Don't Blame China for the U.S. Financial Crisis

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Includes: DIA, SPY
by: Nikhil Raheja

It has been claimed by the Federal Reserve chairman, Ben Bernanke, that the current financial crisis was caused by the mysterious “global savings glut,” leading to a high inflow of capital into the US, which led to lower interest rates in the US and spurred the housing bubble.

Nothing could be further from the truth. A savings glut, if there was one, can lower the rates in the country, but it surely cannot increase the prices for houses since that can only happen if the total money supply has been raised.

A bubble in real estate is always caused by low interest rates. As interest rates are lowered in the country, it gives an incentive to people to borrow instead of invest. As a result, people lower their savings, or "dissave," leading to lower total supply of money available for lending. This action is countered by the Federal Reserve, as they add even more money and lower the Federal Funds Rate even more. As a result, the "dissaving" is countered by the Federal Reserve’s easy money and the interest rates in the entire economy fall. Also, people generally borrow more money for consumption than for opening businesses.

In any economy, people are likely to borrow more than they save if the interest rate offered by the CD in a bank is less than what they would desire. They instead use their money for consumption and also borrow to buy even more. The higher supply of consumer credit leads to higher prices in the products bought with the credit, such as houses, cars etc. This boom in asset prices lasts until the easy money lasts. As prices rise, interest rates rise and consumer credit shrinks, leading to lower prices in the same assets. This causes the lenders to lose money, and they in response restrict credit. The restriction of credit creates a vicious circle of falling asset prices and bank credit. This is a summary of the financial crisis of 2008. Hence, we can trace the crisis back to the easy money that increased the total supply of money. Without an increase in the supply of money, there cannot be an asset price bubble, and therefore, no bust. So, where does China fit into this crisis?

China earns close to $40 billion a month from exports to the US. It then recycles the money back to the US, where it is invested in treasuries, private sector debt and equities. It is claimed by the Ben Bernanke that China lowers the interest rates in the economy since it has a lower time preference. Time preference of an individual or a country indicates how high an interest rate the entity demands before it lends or invests its money. So, since China demands lower interest rates, it invests and reinvests its money until the interest rates come down. This may be true.

China can lower the interest rates; however it cannot increase the money that is used for consumption since extra savings/investments do not lead to higher income for consumption. That can only be done if the total money supply is increased. So, can we assume that China raised the total money stock of the country? What if China invested its surplus Dollars that it has hoarded over the previous years in the US all in one year? No, since an increase in the total money supply would lower the Federal Funds Rate, which is fixed and monitored closely by the Federal Reserve and any change in it is easily neutralized by the Federal Reserve’s open market operations. The Open market operations increase or decrease the total reserves at the Banks to affect the Federal Funds Rate (FFR). Hence, China has no ability to change the FFR, only the Federal Reserve does.

This crisis was caused by the low interest rates in the economy, where the FFR was kept at 1% between 2003 and 2004. This spurred consumption and led to the bubble. Unfortunately, most economists believe the theory proposed by Ben Bernanke. Case in point is the blame put on China during the recent meeting between the US Government and the senior Chinese leaders. China is being forced to revalue its currency, so it can no longer export to the US and the trade deficit in the US improves. This is a fallacy since the trade deficit too is not possible without the assistance of the Federal Reserve. The trade deficit can only exist in a country where the supply of money is increased constantly so the domestic producers are not hurt by the foreign competition. Else, the domestic producers would continue to lose money and will therefore open businesses that export more, hence leading to balanced trade. Until sense returns to the government and the Ivy League economists, the economic prospects of this country should not be expected to improve over the longer term.