Money Supply Taste Test: Water or Honey?

飞雪寒冰

Man is currently conducting a great, new monetary experiment. Interest rates controlled by central banks in Europe, the United States and Japan all stand at near zero. China is returning to the days of old when money supply exceeded economic growth.

What effect will these "monetary emissions" (as German Chancellor Angela Merkel calls them) have on the Chinese economy?

Most of the commentary I have read downplays the issue. In any case, price indexes are still falling. Although there are no precise statistics for unemployment, export growth in coastal areas -- the focal point of Chinese employment -- has started to decline.

飞雪寒冰

And what can be said about the Chinese government's fiscal income? The days of it growing at twice the speed of GDP are over; fiscal income fell year-over-year during the first few months of this year. Provided this sort of situation continues, even if domestic investment and consumption are both vigorous, experts agree there will be no inflation this year.

On CCTV June 10, Robert Mundell went so far as to state, "China needs a more expansionary monetary policy. In order to achieve this goal, the U.S. Federal Reserve and the People's Bank of China both need to increase the amount of money in circulation." Even if the PBOC doesn't follow the advice of this celebrated Nobel laureate and "father of the euro" to the letter, it is generally believed that "loose" monetary policy will persist.

飞雪寒冰

This is a rare opportunity to see just what happens when a massive amount of money is poured into the real economy and markets. What will result? It's a rare opportunity because the only laboratory for economic research is the economy itself, making it an expensive experiment. This opening of the monetary faucet by the world's major economies is the most generous experiment in history. Economics researchers hoping to gain knowledge from the experience cannot miss the opportunity.

Experience says bringing a question into practice is far better than pure, objective observation. But that does not go far enough. It would be best to make an educated guess as to what might happen, and use the results of this observation to test and verify the guess. This educated guess that awaits testing is the "hypothesis."

A good hypothesis is a guide to observing a complicated phenomenon, and is a key link to understanding the rules behind such a phenomenon. So what hypothesis is worth being used to observe and test the question, "What are the consequences of a large influx of cash into the economy and markets?"

飞雪寒冰

Twin Theories

We will call the first theory "currency is like water." The general idea is that currency has no use other than to act as an intermediary in commodity transactions. Therefore, excess currency in the economy and market will not increase the amount of goods in the market, but certainly will increase overall price levels.

Imagine a cash-laden helicopter flying over a small country and dropping enough currency on its citizenry to double everyone's cash stash. What follows? Will everyone in the country be able to afford twice as many goods? Or will prices double? If you choose the second option, congratulations; Milton Friedman, the great master of monetarism, would be proud. But why would a cash drop from a helicopter double everyone's money？ Because money behaves like water: As soon as it enters the real world, it flows evenly into the open, offering equal access to all.

Another theory we will call "money is like honey." This theory holds that new money, after it's put into the economy and markets, sticks like honey. While flowing, it can accumulate in one area before gradually evening out. This means an oversupply of currency “roams” between different types of assets and goods, changing the relative prices of various assets and goods. This was the theory espoused by economist Friedrich August von Hayek, who emphasized that inflation has a "fluid equilibrium" quality.

飞雪寒冰

Changes in relative prices create investment opportunities for some people. However, even if the market experiences "me-too-ism" and fanatical speculation, a single "hot spot" is hard to maintain. This is because honey continues to flow. The bumps eventually become smooth.

Each theory is interesting. What's important, though, is that from these theories we can infer an unambiguous thesis to test, with observable results.

The "money is like water" theory predicts that a currency influx beyond what the economy or markets require will inevitably result in higher overall price levels. The "money is like honey" theory, on the other hand, predicts that as money experiences friction of varying intensities in different areas while flowing through the economy, it temporarily changes the relative prices of assets and goods, stimulating changes in investment and consumer behavior.

No matter which theory we adopt, or even if we have doubts about both, clear predictions like these are easy to test. Comparatively, those economic "forecasts" that include all kinds of vague possibilities, with the exception of allowing future claims of "I predicted that a long time ago," do little to increase understanding of the rules behind a phenomenon.

飞雪寒冰

These theories also have important distinctions. The core of the "money is like water" theory lies in the total sum – the overall level of prices. The "money is like honey" theory gives more weight to changes in relative prices during the process. However, it should not be said that the difference between the two is too great. After all, Friedman's monetarism and Hayek's Austrian school have a common starting point: Both exhibit rational distrust of the "statutory non-cash currency" system.

A string of events have linked the breathtaking rise and fall of the Chinese economy since 2004. The first event was structural overheating, from iron and steel to cement and electrolytic aluminum, which spread to a large number of investment sectors. This was followed by rapid increases and declines in the real estate and stock markets, which resulted in steep fluctuations in overall price levels.

Perhaps we can merge the two theories: As currency enters a market, its stickiness causes changes in relative prices, which eventually push up overall price levels. Yes, money is like honey, but in the end it is more like sticky water