The Chinese stock market crash

I’ve been asked to discuss something that I don’t know much about, the Chinese stock market.  So here goes:

1.  Stock crashes are often predictions of bad times ahead.  Sometimes they are correct (the US in 1929, 2008) and sometimes they are incorrect (1987).  We know from 1987 that stock crashes don’t actually cause economic problems. Roosters don’t cause dawn.  Chinese stocks are still much higher than a year ago, and the Chinese people won’t decide to stop working just because stocks crash.  Indeed they may work even harder.

2.  It’s possible that the Chinese crash is not a prediction of economic distress, but rather just a sort of mass panic.  But the Australian dollar has been falling in sympathy with Chinese equities, which means that in this case it’s not just panic; it’s actual worry about a slowing economy.  (Unless Australian mass hysteria is correlated with Chinese mass hysteria, which I doubt.)

3.  Tyler Cowen often (wisely) points out that lots of things that superficially look stupid actually have good reasons if you look deeper.  Here he speculates as to why the Chinese government might have wanted to prevent a stock market crash.

4.  However even if Tyler is right, in this case the Chinese government probably is being stupid.  The techniques they are using (such as banning the sale of many types of stock) will actually create more panic, and will lead to more sales from that part of the investment community that is still free to sell.  Just as European governments that make it hard to fire workers end up causing higher unemployment, as people are afraid to hire them.

5.  There’s a lesson here for “bubbles.”  Even if you disagree with my view that bubbles are not a useful concept, there is very little evidence that governments can do anything about them.  The Chinese government tried to stop the bubble on the upside, and then more recently tried to stop the price collapse. It tried hard.  It failed miserably.  China will learn from this lesson.

6.  One reason why bubbles are not a useful concept is that it’s hard to tell what the right price should be in any “fundamental” sense.  Some people thought 1987 was a bubble.  After the huge price collapse of late 1987 they said, “I told you so.”  At that point there seemed to be a consensus among experts that prices had gone way too high, and that a correction was inevitable.  In fact, we now know that prices at the peak of the 1987 “bubble” (Dow 2700) were quite reasonable.  (The Dow was 1700 after the crash.)  If you bought at the peak and held stocks for 10 years, or 20 years, or 28 years (up to today) you did fine.  So the experts were wrong.  Thus even after an apparent bubble collapses, it’s really hard to know which price was right, the peak level or the later trough.  In 20 years we’ll have a better idea whether the Shanghai market should now be at 5000 or 3500 3400 (down 100 since I started typing).  Right now no one has a clue, just as no one in 1987 had any idea that the Dow would be at 17,000 today.

7.  I’d rather the Chinese government stay out of the stock market, but this intervention is of trivial importance compared to the bigger changes occurring in China.  I wouldn’t want the US government to spend a trillion dollars on Vanguard index funds, but if they did so it wouldn’t cause much of a problem.  The tiny Norwegian government has almost a trillion dollars in stocks, and it doesn’t seem to have hurt Norway.  There’s a lot of ruin in a nation as big as China, and China should be far more worried that the PBoC will fail to keep NGDP growing at 5% or more, and/or that Premier Li stops the economic reform process that’s been underway for 35 years, than about whether the Chinese government purchases some stocks.

8.  When I first visited China in 1994 almost no one had cars or owned stocks.  I was fascinated by the country, by the urgent moral issue of raising hundreds of millions of people out of abject poverty and misery.  Quite frankly, I find the modern problems of pollution, traffic congestion and stock market crashes to be rather boring.  Even today poverty is a much more urgent problem for China, but overall the situation is dramatically improved.

PS.  Fascinating story from Ambrose Evans-Pritchardmaybe even true.  If so, is a deal still possible?  (This link is better.)


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68 Responses to “The Chinese stock market crash”

  1. Gravatar of Kevin Erdmann Kevin Erdmann
    8. July 2015 at 18:48

    The ability of how to identify a bubble is even worse than that. The current price is only the aggregate possible value of innumerable possible outcomes. We will only experience one of those outcomes. Whether the current price is right or not, the eventual price – especially a decade or more from now – will overwhelmingly be determined by real shocks that happen in the future.

  2. Gravatar of Britonomist Britonomist
    8. July 2015 at 18:55

    This whole idea that because an asset’s price surpassed the ‘bubble peak’ after 10 – 15 years, it was never a bubble, seems to only work if you assume the asset prices are a stationary process, which appears to be a bizarre assumption for things like stocks.

  3. Gravatar of ssumner ssumner
    8. July 2015 at 19:18

    Kevin, That’s right.

    Britonomist, Who made that claim?

  4. Gravatar of Andrew_FL Andrew_FL
    8. July 2015 at 20:20

    Is the entire bubble/anti-bubble divide really just between people who buy and hold and people who don’t?

  5. Gravatar of Vivian Darkbloom Vivian Darkbloom
    8. July 2015 at 21:53

    Here’s an interesting chart, even if they refer to it as explaining a “bubble”:

    http://www.vox.com/2015/7/8/8912771/china-stock-bubble-chart

  6. Gravatar of Chuck Chuck
    8. July 2015 at 22:43

    I’m curious Scott. What do you think causes these periodic sharp rises and falls in stock markets?

  7. Gravatar of Maurizio Maurizio
    8. July 2015 at 23:30

    “Even if you disagree with my view that bubbles are not a useful concept, there is very little evidence that governments can do anything about them.”

