contrast to the high-inflation era in early and mid 90s (see graph below). The only conclusion is China's central bankers became much more experienced in controlling inflation.

So what is the policy implication? Chinese government may need to pump more money into the economy and in a quick fashion. This is not a common average-Joe recession, so policy needs to be flexible and adaptive.