What China Could Be Building

Scott recently expressed his optimism in the Chinese growth story, and sees no reason why the recent trouble with housing markets should jeopardize its growth. As a fellow traveler in China, I have to express reservations about his outlook.

One of Scott's central arguments is that Chinese people want housing. No doubt, people want somewhere to live, and recent waves of urbanization have moved more and more of demand to the cities. However, I'm not sure why this translates into an argument that the current housing situation can't be a bubble. Just because there's a need for housing does not mean that there is enough quantity demanded at current prices. There's no physical overstock, but there's a massive market overhang at current levels. If I were a homeless person who just got a job making thousands of dollars, my first priority would certainly not be moving into a sleek urban apartment whose rent would take up almost the entirety of my income. There are other, cheaper options that are not the drivers behind the current real estate rally.

This is likely because the price of houses represents more than the discounted stream of housing services, it rather represents expectations of future growth. Financial repression and low bank deposit rates force wealthy Chinese to try to grow their wealth by investing into assets such as gold, jade, or housing. Shanghai families view housing as critical to "preserving value" in a household, and the purchase of a house may reflect excessive optimism about the future price path due to other people's purchasing, instead of expectations of the value of future housing services. Printing money wouldn't solve the issue because the real cost of those items are too high, so monetary expansion would only worsen the balance sheets of the savers with bank deposits and strengthen those who had the resources to invest in housing.

The crux of the matter is inequality. Who is buying all those consumption goods you see on TV? Who is buying houses to preserve value? Yogi Berra's quote "nobody goes there, it's too crowded" does not fully apply. Nobody goes there because it's too expensive to live for the "millions of of Chinese living in tiny ramshackle homes." But the houses give just enough return for wealthy Chinese investors, who represent a small, but incredibly influential minority.

The real risk is not that the housing won't be used, but that the crash would have secondary effects. Local governments are dependent upon land sales for revenues, meaning a housing crash could have serious implications for government. In Guangdong province, some local governments are actually tearing down mountains to make new land in the ocean, all to sell the land. This, along with the recent reversal of capital flows and possible insolvency of private wealth management firms, represents a serious liquidity risk that can have disastrous consequences.

In terms of sources, I would recommend looking at Patrick Chovanec's articles on the Chinese housing market and financial system. I don't have much time to provide the direct link for each of my claims, but if there seems like something that doesn't jive right I would be happy to explain further.

So let's answer Scott's fundamental question:

So here’s my question for all of you China skeptics that insist they are building way too much housing, infrastructure, heavy industry, etc.  What precisely do you want them to build more of?  And what are the 100s of millions of Chinese living in tiny ramshackle homes to do?  Sit tight for a few more decades while resources pour into nice urban services for the pampered elite?

I want them to start building leaf blowers, so we don't have so many Chinese people in the low productivity position of sweeping streets. I want them to start building farm equipment, so we don't have so many Chinese farmers tending the fields. I want them to build more laundry machines, to free the rural Chinese from scrubbing clothes on washboards. I want them to build electric stoves, so my Grandpa can put away the coal fired outside oven. I want them to build computers that can deliver cheaper education to the masses.

Instead of just focusing on "building," I want them to invest in human capital, so productivity can be at a level that we don't need "make work" jobs. I want them to build more schools and hire better teachers, so classes aren't as large and you're not damned if you can't make it in a top elementary school. I want productivity to be high enough that high end stores don't need more clerks than actual customers.

I want these things among many others that will only be more obvious in a freer market.

That Scott can get a haircut for $4 or an ice cream cone for 50 cents shows how low productivity and wages are in China. Yet they will not grow any faster with more housing or more state directed investments. Cheap subway rides are nice, but are they not just another sign that transportation infrastructure has been built too quickly? I'm not saying China is hitting a ceiling for growth, or that vast swaths of China are condemned to poverty. But what I am saying is that we need to worry about the systemic fragility that underpins the Chinese system, and be very, very concerned about the unknown magnitude of the downside risk.

Money Market Funds and Monetary Policy

A middle ground between Beckworth and Garcia

Recently there's been an interesting back and forth between David Beckworth of Macro and other Market Musings and Cardiff Garcia on the interaction of monetary policy, interest on excess reserves (IOER), quantitative easing, and money market funds, as well as the implications for policy. Garcia puts forth the argument that paying interest on excess reserves is a key mechanism keeping yields on treasuries above zero, which maintains the solvency of money market funds. As a result, cutting interest on excess reserves would be dangerous because it would effectively disable a $2.7 trillion industry that plays a critical role in fodern financial intermediation. This would lead to zero rates on deposits, withdrawal of cash from banks, and massive money hoarding. On the other side, David Beckworth argues that the regime change embodied by a reduction in IOER along with a committment to NGDPLT would spur safe asset creation and allow money market funds to stay afloat in spite of zero IOER. So, yes, while an incremental decrease in IOER would have a negative effect, if only it is combined with a large enough policy change it will be expansionary.

I have previously written on the relationship between money market funds and conventional monetary policy tools such as quantitative easing. The core of the argument is that, in this world of nonlinear expectations, policy results become non-linear and non-monotonic as well.