    How about having a non discretionary, fully automatic central bank? Bubbles are formed because investors don’t know when the central bank will stop pumping money. If central banks become automatic predictable, bubbles cannot form.

  8. Gravatar of Postkey Postkey
    9. July 2015 at 00:30

    “Even if you disagree with my view that bubbles are not a useful concept, there is very little evidence that governments can do anything about them.”

    According to Prof R.A. Werner there is evidence that government action can be ‘effective’.

    “According to equation (16), asset inflation and boom/bust cycles – and hence systemic banking crises – can be avoided if banks do not extend credit for asset transactions. It also follows fairly quickly from equation (15) that credit of the type that increases productivity or the amount of goods and services available in the economy is less likely to produce consumer price inflation than credit creation in the form of consumer loans. We can thus usefully distinguish between productive,
    speculative and consumptive credit creation and its monitoring can serve to predict and prevent undesirable outcomes caused by credit creation. For details, see Werner (2005).”

    http://eprints.soton.ac.uk/339271/1/Werner_IRFA_QTC_2012.pdf

  9. Gravatar of Ray Lopez Ray Lopez
    9. July 2015 at 02:50

    Sumner’s Pollyanna views on bubbles reminds me of a quote by Keynes that a weather forecaster’s prediction that seas will eventually be calm is of no comfort to a mariner stuck in stormy weather.

    OT: Explanation of the Greek Bailout. “”In a Greek village, times are tough, everybody is in debt, and everybody lives on credit. A rich German tourist is driving through the village, stops at the local hotel and lays a €100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night. The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the €100 note and runs next door to pay his debt to the butcher. The butcher takes the €100 note and runs down the street to repay his debt to the pig farmer. The pig farmer slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him services on credit. The hooker then rushes to the hotel and pays off her room bill to the hotel owner with the €100 note. The hotel proprietor then places the €100 note back on the counter so the rich traveler will not suspect anything. At that moment the traveler comes down the stairs, picks up the €100 note, states that the rooms are not satisfactory, pockets the money, and leaves town. No one produced anything. No one earned anything. However, the whole village is now out of debt and looking to the future with a lot more optimism.”
    My explanation: this parable violates Say’s Law and is thus invalid. It further presupposes that being in debt is bad, when in fact Ricardo Equivalence says being “paid up” (via taxes) is the same as being “in debt”(future taxes). It also violates a half dozen tenets of Austrian theory and is thus bogus.

  10. Gravatar of Mike Sax Mike Sax
    9. July 2015 at 02:57

    This blog post Pritchard wrote back in December last year seems to strongly suggest he does know what he’s talking about-that Greece is in disarray.

    The reason I say this is that Varofoukis himself printed the post ver batim at his own blog

    http://yanisvaroufakis.eu/2014/12/11/ambrose-evans-pritchard-on-greece-and-the-rise-of-syriza-from-telegraph/

  11. Gravatar of Postkey Postkey
    9. July 2015 at 03:03

    ‘ When Barro released his paper (late 1970s) there was a torrent of empirical work examining its “predictive capacity”.
    It was opportune that about that time the US Congress gave out large tax cuts (in August 1981) and this provided the first real world experiment possible of the Barro conjecture. The US was mired in recession and it was decided to introduce a stimulus. The tax cuts were legislated to be operational over 1982-84 to provide such a stimulus to aggregate demand.
    Barro’s adherents, consistent with the Ricardian Equivalence models, all predicted there would be no change in consumption and saving should have risen to “pay for the future tax burden” which was implied by the rise in public debt at the time.
    What happened? If you examine the US data you will see categorically that the personal saving rate fell between 1982-84 (from 7.5 per cent in 1981 to an average of 5.7 per cent in 1982-84).
    In other words, Ricardian Equivalence models got it exactly wrong. There was no predictive capacity irrespective of the problem with the assumptions. ‘
    http://bilbo.economicoutlook.net/blog/?p=15028 more-15028

  12. Gravatar of Ray Lopez Ray Lopez
    9. July 2015 at 03:13

    @Postkey: thanks, I don’t believe too much in Barro-Ricardian equivalence anyway

    re Evans-Pritchard: he’s a rabble rouser, and prediction markets where real money is being bet (Ladbrokes) were saying before Sunday’s referendum that “NO” would win by 2:1, which happened (apparently non-money betting prediction markets were saying the opposite, which is what T. Cowen reported on his blog). So E-P’s speculation is wrong.

  13. Gravatar of Njnnja Njnnja
    9. July 2015 at 03:49

    The Chinese government tried to stop the bubble on the upside, and then more recently tried to stop the price collapse. It tried hard. It failed miserably.
    Clearly the Chinese government just needs more power and control over the markets and economy. Somewhere in Shanghai there is an insightful OpEd columnist lamenting “if we could be North Korea for just one day!”
    😉

  14. Gravatar of ssumner ssumner
    9. July 2015 at 03:54

    Chuck, I don’t know. Some are caused by business cycles, but others are mysterious.

    Maurizio, That would probably make them a bit less volatile, but there’d still be big swings in the market.

  15. Gravatar of Anthony McNease Anthony McNease
    9. July 2015 at 04:38

    Scott, good job this morning (just now really) on Sirius-XM POTUS!

