The Great Wall of Credit: Lessons From Chinese Housing

Despite centuries of study, most mainstream economists are still baffled by the phenomenon of market bubbles and periodic corrections. Most, following in the footsteps of John Maynard Keynes, seem content to throw up their hands and ascribe these fluctuations to unpredictable "animal spirits," the irrational behavior of consumers that leads to insufficient demand. Others make the even greater mistake of blaming recessions on too much freedom, too much deregulation of markets, insisting that all we need is more government spending to bring stability to the markets, despite all the historical evidence to the contrary.

None of these talking heads seems to realize that there exists an economic theory that perfectly explains these market phenomena, an explanation that has been around for well over a century yet which, despite its predictive and explanatory success, and despite the fact that F. A. Hayek was awarded a Nobel Prize for its development, remains neglected by all but a few "fringe" academics.

This is the Austrian theory of business cycles, which, in brief, holds that the expansion of credit by government sends false market signals to investors. The overestimation of consumer demand then results in investments that don't pay off, and economic pain as the market corrects itself.

No better example of this misguided policy can be found than that of China's housing market. The residential real estate market in China is the most critical sector of the world economy. The extraordinary growth of economy, driven chiefly by exports to the West, resulted in China becoming the world's workshop. Starting in the late 1970s, as the country moved from an agrarian economy into an industrial, and eventually a service-based, one, the population was drawn out of the countryside and into urban centers in the largest mass-migration the world has ever seen.

Not surprisingly, the chief demand of Chinese workers upon arriving in cities was for decent, affordable housing. The increased wage growth driven by China's booming economy, combined with the surge in demand, caused home prices to skyrocket. In the aftermath of 1976's Great Leap Forward, the existing housing stock was in deplorable condition, and massive construction projects were implemented in an effort to keep up with demand, which further contributed to higher prices. As affordability became an issue, the Chinese government saw no need to pay attention to the fundamentals of supply and demand. "If you build it," they reasoned, "they will come." They had no reason to think otherwise, as continuing migration painted a picture of an inexhaustible demand.

Of course, demand is never inexhaustible. As migration began to slow, housing developments began to lie vacant. Entire "ghost cities" now litter the Chinese countryside, where homes were built without regard to whether consumers wanted or could afford them.

Rather than allowing prices to fall, the proper reaction to an excess of supply, the government kept subsidizing developers, propping up friends of the Party and expanding credit to encourage further home buying by the newly developing middle class. The incentives were overwhelmingly for overinvestment in a market that has no fundamental ability to sustain itself.

The easy credit policies adopted by China have left investors with few options. Inflation is too high to hold on to currency, and the government's willingness to continue to inflate the housing bubble and bail out failing enterprises makes housing the most sensible choice for most investors, even if it means long-term economic pain when the bubble finally bursts.

There is precedent for what is going on in China. When Japan tried to stubbornly keep reinflating its housing bubble in the early 1990s, the economy stalled for more than a decade. Here in America, we have seen firsthand what happens when the government practices interventionism in the real estate business. Still reeling from the pain of the housing crisis in 2007, one would hope that the rest of the world could learn a lesson from our failed policies. As things stand now, it doesn't look good.

The Chinese government is now faced with a choice: It can liberalize markets and let the market readjust to the proper equilibrium, or it can continue to kick the can down the road. Both options will come with economic pain, but the latter's will be far more severe and persistent in the long run. As Murray Rothbard, one of the chief exponents of Austrian business cycle theory, wrote, "As soon as credit expansion stops, then the piper must be paid, and the inevitable readjustments liquidate the unsound over-investment of the boom."

The question for China, then, is not if the crisis will come, but when. And with the size and influence of China's economy, the answer will have implications for every nation in the world.