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A Circuit Breaker For Circuit Breakers

circuit breaker, detail
photo by Yusmar Yahaya

Before the sun even rose on Wall Street for the first business day of 2016, it was clear that the new year was about to get off to a rough start.

There had been carnage overnight in the Asian markets, but nowhere worse than in China. There, shortly after the midday break, the key index of 300 leading stocks on the Shanghai and Shenzen exchanges had declined 5 percent for the day, triggering a 15-minute trading halt under a “circuit breaker” rule that was announced just last month. Stocks continued to fall once trading resumed, and by 1:34 p.m. local time the plunge had reached 7 percent. That triggered the more draconian provisions of the circuit breaker, halting domestic trading in Chinese stocks for the rest of the day.

Three days later, it happened again. But on Thursday, it scarcely took 30 minutes from the opening bell to trigger the daylong trading halt - and half of that time was consumed by the initial 15-minute delay. By Thursday afternoon, there was considerable sentiment that the circuit breakers, which were imposed as a response to last summer’s turmoil in the Chinese markets, were actually making things worse. So on Friday the country’s regulators announced that the circuit breakers are being suspended - a circuit breaker for circuit breakers, if you will.

The troubles did not stay in Asia. European markets were hit hard, notably in Germany, whose export-driven economy depends heavily on demand in China and other developing economies. And the U.S. market recorded its worst opening week in records that stretch back nearly 90 years.

By itself, last week’s roller coaster plunge tells us little that we did not already know. China’s growth is slowing (or maybe, by this point, fictional); a strengthening greenback is hurting U.S. manufacturing and other exports while reducing the dollar value of profits American companies earn overseas; the oil and natural gas markets are glutted, with prices at decadal lows. We already knew all that.

One thing we did not know, until the latest statistics were announced Friday, is that the U.S. economy added a solid 292,000 jobs in December (though how many are merely seasonal remains to be seen), and that wage growth, at 2.5 percent over the prior year, is not all that bad when you consider the near-absence of inflation. If these trends hold up - admittedly, a big if - American consumer demand should not fall off a cliff. U.S. auto sales reached an all-time high last year, topping a record set in 2000, as we finally got around to modernizing an aging fleet.

Unlike 2000 and 2008, when the stock markets entered their two big recent dives, there is no obvious and huge distortion in either the economy or the markets. There is nothing like the Internet bubble of the 1990s and nothing resembling the housing bubble of the mid-2000s. Stocks are a little pricier than their long-term average, but that is partly a mathematical function of extremely low interest rates that make stocks’ dividends and capital gains more attractive. If there is going to be a big shock to the system, it will come from some external event, such as open warfare between the Saudis and the Iranians in the Persian Gulf, or a catastrophic terrorist attack, or a potential breakup of the European Union.

What about China? The world’s second-biggest economy seems to have reached a stalemate: Its government does not trust the markets, and the markets do not trust its government to set policy and establish rules predictably and transparently. Thursday’s panic selling was sparked by another apparently abrupt change in policy, when China’s central bank signaled a desire to see the currency fall more quickly. It was an echo of turmoil that China set off with a devaluation last August.

Circuit breakers have a practical purpose and a political purpose. All you need to know is that the first is good and the second is bad. A good circuit breaker will temporarily halt trading when markets are simply not functioning. If a computer failure or a massive erroneous trade triggers a chain reaction in which the quoted prices do not reflect reality - where there is not a willing buyer and a willing seller who want to transact business at the quoted price - it makes sense to halt trading. If a disaster occurs whose magnitude is compelling but not immediately obvious or which prevents many traders from simply doing their work, as was the case in the hours and days following the 9/11 attacks, a trading halt also is warranted.

But why halt trading just because the markets are dropping sharply? China was criticized because its circuit breaker took effect at a modest 7 percent, which is obviously too little considering the volatility of Chinese stocks. Here in the States, market circuit breakers can halt trading for the day after a 20 percent decline. We feel superior, but we shouldn’t.

Every trade involves a buyer and a seller, both of whom want to transact business at a certain price. It should be considered an extraordinary intervention, by either the stock exchanges or the government, to prevent them from doing so by shutting down a country’s financial machinery. The rationales are purely political. Want proof? Consider this: There are no circuit breakers that would shut down a stock exchange for prices that rose too much or too fast.

It remains to be seen whether the United States can resist the economic headwinds that are slowing the rest of the world. History would make us doubt it, which is why I would not be surprised to see a recession in the next year or two. The markets may be starting to tell us to expect one. But I wouldn’t put too much stock in last week’s events. Circuit breakers turn off the lights just when we need to see what is really going on.

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