Why China crashed last month

Last week I started to air my wacky views on economics. I outed myself as being from the monetarist school of thought – as opposed to the Austrian school, or the Keynesian school.

China

Last week I started to air my wacky views on economics. I outed myself as being from the monetarist school of thought – as opposed to the Austrian school, or the Keynesian school.

Monetarists put great store in the importance of the money supply / central banks / monetary policy when it comes to the health of the economy. We think that more often than not, central bank policy explains what’s going on.

We think that inflation is the result of central banks allowing the money supply to get too big, and recessions are usually the result of central banks allowing the money supply to get too small.

There’s a pleasing symmetry and simplicity to it (probably part of why I like it). But of course the main reason is that it seems to work. That simple framework seems to fit the data very nicely. It helps me to make sense of the world.

The crash in 2008? Shrinking money supply as people started to hoard cash. The rebound that started in early 2009? Expanding money supply due to QE. Australia’s steady economy since 2008? Steady money supply in Australia. Japan’s comeback since 2013? A big boost to its money supply. And so on!

So whenever something extraordinary happens, like a crash or a bout of inflation or deflation, the first thing I do is take a look at what’s going on with monetary policy.

Things I look out for: new money printing by the central bank. New promises to print money in future by the central bank. Failure on the central bank’s part to intervene when it’s expected to. Signs that ordinary people are hoarding cash (which reduces the money supply). A change in the value of “pegged” currencies.

The Chinese stock market crashed last month, and the economy looks to be hitting the skids. What happened? (Hint: monetary policy!)

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Something changed

China’s currency is “pegged” to the US dollar. Pegging your currency means you don’t allow its value to change, relative to the currency it’s pegged to. So China’s central bank prints as many yuan as needed, to keep the yuan at a specific US dollar value.

There’re good reasons why countries choose to do this. But pegging your currency has one very important drawback. It means you hand over control of your own monetary policy. Instead of choosing the money supply which keeps your economy running smoothly, you choose the money supply that keeps your currency at its pegged rate.

So whenever the dollar gets weaker, China prints more yuan to keep the two currencies “pegged” at the same level. And whenever the dollar gets stronger, China tightens the supply of yuan.

In the last few years the dollar has risen in value. So to keep their peg going, China has had to cut its money supply.

Cutting your money supply is usually a bad idea – especially in a fast-growing economy like China. The monetarist textbook says that this should lead to deflation and unemployment.

What’s happening on the ground? Well, the most recent figures show that China experienced deflation in the first quarter of this year – which is pretty much unprecedented for a fast growing country like China. Unemployment is up.

I don’t know for certain that tighter monetary policy is causing the slowdown over there. China’s miles away from my desk in Southwark. And it’s a big complicated place.

But I have a strong suspicion China’s economy is behaving the same way as any other economy does when you mess with its money supply. Money matters.

Best wishes,

Sean Keyes

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