Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
John Maynard Keynes
As a consequence of the latest and greatest of financial crises, the West’s increasingly unstable economic and political system of the last thirty years has started to buckle. The GFC was the culmination of an ever-expanding series of crises powered by an out-of-control credit creation machine and the naive indulgence of governments and central bankers in thrall to the marvels of a growing finance industry. Instead of protecting its citizens from the school bully, the authorities behaved more like parents who refuse to discipline an unruly but bright child, overlooking and excusing its serial misbehaviour.
Within each credit cycle of the last thirty years, each individual decision may, taken in isolation, have been rational; at the macro or collective level, the aggregation of individual decisions generated credit growth far in excess of underlying economic growth and its ability to support the heavier mass of debt.
Financial crises resulting from chronic excessive debt creation are a consequence of three deadly factors.
• The problem of the ‘generalisation principle’ we explored in Chapter 3. The free-market-knows-best school of economics is clearly immune to the perverse functioning of a financial sector which does not limit itself, as Hyman Minsky has persuasively argued.1
• The self-reinforcing nature of rising asset prices is destabilising as humans are attracted to the honey pot of capital gains. In another case of perverse behaviour, and in stark contrast to economic theory’s assumption that higher goods prices lead to lower demand, rising asset prices beget higher demand. But asset prices often rise under the impetus of easy liquidity and leverage. This is a recipe for overheated markets and financial crashes.
• A political and central banking establishment in denial about the inadequacies of the free market in the financial industry.
These factors escalated in importance as the authorities dared not let the market purge itself through sufficient bankruptcies and write-offs to reset the system on a sound footing for fear of the short-term pain of mass unemployment, plummeting living standards and the wrath of the electorate.
The problem engendered by the generalisation principle arises from the selfishness and self-centredness of human nature and a lack of awareness of the impact of one’s own behaviour when replicated by many others. If individual bankers are motivated to grow their profits by 10 per cent per annum in a world of 4 per cent growth because, rationally, they are seeking to make their fortunes, society somewhere will become increasingly leveraged to the point of instability.
If enough debtors get into difficulty and are forced to sell assets (or their creditors are), then the entire debt structure risks collapse. Eventually, this tipping point is reached as lenders run out of safe loans they can make to sound borrowers; the virtuous circle goes into reverse; prices fall; more borrowers default; lenders cannot recoup their loans; credit conditions tighten, and cascading bankruptcies threaten.
For economists and politicians brought up with quasi-biblical reverence for Adam Smith’s invisible hand and indoctrinated with belief in the collective wisdom of the market, the rational decisions of individuals translate into good rational decisions for society. As Keynes remarked, ‘Capitalism is the extraordinary belief that the nastiest of men, for the nastiest of reasons, will somehow work for the benefit of us all.’
Economic textbooks are reluctant to acknowledge exceptions to Smith’s model, which is intellectually satisfying, if flawed in practice. As we saw in Chapter 3, they do concede a few exceptions or special cases, such as public ‘goods’ (justice for example) or public ‘bads’ (for example pollution,) where they acknowledge the inefficiency of the market mechanism at a society level.
However, Adair Turner is one of the few establishment figures lucid and honest enough to acknowledge that the failure of markets extends to the financial industry: ‘there is a negative social externality [economists’ jargon for bad social effects] of debt creation: debt can be a form of economic pollution’.2 In other words, finance, by its special nature at the centre of the economic machine, charged with recycling or creating money, if left to its own devices is incentivised to lead to perverse outcomes at the aggregate level.
The conveniently neat world at the micro level of each individual making isolated decisions that are right for him/her does not factor in the often negative consequences for society at the macro level. That is because the early economists, operating in a completely different economic system, were principally interested in the positive consequences of aggregating individual decisions through the signals of demand and supply and the price mechanism for goods. As Minsky devastatingly quips in his book, the market may be good at finding how many different flavours of ice cream to supply, but not so good at reaching a general equilibrium of demand or distribution of income, education or training. The free market has been surprisingly slow or reluctant to see its catastrophic implications when it comes to generalised, self-interested lending.
The second inconvenient anomaly in classical economic theory is presented by the behaviour of asset prices. Contrary to classical economic theory, where the higher the price of a good, the lower the demand, asset markets often behave the other way around. Rising asset prices may actually beget more demand as investors are attracted to the prospect of capital gains and reassured by the apparent enthusiasm of their peers to continue to buy, even if valuations become stretched. In a world where value is ultimately subjective and determined by the price that someone is willing to pay, the market can always justify the prices it is paying.
