Global Economy Caught In the Middle of Central Bankers
In a poll of 15 economists conducted by Caixin, a Chinese media outlet, Chinese exports were predicted to fall by 3.8% in September in dollar terms. That would have been slightly worse than August but still marginally better than the past few months that had seen some growing optimism the world economy was at least stabilizing, as seen through China. Instead, updated figures released Wednesday night from the General Administration of Customs showed that Chinese exports fell by an alarming 10% in September.
While that was the biggest contraction in exports since February, in many ways there hasn't been any actual difference in economic conditions, exports or otherwise, no matter what the month-to-month changes in rates. Exports were once the lifeblood of China's "miracle" expansion. In the 21 quarters starting the middle of 2002 until the third quarter of 2007, the one containing August 9 and the events that would mark a permanent change in the eurodollar system, Chinese exports on a quarterly basis grew by more than 25% in all but two of them; and in those two quarters growth was still better than 20%. In the eleven quarters between Q4 2002 and Q2 2005, the increase in exports was less than 30% just once, and that single violation was at 29.7%.
From this view, the one in which the Chinese economy was expecting of the aftermath of the Great "Recession", there isn't a functional difference at all between -3.8% and -10%. Instead, what economists are seeking is the linear point at which they assume this will all end; cyclicality will be restored and "normal" growth will resume. This is what mainstream economics has been reduced to, parsing monthly variations in order to declare, time and again, that "it" is over so that we can all go back to loving their world-saving efforts.
Instead, those declarations are regularly thwarted and dispersed by mystery. In China, GAC spokesman Huang Songping admitted that, "The global economic recovery was sluggish, and overseas demand remained low." He also added that grave "uncertainties" remain, a troubling prospect given that these same "uncertainties" have been feared and dismissed by turn for more than two years now. The alternating tide of almost euphoria turned back by uncertainty time and again is itself the most significant part of all this, rather than the specific negative (or sometimes positive) number which determines the these relative viewpoints.
As noted last week on Japanese comparisons, this bears the hallmark of unstable monetary conditions. In Chinese terms, this is something that the country has seen before, perhaps most relevant in association with the 1930's.
Orthodox economics views the Chinese economy quite favorably during the otherwise global collapse into the Great Depression. China had been on a silver standard but one fixed by weight. The yuan could and did depreciate relative to other currencies that were fixed by gold, allowing internal prices to remain relatively stable and thus sparing the Chinese economy the worst parts of monetary deflation that amplified greatly the global collapse elsewhere. But that relative good fortune was only temporary.
Arthur Young, who was a financial advisor to the Chinese Nationalist government, would later note that beyond 1935 the country had moved from "moderate prosperity to deep depression." The crippling deflation the nation had avoided in the early 1930's soon turned to its opposite, equally devastating. Just two years after, in 1937, the Japanese invaded a desperately weakened China and many ways began what would become World War II.
There is a rather long catalog of research dedicated to explaining what happened, and with good reason. Just as medical researchers have huge interest in figuring out why an alligator's immune system is so effective, often ferociously so, economists are interested in the first part of China's 1930's experience in similar if monetary terms. They want to see silver as William Jennings Bryan saw it, an element of monetary flexibility that in the "right" hands is entirely useful to avoiding these awful predicaments that too often lead to the worst of the worst social consequences.
The (acceptable) answer was provided by Milton Friedman and Anna Schwartz who in A Monetary History describe the usual balance of payments effects. This time, however, the Chinese response in silver was not due to market collapse but rather, importantly, to government actions elsewhere, especially the United States. The US under FDR had radically altered its monetary affairs, and in the mess of the bottom of the Great Depression the way in which it had was just as messy. Silver "agitators" took advantage such that the US government's official policy was to dramatically increase the amount of monetary silver.
Though the President through the Treasury Secretary had wide discretion in determining how to carry out re-monetizing silver, from the passage of the Silver Act in 1933 to the end of that year silver prices rose 75% in dollar terms. By the middle of 1935, its price had tripled. To demonstrate the polluting corruption of that change, Schwartz and Friedman write that it was the same as if Britain had experienced a rise in the dollar price of the pound from $4.85 to almost $15.00 due to nothing in and about Britain but rather US policies. In their view, the immense drain of monetary silver from China was but the predictable next step.
And monetary silver did flee China's borders. The global Great Depression had pushed China to export silver for the first time since WWI in 1932, amounting to about C$ 10 million. The next year as the Depression worsened, silver exports increased to about C$ 14 million. In 1934, however, China lost some C$ 280 million and then another C$ 289 million the following year.
Others have since revised the Friedman/Schwartz explanation. The dispersal of silver movements suggested perhaps different factors to consider. In 1934 especially, a vast majority of silver exports were carried out by foreign banks destocking silver supplies they had accumulated when relatively low silver prices had discouraged conversion into non-China currencies. As the silver price rose, especially in the US and especially in official purchases, foreign banks essentially cashed in on what was to them a windfall. They had possessed some C$ 275.7 million in silver reserves at the start of 1934, disposing of about 85% throughout the year.
