And the scary part is...

The good news is that the whole process also tends work in reverse. If we can jump straight to higher prices, we can jump straight to lower prices (this article follows on from What's the scariest thing out there at moment?). One way for the Chinese central bank to lower prices is to lower the money supply, which lowers spending, so less production occurs in businesses (a recession occurs). Finally firms lower prices to induce more people to buy their goods.

But who wants a recession? For most countries, painless disinflation (or lower prices in our example) is all about controlling expectations of inflation. If the central bank can convince the public they are going to lower the money supply, then rather than risk lower demand for their products, firms can immediately lower their price in an effort to avoid the recession, and induce more spending. However China is not most countries. Controlling expectations is for suckers and democracies. If the Chinese want businesses to lower their prices, they can just force them to. They don’t need to convince the public lower inflation is coming. They have a whole bag of weird and dare I say wonderful tricks to help them lower prices without a recession. Where leaders get it wrong is when they forget that this must be coupled with a lowering of the money supply for sustainable deflation (lower prices) to occur. The temptation is for governments to continue printing money to stimulate growth, while holding prices down artificially with controls.

Of course any economist will tell you the consequences of this: shortages and black markets, plus indirect inflation. If prices are artificially low, people will demand more of the product than businesses are willing to supply; simple demand and supply analysis, which any first year economics student could tell you about (but apparently not some politicians). Black markets tend to appear because suppliers realise that they can easily find buyers willing to pay a higher price than that stipulated by the state, so they take their product off the shelves and sell it in secret. You can bet that these sales aren’t reported to the tax department either, so real tax receipts tend to fall. Finally, indirect inflation occurs because firms realise they can’t raise their prices on a product, but they might be able to lower the quantity of it in each unit. Beer stays the same price but there is less in each bottle. Tissue boxes contain fewer tissues, candy bars weigh less, condom packets… well, you get the idea. Inflation continues to erode efficiency and productivity. The scariest part is that all we have learnt since the eighties is that there is no shortcut to reducing prices (or slowing price growth). The Chinese should have an unmatched ability to reduce inflation without inciting a recession; a so called hard landing. As inflation continues to creep higher, the risk of this hard landing seems ever more likely. And slightly scarier again; the higher inflation rocking the democratic Indian economy with less options next door.

What's the scariest thing out there at the moment?

There are many things out there at the moment scaring markets, and sometimes it’s hard to know which direction to be scared in. During the 1970s and early 1980s what was eventually termed the great inflation gripped America, and double digit price increases wiped out productivity and hindered efficiency. Price controls were put in place to stop companies raising prices. Wage controls were erected to keep companies costs down. Many tricks were played by the government to try and lower inflation without slowing the growth in the money supply, but in the end the only way to slow inflation was a cold hard recession, brought about by higher interest rates and slow money growth. There are many things to be scared about at the moment, but the scariest might be rising inflation in China.

When the Chinese increase the money supply, people find they have excess reserves of cash so they spend more. Business are then selling more, which makes them happy because their incomes rise (this is generally the central bank’s intention). Eventually firms realise they can’t keep up though, and they decide to raise prices to curb the demand. Higher prices do what they always do, and people buy less. Production falls to its original level (but now with a higher price level).

Firms today however are wise to the central bank, and try to predict when there will be general inflation. Why go to all the trouble of increasing production (that’s hard work!) when you can just raise your prices when the central bank prints money. In this way inflation expectations become very important for the central bank. If businesses expect the central bank to print money, no increases in production occur. We’ll just jump straight to higher prices.

Furthermore, because of inflation expectations no actual money printing need occur in China for inflation to take hold. Higher inflation expectations mean firms expect higher costs as input material suppliers raise their prices, plus higher wages negotiated by their employees who think prices will rise. In expectation of these cost increases firms increase their prices. The point is inflation expectations are very important determinants of where inflation is headed, and expectations tend to become self-fulfilling prophecies.

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