In this case, crowd behaviour takes over as another example of the generalisation principle: once individuals notice the price of a good or asset is rising, it is rational for them to buy in the expectation of reselling at a profit. While this is rational at the individual level, it cannot be at the aggregate level, since it is a zero-sum game. The total population cannot hope to buy to pass on to itself at a profit. In so far as a participating individual understands this, it remains rational for him/her to buy if and only if he/she assumes he/she will be able to sell before the market runs out of like-minded buyers. Of course, this assumption cannot be generalised for all buyers. The momentum-chasing tendency of human nature is unchanging and sometimes overrides a sense of good value for money. It is itself another major reason for the inherently destabilising nature of the financial industry, to the extent that it creates the credit for people to chase asset prices higher, and will always be so unless and until human nature changes.
The third factor contributing to the Great Financial Crisis of 2008 was inconsistency at the heart of monetary doctrine and policy. Ideological blind faith in the free market since Reagan and Thatcher has allowed the finance industry to ramp up its output unhindered over three decades, even though punctuated by a series of ever deeper busts. Worse, each time a debt build-up turned to bust, the authorities rushed to the rescue to mitigate the implied losses to creditors and investors, terrified of likely collateral damage to the real economy. But the very act of providing a lender-of-last-resort guarantee to the bankers has encouraged moral hazard, leading to a resumption of the lending binge with assumed impunity.
Since the 1980s central banks and governments have not dared interfere with the free market, however worrying the obvious symptoms of excess such as leverage ratios and galloping asset prices. By definition, the markets know best. But asset markets tend to crash every few years, and if left unattended, risk setting off a deep or prolonged economic recession and massive unemployment. The latter was the lesson learned from the Great Depression of the 1930s. So periodically the authorities have had to intervene after the event, to save the financial system from itself and from affecting the real economy.
Alan Greenspan famously remarked that because one could not tell when market excess had been reached, it was wrong to interfere pre-emptively. One could only know there had been a market aberration or price bubble after it had burst. Only then was it correct for the authorities to switch from being bystanders to becoming involved in mopping up the mess. This is a bit like saying that one should not get involved if someone starts experimenting with heroin as it is impossible to know if they are addicted until they are no longer able to function without constant ingestion of the drug, at which point one should try to wean them off it.
Somewhat mysteriously, the economic elite have remained wilfully blind to this self-contradiction in its system of beliefs – a perfect market needing occasional saving from itself – and have been obliged to tie themselves into intellectual knots to avoid recognising the obvious.
The combination of failing to pay any attention to the collective consequences of individual borrowing binges and refusing to allow the system to cleanse itself from the debt build-up in each cycle for fear of the consequences, has threatened to become terminal. By cutting out the ultimate downside of each burst bubble, the authorities have prioritised short-term avoidance of pain over the long-term gain that would ensue from pressing the reset button and purging the system of its excesses. Eventually, the accumulated mountain of debt became simply too big to deal with. All the king’s horses and all the king’s men, couldn’t put Humpty together again. In a Marxian sense, the system was planting the seeds of its own destruction.
Western economies may appear to have recovered from the last crisis as unemployment has fallen and growth has resumed. However, except for the minority who are asset rich or in jobs not yet threatened by cheap international labour or technology, standards of living remain stagnant and much of our public infrastructure is old and worn. To understand how we have arrived at this unhappy state of affairs, we need to revisit the negligence of the authorities faced with ever greater financial crises that risked spilling over into the real economy. Casino capitalism was underwritten by those in positions of power who failed to exercise their social and political responsibilities.
Alan Greenspan, cheerleader-in-chief for the finance industry in the 1980s and 90s, serenely presided over the inflation of arguably the greatest financial bubble in history, dazzled by the industry’s clever financial engineering, itself enabled by the arrival of powerful and cheap computing power. Sitting on top of the world’s most powerful central bank, with access to unparalleled resources, information and a veritable army of economics PhDs, he understood the rising risks only a little better than the investors who lost fortunes buying new complicated mortgages and the other opaque assets created by the bankers.
Speaking in October 2014, Greenspan welcomed a new pool of borrowers: ‘Improvements in lending practices, driven by information technology, have enabled lenders to reach out to households with previously unrecognised borrowing capabilities.’ Just a few years later, these new borrowers, later known as ‘sub-prime’, would prove unable to pay their debts. In defence of sitting-on-the-sidelines-do-nothing fatalism, he explained in his signature tortured prose:
But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.
