Paul Krugman: China’s Stock Market Crash Could Lead to Economic Collapse

Paul Krugman
Image by Commonwealth Club

Despite spectacular growth over the last 25 years, the Chinese economy may be headed for an economic collapse after the government’s inept handling of a stock market crash. The Shanghai Composite Index fell by nearly 30% since June 12th, a decline precipitated by regulatory changes in China’s financial sector.

The Chinese government’s actions have drawn the ire of Paul Krugman, a Nobel Prize-winning economist who also writes for The New York Times. According to the famous professor, too many analysts wrongfully attribute the success of China’s economy to its leaders.

“The big news here isn’t about the Chinese economy; it’s about China’s leaders,” writes Krugman. “Forget everything you’ve heard about their brilliance and foresightedness […] they have no clue what they’re doing.” (Source: The New York Times, July 31, 2015.)

The truth behind China’s success is more complicated. Rapid urbanisation drew on the strength of the country’s demographics by luring poor farmers from the central provinces to the coastal regions. Growth was spectacular during this phase as China had a surplus of labor and capital, two essential ingredients for economic expansion.

Both labor and capital are increasingly scarce. China’s growth can no longer depend on its ability to produce things; its development must derive from an increase in living standards. Despite having the second-largest economy in the world, China’s consumption levels are incredibly low.

The average person in China consumes $1,307 worth of goods and services every year, far below the average American consumption rate of $31,190. In order for the country to move forward, Chinese living standards must rise. (Source: World Bank, last accessed August 3, 2015.)

The worry is that China’s economy is not built for that kind of expansion. “China’s leaders appear to be terrified,” says Krugman. “They’ve been pumping up demand by, in effect, force-feeding the system with credit, including fostering a stock market boom.”

In June 2014, the Chinese government allowed investors to leverage their equity investments. Over the next year, the stock exchange boomed, rising 150% as bank loans were used to buy shares. The credit-fueled boom looked eerily like the 2008 financial crisis, causing Chinese regulators to reverse the policy in June 2015. (Source: Bloomberg, June 28, 2015.)

When investors began to flee the market, China’s policy makers banned selling and suspended trading on endangered companies. They quickly reversed their stance on margin trading yet again—a move intended to prevent further capital flight. Krugman concludes that this “is especially troubling because China has a huge ‘shadow banking’ sector that is essentially unregulated and could easily experience a wave of bank runs.”