Chinese House Buying Negotiations

Today I went with my family to go look at houses in some Shanghai suburbs an hour from the city. The houses were what we call "别墅", or multi-story mansions at around 320 square meters (~3000 square feet). What struck me as very humorous was how Victorian the sellers would adorn the showcase houses. The curtains were very gaudy, and the walls were often covered with old fashioned paintings of people from 18th century England. Photos were strictly of Europeans and Americans, adding to the western image.

Yet beneath the facade of grandeur, there seemed to be signs of something more pernicious. When we sat down to discuss prices, the agents asked for us to, on the spot, give them ¥100,000 RMB (~$16,000 USD) for a voucher. The voucher would reimburse us for ¥100,000 RMB if we decided to buy the house and would also  guarantee us the opportunity to buy one of the "few" houses that were still selling at about ¥3.5 million RMB (~$550,000 USD). We were a bit taken back, but they explained to us how it would be an almost zero-risk transaction, as the fee wouldn't commit us to actually purchasing the house -- it would just be an indication that we attended their showing and were interested in buying. If we decided not to purchase, we could withdraw our money a month later without any fee. The conversation went something like this:

"Is there some contract or paperwork for this agreement?" my mother asked.

"No, it's just this voucher -- see here. After you swipe your card, then we give you this voucher that clearly says that you are entitled ¥100,000 RMB towards buying a house. And your money will be safe if you don't want to buy, you can get your money back after a month," one agent said.

"Well, I don't have ¥100,000 available to me today. I plan on taking out a loan to buy a house."

Another agent introduced himself as the deputy-manager and said, "If you don't have it all today, that's fine. You can pay ¥20, ¥30 thousand today and pay the rest tomorrow."

"I don't know. Isn't there some kind of something that I can get signed?"

Yet another agent, lanky and with a pen twirling in his hand, replied, "How about this, I can write out a note saying that you have a right to the ¥100,000, and I'll sign it."

I perked up and asked, "Why do you need the ¥100,000 anyways if it doesn't commit us to buying the house?"

"Well, we need the cash flow. We can't keep the bosses always waiting, and they won't be happy if we don't bring in some near term revenue," the first agent replied.

In the end, we didn't give them the money. But the discussion along with other observations seemed to confirm several running hypotheses about China right now.

First, there seems to be a serious liquidity, if not solvency, problem among Chinese housing companies. The housing complex that we were looking at has had difficulty selling in the past two months, and they actually had just cut prices by about a million RMB to boost sales. While they tried to project an image that people were scrambling to buy the houses, there were still three agents aggressively trying to get us to sign. Admittedly, there were quite a few other families looking at houses, yet the agents' ploy for ¥100,000 still seemed like a desperate attempt for liquidity to meet payroll or something more fundamental. This anecdote seems to confirm Patrick Chovanec's analysis that many loans are coming due during this second half of the year, making it difficult for property developers to stay afloat.

Second, Chinese finance is highly uncertain. What did we have to guarantee that the company would actually pay back our ¥100,000? In truth, nothing. There was no hard contract that we could take to the courts, and if the company took a hit from collateral calls as their loans came due, we would be dead in the water. They would be playing with, as Karl Smith likes to say, "other people's money". Once we think about this precarious credit situation in the context of rapidly slowing manufacturing and fragile credit guarantee companies, things are not looking good at all.

NBER Macrohistory: A Few Interesting Results

As I was browsing the FRED database for data, I noticed the front page posting of academic historical data that covers various time series that cover the time between the mid 1800's to the mid 1900's. It's quite amazing the wealth of data available, and I thought I would corroborate some conclusions that fellow bloggers and I have regarding the impact of certain economic policies and phenomena.

First exhibit: Openness to Trade

While the Bretton Woods period after the Gold Standard is typically characterized as a dark era for international trade, in reality trade grew at a steady clip. From 1870 to 1944, trade grew an average of 4.0% every year, whereas during the Bretton Woods period, from 1944 to 1971, trade grew at about 6.6% per year. However, after the breakup of Bretton Woods, trade boomed, with yearly growth in trade averaging 9.6%. This corroborates Evan's analysis that trade went parabolic in the 1970's as global trade barriers steadily went down. I've graphed the data below in terms of log of the index, so the distance between two vertical values is actually a measure of percent change, making historical comparisons much simpler.

Looking at the data, we can also see that, among the post war recessions, trade has fallen the most in percentage terms in the Great Recession than in any other recession. A close inspection indicates that it still has not caught up with the pre-recession trend, but an even closer inspection indicates that the lack of catch-up growth should not be too surprising, as in the last two recessions, trade never caught up to the pre-crisis trend.

