The Chinese clearly fear a bubble—Premier Wen Jiabao has commented on it himself and the sharp reactions to speculation show more than just rhetoric. However, if another monetary stimulus appears to be counterproductive to letting the air out of a bubble, that's because it is. The opposing policy aims unearth a structural conflict within China.
On the one hand, the Chinese government feels it needs to maintain at least 8 percent growth in GDP each year in order to provide enough work for its citizens. The monetary stimulus is funding waves of infrastructure projects that provide jobs and promote economic growth. On the other hand, that growth is only going to attract more Chinese looking for better jobs to the major metropolises and further widen the housing supply and demand mismatch.
Thus, China finds itself caught in a trap. Call it the Dwelling Narrowness Trap. If China continues to stimulate its economy, including tools such as currency manipulation in order to promote a robust export economy, production will grow. This is not evidence that a command-and-control economy could be successful anywhere. China has rapidly grown from a second-tier nation to third largest economy in the world in over 20 years largely due to its years of repressed consumption. The nation is so starved for infrastructure that it isn't hard for the country to throw money at the economy and find places for successful investment. The United States and other developed nations are not in the same position. As the Chinese will find out soon, economic stimulus is not a sustainable position. And the more developed a nation is, the harder it is for governments to pick winners and losers in the marketplace. For now, though, China is able to stimulate growth at will it seems.
The problem is that the productivity growth has kept the property bubble inflated, pricing out those looking to get into the housing market. Across China, new workers struggling to find affordable housing are becoming resentful. It is hard to know what will happen with this social unrest in China. However, China faces even more social unrest if the bubble bursts. The trap. Think of the millions of middle class families who have their wealth tied up in real estate. Without the real estate bubble, all that wealth could simply disappear. Furthermore, if Chinese productivity were to diminish, those hundreds of millions streaming into the cities would find it difficult to obtain work, only increasing the sectors of social unrest in China.
The Chinese government sees no immediate solution other than to maintain the stimulus. In the long-term though, there will need to be a policy course shift. All the people coming into the cities to find the work that the export economy is offering them won't be demanding the available housing. They will want housing commensurate with their low-income levels. Either massive new developments for low-income housing will need to emerge, or the prices for the available housing will have to fall to affordable levels, wiping out middle class wealth in process.
The trap is simply that needed monetary expansion of the Chinese economy continuing to grow will price out the younger population and lower-classes looking for homes as increased demand drives up prices; but once the bubble busts (with or without the Chinese government easing off the monetary pedal) they will face a social problem in that unemployment could grow rapidly in the major cities while the same time the wealthy will have much of the wealth wiped out.
The good news for China is that their economy would likely bounce back from a burst bubble quickly. Just as the U.S. recession following the dot-com bubble was short-and what pain was felt was exacerbated by the 9/11 attack-the Chinese wouldn't find their country in a debt crisis post-bubble. Sure, a lot of middle class wealth would be wiped out. The national government may need to bailout local governments that are over extended in development projects. And to do this the Chinese may need to raise cash by selling some of its $2.2 trillion in U.S. treasury bonds, which would drive up treasury yields and make it more expensive for America to borrow.
But assuming the bubble deflates in the next one to twenty years, there will still be a lot of room for growth in China. The huge nation has a wide range of development and investment opportunities, if the Chinese government rolls back restrictions to allow the private sector to pursue them. Companies that sell commodities to China, especially construction materials, would be affected by a burst, but see resurgence in demand. This won't mean that the wealth of the families will come back, but a big resource distribution correction coming out of a bursting bubble could be the best thing for the Chinese economy.