Twofish's Blog

June 28, 2006

M2 and GDP – The echo chamber

Filed under: china, finance — twofish @ 7:00 am

My we do have an echo chamber in here.  It’s interesting when you see the same idea start bouncing around, and you can trace it back to the source.

There is this article by David Frum quoted by Victor Shih
which one can trace back to John Makin,pubID.24309/pub_detail.asp

China’s M2 money supply, thanks largely to heavy currency market intervention, is rising by about 17 percent annually while the economy is growing at a rate of approximately 10 percent. The Chinese claim an inflation rate of about 1 percent. There is a serious discrepancy here. With the money supply growing at 17 percent and nominal GDP (the sum of real growth and inflation) growing at 11 percent, the ratio of money to GDP must be rising at a rate of about 6 percent a year. To validate these numbers, either the demand for money in China has to be growing rapidly (unlikely) or, alternatively, the inflation plus growth numbers are way too low. If money demand is stable, that is if Chinese citizens wish to hold a fairly constant portion of their income as M2 money balances, it is true by definition that nominal growth (the sum of real growth and inflation) has to equal money growth.

The problem with that argument is that Chinese M2 growth has always been higher than nominal GDP growth since 1978, and a six percent discrepancy is actually quite a bit lower than what the difference was in the 1980’s.  The reason for this is “financial deepening” basically there are more types of assets and more things to spend your money on, so part of the growth of M2 involves the fact that money indeed is travelling through the system faster.

Some other points….

It’s hard for me to accept the argument that currency policy is generating that much liquidity in the banking system.  The PBC gets dollars which it uses to buy Treasuries and MBO’s, which means that the liquidity in the system gets tossed back at the United States.

It’s hard for me to accept the premise that the Chinese economy is not controllable, and that the PBC does not have effective tools to cool the economy, when the PBC did just that in 2004.  It took its foot off the brake a little early, but the brakes are still there.


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