The man with his hand on the money printing press attempted to reconcile his faith in the superiority of markets with the need to mop up their mess. This fatalistic doctrine was the truly pernicious and serious error of someone endowed with enormous powers. For Greenspan, that human nature is driven by greed inevitably leading to excess from time to time did not imply that one should strive to mitigate those excesses before they become catastrophic.
‘Bubbles are aspects of human nature, and you can try as hard as you like, you will not alter the path,’ Greenspan told the audience at Citigroup’s European credit conference via a video link from Washington.3 ‘I still hold to the general view that unless you have debts supporting the bubble, I would just let it alone because certain things about human nature cannot be changed and I’ve come to the conclusion this is one of them.’
Greenspan remained unapologetic about the tech bubble of the late 1990s, saying in a December 2002 speech that central banks had ‘little experience’ in dealing with market bubbles, and again that ‘dealing aggressively with the aftermath of a bubble’ was ‘likely to avert long-term damage’.4 He also suggested that history showed that taking action against a so-called bubble, such as in the stock market in 1929, could have devastating consequences in the form of triggering an economic depression.
As boss of the most powerful central bank, presiding over the world’s reserve currency, Greenspan set the tone for the rest of the developed world. No one dared challenge the markets and nearly everyone hurtled over the cliff behind this monetary pied piper.
The political roots of the GFC go back three decades to the free-market ideology and deregulation zealotry of the 1980s. As we’ve seen, this ideology was born from a reaction to the perceived failure of the previous system of fixed exchange rates, regulated markets, unionised labour and capital controls that culminated in the inflation of the 1970s.
Arguably, the real culprit for the problems of the 1970s was irresponsible monetary policy after the end of the Bretton Woods Agreement, contaminated by excessive spending by governments – to fund the Vietnam war in the US, for example. Whatever the pretext, it suited certain economic and political interests of the time to wrest back power by appealing to a plausible and respectable economic theory, albeit several centuries out of date, grounded in an era when the organisation of key economic units was very different.
President Reagan did not renew Paul Volcker’s mandate as Fed chairman in 1987. He understood that Volcker was at heart a rules-based disciplinarian rather than a fully paid-up member of the free-market party. He appointed in his place arch free-marketeer Greenspan, a friend and disciple of the ultra-conservative writer Ayn Rand.
The ideal social system, Rand believed, is laissez-faire capitalism. Economically, this means not today’s mixture of freedom and government controls but ‘a complete separation of state and economics, in the same way and for the same reasons as the separation of state and church’. In laissez-faire capitalism, Rand argued, ‘the government has only one function, albeit a vital one: to protect the rights of each individual by placing the retaliatory use of physical force under objective control’.5
There has been criticism of her ideas, especially from the political left, with critics blaming the economic crisis on her support of selfishness and free markets, particularly through her influence on Alan Greenspan.6 For example, Greenspan has opposed tariffs against China for its refusal to let the yuan rise, suggesting instead that any American workers displaced by Chinese trade could be compensated through unemployment insurance and retraining programmes.7
As we now know, this ideology only contributed to the degradation of Western workers’ share of national income, stagnant real wages and the massive accumulation of wealth and income in China.
The policy template that we are still ruled by today was set only a few months into Greenspan’s mandate. The Fed had raised its key Fed Funds (overnight interest) rate from around 6 per cent at the beginning of 1987 to 7.25 per cent in September. This halted a runaway speculative rally in the stock market that had jumped close to 35 per cent in the eight months to August without any fundamental justification. This asset bubble collapsed on 19 October 1987 in an unprecedented Wall Street one-day swoon of 22.6 per cent. The Greenspan Fed, in complete contradiction to Greenspan’s later pronouncements above, panicked and decided to shoot first and ask questions later: ‘Shortly after the crash, the Federal Reserve decided to intervene to prevent an even greater crisis. Short-term interest rates were instantly lowered to prevent a recession and banking crisis [my italics]. Remarkably, the markets recovered fairly quickly from the worst one-day stock market crash in history. Unlike after the stock market crash of 1929, the stock market quickly embarked on a bull run after the October crash.’8
This was in no small measure thanks to the Fed not only providing liquidity to the banking system and encouraging it to pass it on to stockbrokers, but also through a loosening of monetary policy in the form of cuts in interest rates. The Greenspan Fed feared the collateral damage on the real economy that the virtual financial system, represented by the stock market and the banks, could inflict.
