Cameron Spencer/Getty Images

Here’s what you need to know:

1. Yes, it's a crash, and it's not over yet.

Here's a long-term chart of the Chinese stock market, to put this in perspective.

We're on our way down right now, there's further to fall, and the main reason that stocks haven't fallen further already is just that they aren't trading at all.

2. But, just because the stock market is crashing, doesn't necessarily mean the end of the world.

Americans have grown up with newscasts which somberly tell you every day whether the stock market went up or down, as though that matters. (It doesn't.) The stock market is not a barometer of how the economy is doing, it's mainly just a barometer of how rich rich people are. When stocks are going up, rich people are getting richer; when stocks are going down, rich people are getting poorer.

Advertisement

That said, however, the stock market also performs a task known as price discovery: it provides a valuation for all the public companies in America. That's the ostensible reason why non-rich-people should care about the stock market: if our companies are worth lots of money, that's generally a good thing, and if they're not worth very much, that's probably a bad thing.

In China, however, stocks really aren't about price discovery: it's not a market where value investors like Warren Buffett carefully look at fundamentals and buy stocks they consider to be cheap. The Chinese stock market is much less mature than the US stock market, and it can feel much like a gambling parlor: indeed, this latest boom in Chinese stocks took place just as the Chinese government cracked down on old-fashioned gambling in Macau. It's almost as if China took the money it would otherwise have spent on baccarat, and spent it on stocks instead.

Up until very recently, Chinese stocks were basically just a way for rich people to be rich. If rich people are less rich than they were a couple of months ago, but still a lot richer than they were a year ago, there's really no reason to worry about anything much.

Advertisement

And in general, stock-market crashes aren't that harmful. We had a big one in the USA in 2000, and the economy (at least outside the Bay Area) was basically fine.

3. On the other hand, there really is a problem here.

The problem with the Chinese stock-market crash is that a few months ago it stopped being a rich-people thing, and started being a mania for everybody. Here's a chart showing how many new share-trading accounts were opened in China over the past 10 years:

That spike on the right is not rich people, it's the Chinese middle classes, investing money which they can't easily afford to lose. So while China's rich have been invested in stocks for a while and are still doing well, China's not-so-rich have only been investing for a few months, and a lot of them are getting wiped out.

4. Because the worry here isn't really about equities, it's about debt.

The big run-up in Chinese stocks was caused precisely by all the buying from those middle-class Chinese people. And they weren't buying because they thought stocks were a bargain, they were buying because stocks were going up, and buying stocks was a great way to make money quickly. Which meant that they wanted to buy as many stocks as they could, and that in turn meant that they weren't only investing their savings: they were investing money they had borrowed.

Here's a chart showing how much of the stock market was bought using borrowed money (or "margin debt", as it's known).

This is really scary, because if you've bought stocks with borrowed money, then when stocks fall, you're forced to sell. You can't just sit out the crash and hold the stocks for the long term. You have to sell anything you can, so that you can pay your lender back what you borrowed. If you can't sell the stocks which are falling (because they're suspended, say), then you have to sell all your other stocks instead.

Advertisement

And if the stock market falls too far, too fast, then maybe you lose all your money, and you can't afford to pay your lender back at all, and then your lender loses money too.

Which sounds less like what happened in the USA in 2000, when the stock market crashed, and more like what happened in the USA in 2008, when the subprime crisis caused the housing market to crash. And that, as everybody knows, caused massive economic damage.

5. And then there's an even bigger worry, which is about China's control over its own economy.

China is run – almost micromanaged – by the Communist Party. The amount of debt in the economy, the amount of economic activity, the value of the Chinese currency – all of these things are carefully overseen by a government which, until now, has been extremely successful at building an economy based on what you might call undemocratic capitalism.

Advertisement

But the chaotic way in which the stock market rose in recent months, and then the even more chaotic way in which the stock market fell in recent weeks, is an indication that the Chinese government has rather less control over its economy and markets than it would like. And that, in turn, implies that China's command-and-control economic model might be reaching its limit.

If that's the case, then there's a real problem. China isn't going to simply give up on one-party rule and become a liberal democracy: if it ever comes down to a choice between autocracy and free markets, autocracy is going to win and markets are going to lose.

The big risk with China's stock-market crash, then, is that it might cause the Chinese government to pull back from its all-out commitment to growth through capitalism. The Chinese economic miracle has created an economic powerhouse and brought hundreds of millions of people out of poverty. What's more, China is by far the biggest hope for anybody who expects healthy global growth in the future. But if China's institutions see the economy slipping out of their control, they will let the economy suffer long before the give up their grip on power. And that, in turn, could have very nasty economic repercussions for the rest of the world.