Tough Week In The Markets....

In case anyone missed it, Tuesday, the Shanghai market dropped by nearly 10% in price in one session. The drop was due to concerns surrounding a proposal by the Chinese government to.....

RAISE CAPITAL GAINS TAXES.

It is facinating, that a communist country, where there is still much controlled by central command, reacts so quickly to such taxes. But since the common person has so little options to invest their savings, and there are so many fewer restrictions on their ability to change behavior, that they take actions quickly. The trail balloon was floated since the Chinese authorities are looking for ways to cool the speculative excesses in the Chinese economy and they floated this trial balloon. So for all you leftist, liberals and American Democrats, higher taxes have negative consequences as this week's activity in China shows. Higher taxes cause decreases in capital values and after tax incomes and drive prices down. People know this and act rationally. Prices fall so so the same risk adjusted after tax cash flows are created. Even liberal economist Arthur Okun knew this when recommending a cut in taxes to Democrat President Kennedy 45 years ago.

The rich have less incentive to work because high marginal tax rates take a large fraction of their additional income (top tax rates were between 50 and 70 percent at the time he was writing). The relatively rich also have more of an incentive to spend on tax-deductible items and on tax shelters as a way of avoiding taxes. "High tax rates," wrote Okun, "are followed by attempts of ingenious men to beat them as surely as snow is followed by little boys on sleds." For these insights, Okun can be considered one of the original supply-siders.

The rich have less incentive to work and to invest. Lower after tax returns do not reduce the risk of losses, so prices have to fall in order to compensate for the changes in after tax cash flows. So, the Chinese authorities recognized this natural response, came out and took the proposal off the table and the market stabilized.

The big problem that China has, due to the brittleness of the regulations surrounding capital flows, China is having a difficult time sterilizing capital flows. The way that it works is like this....

Money flows into China in the form of investment or in trade surplus.

The holders of this foreign exchange income/flows go to the government to get local currency, RMB for their foreign exchange.

The government gives RMB for the foreign currency.

So the government creates a credit in the banking system in RMB against receiving the foreign currency.

The government then has to decide what it will after creating the new RMB deposit in the banking system.

They can either just let it be which increases the supply of money, essentially creating new money out of thin air and risking inflation. Excess creation of the supply of money generally creates a situation where prices and inflation of prices of various things may occur ...

Or sterilize the capital flow by buying the RMB so that the money supply does not grow faster than demand for money dictates.

There are problems with the excess foreign capital flows and trade surpluses. First is that if the government doesn't sterilize and take the money out of circulation, then there could be large increases in prices or inflation.

The second is that if it is sterilized, then it cost money to sterilize. The government (I say the government when I mean the Central Bank) buys the excess RMB in the system by issuing bonds. They obviously have to pay interest on the bonds and this costs the government money. Or they can raise reserve requirements that costs the banking system, since the money is given to the Central Bank without interest.

Either way, it creates some form of financial stress.

It appears to me, that given the rampant speculative excesses in China as of late in the stock and property markets, that the government has not been able to fully sterilize or unwilling to fully sterilize the excess money created in the financial system. they have chosen to take short-term growth in exchange for risks of longer-term increase in inflation. And a Milton Friedman has pointed out numerous times, it is something that doesn't really work, since eventually a central bank will have to squeeze money supply hard to squeeze out the speculative excesses.

Expect more of the same in China. Also, in the US, the central bank, the Federal Reserve, has raised interest rates from the low rates a number of years ago. We have seen the tightening monetary policy manifest itself in weakening residential real estate prices and stress in the credit markets, particularly those credit products where excess risk was taken, such as sub-prime mortgages.