  16. Gravatar of collin collin
    9. July 2015 at 05:16

    In terms of the Chinese economy I see

    1) I do think the Chinese does have a recession in its future but more similar to the Black Monday/S&L crisis that led to the 1990 jobless recovery recession. (The fall in 1990 was not in great size but jobs did not recovery for several years.)

    2) Has China hit some kind of Lewis Point? Everyone buys Chinese made products but not Chinese brands. So the Chinese get little surplus gains compared to the US/Japan/Korea brands. So is there a limit to growth as manufacturing continues to be automated?

    3) Tyler Cowen has noted Chinese corporate profits have been stagnant the last several years. So Chinese economy deal with companies that are created for maximum profit versus employing workers? (That is why it is so interesting to see how much the Chinese government react so much to this stock market crash.)

  17. Gravatar of Brian Donohue Brian Donohue
    9. July 2015 at 05:19

    re #6. That was 28 years ago.

    If you bought the S&P 500 at the peak (10/5/87) you’ve earned a 9.3% CAGR over the past 28 years.

    If you bought at the subsequent trough (12/4/87) you’ve earned a 10.8% CAGR.

    Definitely a bubble, Bob.

  18. Gravatar of Njnnja Njnnja
    9. July 2015 at 05:20

    @Britonomist

    Standard stochastic models of stock prices assume that stock *returns* are stationary (or nearly so; lots of work on autocorrelations and microstructure), not stock *prices*.

  19. Gravatar of What China’s stock market crash means for the U.S. and the world – The Washington Post What China’s stock market crash means for the U.S. and the world - The Washington Post
    9. July 2015 at 06:04

    […] Chinese factories don't have as much demand for them anymore. That'd fit, as economist Scott Sumner points out, with the fact that the Australian dollars, which tends to move in tandem with China's […]

  20. Gravatar of benjamin cole benjamin cole
    9. July 2015 at 06:59

    You know a funny thing….check the public company named YY, that is also its trading symbol. Management announced a going private transaction today. There are many Chinese companies of late going private even though the market is up 85 percent YoY.

    I do believe in bubbles… For gold and certain modern art. Really, $37 million for an Andy Warhol limited edition? And in 50 years what will that be worth?
    I confess when entire stock markets trade at close to 100 times earnings, I begin to wonder if the word “bubble” might be appropriate. But those are rare and fleeting episodes.

  21. Gravatar of Butter Butter
    9. July 2015 at 07:14

    I’m surprised you don’t believe that “bubbles are a useful concept”. They form precisely because large numbers of people begin to “reason from a price change” which I believe you may have warned about at some point on here. As an expert, you should be able to spot instances of this and at least give Bayesian probabilities that prices don’t reflect fundamentals. You do it all the time on this blog.

  22. Gravatar of Dustin Dustin
    9. July 2015 at 07:19

    Brian,
    How does that indicate a bubble… or sarcasm maybe?

  23. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    9. July 2015 at 08:56

    @Postkey
    This time I agree with Prof Werner, without leverage the idea of a bubble (only recognized ex-post!) is meaningless.

    Prof. Sumner has a point about the concept of bubble. Because it is very hard to accurately reconize it ex-ante (in order to be able to act on it). Ex post, I think it is possible to recognize that a lot of market participants failed to identify proper risk in an investment (house prices never go down, government guarantees credit) and levered up in a failed project (buy a lot of real estate on credit). When house prices did go down, a lot of wealth was destroyed. Ex-post, it is not hard do accept the idea that this was a “bubble”.

  24. Gravatar of marcus nunes marcus nunes
    9. July 2015 at 08:58

    Chinese stocks: “Dangerous Playground”
    https://thefaintofheart.wordpress.com/2015/07/06/dangerous-playground-keep-off/

  25. Gravatar of Randomize Randomize
    9. July 2015 at 09:10

    I’d be completely fine with the US government buying a trillion dollars in Vanguard index funds. Just imagine how many years of life could be added to the Social Security trust if they mixed in some stocks and investment-grade bonds as opposed to their current 100% allocation in T-Bonds?

  26. Gravatar of Randomize Randomize
    9. July 2015 at 10:04

    The NDGP/Debt chart in the second link is particularly damning for the ECB. If there was ever a case for NGDPLT, there it is. http://cloud.highcharts.com/embed/adakiq

  27. Gravatar of JimP JimP
    9. July 2015 at 10:05

    Hi everyone

    My names is JimP. I am an early reader of and occasional poster on this blog. I have not posted here for three years or so – because I am not a trained economist and my opinions on complex money things are not informed.

    But I do have a question for the collective opinion on Greece and Grexit.

    I don’t think Germany can give much on (to) Greece- even thorough the (in my opinion overly loud) AP says the entire world is doomed. (I think the guy is a loud smart idiot)

    No-one is going to give a better deal to a country whose basic negotiation is to call the other guy (Germany) a Nazi in public and then threaten the other guy (Germany) in public with a threat the the other guy is not is not threatened by. (We will just leave and boy will you guys miss us.) If someone talks to me like that I open the door for them and boot them right out.I do not think Germany has a choice in this.

    But I also think all the AP chatter about the US siding up with France and Italy and moaning and groaning in pubic about it is AP bunk. “NATO is going to fall apart and the US is going to turn its back on Germany and feed Germany to Russia”. I just don’t think so. Here AP is confusing what he wants to have happen with his predictions about what he thinks will happen.(He has done that before).

