China's woes and a still flawed global economy

With share prices in Shanghai and Hong Kong up and down all day, it would be premature to say that yesterday's decision by the People's Bank of China to cut interest rates and make it easier for banks to lend has brought calm to stock markets.

That is especially so after last night's gyration on Wall Street, when shares lurched downwards towards the close, after being up for most of the session.

Anxiety rules among investors.

And as I said last night on the News at Ten, in some ways I thought yesterday's events on markets were if anything more disturbing than Monday's global rout.

Because if share price gains could not hold after the significant monetary easing by China's central bank, then mistrust about the true state of the world's second largest economy (actually the number-one economy on the purchasing-power-parity measure of GDP) has become very pronounced indeed.

And another thing, the Chinese interest rate cuts will exacerbate the phenomenon that has caused so much stress in so many different global markets, from commodities, to foreign exchange, to stocks and bond - the fall in the Chinese currency, the RMB, since it was allowed by Beijing to float more freely on 11 August.

Since then, share prices alone - in other words excluding other huge markets such as oil - have lost $8tn in value.

The point is that the cut in Chinese interest rates is likely to speed up the withdrawal of capital from China, putting further downward pressure on the RMB.

And in making Chinese exports cheaper, that causes pain for competitor economies - especially Asian ones, like Malaysia, Thailand and Indonesia - whose own currencies then fall (as they continued to do today).

This process of competitive devaluation among emerging economies ends up undermining their growth prospects - which matters to us all, since they account for half of global GDP and most of the world's growth.

And also means that lower prices or deflation is exported to the rich West.

Now you may say yippee, that we can buy more petrol and food for our pounds, euros and dollars.

But that is a short term windfall. In the long term, it creates less "balanced" growth - it encourages us to live beyond our means, because the weakness of demand in the rest of the world means we can't sell enough abroad to match all the spending we want to do.

And for those of you with short memories, it was those deficits of the consuming countries like ours, the corollary of giant surpluses of the producing ones like China and Germany, which was such a big contributor to the Crash of 2007-08.

Which is one reason why the influential governor of the Reserve Bank of India, Raghuram Rajan, said - in a BBC interview yesterday - that he feels governments are expecting too much of central banks when it comes to fixing the world's economic problems.

In a slowdown, central banks can give economies a temporary boost by making money cheaper and more plentiful, to encourage spending and investment. But if the fundamental flaws in economies are to do with industrial inefficiency or lack of competition, for example, well those are problems only governments and businesses can fix.

In fact, monetary easing by central banks can make matters considerably worse in the long term, by encouraging excessive lending while governments dither and delay over politically unpopular economic reforms.

So here is the dilemma faced today by the US Federal Reserve and the Bank of England, both of which are desperate to end the era of near-zero interest rates in developed economies, by slowly and gradually increasing interest rates.

They wanted to start raising rates in a matter of weeks and months. But were they to do that at this moment of chronic anxiety about the health the global economy, well they could turn a slowdown into something much worse.

That is why the first rise in interest rates, in the US and UK, is likely to be deferred yet again.

It also explains why the influential economies and former Treasury secretary, Larry Summers, is mooting that the Fed may need to resort to yet more money creation through quantitative easing.

His view is not that of the consensus.

But the fact that he is able to make a credible case for QE shows that even seven years on from the worst crash and recession since the 1930s, the global economy is still some distance from being mended in a structural sense.