Markets can be… let’s just say quite convincing. When those in charge of governments and central banks see prices collapsing and the thought crosses their mind that the financial system or even economic model could collapse on their watch, a very strong incentive to simply give the market what it wants emerges.
But what if the market wants something unsustainable, for example what if it wants governments and central banks to keep kicking the proverbial can down the road and come to the rescue of various assets by taking on more debt, “printing” money, artificially lowering interest rates and so on? To put it differently, what if the market is willing to offer short to mid-term relief but in exchange, wants countries to embark on a very dangerous journey as far as the long-term dimension is concerned?
For example, what if Alan Greenspan wouldn’t have rescued assets by lowering interest rates from 6.5% all the way to 1% (a very bold move at the time) and instead, would have simply let markets function in the absence of major intervention?
On the one hand, the financial system over in the US might have collapsed, perhaps even the worldwide financial system or… dare we say it, economy. But then again, perhaps there wouldn’t have been such a dire outcome and instead, markets would have mostly recovered after some bitter short-term pain or “medicine” if you will. To turn this into an “us vs. them” debate, think of it as the war between Keynesianism and Austrian Economics, between interventionism and non-interventionism and so on.
On the other hand, however, perhaps the proverbial end of the (financial) world wouldn’t have come and the overall landscape would have been much healthier in the absence of ultra-low interest rates, which (as we now know) facilitated the inflation of an even larger bubble, the one which led to the Great Recession. A Great Recession which was combated through even more unprecedented measures, which paved the way for 2020’s insanity and as can be seen, the interconnected nature of this entire equation cannot be denied.
Can a compelling case be made that giving markets what they want results in a bit of a “poisonous gift” scenario, one which involves the market ultimately rewarding politicians with much-needed (short to mid-term) relief once it has received its proverbial fix but the price which needs to be paid being increased long-term instability?
While it is impossible to put a clear verdict on the table, it is a discussion worth having, especially since many financial calamities have a major incentives problem at their core. For example, perhaps the Mortgage-Backed Security fiasco could have been avoided if those in the banking industry wouldn’t have been rewarded with high bonuses for awarding let us call them questionable loans. The same way, it doesn’t take much to realize that today’s politicians are (strongly!) incentivized to accept what might be a poisonous gift from markets.
Because as far as they are concerned, there are two main scenarios:
- If the gift was not poisonous, it means they have made the right call and there is nothing to worry about
- If the opposite is true and the market’s poisonous gift ultimately leads to much harsher long-term problems, they know that things will not break on their watch or in other words, that other politicians will have to handle the problem
Moral hazard at its finest?
Of course: how else could a situation be described where if things go your way, you reap rewards and are praised, whereas if they turn sour, other politicians will have to deal with the problems in question?
What should China do in such instances?
Let’s just say that unlike Western nations, the lack of a real democracy, while representing a disadvantage in many (!) cases, can represent an advantage in this specific instance.
For example, we are in 2020 and it is election year over in the United States. As such, it should come as no surprise that the current president (Donald Trump in our case but the same principle would have been valid with pretty much any other politician) has every incentive in the world to do anything humanly possible to make asset prices turn around in light of the fact that a potential re-election could depend on precisely this variable.
Again, a problem of incentives.
Xi Jinping, needless to say, does not have such concerns.
Therefore, from the perspective of political equations, China is in a better shape than Western nations to deny the market its desires if it considers them unreasonable. At the same time, however, there is more to this than the political dimension because at the end of the day, “upsetting” the market can have a wide range of other consequences: foreign investors packing up their bags and leaving, international bond buyers no longer emerging, Chinese assets such as shares being panic sold and the list could go on and on.
Needless to say, it is hard to quantify just how much damage could be done if China were to lose market access and as such, it would be a bit of a stretch to assume that some kind of leverage isn’t there… that is hardly the case.
Compared to Western nations, yes.
Most definitely not.
We would love nothing more than for this article to have a simple to follow conclusion but unfortunately, it doesn’t. The main takeaway, in our opinion at least, is represented by the fact that this is a discussion worth having: to what lengths should those in charge of a country go to please markets in light of the fact that there is a distinct possibility that what markets desire isn’t always in the realm of true long-term sustainability? A valid case could be made that China is in a better position than the West to experiment in this direction and, of course, the ChinaFund.com team will continue keeping its ear to the ground.