The world economy through a crystal ball

In recent years, however, China has begun to display some of the characteristics exhibited by Japan during the “bubble” years of the late 1980s. In particular, as a by-product of its determination (for reasons that, from a Chinese perspective, are perfectly understandable) to maintain a stable exchange rate, the People’s Bank of China has been printing trillions of renminbi in order to buy billions of US dollars. This is with a view to preventing the appreciation of the renminbi against the dollar that would otherwise have been the inevitable consequence of China’s swelling current account surplus and rising inflows of foreign investment.

This is exactly what the Bank of Japan did in the late 1980s - with the difference that it did so at the behest of the Americans (who did not want the US dollar to fall below ¥120), whereas the People’s Bank of China is doing it despite American pleas to allow the dollar to fall against the renminbi.

Just as occurred in Japan in the late 1980s, the People’s Bank of China’s currency-pegging operations have fuelled a massive monetary expansion, which they have been unable to fully “sterilise” via sales of Chinese Government or central bank paper to domestic financial institutions.

In 2004, a good deal of this “excess liquidity” found its way into the real estate markets of China’s booming cities, particularly Shanghai. Last year, rising property prices were suppressed by a combination of “window guidance” to Chinese banks to refrain from lending for speculative real estate ventures, and the imposition of capital gains taxes on real estate ventures by local or provincial authorities.

But as Chinese banks increasingly come under the influence of foreign shareholders and managers (who will be understandably looking for opportunities to make profitable loans), it will prove harder to keep this “bubble” under wraps by administrative measures such as these.

The 1980s Japanese bubble came to an end when it did because of a change in the leadership of the Bank of Japan in 1988. The newly installed governor, Yasushi Mieno, took the view that the bubble was undermining the moral fabric of Japanese society by encouraging the view that the path to wealth was no longer through working hard and saving lots, but instead through debt-funded speculation in shares and property. Mieno-san therefore took it upon himself to puncture the bubble by raising interest rates - even though there was no inflation in the traditional sense of rising consumer prices - until the bubble burst at the end of 1989.

It is surely not stretching the imagination too much to suggest that there may come a point where, if the “bubble” in Chinese asset markets re-emerges in the lead-up to the Beijing Olympics (as I think it will), the Chinese authorities may come to the view that an orgy of debt-fuelled speculation in urban real estate is inconsistent with the “socialist market economy” to which the Chinese Communist Party under Hu Jintao (more so than under Jiang Zemin) is ostensibly committed. Indeed they could be assisted in coming to that view by increasing resentment on the part of those not benefiting from such speculation, who might as a result begin to wonder about alternative possibilities for governing China.

Clearly the Chinese authorities would not implement any actions intended to burst a bubble in Chinese asset markets before the 2008 Olympics. But one of the key lessons of 1989 is that, if it comes to a choice between sustaining economic growth and sustaining the CCP’s monopoly of political power, the Chinese authorities will opt for the latter. They have no need to coin the Mandarin equivalent of “recession we had to have”.

Rather than raising interest rates, as Mieno-san did in Japan 16 years ago, bursting the Chinese bubble will entail the People’s Bank of China “pulling the plug” on the money-creation that is the by-product of its determination to keep the renminbi exchange rate stable.

The ramifications of this will extend far beyond China. If the People’s Bank of China scales back its purchases of US dollars - which over the past two years have averaged nearly US$200 billion per annum - then the US will find it harder to finance its current account and budget deficits. In the absence of any other source of financing, the US dollar will fall and US bond yields will rise, perhaps sharply. Higher US bond yields will translate into higher US mortgage rates (which, unlike in Australia, are priced off longer-term rates) and thence into a weaker US housing market and softer US consumer spending.

Indeed, it is quite possible that the next downturn in the US economy could be made in Beijing, rather than Washington. It is a sad reflection on the depth of understanding of how the international economy works these days that this is exactly what a majority of the US Congress, and a number of administration officials, would have Beijing do.

And just as global consequences of the US “panic” of 1907 served to announce the arrival of the US as “Top Nation” when everyone still thought Britain was, so to may the downturn of 2008 or 2009 serve as a harbinger of China’s eclipse of the US as the world’s largest (though far from the richest) economy some time after 2015.