Inflation doesn't happen here. Bad debts actually take money out of the system. Recapitalizing the banks just add back the destroyed money.

Modern monetary policies don't "print" money anymore. Debt creation and destruction are used as the primary mean to create and destroy money. Below is a very simplified version of money creation, skipping many other aspects.

The banks lend their deposit out to the public and money is created out of the thin air and starts to circulate in the system. The banks are regulated by the central bank to maintain a certain reserve ratio on the deposit so there is a maximum level that can be lent out and that becomes the limit on the money supply. When loans are paid back, the money is destroyed but the returned money can be lent out again thus the money supply is not changed.

Central banks can influence the money supply by setting the interest rate. Lowering rate causes more loans to be made thus expanding the money supply, conversely for raising rate.

Now when a loan has gone bad, there is no money paid back to the bank. The bank is short of that amount of money. It still has to maintain the reserve ratio and can't lend that much out again. The money is gone; essentially it has been destroyed from the system.

So a bad loan actually shrinks the money in circulation, lowering the money supply. Too many bad loans would cause a credit crunch - the banks simply can't get the loan money back to re-lend them out and thus there's not enough money to go around.

Here's where the central banks step in. They recapitalize the banks (fancy word to create money out of the thin air), by either giving created money to the banks to write off the bad loans, or in the U.S. case in 2008 the Fed buying the bad debts from the banks with new money it created out of the thin air. In either case the banks get money for getting rid off the bad debts and can lend again, re-balancing the money taken out of the system due to bad debts. Thus the money supply is back to normal and life goes on.

The bad debts held by the central banks are simply some numbers on some papers, whose value are questionable. Someday it might be decided that they are worthless and, puff, they are gone.

The Chinese central bank is basically using the same mechanisms to deal with bad debts.

Bravo, someone who gets it. The subtle difference with China is when the bailout happens, the government doesn't go into debt to do it and stick the taxpayer with the eventual interest bearing burden of the bailout. Instead, they print the money. This creates moral hazard. I think China's political system is better at dealing with banker moral hazard than ours is unfortunately.

Well, their bankers making the bad loans and the people failed to repay the loans might go the jail or got executed when illegal lending involved. Here bonuses are reduced.

I was just about to say, your OP was a great quick summary, but glossed over the loss of risk/punishment inherent in the system. Consider the loophole closed.

Couple of points...

- There has been no economy that has been able to grow debt as fast as China has without accumulating a large amount of bad debt. This is just as true for the US in the 1920's, Japan in the 1980's, Greece, Spain, Iceland, Portugal, Brazil, Mexico, etc.

- China has grown debt to GDP at a breathtaking pace.

- Savings and debt are opposite sides of the same coin. Once a loan goes bad the debtor's promise to provide economic value is broken. At this point somebody has to bear the loss through a reduction in future consumption, there is no free lunch.

- There are choices in how those costs are allocated. For example they can be through the bankruptcy courts, inflation, reduced interest in savings, taxes and reduced social services (by taking it on the government balance sheet) and external default.

- How those losses are allocated are politically sensitive. They can and often lead to revolution and war.

- Savy investors are aware of these trade offs and will attempt to position themselves to avoid losses.

- The central bank has its own balance sheet which aren't just numbers on that can be written off. A central bank which bought bad debt and then wrote it off would be insolvent and would require recapitalization itself.

- Giving money is the prerogative of government. A central bank who gives money in the guise of a loan would quickly find themselves in conflict with the government. That is why the US had both TARP and QE.

- Even if the government gave permission for the central bank to montetize the bad debt Savvy investors would know that monetization of bad debt would lead to inflation. Investors would respond by hoarding commodities, capital flight and leveraging assets (which is happening now). This is happening now (capital flight, accelerating debt growth, hoarding of gold)

Fair points. There will certainly be turmoil and pain in a downturn.

The main thrust of my comment was to dispel the notion that recapitalizing banks or QE to write off non-performing loans would cause uncontrolled inflation. This misconception is a misunderstanding of how fiat money creation and destruction work in the modern economies. The oppose is true. Not doing those would cause credit crunch. The Great Depression at 1929 was the result of credit freeze when banks saddled with bad debts could not function at normal money creation.

I'll address one of your points. Central banks writing off the debt it bought would not go insolvent and don't need recapitalization by others. Central banks can create all the money they need at will. Insolvent is when you can't pay back the debt. The central banks don't owe debt. They own the debt; they can do however they like with them, including forgiving the debtors.

