China: The problem is easy credit, not easy money

Tyler Cowen linked to this interesting NYT story:

HONG KONG “” Move over, Janet Yellen and Ben Bernanke. Step aside, Mario Draghi and Haruhiko Kuroda. When it comes to monetary stimulas, Zhou Xiaochuan, the longtime governor of the People’s Bank of China, has no rivals.

The latest data released by China on Wednesday shows that the country’s rapid growth in money supply has continued. Mr. Zhou and his colleagues at the Chinese central bank have only begun the difficult and dangerous task of reining it in.

The amount of money sloshing around China’s economy, according to a broad measure that is closely watched here, has now tripled since the end of 2006. China’s tidal wave of money has powered the economy to new heights but it has also helped drive asset prices through the roof. Housing prices have soared, feeding fears of a bubble while leaving many ordinary Chinese feeling poor and left out.

.   .   .

This means the money supply is still charging well ahead of inflation-adjusted economic growth, which has been about 7.6 percent; the exact figure for the fourth quarter of last year is scheduled for release on Monday.

Growth in M2 almost reached 30 percent at the end of 2009, when China was using monetary policy to offset the effects of the global financial crisis. China has reduced the pace of money supply growth since then, but kept it well above the pace of economic growth throughout, which means it has done little to sop up the extra cash issued during the crisis.

The question now is whether the central bank can further slow the growth of credit and the money supply without causing a slump in housing prices or a sharp slowdown in the credit-dependent corporate sector. Even the very modest slowdown in money supply growth so far has already contributed to two sharp but short-lived increases in interbank interest rates in June and December, which roiled markets in China and around the world.

China’s central bank “is in a very difficult situation; it needs to tighten but the whole system is not used to tightening, they are used to money printing,” said Shen Jianguang, a China monetary economist in the Hong Kong office of Mizuho Securities, a Japanese investment bank.

M2 encompasses money in circulation, checking accounts, savings accounts and certificates of deposit. It is the main money supply indicator watched by the People’s Bank of China in trying to balance the need for economic growth with the dangers of inflation.

M2 has grown so fast in China not just because the central bank has been issuing a lot of renminbi but also because the state-owned banking system has lent and relent those renminbi with encouragement from the government, creating a multiplier effect.

China has also undergone a financial liberalization in the past five years that has accelerated the pace of lending. An extensive and loosely regulated shadow banking system has emerged, partly because of the willingness of regulators to allow banks to classify loans to new financing companies not as corporate loans but as interbank loans, for which little capital needs to be reserved.

.   .   .

Consumer inflation has not yet become a big problem in China: Falling commodity prices and widespread manufacturing overcapacity held down consumer inflation to 2.6 percent last year.

This is what happens when a journalist confuses money and credit.  Monetary policy is not especially easy by Chinese standards.  Yes, NGDP growth is running around 10%, but that number is down from previous decades.  Even if the number is too high (and it probably is) it’s changes in the rate of NGDP growth that really matter.  A NGDP growth rate that is gradually slowing year by year does not causes rapid RGDP growth in China.  It’s productivity growth that explains the China boom.

Now when we turn to the broad M2 “money supply” we are actually looking at credit, not money. This is a completely different issue.  I’d expect credit to grow faster than money in a developing country like China, but even so, I think it quite likely that credit growth (and hence M2 growth) is too rapid. The moral hazard problem in China is an order of magnitude worse than in the US.  This means there is a lot of misallocation of resources by the big banks.  Too much housing and infrastructure construction in secondary cities, for instance.

But the solution is not “tight money,” which would simply cause another sort of misallocation of resources.  Instead of too much construction you’d get too much leisure time, aka unemployment. The solution is a tighter credit policy, not tight money, which is of course politically difficult to do under the Chinese economic regime.  This is why they need to reform the banking system by making it less bad.  Adopting the horrible US banking system would be a huge improvement for China.  The Canadian system would be far better.

For the moment they’ll stick with their current system and continue to misallocate resources.  At some point there may be a tipping point and they’ll get a little bit of stagflation if they are lucky, or mass unemployment if the follow the BOJ/Fed/ECB playbook.  Let’s hope they keep NGDP growth stable and opt for stagflation.  Or better yet market reforms.

PS.  I have a post offering half-hearted praise to Keynesians, over at Econlog.



26 Responses to “China: The problem is easy credit, not easy money”

  1. Gravatar of TravisV TravisV
    15. January 2014 at 14:37

    Clearly, the PBOC has been tightening monetary policy the past couple years (and NGDP growth has been falling).

    But how much more can they possibly tighten? As economic growth slows, won’t there be lots of political pressure on the PBOC to stop tightening?

    China’s government has successfully stayed in power peacefully for decades by consistently delivering growth. Shouldn’t those same political pressures that have been motivating it for decades ultimately prevail the PBOC from tightening and tightening and tightening?

