But the policy failures fueling the stock-market fiasco go back further, to the massive government-fueled surge in credit since the global financial crisis. Without that, brokerages would not have had all of that liquidity to lend for margin trading.

After the financial crisis struck, instead of recognizing the decline in potential growth and adjusting accordingly, the government remained implicitly wedded to an unrealistic target of 10 percent annual GDP growth. But while the 4 trillion yuan ($628.6 billion) stimulus package propped up growth temporarily, return on investment was deteriorating, because potential growth was already lower than actual growth. As a result, credit demand was relatively weak; in many cases, commercial banks had to persuade enterprises to accept loans, with a large proportion of the credit ultimately devoted to chasing assets in the capital market.

At first, the excess liquidity fueled bubbles in the real estate sector. After the government clamped down on lending for residential and commercial projects, risky shadow banking activity surged. And following the government clamped down on that too, the liquidity was channeled toward stock exchanges; once those crashed, it sloshed into the bond market. But the bond market is not large enough to absorb it all, so some has now returned to the stock exchanges, leading to part recovery of share prices, with the Shanghai Composite Index reaching 3,500.

Declining economic growth strengthens the temptation to loosen monetary policy. But in today's deflationary environment, typical monetary expansion alone can do little to help the real economy, because the money either remains idle or fuels asset bubbles and capital outflows.

If China's government is to prevent a debt-deflation spiral from causing a hard landing, it should shift its focus to targeted expansionary fiscal policy. With a budget deficit of 2.3 percent of GDP, China can certainly afford to increase government expenditure and reduce taxes.

Critically, the package should be financed by government bonds issued by the Ministry of Finance, not by commercial banks via local-government financing vehicles. Any loosening of monetary policy should be aimed directly at accommodating fiscal policy. That way, financial resources would be channeled into the real economy, rather than inflating asset bubbles.

The author, a former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, served on the Monetary Policy Committee of the People's Bank of China from 2004 to 2006.

Project Syndicate