Second exhibit: Price Stability

Prices were incredibly stable during the Gold Standard era, to the point of bordering on pathology. The prospect of decades of deflation is unthinkable now, but it was something that Americans had to deal with during the time period from 1880 to 1900. It's amazing to think that the price level was fundamentally controlled by gold discoveries, as the mid 1860's boom in the price level can be directly traced to the gold rush during that time period. Yet as production rose, the price level fell, the natural result of a commodity price regime in which the supply of the commodity is severely limited.

The behavior of prices during the interwar period is also interesting, as prices doubled with the beginning of World War I, and then collapsed 40% with the onset of the Great Depression. And during the Great Depression, although FDR's dollar debasement strategy did work to significantly raise the price level, it was not enough to return it to its pre-war trend before he cut it off with his policy reversals in 1937.

Third Exhibit: Turn of the Century Wage Levels

This provides an interesting complement to the price stability graph because it seems to show that the rise and fall in the price level were the ultimate drivers of the wage rate, and not so much other factors such as the extremely large flows of immigrants in the late 1800's and early 1900's. By looking at the graph, it would be impossible to try to pin down when immigration was at its highest or when restrictions on immigrants were put into place. This goes down as a historical point to explain in debates about unskilled immigration and wage rates, a some of the most prosperous periods of American history took place side by side with large immigration flows. On the other hand, hard money seems to be a serious issue holding back wage growth, so this graph should help in showing how problematic the Gold Standard truly was and how a similar commodity standard today would be seriously detrimental to necessary growth in nominal GDP.

The Fed's Balance Sheet, Interest on Reserves, and the Zero Lower Bound

A look at some time series evidence and conclusions for IOER and NGDP

Is the Fed powerless at the zero lower bound? Most market monetarists would say no, the Fed always has a wide range of unconventional policies that affect expectations and can boost nominal spending growth. As long as it can boost the monetary base, there can be an effect on expectations and NGDP. Miles Kimball argues that QE is effective because it takes advantage of small monetary frictions to achieve large real effects. Karl Smith suggests that QE is effective because the central bank will unwind QE before it raises short term interest rates, making QE a commitment mechanism for forward guidance.

However, some detractors argue that, because of interest on excess reserves, policies such as quantitative easing are useless. Because banks can just hoard the money and get interest payments from the Fed, QE doesn't spur any additional lending. Others argue that QE just takes collateral out from the financial system, thereby shortening collateral chains and contracting the economy.

So what does the data say?

Not surprisingly, expansions of the monetary base, even at the zero lower bound, have a powerful effect on both current inflation and expectations of future inflation. The graphs below are changes in inflation and inflation expectations with respect to changes in the monetary base.

The first two growth spurts of the monetary base in the two graphs are QE I, QE II, respectively. The fact that inflation moved with the monetary base is important. In the time periods for both graphs, IOER was at 0.25% and the fed funds rate was at 0-0.25%. However, this did not nullify the effects of a monetary base expansion on inflation or the expectations thereof.

Therefore, these graphs provide a tentative answer to the debate over negative rates, nominal GDP targeting, QE, IOER, and collateralization. First, expanding the monetary base boosts inflation and nominal GDP. This happens in spite of the removal of safe collateral from the repo market. Additionally, IOER has not proven to be a barrier to QE or other expansions of the monetary base. Under such conditions, why not maintain IOER? Money market funds can reap the benefits of a guaranteed income stream AND higher nominal GDP growth. The debate on negative rates and IOER becomes a moot point. Given IOER is not a barrier to monetary expansion, the Fed can leave it untouched and pursue a transition to a nominal GDP target in different ways.

As a result, I stand by my original policy suggestion of continued interest rate guidance combined with more QE while leaving IOER untouched. Quantitative easing fundamentally changes what forward guidance means. Because low interest rates are not reliable indicators of monetary policy, a policy that only commits to a long period of low interest rates may be perceived as a Delphian prediction that nominal GDP growth will be slow. On the other hand, if QE provides the pressure for rising inflation and nominal GDP growth, forward guidance turns into an Odyssean commitment to low interest rates in spite of higher nominal GDP growth. With IOER still around to guard against any uncertain effects of negative rates, this policy would maintain financial stability while guarantee robust nominal GDP growth.

What firms See and not See

Matt Yglesias replies to Brian Caplan on why right-wing economists tend to like Bastiat much more than left-wing economists do. I think Matt is correct in saying that those who quote Bastiat often already assume government intervention is undesirable, but I wonder why those who support limited government intervention don't employ Bastiat as well.

