A classical economist — at least up to 1840 and excluding Malthus — would have warned that loose monetary policies are inflationary and that they "derange" production with the result that you get a boom followed by a recession or as they might say: "a revulsion". (Unfortunately these economists failed to grasp the actual process.) The following chart shows just how loose monetary policy was for 2009.

From February to November M1 expanded by nearly 30 per cent. If these figures are accurate — some think they are much greater — they reveal a thoroughly reckless disregard for monetary theory that can have dire consequences. Last November Yu Yongding, economics professor at the Chinese Academy of Social Sciences, told the Australian Productivity Commission: 

In November 2008, the Government introduced a Rmb 4 trillion stimulus package for 2009 and 2010. The prescribed dosage of the stimulus is very large, at 14 per cent of GDP in 2008.

If this figure is correct — and there is no reason to doubt that it is — then it amounts to a massive sum that dwarfs even Obama's reckless splurge. In fact, it has been estimated that Beijing's spending package was three time bigger than Obama's. The World Bank calculated that last year government spending accounted for more than 80 per cent of China's growth. The problem is that this is not growth. It's ludicrous to suggest that adding government spending to GDP is the same as capital accumulation, the process that we usually call growth. Looking at it from this angle we can see that government policy is greatly inflating GDP. We can also see from the chart that it is still doing it.

We are getting numerous reports of massive "over-investment" with factories still being built, steel production increasing and the continual expansion of capital goods even though there appears to be little "final demand". This view appears to be supported by largely vacant office blocks and rising vacancy rates in new shopping centres.

There is absolutely no such thing as general "over-investment". Although this fallacy was effectively dealt with nearly 200 years it still keeps being resurrected by people who simply have not done their homework. You cannot invest without saving*. It is that simple. The problem is that monetary expansion discoordinates production, causing too much investment in the higher stages of production at the expense of the lower stages. One symptom of discoordination is the emergence of bottlenecks. An inevitable event because of the heterogeneous nature of capital.

Another phenomenon frequently encountered but only explained by the Austrian school of economics is the apparent disappearance of investment opportunities. This now seems to be happening in China. But do they really dry up? No, is the answer. Monetary expansion distorts the pattern of production by raising the rate of return in some lines of production at the expense of others which then makes them unprofitable. This gives the false impression that the range of profitable opportunities are narrowing. (F. A. Hayek, in Profits, Interest and Investment, Augustus M. Kelley Publishers, 1975, pp. 34-35).

As a rule this will not present a problem if the monetary authorities terminate the boom in time. If it is allowed to continue then the only way to prevent these 'unprofitable' sectors from going under is to accelerate the money supply. Naturally, more and more credit will have to be injected into the economy to obtain the same level of output. In the meantime this easy money policy will be fuelling more and more speculation. This certainly seems to be the case in China. I was given figures showing that from 2008-2009 it took $1.5 of debt to produce $1 of GDP. A ratio of 1.5:1. The ratio is now $7 debt to yield $1 of GDP. This is definitely not good.

*An inflation can create a situation where the mass of people are forced to restrict their consumption in favour of greater investment. It must be stressed that the restriction is the consequences of an inflation-induced change on the pattern of incomes. Therefore anyone who argues that government surpluses are forced savings has absolutely no understanding of the concept. See Why Obama's big spending big taxing regime will cripple the US economy

Gerard Jackson is Brookesnews' economics editor