In an article titled “China’s monetary policy must change” Alasdair Macleod discusses a path that China’s government could take to make the Yuan gold-backed and thus bring about greater economic stability in China. Keith Weiner pointed out some flaws in the Macleod article, including the fact that the sort of Gold Standard that involves pegging a national currency to gold is just another government price-fixing scheme and therefore doomed to fail. We will single out an error in the article that Keith didn’t address and then briefly explain why a gold-backed Yuan is a pipe dream.

This excerpt from the article contains the error we want to focus on:

“China’s manufacturing economy will be particularly hard hit by the rise in interest rates that normally triggers a credit crisis. Higher interest rates turn previous capital investments in the production of goods into malinvestments, because the profit calculations based on lower interest rates and lower input prices become invalid.”

No, higher interest rates do not turn previous capital investments in the production of goods into malinvestments. A rise in interest rates can help reveal malinvestments for what they are, but it doesn’t create them.

Malinvestment occurs on a grand scale when the banking system creates a large amount of money out of nothing, generating false interest-rate signals and making it seem as if the amount of real savings in the economy is much greater than is actually the case. In response to the misleading (artificially low) interest rates and the increased future demand that these interest rates imply (more saving in the present implies more consumption in the future), investments are made in productive capacity. Many of these investments will prove to be ill-conceived, because future demand will turn out to be lower than expected. The investments only appeared to make sense due to the false impressions created by banks loaning copious quantities of new money into existence.