    Surely the creditor nations have thought about what they will do after Grexit. Here is what I think they should do – and this is what I would like the collective opinion on. Will this work?

    The creditor nations will (should) say to the debtor nations “unlike Greece you did not threaten us in public and call us us Nazis. Therefore we are going to give YOU better terms. And here they are – A B C – .”

    “And in addition to that, we (Germany) are going to talk to our electorate about nominal targets – about rule bound money creation – and then we are going to print up several nice euros and toss them out of helicopters.”

    I am not predicting the creditor nations will do this – I am just wondering if it would work if they did it.

    Thanks

  28. Gravatar of Chris Chris
    9. July 2015 at 11:12

    @JimP
    “The creditor nations will (should) say to the debtor nations “unlike Greece you did not threaten us in public and call us us Nazis. Therefore we are going to give YOU better terms. And here they are – A B C – .”

    What kind of weird deal would that be? Paying billions over decades for not being called a Nazi? It’s really not about the Nazi thing. Syriza needs to put real reforms on the table or they might not get better conditions. It’s tit for tat now.

    “And in addition to that, we (Germany) are going to talk to our electorate about nominal targets – about rule bound money creation – and then we are going to print up several nice euros and toss them out of helicopters.”

    This is the money illusion blog that favors NGDP targeting. So yes of course NGDP targeting would work. Greece would still need austerity and some structural reforms though.

  29. Gravatar of Christian List Christian List
    9. July 2015 at 11:17

    A bit OT but it might interest Mr. Sumner. Am I unterstanding this correctly? Is Krugman now saying that monetary offset and austerity is working?

    “For comparison, look at everyone’s favorite example of successful austerity, Canada in the 1990s.

    What was Canada’s secret? The answer was, easy money and a large currency depreciation. These offset the drag from austerity, allowing growth to continue.”
    http://krugman.blogs.nytimes.com/2015/07/08/policy-lessons-from-the-eurodebacle/

  30. Gravatar of Christian List Christian List
    9. July 2015 at 11:30

    On last comment before I get to tired again and mix up all grammar and punctuation again and so on.

    I don’t get what’s so great about the piece by Ambrose Evans-Pritchard. Most of the things he says are already known. The news in his piece sound more like wild speculations and conspiracy theories than substantial insight. Aside from that it also doesn’t make much sense. Maybe I’m missing something?

  31. Gravatar of collin collin
    9. July 2015 at 11:38

    JimP,

    One problem with the whole Germany/Greece discussion is the Euro is a lot nations and the Baltic nations also got hit is crisis as well. For the most part lower wage nations have survived a lot of economic pain and can’t stand the Greek whining. (Finland and Ireland population don’t care for Greek problem as well.) Since most of the Euro nations outside of Greece are past low points, the Euro nations can simply think of Greece as a failed nation and almost treat it look a corporate spinoff. The US can ‘care’ a lot because it ain’t our money and Germany is sure not spending a lot on the military which weakens the NATO alliance with the potential of closer Greece and Russia relations. (And the US does have a small Puerto Rico bankrupt territory in which the population ain’t caring about as well. And to be honest the NATO stuff is foreign policy nonsense from old Cold War days.)

    Frankly, I think Germany and other Euro nations are writing up divorce papers as we speak.

  32. Gravatar of Njnnja Njnnja
    9. July 2015 at 12:00

    @Randomize:

    I’d be completely fine with the US government buying a trillion dollars in Vanguard index funds. Just imagine how many years of life could be added to the Social Security trust if they mixed in some stocks and investment-grade bonds as opposed to their current 100% allocation in T-Bonds?

    This is exactly the problem that municipalities get into when they think that investing more into higher expected return securities (e.g. stocks instead of bonds) makes their pension plans better funded. Sadly it doesn’t.

    It is similar to the old question “Which weighs more, a pound of feathers or a pound of bricks?” Of course they both weigh the same. In the same way, $1 million dollars worth of stock is worth the same as $1 million dollars worth of Treasuries (or else the market wouldn’t make it be worth $1 million dollars). So if the problem is that if you owe future retirees $2 million, it doesn’t matter if today you have $1 million in stock or $1 million in Treasuries – you have exactly the same funding problem.

  33. Gravatar of Christian List Christian List
    9. July 2015 at 12:04

    @collin

    “Frankly, I think Germany and other Euro nations are writing up divorce papers as we speak.”

    If you think that then you don’t know German politics well.

    All the rest of your analysis is correct though.

  34. Gravatar of Randomize Randomize
    9. July 2015 at 12:43

    Njnnja,

    From a theoretical risk/reward standpoint, you’re correct. From a reality-based standpoint, stocks will almost certainly yield more earnings over time than risk-free treasuries.

  35. Gravatar of TravisV TravisV
    9. July 2015 at 13:07

    Yglesias wrote this, which I thought was interesting:

    “In a healthy society, a business leader might invest time and resources in rent-seeking but he wouldn’t brag about doing so and certainly he might choose to take the honorable path and not do it. But the current paradigm in the implicit US political philosophy is that he has a moral obligation to divert resources away from R&D and toward lobbying if the ROI on lobbying is higher. It says he has a moral obligation to find ways to trick customers into overpaying if he can find them. It says he has a moral obligation to violate regulations if the Net Present Value of paying the fines when you are caught exceeds the cost of compliance.