A major problem with this scenario is that the market response function becomes highly nonlinear. With no policy action the market contracts. With some policy action the market contracts further. Only with outsize policy action are private agents convinced of a stable future NGDP target, and do collateral chains continue to expand. In this situation, it would be hard for a central banker to tell how many asset purchases "would be enough". Consequently, a credible NGDP target becomes even more important. First, it facilitates private safe asset creation. Second, it assures the market that the Fed won't end up in the middle where collateral chains contract and monetary expansion fails to raise output or prices. This is a critical argument in favor of NGDP targeting in an increasingly complex world. In spite of all of the complications in modern finance and banking, stable nominal expectations can help smooth those problems over and maintain the processes of safe asset creation. 

So can lowering IOER improve MMF solvency? Only if, as I have written above, it can translate into higher trend nominal GDP growth. In other words, reducing IOER translates into concrete committments about the future money supply, ala Woodford. Beckworth does point out such a channel:

Here is my take.  The FT Alphaville story fails because it ignores the broader effect of the Fed lowering the IOER.  Such an announcement, if credible, would send a loud signal to markets of more monetary stimulus.  And if done right, this signal would have a huge impact because lowering the IOER is tantamount to saying the Fed is going to permanently increase the monetary base.  A permanent increase in the monetary base implies a permanently higher price level and permanently higher NGDP level down the road.  In other words, lowering the IOER would permanently raise expectations of future nominal spending and income.  As a result, demand for financial intermediation services would increase today as firms, households, and governments planned for the higher level of NGDP.  The increased demand for credit would raise financial firms' net interest margins and more privately-produced safe assets would appear.  No doomsday for MMF and a recovery ensues.

But does it? What I think is missing from the discussion is the importance of zero. When IOER approaches zero while deposit rates are low, there is a non-zero probability for the FT Alphaville scenario to play out, and people start taking out the money as currency and hoarding it. While this adds to the monetary base, it cripples the money supply. Beckworth argues that "demand for financial intermediation services would increase today as firms, households, and governments planned for the higher level of NGDP" but I find that doubtful. Financial markets move quite fast. So if many money market funds suddenly broke the buck and there was another run on the banks, the effect would be severe and immediate. In the words of Garcia.

David assumes that the the signaling effect would be enough to raise companies' demand for loans, and that this would raise banks' net interest margins (meaning that banks wouldn't have to play the MMF funding/excess reserves arbitrage). Even if he is right, this would surely take time, whereas an MMF breaking the buck or a run on MMFs by nervous investors can happen extremely quickly. See: 2008, September.

On the other hand, the real economy inherently contains lags and would respond second. For as much as money market funds are risky ventures, they do help a lot of businesses with payroll and inventory financing. As a result, such a hit to the financial sector would undoubtedly reduce the expectation that nominal GDP was on path to being restored. At this point, if the expectation is uncertain, IOER would not function as an effective regime shift. This is what differentiates lowering IOER from FDR's bold move off of the gold standard. While lowering IOER can have an ambiguous effect, there was no such ambiguity for the gold standard. Inflation expectations were going to go up, real interest rates went down, and investment increased. This, of course, ignores the fact that there was nowhere near a well developed system of shadow banks and money market funds in that era.

Even if IOER was an effective regime shift, the credibility of the new regime is still an issue. If IOER is going to release so much currency, and if that currency really was going to be spent instead of just hoarded, then there could be a massive burst in nominal GDP. If the public does not see such a massive boost in nominal GDP as something the central bank could credibly maintain, then how would the nominal GDP target be credible?

So are there any alternatives? I think the role in IOER in maintaining solvent balance sheets should not be underestimated. It is keeping money market funds afloat, and as a consequence much of the modern financial intermediation sector. Without these banks, much of the buying and selling of treasuries would be hurt, and monetary transmission would be reduced. However, we do need more expansionary monetary policy and must chart a path forward. One proposal is to engage in quantitative easing until a certain dual threshold, such as 7% unemployment or 3% inflation, is reached. Alternatively, the Fed could committ to forward guidance on interest rates while purchasing MBS or more long term treasuries to show its committment to low interest rates in spite of better economic conditions. This would accomplish what Beckworth calls for in committing to a larger future monetary base without jeopardizing the financial stability of money market funds. These would all increase expectations of nominal GDP as a result. But no matter the final option, we cannot neglect the role of IOER in maintaining the financial sector, the key mechanism of monetary transmission, and the possibility of effective monetary policy.

Muddled Monetary Policy and Negative Money Multipliers

A deviation from the textbook to a complex world of shadow banking and collateral chains

An effective monetary regime requires a functioning concrete mechanism. For as much as Nick Rowe discusses nonlinear chains of causality or the chuck Norris expectations model of monetary policy, the concerns of those of the concrete steppes cannot be totally ignored. A recent Voxeu paper by Manmohan Singh and Peter Stella provides a cautionary tale for those who want to leap off the concrete steppes without a closer look. What's the problem? A potential monetary policy negative money multiplier.


