Is China Being Political or Just Plain Stupid?

By Vedran Vuk

With consumer prices in China up 4.4% this October over last year, the country has taken another move to avert inflation: price controls. There’s just one problem. Thirty years ago this would have been a viable policy alternative, but those days are long gone. In fact, the vast majority of economists agree that price controls do nothing to prevent inflation and only lead to shortages.

This isn’t a wise insight from an obscure economist. It’s the view of even the most basic of microeconomics textbooks.

China isn’t ignoring inflation; it simply isn’t using interest rates to solve the problem. And raising rates just happens to be best way of dealing with inflation – remember Volcker. So why not use the most effective policy tool, as opposed to laying on price controls – one of the very few policies that almost all economists can agree on as being wrong-headed.

So is China being just plain stupid?

Perhaps. After all, if Chinese economists really believe that price controls will effectively combat inflation, the country is headed for trouble, and fast.

Unfortunately, despite Geithner’s calls for the Chinese to let their currency appreciate, inflation will have the exact opposite effect.

Yet, in part due to the prodding by the U.S. and other trading partners, China is undertaking a number of measures to combat inflation – other than raising rates.

For example, in an attempt to head off a bubble, China has placed controls on real estate. These measures include higher down payment ratios for second-home buyers and limits on government land auctions. But again, these tools are ineffective ways of dealing with the underlying problem.

Also, last week China again increased reserve requirements for banks by 50 basis points. On November 10, they enacted an identical 50-point hike. In the past year alone, China has increased the reserve requirement five times. However, the interest rate has been increased only once. Higher reserve requirements contract the money supply, as do higher interest rates, but in a different way. As banks must hold greater reserves, the flow of money throughout the system begins to slow down. Fewer loans are made, and money cycles through the system less rapidly. To put it in more formal terms, the velocity of money goes down.

If China simply raised rates, inflation concerns would subside – these other shenanigans are entirely unnecessary. If anyone knows how to control a currency, it’s China. And this case isn’t rocket science or a central banking mystery where new methods and alternatives must be devised. Like price controls, this is macroeconomics 101 kind of stuff.

In my opinion, by attempting to use poor policy tools to fight inflation, the Chinese are playing a very dangerous game. So why not just raise rates? For one thing, they don’t want to be seen as caving in to U.S. demands that they raise rates and, as a result, boost their currency. Also, they are concerned about scaring investors with higher rates and risking causing a crash in the Hang Seng index.

In a way, the central bank of China is trying to have its cake and eat it too. And so far their plan has worked reasonably well. But this dangerous game could get out of hand very quickly. If it does, the consequences of the resulting inflation will be far worse than losing face on the international scene and a couple of points lost on the Hang Seng.

For us as investors, watching the policy measures used by the Chinese officials in the weeks and months ahead will be very helpful in anticipating the outlook for that increasingly important global economic powerhouse and, by extension, the U.S. economy.