The mandate for central banks, at least in the U.S., is to keep inflation at a modest low rate window and keep unemployment low. Everything else is secondary.

The thrust of my comment is that resolving bad debt isn't merely a painless exercise in monetary policy. Resolving the bad debt requires somebody to absorb those losses through reduced future consumption. Who absorbs those losses is essentially a matter of public policy, not monetary policy.

The only thing that is special about a central bank is that their special relationship with the government exempts them from the regulations that apply to other banks. However, they still have a balance sheet with debts, which are deposits with the central banks and federal reserve notes (cash) and assets which are assets and loans that have been purchased on the open market.

The central bank also has a small amount of capital which is the ownership stakes of the member banks. Half of which is on deposit with the Federal Reserve and half of which isn't invested but can be called if required. That ownership stake has a guaranteed 8% return (and an effective 16% return) which is a nice deal if you can get it.

Due to its special status a central bank can't be subject to bank runs or be forced into receivership by regulators but it can still be balance-sheet insolvent. And a balance sheet insolvent central bank is a wounded central bank because it loses some of it's ability to control monetary policy through reducing its balance sheets.

In severe deflationary conditions a central bank may take more risks that may put it in a position of being balance sheet insolvent. For example, through the purchase of long term zero coupon government bonds at face value. The effect is to tell the markets that the central bank is putting a ceiling on interest rates long term regardless of inflation which encourages speculation.

Ultimately if a central bank has a consequence free way of creating all the money they needed at will their would be no need for taxes because the central bank could just give the government all the money it wanted.

The bad debt was used for capital creation. The capital created may be wasted. The restriction of consumption has already happened during the boom when the investment of the money in creation of capital goods caused individuals to restrict consumption for other reasons.

As an example, consider that perfectly good farmland in the central valley was being used to construct houses that would later be marked down to half their value during the bust. The land, labor and capital were being drawn away from other uses during that period of investment. So your argument that the payment must be made later in the real economy ignores the disruption that the initial boom created. The boom is not the free lunch that must later be paid for, the boom is the destruction of the existing structure of the economy that will hopefully increase efficiency enough to provide for increased consumption of consumer goods at a later time to make up for the restrictions during the boom.

In China, instead of creating a period of reseting to the previous price relationships that existed before the boom and returning all the property back to the lenders or those who lend new money from them, they simply warp the economy in yet another direction that the central planners and their partially privatized counterparts in the bank think will improve production capacity.

The government in China regularly lets very bad investments fail, and many important hedge funds and such have failed completely where in the west they would be saved.

The U.S central bank has a balance sheet but they can create unlimited liabilities. Federal Reserve Notes are debt of the federal reserve that is redeemable for 1 for 1 with other federal reserve notes and has the handy and unique property that it is the only valid legal tender for paying federal taxes and must be accepted for settlement of any debt, which is what gives its intrinsic value.

Going to the farmland example and assuming it is a closed system.

The default process isn't painless as losses have to be allocated between the banks investors, farmer, suppliers and construction workers. While the question of who takes the loss is worked out there is considerable uncertainty. Who's going to make large purchase decisions when they aren't sure how much purchasing power that they have?

The result is that while losses are being allocated the velocity of money slows which lowers GDP and as those effects ripple through the economy it creates deflation.

I see you have a theory. So do the guys who write all these China crisis articles, but the empirical evidence proves them wrong and they don't care. They just write another article every six months. I'm sure I'll be back here in another six months arguing the flaws in the antiquated quantity theory of money.

Briefly, the problem is that you are only looking at the supply of money and not the demand. If China increases the money supply 2x and goods and services output increases 4x there will not be inflation and this has been roughly the case during China's economic expansion. A country like Venezuela or Zimbabwe that has falling output will have hyperinflation if they tried the same thing.

Uh, based on what evidence? Empirically speaking, the Chinese stock market has, observably, lost enormous value in the past year, with probably further to fall.

>Printing money on this scale doesn't add wealth to the economy

Ceteris Peribus...

But when vast amounts of wealth vanish in a broad deleveraging you are merely replacing money. Case-in-point, the US pumped over $1TT into the economy since 2008, and yet the value of the dollar has gone through the roof, despite the cries that hyperinflation was around the corner.

Probably something to do with the safe haven status of the dollar. Whenever there is a sign of trouble in the global economy, investors dump soft/emerging economy currencies and buy dollars, yen and Swiss franc

You don't generally get much inflation in a credit crisis so your points tend not to be the main issue.