  2. Gravatar of TravisV TravisV
    15. January 2014 at 14:43

    Excellent analysis by Lars Christensen below (in July 2013):

    “it is probably safe to say that based on a PPT measure Chinese monetary policy has become tighter over the past 18 months or so and have become excessively tight within the last couple of quarters”

    I also like the graph here illustrating the fall in China’s NGDP growth:

  3. Gravatar of TravisV TravisV
    15. January 2014 at 14:46

    Graph: Chinese Nominal GDP growth vs. Total Credit growth:

  4. Gravatar of Benny Lava Benny Lava
    15. January 2014 at 16:12

    Two things:

    1. Typo in this sentence “money is a developing country like China”.

    2. Do you really think there is too much construction in China? I thought you previously dismissed that view. Chimerical view. Is this an accurate representation of your thoughts?

  5. Gravatar of TravisV TravisV
    15. January 2014 at 16:22

    Benny Lava,

    I think Prof. Sumner believes in mis-allocation of housing construction. Specifically that “housing investment since 2008 has been directed at smaller cities where population growth is ebbing and not toward large cities where population is rising.”

    See the two links below:

  6. Gravatar of JN JN
    15. January 2014 at 16:25

    “The solution is a tighter credit policy”

    How do you do that?

  7. Gravatar of benjamin cole benjamin cole
    15. January 2014 at 17:14

    Excellent blogging. The non-independent PBOC has fueled a gigantic expansion of the Chinese economy in the last 25 years and they avoided the 2008 Great Recession.
    Compare that to Japan and the USA…and Europe for that matter…
    Shouldn’t our central bankers and economists being visiting the PBOC…to take lessons?

  8. Gravatar of Saturos Saturos
    15. January 2014 at 17:27

    Are you sure that curtailing M2 growth wouldn’t mean a negative shock to NGDP growth?

  9. Gravatar of Chris H Chris H
    15. January 2014 at 18:25

    @Benny Lava

    For your point two I think the key words Scott said were “secondary cities.” The major cities and regions of the coast clearly need a ton of infrastructure to maintain their growth, but a lot of the interior regions of China are seeing population losses and thus presumably don’t need much investment.

    Possibly the best example of this is the high speed rail line to Tibet That usage of resources seems more politically than economically motivated, a symbol to say “Tibet is Chinese now and forever.” Tibet is after all almost the poorest region of China and the least densely populated. There’s almost no real migratory push into Tibet these days and few Tibetans who might use the line to visit home when on vacation from factory jobs. There might be some tourism and cargo advantages, but those are pretty weak. Getting high speed rail out there seems like it should be pretty low priority compared to expanding lines closer to the coast. So that seems like it would be an example more along the lines of what Scott is saying (though he’d might include private investments as well).

  10. Gravatar of 8 8
    16. January 2014 at 01:08

    @Benjamin Cole

    If you go back 25 years, the renminbi collapsed by 50% 1994. They used financial repression to clean up bank balance sheets in the early 2000s, only to stuff them full of bad debts again in the post-2008 forced lending spree.

    I don’t see anything particularly impressive about the Chinese growth from the standpoint of the leadership. It is impressive because the Chinese people are smart, hardworking and save, and their success comes despite the government’s still massive interference in the economy and centrally directed investment.

  11. Gravatar of Rajat Rajat
    16. January 2014 at 03:37

    On Saturos’s point, I’m a bit confused by what the ‘M’ is in MV=PY. If it’s narrow/base money, then does V have something to do with credit creation? If not, then as per Saturos, are credit creation and broader monetary aggregates irrelevant to the determination of NGDP?

  12. Gravatar of benjamin cole benjamin cole
    16. January 2014 at 05:44

    No doubt there are shortcomings in the PBOC. The fact remains they have boomed for decades and are still growing rapidly.
    Sure Chinese have a strong culture—so does Japan. Didn’t help the Japanese.
    As for central (or state) planning in China, the topic is too big to understand. Every nation needs some planning for infrastructure and defense etc. China is doing it wrong? What about Japan? The USA? Europe.
    The fact is China has has great growth and moderate inflation for a good long run…that suggests a sound monetary policy. I say hire the PBOC to run the Fed…

  13. Gravatar of TravisV TravisV
    16. January 2014 at 06:03

    Ben Cole, very insightful as always!

    Saturos, good question.

    This topic is fascinating. Thanks for the comments, guys!

  14. Gravatar of ssumner ssumner
    16. January 2014 at 06:05

    Travis, Those NGDP figures for China seem pretty high. Are you sure they are accurate?

    Benny, I am reluctant to say China is doing too much construction. It makes sense for China to do a lot of construction right now. But I do believe the state owned banking system often directs resources to the wrong places.

