Today we are fortunate to have a guest contribution written by Jeffrey Frankel, Harpel Professor of Capital Formation and Growth at Harvard University, and former Member of the Council of Economic Advisers, 1997-99.
The plunge of China’s stock market that has taken place since June has received a lot of attention. The commentary says that the Chinese authorities not only have taken a variety of measures to try to boost the market on the way down but also that they did the same during the huge run-up in stock prices between mid-2014 and mid-2015, when the Shanghai stock composite market index more than doubled. The finger-wagging implications are that the Chinese authorities, particularly the stock market regulator, have not learned how to let the market operate and that they had only themselves to blame for the bubble in the first place.
There is unquestionably a lot of truth to this overall story. But am I the only one to notice that the Chinese authorities repeatedly tightened margin requirements during the bubble, in January and April 2015? And that in fact the event which apparently in the end “pricked” the bubble was the June 12 announcement by the China Securities Regulatory Commission of plans to limit the amount brokerages can lend for stock trading?
It does seem pretty clear that the extraordinary run-up in stock market prices from June 2014 to June 2015 was indeed fueled by an excessive increase in margin borrowing over the same period. Reasons for the increase in margin borrowing include its original legalization in 2010-11, moves toward monetary easing by the People’s Bank of China since November 2014 (in response to slowing growth and inflation), and the eagerness of an increasing number of Chinese to take advantage of the ability to buy stocks on credit. Nevertheless, it appears that the stock market regulator responded by leaning in the opposite direction.
This is the sort of counter-cyclical macroprudential regulatory policy that we economists often call for, but do not often see in practice. (I survey some of the research in the 2015#2 issue of the NBER Reporter. For example a recent study by Federico, Végh, and Vuletin found that China and a majority of other developing countries also adjust bank reserve requirements counter-cyclically.)
Someone could criticize the Chinese increases in margin requirements earlier this year by saying either, on the one hand, that their effects on the stock market did not last long (January and April) or, on the other hand, that they caused the crash (June). But at least the moves were in the right direction, which is not a trivial point.
This post written by Jeffrey Frankel.
Too bad Alan Greenspan wasn’t this smart back in the late 90s. Many economists urged Greenspan to raise margin requirements as the stock bubble expanded but of course he ignored them because rational agents, efficient markets, argle bargle.
I agree. As it happens, I myself asked Alan Greenspan why he didn’t support raising margin requirements to follow up on his one famous comment about possible “Irrational exuberance” in the stock market. This would have been around 1998, when the US stock market seemed more clearly to have moved into bubble territory. (At the time, I was a Member of the president’s Council of Economic Advisers; a privilege that goes with that position is a monthly lunch with the Federal Reserve Governors.) The answer he gave at the time was not “rational expectations” or market efficiency. Rather he said he didn’t think raising margin requirements would work. That didn’t seem a very good answer to me: if it didn’t work, then no harm would be done. Also, I knew some research had been done suggesting that reserve requirement might indeed have effects. (I had in mind a paper by Gikas Hardouvelis, a former student/co-author of mine. Until this January he was Greek Finance Minister.) But I didn’t argue any further with Greenspan.
Why would raising margin requirements be important in the late ’90s?
U.S. tech stocks were driven by revenues in the late ’90s and then by earnings in the 2000s.
The result was big tech firms that eventually earned high profit margins.
Anyway, controlling the macroeconomy was Greenspan’s job, not the stock market.
Greenspan achieved a big economic boom in 1995-00, a quick and massive “creative-destruction” process, mostly in 2000-02, and in a mild recession in 2001.
Then, he built an expansion on top of the 1982-00 boom, extending the “long-boom,” till 2007.
Many of us agree that the US stock market boom of the 1990s was initially primarily by fundamentals such as ICT investment and a record-length economic expansion, but think that by the end of the decade it was in bubble territory. I thought that even before the fall in 2000-02.
Despite my comment about reserve requirements, I think Alan Greenspan generally did quite a good job as Fed Chairman during that period. In my personal view, his serious mistakes came later.
JF, I don’t know what “serious mistakes” Greenspan made. He was Fed Chairman till January 2006.
It seemed appropriate the Fed Funds Rate was raised from 1% in June 2004 to 5 1/4% in June 2006 – 25 basis points at every FOMC meeting.
In the 2000s, there was lax housing lending standards (I doubt Greenspan would go against Congress), oil prices were rising sharply, and there was overconsumption, reflected in huge current account deficits, while the country was near full employment.
When Bernanke became Fed Chairman, he raised the Fed Funds rate to 5 1/4% and maintained it, until September 2008, perhaps trying to prove he wasn’t an “inflation dove.”
Nonetheless, Bernanke was in a tough position. He began easing the money supply when oil prices continued to rise sharply, peaking at $150 a barrel in mid-2008, the economy was running out of steam, in part, because of huge household debt, and then had to deal with the moral hazard built in the financial industry.
Sorry, meant Bernanke maintained 5 1/4% till September 2007
By the way, I thought this was a good post, even if it got no traction with the commentati.
Question: did the regulators allow margin buying because they believed buyers would borrow money to buy stocks, meaning the regulators thought it was necessary given the underlying demand and the way buyers would circumvent margin rules – perhaps dangerously – through outside financing that mimics margin?