That was, in part, the argument that US officials had made at the time. They felt they would actually aid the Chinese and by doing so aid the ailing American export sector that badly needed it. A higher silver price, it was thought, especially by key political figures such as Nevada (the silver state) Senator Key Pittman, would mean more dollars for the Chinese which they would use to buy more American goods - everybody wins. In monetary terms, the drain of silver was not a monetary contraction but more so a redistribution.
The higher price of silver would have allowed Chinese banks to circulate more currency for even a smaller quantity of silver reserves. In other words, what would change was the composition of Chinese money, more currency, less reserves, not the overall balance. There is some truth to this supposition, as contemporary statistics do show just this kind of rebalancing, especially consumer prices. The Chinese economy had not been completely free of deflation in the early 1930's, just obtaining far less than others. By 1934, just as silver exports surged, deflation all but disappeared, the opposite of what you would expect (Friedman/Schwartz). Output estimates also show that in 1934 and 1935 there was little if any economic disruption during those years as silver left via largely foreign banks.
In 1988, Brant and Sargent proposed in their paper that very much like those foreign banks, China overall had been given a huge "windfall" caused by the dramatic silver price appreciation that allowed them to support a greatly expanded internal monetary base. Essentially, China "spent" this one-time boost in consumption by exporting it. But China's trade deficit narrowed in these two years, suggesting problems with this approach. If the "windfall" explanation was accurate, then the boost of consumption provided via dumping silver to countries trying desperately for monetary expansion should have manifested in China's imports; it didn't.
Also in 1988, a paper by Pang-Hua Kevin Chang of MIT proposed another explanation that accounted for both the huge silver flows as well as the seemingly contradictory economic numbers. The monetary outflows were "capital flight" rather than a windfall; that is why there was no increase in inbound traded goods as Senator Pittman had hypothesized.
One important factor to consider, as pointed out by Chang, was that during this period the Chinese had been exporting gold to make up their current account deficit. Whereas in 1932 and 1933 silver exports were small, gold exports were not. In 1934 and 1935, however, gold exports declined by 41% while silver exports exploded by 1,900%. The shift might be better explained by the increasing agitation of the Chinese government in response to foreign particularly US silver policies.
At first, the Chinese government asked for more considerations on the part of foreign governments in their silver tactics. By late 1934, however, events began to accelerate, thus "validating" the wariness of foreign banks that had already moved silver out of the country, convincing them to complete the project the following year. The Nanking government in October 1934 suspended the conversion of notes into silver, and then implemented an export duty on the metal, beginning what was surely the anticipated regime of tightening capital controls.
By early 1935, silver dollars were trading at dangerous premiums to bank notes (currency); perhaps as much as 27% in Canton, with money shortages reported in other regions. A month later, it was rumored and reported that the Chinese government had begun harassing anyone trying to convert bank notes in large quantities. By July 1935 in Shanghai, banks were refusing to issue silver altogether, with banking difficulties spreading, including isolated runs that all but guaranteed at some point full suspension and government control.
On November 3, 1935, the Chinese government issued its Currency Decree and finally nationalizing silver, removing the country from the hard money standard and implementing a "managed fiduciary standard" of fractional silver for which the Chinese people would hold no rights whatsoever for convertibility. The only acceptable currency would be that issued by the three largest now-government owned banks: Bank of China, the Bank of Communications, and the Central Bank of China. The new currency called fai-pai was managed by the Central Bank of China, allowing for other private bank notes in first fixed quantities to continue to circulate temporarily before being phased out altogether. Individuals on pain of death were required to turn in any private silver holdings in exchange for fai-pai within six months of the adoption of the Currency Law.
To counteract any fears over the new paper currency, the law established an exchange stabilization fund purposed to buy and sell foreign currencies as necessary. In place of the hard money restraint against inflation was put a government "guarantee" for responsible stewardship, a move that was widely hailed by eminent economists of the time as the Chinese finally moving toward a modern monetary system on par with Europe and then the US.
After November 1935, however, the Nationalist government did what governments are always tempted to do when given monetary authority; they began monetizing their debts through unbacked (by silver or "real bills") money printing. From 1937 forward, China would fall victim to hyperinflation, opening the door to Japanese aggression - a possibility that US officials had feared years before. In late 1934, for example, US Treasury Secretary Henry Morganthau warned FDR that there would be grave implications if US silver policies did, in fact, increasingly weaken China for which a militant Japan would surely respond. For a few weeks in December 1934, the US actually placed a price ceiling on its silver purchases before pressure from silver "agitators", including Senator Pittman, won its rescission.
China had supposedly survived the collapse into the Great Depression only to be robbed of its soundness by the "modern" responses to it; leaving it exposed via economy to then war and the rest of the worst of the worst cases. For being so favorably situated in terms of its pre-1930's silver "flexibility", "somehow" the Chinese made out worse than almost anyone else. For that, economists argue, we should, essentially, pay attention only to the good parts where monetary flexibility is supposedly paramount but ignore the bad as c'est la vie.
