When Will China Overheat?

Today Greenspan (not my favorite person these days – see the preceding post – but anyway…) made some remarks about China:

WASHINGTON (CBS.MW) — China could be forced to limit its dollar purchases to avoid excessive economic growth, Federal Reserve Board Chairman Alan Greenspan warned Tuesday.

“China’s central bank purchases of dollars, unless offset, threaten an excess of so-called high-powered money expansion and a consequent overheating of the Chinese economy,” Greenspan said in prepared remarks to the Economic Club of New York.

Yes. This is what we would expect. Continual purchases of US dollars by Asian central banks is causing their money supplies to zoom. And we would normally expect this to have some repercussions on the economy, such as increased inflation.

The mystery is therefore this: why isn’t it happening? How can China be increasing its money supply by 20 or 30 percent per year while inflation remains very, very low? Certainly asset prices have risen, but why aren’t prices for goods and services rising too? Why are our normal economic expectations letting us down? Is this just a good demonstration of why my Fed friends think that the money supply doesn’t matter? Is it just a question of waiting a bit longer for inflation to pick up?

The answers are important, because until we start seeing typical inflation in China, the Chinese central bank will face no pressure to reduce their purchases of US dollars and let the yuan appreciate. And the effects of such a change on the US – both positive and negative – could be significant.