The Death of Money (12 page)

This passage is the Rosetta stone for interpreting all of Bernanke’s policies relating
to monetary policy during his time as chairman of the Federal Reserve. After 2008,
Bernanke’s Fed would increase the cost of waiting by offering investors zero return
on cash, and it would reduce the cost of moving ahead by offering forward guidance
on policy. By increasing the costs of waiting and reducing the costs of moving ahead,
Bernanke would tip the scales in favor of immediate investment and help the economy
grow through the jobs and incomes that go with such investment. Bernanke would be
the master planner who pushes capitalists back into the investment game. He showed
his hand when he wrote, “
It would not be difficult to recast our example of the . . . economy in an equilibrium
business cycle mold. As given, the economy . . . is best thought of as being run by
a central planner.”

Bernanke’s logic is deeply flawed because it supposes that the agency that
reduces
uncertainty does not also
add
to uncertainty by its conduct. When the Fed offers forward guidance on interest rates,
how certain can investors be that it will not change its mind? When the Fed says it
will raise interest rates upon the occurrence of certain conditions, how certain can
investors be that those conditions will ever be satisfied? In trying to remove one
type of uncertainty, the Fed merely substitutes a new uncertainty related to its ability
to perform the first task. Uncertainty about future policy has been replaced with
uncertainty about the reliability of forward guidance. This may be the second derivative
of uncertainty, but it is uncertainty nonetheless, made worse by dependence on planners’
whims rather than the market’s operation.

An important paper by Robert Hall of Stanford University, delivered at the Fed’s Jackson
Hole gathering in August 2013, demonstrates
the counterproductive nature of Bernanke’s reasoning. Hall’s paper makes the point
that the decision to hire a new worker implicitly involves a
calculation by the employer of the present value of the worker’s future output. Present
value calculations depend on the discount rates used to convert future returns into
current dollars. But uncertainty caused by the Fed’s policy flip-flops makes the discount
rate difficult to ascertain and causes employers to reduce or delay hiring. In effect,
the Fed’s efforts to stimulate the economy are actually retarding it.

Free markets matter not because of ideology but because of efficiency; they are imperfect,
yet they are better than the next best thing. Akerlof illustrates the costs of information
asymmetry at one point in time, while Bernanke shows the costs of information uncertainty
over time. Both are correct about these theoretical costs, but both ignore the full
costs of trying to fix the problem with government intervention. Akerlof was at least
humble about these limitations, while Bernanke exhibited a central planner’s hubris
throughout his career.

Adam Smith and Friedrich Hayek warned of the impossibility of the Fed’s task and the
dangers of attempting it, but Charles Goodhart points to a greater danger. Even the
central planner requires market signals to implement a plan. A Soviet-style clothing
commissar who orders that all wool socks be the color green might be interested to
know that green is deeply unpopular and the socks will sit on the shelves. The Fed
relies on price signals too, particularly those related to inflation, commodity prices,
stock prices, unemployment, housing, and many other variables. What happens when you
manipulate markets using price signals that are the output of manipulated markets?
This is the question posed by Goodhart’s Law.

The central planner must suspend belief in one’s own intervention to gather information
about the intervention’s effects. But that information is a false signal because it
is not the result of free-market activity. This is a recursive function. In plain
English, the central planner has no option but to drink his own Kool-Aid. This is
the great dilemma for the Federal Reserve and all central banks that seek to direct
their economies out of the new depression. The more these institutions intervene in
markets, the less they know about real economic conditions, and the greater the need
to intervene. One form of Knightian uncertainty is replaced by another. Regime uncertainty
becomes pervasive as capital waits for the return of real markets.

Unlike Shakespeare’s Salanio, we can no longer trust what the markets tell us. That’s
because those who control them do not trust the markets themselves; Yellen and the
rest have come to think their academic hand is more powerful than Adam Smith’s invisible
one. The result has been the slow demise of market utility that, in turn, presages
the slow demise of the real economy—and of the dollar.

