Home > Uncategorized > Why China had to crash: Part 2

Why China had to crash: Part 2

from Steve Keen                          Why China had to crash: Part 1

One thing my 28 years as a card-carrying economist have taught me is that conventional economic theory is the best guide to what is likely to happen in the economy.

Read whatever it advises or predicts, and then advise or expect the opposite. You (almost) can’t go wrong.

Nowhere is this more obvious than in its strident assurances that the value of shares is unaffected by the level of debt taken on, either by the firms themselves or by the speculators who have purchased them. This theory, known as the “Modigliani-Miller theorem”, asserted that since a debt-free company could be purchased by a highly levered speculator, or a debt-laden company could be purchased by a debt-free speculator, therefore (under the usual host of Neoclassical “simplifying assumptions”, which are better described as fantasies) the level of leverage of neither firm nor speculator had any impact on a firm’s value—and hence its share price. The sole determinant of the share price, it argued, was the rationally discounted value of the firm’s expected future cash flows.

Armed with that theorem, I was always confident of the contrary assertion: that debt played a crucial role in determining stock prices. So, like the fictional 19th century French detective who began every investigation with the cry “Cherchez La Femme!”, my first port of call in understanding any stock market bubble is “Cherchez La Debt!”.

It took a while to locate Shanghai’s margin debt data (the easier to find stock index data is here), but once I plotted it, the reliability of my trusty old contrarian indicator was obvious. While these figures may well substantially understate the actual level of margin debt [see also here], they imply that, starting at the truly negligible level of 0.000014% of China’s GDP in early 2010, margin debt rose to over 2% of China’s GDP at its peak in June of this year. It has since plunged to just under 1% of GDP—see Figure 1.

Figure 1: Margin debt as a percent of China’s GDP: from 0.000014% to 2% in 5 years–and back down again


The ups and downs of margin debt have both paralleled and driven the stock market boom and bust in China: as the leverage of speculators rose and fell, so did the market—see Figure 2.

Figure 2: A debt bubble begets a stock market bubble


This isn’t just correlation. As I explained briefly here, demand in our economies is the sum of demand from the turnover of existing money, plus demand from newly created money—which overwhelmingly comes from bank lending. This demand is then spend on both goods and services, and assets—property and shares.

Since leverage forms a large part of the demand for property (via mortgages) and shares (via margin debt, and the leverage used by professional stock market firms to amplify relatively small gains from high frequency trading and the like), the flow of demand into these markets is largely determined by the change in the relevant type of debt. The flow of supply is the flow of existing or new assets being placed onto the market for sale, and is much less volatile than demand.

If the two flows are roughly equal, then the price index will remain constant. There is thus a causal link between the rate of change of margin debt and the level of stock prices (and ditto a link between the rate of change of mortgage debt and the level of house prices).  This implies a causal link between the acceleration of margin debt and the change in stock prices—which is borne out for China by Figure 3.

Figure 3: The correlation between margin debt acceleration & monthly change in the Shanghai index is 0.69 since 2014 & 0.87 since 2015


Just as the Chinese private sector dived into debt far faster than America or Japan, Chinese speculators have dived into margin debt far faster than their Yankee counterparts. It took America 9 years to go from margin debt being 0.5% of GDP to 2%; China made that transition in about 10 months (see Figure 4). They are piling out just as quickly, and the end of that process is nowhere near in sight.

Figure 4: Chinese margin debt has risen much faster than the USA’s


The Chinese stock market will continue to plunge as the leverage piles out of it, and this could well take the index back to 2000 or below. Nor can this process be stopped by government intervention or edicts: there is no chance of Chinese authorities somehow enticing Chinese people to remain levered, let alone re-lever, after they have already been so badly burned in the crash to date.

What does this dramatic unwind of the over-levered Chinese stock market imply for the real economy? As I noted in last week’s post (“China Crash: You Can’t Keep Accelerating Forever”), the previous Shanghai stock market crash in 2007 didn’t qualify as a harbinger of crisis, because private debt had been both low (relative to the West) and relatively constant (at about 100% of GDP since 2000). It was a crash where speculators themselves were either overwhelmingly cash-financed, or got their debt from less volatile sources than margin debt.

