How a Chinese Equity Black Monday Transmits to a Global Money Supply Collapse

China’s stock markets are having a really bad day. A black Monday, down 8.45%, with knock on falls in closely intertwined markets such as Japan and Australia- and now spreading globally.

There are still those that doubt whether a stock market collapse has an impact on ‘real’ economies – so it is worth spelling out precisely the transmission mechanism via the banking system.

Stock market bubbles are fulled on speculation – on what Guzman and Stiglitz (2015) call tellingly ‘pseudo wealth’.  It is the collapse in that pseudo wealth that causes aggregate demand collapse in the wider economy.

The transmission mechanism is through the banking system, principally through the collapse in the perceived real value of equities and company assets held as security on loans.  Collateral enables banks to leverage their ability to lend – their ‘lending power’.  Banks are not passive intermediaries they can create money at the stroke of a pen, but not without limit.  They need existing assets (equity) and then leverage those assets depending on the collateral lenders provide and future perceived income streams from lending.

When perceived future revenue streams provide to be pseudo-wealth then this has a strong feedback loop on the ability of banks to lend.  Non performing loans increase and banks can leverage less with less collateral to bank their existing loans books.  The ability of banks to lend – their lending power – their ‘charter value’ as it is known collapses.  From levering we go to deleveraging and the familiar debt deflationary cycle described famously by Fisher and elaborated by Minksy, Steve Keen and others.

In good times banks expand the money supply, but this is not deflationary as the money is destroyed on repayment of loans and if the investment is used to reduce factor inputs it may raise wealth and even deflate prices increasing real wealth.  If however the loans are spend on assets and ‘pseudo wealth’ the repayment of debts in a downturn becomes purely deflationary not backed by increases in productivity and we get a depressionary cycle.

This is why an equity collapse, in a highly leveraged economy, can have non linear impacts on money supply and growth.  In China a collapse in formal bank lending will also have a knock on impact on shadow banking because of the carry trade to less well regulated shadow banking.

Can the global economy cope with a trillion dollars knocked off equities in one day? What matters though it how leveraged that equity is.  The answer is straightforward; it is highly leveraged and no it can’t.

Their is only one possible response for the Chinese authorities.  Flood the Chinese banks with ‘helicopter money’ to prevent a banking collapse, it that leads to a collapse in the Yuan so be it.  The global response has to be to avoid a ‘currency wars’ response.  This is precisely what was done to the Japanese banking system in the Great Depression and worked well compared to the dramatic austerity in Europe for example in the same period.

Their would be some irony then if China and its closely interlocked economies saw their savior in an economic measure derided as ‘Corbynomics‘.