In his semi-annual testimony to the House Banking Committee on 23 February 1988 Greenspan noted that the sudden loss in financial wealth and subsequent erosion of business and consumer confidence threatened to reduce spending. Greenspan reduced the rate again to 6.5 per cent in between the governing Federal Open Market Committee (FOMC)’s meetings in January and February 1988.
This increased liquidity, and the rapid U-turn on rate rises contributed to higher growth and inflation accelerating from 3.6 per cent in 1987 to 5.4 per cent in 1990. Of course, with the benefit of hindsight the Fed’s immediate relaxation of monetary policy after the 1987 crash looks questionable given the strength of the real economy. If anyone’s consumption was going to be drastically curtailed by the crash, it was that of the brokers and bankers on Wall Street rather than the shoppers on Main Street. One can attribute the Fed’s febrile reaction to wanting to take out insurance against the risk of disaster. The chairman recognised the power of the financial industry to make or break the economy. This set the precedent for the Fed’s rapid-response rescue of the stock market and the banks whenever these came under pressure in the ensuing busts caused by their imprudent profit-maximising behaviour.
The re-acceleration of growth forced the Fed to once again raise rates, this time to 9.75 per cent by March 1989. This exposed what had been a simmering problem in one corner of the financial industry: savings and loans institutions (S&Ls), mortgage providers similar to UK building societies. These lenders financed the fixed long-term mortgages they granted from short-term deposits. As interest rates rose in the late 1970s and early 1980s, S&Ls started to lose money because they borrowed much of their funds at the prevailing rate but lent mainly at fixed rates. As rates rose, the need to finance themselves at the newer higher rates overtook the rates they earned on the older loans they had already made, and some became insolvent. By 1982, S&Ls were losing $4 billion a year, down from a profit of $781 million in 1980.9 President Reagan’s solution was to deregulate them in the hope they could become more profitable by lending even more, and to riskier customers, to whom they could charge higher rates. This was a strategy that would turn round to bite them.
The 1982 Garn-St. Germain Depository Institutions Act solidified the elimination of the interest rate cap. It also permitted banks to have up to 40 per cent of their assets in commercial loans and 30 per cent in consumer loans. In particular, the law removed restrictions on loan-to-value ratios. That allowed the S&Ls to use federally insured deposits to make risky loans. At the same time, budget cuts reduced the regulatory staff at the Federal Home Loan Bank Board (FHLBB), which impaired its ability to investigate bad loans. Between 1982 and 1985, S&L assets increased by 56 per cent. Legislators in California, Texas and Florida passed laws allowing their S&Ls to invest in speculative real estate, while in Texas forty S&Ls tripled in size.
But as the Fed raised rates from 5.85 per cent in October 1986 to nearly 10 per cent by March 1989, briefly interrupted by the 1987 crash (see Figure 6.1 overleaf), the trickle of bankruptcies turned into a flood, especially as many of the S&Ls had over-expanded and taken more risk. In 1988 190 S&Ls went bust, up from 59 in 1987.10 From 1986 to 1995, the number of federally insured savings and loans in the United States declined from 3,234 to 1,645.11 This was primarily, but not exclusively, due to unsound real estate lending.12
Figure 6.1: Effective federal funds rate, US 1982–2016
It must be concluded that the savings and loan crisis reflected a massive public policy failure. The final cost of resolving failed S&Ls is estimated at just over $160 billion, including $132 billion from federal taxpayers and much of this cost could have been avoided if the government had had the political will to recognise its obligation to depositors in the early 1980s, rather than viewing the situation as an industry bail-out. Believing that the marketplace would provide its own discipline, the government used rapid deregulation and forbearance instead of taking steps to protect depositors. The government guarantee of insured deposits nonetheless exposed US taxpayers to the risk of loss while the profits made possible by deregulation and forbearance would accrue to the owners and managers of the savings and loans.13
The ensuing slowdown in the finance industry including real estate was probably a contributing cause to the 1990–1 recession. Between 1986 and 1991 the number of housing starts more than halved from about 2 million per year to less than 1 million, at the time the lowest rate for over 25 years.14 It is probable that this taxpayer-funded bail-out of the savings and loans institutions encouraged financial institutions to take risks in the knowledge that they would be rescued if required. The savings and loans crisis was a dress rehearsal for the real event less than two decades later.
The crisis in the S&L industry prompted the Fed to begin cutting interest rates in June 1989. This was not sufficient to avert a mild recession in 1990 (see Figure 6.1), although it is impossible to disentangle other contributory factors. The first Iraq War and the related spike in oil prices probably served to dampen sentiment in an economy that was already slowing down as the number of home loans fell and the accumulated rate rises of the last three years began to bite.