Most reasoned arguments for government intervention happen on welfare-theoretic grounds, so why not use those types of "unseen" costs or benefits as reasons for government intervention? When a people pay for immunizations, what they see is the cost in both time and money to get the shot, while what stays "unseen" is the population of other people who are not going to contract the disease. When an oil rig is opened, what is seen is the growth in economic activity and jobs, while what stays unseen is the pollution that contaminates other towns. When Wall Street firms overleverage, what they see is the higher return when times are good, what remains unseen is the systemic risk that devastates the system when times are bad.

In these situations, government policy can allow the market to see what was previously unseen. Subsidized immunizations show parents that immunizing their children can save the lives of others. Carbon taxes show companies that their oil consumption hurts the health of others. Higher capital requirements show banks that their higher return can lead to the fragility of others. Often times, transaction costs are too high for the Coase theorem to internalize these externalities, and it becomes necessary for the government to try to reveal the true costs of actions to the market.

Of course, perhaps there's a government failure, perhaps the government does not have the necessary information to intervene. But at this point, Bastiat stops becoming a sufficient argument, therefore we need to look at the empirical data. For this reason, I read Bastiat and am left with "meh"; it is much too general to strike at truth.

Nominal and Real GDP: A Barrier to a Statistical Approach

Scott Sumner regularly talks about how almost all discussions of inflation become much clearer in terms of NGDP. This is because people have a hard time differentiating between inflation as a result of more aggregate demand (demand-push) and inflation as a result of less aggregate supply (cost-pull). The difference is summarized in the textbook aggregate demand/aggregate supply diagrams below:

Aggregate demand expansion = Inflation

Aggregate supply contraction = inflation

The first kind of inflation changes NGDP, while the second has minimal impact. This way, when we are in a recession and demand more inflation, what we really mean is that we need more of the first kind of inflation because we need more NGDP. If we were in the second situation, we wouldn't be demanding more or less NGDP because the supply shock would have had minimal impact.

Another example in which NGDP makes explanations easier is in discussions of whether deflation is bad in an economy. Often times, liberal economists will point to the recent recession and say deflation is bad, while libertarians might point to the late 19th century, early 20th century and say that deflation is good. The more correct answer is that stable NGDP is best. So because the first kind of deflation reduced NGDP, it was bad, while the second type of deflation kept NGDP steady, and therefore was good.

While NGDP is simple, it makes it hard to statistically show NGDP boosts RGDP. You can't look at a graph and point to any correlation; a skeptic could just say that it's the RGDP that's driving the movements in NGDP, and not the other way around. In the end, to explain the relationship between nominal and real output in AD shocks, I have to find specific channels, such as nominal debt. On the other hand, inflation and output make much more sense in terms of trying to find statistical relationships. These concepts are far enough in people's minds that a relationship doesn't seem like a tautology. However, when you start directly talking about NGDP and RGDP, it's too easy for people to think the observed relationship between NGDP and RGDP is just because the second is a component of the first.

How Does Paul Ryan Want to Target Inflation?

He would have to use Quantitative Easing anyways

While my previous post talked about the variety of ways Paul Ryan should prefer an NGDP target over an inflation target, I realized that a lot of the Fed's policies that Paul opposes would still be necessary in a world of inflation targeting. In his 2010 Op-Ed with John Taylor, he called the quantitative easing programs  "departures from rules-based monetary policy" that have "increased economic instability and endangered the central bank's independence." But would strict inflation targeting really solve the problem?

Below I've created a graph plotting quarterly annualized headline CPI inflation which includes commodity prices, the 2% inflation target, along with zones indicating when the two quantitative easing programs were hinted at and then executed. The dates for the QE announcements were taken from a conference paper, and they are used to show how policy and inflation were related.


As you can see, for much of the past four years, headline inflation was significantly below the 2% target traditionally set for the Fed. In response, the Fed hinted at the quantitative easing programs and drove up inflation. Yet Paul Ryan opposes these policy interventions. The question that I pose to Paul Ryan and his supporters is "what would you have had the Fed do during those time periods?" The short term interest rate was already at zero, so what would Ryan have suggested to fulfill the mandate? Paul would have been forced into unconventional monetary policy such as QE or Operation Twist just to fulfill his proposed mandate!

Under these conditions, there's no reason for Paul Ryan to not opt for an NGDP target instead. If you're going to be using unconventional monetary policy tools, you might as well use them to target a metric that is critical for stable, robust growth. An NGDP regime would be simple, rule based, and verifiable. So when choosing a monetary policy regime, why not NGDP level targeting?

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.