    In other words, it replicates Banfield’s amoral familism but with shareholders replacing the nuclear family as the local of ethical thinking……”

    http://tinyletter.com/mattyglesias/letters/sounds-like-a-lot-of-money

  36. Gravatar of TallDave TallDave
    9. July 2015 at 14:59

    Scott knows I’m not nearly the China optimist he is, but it’s way too soon to make much of this — the volatility of Chinese equity valuations is much too high. That in itself is troubling, but check back in a month and see how things look then.

  37. Gravatar of Carl Carl
    9. July 2015 at 15:04

    Ray:
    Why are you comparing Sumner’s post to a parable involving Greeks paying off their debts painlessly by cycling a German tourist’s money through their town? (Well, not actually painlessly, of course, since the hotel owner is out the $100 formerly owed by the prostitute.)

  38. Gravatar of TallDave TallDave
    9. July 2015 at 15:04

    Travis — The problem with that is that the real issue is with the government, not the shareholders or the managers, who must play the game by the rules others set — e.g., it’s the responsibility of government officials to not take bribes, which in effect make the ROI of lobbying zero. The logic is the same for fines, etc.

    None of this is new, Adam Smith wrote much the same hundreds of years ago.

    As far as “tricking customers into overpaying” this is no different than “tricking sellers into accepting prices that are too low.” No one has any obligation to sell or buy anything at any particular price and everyone defines value differently. Does LeBron James trick people into paying for basketball merchandise?

  39. Gravatar of Jim Glass Jim Glass
    9. July 2015 at 15:12

    So if the problem is that if you owe future retirees $2 million, it doesn’t matter if today you have $1 million in stock or $1 million in Treasuries – you have exactly the same funding problem.

    Fair enough point as to state and private pension plans. But as to the specific example given of Social Security…

    It matters plenty if you are the US govt holding the Treasuries and owing the debt, because then you have $0 — as a bond issued to yourself is both an asset and a liability to you in equal dollar amount, balancing out to a net value of zip nada.

    Which is why the Treasury reports all the T-bonds in the all the Trust funds combined (SS, Medicare and all the rest) as having a value of $0.00 on the Consolidated Balance Sheet of the US Government.

  40. Gravatar of Tom Brown Tom Brown
    9. July 2015 at 15:22

    @Christian List,

    I could be wrong, but I think Krugman has always said that. The issue between MMs and Krugman isn’t monetary offset per se, but monetary offset in a liquidity trap (LT): the former (MMs) claim monetary offset still works in LTs and the latter (Krugman & some other Keynesians) say it doesn’t.

    Regarding Canada in the 1990s, if they were not in an LT (I don’t think they were) then there’s not much daylight between the two positions.

  41. Gravatar of Tom Brown Tom Brown
    9. July 2015 at 15:34

    @Christian List, I pointed the same quote out to Sumner in a post a few days ago, and here’s his response:
    https://www.themoneyillusion.com/?p=29858#comment-394378

  42. Gravatar of Major.Freedom Major.Freedom
    9. July 2015 at 15:51

    “One reason why bubbles are not a useful concept is that it’s hard to tell what the right price should be in any “fundamental” sense.”

    This reasoning is so horrible. I see it over and over on this blog. It is the presumption that the only “useful” knowledge is that which can be observed.

    If the world was a totalitarian socialist hell, and people had no positivist knowledge of free market capitalism, it would be wrong to claim that economic science that is based on individualism, would be “useless”. It would also be wrong to claim that arguments concerning the destruction that socialism unleashes against entrepreneurial activity are somehow useless on the basis that we cannot observe entrepreneurship and would not have any positive evidence against which to compare the socialist nightmare that people are living in.

    Now scale things back a bit. The same logic applies. Even though we do not live in a world with a free market in money, that does NOT imply that arguments concerning what prices “should” hwve been are useless.

    Yes, it would be very hard, very difficult for anyone who was born into worldwide socialism to think of what entrepreneurship might be like, and what production might be like, and how life might be. But that being “difficult” does not mean capitalism is useless.

    Thoughts always precede action. If a particular thought, such as free market prices, is not (yet) a social activity, it would be absurd to believe that it is useless and so we should all focus our attention on socialist production and how to get the state to bring about the production of more potatoes versus more cabbages, by using econometric equations and positivist reasoning.

    To be an economist requires a healthy imagination, creativity, and an open mind. Any alleged economist who prattles on about “usefulness” in a positivist “If I cannot observe it then it is not important” should choose another past time and leave the real economics to the experts.

  43. Gravatar of Major.Freedom Major.Freedom
    9. July 2015 at 15:55

    Where is Sumner’s pleas that it is a good idea the Chinese government are considering using the central bank to buy stocks in companies to prevent spending from falling?

    Remember the previous posts of “Buy everything even the kitchen sink if necessary?”

    Sumner’s advocacy for a movement back towards communism, I notice is absent in this particular post.

    Come on Sumner, let us hear the red cheers, the revolutionary efforts to stabilize society by governmental take over!

  44. Gravatar of Major.Freedom Major.Freedom
    9. July 2015 at 16:14

    I predict this blog will not offer any engaging rebuttal to theory of malinvestment caused by years of inflstion in China.

    I predict a lot of denials, rhetorical questions, and evasions. But ZERO engaged criticisms.

  45. Gravatar of Edward Edward
    9. July 2015 at 17:30

    I predict that you will not stop flogging your Austrian zombies and being a general annoyance.

