Ad Hoc Commentary – China should print money and retire all its central government debt
Albert Einstein’s ‘Does the Inertia of a Body Depend Upon Its Energy Content?’ paper published on Sep 27 1905 introduced the world to the equation E = mc2. Einstein ushered in the age of atomic bombs by connecting the dots between the mass of an object with its energy. The interested reader can read a contemporary account of the great mind at: http://www.theguardian.com/science/2014/apr/05/einstein-equation-emc2-special-relativity-alok-jha
It is curious that while the world respects Einstein, not many in the economics profession remembers what Einstein had to say about compound interest. Instead, all the economics profession seems to remember is the theories of Keynes and Friedman. Yours truly believes that in this age of sovereign debt crisis, economists should remember Einstein’s insight on compound interest:
“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.”
― Albert Einstein
With Einstein’s insight, we analyze America’s sovereign debt situation. In the latest fiscal year (2013) that runs from October to September, America paid US$ 415.667 billion in interest expense on US debt outstanding (IEDOUS Index on your Bloomberg terminals). If you added up all the interest expense since Oct 1987 (a combination of FDEBINTR Index and IEDOUS Index), you will arrive at US$ 9,185.68 billion. Since the total debt outstanding (DEBPTOTL Index) is US$ 17,601.227 billion, it means that 52% of America’s past debt is interest expense since Oct 1987. That is Albert Einstein’s Eight Wonder of the World. Einstein’s Eight Wonder is repeated all around the world especially in Japan and Europe.
When you tell people to print, they usually come out with the objection that printing is inflationary. Those who read my previous post would know that is a fertile fallacy. As we said:
“…So the belief that printing is inflationary is filled with caveats. The Americans printed, the Japanese printed, the English printed. Where is the hyperinflation that the inflation-mongers and even gold-bugs were clamoring about? Obviously someone forgot to tell them that Irving Fisher wrote MV = PQ, not M = P…”
The reason the mainstream believes that printing is inflationary is perhaps because periods of hyper-inflation is always associated with printing. Zimbabwe late 2000s and Germany early 1920s are case in points. Printing is inflationary when there is no confidence in the government that is printing. When there is confidence, printing need not be inflationary. In fact, when there is confidence in the central government, central government borrowing is more inflationary than printing. That statement might throw you back. But let’s go back to first principles on the definition of M1.
When government prints, they are essentially borrowing with zero interest rate. When government borrows, they are borrowing with non-zero interest rate. Our definition of M1 today is too narrow for us to see the inflationary aspect of government borrowing. M1 today consists of cash and demand deposits. We do not consider government borrowing as money even though governments keep bailing out their bonds with QE. Let’s face it, if you bail it out, then it is money. If it wasn’t money, then why are we so worried about the sovereign debt crisis? Why print cash to buy government bonds that many pundits believe will eventually likely be worth much less than today in real terms? Government bonds and cash are money except in the very narrow official definition of M1.
If we can agree that money should include government bonds, then we can see that if the Americans printed, the national ‘debt’ will only be 8 trillion dollars as opposed to the 17 trillion dollars we see today. Those who assume the central government debt is not money is indirectly assuming that if you have 100 dollars in central government debt, you will not necessarily be able to find the liquidity to convert it to cash if you need to spend the 100 dollars. That is technically true. But in practice, it is a very unlikely event. Looking at how our Fed behaved after 2007, when the Fed even had to bail-out mortgage paper, my guess is that the liquidity in government bonds will never disappear. If it did, it would have been a catastrophe that none in the financial elite or political elite will allow to happen under their watch. In other words, it is a close impossibility. Of course, history is littered with mad-men and we cannot say with certainty that it is impossible.
If we can agree that government bonds are money, then we can expand our M1 to include government bonds. And it follows that borrowing is more inflationary than printing because of Einstein’s Eight Wonder. Those who still cannot agree are still stuck in a world where government bonds are allowed to fail. You are entitled to believe what you want, but in yours truly world, the Fed will save the government bond market.
