China's massive stimulus programme is being fuelled by an unprecedented increase in bank lending. More credit has been extended in the first quarter of 2009 than for all of 2007, and bank lending is growing by nearly 30 per cent on an annual basis compared to about 15 per cent in October 2008. That lending spree reflects an ultra-easy monetary policy with both the monetary base (currency plus bank reserves) and broad money (M2) growing at more than 25 per cent a year.
The excessive growth of money and credit relative to real gross domestic product growth of slightly more than 6 per cent poses a significant inflationary risk if the People's Bank of China (PBOC) does not put on the brakes later this year. Once the inflationary genie is out of the bottle, it will be difficult to put him back in.
More significant, most of the new loans are flowing from state-owned banks to state-owned enterprises. Those loans and investments are heavily influenced by political decisions rather than by sound cost-benefit analysis based on market prices. Consequently, China's stimulus plan is affecting the structure of its economy, with state-led development gaining ground and the dynamic private sector losing ground. If that trend were to continue, there would be a negative impact on China's highly successful marketisation process and an increase in the power of government over economic life.
It is ironic that, after celebrating 30 years of China's economic liberalisation and opening to the outside world, Beijing is now reverting to the old model of state-led development. Stimulating the economy through monetary expansion may work in the short term, but the risks to long-term price stability, prosperity and freedom are significant. Monetary mischief and artificially low interest rates could lead to a large misallocation of credit and an increase in non-performing loans. The PBOC's easy money policy risks repeating the same boom-bust cycles of 1985, 1988 and 1993-95, when the central bank allowed the money supply to far outpace real economic growth.
At present, China is experiencing deflation, not inflation. But no country - including China - has ever escaped inflation when its central bank persists in creating an excess supply of money. In a careful study of China's monetary policy, Gregory Chow of Princeton University found that when the central bank has controlled the growth of the monetary base, inflation has been tamed, as when then-premier Zhu Rongji brought inflation down from 22 per cent in 1994 to less than 1 per cent in 1997.
Today, the PBOC is putting less emphasis on controlling inflation and more on stimulating the economy. But there are limits to monetary policy: printing money cannot take the place of institutional changes that promote economic freedom and prosperity. Zimbabwe was once a rich country but is now impoverished because it destroyed sound money, imposed price controls, undermined private property rights and abandoned the rule of law. Rather than stimulating the economy, excessive money creation erodes the value of the currency, distorts market prices, slows economic growth, and reduces both economic and personal liberties.
Governments gain power when money is mismanaged. Inflation is a tax on real cash balances and, if inflation is suppressed by wage and price controls, governments resort to rationing and administrative means to determine the allocation of goods and services. The result is widespread shortages, corruption and an underground economy.