Is there an inflation blowback coming from China?

James Rickards wrote the book Currency Wars a few years back. (source video) He is supported by the Charles Koch Institute.

He says the US wanted China to appreciate their currency, so that the dollar would depreciate, because the fed wanted to import inflation in order to meet their nominal GDP targets.

His view is that the Fed is printing money and this money is going to China in the form of current account surplus, portfolio investment and hot money inflows. So then he says that China has to print money in order to soak up the dollars, mostly from exports to the US.

He says that the inflation one would have expected to see in the US when the Fed was printing all that money was actually exported to China, because China was receiving those dollars, which had to be converted into Chinese currency since the two currencies were essentially pegged.

He says that inflation has had a politically destabilizing effect in China for thousands of years. So at some point China will stop accepting the imported inflation from the US and appreciate their currency. Then the massive inflation that should have happened in the US will blow back to the US.

My thoughts on his theory are these…

  • China is using exports to develop their country. They are investing in grand style. People are working. Real incomes are rising. Real estate prices are soaring. Money is flowing. GDP is growing. There must be inflation right? And his theory is based on the assumption that China will blink in the face of high inflation and stop pegging their currency with the dollar. So what is the inflation rate in China? Trading Economics reports that is currently 2.6% having risen to 6.5% in mid-July 2011 when Jim Rickards was promoting his book…

“China Inflation Rate

“The inflation rate in China was recorded at 2.60 percent in August of 2013. Inflation Rate in China is reported by the National Bureau of Statistics of China. China Inflation Rate averaged 5.82 Percent from 1986 until 2013, reaching an all time high of 28.40 Percent in February of 1989 and a record low of -2.20 Percent in April of 1999. In China, the most important components of the CPI basket are Food (31.8 percent of total weight) and Residence (17.2 percent). Recreation, Education and Culture Articles account for 13.8 percent; Transportation and Communication for 10 percent, Healthcare and Personal Articles for 9.6 percent, Clothing for 8.5 percent; Households Facilities, Articles and Services for 5.6 percent; Tobacco, Liquor and Articles for the remaining 3.5 percent. The CPI basket is reviewed every five years on the basis of household surveys.”

So inflation in China is not high. There is price stability with managed wage growth. So I do not see the inflation in China that he is talking about.

  • Now if the inflation in China has come down to 2.6% since 2011, then shouldn’t we have seen more inflation in the US according to his theory? But we don’t see it. The mechanism to transfer inflation through currencies that he is describing has not manifested itself. Does the dollar have to depreciate first? He would say yes.
  • Will we see a depreciation of the dollar? Not much… As soon as the Fed starts tapering some time in the next 10 years year, the dollar will appreciate, but the Fed funds rate will still stay low.

Why are economists like James Rickards supported, when their views are not based on sound assumptions? It seems they tell a story that is appreciated by those with conservative ideologies.

The increased inequality of income, in the US and in China, is making it look like there should be more inflation, but economists don’t seem to realize that the bulk of consumption comes from labor. and the income of labor is weak in both countries. Household consumption is still below 40% of Chinese GDP. Labor share in the US has dropped 5% since the crisis.

We are not going to see inflation under these conditions of weak labor income. Prices are maintained to correspond to controlled wages. Many people in both countries are struggling to meet expenses. Wages are controlled below a level where people could bid up a widespread increase in prices. Money is flowing, that is true. But it is not flowing among labor. Inflation depends on labor income and if output can keep ahead of it or fall behind it.

There is no inflation that is going to blow back from China to the US. The days of that kind of thinking are gone. The economy has fundamentally changed. We are at a new normal.

To wrap up…

The real danger will come when real GDP hits the effective demand limit at around $16.1 trillion (2009 dollars) and the Fed thinks that real GDP should keep rising to $17 trillion. Then the Fed will keep pushing demand as output grinds slower. The increased momentum of demand will then have to be expressed in higher prices and wages somehow. However, if there is no mechanism to transmit that excess liquidity to labor and prices of household items, then there will be an asset bubble. The Fed will have to react and tighten somehow. They couldn’t just let a bubble get out of control. That would bring down demand and opportunistic behavior by investors… and with it the start of a recession.