The Commodities Boom and China: The Missing Ingredient
A great deal has been said about the current commodity boom -- nearly all of it wrong. As usual so-called analysts fell into the trap of confusing symptoms with causes. To make it worse, we have economists, particularly in Australia, 'explaining' the boom in Keynesian terms of "surplus savings" caused by a "shortage of aggregate demand". There seems no way of escaping Keynes' curse.
What these commentators have forgotten is that if there is a "shortage of aggregate demand" then according to Keynesianism the world should be in the grip of a recession. Obviously it isn't. Unable to wrench free of Keynesian dogma these commentators are reduced to blindly making contradictory statements. Thus we get statements like excess savings amount to "about 60 per cent of the world economy, reflected in current account surpluses and large international reserves".
But current account surpluses are not savings. And the fact that a country is running a current account deficit doesn't necessarily mean that it is dissaving. Additionally, the notion that China, for example, is accumulating masses of idle dollar reserves is ridiculous. (Proponents of this surplus savings thesis are making the Keynesian error of confusing savings with cash balances).
Any economist should know, even Keynesians, that as export receipts in the form of US dollars flow into China the PBOC (People's bank of China) buys them with renminbi. This can have the effect of maintaining the exchange rate. However, unless the inflow is sterilised the process inflates the domestic money supply, generating inflation. Additionally, the newly acquired dollars will be used by China to buy treasury bonds and other US assets. Nothing is for nothing.
If so-called "excess savings" are not driving the commodity boom, what is? The usual response to that question is to point the finger at Chinese demand. But where is this demand coming from? This question is rarely if ever asked. It is almost automatically assumed that demand is being wholly fuelled by Chinese savings. But it isn't.
M1B is defined by the PBOC as M1A plus passbook savings deposits of individuals (including non-profit organizations) in monetary institutions. I have assumed that this definition amounts to all currency outside the banking system plus all bank deposits, including government deposits and bank deposits with the PBOC.
From November 1999 to December 2005 M1B grew by nearly 67 per cent, nearly all of it credit, suggesting that a massive and unsustainable credit expansion has been fuelling China's boom and her demand for commodities.
Unfortunately it very clear that Chinese economists are blind to what has been happening. Zhou Xiaochuan, the PBOC's governor, wants to continue with the bank's dangerous monetary course. In this he is supported by Qin Chijiang, deputy secretary-general of the China Society of Finance and Wang Yuanhong, a senior analyst with the State Information Centre.
Chinese economists focus on M2 which is M1B plus "quasi-money". Now "quasi-money" includes credit instruments like repurchase agreements and negotiable certificates of deposit. These things are not money nor are they money substitutes.
This confusion about what constitutes money was easily dealt with by Walter Boyd whose Letter to Pitt the Younger (1801) laid out with admirable clarity the distinction between "ready money" and so-called money substitutes:
By the words 'Medium of Exchange', 'Circulating Medium', and 'Currency', which are used almost as synonymous terms in this letter, I understand always ready money, whether consisting of Bank Notes or specie, in contradistinction to Bills of Exhange, Navy Bills, Exchequer Bills, or any other negotiable paper, which form no part of the circulating medium, as I have always understood that term. The latter is the Circulator; the former are merely objects of circulation.
Boyd made the clear distinction between "ready money" as the final payment and financial intermediaries, a distinction that is lost on most modern economists. Using Boyd's sensible definition of money we conclude that travellers' cheques, certificates of deposits and other credit transactions are not part of the money supply while demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank are money.
This confusion between money and the "objects of circulation" could have been easily removed if only economists had taken the trouble to seek out Boyd's work and give it the intellectual recognition it deserves. By not doing so economists lost sight of the nature of money and its power.
Therefore, the so-called "global oversupply of money" and "excess savings" are nothing more than central banks flooding their economies with credit. It is this credit that is driving the commodities boom. Sooner or later the brakes will have to be applied. What this would mean for China I cannot say.