    JN, I’m not sure how you tighten credit policy. But I would start by reforming the banking system. Make it more market-oriented. Reduce moral hazard. If it’s politically impossible to reform the system, perhaps you’d want to regulate the state-owned banks more tightly.

    Saturos. I would expect slower M2 to be associated with slower NGDP growth, but it doesn’t have to be that way. You can tighten credit policy and loosen monetary policy enough to support NGDP growth at the same time.

    Rajat, M is the monetary base in this blog. There is no necessary link between money and credit, although of course central banks may choose a policy that effectively links them.

  15. Gravatar of Ralph Musgrave Ralph Musgrave
    16. January 2014 at 09:30

    There’s no sharp dividing line between credit and money. Checking accounts are normally counted as money, while term accounts where the account holder deposits the money and cannot get access to it within a month are normally not counted as money. But it’s impossible to say where to draw the line, and practice varies from country to country.

    The distinction would become much clearer under the banking system advocated by Lawrence Kotlikoff (which John Cochrane sort of supports). Under that system, depositors have two sorts of account. First checking / instant access accounts which are 100% reserve: i.e. all deposits are backed with base money. That money earns no interest. Second, where depositors want interest, they put their money into mutual funds. Depositors can choose what sort of loans their money funds: NINJA mortgages, safe mortgages or whatever. And as is normal with mutual funds, if the underlying loans go bad, depositors take a hair-cut.

    The advantage of that system is that banks cannot suddenly go bust, so bye-bye credit crunches. And second the TBTF subsidy vanishes: something the incompetent duo Dodd and Frank have failed to achieve, as have the Basel regulators. For Kotlikoff and Cochrane, see:

  16. Gravatar of Doug M Doug M
    16. January 2014 at 10:31

    I may be willing to concede that China is different.

    But, in a free market, money and credit are inexorably linked. Credit is the vehicle that lets the money flow from those who have it, but don’t necessarily want to spent it, to those who want it and are ready to pay to get it.

  17. Gravatar of errorr errorr
    16. January 2014 at 10:38

    Are there ANY country that doesn’t link credit and money? The link is implicit in an interest rate targeting scheme right? If you chose to loosen monetary policy while restricting credit how would that work? How would the money enter the economy without affecting credit? Would it just be give money to everyone? Just print money and hand it to people might work but otherwise using conventional tools how can you restrict credit through a market mechanism? Do you raise reserve requirements while lowering interest rates? Does that work? I can’t seem to figure it out in my head.

  18. Gravatar of Jim Crow Jim Crow
    16. January 2014 at 12:41

    My naive understanding is that the PBOC uses deposit rates and credit quotas in addition to reserve requirements for their monetary policy. And while they’ve let the RMB has strengthen quite a bit in the last year, as far as I know, they still intervene in the exchange markets quite heavily. Partial intervention has lead to published accounts of fraud happening with trade between China and Hong Kong due to a combination of tax avoidance strategies and one-way bets on RMB appreciation. That may be a good thing from a liquidity standpoint, though. I’m a non-economist so I’ll ask an obvious question. If China followed Scott’s suggestion and tightened credit while loosening money can they still maintain their ‘dirty’ peg?

  19. Gravatar of Geoff Geoff
    16. January 2014 at 17:18

    “But the solution is not “tight money,” which would simply cause another sort of misallocation of resources.”

    That’s hilarious.

    Sumner is either clueless about the fact that “misallocation of resources” occurs with loose money, such as in China, or he is purposefully just claiming the opposite of the truth, so as to make it seem like the concept of misallocation of resources, which nobody would deny as true in the abstract, is allegedly connected with “tight” money instead of what’s actually true, namely loose money.

    Tight money after a period of loose money in fact reverses misallocation of resources.

  20. Gravatar of TravisV TravisV
    16. January 2014 at 19:44

    “Chinese Stocks Tumble On Contagion Concerns From First Shadow-Banking Default”

  21. Gravatar of Fed Up Fed Up
    17. January 2014 at 09:44

    Rajat said: “it’s narrow/base money, then does V have something to do with credit creation? If not, then as per Saturos, are credit creation and broader monetary aggregates irrelevant to the determination of NGDP?”

    ssumner said: “Rajat, M is the monetary base in this blog. There is no necessary link between money and credit, although of course central banks may choose a policy that effectively links them.”

    1) What policy would that be?

    2) Using a gold standard with no banks, gold is MOA, and one ounce of gold is UOA. There are 1,000 ounces of gold. Gold is not used as MOE at first. If V of gold = 0, then NGDP = 0. That is a problem. Solution: Add currency as MOE. Fix convertibility at 1 ounce to $1 (relative pricing). Everyone turns in their gold for $1,000 in currency. The currency entity gets the 1,000 ounces of gold. Everyone now quotes prices in terms of gold and currency at the same price because of the 1 to 1 convertibility. The $1,000 in currency starts circulating with a velocity of 2. NGDP = $2,000.

