What went wrong for the USA?

What's wrong with America? Who is to blame for the current financial and economic meltdown?

Some people blame the government for running up too much debt. Others blame the poor people for borrowing too much that they cannot afford to pay back. But the real cause is that America's financial industry outgrew the rest of the economy.

Financial industry does not create wealth. Let me repeat it again: financial industry does not create wealth. It only re-distributes wealth. Wealth is created in the real economy, the goods-producing economy. The problem is that America is producing less and less goods, because manufacturing has been increasingly outsourced to overseas. America's economy is becoming an empty shell. If this trend continues, our children will only find jobs in either Walmart, or Wall Street. No wonder we have seen in this country the wealth gap widening, and middle-class disappearing, because the good-paying manufacturing jobs have all but gone overseas. First was the textile industry, then the electronic industry, and now the automobile industry. If the US auto industry should disappear, and most likely it will, I don't know what real stuff America can produce any more.

On the other hand, the financial industry has been growing, and it has been obsessed with growth. It forced main-street companies to move production to low cost countries, so the profit can be larger and stock prices higher. Not only that, the financial industry has been using all kinds of tricks to convince peope to borrow more, because the more we borrow, the more profit for the industry. It uses all kinds of innovative financial engineering to make borrowing easier for everyone. To persuade individuals to borrow, they give us credit cards with rewards. The more you buy, the more you save. If you own a house, they want you to borrow against your house. They call that home equity loan. After you exhausted your home equity, they ask you to borrow against your next paycheck. To persuade government to borrow, they always support lower tax and higher spending. When it comes to persuading corporations to borrow, that is where they get extremely innovative. They design all kinds of financial instruments to allow corporations to borrow easily.

The end result was the enormous growth in credit, which in turn stimulated growth of the entire economy. But this type of growth can't sustain. When individuals, government, and corporations exhausted their ability to borrow further, that is when the house starts to crumble. That is exactly what is happening now.

Don't get me wrong. I have nothing against the financial industry (I for one work for the industry). The financial industry serves a vital function, which is to promote most efficient capital allocation. In a normally functioning financial market, capitals are taken away from failing businesses to support value-creating businesses.

Because of the vital role the financial market plays in real economy, there have to be stringent and adequate rules and regulations. You cannot have a great basketball game if there are no clear rules and referees, no matter how talented the players are. The problem with our current financial system is that government under enormous lobbying pressure does not want to set rules. Existing laws are antiquated because the industry always try to find ways to circumvent them. For example, banks set up SIVs, or Structured Investment Vehicles, to engage in non-regulated investment activities, putting depositors capital under risk. Insurance companies sell innovative quasi-insurance products, such as CDS, credit default swaps, without putting sufficient capital reserve as collateral. That was how AIG got into trouble. AIG's traditional insurance business was doing just fine. It was its non-regulated business (selling CDS) that incurred huge losses and needed $155B bailout from the government.