  46. Gravatar of Carl Carl
    9. July 2015 at 17:35

    Major Freedom:
    How do you define a malinvestment? The way I read your comment, you’re saying that all government spending is by definition malinvestment.

  47. Gravatar of TallDave TallDave
    9. July 2015 at 18:12

    Tom — it might be more accurate to say LTs cannot exist in the MM world. In the Keynesian view, monetary policy is limited to nominal interest rates. In the MM view, CBs can always inflate.

    The Keynesian view ought to be self-refuting since CBs clearly can always inflate, at least until they run out of ink, but it has a lot of adherents because argues for more government spending — five of the six richest counties in America are DC suburbs and most of the world is even worse than we are. The power to coerce trillions of dollars is horrible corrupting.

  48. Gravatar of Major.Freedom Major.Freedom
    9. July 2015 at 18:15

    Edward:

    Monetarism and Keynesianism are zombies.

    Carl:

    There are different kinds.

    A division of labor economy requires each individual to produce a component of not only the output of their respective companies, but all output in the world. This requires relative coordination in real terms.

    I highly recommend the essay “I, Pencil” by Leonard Read. This essay is the best short explanation of the workings and underpinnings of the division of labor.

    The law of marginal utility determines the extent to which each line of production, including components and factors for use in further production, is extended relative to others.

    It also determines what is to be extended.

    Aggregated conceptualizations, concepts such as RGDP and NGDP, these are virtually useless tools in understanding not only economics in general, but the business cycle in particular.

    The desire for goods in general is practically infinite. As long as there are acting humans, there is seeking of gains and avoiding of losses, I.e. productive activity.

    Periods of time when cash preference rises for one, two, a hundred, a million, 150 million, or 300 million people, are never without non-cash reasons. A person or 300 million people choose to change their cash balances for very good reasons. Always.

    These changes in cash preference that lead to historically large swings in the sum total of all individual spending, where some individuals may in fact be increasing their spending to some positive amount as others reduce their spending (this is in fact necessary in the aggregate, since for anyone to accumulate cash, there has to be other individuals DEcumulating cash), are not merely periods of time where money printers “failed to print enough notes”, for some people in the society to spend, so that their own spending offsets the decline in other people’s reduced spending, such that the statistical total spending from the first and second group of people add up to a number larger than yesterday.

    There is something else more important going on that caused the money printers to even be in the situation they are in of “If we don’t print more, then the rising cash preference in society will result in a statistical drop in total spending compared to yesterday.”

    This something else is a widespread, unobservable did coordination between a sufficient number of individuals who have found themselves producing the wrong things to the wrong extent, such that physical reality has reared its head, and is manifesting in a felt experience of “not enough money” and “credit crunch” and “deflation” and “spending decline”.

    The superificial, easy way out (and certainly incorrect) mentality is that all problems that cause declines in total spending, can be fixed with increases in spending, due to the misdiagnosis that all declines in spending are “demand problems” only, never real problems. This flawed mentality is what underlies the entirety of MM, which is one reason (among many) for why I reject it.

  49. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    9. July 2015 at 19:52

    @MF
    I am very sympathetic to the austrian views, I am, really. But one thing that some austrians failed to recognize is that commodity money is what society chose as medium of exchange and store of value when it had nothing else. The gold standar stuck (and worked) for so long because it was the only credible nominal anchor available. One can use other anchors, as long it is credible (long and variable leads).
    I think that when Prof Sumner says that under a gold standard, and choosing to do nothing when under a negative demand or supply shock, society is actually choosing one kind of intervention (by omission), which is to have tight money monetary stance. This has serious implications for relative price adjustments. Prices are sticky, that is a fact, and although they end up adjusting, that takes time. And dependending on how much time it takes, the real cost can be very high. Some austrians authors accept this, and concede that free banking will expand money supply in a world where velocity of money is slowing because demand for money is increasing. If you think about it, that is exactly what market monetarists defend …

  50. Gravatar of Nathan Nathan
    9. July 2015 at 21:25

    I don’t think it’s obvious that Australian mass panic is uncorrelated with Chinese mass panic. We’re very aware that the strength of our economy is reliant on theirs to a significant degree (probably the average Australian would even overstate the extent to which this is true).

    I’m not saying Chinese stock market turmoil is definitely going to affect our markets, but it’s not an obviously unreasonable theory.

  51. Gravatar of benjamin cole benjamin cole
    9. July 2015 at 23:22

    BTW Shanghai up 10% in last two days…

  52. Gravatar of TravisV TravisV
    10. July 2015 at 01:25

    Prof. Sumner,

    The recent fall in the Australian dollar has been very tame. The AUD has not fallen nearly as much as Chinese stocks have. In fact, the AUD / USD exchange rate is at the same level it was at in mid-March.

  53. Gravatar of Major.Freedom Major.Freedom
    10. July 2015 at 03:12

    Jose:

    ” am very sympathetic to the austrian views, I am, really. But one thing that some austrians failed to recognize is that commodity money is what society chose as medium of exchange and store of value when it had nothing else.”

    Austrian economics does not advocate for commodity money, indeednit contains no advocacies at all. It is wertfrei.

    I do not advocate for any commodity money either.

    I advocate for a free market in money. Let individuals decide for themselves.

    BTW, “society” does not make an choices. Society does not think. Society does not act. Society does not feel.

    Only individuals choose, think, act and feel.

