China’s answer’s to economic freefall this week appears to be much the same as the Federal Reserve’s in the financial crash of 2008: Hose the markets with money so that investors can keep trading and prices can steady at a new equilibrium.
That’s the 21st century textbook solution for economic crises: It worked for the U.S. in the last financial crash — sort of. The Fed pumped enough liquidity into Wall Street (and other global markets) to ease the panic. It became a buyer of last resort for otherwise untradeable debt. In the wash of money, orderly markets gradually returned.
China has been chugging the liquidity tonic this month as it copes with the effects of sharp stock-market declines and a bumpy currency devaluation. The People’s Bank of China is planning cuts in bank reserve requirements, according to the Wall Street Journal, to free up cash for banks to make new loans. Easier central bank policy will paper over bad loans, weak state-owned enterprises and China’s debt and equity bubbles.
By stabilizing markets, the money cure provides significant short-term benefits. But it’s increasingly clear, looking at the U.S. experience, that it doesn’t fix the underlying imbalances that led to financial trouble. People are happy to trade using what’s, in effect, free money. But when it comes to taking risks and otherwise displaying the “animal spirits” (as John Maynard Keynes famously called them) that are essential to real economic growth, the liquidity pump is the monetary equivalent of catnip. Its effects are weak and temporary.
The International Monetary Fund summarized China’s basic challenge succinctly in a report last month: “China is moving to a ‘new normal,’ characterized by slower yet safer and more sustainable growth….Managing the slowdown is a key challenge: Going too slow will lead to a continued rise in vulnerabilities, while going too fast risks a disorderly adjustment.”
The problem is that as China tries to turn this corner toward slower growth, it swings the rest of the global economy along behind, as in a game of “crack the whip.” What begins as an orderly transition becomes a disorderly rout—exacerbating the very problems that China was trying to cure.
David Smick, a financial consultant who’s very wise about international markets, writes in the latest issue of his magazine, “The International Economy” that hosing markets with money doesn’t change the fundamentals of investor behavior. He estimates that after 2008, more than $17 trillion was devoted worldwide to programs for stimulus, bailouts or guarantees. “The result: After an initial sugar rush of economic activity, global growth, trade and cross-border financing since 2010 have all plummeted,” writes Smick. “It turns out the massive flood of money failed to drive human behavior.”
Central bankers, in Washington and Beijing, need to think first about maintaining financial stability in moments like these. That means opening the spigot of the money hose. But nobody should confuse this short-term rescue with long-term reforms that provide sustainable growth. Here in America, we’re still working on that puzzle seven years after the Lehman crash.