In spite of the fact that the 1990 recession was very mild, did not last long (see Figure 6.2 overleaf), and growth soon bounced back to 3 per cent in 1992, the Fed continued to aggressively slash interest rates to just under 3 per cent by December 1992 (Figure 6.1) and hold them there for over a year. No doubt the Fed was shaken by the crisis and the collapse of the home construction market and continued to ease to insure against further damage.
The massive cheapening in the cost of credit was like a red rag to the bull of Wall Street, and the banks lost little time identifying how to make the most profit from this gift, this time by channelling cheap money to the emerging markets of Mexico and south-east Asia. High growth and interest rates in these markets offered big opportunities to borrow at home at low rates and reinvest abroad at much higher rates.
Figure 6.2: US annual GDP growth
With US growth well on its way to 4 per cent, the Fed embarked on its next monetary tightening cycle in February 1994.
The Mexican crisis of 1994, sometimes referred to as the Tequila Crisis, is a case study in how the finance industry rushes to lend for short-term gain when conditions are good. It is also an example of how each economic unit behaves as if in a vacuum and ignores how its actions are replicated beyond the collective danger point by its peers. Each foreign loan and investment looked secure under the conditions of 1992–3, but ceased to be so if US rates rose beyond a certain threshold, with unintended consequences.
In 1992 the local interest rate in Mexico was 13.27 per cent compared to only 3.73 per cent on US treasury bills. This meant you could lock in almost 10 per cent per annum of profit by borrowing in the US and lending to Mexico. Unsurprisingly, this attracted a large flow of capital to Mexico. Joseph Whit has analysed what happened next: ‘By December 1993 foreign holdings had soared to 47.7 billion pesos, 66 per cent of the amount outstanding.’15 Clearly, this was a case of excessive and potentially destabilising lending, but no one paid any attention as short-term gains took priority.
By 1994, signs of political instability in Mexico, combined with the US Fed raising rates to 5 per cent and US bond yields rising sharply, caused a rapid reversal in the flow of funds out of Mexico, putting downward pressure on the Mexican peso’s fixed exchange rate to the US dollar.
Mexico’s central bank devalued the peso on 20 December 1994 to a lower band against the US dollar. However, the Mexican government’s loss of credibility prompted further outflows and loss of foreign reserves. Mexico abandoned the new rate and let the peso float freely only two days later. A crisis ensued as the currency plunged nearly 40 per cent compared to prior to the devaluation by the end of December, while inflation and some interest rates soared to over 24 per cent. By early 1995, it was evident that Mexico was heading for default as foreign holders would not roll over maturing debt. President Clinton was forced to arrange a rescue loan package with the IMF and the Bank of International Settlements worth in excess of $50 billion, rather than risk the collapse of its large neighbour.16
The US Fed cut its key interest rate (Fed Funds) from the peak of 6 per cent in April 1995 to 5.25 per cent by January 2006, probably to alleviate pressures on the US banking system from Mexico. The cuts did not seem justified by domestic American conditions, since the economy remained in rude health with growth close to 3 per cent and no sign of it tipping into recession. The Greenspan Fed was, once again, showing its acute sensitivity to the fortunes of banks and financial markets rather than the real economy, which promptly responded to this uncalled-for loosening of monetary policy by accelerating to a 4 per cent growth rate.
With Mexico a busted flush, the banks turned their attention elsewhere, looking for a new hunting ground for quick lending profits – this time to south-east Asia.
Undeterred by the outcome in Mexico, footloose money seeking higher rates of return poured into south-east Asia, where once again higher interest and growth rates were enticing investors to participate in the ‘Asian miracle’. Thailand, Indonesia and South Korea were flooded with US dollars, pushing up local asset prices.
Increasing capital inflows were required to keep asset prices and profits rising, in national versions of a Ponzi scheme. In Indonesia gross liabilities rose from $37 billion in 1993 to $60 billion in 1997. Similarly, external liabilities in Thailand rose from $34 billion to $98 billion over the period. At the same time, several countries such as Thailand were running large current-account deficits (−6.6 per cent of GDP), which made them acutely vulnerable to any loss of foreign investor confidence. By the end of 1996 the ratio of short-term debt to foreign reserves was over 100 per cent in Thailand, Korea and Indonesia.17
US interest rates started to edge up again in early 1997, and with them the US dollar. The same pattern as in the Tequila Crisis began to unfold. The flows of hot money dried up and then reversed, testing the fixed exchange rates of these countries to breaking point. A vicious circle took hold as Western creditors sought to repatriate their capital, causing a shortage of credit and bankruptcies. Countries depleted foreign exchange reserves to prevent their currencies from collapsing under the sudden weight of money outflows, but it was only a matter of time before the dam burst. The situation was made worse by governments raising interest rates in attempts to stop their currencies from collapsing, causing further bankruptcies. When this proved counterproductive, the authorities stopped defending their fixed exchange rates to the US dollar, letting their currencies depreciate.
