China Series II of III: Stock Market vs. Real Estate Bubbles
“He that is without sin among you, let him cast a first stone at her.” John 8:7
American economists and financial analysts have expressed great concern at the presence of a bubble waiting to collapse in China’s real estate market. Many Americans first became aware of this issue when the large developer Evergrande defaulted on its debt. This default was followed by other developers defaulting and the the announcement + partial withdrawal of a “three red lines” policy to control the proliferation of leverage in the property sector. While President Xi has attempted to persuade the Chinese middle class that “housing is for living in, not for speculation,” many American commentators still believe that the Chinese property sector is ridden with ghost towns and bad debt.
Whatever the reality of the American diagnosis is, one reason to speculate that policymakers who have overseen one of the best-performing economies would allow such a situation to develop has to do with the political pressures imposed by the property sector’s investors. As President Xi’s maxim implies, the Chinese middle class currently invests a large proportion of its savings in the real estate market. If the market were to experience a major downturn, many average Chinese citizens would feel poorer as the paper value of their wealth falls.
Not only would this cause unhappiness by reducing consumption and slowing down the economy. Besides reducing demand for construction services and inputs, it would also cause frustration simply by causing people who—by and large have seen their wealth rise for their entire lives—to lose a substantial amount of money (at least on paper) for the first time. It is perhaps the fear of incurring the middle class’s wrath that motivates Chinese economic managers not to let the property market simply collapse and rebuild on stronger foundations.
Political pressure to prevent disruptive movements in asset markets which contain large proportions of middle-class wealth is awfully uncanny: it should remind Americans of ourselves. Starting in 1987, we have coined the term “fed put” to describe the widely held expectation that the Federal Reserve will intervene with rate cuts and/or quantitative easing to prevent any large drawdowns in public equity markets. Assuming that there is something right about the market’s expectation, we might speculate that the motivations for the Fed’s behavior are similar to those that explain Chinese policymakers’ partial toleration of a real estate asset bubble. Specifically, we can observe that a large portion of American wealth is stored in public equity markets. A lot of this wealth is owned by generally older Americans, who have much higher voter turnout than others.
An important way these Americans measure their own welfare and the performance of the economy is by observing their portfolios. The political economy mechanism to which these facts point is simple: in order to avoid alarming the middle class, policymakers will intervene when the asset markets in which the middle class stores its wealth (hencceforth called “middle class wealth stores” or MCWSs) undergo significant drawdowns.
If we think that all managers of economies containing a significant middle-class face pressure not to allow MCWSs to decline significantly, then we are forced to evaluate China’s real estate bubble in different terms. Rather than comparing the Chinese economy as it exists today—allegedly containing a real estate bubble—with a counterfactual economy that does not contain such a bubble, it is more realistic to consider not a hypothetical economy that does not contain any inflated asset markets, but rather an economy that is forced to tolerate an inflated asset market at least somewhere. Once we accept that all states with middle classes are unlikely to ruthlessly enforce efficient outcomes in the markets for MCWS assets, then we see that there is no option for the PRC to avoid the formation of an asset bubble. The question then becomes in what market is would it be least harmful for inflated asset values to occur.
I am not an economist and can offer no rigorous theories with which to understand that question in either abstract terms or in the concrete case of China. What I would like to do instead is suggest some basic intuitive reasons why a real estate bubble might be preferable to a stock market bubble. The point of this discussion is not to definitively persuade the reader of this view—and I am not even persuaded myself—but rather to suggest that is at least plausible that such a thing could be true.
The policy journal American Affairs has published a spate of articles examining the effects of inflated public equity valuations on the American economy. To summarize their work, we might say that one major problem with inflated equity valuations is that they put pressure on firm managers to increase valuations (in order to remain competitive with the rest of the market) to a larger degree than might be economically desirable. According to neoclassical economic theory—other than in the case of externalities like pollution—a firm increasing attempting to increase its valuations should never harm the economy. Doesn’t a firm’s value reflect the degree to which it contributes to growth?
American Affairs, in particular its editor Julius Krein, has sought to argue that asset values do not necessarily reflect a firm’s contribution to economic growth and that the excessive pursuit of high valuations can even do the opposite. One specific mechanism on which American Affairs has focused is that investors generally prefer asset-light balance sheets. In order to achieve higher valuations, firms pursue transactions like spin-offs and outsourcing in order to segregate unattractive capital-intensive manufacturing income streams from attractive rent-based income streams based on controlling IP and design processes. Krein writes:
At bottom, this strategy…is not primarily a strategy for maximizing growth or profits but rather the sequestration of rents, via the separation of revenues as far as possible from capital, labor, and other costs. It is, in other words, principally a strategy for maximizing the valuation of those rents.