  54. Gravatar of Major.Freedom Major.Freedom
    10. July 2015 at 03:18

    And no offense, but what you are “sympathetic” towards, like “really are”, is of no concern to me.

    Prices are not sticky. Inflation and demand changes have a lagged effect. That makes prices seem sticky.

    The real costs of socialist money far outweigh the costs of liberty in money. The proof is that violence and coercion are required to force people to incur the costs of socialist money that they otherwise would not occur voluntarily as in a free market!

    Jose, you are so very wrong. Your psychological fixes you get when speaking as if you know what’s best for me and everyone else, you fake concern trolling, is something that does not fool me at all.

  55. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    10. July 2015 at 04:26

    @MF
    You said “Inflation and demand changes have a lagged effect”. That is the definition os price stickiness, because there is also the question of time, how long does it take for prices to adjust.

    You said:”speaking as if you know what’s best for me and everyone else”
    Yes, that is me.

  56. Gravatar of Njnnja Njnnja
    10. July 2015 at 05:22

    @Randomize:

    If you invest in the stock market instead of bonds, you haven’t reduced your funding problem, you have just changed the type of risk that you have.

    For example, let’s say that you are Warren Buffett, and you are thinking of buying company A, which is worth $10 billion (except for its pension plan), and has a pension plan that is going to owe $5 billion to retirees, but has $3 billion in Treasuries. Clearly this company is worth $8 billion (10-5+3 = 8).

    OK then imagine company B, which is exactly the same, except the $3 billion is invested in stocks. Is the company worth any more money? Of course not.

    You say “almost certainly” but that masks the fact that there is a risk with stocks that there isn’t with bonds. So you aren’t comparing apples to apples. Let’s say that you had enough Treasuries to fully fund your retirement system. Would you then recommend rolling the dice with a stock allocation? Or are you only willing to increase the risk to the system because you would rather take a small chance that you cut benefits at the last minute (if stocks *don’t* have the higher return that you expect), so long as it is possible that you can fund the entire benefit and therefore don’t have to have any awkward benefit reductions today (to reflect the actual funding status of the plan)? See heuristic biases such as endowment effect and loss aversion.

    So why invest in stocks? Why not real estate, or artwork, or a giant mound of copper? You can make a claim that even on a risk-adjusted basis, US equities are a better asset than others, but what you are then arguing is that the market is wrong and you are right. And that is a typically very hard case to make.

  57. Gravatar of Andrew_FL Andrew_FL
    10. July 2015 at 07:23

    @Jose Romeu Robazzi-I think I’ve made this point before at Econlog, but the problem with the term “sticky prices” is that it treats the tendency of prices not to adjust immediately in proportion to changes in the effective money stream as A) a mechanical law of nature and B) the result of some kind of rationality failure on the part of entrepreneurs. Both of these are theoretical and methodological mistakes. To be sure there are menu cost arguments that are not wrong as far as they go. However, one has to examine the actual process by which price adjustments must occur to understand what is actually going on.

    An injection of new money into the market, even if correctly anticipated by market participants, does not have as the correct, rational response for all sellers of goods to raise the prices they ask for goods as if they can expect all demand schedules to shift in perfect proportion. After all, there is no reason to expect that his costumers in particular have gotten a share of the new money in proportion to their income, and even if he does have reason to believe that, that is no guarantee they will demand more of his goods as a result. Rather, if an entrepreneur possesses knowledge of recent increases in the supply of money, he must search for the correct new price for the goods he wishes to sell. The same is true in cases where the effective money stream declines.

    It would in fact be extremely troubling if prices really did adjust immediately to such changes. The task of explaining how would be the most daunting economics has yet faced.

    The term “sticky prices” comes from an attempt to classify deviations from the “perfection” of the Walrasian auctioneer. But the Walrasian auctioneer is the very fiction that convinced the “Market Socialists” that central planning was possible. This was of course incorrect.

    If you start from a correct price theory, there are no sticky prices. There is only the market process.

  58. Gravatar of Ray Lopez Ray Lopez
    10. July 2015 at 08:06

    @Andrew_FL – to demonstrate non-sticky prices, consider gold miners deep in the Amazon. A documentary back in the 1970s, before the age of cell phones, found that prices deep
    in the jungle for an ounce of gold were remarkably close to the actual world price of Au for any particular day. Prices are not 100% non-sticky, but they are so close to being non-sticky that for all practical purposes they are not sticky.

  59. Gravatar of Jose Romeu Robazzi Jose Romeu Robazzi
    10. July 2015 at 08:26

    @Andrew_FL, Ray
    You do recognize that there is empirical evidence for price stickness, don’t you? Besides, some prices are stickier than others, and for the purpose of macro analysis, the prices that matter are wages… Look at Greece and Spain, this countries have been adjusting wages for 5-6 years now, and the process seem to not be over … I agree that the market process can adjust prices, the problem is always at what cost.

  60. Gravatar of Andrew_FL Andrew_FL
    10. July 2015 at 08:44

    @Jose Romeu Robazzi-Don’t confuse what I’m telling you with what Ray says. He’s nuts.

    If you’re asking me whether I recognize that prices don’t adjust immediately, of course I do: I told you why they don’t adjust immediately, why the could not and should not adjust immediately.

    What I’m telling you is that calling them “sticky prices” is just a handwaving exercise that doesn’t improve our understand what is going on. It doesn’t actually tell you why prices don’t “adjust immediately” and just leaves you puzzledly wondering why they don’t, as if you should have expected them to.