The crisis struck when Thailand broke the fixed peg with the dollar and devalued the baht on 2 July 1997. The baht lost over half its value against the US dollar and Thailand’s stock market plummeted by 75 per cent. There were massive lay-offs of workers in real estate and construction. Once again countries had to go cap in hand to the IMF for assistance. In 1997 Thailand obtained a package arranged by the IMF worth about $17 billion, but the significant depreciation of its currency and the knock-on effects meant that GDP shrank by over 10 per cent in 1998.18
This led to regional contagion as foreign investors fled weak currencies. Even larger bail-outs had to be provided to Indonesia and South Korea, whose economies and markets were also hit and political leaders toppled. The Indonesian rupiah had fallen by 65 per cent by July 1998 compared to the end of 1997, and there was widespread social and political unrest culminating in the fall of President Suharto. Indonesia’s GDP shrank 14 per cent and inflation soared to 64 per cent in 1998. International institutions spearheaded by the IMF pledged over $30 billion to stabilise the country. Malaysia, South Korea and the Philippines were also hit as speculators rushed for the exit and companies went bust, weighed down by dollar debts they could not repay. The countries fell into recession. In some cases crisis measures restricting the flow of capital remained for many years.
Reflecting on the crisis in 2013, Michael Carson and John Clark of the Federal Reserve Bank of New York concluded,
as the crisis unfolded, it became clear that the strong growth record of these economies had masked important vulnerabilities. In particular, years of rapid domestic credit growth and inadequate supervisory oversight had resulted in a significant build-up of financial leverage and doubtful loans. Overheating domestic economies and real estate markets added to the risks and led to increased reliance on foreign savings, reflected in mounting current account deficits and a build-up in external debt … In response to the spreading crisis, the international community mobilised large loans totalling $118 billion for Thailand, Indonesia, and South Korea, and took other actions to stabilise the most affected countries. Financial support came from the International Monetary Fund, the World Bank, the Asian Development Bank, and governments in the Asia-Pacific region, Europe, and the United States.
Clearly even the most successful high-growth economies could run into serious trouble through over-leverage and excessive lending, at times to doubtful borrowers. Banks neither exercised the requisite prudence and rigorous lending standards case-by-case nor took into account the aggregation of their collective lending on the macro-economic stability of entire countries.
No sooner had the Asian crisis been contained, than the ensuing weakness in demand contributed to a crash in commodity prices. This set up the next domino to fall, Russia. Western banks and money management firms had been attracted not only by 40 per cent interest rates in a currency pegged to the US dollar, but also by the value of the assets up for grabs in the aftermath of the collapse of the Soviet Union.
Money managers described Russia as an ‘asset play’. There was a sense that, compared to elsewhere, assets such as barrels of oil or cubic metres of gas were significantly undervalued. Coinciding with a progressive relaxation in restrictions on foreign portfolio investment, the sense of improving economic prospects – of a short-term upside – led to a boom in foreign financial participation in 1997. Portfolio flows into the GKO (Russian government debt) market just in the first quarter of 1997 were more than three times the amount for the whole of 1996.19 By late 1997, roughly 30 per cent of the GKO market was accounted for by non-residents.20
In contrast to south-east Asia, the rush to invest in Russia was not a story of high growth and profitability; quite the reverse. Since the collapse of the Soviet Union, the economy had been shrinking dramatically and the government running high budget deficits, due in part to the widespread non-payment of tax. In this case the rush of capital was partly a ‘recovery story’, but also a cynical short-term ploy to exploit the unsustainable anomaly of high interest rates available in a currency with a fixed exchange rate to the dollar. The assumption was that once this arrangement failed, as it was likely to, the West would bail it out. In other words, the banks were assuming that governments would pay the bill to save the system after they had milked all the profits they could.
