Most Chinese have been feeling the pressure of rising pork prices for more than 13 weeks and increasing egg prices for six weeks. But we can hardly say that inflation is staring us in the face on the basis of just rising pork and egg prices.

We consume a huge variety of products, not only pork and eggs, everyday. So we cannot ignore the fact that prices of other consumer products such as clothes and electronics are actually falling. In fact, the consumer price index (CPI) shows negative growth, even though pork and egg prices have risen continuously. And the CPI is the most important measure of inflation.

To determine whether we are facing inflation, we have to first understand what inflation really is. Generally, classical economists have three viewpoints on inflation. Some believe a continuous price rise indicates inflation. Others suppose that only rising prices caused by excessive monetary supply can trigger inflation. The third group sees inflation as the continuous decline in people's purchasing capacity.

In the light of these definitions, a loose monetary policy almost equals to excessive money supply. Statistics show that in the first half of this year, China's broad monetary base has increased nearly 30 percent, confirming that there has been excessive money supply.

Moreover, the rise in prices of some specific consumer products has actually led to a decline in purchasing capacity. All these evidence seem to support the view that we are staring at inflation.

Economists generally see inflation as a monetary phenomenon, but we should recognize the reason behind that. Inflation is the result of productivity change. In other words, inflation reflects the shortage of production capacity. When supply is unable to meet demand because of output shortage, it causes prices to rise, that is, inflation. On the contrary, deflation is the result of excess production capacity.

According to this view, inflation should be defined in terms of production capacity instead of money. But inflation cannot have hit China now because its economy has excess production capacity.

Some may question that if excess production capacity does not lead to inflation, why are prices of specific consumer products such as pork and eggs rising. To answer this question, we should understand two things.

First, overall excess production capacity does not mean the output capability of every definable product is excessive. Take crops for instance. Frequent natural disasters this summer have made people believe that crop output may fall this year. That has resulted in the rise of food and feed prices, which in turn has caused pork and egg prices to shoot up. This process can be seen as a temporary fall in a specific sector's output capacity.

Second, many other industries, especially in the exports sector, are facing insufficient demand. Many enterprises have lowered the prices of their products to increase market share. That is why the negative growth of CPI these days reflects the overall excess production capacity in China.

Some believe that the rise in prices of consumer products such as pork and eggs will certainly lead to an increase in labor cost. The transmission of labor cost to the overall cost of production could force prices of products from other industries to rise. But for me, this reasoning does not hold water.

It is supply and demand, rather than cost, that decide the prices of products, which cannot be raised in the absence of demand.

I have always disagreed with the theory of imported inflation. It seems that pork and egg prices have risen because of the increase in feed prices. But the fact is that the rise in the prices of feed has raised the cost of raising pigs and chickens. Pork and egg prices fluctuate frequently because their production cycles are much shorter than those of other sectors.

So there's no evidence that China is facing inflation.

There are some experts who regard the existence of so-called asset bubbles as proof of inflation. They are worried over China's stock market because they believe the rise in bourses worldwide is unsustainable. Some even believe that the rising price of assets will lead to a decline in purchasing power, which is also an evidence of inflation.

Admittedly, the fluctuation in the stock market is connected with inflation. But there is a negative correlation between stock market fluctuation and inflation. In other words, inflation leads to a decrease in stock prices, while deflation boosts them.

We should analyze this phenomenon from the productivity point of view. Since inflation indicates a shortage of production capacity, the market may encourage more production. More producers, with different levels of efficiency, will rush into the market. And they may decrease the market's overall efficiency level, and eventually lower the values of the stock market and the economic entity.

Since deflation indicates excess production capacity. This causes enterprises' profit margins to fall sharply, forcing them to either boost their efficiency or switch to other modes or areas of production. It means the expected appreciation of the entire economic entity's value will increase, and the value of the stock market will rise as well.

The only possible momentum of the recent bullish market is the increase of valuation because of deflation, given that the real economy hasn't recovered yet.

All these show that what we are going through is deflation, not inflation.

The author is a professor in Harbin University of Commerce.

(China Daily 09/24/2009 page9)