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Friday is an anniversary of sorts.  Thirty-seven years ago, in 1971, President Nixon stunned the US by announcing the imposition of extensive wage and price controls in an effort to reverse rising inflation in the US. In retrospect it is pretty clear that the price and wage controls were unlikely to reverse several years of booming money creation, and even the WIN buttons (“Whip Inflation Now”) distributed by President Ford a few years later weren’t enough to do the trick. 

The EconReview gives a short, potted history of the time:

In a move widely applauded by the public and a fair number of (but by no means all) economists, President Nixon imposed wage and price controls.  The 90 day freeze was unprecedented in peacetime, but such drastic measures were thought necessary.  Inflation had been raging, exceeding 6% briefly in 1970 and persisting above 4% in 1971.  By the prevailing historical standards, such inflation rates were thought to be completely intolerable. The 90 day freeze turned into nearly 1,000 days of measures known as Phases One, Two, Three, and Four.  The initial attempt to dampen inflation by calming inflationary expectations was a monumental failure. 


…The wage and price controls were mostly dismantled by April, 1974.  By that time, the U.S. inflation rate had reached double digits.  While there were skeptics in August, 1971, there were a great many who thought "temporary" wage and price controls could cure inflation.  By 1974, this notion was thoroughly discredited, and attention gradually turned toward a monetary approach to inflation.  In a complete reversal, the policy to curb inflation in now thought to be an increase in interest rates rather than an attempt to hold them down. 

A quick look at inflation rates in the US show that inflation had reached a temporary peak of 6.19% in 1971 Q1, and had been declining when Nixon imposed the controls in the middle of Q3 (5.46% and 4.26% over Q2 and Q3). It continued to decline thereafter for several more months, reaching a low of 2.18% in 1972 Q2, before reversing course and marching upwards over the next two years to hit a second temporary peak of 12.38% during the third quarter of 1974.  

After another period of improvement over the next two years (inflation declined to 4.21% by the second quarter of 1976), prices began another surge, which took inflation up over four years to a high of 10.36% in the fourth quarter of 1980 (it actually peaked in March at nearly 15%), after which time the very sharp and brutal economic contraction engineered by Paul Volcker of the Fed brought inflation back down again. 

One has to be careful about drawing lessons. What happened to the US in the 1970s tells us nothing about what must happen to China today, but it is worth remembering a couple of important points.  First, following a period of rapid monetary growth, which at first was able to deliver rapid economic and productivity growth, booming stock, real estate and art markets, and low inflation, the consequences of excess money creation only later led inexorably to higher prices.  Although a number of economists proposed higher interest rates and tighter money to combat the rising prices, the first instinct of Nixon’s economic advisors was to protect economic growth by using administrative measures to rein in inflation. This didn’t work. 

The second important point is that the process of rising inflation is rarely a straight line.  The US saw several fairly long-term reversals of the upward inflation path, but these reversals were temporary as long as the root cause of inflation – excessive growth in money – was not addressed. In the end, however, the overall trend was upward and the cost of reversing it was significant – and it probably lost the election for Jimmy Carter. 

One of the things we are wrestling with here in China is the extent to which the US experience is relevant.  In many ways it is not. For example, today the National Bureau of Statistics released a report that had total investment in fixed assets for the first seven months of 2008 at RMB 7.2 trillion. This represents 27.3% increase over the same period last year. For the six months before July, FAI grew by 26.8%, and most analysts were expecting July’s number to be a little below that. FAI is clearly very high. 

I have been discussing the implication of these recent figures, including PPI and CPI inflation numbers, with several of my friends.  One of the questions that is always raised is about the transmission mechanism from high PPI inflation to rising CPI inflation.  On the face of it the surge in FAI suggests a future surge in industrial production that, especially given faltering global demand, is likely to create an oversupply of manufactured goods in China, which should make it more difficult for producers to pass rising cots onto consumers.  In that sense, it seems that the reduction in CPI inflation may be sustainable, even with last months’ unexpected jump in PPI inflation. 

But I have to confess that I have a problem – perhaps instinctual – with this line of reasoning.  It is true that an excess of manufactured goods should put downward pressure on prices of those goods – or at least limit the ability of producers to raise prices – but is this enough to eliminate inflation? 

The way I see it, excess money growth creates excess demand for goods and services at current prices. This excess demand isn’t necessarily uniform, but it exists, and it should result in rising prices on average. During the past year in China, the excess demand coincided (perhaps) with problems in the food supply, so that food prices soared. There was a lot of talk a few months ago about food hoarding, and this talk has all but disappeared, so it may very well be that rising food prices were at first exacerbated by speculative hoarding, but at some point this behavior in turn put downward pressure on food prices as speculators sell off stocks (I am only guessing that this might have happened but have no real proof). 

At any rate rising food prices absorbed all or most of the excess demand, so that there was little upward price pressure on the non-food sector.  In fact, there should have been significant downward price pressure on the non-food sector given the huge run-up in food prices, but we actually saw non-food inflation low but rising. This, by the way, is why I believed and still believe that inflation in China was caused by monetary conditions, and not by a food-supply problem. 

What happens if rising FAI and surging industrial production now put downward pressure on the prices of manufactured goods or, at the very least, make it hard for companies to pass on price increases?  One obvious thing is that profits will sag, bankruptcies will rise, and companies will eventually be forced to cut back sharply on investment and production (exports might also surge).  

But what happened to the excess demand caused by excessively rapid money growth? It still has to have an impact on the average price level.  One possibility may be that we will once again see food consumption surge and, with it, the price of food.  Another possibility is that price increases will show up in the service sector.  A third is that they show up also in the price of manufactured goods that are not in oversupply, where there will be bottlenecks. Inflation, in other words, won’t disappear. 

There is also another, perhaps even less benign, scenario.  It is possible for there to be no inflation because there is a sudden collapse in the money supply.

How could that happen? In a worst case scenario rising bankruptcies could put so much pressure on the banking system that Chinese banks would be forced to cut back on lending and Chinese banks and businesses would begin to hoard liquidity.  This would result, I believe, in a sharp reduction in money supply (via a collapse in velocity perhaps?) that would cause China to exchange the risk of inflation for the risk of deflation.   

I think this is what happened in the US in the 1930s.  Following a period of rising inflation in the 1920s – and for many of the same reasons: a rapid expansion in the US money supply caused by massive reserve accumulation in the 1920s – the overextended banking system was unable to survive the economic downturn, and a previously inflationary period was suddenly converted into a period of sharp deflation.  There was even a 2-year period at the end of the inflationary period (1927-29) in which the US was absolutely swamped with speculative inflows. 

There are lots of different periods in US economic history to look at to get a sense of some of the issues that China needs to deal with.  Unfortunately none of this makes prediction easy, but I think there is one prediction I can safely make: so many years of wild money growth must result in an adjustment and this adjustment is not going to be easy. Whether the adjustment results in inflation or deflation depends crucially, I think, on the state of the banking system and the reaction by banks to an economic downturn. 

On another note, the stock market had its first good day in a while. It closed at 2461, up 0.9%. Most of China is still focused on the medal count, although I should mention that we’ve had our first day of really beautiful weather in Beijing today.

Source: The Anniversary of Nixon's Price Controls