How are we to describe the events that have convulsed the global economy since 2007? Almost everyone seems to agree that there was a financial crisis, which gave rise to a recession. While the latter is commonly described as the worst since the Great Depression, the widely held view is that swift action by the US government to bail out financial corporations averted the threat of depression, opening the way for the ‘green shoots’ of recovery discerned already at the end of summer 2009 by Federal Reserve chairman Ben Bernanke.1 Some economists and journalists did not expect full economic bloom until another year or two, while almost all agreed that even an improved economy would take the form of a ‘jobless recovery’. But the consensus view, when I finished writing this book in mid-2010, was that we were already on the way out of what had come to be called, ruefully, the Great Recession – a view officially confirmed by the Business Cycle Dating Committee of the National Bureau of Economic Research when it announced in September 2010 that the recession had ended fifteen months earlier.
There was general agreement as well about the causes of the collapse of the American finance industry that set the global downturn in motion: this collapse was an unintended consequence (though perhaps an expectable one, even if most economists and financiers did not expect it) of unparalleled financial risk-taking, stimulated by the fantastic profits achieved by this sector in the 1990s, helped along by lax governmental regulation. This line of thinking points, for example, to the enormous salaries and bonuses reaped by professional speculators working at banks, hedge funds and other financial enterprises, which gave them an incentive to risk their firms’ money, and especially other people’s money borrowed by their firms, to pursue short-term profits to the limits allowed by government regulators (and even beyond). Thus, to cite a particularly simple-minded example, the Nobel-prize-winning economics professor Paul Krugman used his column in the New York Times to opine that ‘reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis a few years down the road’.2
Although over-leveraged, risk-taking speculation was an international phenomenon, the heart of the problem lay in the United States, the world’s dominant economy and financial centre. Here the traders’ risky behaviour had a home in what is commonly described as a culture of self-indulgent high living. As individuals, too many Americans borrowed too much money; too many banks made loans to unreliable customers. The danger inherent in this situation was magnified by a technical innovation that was supposed to manage risk by spreading it, the ‘securitization’ of mortgages and other types of loan – their grouping together into bundles sold as bonds. In this way the bank that makes the loans doesn’t tie up its money in an actual piece of property, waiting for the loan to be repaid, but sells the right to collect the interest on those mortgages (or, for example, credit card accounts) to investors – other banks, pension funds and so on – in complexly structured packages called ‘collateralized debt obligations’. The investors, of course, can sell these CDOs to others, or use them as collateral to take out giant loans to buy more securities or to gamble in the rapidly expanding field of derivatives, a type of investment well described in the Financial Times as ‘like putting a mirror in front of another mirror, allowing a physical object to be reflected into infinity’; about $62 trillion in credit default swap derivatives, for example, were floating around when the crisis hit. By January 2007, the US mortgage-based bonds on which this inverted pyramid of financial instruments rested, themselves rising far from actual houses and the money to be paid for them, had a total value of $5.8 trillion. Of this, 14 per cent represented sub-prime mortgages, entered into by people with poor financial resources. In 2006 these people began to have a hard time making their payments and the pyramid fractured.
The foreclosure wave should not have been surprising, as the real wages of non-supervisory workers in the US had reached their peak in the early 1970s and stagnated since then (the years after 2000 saw in particular a rapid decline in employer-financed health insurance), along with employment. When variable mortgage payments jumped, more and more people couldn’t make them. Meanwhile, the Fed raised interest rates starting in 2004. The same institution’s earlier lowering of interest rates had encouraged borrowing, including for speculative purposes. As they went up, mortgages became more expensive, houses were harder to sell and house prices stalled or fell. These developments in turn made it difficult or impossible to refinance, as many homebuyers had been assured by lenders they would be able to do. By Dec ember 2007 nearly a million US households were facing foreclosure. Housing prices began to fall more rapidly; the mortgage market collapsed, taking with it the whole structure of securitized investments, now a massive part of the financial structure in the US and around the world.