Long after all that was over, in the industrialization of first the 1980's, the currency arrangements of now renminbi were overhauled quite favorably as to these orthodox views; including those of floating currencies as described by Milton Friedman. As I wrote at the end of last month:
In his [Friedman's] version of a floating currency, the central bank sets internal monetary policy but has no currency policy whatsoever. You can only pick one in order to allow righteous market forces to at least indicate imbalances. The fixed option, what Friedman called the "unified currency", reverses the policy target; a currency board sets policy for the currency but can have no internal monetary policy. Another option under this view is "dollarization" whereby the country uses a foreign currency to set its own internal circumstances.
The Chinese have been operating under that last option, a fact easily established by the briefest glimpse of the PBOC's balance sheet. The asset side is majority "foreign reserves" of some unknown composition but primarily by inference "dollars", meaning that Chinese money of both physical currency and bank reserves (RMB) are set by pace and tone of foreign primarily "dollar" circumstances. Any economist or other official here or elsewhere who screams about the political dangers of the Chinese selling all their US Treasuries should be immediately disqualified from further discussion for so clearly his ignorance. For the Chinese to do so would mean biblical levels of monetary contraction - unless the PBOC responded as the National government did in November 1935 and moved China back to an unbacked currency all over again.
In other words, what I wrote in mid-September truly applies:
"Without the ‘dollar' inflow into the PBOC's asset side, that leaves only fiat as the option for continuing internal RMB expansion (on the liability side, which is ‘money'). There are other accounts by which the PBOC can expand on the asset side to deliver bank reserves on the liability side. The problem of doing so is the age-old problem of RMB, the reason it took the forex ‘dollar' short cut in the first place. The ‘market', or whatever is left of it, will view any such naked expansion as ‘inflationary' and thus ‘weakening' the currency. It will (or at least the PBOC gravely fears that it might be received in such fashion) introduce further negative currency pressures where the Chinese can least afford them.
"Thus, China is stuck; they can no longer count on the asset side growing via ‘dollars' while at the same time they clearly fear expanding in their own RMB terms lest it further push ‘devaluation' pressures that would make an already dangerous ‘dollar' situation perhaps explosively so. The result is direct translation of ‘dollar' pressures into RMB illiquidity."
The economic effects of this are no less dangerous, including the direct effect of "dollar" problems on the "uncertainties" surrounding variably weak global demand. The Chinese cannot affect overseas economies with their own money but at the same time are highly constrained what they may do for themselves. Monetary contraction in "dollars" reduces(d) further demand for Chinese goods at export while simultaneously constricting China's money growth and with it its own economy. The result is this seemingly "mysterious" but "somehow" stubborn economic deceleration and often, as exports, outright contraction where once before the eurodollar crisis there was only the "miracle" of robustness.
The comparison between China in 1934 and China in 2016 is striking no matter how "modern" the current arrangement. Now, as then, the Chinese are faced with monetary strangulation of foreign origin; the 1930's as hard money withdrawal; the 2010's as eurodollar contraction. Both are felt as "capital flight" of increasingly unenviable traps. You have to believe, however, that like Germans and their own history of hyperinflation the Chinese remain extremely reluctant to face up to 1935 all over again.
There are no easy answers, especially with history's unreformed verdict as to how grave monetary imbalances are often resolved. In China, it once meant, again, the worst possible outcome. What is offered today and for the past few years has been the same "fingers crossed" strategy implemented so often everywhere else: try to manage any short term disruptions with "stimulus" in the (vain) hope that it all just goes away. But like economists always extrapolating that next less negative number into that final bottom, there is only disappointment.
The "dollar" system has been malfunctioning since August 9, 2007, therefore after nine years it is rather reasonable and safe to conclude that we are well past Humpty Dumpty time. At various times over the past decade, officials, economists, and policymakers themselves have in many ways responded as if the answer is a vast and dramatic expansion of the global dollar supply and that it could be done; that was, in raw terms, what QE was all about. That view, as we see perhaps most clearly via China today as well as historically, is predicated on a great lie.
No matter what they do, we find instead only growing indications that the supply and distribution of "dollars" remains unfixed and still disruptive. It's roughly the same scenario as in 2007 if to a much less degree; that the Fed would fix the dollar supply and was doing it, therefore so many people walked off a cliff anticipating that dollars were going to be super plentiful. There is much less faith in that scenario today and, as in the middle of 2008, a great deal of risk of the lie being exposed all over again (as it was in 2015).
Meanwhile, the global economy is caught in the middle of central bankers not knowing a single useful thing about truly modern money; a verdict made possible by their intentionally narrowed view of especially the early 1930's (as if economic history began in October 1929 and ended with FDR's One Hundred Days). Despite having been handed their "modern" system no longer restrained by hard money, we are still facing the same circumstances and, if we aren't careful (meaning forcing political changes such that "experts" are revealed for what they really are), the same kinds of worst of the worst scenarios.
