The global stock market crash, explained

Stock markets around the world plunged on Monday. The carnage began with an 8.5 percent drop in China's benchmark Shanghai Composite index. Markets in Japan, South Korea, and Australia followed suit. That sparked selloffs in European markets and then the United States. The Standard and Poor's index of 500 large US stocks fell by nearly 4 percent on Monday, adding to losses last week.

The media did not take the news calmly. CNN's homepage was fairly representative:

Get your guns, get your ammo.

There were some real reasons for investors to worry about the future of the global economy.

In the United States, six years of gains have produced prices that some experts believe are unsustainable. China's economy is slowing down, which could produce not only economic hardship but also political challenges for the Chinese government. And much of Europe is still struggling to emerge from the last economic downturn; more market turbulence is the last thing it needs.

In other words, several of the world's major drivers of economic demand face problems ahead. And if they all crack up simultaneously, that would be a bad thing.

But it's also possible that this week's stock market turbulence won't have much broader significance. Sometimes traders panic over what looks like bad economic news, but then world economies wind up doing fine.

The American stock market has been booming for six years

The US stock market is down about 10 percent from its highs earlier this summer. That's a significant drop, but it looks less significant when you consider the larger picture. That's because the US stock market has enjoyed a huge boom over the past six years. Even after Monday's fall, the Standard and Poor's 500 index is 170 percent above the low point of the 2009 stock market crash, and 20 percent above the previous stock market peak in 2007.

Google Finance

Has the market gone too high? One way to judge this is to compare companies' stock prices with their profits. This ratio, known as the price-to-earnings ratio, has historically been a pretty good indicator of whether the market is over- or undervalued. And right now, it's significantly higher than the historical average:

multpl.com, with data from Robert Shiller

At the start of 2015, the P/E ratio was around 26. That's almost as high as the peak of the 1929 stock market bubble, and higher than at any point between 1930 and 1990. If a high P/E ratio is an indicator that the market is overvalued, then this chart should make stockholders very nervous.

The counterargument, however, is that P/E ratios are affected by interest rates. When interest rates are low, people are willing to pay more for stocks in order to boost their returns. When interest rates are high — as in the late 1970s and early 1980s — stock prices tend to fall, since people can get high returns without taking the risk of owning volatile stocks.

So whether you believe stocks are overvalued depends a lot on what you think will happen to interest rates. If interest rates rise quickly in the next few years, stock prices could fall a lot further. On the other hand, if interest rates stay low, stocks could stay high for a long time.

China's economic model is running out of steam

For the past 25 years, the Chinese economy has delivered impressive economic growth. Where the US economy has grown by 2 or 3 percent per year, China has grown by 7 to 10 percent annually. That growth was facilitated by an export-oriented development strategy that put Chinese people to work making products for international companies.

The strategy has been successful so far, but it also has inherent limits. There's only so much global demand for this kind of work, and as China's living standards rise, it will become harder to compete with other low-wage countries.

So to continue growing, China needs to diversify its economy. Chinese companies need to produce more goods and services for domestic consumption rather than for export. And they need to become better at designing and marketing new products, rather than just manufacturing them.

To continue growing, China needs to diversify its economy

But the Chinese economy isn't set up for this kind of internally driven growth. A big share of China's economy is controlled by bureaucratic and perpetually money-losing state-owned enterprises. These companies are insulated from market forces, and as a result they often make production decisions based on political rather than commercial considerations.

Over the last year, there have been growing signs that the Chinese economy is slowing. The official growth rate is 7 percent over the past year, but it's widely suspected that this figure is inflated. Even some Chinese officials have privately admitted that Chinese economic growth figures are unreliable.

Javier Zarracina/Vox

Javier Zarracina/Vox

In mid-2014, China's stock market began to boom despite the country's increasingly gloomy economic outlook. One reason was that the government relaxed regulations designed to prevent ordinary investors from buying stocks with borrowed money. By early 2015, they became concerned that stocks had become overvalued and began tapping the brakes, which triggered the stock market decline that began in June 2015.

In July, China took a number of drastic measures to try to stop the market's fall. In the process, the government tied its own prestige more tightly to the stock market. That made it particularly embarrassing when stocks began to fall again last week.

The real danger for the government isn't just that China will fall into a recession. It's that a plunging stock market and economic downturn will shake public confidence in China's political institutions more generally. The Chinese government has made rapid economic growth a central part of its bargain with the Chinese people. If that growth falters, it could do real damage to the government's legitimacy.

Western economies — especially in Europe — are still fragile

The Chinese economy is big, but it's not so big that a faltering Chinese economy necessarily spells doom for developed economies in the West. For example, exports to China accounted for less than 1 percent of US economic output in 2012.

But there are two reasons that a declining Chinese economy would be bad news for publicly traded companies in the United States and Europe.

One is that many Western countries are still suffering an economic hangover from the 2008 financial crisis. Ordinarily, central banks fight recessions by cutting interest rates. But in both the United States and the Eurozone, short-term interest rates have already fallen to zero, making these techniques ineffective.

Central banks' other option, known as "quantitative easing," was controversial, and so the Federal Reserve and the European Central Bank used it sparingly. The result: a sluggish recovery in the United States, and even worse results in some parts of Europe, where unemployment is still in the double digits. And that economic sluggishness — and central banks' reluctance to use unconventional techniques to boost the economy — makes them particularly susceptible to declining exports.

Second, the companies listed in American and European stock markets are disproportionately multinational firms that do a significant amount of business in China. For example, about a quarter of Apple's revenue comes from China, so an economic downturn in China is a big deal for the largest American stock.

Or Monday's crash might not have any broader significance

When the stock market crashes, pundits have a natural inclination to paint it as a sign of broader economic trends. And it's possible that Monday's stock market turmoil will — like stock market declines in 2000 and 2007 — turn out to be the first tremors of a bigger economic earthquake.

But sometimes traders panic for no good reason. For example, the stock market fell by more than 20 percent on October 19, 1987. And after that, the American economy was totally fine. The economy kept growing. The stock market recovered its losses in less than two years, and went on to produce the bull market of the 1990s.

This week's stock market turbulence could turn out to be a lot like that — a source of stress for traders in the world's stock markets, but not necessarily a sign that larger economic problems are looming.

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