The plunge in U.S. stock markets, along with various bourses around the world, is a result of fears that whatever is happening in China is a portent of worse things to come, and that what happens in China is contagious. Whether that is true is difficult to discern, however: We don’t have any historical record to base this on because China hasn’t experienced a bona fide recession since it embraced a quasi-market system in the early 1980s. Over the last 37 years it has averaged a growth rate of nearly ten percent, and its economy is 26 times larger than it was when the economy started to open up.
China did this by both embracing market capitalism but also by emulating Japan and the rest of the Asian tigers and practicing a form of mercantilist economics, whereby most of the growth is driven by the development of the export sector of the economy, and most capital investment is directed by the state. The problem is that the state turns out to not be very good at allocating capital investment. When an economy has no capital it’s hard to go wrong–every investment tends to pay off in some way—but when the economy is more developed it becomes a bit trickier. Investments start going to politically important industries or—in China’s case—they may go to prop up state-owned industries that have trouble competing with the private sector or with foreign competitors. As a result, growth begins to stall. Japan’s spent the last two decades mired in moribund economic growth and South Korea has had mediocre growth lately as well.
The current premier of China, Li Keqiang, appeared to recognize the problems inherent in the economy and started taking them on as soon as he assumed his office. He began trying to get China away from an export-driven economy and recast it as a consumer-driven society. He pushed to have the state assume less of a role in the allocation of capital, and made a concerted effort to root out corruption in government.
These are all sensible things to do but it takes time before they have a beneficial impact on the economy. In the meantime, the state also went to great lengths to boost the stock market, and its sharp, predictable collapse this summer sent shockwaves through the Chinese economy. The state has gone to considerable lengths to prop it up, just recently giving the okay for state pension funds to invest a portion of their funds in the market. In the meantime, various measures of economic activity are going down the tubes, suggesting that there may be a recession brewing in the country.
No one knows how this might play out, and it’s the uncertainty that’s killing the markets.
It’s always been a truism that the people put up with the restrictions imposed by the communist government as long as it delivers solid growth, and it looks like we are about to see what happens when one side doesn’t keep up its end of the bargain. The fear is that the Chinese government reverses its sensible reforms for the sake of momentarily propping up the economy, or delivers needlessly strong fiscal or monetary stimulus—such as building more needless bridges or airports, or flooding the market with Yuan—to forestall a quarter where economic growth is negative.
Some of this has been occurring for a while: We’ve written on these pages about how China has resorted to using bogus regulatory enforcement to hinder the operations of foreign firms successfully competing against state-owned businesses, with few objections uttered from foreign countries anxious to stay on the massive country’s good side. There may be more such behavior in the offing.
The greater fear is that we have civil unrest in the country, which could potentially crush the Chinese economy and take the economies of the rest of Asia with it. Or that its leaders foment a military encounter with one of its neighbors in a wag-the-dog scenario, perhaps by picking a fight with Vietnam or else following through on its claim on Taiwan.
Even if the Chinese government refrains from going to war, the fact remains that we have no precedent for this. How will the slow-down affect the other Asian economies, Europe, and the U.S.? We’re just guessing at this point. It ought to be able for a recession to exist in China alone and not impact the rest of the global economy, but that’s predicated on most other economic actors believing that to be the case.
If they don’t, then we could very well see companies in the U.S. and elsewhere cut back, investors flee to safety, and consumers dramatically cut back on spending, which would plunge us into another recession. The tanking stock market suggests that this may very well be how we react to a quiescent China, but it’s hard to game out this early.
At this point, the market is waiting to see if the Federal Reserve will go forward with its plan to increase the discount rate at its next meeting in September. The market is hoping it postpones its move. The Fed is in a tough spot: It doesn’t want to be seen as the entity that protects stock market investors—it has struggled to rid the market of the notion of the infamous “Greenspan put” for some time, albeit not very successfully.
However, no one on its FOMC wants to be raising rates if there’s a genuine chance of the economy faltering in the near future, and the uncertainty engendered by China’s malaise certainly boosts the odds of some sort of decline. Add to that the fact that the current inflation rate is just over 1 percent and falling, well below the Fed’s declared target of 2 percent, and we are left with an environment that makes raising rates problematic.
It leaves investors with an environment with a high degree of uncertainty. Some of those brave enough to keep investing will make a killing, but some will lose their shirt—and many others will head to the sideline and wait for this to pass and for the market to resume its steadily increasing ways.
They may be waiting a while.
Ike Brannon is President of Capital Policy Analytics, a consulting firm in Washington, D.C.