Alan S. Blinder, former Federal Reserve Bank governor and now Krugman’s fellow professor at Princeton University, put it this way: ‘It’s easy to forget amid all the fancy stuff – credit derivatives, swaps – that the root cause of all this is declining house prices.’ People, from humble homeowners to Wall Street Masters of the Universe, imagined that house prices would climb forever. When they started to fall, the institutions that bought mortgages and borrowed against them, treating them as the equivalent of high-valued houses, suddenly found themselves unable to meet their obligations. Because so many institutions had become embroiled in the mortgage market by buying securitized mortgages, the effect on the whole financial system was swift and deadly: as more and more payments could not be met, more collateral was demanded to back up borrowings, which further depressed the institutions’ ability to manoeuvre. Major banks were forced into mergers or bankruptcy, while the insurance giant American International Group, which had insured billions of dollars’ worth of these transactions, survived only thanks to a massive injection of US government funds. Bank credit became unavailable – and capitalism lives on credit, required not only by individuals rolling over their monthly credit-card bills but by businesses of all sizes meeting weekly payrolls and other operating expenses. In short order, therefore, the financial crisis – in this account – produced the Great Recession.
A more complex version of this story invokes a global dimension: the American economic expansion of recent decades, after all, involved a growing trade and current-accounts deficit in relation to the rest of the world. Americans bought more goods from the rest of the world than they produced to sell. And the money they spent flowed back to the USA, invested in stocks, bonds and real estate, but also in the government securities that, in a circle that was vicious or virtuous depending on one’s point of view, financed the persistent outflow of dollars to buy goods from around the world. This inflow helped keep American interest rates low, allowing people to buy foreign-made goods as well as to take out mortgages and purchase houses and apartments. While many nations were involved in this, the Chinese government became the largest holder of US Treasury bonds, thus financing the growing appetite for Chinese-made goods on the part of American consumers and keeping the prices of those goods low (since the massive flow of dollars into China would otherwise have pushed up the value of the Chinese currency, the renminbi,3 making Chinese goods more expensive on the world market). Thus China, and the other major dollar-hoarding countries, enabled (as they say in rehab) the American consumption habit, and with it the debt expansion and hypertrophied speculation that led to the financial collapse. In the words of a leading columnist for the Financial Times, Martin Wolf,
High-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.4
Conversely, once the financial system seized up in the United States, it was bound to spread throughout a world in which national economies are knitted together by financial and trade flows.
All of this makes sense, as far as it goes, and corresponds to phenomena apparent to anyone reading the financial pages of the world’s mainstream newspapers. The outstanding issues seem to be those of what to do next. What sorts of reforms of the financial system are necessary (and possible)? Is more stimulus money needed in one nation or another to fully prime the economic pump or has enough been spent already? What measures should be taken to aid the unemployed and maintain state services while the economy returns to normal? John E. Silvia, chief economist for Wells Fargo, expressed the most optimistic version of this perspective in a ‘research note’ published in the New York Times on 29 July 2009: ‘The recession is over, the economy is recovering – let’s look forward and stop the backward-looking focus.’
In taking this stance, Silvia only affirmed his faith in the currently dominant strain of economic theory. According to the leading economists of the last thirty years, the financial trans actions that played such a central role in the current debacle are an efficient mechanism for allocating resources among potential uses. The same Martin Wolf who now laments a fundamental imbalance in the world economy saw a means for stability in global financial flows in 2004, his only caveat being that ‘if some people (Asians) wish to spend less than they earn today, then others need to be encouraged to spend more’.5 Meanwhile, what was in fact, in historical terms, a relatively stagnant economy, moving through recessions of various degrees of severity and undergoing an unending series of banking, debt and currency crises, was described as essentially stable. Thus Nobel Prize winner Robert E. Lucas Jr wrote in the Wall Street Journal – in late 2007, when realestate finance was already disintegrating – that he was
skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession. Every step in this chain is questionable and none has been quantified. If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.6
What perturbations there were, according to this vision of capitalism, could originate only from outside the economic mechanism proper – above all from mistaken government regulative, fiscal and monetary policy.
