China is trying to save its market with failed policies

China's stock market gets a reality check
China's stock market gets a reality check

If financial history repeats itself, it won't be good for China.

China's stock market is in a meltdown. The main Shanghai Index has fallen about 30% since it's peak on June 12. The Chinese government is freaking out, and it's responding like a frightened momma bear, unleashing numerous efforts to stop the plunge.

But the two big interventions have been the Chinese government actually buying up stocks and halting any more IPOs.

In theory, these moves sound great: buying stocks should keep prices from falling further. And preventing new companies from doing IPOs is supposed to keep investors focused on buying stocks already in the market.

Unfortunately, these policies have been tried before and they haven't worked out well in the United States and the United Kingdom.

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The 1929 fail: On October 24, 1929 -- sometimes called "Black Thursday" -- the U.S. market was tumbling sharply. Bankers were worried and some of the top ones got together and decided to pool a lot of money and start buying stocks in an effort to stem the panic.

The wealthy bankers sent Richard Whitney, then the acting head of the New York Stock Exchange, out onto the exchange floor as their front man.

"[Whitney] started issuing orders, and the markets did stabilize," says Richard Sylla, a professor of financial and market history at New York University's Stern School of Business.

But it didn't last long. The following Monday and Tuesday the market tanked, sparking a terrible bear market period that lasted for years.

We've seen something similar in China. Monday Chinese stocks slid 8.5%, the worst drop since 2007. Overall, Chinese stocks are still down sharply in July -- about 15% -- despite all the government efforts to buy stocks.

"Attempts to stabilize the market don't really work," says Sylla.

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'Plunge Protection Team': A more direct U.S. government response to stock market crashes was the Working Group on Financial Markets that President Ronald Reagan put together in 1988 in response to the 1987 market plunge.

It became known as the "Plunge Protection Team." The idea was to get some of the top economic minds in government together to figure out how to prevent future crises and if it would be possible to intervene.

There's debate about whether the team ever did any direct buying of stocks, especially during the 2008 financial crisis, but Sylla says one of the things they did promote was so-called "circuit breakers" where stocks would stop trading if they fell too much.

The circuit breakers are in place on some assets in the U.S. and appear to be in place in China now as well. It gives a short cool off period for traders. But it's "of limited effectiveness," argues Sylla, "because what's going to happen overnight that would change people's attitudes?"

It's notable that since the Plunge Protection Team was put in place, the U.S. has suffered the Dot-com bubble and 2008 Financial Crisis.

"[China's] learning somewhat from our mistakes and others, but they'll make some of their own," says Jeff Hirsch, head of Stock Trader's Almanac.

The U.S. Federal Reserve has arguably been the most effective. Policymakers around the world credit the Fed for pumping massive amounts of liquidity back into the markets after the 2008 crisis and sparking a bull market that began in March 2009 and is still going today. China's Central Bank has slashed interest rates, although it has yet to go as far as the Fed's famous quantitative easing measures.

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Halting IPOs can backfire: As for IPOs, a widespread shutdown of the IPO market like what China has done occurred in Britain way back in the South Sea Bubble in the 1700s.

The plan was for the South Sea Company to take over some of Britain's national debt. The higher the company's share price was, the cheaper it would be for the company to take over some of the debt. So both the company and the government were motivated to push shares up.

A bubble ensued and many other companies wanted to issue shares to take advantage of soaring prices. So the South Sea Company got British Parliament to do an IPO ban in the hopes that people would keep buying the company's shares instead of all the new entrants in the market.

"It didn't work then. It backfired. It was meant to keep the bubble going, but actually deflated the bubble" as people got scared, says Sylla.

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The big problem: Part of the problem is that when there's a big intervention like what the bankers tried to do in 1929 or what China's government is doing now, it's akin to several fire engines showing up with their lights and sirens blaring. It looks bad to outsiders (or, in this case, to investors). After checking out what's going on, they typically want to get away.

"Statements by high officials are practically always misleading when they are designed to bolster a falling market," said Gerald Loeb, a prominent Wall Street trader in the early 20th Century and author of "The Battle For Investment Survival," a bestseller during the Great Depression.

Of course, China has to do something. The stock market plunge is a political crisis more so than an economic one for China, coming at a time when leader Xi Jinping is trying to craft a new five-year plan for the country.

You can't blame them for trying to intervene. If policymakers really knew how to turn markets around, more countries would try it.

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