This time is different, because at over 180% of GDP at the start of 2015, private debt in China far exceeds the 170% of GDP peak that the USA achieved in 2010 (long after its economy had crashed). The unwinding of margin debt is both the first sign of a reversal in direction for Chinese credit—from expansion to contraction—and it will also trigger distress selling of other assets to meet margin calls. So credit, which propelled China out of the Global Financial Crisis in 2008, is now propelling it into a financial and economic crisis all of its own.

  1. graccibros
    September 15, 2015 at 7:21 pm

    Everyone knows the Chinese are great savers, so these dramatic numbers you are supplying on the level of private debt surpassing the United States levels at an err…embarrassing time, must be wrong.

    Let’s get with the program, Mr. Keen, and the program’s motto is: “What, me worry?”

  2. September 15, 2015 at 11:40 pm

    Speaking as a lowly apprentice field economist, the price of junk cars for the shredder has crashed, same as the last time. Good indicator. I actually saw junk car price momentum stall.

    China is running into the facts of life. Already developed countries are not the ones to grant historical development pollution rights. The world is already polluted and China will do well to abandon the corporatist model which externalizes the full cost of environmental destruction. Earth will accept more pollution even though at this time pollution converts to direct friction. The invisible hand.

  3. graccibros
    September 16, 2015 at 2:00 am

    On a more serious note than my previous comment above: China could show the world something, as Garrett suggests, abandon the old models, and put their amble reserves behind a program of green Keynesianism – and especially since they seem to have exhausted most of the typical infrastructure spending possibilities.

    From all we’ve heard, China has terribly polluted air, water and soil…and presumably, making all those inexpensive solar panels, it could head away from coal and go solar in a large scale way. Since Richard Smith has a background in China, and wrote “Green Capitalism: The God that Failed,” isn’t it logical that he should chime in here: paging Mr. Smith….could you please weigh in…is this possible to do in China?

    Then again, this speaks to the great divide between ecology and economics, with Mr. Smith citing how few pages even the most famous of the college text authors devote to ecological matters. Greenpeace’s rep. in Greece weighed in too late and too light urging the poor Greeks to go this route, especially if they struck out on their own, but I’ve picked up very little policy discussion pertaining to Greece to seriously explore this pathway out of trouble for them. It just didn’t have a place on policy agendas during the crisis.

    China seems to cry out for it…with its blatant eco pollution problems.

  4. September 16, 2015 at 11:14 am

    Bound to crash
    Comment on Steve Keen on ‘Why China had to crash: Part 2’

    Because Orthodoxy is a scientific failure it is, indeed, an intuitively promising approach to start from the exact opposite assumptions.

    Roughly speaking, you have shown that leverage, or more precisely debt acceleration, is the ultimate cause of the boom/crash of the Chinese stock market. This is equally true for the subprime meltdown in 2008 and for the crash in 1929.*

    The general conclusion is that markets do not work as the textbook story suggests and that the supply-demand-equilibrium paradigm is empirically refuted for the financial markets.

    The pervasive boom/crash phenomenon tells us that the institutional framework and in particular the monetary order in the U.S. is fundamentally flawed. The conclusion for China and other countries is to identify the defect and to come up with a superior institutional framework.

    Until now China has mainly adopted the U.S. financial market blueprint. Therefore, it does not come as a surprise that it crashes against the wall just like the U.S. did on several occasions since 1929.

    Rethinking the actual stock market crash China first of all has to ask herself (i) whether she needs a stock market in the first place, and if so (ii), whether her stock market should institutionalize the possibility of leverage.

    The U.S. are not very talented at institution building. The Wall St/FED configuration is not a success story. If China wants to overtake the U.S. she has to create a superior institutional framework.

    In a sense Modigliani-Miller was right: ultimately it is a matter of indifference whether a firm is financed by equity or debt. And if equity is not needed the stock market is not needed.

    What China urgently needs is the correct economic theory. Financial crashes and persistent unemployment are the empirical mirror images of false monetary and employment theories. Standard economics has scientifically crashed, that is, China needs a superior approach. Can Heterodoxy deliver?

