Don’t blame China for America’s economic woes

US policies are responsible for America’s economic problems, not China. Perhaps the most damaging such policy was the repeal of the 1933 Glass-Steagall Act (GSA) in 2000, which paved the way for “casino banking” practices that eventually led to the 2008 financial crisis and the “Great Recession.”

The GSA was the result of a nationwide financial breakdown caused by reckless banking practices in the 1920s. In those days, retail or commercial banks were allowed to invest in businesses and were relatively liberal in making loans.

During the 1920s, known as the “Roaring Twenties,” America’s economy was booming, emboldening banks and people to invest in risky businesses and speculate in the stock market. Like all good things, however, the overconfidence in the market popped like a bubble, causing a nationwide financial meltdown that in turn might have caused the 1929 stock-market crash and the 1930s Great Depression.

Reckless banking practices were blamed for the financial breakdown, resulting in the passing of the 1933 GSA, which barred commercial or retail banks from engaging in risky investments and placing them under strict US Federal Reserve regulatory regimes. Investment banking activities were also put under close supervision.

The GSA was credited with the stabilization of banking in the US, which raises the question: Why was it repealed?

There were many reasons – to liberalize the financial system, put commercial banks at the same level playing field as investment banks, etc. For whatever reason, it might have been the root cause of the 2008 financial crisis.

Effects of GSA repeal

The repeal of the GSA gave commercial banks in the investment business greater scope for competing in derivative creation and trading, resulting in reckless practices. Derivatives are contracts whose values are derived from banks’ existing financial assets holdings (such as Treasury bills and mortgages) and their performance. Selling the contracts to investors increases banks’ reserves or lendable funds because the sales proceeds are considered deposits.

Under the fractional reserve banking system, banks are required to set aside a small percentage referred to as required reserves (RR) and lend the remainder, creating a money multiplier the size of which depends on the size of the RR. If the RR is 5%, the amount of money or liquidity that the banking system could expand by is 1/0.05 = 20 times.

In this regard, derivatives are actually stimulus in that they increase consumption and investment, a reason for the United States’ prolonged period of economic growth in the 1990s. The problem, however, is that the more derivatives were being created and traded, the riskier they became because the underlying collateral was riskier. For example, banks were running out of riskless or less risky collateral, forcing them to use car loans and other default-prone assets. Worse yet, the risky assets were used many times, which amounted to selling multiple contracts on the same asset.

Blaming China seems to be a popular pastime in American foreign policy circles. The latest is the US-China trade war, which was launched on the pretext that China was “eating America’s lunch,” when it could be argued that it was the other way around

Equally damaging to the financial system, and by extension to the economy, was the “subprime mortgage,” a low monthly payment that did not even cover the interest charges borrowers were required to pay in a fixed time period. The mortgages were loaned out to people without good credit, money and jobs. When the “subprime” period expired, most could not repay the loans, culminating in massive housing foreclosures and a housing bubble.

The rest, as they say, is history. The developed economies have yet to recover from the financial crisis. But instead of coming to terms with the fact that it was bad policies that created the financial and economic mess, some blamed China.

If things go wrong, blame China

Former Federal Reserve chairman Ben Bernanke and others blamed “excessive Asian savings” (read: Chinese savings) for causing the financial crisis. His logic was the “excessive savings” reduced interest rates, “seducing” the US government, businesses and consumers into a “debt trap” with loans which they could not repay.

Bernanke was wrong for the reasons cited above;  blaming excessive savings is like a criminal saying a bank “seduced” him into robbing it.

Blaming China seems to be a popular pastime in American foreign policy circles. The latest is the US-China trade war, which was launched on the pretext that China was “eating America’s lunch,” when it could be argued that it was the other way around. Taking advantage of China’s relatively “cheap” labor costs, companies like Apple were making huge profits. According to the US journal The Conversation, China earned less then US$8.50 from making Apple’s iPhone, which was selling for around $650.

Contrary to US President Donald Trump’s boast that tariffs on Chinese goods are good for America, the opposite might be true. The tariffs are an excise tax paid by US importers and passed on to American consumers. A joint study by the Federal Reserve Bank of New York, Princeton and Columbia universities estimated that the tariffs reduced US income by $1.4 billion per month because they were passed on to consumers.

In addition, the tariffs adversely impacted investment and farmers and, by extension, economic growth. The World Bank and other supranational institutions estimated that US economic growth would be reduced to around 2.5% and 1.8% in 2019 and 2020 respectively.

With Trump unexpectedly increasing tariffs from 10% to 25% on $200 billion worth of Chinese goods, the US economy could dive lower, dragging the world economy with it. Even Trump’s economic adviser, Larry Kudlow, has suggested that the US economy will be hit by the erratic president’s flawed policies.

It could be argued that it is US politicians and their flawed policies that are “eating America’s lunch,” not China or any other country.