Now that we agree that printing is less inflationary than borrowing, we can focus our attention on China. What happened in China is very nicely summed up in Box 4 of Apr 2014 IMF Fiscal Monitor:
“…The financing of local infrastructure projects is a potential source of fiscal risk in China. Subnational governments in China are generally prohibited from borrowing directly, but on-budget revenue has not been adequate to finance their current spending (subnational governments account for the majority of social spending) and infrastructure. Therefore, subnational governments have financed infrastructure spending off budget, through the creation of local-government financing vehicles (LGFVs) that borrow directly from banks and capital markets, possibly collateralized by state-owned assets or land. Many existing LGFVs also rely on proceeds from land sales to repay their debt (Figure 4.1). LGFV borrowing accelerated as subnational governments were assigned the responsibility to spend three fourths of the Y4 trillion stimulus package (about 12 percent of GDP) in response to the global economic crisis, but lacked the financial resources to do so. The resulting infrastructure spending provided significant countercyclical support to the economy, but has raised concerns about the size of the public debt, the sustainability of subnational government finances, and the risk of deterioration in bank asset quality…”
In short, the emperor told the provinces to spend. And since no mayor dares to deny the emperor, they borrowed off-balance sheet to fulfill the emperor’s wishes. China has put out reforms and perhaps the best read is at the Ministry of Finance website: http://www.mof.gov.cn/zhuantihuigu/2014ysbg/ysbg2014/201403/t20140315_1055691.html
Those who prefer a contemporary account on China’s reforms will prefer to read the freshly off the press World Bank report at: http://www.worldbank.org/content/dam/Worldbank/document/EAP/region/eap-update-april-2014-full-report.pdf
The most important reform is to legalize on-balance sheet local government debt because you cannot regulate what you say officially cannot happen. However, one big assumption in the reforms is that there will be good demand for local government debt. Of course, there will be some demand but will it be at a right price and at a sufficient size given the uncertainty of how much is truly outstanding today. The Chinese National Audit Office (NAO) reported that local government debt is RMB 17.7 trillion in mid-2013. Yours truly believes the NAO, but it is the human nature of fear that put doubts in my mind. After all, the numbers were put together during period of much uncertainty because no mayor really knows what the new emperor Xi Jinping is thinking about.
So, the best solution in yours truly mind, is to print RMB to retire the RMB 86,750.46 x 100 million of central government debt, i.e. based on a 2013 GDP of RMB 568,845.21 x 100 million it is 15% of GDP. The discerning reader might notice that this 15% is different from the number in IMF’s Fiscal Monitor which puts it at 22.9%. The reason is in the footnote of the IMF report which states that the 22.9% includes a combination of central government and local government debt. Yours truly prefer the MOF’s number. At the exchange rate of 6.2, the Chinese would effectively be potentially printing USD 1.4 trillion to retire the entire stock of Chinese central government debt. The PBOC balance sheet shows that they are holding RMB 13,312.73 x 100 million central government debt, i.e. about 18% of the total central government debt. Of course, you do not print a trillion dollar without impact. Thus communication of intent is important. Or as we like to say, forward guidance is paramount. The government had to be very clear that they are retiring the whole national debt because Einstein said that he who doesn’t understand compound interest pays it. China understands so it doesn’t want to pay it.
Next, they would likely need to say that they will not compete with local government for capital. Thus, the budget moving forward will be capped at a percentage of GDP. The central government deficit, i.e. the difference between tax and expenditure, moving forward will be borrowed using zero-coupon bonds that the central bank must buy. There would be limits placed on how much cumulative deficit spending is allowed. But the key is that it will be at zero interest rate. They can eliminate the income tax and replace it with the widely discussed property tax that will help make land-use more efficient. If they are afraid that the printing to retire the national debt will be inflationary, they can even print investment dollars instead. Investment dollars can only be channeled first into local government infrastructure investments in the form of public-private partnerships (PPP). The PBOC can take a lead in buying infrastructure loans with their newly monetized RMB 13,312.73 x 100 million. Their buying would, like Fannie Mae’s in the US mortgage market, encourage the standardization of repayment contracts and credit underwriting procedures for infrastructure loans. Of course, they don’t even need to follow the traditional infrastructure finance structure of equity, mezzanine and debt capital. They could just use securitization to achieve that end with much less pain.
The Chinese has the ability to retire their national debt and avoid the mistakes of America, Japan and Europe. The Chinese QE would also help in finding a correct level for the USDCNY. Let’s face it, teaching the speculators using CNY fixings is less powerful than a true economic method like this. The Chinese will emerge out of the QE immune from future sovereign debt crisis because there is no central government debt to talk about.
Good luck in the markets.