    Egmont Kakarot-Handtke

    * See also ‘Mathematical Proof of the Breakdown of Capitalism’

    • graccibros
      September 16, 2015 at 2:45 pm


      I like your comments here. All I can add is that it is my distinct impression that the grand run-up in the Chinese stock market over the past year was regime induced in a fairly desperate attempt to counter-act the slow down in the “real” (manufacturing) economy. A look at the charts shows how contrived, bizarre and dangerous this speculative venture was. We can all take solid pokes at the US dot com boom of the late 1990’s, which was silly enough for many firms showing no profitability…but at least it was grounded in the “reality” and hopes of an emerging sector.

      So we are back to the deeper questions then of how to manage the structural transitions of the underlying Chinese economy, which so many have broadly outlined as the transition from a high saving (personal and governmental) economy to a higher spending consumer economy. Not so unlike – depending on your “school of thought” of course – much that has been written about the U.S. economy in the 1920’s and into the great crisis of the Great Depression. And maybe that’s where I might diverge a bit, as any good old New Dealer might: that while surely the leveraged stock market of 1929 was a precipitating cause (read John Kenneth Galbraiths still classic account, but remember most of what he wrote after that was not about finance), what followed sure looked like an absence of broadly spread demand…that just couldn’t get the economy recovered. Some recovery to be sure, substantial some argue from the domestic New Deal spending, but not until a national drive, defense centered, was there enough demand to sustain a “recovery.” And don’t underestimate the civilian saving-future spending component coming from full-employment…even if consumption was suppressed because of material and product rationing and the shift from cars to tanks and planes. And a much more powerful labor movement was a component in creating and holding up demand in the future. This labor movement even wanted a say in how production was organized and carried out. The nerve of demanding to be fully human. (Phil Murray and Walter Reuther were rising stars. Any of you economists out there ever refer to Mordecai Ezekiel, and his two books of the period: “$2500 a Year,” (1936) and even more shocking, in 1939, “Jobs for All.”

      Alan Brinkley’s book, “The End of Reform: New Deal Liberalism in Recession and War” (1995) does a good job at explaining how these notions from the unions and dissenting economists like Ezekiel were stamped out. Brinkley’s book – I like to think of as having been written and published at an ironic time, the nadir of the American left and liberalism in general – the roaring ’90’s – so there is an ironic and sad tone which colors his reconstruction of the high tide of the American left in the 1930’s…I trust you know what happened to labor’s attempt in the Full Employment legislation of the late 1940’s…and the impact of Taft-Hartley in 1947. We’re still living with those dashed hopes, compounded by the Carter 1970’s…so that when the situation in 2015 rolls around on Labor Day, the head of the AFL-CIO, Richard Trumka, can’t even give an independent address when the circumstances literally beg for one…he’s out courting Joe Biden on Labor Day.

      And in some ways what I have written hear does not solve, but highlights the tensions between those who stress too much our obviously dysfunctional financial system, which, even if we could solve by breaking up the banks or even going further in the creation of new methods of lending and money creation, still leaves the huge question of “making things”: don’t look now but we gave most of that away to Asia in the 1980’s and 1990’s…and you’ll listen in vain tonight on how we are going to get at least some of it back…I guess throwing tantrums at the bargaining table. Good luck with that: I’m still waiting for an adult discussion on how American trade and manufacturing was hijacked by our international business giants into their self interested dreams and realities (China market! Labor broken! Free Trade for all!) while the national good was left to academic economists justifying it all…The world is desperate for growth and jobs, but don’t look now: Brazil, Russia, Canada and South Africa are in recessions, a good part of Europe too (or much worse)…they will do anything to keep their heads above water…so “claw backs” to redress the skewed tableau of economic functions – the division of labor – will be no “piece of cake” to rebalance.

  5. September 16, 2015 at 8:55 pm

    Instead of financing investment with interest bearing debt we can CrowdFund investment by end users of the investment getting the transferrable right to purchase future products or services produced by the investment. These rights can have a discount attached so that the value of services or products increases over time in a linear fashion – not exponentially as with debt. See my blog http://kevinrosscox.me/2015/09/01/gunsmoke-article-investing-in-canberra/ for the mechanics of how to do it.

    Governments will now have the mechanism to stabilise the economy by only issuing crowdfunding tokens if there is excess capacity in the economy. By issuing rights to purchase the rights to the whole population will increase the spending power of consumers who will then have money to purchase the goods and services produced by the investments.

    This now makes investments in ways to produce goods and services compound instead of the current diversion of investments to the non productive FIRE industries.

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