In October 1997 the Russian government was counting on 2 per cent economic growth in 1998 to compensate for debt growth, and the economy was showing signs of turning the corner, offering some basis for the recovery rationale for investment. Unfortunately, events began to unfold that would further strain Russia’s economy. The collapse of its main source of revenue, the oil price, to eleven dollars per barrel by May 1998 meant that Russia had little hope of paying the high rates of interest demanded by its creditors on the mountain of Soviet-era debt, let alone servicing more recent high-maintenance Western credits. The failure to agree an aid package with the IMF, as well as the collapse of a meeting between Lawrence Summers of the US and the Russian prime minister, rattled investor sentiment even further.
In August 1998, after recording its first year of positive economic growth since the fall of the Soviet Union, Russia was forced to default on its sovereign debt, devalue the rouble and declare a suspension of payments by commercial banks to foreign creditors. In what was by now becoming a familiar pattern, the Russian rouble collapsed from around five to the dollar to twenty-five, and the stock market gave up 75 per cent of its value. Instead of growth in 1998, real GDP declined by 4.9 per cent.
On their own, the Asian and Russian crises could have been contained without major consequences for the rest of the world. However, by this point the financial system was globally interlinked, not only by footloose capital hungrily scouring the globe for large profit opportunities, but also indirectly in the form of speculative positions taken by leveraged investors such as hedge funds and bank trading desks, betting on the relative price movements between various instruments and investments affected by macroeconomic factors such as interest and exchange rates. These positions were often partly financed with credit provided by the major Western banks, in what was beginning to resemble a global casino played with ultra-high stakes.
The next domino to fall, out of the blue and as a consequence of the Asian and Russian crises, was the comically misnamed hedge fund Long Term Capital Management (LTCM). Advised and managed by a star-studded cast of Nobel laureates and big-name traders like John Meriwether, LTCM had placed big bets that the level of risks in the debt markets would reduce. These were showing quite high readings after the Mexican and Asian crises, so they bet that these would revert to more normal, subdued levels. In other words, things would calm down in the financial markets now that the storm was over. They were so confident that normal service would resume, as it had in the past, that they bet around $30 for every $1 of real investor capital in the fund. This very high leverage meant any 1 per cent move up or down in the value of its underlying positions was magnified thirty times in terms of the fund’s profit or loss.
LTCM lost 44 per cent of its capital in August 1998 when Russia defaulted on its debt, and by early September it was widely known to be in deep trouble. A collapse of its $4.6 billion fund would have caused it to default on its contracts with banks and brokers, and the ripple effect could have led to a general meltdown of the financial system. Aware of the stakes, the Fed engineered a $3.625 billion bail-out of the fund by a consortium of fourteen financial institutions, all but wiping out the original partners and investors. LTCM’s positions were liquidated in an orderly fashion over the following months.
Although the Fed was careful not to contribute any of its own money to the bail-out, it did reduce its key lending rate from 5.5 per cent in September 1998 to 4.625 per cent by January 1999 even though the US was growing at over 4 per cent in real terms. In other words, it once again loosened monetary policy to protect Wall Street, even though Main Street was doing fine. When push came to shove, the American central bank’s priority was to save the banks rather than follow the real economy.
The cutting of interest rates and bail-out of LTCM even when the economy was healthy encouraged financial markets to think that the Fed would always intervene to safeguard the banks and brokers on Wall Street. This assumed guarantee became known as the ‘Greenspan put’, a term for the notion that, to prevent the entire edifice from crumbling, Wall Street would always be bailed out by the authorities if the giant banks, seen as too big to fail, placed huge bets that went wrong. Technically, a ‘put’ is an option to sell an asset at a predetermined price, thereby limiting an investor’s loss. In this context, investors assumed that, if the market fell below a certain level, the Fed would limit their losses by taking supportive measures.
Slashing interest rates to relieve the pressure on the banks amounted to pouring kerosene onto an already roaring stock market fire. This undoubtedly contributed to the last leg of the technology stocks mania that inflated the market to unprecedented levels of speculation in late 1999, with prices that bore no relation to the reality of underlying company profits and growth rates.
Led by technology, media and telecom companies, which were seen as the vanguard of the new digital ‘weightless economy’, the market took off, creating the ‘TMT bubble’. It was telling that the authorities could not even see it, so much were they enthralled and dazzled by the brave new world. Conventional yardsticks of market valuation, such as the price-to-earnings ratio, were dismissed as inapplicable to the new age. Cheerleaders for the market defended its ridiculously expensive levels with the mantra ‘this time is different’ and that old-timers simply ‘didn’t get it.’