CHINA’S NEW FINANCIAL WARLORDS

Most countries fail in the reform and adjustment process precisely because the sectors
of the economy that have benefitted from . . . distortions are powerful enough to
block any attempt to eliminate those distortions.

Michael Pettis

Peking University

December 2012

China’s shadow banking sector has become a potential source of systemic financial
risk. . . . To some extent, this is fundamentally a Ponzi scheme.

Xiao Gang

Chairman, Bank of China

October 2012

■
History’s Burden

To contemporary Western eyes, China appears like a monolithic juggernaut poised to
dominate East Asia and surpass the West in wealth and output in a matter of years.
In fact, China is a fragile construct that could easily descend into chaos, as it
has many times before. No one is more aware of this than the Chinese themselves, who
understand that China’s future is highly uncertain.

China’s is the longest continuous civilization in world history, encompassing twelve
major dynasties, scores of minor ones, and hundreds of rulers and regimes. Far from
being homogeneous, however, China is composed of countless cultures and ethnicities,
comprising a dense, complex
network of regions, cities, towns, and villages linked by trade and infrastructure,
that has avoided the terminal discontinuities of other great civilizations, from the
Aztec to the Zimbabwe.

A main contributor to the longevity of Chinese civilization is the in-and-out nature
of governance consisting of periods of centralization, followed by periods of decentralization,
then recentralization, and so on across the millennia. This history is like the action
of an accordion that expands and contracts while playing a single song. The tendency
to decentralize politically has given Chinese civilization the robustness needed to
avoid a complete collapse at the center, characteristic of Rome and the Inca. Conversely,
an ability to centralize politically has prevented thousands of local nodes from devolving
into an agrarian mosaic, disparate and disconnected. China ebbs and flows but never
disappears.

Recognizing the Chinese history of centralization, disintegration, and reemerging
order is indispensible to understanding China today. Western financial analysts often
approach China with an exaggerated confidence in market data and not enough historical
perspective to understand its cultural dynamics. The Zhou Dynasty philosopher Lao
Tzu expressed the Chinese sense of history in the
Tao Te Ching
—“
Things grow and grow, but each goes back to its root.” Appreciating that view is no
less important today.

The centralized ancient dynasties include the Zhou, from around 1100
B.C.
; the Qin, from 221
B.C.
; and the Han, which immediately followed the Qin and lasted until
A.D.
220. In the middle period of Chinese civilization came the centralized Sui Dynasty
in
A.D.
581 and the Tang Dynasty, which followed the Sui in
A.D.
618. The past millennium has been characterized more by political centralization
than disorder, under four great centralized dynasties. These began with Kublai Khan’s
legendary Yuan Dynasty in 1271 and continued through the Ming in 1378, the Qing in
1644, and the Communist Dynasty in 1949.

Famous episodes of decentralization and discord include the Warring States period
around 350
B.C.,
when fourteen kingdoms competed for power in an area between the Yangtze and Huang
He Rivers. Six hundred years later, in
A.D.
220, another decentralized phase began with the Three Kingdoms of the Wei, Shu, and
Wu, followed by rivalries between the former Qin and the rising Jin Dynasties. Instability
was intermittent
through the sixth century, with fighting among the Chen, Northern Zhou, Northern Qi,
and Western Liang kingdoms, before another unified period began with the Sui Dynasty.
A final period of disunity arose around
A.D.
923, when eight kingdoms competed for power in eastern and central China.

However, discord was not limited to the long decentralized periods. Even the periods
of centralization included disorderly stages that were suppressed or that marked a
tumultuous transition from one dynasty to another. Possibly the most dangerous of
these episodes was the Taiping Rebellion, from 1850 to 1864. The origins of this rebellion,
which turned into a civil war, seem incredible today. A candidate for the administrative
elite, Hong Ziuquan, repeatedly failed the imperial examination in the late 1830s,
ending his chance to join the scholars who made up the elite. He later attributed
his failure to a vision that told him he was the younger brother of Jesus. With help
from friends and a missionary, he began a campaign to rid China of “devils.” Throughout
the 1840s he attracted more followers and began to exert local autonomy in opposition
to the ruling Qing Dynasty.

