3 July, 2022


China Adopts A New Monetary Policy In 2021 

By Hema Senanayake

Hema Senanayake

In adopting this new policy China takes an unnecessary macroeconomic risk hoping to contain a persistent risk of growing systemic debt. This is a policy never adopted in the US, Europe and other OECD countries. In fact, as far as I know there is no country that has adopted this policy at least for a short period of time in history. However, this idea or policy prescription has not been formulated by Chinese scholars but by American scholars. Most notably American economist Milton Friedman developed this idea. Subsequently, students of American economist Irving Fisher, promote their monetary reform plan known as Chicago Plan by incorporating Friedman’s idea. None of these ideas have been tested in any developed country but now China is going to do it in 2021 and beyond. What is this new policy?

On January 08th, 2021, Reuter reports that the governor Yi Gang said that the central bank ensures the growth of broad money supply and total social financing in accordance with the nominal economic growth. In other words, the growth of money supply is linked to the GDP growth. Why do they do this?

According to the governor the central bank adopts this policy because, in 2021 monetary policy should prioritize stability to maintain … sustainability.” Does this mean that if China continues with the previous policy, would the economy be not stable? Perhaps, yes. Will the new policy ensure stability? Most probably not. 

The policy to be adopted by Chinese central bank did not come out of thin air. Even though China achieved double digit economic growth in previous decades it began to slow down and began to show some vulnerabilities in recent years. Mainly its total debt to GDP ratio surpassed the comparable figure of the U.S. Before the pandemic, in 2019, China’s total debt to GDP was at 257.6% while the U.S. posted the same ratio as 253.9%. However, the difference is, when the U.S. posted higher public debt to GDP ratio, China posted lower public data to GDP. At a glance this might appear as a strength of China. It is not so because, this means China’s non-financial private sector that is businesses plus households, is highly vulnerable than the non-financial sector of the US. Again, this mean that a debt crisis in private sector could emerge at any time. If this happens, sooner private debt crisis would become a public debt problem or crisis, having to bail out entrepreneurial sector. All these mean that in China there is a significant debt bubble. So, the solution devised by Chinese central bank is to adopt Milton Friedman’s monetary rule in which he suggests that, if monetary growth takes place in par with GDP growth there won’t be any debt bubble or inflation. He used the equation of exchange to explain it.  

Friedman and his fellow economists of the Chicago school of economic thought (monetarists), argued that in regard to the U.S., crises could be prevented by introducing a monetary rule (for example, 3% growth of money supply when GDP increases by 3%) for the monetary policy. They have come to this conclusion basically as follows. In economics there is a well-known equation call the equation of exchange which is MV = PQ. In this equation; M = money supply, V = velocity or the number of times money changes hand in a given period, Q = output and P = average price level.

Then Friedman pointed out that the equation of exchange can be expressed by rates of change of all variables as follows:

%M. %V = %P. % Q.

In the above equation, usually V is almost a constant, hence %V = 0. If we assume there is no change in output, then %Q = 0. So, we remove both variables from the equation. Then, %M = %P; this means that any increase of money supply must increase prices or in other words the inflation. Again, if Q, i.e. output, increases, in order for the prices to be stable there should be an equal amount in the rate of the growth in money stock. This concludes that it is possible to have a monetary rule in the rate of the growth of money stock comparable to the growth in the output while having stable price levels. In this arrangement, major swings in the business fluctuations are not possible. This is why monetarists see major business fluctuations, severe economic contractions, depressions relate to the large swings in the monetary growth, and the solution is to have a monetary rule as it could prevent severe changes in the stock of money.

However, this theory had never been adopted by central banks in the U.S. or in Europe. But Chinese central bank says that China would adopt this policy in 2021 and beyond.

Interestingly, Irving Fisher’s students has a different opinion. They suggest having a monetary reform first to get rid of the current banking practice of Fractional Reserve Banking in which most of the money is created by commercial banks and then incorporate Friedman’s monetary rule to ensure liquidity to support growth. China has never intimated that it would get rid of Fractional Reserve Banking and put Full Reserve Banking system instead. This is a policy mismatch.

However, my opinion is that the monetary policy should arise to support the macroeconomic behavior of the economy. The world needs to come to this understanding. Arbitrary solutions might work in short term, but such solutions would not support long term stability. This is true for western economies and China as well. A leading American economist namely Lowrance Summers recently explained that developed economies cannot achieve significant economic growth without creating “unsustainable financial conditions.” Here, “unsustainable financial conditions” means overwhelming debt. Chinese new policy will never change this dynamic. This means Chinese new policy might be self-defeating.  

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Latest comments

  • 5

    Hema is there any thing original, Made in China except for I guess Mao and Covid. Do not be fooled by NEW. The trick is every failed product,stock, company returns back re -branding as New. Have you ever heard of new Apple, new Microsoft and new Google ???? Now that China has many on debt , it is is easy for them to pressure such countries to trade in Yuan instead of usual $. The problem is when their own govt keeps manipulating its own currency for trade advantage, countries which hold Yuan will never know the true value of it.

    • 0

      “Have you ever heard of new Apple, new Microsoft and new Google ????”
      I have heard of President Franklin D. Roosevelt’s New Deal though.
      There are New York, New Jersey, New Mexico etc. I doubt if they were designed as substitutes or rivals.
      Besides the New Year which does not last very long, there is also new potato (which tastes very nice).
      One reason why there is no New Apple etc. is that Apple etc. are registered trade names. Adding a “new” will be under special circumstances. But one never knows.
      However, we have quite a few New Pilawoos Hotels in Sri Lanka, a New Woodlands School in Bromley, UK and a New Woodlands Hotel in Chennai.

      • 4

        I guess that the Europeans introduced porcelain, paper, block printing, ink, playing cards, gunpowder, the mariner’s compass, and silk. Perhaps the soy bean too.
        The highly acclaimed work “Science and Civilization in China’ by Joseph Needham must be a fake.

  • 2

    Mr. Trump to his credit kept the Yellow Peril under check. Good on him. The corrupt politicians of the world are the greatest asset of the Chinese regime.

  • 0

    As the Velocity and Outputs(Q) are to be non-existent zeros, it seems that the elasticity for humans to be comfortable will be much refuced. $
    Chinese livelihoods will have to revolve around Money and Prices being set to high constants. So, the price of noodles are to remain $5, and those who cannot afford it have to eat a lesser or no share….government won’t subsidize. Workers will have to take reduced pay to keep Prices constant. Interest rates won’t adjust for house mortgage affordability.
    Other countries keep adjusting the equation to keep their people comfortable, and for their governments to win elections. But in a dictatorship will citizens be forced to live and work according to the set money God standard.
    Country and governing bodies will be rich. Citizens will be poor. Rich Chinese gov. will further propagate the system to the places they colonize.
    The battle to overturn the established global monetary system will be mits painful.

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