    But I completely disagree that some prices matter more than other prices. All prices matter.

  61. Gravatar of Randomize Randomize
    10. July 2015 at 09:02

    Njnnja,

    You’re preaching to forum full of economists. We get it: risk-adjusted returns should be the same for all individual assets. What you’re leaving in is everything we’ve learned about Modern Portfolio Theory whereby diversified portfolios outperform individual assets from a risk/reward perspective and that a good portfolio mix should attempt to find the efficient frontier where we can obtain the most reward for a given level of risk.

    We know that, historically speaking, a mix of about 75% bonds & 25% stocks carries the same risk level as a portfolio of 100% bonds due but yields better returns. We also know that, historically speaking, blending in a minority portion of riskier foreign stocks with US stocks can yield more returns for the same level of risk as a mix of 100% US stocks.

    The point is that we can keep risk levels the same while mixing in a small amount of stocks to significantly improve returns.

  62. Gravatar of Tom Brown Tom Brown
    10. July 2015 at 09:48

    @TallDave, I almost wrote (what you did) that the existence of LTs is disputed by MMs, but I kept it simple: it sort of amounts to the same thing: if an economy is in a Keynesian defined LT, then MMs say it’s not really a “trap.”

    However, AFAIK, regarding what Keynesians say to do for stimulus when in a Keynesian defined LT, it doesn’t have to be government spending. It can be tax cuts. There may be some discussion about what’s more effective (tax cuts or gov spending) but both generally qualify as fiscal stimulus. I don’t see the Keynesian position as inherently more pro-spending. I suppose the common denominator is potentially bigger government deficits.

    And in terms of always being able to inflate: I’m not so sure it’s as simple as you make it out to be. Maybe it is. But perhaps an arbitrary inflation rate isn’t always so easy to realize. Maybe hyperinflation is always a choice (ignoring political considerations), but is any inflation rate always a possibility in every economy at every point in their history? Or, put another way, is monetary policy always equally effective in every economy at every point in their history? For example, this plot suggests to me (by the exponent on MB: chosen along with the offset to make the blue curve fit the green curve as closely as possible from 2009 to 2015) that perhaps monetary policy lost some of it’s effectiveness during the Keyneisan defined LT in the US.

  63. Gravatar of Njnnja Njnnja
    10. July 2015 at 10:00

    @Randomize:

    2 points: one general, one specific:

    In general, you claim that based on your historical analysis, and analyses that you have seen, that there is a mispricing in US equities such that one can add them to a portfolio in such a way that you can increase portfolio returns without increasing risk. I know different people have different levels of belief in EMH but a believer in even a mild form of EMH would find that claim highly suspect.

    And specifically, where a classic MPT model falls down is that it makes important assumptions about deterministic (even constant) vols and correlations between assets (or asset classes) that are very hard to justify. So yes, you can run a calculation that shows that a portfolio of asset A + asset B has a good return, and less *standard deviation of returns conditional on a particular correlation* than either A or B alone; but the value of the CAPM “sigma” is not the only risk that we need to concern ourselves with. There are third and 4th moments (and higher) of the distribution that can and do blow up when you do a better job accounting for the stochastic nature of vols and correlations. And that, generally, is why people think they get a free lunch – they push risk into the tail of the distribution and then hope that they never see it. If you wanted to buy a basket option on different asset classes you would see that there is a value of implied correlation that you have to pay money to hedge away.

  64. Gravatar of Major.Freedom Major.Freedom
    10. July 2015 at 15:38

    With all this volatility in the Shanghai Stock Exchange Composite Index, I am sure Sumner is going to make a post arguing that “Nobody knows what the value of the index is”, just like he argued about the volatility innthe dollar price of Bitcoins.

    Right?

    Anyone? Beuller?

  65. Gravatar of Major.Freedom Major.Freedom
    10. July 2015 at 15:47

    Jose:

    “You said “Inflation and demand changes have a lagged effect”. That is the definition os price stickiness, because there is also the question of time, how long does it take for prices to adjust.”

    No, it is a characteristic of inflation and demand. Inflation and demand affect prices in a particular way. This is not prices being sticky, this is prices responding neither sticky nor non-sticky, neither quick nor slow.

    Prices cannot rise if the people who pay those prices have not yet experienced an increased income because the initial round of inflation has increased the incomes of others first, and time is needed for inflation and demand to rise for those who pay those prices.

    It is wrong to say that the $20 I pay my neighbor’s kid to mow my lawn is a “sticky price” on the basis that the Fed engaged in QE yesterday but my own income and the income of my neighbors has not yet increased such that we are in a position to pay the kid $25 instead.

  66. Gravatar of ssumner ssumner
    11. July 2015 at 05:09

    Well I answered all these comments yesterday, and now I can’t find my response. I’ll just do a few again.

    Butter. I believe individuals do lots of silly reasoning, but markets are much smarter than individuals. Markets can distinguish between price changes from supply changes and price changes from demand shifts.

    JimP, Good to have you back.

    Christian, His fans don’t know it, but Krugman’s always believed in monetary offset at positive interest rates.

    Travis, The other problem is that regulation makes culture more corrupt.

    Nathan, That’s possible, but it’s unlikely that irrational panic in two different countries is highly correlated.

    Travis, You’d expect the Aussie dollar to fall less, as the effects there are very indirect.

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