By 1850, Hong’s local religious sect had emerged as a cohesive military force and
began to win notable victories against Qing armies. The Taiping Heavenly Kingdom was
declared, with its capital in Nanjing. The Heavenly Kingdom, which exercised authority
over more than 100 million Chinese in the south, moved to seize Shanghai in August
1860. The attack on Shanghai was repulsed by Qing armies, now led and advised by European
commanders, supplemented with Western troops and arms. By 1864, the rebellion had
been crushed, but the cost was great. Scholarly estimates of those killed in the rebellion
range from 20 million to 40 million.

A similarly chaotic stage emerged in the so-called Warlord Period of 1916 to 1928,
when China was centrally governed in name only. Power was contested by twenty-seven
cliques led by warlords, who allied and broke apart in various combinations. Not until
Chiang Kai-shek and the National Revolutionary Army finally defeated rival warlords
in 1928 was a semblance of unity established. Even then the Chinese Communist Party,
which had been ruthlessly purged by Chiang in 1927, managed to survive in southern
enclaves before undertaking the Long March, a
strategic retreat from attacking Nationalist forces, finally finding refuge in the
Shaanxi Province of north-central China.

The most recent period of decentralized political chaos arose in the midst of the
Communist Dynasty during the Cultural Revolution of 1966 to 1976. In this chaotic
period, Mao Zedong mobilized youth cadres called Red Guards to identify and root out
alleged bourgeois and revisionist elements in government, military, academic, and
other institutional settings. Millions were killed, tortured, degraded, or forcibly
relocated from cities to the countryside. Historic sites were looted and artifacts
smashed in an effort to “destroy the old world and forge the new world,” in the words
of one slogan. Only with Mao’s death in 1976, and the arrest of the radical Gang of
Four, who briefly seized power after Mao’s death, were the flames of cultural and
economic destruction finally extinguished.

Historical memories of these turbulent episodes run deep in the minds of China’s leadership.
This explains the brutal suppressions of nations such as Tibet, cultures such as the
Uighurs, and spiritual sects such as Falun Gong. The Communist Party does not know
when the next Heavenly Kingdom might arise, but they fear its emergence. The slaughter
of students and others in Tiananmen Square in 1989 sprang from this same insecurity.
A protest that in the West would have been controlled with tear gas and arrests was
to Communist officials a movement that could have cascaded out of control and therefore
justified lethal force to suppress.

David T. C. Lie, a senior princeling, the contemporary offspring of Communist revolutionary
heroes, recently said in Shanghai that
the current Communist leadership’s greatest fear is not the U.S. military but a volatile
convergence of migrant workers and Twitter mobile apps. China has over 200 million
migrant workers who live in cities without official permission to do so, and they
can be forcibly returned to the countryside on Communist Party orders. China exercises
tight control over the Internet, but mobile apps, transmitting through 4G wireless
mobile broadband channels, are more difficult to monitor. This combination of rootless
workers and uncontrolled broadband is no less dangerous in official eyes than the
zeal of a failed mandarin who believed he was the brother of Jesus Christ. This potential
for instability is why economic growth is
paramount to China’s leadership—growth is the counterweight to emerging dissent.

Prior to 1979, the Chinese economy operated on the “iron rice bowl” principle. The
leadership did not promise high growth, jobs, or opportunities; instead, it promised
sufficient food and life’s basic necessities. Collective farms, forced labor, and
central planning were enough to deliver on these promises, but not much more. Stability
was the goal, and growth was an afterthought.

Beginning in 1979, Deng Xiaoping broke the iron rice bowl and replaced it with a growth-driven
economy that would not guarantee food and necessities so much as provide people the
opportunity to find them on their own. It was not a free market by any means, and
there was no relaxation of Communist Party control. Still, it was enough to allow
local managers and foreign buyers to utilize both cheap labor and imported know-how
in order to create comparative advantage in a wide range of tradable manufactured
goods.

