Can't Fit a Square Peg in a Round Hole

Posted: Jan 09, 2016 12:01 AM
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Can't Fit a Square Peg in a Round Hole

The year 2016 hasn't been kind to global investors and China bears most of the blame. In four days, China's Blue chip stock index dropped more than 11% and triggered a worldwide selloff. This Thursday was the worst day for the Chinese stock market when thenewly launched circuit breaker halted trading for the day only 30 minutes into the trading session, which marked the shortest trading day in human history. To make matters worse, this was the second time within four days that the circuit breaker shut down China's stock market. Shortly after, China announced a timeout on the circuit breaker process, which was only started on January 1st, 2016. Similar circuit breakers have existed in US stock exchanges since 1988 and have only halted trading twice since then.

The obvious explanations of the Chinese market selloff are twofold: first, the most recent reading of China's Purchasing Managers' Indices (PMI) shows beyond any reasonable doubt that the Chinese economy has slowed down; second, a bailout measure instituted by the Chinese government last summer, which forbade large shareholders from selling their holdings, was supposed to expire as of this Friday. The fear that lifting such a moratorium could trigger a selloff became a self-fulfilling prophesy.

But this New Year selloff in China, along with its stock market plunge last summer, represents something much more serious. In the last thirty years, China has prided itself on building a market economy "with Chinese characteristics." In another words, Chinese authorities believed they had the wisdom and know-how to tame the market with its authoritarian regime. They had found the magic formula of fitting a square peg into a round hole. Government officials pointed to skyscrapers in Shanghai and BMW dealerships in Beijing as evidence that socialism has the power to domesticate the wild beast called the market, to force it to do as it’s told so it can produce economic miracles without Capitalism's "normal side effects" such as stock market crashes, economic recessions, and the distorted income distribution mechanism which causes the rich to get richer and the poor to get poorer.

To fight the 2008 global recession, China borrowed heavily to finance governmental spending and consequently, China's public debt rose from $7 trillion in 2007 to $28 trillion in 2014. Early last year, the Chinese government tried to reduce its debt burden by creating a stock market frenzy. Chinese investors were told the stock market could only go up and they were encouraged to trade stocks on margin. That man-made stock bubble burst last summer. Within a few weeks, the Chinese stock market went down more than 40% and about $4 trillion of paper wealth was wiped out.

Yet Chinese authorities still had faith in their ability to control the market. They came up with all kinds of onerous administrative measures: halting new IPOs, putting a moratorium on large shareholders from selling holdings; lending moneys to government-owned investment arms (so called national teams), and requiring them to buy stocks. Authorities even arrested a couple of Chinese hedge fund managers, accusing them of "manipulating market," even though the Chinese government was the worst offender of market manipulation. Government intervention seemed to be working initially. The Shanghai stock market index finished 2015 up 9%. But as soon as the New Year began, the stock selloff resumed at a fast and furious pace.

Nothing symbolizes free markets like a stock market, where buyers and sellers meet free of coercion, make transactions and take risks on a voluntarily basis, providing capital to grow the economy with the aim of a profitable return. What has happened in China shows when bureaucrats meddle the market, it only leads to disaster, no matter how good their intentions are.

Unfortunately, many people around the world, especially some in the west, share the Chinese authorities’ sentiment that market economy can only function at its best with extensive government intervention. All you have to do is to take a look at both Bernie Sanders’ and Hillary Clinton's economic policy proposals. You will find examples that mirror the Chinese government's approach. For instance, Hillary's proposal on reining in high-frequency trading seems like a twin sister to a similar proposal coming out China. As for Bernie, he is just outright against free markets. Had he lived in China, he would have been elected to People's Congress.

Dr. Milton Friedman reminded us that "underlying most arguments against the free market is a lack of belief in freedom itself." Not surprisingly, China's stock market failure is a manifestation of its authoritarian regime's lacking of faith in personal freedom and its strong desire to control its people. The lesson for us, Americans, is a reminder that our prosperity today is the result of free people having been able to choose how to live their lives for more than 200 years. Free market economy and big government are incompatible; freedom and coercion are irreconcilable. China tried to fit a square peg in a round hole and failed spectacularly. Let's not follow their suit.