Krein argues that because American corporate managers have gotten so good at impressing investors by isolating profitable rent cashflows from capital-intensive processes, firms that can offer such cashflows suck up all the financing and leave capital-hungry sectors with no investment. China, and to some extent similarly-structured economies like Japan and Germany, fill in the gap by offering themselves as attractive jurisdictions for outsourcing this manufacturing, with attractive wage arbitrage dynamics to boot. The result is that even as valuations increase, the valuation is actually derived from reducing the productive potential of the economy by getting rid of the kinds of cashflows that investors don’t generally find attractive.
What does this have to do with the fed put and the allegation that the United States has an overvalued stock market? Part of the story has to do with hurdle rates: the internal metrics that firms set for how much a potential investment must return in order for the project to be pursued. By supporting all public firm valuations through rate cuts and QE interventions, the Fed implicitly ensures that these hurdle rates remain high, as the higher the market will return in general, the higher the hurdle rate that a firm will set in order to make its return on equity competitive. And as Krein notes in the piece, American corporate managers are obsessed with hurdle rates.
So, by allowing a stock market bubble—or to use less alarmist language: simply by allowing valuations to remain higher than they otherwise hypothetically would without Fed intervention—the Fed creates an environment in which firms are disincentivized from pursuing capital-intensive investment, even if such investment could pay out a positive return. Such positive-returning projects become too unattractive to pursue for investors in a world where the rest of the market can offer more attractive investment opportunities as the Fed allows valuations to be bid up no matter what.
I’d now like to contrast American Affairs’ stylized portrait of the United States’ public equity bubble with my own stylized portrait of China’s real estate bubble. What are the economic effects of an irrationally high level of investment in property? A list might include:
- diverting potentially productive investment into a sector that won’t produce positive returns (bad)
- suppressing consumption by incenting the middle class to spend on real estate investment instead of consumer goods (bad)
- increasing demand for construction inputs (good)
(1) strikes me as not that concerning because China already has an enormous savings rate and a concomitantly high investment rate. There is no shortage of capital to fund potentially productive investment projects. (2) is more of a problem but could potentially be offset to some degree by the positive demand effects of (3). Again, all of this is extremely speculative, and real economic scholarship would be required to actually determine if those effects exist and how they interact. My purpose is not to substitute for that scholarship, but rather to lower the temperature of American panic about China’s real estate bubble by suggesting that it could potentially be a better area of the economy in which to have a bubble than a stock market bubble. And if one buys my earlier argument that it is an inevitable for a large middle-class economy to tolerate an asset bubble at least somewhere, then the relevant question is in which area of the economy is it least harmful to have one; not how to get rid of any inefficient asset bubbles completely.
There is a famous economics thought experiment which involves considering an economy that contains a machine that magically produces cars after one inputs wheat. If the economy is only made up of these two goods, and more cars can be produced by allocating all labor to wheat production and putting wheat into machine than by producing the cars without the machine, then why not use the machine? The punchline of the exercise is that if you then imagine the machine was in fact a port, you have gained the proper intuitions in favor of free trade.
In the spirit of that thought experiment’s leveraging of physical intuitions, imagine that an economy run by policymakers who are incentivized to allow inefficient asset bubbles can be thought of as requiring that a certain amount of its total annual investment be lit on fire every year (the fire representing the investment inefficiencies caused by a distortionary asset bubble). I think China’s real estate bubble should be imagined as a fire that destroys a random portion of this investment every year. That is because its economic effect, especially assuming there is otherwise plentiful enough capital to fund most productive investment opportunities, is merely to divert a portion of consumer savings into a useless black hole. On the other hand, the United States’ stock market bubble should be imagined as a fire which specifically targets the economy’s most productive assets. In an economy where most capital is owned by public shareholders who are seeking maximum return, inflated public equity valuations will distort decision making at the level of investment in productive capacities by incentivizing firms to shed assets and avoid getting involved in any capital-intensive processes. If that story is right, can anyone wonder why China is currently dominating the EV race?
My thought experiment is of course ridiculously crude, but my point is not to definitively prove that it is better to have a bubble in the real estate market than the stock market. Understanding precisely if and when that is true would require much more rigorous theoretical tools and empirical study. My point is rather to suggest that American commentators adopt a less alarmist tone regarding the harms caused by China’s real estate bubble. If we accept that tolerating asset bubbles is an inevitable part of governing a mass middle-class society, then we should not be excessively worried or surprised to observe this phenomenon in China. The real question is whether this kind of bubble or ours will be more harmful in the long run.