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.