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China's Market Crash: One Act in a Long Play

US stock prices opened trading much higher today after yesterday’s rout and the rout the day before that and the rout the day before that. European markets were up also. The Chinese markets, which closed at 3 a.m. New York time, were off by another 7%, but the government cut interest rates to increase liquidity in the economy and raised the requirements to buy on margin (how much of a stock’s value one can borrow from the brokerage firm).

Great news, is it not? We can all relax and enjoy the end of the summer.

Not so fast! The stock market reversed paths like an out of control rocket and ended up diving again, giving back even more than the gains during the day. But even when the markets settle down, the whole episode has sent a troubling message.

The western economies are uncomfortably joined at the hip to the second largest economy in the world and one that works according to a wholly different set of rules. The Chinese economy remains a shadowy affair and highly responsive to the government direction. Directed capital investment has served it well by promoting rapid development, but that policy increasingly has other consequences.

The Chinese find themselves straddling two contradictory economic constructs, attempting to operate a demand economy while integrating with the worldwide markets that are still dominated by the single minded ideology of Reagan and Thatcher. Inevitably, the needs of politicians to pump up growth by more and more public and private borrowing (a massive 282% of GDP as of 2014) create asset price bubbles, prices for real estate and businesses that simply cannot be sustained by actual incomes and profits.

Does this sound familiar? It should.

Awhile back, US politicians faced what they may or may not have properly recognized as the rise of unsustainable income and wealth inequality. They caused outcomes similar to China’s with residential real estate, intended to spread the wealth associated with (assumed) ever-rising real estate prices. The problem was that the plight of middle and low income households was driven by the voracious demand for capital by the financial sector (as well as globalization, technology and the decline of unions) and these households could never earn the incomes necessary to pay their mortgage debt so that the bubble eventually popped.

Compared with China’s, our government was more of a co-conspirator with Wall Street than a direct perpetrator, but the urge of government to generate illusory growth through borrowing that is irrationally mismatched with illiquid assets (as so eloquently described by Lord Adair Turner) is hardly limited to China.

The multiple economic tremors in China are harbingers of trouble ahead. After the crisis of 2008, China kept on rolling by directing massive lending for businesses, infrastructure, and real estate. Because of the huge direct and indirect fiscal stimulus, it was as if the nation was immune from the effects of the worldwide Great Recession.

At the same time, the People’s Bank of China pursued a policy of modernizing the financial sector, complete with a shadow finance component, to look more like the one in the US, yes the one that had brought the world to its knees. Following the PBC’s lead, Chinese households, which save 30% of earnings, plowed increasing amounts into the stock market driving a tremendous buying frenzy that doubled down on the real estate bubble. It was if China had protected itself from the Great Recession by recreating the conditions that caused the Great Recession.

Meanwhile, trade among western nations and China had prospered, generally favoring China and inducing periodic complaints by US politicians of currency manipulation to promote China’s exports and protect against imports from the US. By keeping the yuan weak, especially relative to the US dollar, Chinese exports are less expensive to buyers and US exported products are more expensive.

That ongoing history of currency disagreements is now a real problem. If interest rates in one country move higher relative to interest rates in another, the currency value of the first country increases relative to the currency of the second. Think of it this way: if you can invest dollars at a higher rate than you can yuan, dollars are more valuable and the currency will fetch more yuan when there is an exchange. As a consequence, interest rates, currency and the Chinese economy are now in play with the US economy.

China has dropped interest rates five times since November, including yesterday, to support the weakening economy. At the same time, there is increasing pressure on the US Federal Reserve to ratchet rates upward as unemployment diminishes and fears of future inflation return. But one important reason to push up rates (and begin the unwind of the enormous Quantitative Easing program) is that the Fed has no way to respond to a future recession, if one were to occur, while the all-out policies from the Great Recession are still in place. For example, if interest rates are near 0 already, the Fed cannot act to support the US economy by lowering rates.

Therefore, we may see interest rates in China fall and interest rates in the US climb at the same time, strengthening the dollar and devaluing the yuan. We may be backing into a currency/trade conflict, or perhaps there is an element of intent involved since conflict would take the Chinese public’s mind off of government failures. On the other hand, the plunge of the US stock markets may scare off the Fed from raising rates, though this is uncertain. If that happens, our defenses against another recession remain just as weak.

Europe is not immune from this, of course. Germany is particularly tied to the Chinese economy, as illustrated by the fact that German shares fell further than US shares in response to the China crash.

The dilemma is real. We could find ourselves in a recession triggered by big events in China (perhaps including a type of trade war fueled by the election) and in the emerging markets as well as in Europe, while we still have interest rates near the 0 barrier and a Fed balance sheet swelled to $4 trillion because QE is still in place. That is because the end of the recession in 2009 brought corporate profits but did not bring prosperity to wage earners, so the Fed could never responsibly unwind the policy. A downturn under these circumstances is the worst case formula for the dreaded “secular stagnation,” a recessionary economy in which policy is powerless to reverse the deflationary effects.

There is an answer, and that is to address the underlying reason that the Fed had to take such dramatic actions and keep them in place. American workers do not make enough salary income and the damage to their incomes from recession has persisted longer in each recession since 1980 and the Reagan revolution. Now, recovery may overlap with the next recession. Over the same period, we have invested nowhere close to amounts needed in infrastructure or in R&D and real corporate expansion. The government invests less and less and so do big corporations that prefer playing the markets in their own shares over investing profits in growth.

We have collectively decided to knuckle under to Wall Street so that we have an economy that increasingly is based on finance without asking whether Wall Street is investing in us.

The real problem is the voracious and still poorly constrained financial sector. We desperately need a leader who advocates re-energizing the real economy by shrinking the capital resources devoted to finance so that income and wealth inequality is reversed and we are not so dependent on the perturbations in China. We need policies that will protect us from a replay of the crash of 2008, but applied to securing our own economy and the well-being and security of American households.

The financial sector needs to be shrunk first by reducing the value ascribed by institutional investors to short-term price moves. A good start would be requiring money managers to report on long-term portfolio growth, not just how they did versus the market in the most recent quarter, so that pensioners and 401k investors would understand their long term prospects.

In addition, we need to recognize that the $60 trillion derivatives market is not a way to insure against risk, as advertised, but an enabler of corporate short-termism and a burden on job creation. Derivatives are also a volatile and risky business for the banks that supply the corporations with the products. The Dodd-Frank Act mandated rules to make derivatives safer, but it would be best if their use were severely limited.

But most of all, we need to boldly shrink the financial sector by imposing a financial transaction tax to reduce the secondary market speculative trading and by taking the step of reinstating the separation between deposit-based banking and the new issue and trading markets.