The Trap Set by Financial Markets

Monetary policy has become a slave to boosting asset prices. Sound money has given way to speculative impulses as major central banks suppress interest rates and investors search for yield by taking on more risk. The disconnect between the real economy and financial markets is evident not only in China but in the United States, Japan and Europe.

Unconventional monetary policy since the 2008 financial crisis has ignored the reality that financial stability flows from monetary stability and that when central banks engage in financial repression asset bubbles are sure to develop. Negative real interest rates are unnatural: they harm savers, spur speculation, and misallocate capital.

The lack of transparent rules to guide monetary policy has increased uncertainty in a world of pure fiat monies. Once asset bubbles form, central banks have been reluctant to take away the punch bowl.

The Federal Reserve has held its benchmark policy rate near zero since 2008 and has not increased the federal funds target since 2006, even though the unemployment rate is now 5.3 percent. A rate increase is expected in September, but that could be put on hold if the global economy slows.

The lack of transparent rules to guide monetary policy has increased uncertainty in a world of pure fiat monies.

The U.S. stock market has experienced a strong rebound since the 2008 crisis, and the Fed has been more than willing to sustain that run-up in asset prices by keeping rates low and promising to go slow in increasing rates. That policy has pleased investors.

Wealth has been created, but it is “pseudo wealth” created by distorted interest rates, not by productive investment in real assets. Private saving is weak, businesses are hoarding cash and banks are holding massive amounts of excess reserves.

Monetary policy has been asked to do too much, and policymakers are now fearful of taking any action that would lead to lower asset prices — but the Fed “put” can only last so long. Eventually rates will rise and asset bubbles burst.

China is experiencing the pain of asset price deflation. After a boom in the stock markets, which peaked on June 12 after a rise of 149 percent from a year ago, the Shanghai and Shenzhen indices have lost nearly US$ 3 trillion, about one-third of China’s GDP. Like the Fed, nervous policymakers are taking steps to prop up asset prices, while ignoring the role of government in creating the bubble.

Slower growth last year encouraged top officials to instruct the People’s Bank of China to ease credit by lowering interest rates and relaxing reserve-requirement ratios (RRR) for banks. The PBOC used open market operations to inject liquidity and encouraged brokerage firms to lend to investors on margin. Those leveraged funds were used to buy stocks, especially of smaller companies by retail investors. People rushed into the market with the expectation of even higher prices as the government signaled its support.

Yet, the expected wealth effect has backfired, as stock prices have come tumbling down since June 12. The lack of a rule of law to ground monetary policy and avoid fine-tuning has led to uncertainty. State-owned brokerage firms and banks have a strong incentive to reflate the bubble — and the PBOC is being pressured to come to the rescue of market socialists.

Indeed, the PBOC, like the Fed, is finding it very difficult to change course: the financial markets — and their cronies — are dominating monetary policy. Every dip of stock prices leads to central bank action, with the hope that higher asset prices will stimulate economic growth. That false belief is widely accepted, but could end in tears.

Monetary policy is heavily politicized in the United States — independence is a myth — and even more so in China. Central bankers blame asset bubbles on speculators without acknowledging the supporting role of monetary policy. The PBOC has reacted to the sharp fall in stock prices since June 12 by lowering its benchmark rate and cutting the RRR. The one-year rate on deposits is at a record low of 2 percent, which incentivizes savers to stay in or enter the stock market.

Since November 2014, the PBOC has cut interest rates four times and reduced RRRs to spur stock markets. But policy has been uneven, with China’s central bank injecting liquidity, removing it, and then adding new liquidity when markets weaken.

In its latest move “to safeguard market stability,” the PBOC extended credit to the China Securities Finance Corp. The state-owned entity makes credit available to brokerage firms, which make margin loans — generally to small investors — thus supporting stock prices. Also, part of the PBOC liquidity injection will go to 21 brokerage firms to form an investment fund intended to further stabilize financial markets.

Other measures designed to support stock prices include using the national pension fund and the country’s sovereign wealth fund to buy stocks, and easing margin requirements.

Extending new credit, allocating investment funds to overvalued stocks, and relaxing margin requirements will increase, not reduce, risk exposure and make the next downturn more severe. Foreign investors will be less willing to view China as a viable place to entrust their capital, and market-liberal reforms will be hampered by the lack of capital freedom.

What China needs are real capital markets based on the rule of law, private ownership and trust. State-owned banks, brokerages, and enterprises — and a central bank under the firm grip of the State Council — cannot be trusted to bring about either monetary or financial stability.

James A. Dorn is vice president for monetary studies and a senior fellow at the Cato Institute in Washington.