In this way, at the turn of the twenty-first century economics reaffirmed the rosy view of the private-enterprise system that had characterized the field in its earliest days. Throughout the nineteenth century, economic orthodoxy maintained that the natural state of a capitalist economy was a healthy full employment of resources to produce the maximum amount of goods for consumption. After all, as Adam Smith had already explained in The Wealth of Nations (1776), the whole point of a capitalist economy is that each individual owes his or her living to success in meeting the needs of others. Only what can be sold will be produced; money will be borrowed, land rented and labour hired only because the resulting production meets a need. Conversely, the money earned by selling one’s product will be spent, either on consumption or on further production. David Ricardo, the great systematizer of early nineteenth-century theory, portrayed the economy as tending naturally to a balanced state, in which all products found buyers, with goods selling at ‘natural’ prices. True, Ricardo saw trouble ahead for capitalism, but only because population growth would require the cultivation of increasingly infertile land; the diversion of wealth away from entrepreneurs to landlords that would eventually limit growth was the fault of physical nature, not the economy. As the idea of capitalism’s self-regulation was expressed by Ricardo’s follower J. B. Say, ‘supply creates its own demand’. Since there’s no way of knowing in advance how much of each kind of product will be consumed, there can be momentary imbalances between supply and demand, but the rise and fall of prices will see to it that the necessary adjustments are made.
In the later nineteenth century the ‘classical’ political economy of Smith, Ricardo, and their followers was replaced by a new ‘neoclassical’ mode of theorizing that was in many ways quite different. It emphasized not, like classical theory, the division of income among social classes, but the decision-making of individuals. Borrowing the concept of ‘equilibrium’ from physics, along with the mathematics of static mechanics, the new economics continued to insist that capitalism by its nature tended to settle in a stable state in which each individual is maximally satisfied, given the constraints set by his or her relations to the rest of the system. (How this idea was to be reconciled with the equally basic dogma that capitalism tends to grow as a wealth-producing system was left for future thinkers to resolve.) From this point of view too, therefore, breakdowns of the market system, as opposed to imbalances in particular markets, are out of the question; what general difficulties do occur must be the effects of some non-economic factor, such as the weather, human psychology or mistaken government policies.
The Great Depression that began in 1929 (that name had previously been assigned to the downturn that lasted from 1873 to 1896) finally made it possible for the fiction of natural stability and perpetual growth to be questioned by a figure as institutionally important as John Maynard Keynes, financial representative of the British government at the Versailles conference to end the First World War, professor of economics at Cambridge and all-round leading light of British intellectual life. In his General Theory of Employment, Interest, and Money of 1936 Keynes observed that the insistence of orthodox economics on the self-regulated nature of the capitalist economy had failed to recognize that the system could regulate itself into a state of less than full employment. Sharing with orthodoxy the basic assumption that the point of the economy is the utilization of resources, natural and human, to produce goods for consumption, Keynes proposed that the state should intervene at such moments, borrowing money against future tax receipts to hire workers, thus increasing the number of consumers and so calling forth new investment to meet their needs. Like his predecessors, Keynes ascribed the possibility of breakdown to a non-economic factor, human psychology, which limited the ability of the growth of consumption to keep up with the ability to produce, along with a pattern of expectations, ideally based on experience, about the profits to be earned from investment. But as humans cause the problem, humans could repair it, with government policy undoing the psychologically set limits on full employment and prosperity. This is the origin of the concept of the ‘stimulus’ – the idea that the economy need only be nudged to a different supply–demand equilibrium position for its natural tendency to stabilize to operate at a higher level of employment and consumption.
In 1936, when Keynes published his book, the idea that government spending should make up for the shortfall in capital investment and consumer demand had already been put into practice by governments as different as Adolf Hitler’s and Franklin Delano Roosevelt’s. By the end of the Second World War, the massive military expenditures required had restored high levels of employment and improved the general standard of living, at least in the United States. This gave an enormous boost to the fortunes of Keynesianism (if not precisely to Keynes’s own ideas, as many of Keynes’s theoretical disciples pointed out over the decades, without making much political or academic headway7). Depressions now seemed to be something that could be controlled and even avoided altogether.
