China’s Gradualistic Economic Approach and Financial Markets (Brunnermeier, Sockin, Xiong, AER P&P, 2017)
"A key approach successfully employed by China to reform its economy in the past 30 years is the so-called "crossing the river by touching the stones" approach, a gradualistic method that optimizes policy through experimentation. The government will start with an initial (usually small) policy change, and gradually modify the policy based on the reaction from the economy to this change." BUT, "Can China continue to use its gradualistic approach in the presence of active financial markets?"
In Brunnermeier, Sockin, Xiong, (AER P&P, 2017), they provide the theoretical rationale for potential ineffectiveness of gradualistic policy approach with the existence of an active financial market. In align with the well-known time-inconsistency problem (Kydland and Prescott (1977) and Barro and Gordon (1983) ), incentives of front-run by private agents in expectation of ex post non commitment of the policymaker renders the gradualistic approach ineffective.
The policymaker faces the tradeoff between informativeness of the signal and magnitude of the output. A policymaker uses investment decisions taken by private agents in the economy as a signal to infer their information about economic fundamentals, and more gradual investment reduces the noise in this signal. This motivates the policymaker to adopt gradual policy changes. However, the ex post efficient policy change (the change after knowing the action of private agents) is a change of full magnitude. Without an active financial market, private agents are forced to make investment decisions after the policymaker moves. The availability of financial markets gives private agents greater financing flexibility and allows them to choose investment ahead of the policy maker. If the policymaker cannot commit to a policy rule ex post, which means the policymaker will adjust to the full magnitude change ex post, private agents have incentives to make investment decisions before the policymaker take actions.
They use a simple game theory model to explain the quicker expansion of infrastructure investment, faster growth of a shadow banking sector, more rapid increase rate of leverage across the economy. In particular, they use the breakdown of a policy instrument in China's stock market, the introduction of circuit breakers, as an example for the dramatic responses from private investors and inadequate time for gradual adjustment on the policy market side. The introduction of circuit breaker itself is a failure and shows the potential of over reaction from private investors. I agree on that for the circuit breaker instrument itself, the policymaker cannot apply gradual adjustments to keep the stock market in stable condition.
However, it would be exaggerated to say that it proves that the gradualistic reform of the stock market is determined to be ineffective. In fact, in my view, the introduction of circuit breaker is one small step, though proven to be wrong afterwards, in the whole reform scheme. It is an experiment of the circuit breaker in a different environment (large amount of retail traders, T+1 trading, and daily limit) from the western stock market.
Finn E. Kydland and Edward C. Prescott, Journal of Political Economy Vol. 85, No. 3 (Jun., 1977), pp. 473-492
Barro, Robert J., and David B. Gordon. "Rules, discretion and reputation in a model of monetary policy." Journal of monetary economics 12.1 (1983): 101-121.