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China's stock market is falling again, and it's a huge problem for the government

(Javier Zarracina / Vox)

Three weeks ago, the Chinese government took extreme measures to reverse a massive 32 percent drop in stock prices. The plan worked — over the next two weeks, stocks gained 17 percent. But now the government has a bigger problem: Stocks fell 8.5 percent on Monday, the largest one-day decline in eight years, and people are blaming the government for it.

Stock markets play an essential role in developed economies, directing resources to businesses where they'll be used most productively. But they can only serve this role if governments let them. This month, the Chinese government has made it clear that its political goals will take a higher priority. And now that Beijing has tied its reputation to rising stock market prices, it will be harder than ever to step back.

People now expect the government to rescue the stock market

When the Chinese stock market crashed in early July, the Chinese government took drastic steps to prevent further stock market declines. The government banned major shareholders from selling their shares for six months, ordered companies to buy back some of their own shares, halted initial public offerings of stock, and provided more money for Chinese people to buy stock with borrowed funds.

But while these measures appear to have accomplished the government's short-term objective of halting a politically embarrassing slide in stock prices, the government now faces a problem that could prove more serious in the long run: The Chinese government's reputation is now even more tied to the stock market's fortunes, and the government will face pressure to intervene further every time prices decline.

The Wall Street Journal's write-up of Monday's stock market crash illustrates the problem. It focuses on whether the government will intervene to keep prices up. Some analysts think the government is drawing down support from the stock market. Others predict the government will step in and push stock prices back up in the next few days.

That's not surprising. A couple of weeks ago, the Financial Times reported that students at Tsinghua University, sometimes described as the MIT of China, were instructed to chant the slogan "Revive the A shares, benefit the people" at their graduation ceremony. Obviously, having students chant slogans won't directly boost stock prices. But by holding this kind of demonstration, the government signaled that it was committed to keeping stock prices up.

Political pressure for the Chinese government to prop up stock prices is intensified by the fact that retail investing has exploded in China. Between June 2014 and May 2015, 40 million new brokerage accounts were opened in China, and many of them invested in stocks with borrowed money. China isn't a democracy, but the government is still sensitive to public opinion. Having 40 million Chinese people lose their savings in a stock market crash would be very bad for the government's reputation.

But in the long run, the larger danger may be if the government refuses to let stock prices decline. The government knows it needs to shift away from inefficient state-owned enterprises in favor of allocating investment capital based on market forces. The Chinese stock market is a key part of that effort.

This will only work if the government actually lets the market set the prices of Chinese companies. If the government perpetually props up the value of nominally private companies in China, the country won't enjoy the efficiency benefits of a truly private stock market.