The stock rally that began last year bears a striking resemblance to the credit-fueled American stock bonanza of the late s. It also, however, has much in common with the Japanese market frenzy in the twilight of the s. The uncanny similarities of both episodes also hint at what might await China when its market finally returns to reality.

Dizzying leaps in technology were boosting living standards and giving rise to vibrant consumerism. But that description fits China of the last decade just as well.

The central bank hiked interest rates suddenly, hoping to lightly chill the markets. The stock market began tanking. Real estate prices soon followed. The financial crisis that resulted lasted until the mids, during which seven banks were nationalized.

To understand why the US entered the Great Depression and Japan stagnated for two—plus decades, it helps to turn to the work of Yale economist Irving Fisher. Two things tip a country from recession into depression, according to Fisher: The US messed up by failing to counteract falling prices by freeing up money—in fact, it catastrophically raised interest rates in the immediate wake of the crash.

When deflation sets in, falling prices cause the relative cost of debt to rise. That sinks debtors in even deeper, and makes would-be borrowers unwilling to take out loans to build their businesses. As people desperately sell off assets to pay back what they owe, they drive prices down even further—exactly what happened in the Great Depression. Unemployment surged to a quarter.

More than 5, banks failed, taking with them untold sums of household wealth. Japan avoided a depression after its stock crash—and the property market collapse that followed—by furiously expanding money supply and by ramping up government stimulus to replace vanished demand. Bureaucrats and bankers believed that with enough time and loose money, they could grow out from under the debt burden.

But Japan had too much debt for that approach to work. The chart below shows the percentage of bank customers whose loans were being rolled over. On top of that, by investing so heavily in industry, Japan built itself the capacity to churn out far more goods than anyone actually wanted to buy.

It takes a long time for a factory to need replacing. With enough industrial capacity to last it for many years—even decades—Japan had few other options in which to profitably invest.

So as Japan waited a decade for growth to kick in once again, its debt pile mushroomed even more. The lesson Japan failed to master is that too much debt makes it near-impossible to grow—and that the only way to get rid of that burden is therefore to recognize losses. Whereas in the Great Depression, lots of companies and banks went bust, in s Japan, hardly any did. But it also cleared away debt problems, preparing the country to borrow, invest, and grow again.

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The threat of deflation still looms. The growth-obsessed Chinese government is clearly going to do everything to prevent a Great Depression—which, at least in the short term, is good news for the global economy.

Crowds gather across the street from the New York Stock Exchange as the market crashed on October 24, Written by Gwynn Guilford. Most Popular The most forward-thinking, future-proof college in America teaches every student the exact same stuff.

As economist John Kenneth Galbraith describes in The Great Crash, , a Florida property bubble—and its subsequent burst—preceded the American stock frenzy that took hold later in the decade. In , the Federal Reserve slashed rates, sending forth a gush of credit to be invested in stocks. China too has gone through a property bubble that began bursting in late The subsequent easing of credit since late sent the Chinese stock market rise into overdrive.

Between and the peak, the Dow Jones Industrial Average more than tripled. As for China, at its zenith, the Shanghai Composite Index was more than twice what it had been just a year earlier. An explosion of leverage inflated US stocks even more. Brokerages lent out to small-time investors on margin, allowing them to buy only a small percentage of their stock trades with their own money—and letting them pocket outsized profit when they sold.

Margin finance has been driving the rallies in Shanghai and Shenzhen as well.

As share prices—and the collateral, therefore—have risen in value, borrowers can take out even more credit. This multi-layered shareholding amplified gains and, eventually, magnified losses.

Market Crashes: The Asian Crisis

Even though the stock market officially crashed in October , it suffered an alarming minor collapse in March of that year too. In both instances, corporate barons stepped in to stabilize the market and prevent margin calls from compounding the selloff.

The first instance—when Charles E. However, an October effort by a coalition of bankers to prevent a collapse by buying up shares of big companies failed. Both approaches are similar to what the Chinese government has undertaken to stop the mid-June crash from triggering margin calls.

The suppressed consumption that resulted gave rise to an export boom that boosted industrial profits. However, the moral hazard of cheap money caused an explosion in debt and a buildup of more factory capacity than the economy really needed. But loan officers seldom estimated future cash flow to decide credit-worthiness. Instead, property was widely used as collateral for bank loans. Loans issued with property as collateral often went back into developing still more property—blowing the real estate bubble all the bigger, while also driving economic growth that boosted overall confidence.

That makes property values critical to the flow of credit—and leaves bank balance sheets vulnerable to drop in values.

Indirectly, three-fifths of outstanding credit in China is exposed. Toward the tail end of the stock bubble, more and more profit increases of Japanese companies came from gains in cross-owned stock.

China today has experienced something similar, with the bulk of corporate profits coming from stocks.