China can learn from US history in housing, financial crisis

Financial orthodoxy is well-intentioned, but sometimes it ends up causing more problems than one might think. One of the core ideas in it is moral hazard, that if you bail people out, that they’re not going to pay as much attention on who they lend to, who they borrow from, or what have you. Now, back before 1913, when the Fed was created, and certainly before 1933, when FDR created the Federal Deposit Insurance Corporation, that was the case. If you put your money in a bank, and the bank somehow went under, first, there was nobody to bail out the bank. And secondly, there was nobody to bail out you, the depositor. Well, people still had to use banks, but they didn’t use them quite as much as they normally do. Banks were underutilized. And that’s actually bad for the economy, because banks are a very efficient way of collecting the national saving and putting it to use.

Now, what they ended up doing was making a compromise. FDIC only insured deposits at first up to 40,000, then it went to 100,000. But still 100,000 in the 21st century wasn’t much, it may seem a lot to an individual, but think about a small business that has to make payroll. It’s not hard to have a monthly payroll well in excess of $100,000. So where are you going to keep the money so that your payroll checks clear?

Well, in the 2008 financial crisis, Treasury Secretary Hank Paulson foolishly opposed raising the FDIC cap. As a result, we had a mini bank run. Small business people and others had to start spreading their money around on an almost daily basis, in order to make sure that their money was insured. People were very nervous about which bank would go under. In the end, that kind of banking chaos greatly contributed to the financial crisis that collapses the housing market and all the rest.

This time around, in 2023, Treasury Secretary Yellen played it much wiser. When those banks failed, like Silicon Valley back in 2000, excuse me back in March, she implicitly guaranteed that all depositors would be protected. Result: No bank run, no financial panic, no crisis, no deep recession.

Well, financial orthodoxy doesn’t just exist in America, it applies everywhere. And right now, it’s China, an unusual place for sure to have financial orthodoxy, but it’s creating a similar problem, although somewhat different. You see in China, if you want to buy a new house, ie a new apartment somewhere, you have to pay all your money down before it’s built. Right. Why? Because there was so much demand that builders could command that. So homeowners had to go out, pool all their life saving for the down payment, and then take out a mortgage for the rest on a house that didn’t even exist. Well, guess what? A lot of those builders during COVID ended up not being able to complete the buildings that they had already sold. So people out there were stranded. Their life savings was gone for the down payment, and they were saddled with a mortgage, but didn’t have a house to show for it. This created a big hit to consumer demand in China, particularly among the growing middle class.

China has had a lot of problems with an economic recovery, even though it lists lifted its ridiculous COVID restrictions. Why? Why would you trust, say, the homebuilding industry, or any other industry, if they took your money away? And besides, your money is gone, so you can’t spend. So what Xi needs to do, Xi Jinping, the head of China, is he needs to basically create the equivalent of the FDIC, but in this case retroactively. He’s either got to give the homebuyers their money back, or he’s got to bail out the builders so that they can finish the construction on the buildings that they’ve sold. Well, he’s not doing it, in part because he’s afraid of moral hazard. But also because he doesn’t think it’s right for the government, which has the access to the money, by the way, to bail out others. Now, he’s got a little bit of a case, their national debt is 80% of GDP versus about 105% in the US, the total debt in the economy is 280% of GDP, which is more than what we have in the US. So piling more debt on the on the Chinese nation, you know, is not the smartest idea. But it’s a lot smarter than letting people go broke because the builders didn’t finish the houses they’d already paid for. The government has a responsibility, perhaps, to plug this hole, that or they have bigger economic problems. And they also have problems with the social contract.

The problem with this orthodoxy is: Is it sensible for a small business owner or a potential homeowner to know the financial condition of the bank or the construction company that’s promised to build their home? Nobody has that capacity to do research, only the government regulators do. So in fact, the moral hazard is really on the government to make sure that it is checking on the solvency of these companies like we do for banks. Well, that’s a different version of financial orthodoxy. But it’s not the one that prevailed in the US for a long time. And it’s certainly not the one that prevails in China. And isn’t China kind of a strange place to go back to good old fashioned pre-1913 financial orthodoxy? This is Larry Lindsey for Straight Arrow News.