China Hopes to Defy History of Market Bailouts
China's stock market has had a spot of trouble lately. Perhaps you've heard? You may also know that the Chinese government has intervened heavily to try to prevent a financial panic. And yet, as the Wall Street Journal notes today, the stock market remains well off its peak.
Whether Beijing's policy has "worked" is somewhat subjective; if you think that financial panic was imminent, then maybe it has. But even if you think that the government's policies have prevented a disaster, you still have to ask whether they can actually sustain a recovery.
Organized support of the market is not a new idea, and history suggests that sometimes it does work. J.P. Morgan famously assembled a group of financiers (with some government help) to prevent the market from collapsing during the Panic of 1907, and this does seem to have staved off some panic. Similarly, the Hong Kong government seems to have made some difference in the Asian market crisis of the late 1990s. The Fed organized interventions in cases like Long Term Capital Management that I think can legitimately be said to have stopped some sort of widespread panic.
And yet, even these examples -- the ones that "worked" -- aren't exactly a shining testimony to the power of intervention in the stock markets. The Hang Seng had fallen by two-thirds by the time the government managed to stem the decline. The U.S. market that Morgan and friends "saved" fell more than 40 percent from its peak before stabilizing.
And then there are the interventions that really, really didn't work. The U.S. tried organized support of the stock market again during the Great Depression, and the ultimate result was that, as John Kenneth Galbraith would later write, "Support, organized or otherwise, could not contend with the overwhelming, pathological desire to sell." The Japanese government tried to save the Nikkei, and it eventually bottomed out at around 60 percent off its peak (though it would continue to plumb further bottoms as the "lost decade" stretched over more than 20 years).
What lessons do we learn from this history? The first is that support works best when you have some sort of a limited situation, as with the collapse of Long-Term Capital Management or the Knickerbocker Trust Company, where you are essentially trying to limit the ripples from a single event. As long as the support is bigger than the failing entity, the intervention will probably work.
But what if the problem is larger than a single shock? What if the whole market is unstable because naive or greed-maddened investors have bid up the prices of assets to levels that cannot be supported by the underlying economic activity? In that case, support seems to at best stave off the inevitable market correction -- perhaps prolonging the pain.
Of course, ordinary rules don't always seem to apply to China. Visiting a few years back, I was struck by how ripe the Chinese banking system seemed for collapse -- and how hard it was to define the conditions under which such a collapse would happen. The government exercises control at so many levels that I wasn't even sure whether you could call the Chinese banking system a banking system in any traditional sense, so it's even trickier to map out the normal routes by which banking crises occur. It seemed possible for the government simply to declare by fiat that the banks were sound, and make it so by sheer force of will. Possible. But it probably can't do the same with the stock market.
Could Beijing simply declare the prices on the stock market to be whatever the government wants -- and commit funds as needed to make it so? Sure. But it wouldn't end there.
Having the government buy up all the shares would sort of obviate the point of having a stock market; a Potemkin asset pool obviously does not further the purposes for which the exchange was initially established. Obviously the actual idea is to stop well short of that point, using various levers and pulleys to "restore confidence" in the market, or if you prefer, "to create the appearance of confidence." The Chinese government has been unusually open about its drive to keep the stock market high, and presumably the idea is to give the markets confidence that the government will not let things get out of hand, in much the same way that the Fed and the Treasury strove to restore confidence in the U.S. banking system during the 2008 meltdown.
Frothy asset markets are ultimately driven by the "greater fool theory": I buy an overpriced asset because someone stupider will come along to buy it from me at an even higher price. They collapse when the greatest fool buys at the peak price, and everyone realizes they'd better run for the exits. By being so open with its support, the Chinese government is essentially positioning itself as the greatest fool. And since the government has an enormous amount of money and power, and considerable trust from Chinese citizens, that may work.
But that's a risky move, because ultimately, if assets are overpriced, the gravitational pull of the underlying cash flows will try to pull them back to a more reasonable level. And that means that the government either has to keep playing the fool, or lose some of its reputational capital as it becomes clear that the effort to support the market cannot keep prices from finding their natural home. The end result of "organized support" in the 1930s was that the organizers took a bath. The Chinese government may meet a similar fate.
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