Yesterday’s big news was that the stock market tanked and the government announced tighter lending.

This made me happy.

No, I’m not one of those people sitting around waiting for an economic disaster so I can sit back and watch the lovely chaos that ensues (e.g. the end of Fight Club). Actually, I’m glad that the stock market came down and lending was reined in for very logical reasons: everyone knew that we had some serious bubbles in the economy and that letting some air out sooner rather than later was a good idea.

But I didn’t write about it yesterday, for two reasons: first, because I was busy writing something else; and second, because I wanted to wait on additional guidance/reaction from the government, which I now have in my hot little hands, or rather Inbox.

The government is walking a financial tightrope these days:

The Chinese central bank’s vice governor, Su Ning, was reported as saying it would also use market tools instead of quota-style controls to ensure credit growth was appropriate.

His remarks came after Chinese stocks fell by the largest amount in eight months on Wednesday amid worries that China may take steps to tighten money supply and banks could begin to restrict lending.

The government seems to be swinging the pendulum back and forth this year as bubbles arise and as demand lessens, pumping up the economy and then pulling back as things heat up. The good news is that in China, the government can move pretty quickly. As the FP blog put it, rather nicely:

Being a command economy has its advantages when there’s need for a whole lot of emergency economic commands.

True. Unfortunately, China also has some disadvantages, including a still-developing banking and finance sector, which means that the government has fewer levels to pull when it needs to push the economy in the direction it wants.

But what has the government said? Well, one thing that apparently freaked out the markets was the statement that stimulus money should go towards smarter investment and not be diverted into the stock market and real estate projects. Easier said than done, though. Lots of Gordon Geckos running around diverting stimulus money to their own get-rich-quick schemes.

The government announcements were enough to push the stock market down considerably. Funny, but the last couple of weeks have seen several international investment banks revising their China forecasts upwards dramatically. Undoubtedly, one of the indicators that has drawn their greedy little attention of late has been those yummy stock prices.

So at the same time those glowing forecasts were coming out, I was worrying about bubbles and being cautious. Now that the government had moderated policy and let some air out, I feel more optimistic. I wonder what the investment banker types are thinking this week?

Well, some finance types can’t stop staring at those growth rates. Here’s one guy’s take on the state of the economy (from Foreign Policy):

Despite everything, the Chinese economy has shown incredible resilience recently. Although its biggest customers — the United States and Europe — are struggling (to say the least) and its exports are down more than 20 percent, China is still spitting out economic growth numbers as if there weren’t a worry in the world. The most recent estimate put annual growth at nearly 8 percent.

As I wrote a few days ago, this fascination with China’s GDP number is really misplaced and a bit foolish. I understand that no “worry in the world” language was intentional hyperbole, but still. Eight percent in China means something very different from 8% in developed countries, and either way you look at it, that number is significantly lower than it was a couple years ago.

At least this particular commentator understands the possible consequences to this unsustainable growth, and says so:

This growth will result in a huge pile of bad debt — as forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple: There is no miracle in the Chinese miracle growth, and China will pay a price. The only question is when and how much.

Hence the government’s actions this week. Here’s the big problem. Demand is too low in large part because of the weak export sector. To shore up that demand, the government turns on the fiscal spigot and pumps stimulus money into the economy. Great, but too much and you have bubbles. Can the government really direct the money away from real estate and stocks? Ha ha.

So the pendulum swings back and forth. The question is when does this end? Well, if exports magically firm up again, then that’s one solution. But few experts really want that to happen, they would prefer to see a more balanced Chinese economy with a stronger domestic demand component.

If “smart” stimulus continues to be pumped into the economy at some sort of optimal rate, will we eventually get sustainable domestic demand?

Anyone know? Guesses? Hypotheses? I haven’t heard too much from the government lately about how this is all going to end well, aside from the usual plan to “invest in innovation, education, infrastructure, etc.” Sounds great, but it’s all a bit vague.

Still looking for that magic bullet.