Apart from the unfortunate fact that Mill lost his way with respect to what actually fuels booms, he was, along with most of his contemporaries, spot on about their formation and eventual collapse. Now Mill referred to a “general...rise of prices”. Those who, like myself, have recently spent a little time in China might object that there is no serious inflation there apart from the building and share market booms. This is to misunderstand the nature of inflation.

Before the California and Australian gold discoveries increasing productivity in the industrializing countries was bringing about a secular fall in prices which had the effect of raising real wages. The sudden influx of massive quantities of gold made quickly generated rising prices. The price effects of the gold discoveries appear to have worked themselves out by about 1854, after which general prices remained comparatively stable. John Elliott Cairnes (1823-1875), called by some “the last of the classical economists”, had argued that the price situation was a misleading indicator of inflation. He calculated that the gold-driven inflation had actually depreciated gold by something like 20 per cent to 25 per cent. Cairnes’ was making the crucial observation that an absence of rising prices does not mean there is no inflation. (Cairnes discusses this issue in his The Character and Logical Method of Political Economy, London: Macmillan and Co., 1875, Lecture V, pp. 68-79).

In a situation where productivity is rising against a constant money supply — or at least a monetary expansion that lags behind increasing productivity — prices will fall and real wages will rise. Employees will receive the full and undistorted value of their products. However, this is clearly not the situation in China. Due to the government’s inflationary policy huge numbers of affluent Westerners are reaping a great many of the benefits of China’s rising productivity instead of those who are working in her factories. This abysmal situation is due to bad economics and not politics.

Thanks to the monetary situation that has resulted in creating enormous international imbalances by distorting the pattern of international prices and trade — a fact that certain members of Australia’s Free Market Club deny — China has been accumulating huge reserves of US dollars and other assets, leading to the fear that if she were, for instance, to dump Treasuries this would send interest rates up and the US economy into recession. (Incidentally, I got an abusive email from a demented Democrat in which he gloated about how the US would suffer under Bush once the Chinese sell-off caused a recession. No doubt about it — Dem fanatics are real patriots).

Now those who push this line have overlooked the little fact that, apart from North Korea, the US is the only country in the world that prints greenbacks. In short, China has nothing to do with the US money supply, which is basically what this is about. I got tired of pointing out to people that when the US, for example, runs a current account deficit with China and China uses its newly acquired dollars to buy US assets, then those assets are, in a sense, US exports. We can reason from this fact that China’s dollar reserves are not holding up the US currency because they never left the country. This means that they are no longer part of China’s demand for dollars.

What is also being missed is that there would be no point in China increasing its demand for dollars, which is what a sell-off implies, unless it was going to use them to buy other US assets. Naturally, critics can claim that China could sell them off to foreigners. So what? This would only mean a change of ownership. On the other hand, if China correctly predicted a massive dollar devaluation that would be a different story. In this case the devaluation would be the problem and not the sell-off. Put it another way: if speculators make the mistake of selling a currency in the belief it is over-valued this will result in them suffering losses as those with superior foresight and knowledge profit from this error.

I am therefore happy to declare that the hope of twisted Democrats that China will sink the US economy is a complete fantasy.

Economic commentators should start looking at how loose monetary policies are creating distortions in the pattern of production and international trade, and how this will work out when China goes into recession.

The US dollar and China’s impending recession, part I

Note: I shall take this subject further next week when I shall also introduce readers to what I call Boyd’s Law of Money .

Gerard Jackson is Brookes’ economics editor