Twofish's Blog

February 8, 2009

The big mistake

Filed under: china, finance — twofish @ 4:30 pm

A lot of my thinking revolves around what I think is the fundamental economic mistake that has been made over the last few years, which is the adoption of what I would call “monetarism” or “Greenspanism.” This belief is the idea that governments should be responsible for only managing high level abstract quantities such as interest rates and government spending, and should not and in fact cannot “micromanage” the economy. The monetarist philosophy is basically that governments should just sit interest rates and let the rest of the economy do its own thing.

The big problem with this is that if you view things like interest rates and government spending as the *only* variables that a government can control, you find that you don’t have enough flexibility to avoid big problems.

For example in China right now, if you argue that the only thing the government can control is the supply of money, you’d be forced to make a decision between understimulating the economy or having large numbers of NPL’s in the future. But I’d argue that you have this dilemma because you’ve intentionally reduced the controls that you have to just changing the money supply. Once you realize that you have other controls, then the dilemma is smaller.

Take what happened to the United States in 2001-2002. Yes it was necessary to cut interest rates, but I think that the mortgage bubble and NPL problems could have been avoided with tighter regulation. The reason that there wasn’t tighter regulation, was the belief that the “market knows best.” However, this belief ignores the fact that the dynamics of the market is heavily influenced by the state anyway. The US financial system was designed to put lots of credit into residential housing so any new credit would have gone there unless you took some active regulatory steps to avoid this.

Similarly, the Chinese financial system is currently biased toward providing capital toward SOE’s, and if you just increase credit and do nothing else, you are likely to end up an overabundance of heavy industry in SOE’s. If you are a supporter of “Greenspanism” then your only choice is to reduce credit and contract the economy, at which point people start to riot. However, I’d argue that this dilemma happens only because of limitations you’ve imposed on yourself, and that the solution is to increase credit and figure out ways to “micromanage” things so that this credit doesn’t result in heavy industrial factories. For example, increase credit while at the same time taking dividends from SOE’s and issuing capital budget restrictions.

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