Interestingly enough, the loss of faith in Keynesian theory that came with the return of economic stagnation in the 1970s, now accompanied by inflation, led not to a search for new ways to grapple with the nature of the ‘business cycle’ of alternating contractions and expansions, but to a renewed insistence that the market, if only left to itself, would provide the best of all economic worlds. In economic practice, government stimulus of the economy reached a postwar high point under Ronald Reagan, apostle of the free market and battler against the Evil Empire of the Soviet Union’s state-run economic system. In economic theory, however, the period since the late 1970s saw the dominance of the field by insistence on various forms of the efficient-market hypo thesis. Originating in nineteenth-century studies of the probabilistic nature of business decision-making, this is the idea that stock market prices provide the best available estimates of the real value of shares, and so of the actual state of business enterprises, because ‘the market’ – that is, the bargaining conducted between all buyers and sellers – takes account of all available information in setting the price of an individual stock. The hypothesis thus extended to asset markets – markets for stocks, real estate, commodity futures and other vehicles for speculative investment (including, for example, CDOs) – the assumptions about the self-equilibrating nature of commodity markets basic to the classical theory of laissez-faire.
The degree of dominance that this view achieved within economic discourse in recent decades guaranteed a radical crisis of faith in economic theory when the financial house of cards came tumbling down. ‘What Good Are Economists Anyway?’ asked Business Week’s cover story for 16 April 2009, noting that though the world is ‘simply too complicated’ for ‘exactitude’ in prediction, it is distressing that ‘seven decades after the Depression, economists still haven’t reached consensus on its lessons’. An even harsher rebuke came from within the profession when Paul Krugman asked, in the pages of the New York Times Magazine, ‘How Did Economists Get It So Wrong?’ Despite his title, Krugman did not have all economists in mind, but only those who followed recent neoclassical fashion (he left undiscussed the reasons why Keynesian theory fell into disrepute in the 1970s). Locating ‘the central cause of the profession’s failure’ in ‘the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess’, Krugman dismissed the approaches dominating academic economics over the last 30 years as fundamentally misguided and called for a return to Keynesian theory as part of a recognition of the fundamental ‘messiness’ of the economy.8 Writing in the Financial Times, Robert Skidelsky (best known for his authoritative biography of Keynes) similarly noted that the efficient-market hypothesis’s collision with the iceberg of economic reality had ‘led to the discrediting of mainstream macroeconomics’ and given the lie to economists’ claim to practice a predictive science.9
Such shock at the predictive failure of economics is surprising, given the dismal record of professional forecasting. The enthusiasm spawned after the Second World War by the apparent success of economists in understanding and managing the economy led many companies to hire in-house forecasters in the 1950s and ’60s. But ‘thanks to the poor historical performance of economic forecasting’, today ‘almost none of the Fortune 500 companies directly employ economists. Instead, they avoid relying on forecasts altogether . . .’.10 Clearly, economics is neither a reliable predictive science nor a body of theory on whose basics practitioners can agree. Yet Business Week’s writer, Peter Coy, Krugman and Skidelsky could think of no alternative to further theoretical heavy lifting by the economics profession.
For the most part, as we have seen, even those attempting to face up to the current debacle of economic practice and theory continue to accept the basic dogma of the now discredited approach to economics: the idea of an essentially problem-free nature of capitalism, apart from financial excesses. In the words of George Cooper – a professional fund manager whose recent book reflecting on the crisis-prone nature of the financial system makes a merciless mockery of the efficient-market hypothesis – the ‘markets for goods and services’ are characterized by ‘stability’ but this does ‘not hold for asset markets, credit markets, and the capital market system in general’, which once disequilibrated have no tendency to return to an equilibrium state.11 The problem, that is, is not the capitalist economy as such, the production and distribution for profit of goods and services – often referred to as the ‘real economy’ – but the financial superstructure erected on its basis which, allowed to get out of control, can unravel with consequences for the underlying structure itself. Even some left-wing thinkers, who one might have imagined would be only too happy to proclaim new evidence of capitalism’s obsolescence, chimed in with this strand of the mainstream chorus.12
Other leftists explain the recession by combining the generally noted fragility of the financial structure with the Keynesian diagnosis of insufficient effective demand. Thus David Harvey’s recent book on economic crisis explains the current downturn as the outcome of earlier efforts to maintain capitalist prosperity by lowering the high wages earned by workers in the 1960s:
Moves made to alleviate a crisis of labour supply and to curb the political power of organized labour in the 1970s diminished the effective demand for the product [of industry], which created difficulties for realization of [profit] in the market during the 1990s. Moves to alleviate this last problem by extensions of the credit system among the working classes ultimately led to working-class over-indebtedness relative to income that in turn led to a crisis of confidence in the quality of debt instruments (as began to happen in 2006).13
