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By Karl Smith

The current credit crisis in China is going to be enlightening on a whole bunch of levels. One level is this: how much power does a central bank have over the business cycle. My view, is that in theory, the central bank’s power is essentially absolute. Recessions and booms don’t happen without the central bank’s cooperation.

The wrinkle in that theory is that central banks face a whole bunch of essentially political stumbling blocks. The central government – The legislature in democracies – may or may not be happy with anti-recession measures, for example and the central government ultimately decides who runs the central banks. In the U.S. this plays out as a Congressman riding Ben Bernanke for stoking inflation and/or destroying the dollar. The politics don’t stop there though. Central banks usually are run by committee and the committee has to agree. The methods in their tool box often include promises to do things in the future, which means that whomever will be the future head of the central bank has to agree, and we usually don’t know who that will be. Markets also have to trust that the central bank will want to make good on its promises and this isn’t always the case.

A lot of intrigue. And, it makes it hard to tell how much fundamental power central bankers really have. That’s important, not only for trying to set current policy, but in helping us understand how economies work, how dangerous bubbles are, how likely world wide panics are going to be, etc.

In China, however, the central bank and the central government appear to be both under fairly tight control by the Chinese Communist Party, which in turn seems to be running as a fairly cohesive ruling authority. There are always factions. There is always backstabbing and plotting. There is always the fear that if you screw up badly enough the citizenry will take to the streets. But, as these things go, China seems to be the closest thing we have to a major country with a unified governing structure.

So, if anyone can use central bank power to the fullest, China can. And, as it so happens they are facing a crash.

How in theory then could China use the theoretically unlimited power of the central bank? A host of strategies and tactics are available, and with luck I’ll get a chance to write about some decent fraction of them. For now, however, I will mention one that I have not heard suggested – the Chinese government could radically raise the retail deposit rate.

That is, the Chinese government could give regular Chinese citizens a much higher return on their savings deposits. To do this the central bank would print more yuan, which would be used to subsidize the savings rates of depositors. Why do this? Because it instantly increases the wealth and cash-flow available to regular consumers. As many have pointed out, China’s strategy of shoveling money at business and investment has run into brick walls. Much of the conversation on the Chinese Crisis is about how to tear down those walls.

A competing strategy, however, is to go around them. Start shoveling money at consumers.

Source: How China Can Avoid A Meltdown