China stock market panic shows what happens when stimulants …

China stock market panic shows what happens when stimulants …

US traders work on the floor of the New York Stock Exchange at the start of the trading following ‘Black Monday’ in China. Photograph: Justin Lane/EPA

Related: Asian stock markets fall again after Wall Street slump – live

Financial markets have gone cold turkey. For the past seven years, they have been given regular doses of strong and dangerous narcotics. The threat that the drugs will no longer be available has resulted in severe withdrawal symptoms.

Unlike in 2007, the crash could be seen coming. Wall Street and the City were taken completely by surprise by the subprime crisis, but have had plenty of warning that something nasty might be brewing in China. Anybody caught unawares really hasn’t been paying attention.

But this is about more than China. Financial markets in the west have been booming for the past six years at a time when the real economy has been struggling. Recovery from the last recession has been patchy and weak by historical standards, but that has not prevented a bull market in equities.

The reason for this is simple: the markets have been pumped full of stimulants in the form of quantitative easing, the money creation programmes adopted by central banks as a response to the last crisis.

On the day that QE was launched in the UK, 9 March 2009, the FTSE 100 stood at 3542 points. Its recent peak on 27 April this year was 7103 points, a gain of 100.5%. There is a similar correlation between the three rounds of QE in the US and the performance of the S&P 500, which was up more than 200% during the same period.

Related: Why is China’s stock market falling and how might it affect the global economy?

But there were always doubts about what might happen when central banks decided it was time to remove some of the stimulus they have been providing for the past seven years. Now we know. The Federal Reserve and the Bank of England halted their QE programmes and started to muse publicly about the timing of the first increase in interest rates.

At that point, financial markets merely needed a trigger for a big selloff. China has provided that, because the world’s second biggest economy has shown distinct signs of slowing. What was inevitably dubbed “Black Monday” began in east Asia where there was disappointment that Beijing did not provide fresh support for shares in Shanghai overnight.

Having been accused of acting like quacks dispensing dodgy remedies on previous stock market rescue missions, China’s leaders decided they would tough it out. Big mistake. The stimulus junkies needed a fix and when they didn’t get one they had a bad dose of the shakes.

Beijing will not make that mistake again. Policy will be eased and it will be eased quickly. The People’s Bank of China has plenty of scope to cut interest rates and will use it. In the current circumstances, the long-term plan to rebalance the economy away from a reliance on exported manufactured goods, infrastructure and property speculation will be temporarily abandoned in favour of growth of any sort.

Whether it halts the stock market slide is another matter. Chinese policymakers have lost their aura of invincibility and are now in the awkward position of being damned if they do act and damned if they don’t. Investors have started to scrutinise the Chinese economy in a far more forensic fashion and do not especially like what they see. Taking advantage of a more liberalised regime, capital is leaving the country.

Dominic Rossi, of Fidelity Worldwide Investments, says what is happening in China and other emerging markets represents the third wave of of deflation for the global economy following the financial crash of 2008-09 and the eurozone crisis in 2011-12. Rossi says the deflation will be a double-sword: imports in the west will be cheaper but exports to emerging markets will be lower.

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Analyst Max Wollf says despite the climb back in US stocks after a dramatic early selloff, there are still reasons to be concerned about the US markets and the Chinese economy

Following the six-year bull market, shares in London and New York do not look especially cheap. Corporate profitability will be hurt as companies are forced to match the price of cheaper imported goods. Larry Summers, a former US Treasury secretary, underlined fears that the crash could led to recession on Monday when he said the Fed might need to provide more stimulus.

But, unlike in 2008, interest rates are already zero. Budget deficits mean governments have less scope to cut taxes or raise spending. China’s total debt is four times what it was seven years ago. Central banks have pulled all the conventional policy levers and a few unconventional ones as well. They could shelve plans for interest rate rises and contemplate further rounds of QE, even though that amounts to doubling the dosage for drugs that become less effective every time they are administered.

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China stock market panic shows what happens when stimulants …

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