There has been quite of lot of justified concern among economics pundits about the Chinese economy with some, like Will Hutton, likening the problems there to a Ponzi scheme. A Ponzi scheme operates rather like a chain letter where the earlier entrants into a savings scheme are paid directly from the contributions of later entrants. It is a simple fraud. It has to break down sooner or later. Whatever the shortcomings of Chinese economic regulation may be we don’t have the evidence to accuse the authorities there of allowing these schemes.
The China situation is better described as one of debt-deflation. Money is created and then spent in the private sector when banks make loans. This spending stimulates the market: shares and asset prices prices rise, growth spurts, but the newly created money dwindles in the economy as it is spent and respent with the Govt taking its tax cut on every transaction. But the debts remain and accumulate – slowing down the economy. So more bank lending is needed to keep it going and the same thing happens again. Steve Keen has shown that everything looks OK providing the rate of bank lending is accelerating. But as it can’t do that forever, the effect of the bank lending starts to have a net negative effect and then we can have a slump if the level of private sector debt becomes too high.
The immediate fix is for government to spend, large amounts of cash usually called liquidity, to keep the economy going. Mosler’s Law states that this should always be possible but any crash or slump is still very disruptive. A better solution in the longer term is to rely on monetary policy (ie the variation of interest rates and the ease of bank lending) only to a very limited extent in the regulation of the economy.