But if the Great Recession developed from a financial crisis, why is the world economy still slowing, even as bailouts to the financial system, together with stimuli administered to the general economy, are supposedly producing ‘green shoots’ of recovery? Why will this recovery be a jobless one, thus requiring (as Keynesians of various ideological stripes, from Krugman to Harvey, maintain) government spending to revive demand and increase employment? In the US, when these words were written in spring 2010, big bonuses were back in the financial world, but wages were not going up, to put it mildly, while the average work week declined and unemployment continued to rise. The remaining investment houses were making excellent profits on financial trades, while banks remained unwilling to offer credit to businesses that need it to survive, let alone expand. General Motors, near bankruptcy in 2008, has been saved, apparently, by government action, at the cost of huge numbers of jobs, while those still on the payroll have had to accept lower wage, health and pension terms. But the corporation’s home state of Michigan – along with California, the largest state in the union – was sliding into fiscal collapse, closing universities, schools and libraries while cutting basic services like healthcare. Meanwhile, the European economy continued to slow, with rising unemployment, while Japan remained mired in stagnation. China, it is true, reported growth, at the spectacular rate of 9.1 per cent for 2009. This was no doubt due in part to the continuing ability of Chinese industry to take market share from producers in other countries, thanks to a mixture of government subsidies, continued maintenance of a cheap currency and the efficacy of a police state in keeping wages low and working conditions harsh (despite some limited success of recent workers’ protests and strikes). But it clearly owed much to the 4 trillion renminbi ($590 billion) pumped into the economy by the state, along with a record 9.6 trillion renminbi ($1.4 trillion) of bank debt, much of it channelled into realestate speculation. The artificial character of this ‘growth’, in fact, was such as to prompt official worries ‘that the stimulus drove overspending on factories and other facilities, which could lead to economic problems if producers were forced to slash prices in glutted markets or could not repay bank loans’, not to mention the ripening real-estate development bubble.14
If we disobey John Silvia and allow ourselves a backward-looking look, we are faced with the question of just how the imbalance in the world economy implicated in the financial meltdown came to pass in the first place. To start with the last-mentioned thread of the story, why did the Chinese government (and other East Asian and Middle Eastern nations) facilitate the American housing bubble, with all the financial hijinks it involved, by buying Treasury bonds rather than, say, using their dollars to invest in American industry? Of course, as already noted, this helped solidify their foreign exchange position, protecting the value of their currency. And there would have been little point in financing US production when the basis of developing Chinese capitalism is the replacement of the US as a centre of production. But why did the American economy decline as an engine of production rather than consumption? Why did investment slow in the US, outside of the stock and bond markets, real estate and derivatives, so that by 2007 so-called financial services earned a historically high 28.3 per cent of total corporate profits? Between 2000 and 2005, as one commentator emphasizes, ‘the increase of both non-residential investment and net exports was less than zero, so that personal consumption and residential investment’ – both based on mortgage-debt expansion – ‘were left the drive the economy virtually by themselves’.15
And since this is not only an American story, why was the world economy increasingly devoted to speculative pursuits? How did what were once called ‘developing countries’ turn into ‘developing markets’, with an emphasis on securities, real estate and commodity futures speculation? Even in China, which has been busy turning out everything from steel to teddy bears, vast sums of money have poured into real-estate development, producing a growing bubble that had experts worried before more immediate problems distracted them. It was, as we shall see, largely this worldwide growth in financial activity after 1980 that appeared both as ‘globalization’ and as the American prosperity supposedly powering the world economy. Conversely, the crisis appeared as a financial crisis, not because the rest of the economy was healthy, but because finance was the most dynamic sector of the economy, and therefore the one in which the underlying weakness first manifested itself.
Clearly there is something wrong with the mainstream approach to understanding current economic affairs. Part of the problem lies in the terms with which commentators attempt to understand the social system in which we live. These analytic difficulties are inextricably connected with insufficient attention to the actual course of economic events. To understand what happened and what is still happening in the world economy, we need to take a longer view than that which seemed to support the enthusiasm of recent economic theory. We need to look back at history – the history of capitalism as a system, and the history of this system since the Second World War in particular.