In the traditional Econ 101 explanation of monetary policy, the federal reserve expands the money supply by buying treasuries, thereby expanding the monetary base. Banks use that cash by lending it to businesses that subsequently invest the money. This spending makes its way back to the banks via deposits, thereby adding to the stock of demand deposits and the money supply. A fraction of the deposits, as determined by the reserve ratio, is held in reserve by the banks; the rest is lent out again. This is one of the marvels of fractional reserve banking:The "money" that the fed creates in its open market purchases multiplies itself throughout the money supply through this lending/re-lending process.

Singh and Stella emphasize a different channel of money multiplication: collateral chains. Their fundamental argument is that, in a world of shadow banking, repos, and financial derivatives, a lot of credit creation takes place by pledging the same collateral over and over again, a process otherwise known as rehypothecation. High quality collateral, "safe assets", serves the role deposits serve in the textbook explanation of monetary policy. Safe assets, instead of being deposited like cash, are used over and over again by different firms to obtain financing, thereby expanding the "shadow money supply". Banks who were burned in the past want to limit their loans and try to deleverage. But in this process, banks shorten the collateral chains, make credit less available, and contract the shadow money supply. Central banks can compound the problem by reducing the supply of safe collateral by purchasing the assets in open market operations. As a result, traditional purchases of US treasuries become contractionary. While they may increase the base, they prevent collateral chains from forming and facilitating more credit creation. The cash that financial institutions get from open market operations can't be rehypothecated, and therefore fails to expand credit supplies. Instead, collateral chains contract and this "shadowy" money supply grows more limited. So yes, the Fed can raise prices to any level by printing money. But no, rehypothecation and collateral chains prevent quantitative easing from being fully effective.

Collateralization also brings up the possibility that the Fed could ease not by Quantitative Easing, but rather by Qualitative Easing. Instead of buying up collateral and replacing it with uncollateralizable cash, the Fed could buy up risker assets (mortgage backed securities again?) and replace them with safer treasuries. While it may not expand the size of the Fed's balance sheet, it would help with the collateral chains and expand credit. Fiscal policy then gains new traction, as increases in government debt can 

1) Increase available collateral, thereby directly expanding credit

2) Limit the contractionary effect of the Fed's buying of collateral

An interesting corollary of this is that if fiscal policy becomes more effective, the Federal Reserves interest rate forward guidance becomes more powerful. As I've written before, the interest rate guidance would lose its indeterminancy, and change from Delphian to Odyssean. Low interest rates no longer represent low expectations for NGDP, rather they represent a committment to a temporary period of faster than trend NGDP growth. Interest rates aren't low because of low NGDP, but rather in spite of it.

Meanwhile, David Beckworth's NGDP targeting - safe assets story becomes murkier. David argues that, in a world of stable NGDP growth, private sector safe asset creation goes up significantly. So if the Fed commits to a stable NGDP growth path, the collateral chain problem goes away as there's enough private sector safe assets for rehypothecation. But if the NGDP growth path is uncertain, Quantitative Easing won't help. While the initial treasury purchases may marginally increase lending, the credit contraction from collateral chains may cause the policy to be net contractionary. However, the story is still not that simple. Much like currency depreciation in a small economy, there exists a sufficiently large change that would boost growth. Quantitative Easing would only have an effect once it has collapsed collateral chains to their minimum. After that point "printing money and buying assets" would undoubtedly raise NGDP. This leads to a peculiar result when we take Nick Rowe's concepts of nonlinear causality and expectations into account. If the scale of the initial asset purchases is perceived as credible enough to shape future NGDP expectations, even though initial purchases would shorten collateral chains, the supply of collateral would expand as the private sector created more safe assets. 

A major problem with this scenario is that the market response function becomes highly nonlinear. With no policy action the market contracts. With some policy action the market contracts further. Only with outsize policy action are private agents convinced of a stable future NGDP target, and do collateral chains continue to expand. In this situation, it would be hard for a central banker to tell how many asset purchases "would be enough". Consequently, a credible NGDP target becomes even more important. First, it facilitates private safe asset creation. Second, it assures the market that the Fed won't end up in the middle where collateral chains contract and monetary expansion fails to raise output or prices. This is a critical argument in favor of NGDP targeting in an increasingly complex world. In spite of all of the complications in modern finance and banking, stable nominal expectations can help smooth those problems over and maintain the processes of safe asset creation.

Another lesson we can learn from the debt rehypothecation/shadow money supply story is that nominal GDP targeting has a critical role to play in limiting the negative growth effects of financial regulation. If debt chains serve a function to expand the shadow money supply, then banning debt in a move to a more Black Swan free society can have severe monetary effects, significantly hampering growth. But if the central bank targets nominal GDP (ideally through a mechanism not as bank or debt-centric as treasury purchases), this would help ease in the structural adjustments to build macroeconomic resilience.

Monetary policy is muddled, adjustments are painful, but stable expectations can help. While Singh and Stella's story may not be perfectly applicable now, it is an interesting example of the peculiar nexus of modern finance and modern monetary policy. These uncertainties will only get worse in the future, so it's even more important to find a credible, robust, stable regime now.