U.S. policies responsible for its economic woes, not China
It was the United States policies that caused its economic problems, not China. Arguably the most damaging of which was the repeal of the 1933 Glass Steagall Act (GSA) in 2000, a policy decision that led to the 2008 financial crisis and “Great Recession” from which the world has not seen since the 1930s Great Depression.
What is the GSA and why its repeal might be responsible for the 2008 financial crisis?
The GSA was passed into law in 1933, barring commercial banks from making investments and putting them directly under U.S. Federal Reserve regulatory regimes. Banks’ easy lending policies and making risky investments were deemed responsible for the nationwide financial system failure which might have played a role in the 1929 stock market crash and the Great Depression.
Passing of the GAS in 1933 was to prevent another financial system meltdown and it did. Preventing commercial banks from investing in or conducting risky businesses protected depositors and ensured sound lending practices stabilized the U.S. banking system. Depositors were further protected with the creation of the Federal Deposit Insurance Corporation.
This begs the question: Why was GSA repealed since it stabilized the country’s financial system?
There were many theories – financial system liberalization, putting commercial banks on the same level playing field as investment banks, etc. – explaining why the GSA was repealed. But for whatever reason, the damage was done. Allowing commercial banks to create and trade derivatives, contracts that derive their values from existing assets or underlying collaterals (i.e., Treasury Bills, mortgage loans, etc.) might be the root cause of the 2008 financial crisis.
Consequences of repealing GSA
The GSA’s repeal allowed banks to “flap” their wings in creating and modifying financial products. The most popular were collateralized debt obligations (CDOs), credit default swaps (CDSs) and subprime mortgages (subprime). Their introduction coupled with lax regulatory regimes changed the financial system, banks taking greater risk in the pursuit of higher profits.
CDOs were meant to be securitized, a business welcomed by the commercial banks. The sale proceeds of a derivative were considered a “deposit.” Under the fractional banking system, the bank is required to set aside a small percentage of the deposit and lend the remaining amount to businesses or consumers, creating a money multiplier the size of which depends on the required reserve ratio (RRR). For example, if the RRR is five percent, a 1,000-U.S.-dollar deposit could expand the money supply by 1/0.05 = 20,000 U.S. dollars. What’s more, securitization meant that the banks’ liabilities were passed on to buyers.
The problem, however, was banks were securitizing a CDO more than once, incorporating the same underlying collaterals that were used in the first CDO to package the second and subsequent CDOs. The process amounted to selling many contracts on the same product, increasing the banks’ liabilities and exposing them to higher financial risks.
CDSs were contracts between sellers and buyers in which the former guaranteed the CDOs face value in case of payment defaults. While they were an “insurance policy,” CDSs were different from a conventional one such as life insurance. For example, a life insurance company pays only the indemnifier if a risk occurs, but the CDS issuer must pay all the derivative’s holders, raising the CDS issuer’s liabilities substantially.
That is, banking practices were riskier than betting in casinos, making a 100-U.S.-dollar bet with only 10 U.S. dollars. In casinos, one can only make a 100-U.S.-dollar bet if he/she has the amount. In this sense, it could be argued that over the creation and selling of CDO and CDS was largely responsible for the “credit crunch” and “financial bubble” that occurred during the financial crisis period.
Subprime was not really a mortgage in the traditional sense, but a low monthly payment for a fixed period. The payment was so low that it did not even cover the interest costs of the mortgage, increasing the borrower’s indebtedness on the expiry date. Moreover, subprime was loaned to people who did not qualify for a conventional mortgage, and indeed many did not even have a job and on the verge of bankruptcy.
When the subprime period expired, the vast majority could not make a monthly payment of covering part of the principle and interest on the outstanding loan amount, culminating in massive foreclosures which eventually led to a “housing bubble” because lenders could not sell the millions of abandoned houses.
Had GSA not repealed, commercial banks would not be in the derivative business, investment banks would only be allowed to use underlying collateral once, and subprime mortgage would not have existed because of Federal Reserve regulations bar banks from taking high risks.
Blaming others, particularly China, would not solve America’s problems
However, instead of blaming “flawed policies” for America’ economic woes, some blamed other countries, particularly China. For example, former U.S. Fed chairman Ben Bernanke insisted it was excessive Asian savings (meaning China) that caused the 2008 financial crisis. He reasoned that exorbitant Asian or Chinese savings reduced lending rates, “seducing” governments, businesses and consumers into overborrowing, increasing debts and causing a financial crisis.
The problem with Bernanke’s theory is that blaming China is like the thief blaming the bank for robbing it.
Blaming others, China, in particular, would not solve America’s economic problems simply because they did not cause the issues, but U.S. policies did. U.S. President Trump’s trade war with China, like the GSA repeal, is another example of flawed policies.
The tariffs on Chinese “imports” were a tax on U.S. goods because most of them were made by U.S. firms in China. Adding the tax on parts or final products meant higher production costs and consumer prices. Chinese tit-for-tat tariffs pushed many farmers to the brink of financial disaster. With Trump deciding to increase tariffs from 10 to 25 percent on 200 billion U.S. dollars of Chinese “imports” the U.S. economy could dive further.
It’s time for the U.S. to take responsibility for its policies, and blaming China would not “Make America Great Again.”