    In my example (fixed/pegged convertibility), gold and currency are both MOA. There is a dual MOA. Everyone quotes prices in terms of gold and currency at the same price because of the 1 to 1 convertibility.

    From my example above (fixed/pegged convertibility), 1,000 ounces of gold have a velocity of zero at the currency entity, and $1,000 in currency have a velocity of 2.

    Now mine another 1,000 ounces of gold and have gold be MOE as well as MOA. Everyone keeps their original $1,000 in currency. Another $1,000 in currency needs to be available to maintain the fixed 1 to 1 convertibility. 1,000 ounces of gold have a velocity of zero at the currency entity and 1,000 ounces of gold have a velocity of 2. $1,000 in currency have a velocity of 2, and $1,000 in currency have a velocity of zero at the currency entity. NGDP = 4,000.

    Now have everyone panic and not want to hold any currency/use it as MOE. They swap for gold. 2,000 ounces of gold have a velocity of 2. $2,000 in currency have a velocity of zero at the currency entity. NGDP = 4,000.

    Now have everyone panic and not want to hold any gold/use it as MOE. They swap for currency. 2,000 ounces of gold have a velocity of zero at the currency entity, and $2,000 in currency have a velocity of 2. NGDP = 4,000.

    Notice the fixed/pegged convertibility leads to a dual MOA. Does all of that sound good?

  22. Gravatar of ssumner ssumner
    17. January 2014 at 09:50

    Ralph and Doug, Money and credit are radically different concepts. Money is fundamentally a nominal concept and credit is a real concept.

    As an analogy in 1900 money and goods were fundamentally different concepts, even though one good (gold) happened to also serve as money.

  23. Gravatar of ssumner ssumner
    17. January 2014 at 09:56

    errorr, Credit can be controlled via regulations (capital requirements, etc) that have nothing to do with monetary policy. Imagine a monetary system in a economy with no credit. How would it work? Presumably the government would inject money in some other way, say by paying some government worker salaries in cash.

    Fed up, You asked:

    “1) What policy would that be?”

    one example is reserve requirements.

    And yes, there is a dual MOA under a gold standard.

  24. Gravatar of Fed Up Fed Up
    17. January 2014 at 10:07

    ssumner said: “Fed up, You asked:

    “1) What policy would that be?”

    one example is reserve requirements.

    And yes, there is a dual MOA under a gold standard.”

    1) Any other policies?

    2) Get rid of the gold standard. Now replace it with a demand deposit standard in the place of gold with 1 to 1 convertibility to currency. Now demand deposits and currency are both MOA (and MOE).

  25. Gravatar of ssumner ssumner
    18. January 2014 at 08:54

    Fed Up, Not sure what that means. Does that mean that all checks are good if not counterfeit? What if a bank defaults, is a $1000,000 bank account at that bank still the MOA? I can’t see how.

  26. Gravatar of Fed Up Fed Up
    19. January 2014 at 23:15

    “Does that mean that all checks are good if not counterfeit?”

    In the banking system covered by the fed, it is supposed to be.

    “What if a bank defaults, is a $1000,000 bank account at that bank still the MOA?”

    I assume you are asking about being over the FDIC limit.

    “FDIC Deposit Insurance Coverage

    The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the United States government that protects the funds depositors place in banks and savings associations. FDIC insurance is backed by the full faith and credit of the United States government. Since the FDIC was established in 1933, no depositor has ever lost a single penny of FDIC-insured funds.

    FDIC insurance covers all deposit accounts, including checking and savings accounts, money market deposit accounts and certificates of deposit. FDIC insurance does not cover other financial products and services that banks may offer, such as stocks, bonds, mutual fund shares, life insurance policies, annuities or securities.

    The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.

    The FDIC provides separate coverage for deposits held in different account ownership categories. Depositors may qualify for more coverage if they have funds in different ownership categories and all FDIC requirements are met. (For details on the requirements, go to”

    Let’s assume $250,000 covered by FDIC, and $750,000 is at risk. The bank’s assets go down enough that shareholders and bondholders get nothing. Let’s say that means $750,000 gets marked down to $700,000. The $700,000 is still MOA. The deposit holder will be upset. He/She removes the funds and puts them in a better (probably bigger) bank that does not fail. I believe this how an economy can end up with “too big to fail”. Imagine if JP Morgan failed. Would there be enough MOA (demand deposits) removed from an economy to cause a depression?

    Think of it this way. Assume gold and apples have a fixed conversion rate (both MOA). Allow them both to be MOE. Now have some apples rot so they can no longer be used as MOA and MOE.

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