The China Miracle resulted. Chinese GDP rose from $263 billion in 1979 to $404 billion
in 1990, $1.2 trillion in 2000, and over $7.2 trillion in 2011, an astounding twenty-seven-fold
increase in just over thirty years. Total Chinese economic output now stands at about
half the size of the U.S. economy. This high Chinese growth rate has led to numerous
extrapolations and estimates of a date in the not-so-distant future when the Chinese
economy will surpass that of the United States in total output. At that point, say
the prognosticators, China will resume its role in the first rank of global powers,
a position it held in the long-ago days of the Ming Dynasty.

Extrapolation is seldom a good guide to the future, and these predictions may prove
premature. Close examination of the economic growth process from a low base shows
that such growth is not a miracle at all. If reasonable policies of the kind used
in Singapore and Japan had substituted for the chaos of the Cultural Revolution, high
growth could have happened decades sooner. Today the same analytic scrutiny raises
doubts about China’s ability to continue to grow at the torrid pace of recent years.

Dynamic processes such as economic growth are subject to abrupt changes, for better
or worse, based on the utilization or exhaustion of
factors of production. This was pointed out in a classic 1994 article by Princeton
professor Paul Krugman called “
The Myth of Asia’s Miracle.” This article was widely criticized upon publication for
predicting a slowdown in Chinese growth, but it has proved prophetic.

Krugman began with the basic point that growth in any economy is the result of increases
in labor force participation and productivity. If an economy has a stagnant labor
force operating at a constant level of productivity, it will have constant output
but no growth. The main drivers of labor force expansion are demographics and education,
while the main drivers of productivity are capital and technology. Without those factor
inputs, an economy cannot expand. But when those factor inputs are available in abundance,
rapid growth is well within reach.

By 1980, China was poised to absorb a massive influx of domestic labor and foreign
capital, with predictably positive results. Such a transition requires training that
starts with basic literacy and ultimately includes the development of technical and
vocational skills. The fact that China had over half a billion peasants in 1980 did
not necessarily mean that those peasants could turn into factory workers overnight.
The transition also requires housing and transportation infrastructure. This takes
time, but by 1980 the process had begun.

As labor flowed into the cities in the 1980s and 1990s, capital was mobilized to facilitate
labor productivity. This capital came from private foreign investment, multilateral
institutions such as the World Bank, and China’s domestic savings. Finance capital
was quickly converted into plant, equipment, and infrastructure needed to leverage
the expanding labor pool.

As Krugman points out, this labor-capital factor input model is a two-edged sword.
When the factors are plentiful, growth can be high, but what happens when the factors
are in scarce supply? Krugman answers with the obvious conclusion—as labor and capital
inputs slow down, growth will do the same. While Krugman’s analysis is well known
to scholars and policy makers, it is less known to Wall Street cheerleaders and the
media. Those extrapolating high growth far into the future are ignoring the inevitable
decline in factor inputs.

For example, five factory workers assembling goods by hand will result in a certain
output level. If five peasants then arrive from the countryside and join the existing
factory labor force using the same hand assembly
technique, then output will double since there are twice as many workers performing
the same task. Now assume the factory owner acquires machines that replace hand assembly
with automated assembly, then trains his workers to use the machines. If each machine
doubles output versus hand assembly, and every worker gets one machine, output will
double again. In this example, factory output has increased 400 percent, first by
doubling the labor force, then by automating the process. As Krugman explains, this
is not a “miracle.” It is a straightforward process of expanding labor and productivity.

This process does have limits. Eventually, new workers will stop arriving from the
countryside, and even if workers are available, there may be physical or financial
constraints on the ability to utilize capital. Once every worker has a machine, additional
machines do not increase output if workers can use only one at a time. Economic development
is more complex than this example suggests, and many other forces affect the growth
path. But the fundamental paradigm, that fewer inputs equals lower growth, is inescapable.