Cause of inflation: Shanghai bubble case study

December 5th, 2006

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A few days ago, we learnt about the mad speculative fervour over real estates in Shanghai. From what we hear, the annual salary of an average middle-class worker in Shanghai is somewhere in the order of 50,000 to 100,000 RMB. However, apartments over there can cost up to prices to the order of 1 million RMB. We were simply astounded at the relativity of these two anecdotal figures, which we obtained from people we know who live in Shanghai. How is it possible for people to afford such exorbitantly priced housing? More amazingly, even at such sky high prices, many people over there feel that apartments are still ?cheap? and consider them good ?bargains!? We learnt further that the prevailing attitude over there was that real estate prices can never fall and that if you do not buy today, you will lose out because they will be more expensive tomorrow. Therefore, people piled themselves with debt to buy real estates that they cannot afford. With their assumption that prices will be going up indefinitely, they reckon that if the worst should ever happen, all they need to do is to liquidate their property at higher prices to the next buyer.This is a gigantic bubble that defies all rudiments of proportion, common sense and prudence. We suspect that with the Olympics in 2008, there will be a need for the authorities to at least keep up the spectacle and illusion of prosperity till then. Meanwhile, as we expected, inflation is experienced everywhere in Shanghai. We heard that this scenario is working out in other Chinese cities as well.

Now, it comes to the topic for today: inflation.

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money, in which the effect is the rise in the general level of prices. For the sake of discussion, let us call the mainstream definition as ?price inflation? and the Austrian School?s definition as ?monetary inflation.? We see that the Austrian School?s definition is far more accurate and correct because it goes right down to the root of the problem.

If the economy?s money supply increases relative to the increase in production of goods and services, then prices in nominal terms will have to increase because there will be more money chasing after the same amount of things in demand. As this article, Defining Inflation, said:

Consider the case of a fixed money supply. Whenever people increase their demand for some goods and services, money will be allocated toward other goods. Thus, the prices of some goods will increase?i.e., more money will be spent on them?while the prices of other goods will fall?i.e., less money will be spent on them.

As Ludwig von Mises said in his essay, Inflation: An Unworkable Fiscal Policy:

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.

Therefore, because the approach that mainstream economists take to define inflation is deficient, the benchmark that they use to measure it (an index of the price levels e.g. CPI) is also deficient. Does the CPI (or whatever the alternative price index that central bankers prefer to use) measure the price levels of assets? The answer is no! As a result, the conventional yardstick that mainstream economists use does not fully disclose the full extent of the economy?s inflation problems.

The mainstream economists do not see monetary inflation as an evil?as long as price inflation is not a problem, they do not see the need to care about monetary inflation. But Austrian School economists see that the inevitable consequence of monetary inflation is price inflation because the former is the root cause of the problem and the latter is the effect. That is the reason why Austrian School economists are strong advocates of gold-backed monetary systems because such systems will have automatic built-in checks to prevent undisciplined monetary inflation (aka printing of money).

In the case of Shanghai, we are not the least surprise to see price inflation happening. In fact, if the Chinese central bank does not control monetary inflation (that fuelled the property speculation in the first place), price inflation will get worse before it gets better. When that happens, the common people, especially the poor will suffer. On the other hand, if the Chinese central bank decides to raise interest rates to rein in price inflation, they run the risk of bursting the property bubble, which will have a destabilising deflationary effect. In that case, the speculators (of which many of the middle-class common people are) will suffer first, followed by the rests. It looks to us that the Chinese central bankers may have trapped themselves into a box.

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