The Stock Market Crash: What China and the US are Doing Wrong
by Benjamin Studebaker
Stock markets have been stumbling this week. To some degree, this is happening because corrections are needed, but one of the key reasons these corrections are happening right now is China. China’s stock market has been in a tailspin lately, and the Chinese government has taken a series of measures to prop up its stock market, all of which are only succeeding in making the situation much worse. Right wing commentators in the west are pointing at China and claiming that government intervention in the economy doesn’t work. This is a simplistic and reductive response–the problem is not that China is taking action, but that the specific actions that China is taking are the wrong actions.
China has a classic stock market bubble. In the last year, the Chinese stock market doubled in value, and now the bubble has burst:
Lately, China has been desperately trying to reverse the slide. They’ve done a variety of things. They cut the interest rate:
They’re permitting pension funds to invest 30% of their assets in the market. The central bank loaned state-owned bank money $100 billion to buy up stocks. Regulators have banned those with large stakes in companies from selling for six months. These are just the things we know about in the west–China may be doing more behind the scenes. So far, these policies have not been effective, and the stock market bubble continues to burst. The right is crowing about it.
But what right wing commentators won’t tell you is that this stock bubble got started because, the Chinese government decided to deregulate the financial sector in a crucial way. Starting in 2011, China began permitting investors to buy stocks on margin, i.e. with borrowed money. Initially, China heavily restricted this practice. To margin trade, investors had to have an account at a registered securities firm for 18 months, and this account had to have a minimum of 500,000 renminbi (today, that’s about $78,000). But in 2013, China decided to loosen these restrictions. Now the accounts only had to be open for 6 months and eliminated the minimum balance requirement, allowing brokers to set their own limits. This allowed an immense number of ordinary Chinese people to enter the market, and 40 million new stock accounts were opened between June 2014 and May 2015. These new investors not only had much lower reserves, they were also overwhelmingly very poorly educated. Only 5.7% had an undergraduate degree, and more than half had not even graduated high school:
Because China reduced the government’s regulatory control over the stock market, a stock bubble was created using borrowed funds that had no connection to China’s real economy. Even as China’s growth forecast was reduced (and the real growth rate may be significantly lower than China is willing to publicly admit), the stock bubble continued to inflate:
China realized that its stock market had become utterly disconnected from reality and tried to restore order by installing new margin trading restrictions in June, limiting the total amount of margin trading permitted. Prices began collapsing back to earth, and China has responded by panicking and trying to prop things up again. China needs to recognize that it created an unsustainable stock bubble. It should be trying to protect ordinary Chinese citizens and the real Chinese economy from the fallout, but it cannot expect to sustain the unsustainable. China’s stock market should permitted to settle somewhere near where it was a year ago, and China should reinstate the strict margin trading regulations it had prior to 2013.
The issue is not that China is intervening, it’s that China is intervening wrongly. China needs stronger financial regulations, not stock stimulus.
As for the US stock market? It’s taken a tumble this week, partly due to China’s mistakes and partly due to its own froth. The US stock market has recovered and grown far more rapidly than the real economy. Consider the NASDAQ:
As we can see, the NASDAQ was near a record high, and has grown far more rapidly than is historically usual. Indeed, the markets have been rather volatile since the mid-90’s, with the exception of the mid-00’s when the bubble was housing rather than stocks. The US is overdue for a large correction, and it would likely see one soon irrespective of China. Over the last several decades, the US has developed a malaise in which investors have too much money and consumers have too little. This means that genuinely good investments are scarce. Most firms have little reason to expand production, hire new employees, or purchase new equipment because the demand for the goods and services they supply has been increasingly stagnant. Inflation-adjusted US wages haven’t really gone anywhere in decades:
This has continued under Obama, even for highly educated workers:
Since firms don’t have any reason to expand production, they don’t spend the money they receive from investors. Instead, they in turn invest this money. The money gets passed around from investor to investor, firm to firm, never making its way into the hands of the people who actually buy goods and services. But since everyone is trying to invest whatever capital they have rather than spend it, the price for investments continues to spiral upwards. Immediately during and after the crisis of 2008, investors threw their money into commodities, creating a bubble in prices for things like gold. That bubble has been in the process of deflating for a couple years now:
Fracking has caused oil prices to drop, knocking more wind out of commodities:
So the investment needs somewhere else to go, and so far it has mostly returned to the stock market. Stocks have gone into overdrive as commodities have flagged.
Folks on the right think that this is all the Federal Reserve’s fault–they want the Fed to raise interest rates to reduce the amount of money available for investment. But this will do nothing to put money into the hands of consumers and drive genuine growth. It’s a pessimistic strategy that assumes that the economy is not capable of growing much faster. History suggests higher growth rates are achievable–Bush and Obama are the worst performing US presidents on economic growth post-WWII:
What we need is not to eliminate the money currently being passed around by investors and firms, but to move it from the financial sector into the real economy, by giving it to consumers. There are a number of ways to do this–wage increases, government spending, union strengthening, or even printing money and just handing it to ordinary folks. The inflation rate and the interest rate on US treasuries are both currently quite low–policymakers have lots of room to maneuver:
Both China and the US have too much money in their stock markets. China’s problem is far more severe–there needs to be a large correction accompanied by much tougher government regulations and protections to prevent the real economy from being sucked in. The US correction need not be nearly so large, but if the US wants to break this pattern of investment bubbles it has increasingly found itself in over the past few decades, it needs to recommit itself to its poor and middle class consumers. Domestic consumers are the foundation of the economy. We keep trying to build taller skyscrapers without expanding and strengthening the foundation, and we keep being surprised when the tower falls over. Investment without consumption is unsustainable. The rich cannot get richer without sharing their wealth with the bottom and the middle.
I have no expertise in economics so I cannot make any assessment as to the validity of your arguments. However as a layman your arguments “appear” to make sense and that is why I enjoy your posts so much. You take a highly complex situation and unravel it is such a way that laymen can understand it. I have no idea what path you want to take after your PhD but financial journalism should be one you consider. Nice work.
Very good analysis. Chinese bubbles are of China’s making as you make clear. Borrowing to invest in stocks is a fool’s game and the losses many Chinese now face will pull money out of the economy and hold back the policy of consumption fuelling GDP growth.
The US experience is similar to what is happening in the UK. Unless there is real growth in disposable incomes the economy can not grow as it should. 70% of GDP comes from consumption in Western economies. If the incomes of the lower four quintiles are not keeping pace, growth will be low and the bigger threat is consumption is being financed by private debt to maintain living standards. Lower oil prices should be a bonus on top of incomes keeping pace -not short term relief to hard pressed families
The attack on welfare in the UK is not just inhuman, it is economically illiterate. Those of the lowest income spend all their money just to survive. That circulates around the economy some of which goes back to the Treasury from indirect taxes. Top earners hoard their wealth and the best run companies are cash rich and not investing because they do not see growth prospects that would justify higher investment.