As it became clear that the financial system had been saved and the economy was once more in danger of overheating, the Fed had to play catch-up once again, and raised its interest rates to a peak of 6.5 per cent in June 2000. This was enough to decisively prick the TMT bubble, which began to deflate from its March 2000 peak. The accumulation of interest rate hikes by the Fed was too much for such a speculative market built on cheap money. The stock market started to fall as rapidly as it had gone up, this time tipping the US economy into recession in March 2001. The Fed once again performed a quick U-turn, slashing interest rates down almost 3 per cent to 3.65 per cent by August 2001.
The terrorist attacks of 11 September 2001 only dampened sentiment further, and the stock market continued to plummet. By early 2002, the Fed had cut rates to below 2 per cent, the lowest since the 1960s. The real economy bottomed out a few months later. The US Labor Department estimates that around 2.25 million jobs were lost as the unemployment rate moved up from 4.2 per cent in February 2001 to 6.3 per cent by March 2003. The stock market fell further as business losses at some of the technology darlings of the market, such as Enron and WorldCom, revealed accounting fraud that could no longer be concealed by rising asset prices. By early October 2002 the US stock market had halved from its crazy highs of only thirty-one months earlier.
In spite of the stabilisation of the real economy, the Fed continued to cut interest rates to a low of 1 per cent by early 2003, as the second Iraq War, which was to topple Saddam Hussein, got under way, pressuring the stock market further. This provided further evidence of where the Fed’s priorities lay. Its actions betrayed a tacit acknowledgement that the Frankenstein’s monster of finance it had created was now so big as to threaten the real economy. The tail had grown large enough to wag the dog.
Ominously, Greenspan stated that the drops in rates would have the effect of leading to a surge in home sales and refinancing, adding, ‘Besides sustaining the demand for new construction, mortgage markets have also been a powerful stabilising force over the past two years of economic distress by facilitating the extraction of some of the equity that homeowners have built up over the years.’21 In other words, ‘Bring on the debt!’
Greenspan’s latest and most reckless brainwave to dope the US economy back to apparent health by dropping rates to historic lows, stimulating property inflation and enabling consumers to spend more by using their homes as ATM machines, contributed to the next great bubble, this time in housing. The chief financial fireman had turned serial pyromaniac.
The Federal Reserve acknowledged the connection between lower interest rates, higher home values and the increased liquidity that higher home prices bring to the overall economy: ‘Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission.’
In a speech in February 2004 Greenspan suggested that more homeowners should consider taking out adjustable-rate mortgages (ARMs), where the interest rate adjusts itself to the current interest in the market.22 The Fed’s own funds rate was at a then all-time low of 1 per cent. A few months after his recommendation, with total disregard for those he had advised, Greenspan began raising interest rates in a series of hikes that would bring the funds rate to 5.25 per cent about two years later. A triggering factor in the 2007 sub-prime mortgage financial crisis is believed to be the many sub-prime ARMs that reset at much higher interest rates than the borrower paid during the first few years of their mortgages.
The situation was succinctly summed up by Alex J. Pollock: ‘The so-called “Great Moderation,” for which our fiat-currency central bankers gave themselves so much credit, turned out to be the Era of Great Bubbles. The US, in successive decades, had the Tech Stock Bubble and then the disastrous Housing Bubble. Other countries had real estate and government debt bubbles.’23 He also questioned Alan Greenspan’s role in guiding the macro-economy to a happy outcome: ‘The idea that anybody, no matter how talented, could really be such a Maestro is ridiculous, just as the idea that national house prices could never fall was ridiculous – but both were widely believed and expressed nonetheless. The central bankers, working diligently for their concept of economic Moderation, presided over the Era of Great Bubbles. Is this coincidence? Or does the one cause the other?’
The ready availability of credit combined with inexorably declining interest rates triggered a succession of cycles of over-expansion of credit and market speculation followed by busts and government bail-outs. Each time the financial industry picked on a different sector or region ripe for the massive lending that would satisfy its insatiable appetite for higher profits. Each time the chosen sector borrowed up to the point where it could no longer service its debt without further injections of credit. Each time, as the flow of new credit fell below the level needed to keep the show on the road, a financial crisis occurred. With banks operating with very small reserves and little capital, the imploding sector threatened a collapse of the banking system as the weakest creditors went bankrupt first, dragging down the rest through a domino effect.
While the Volcker Fed in the early 1980s was willing to let rising interest rates purge monetary excesses out of the system, even at the price of some temporary collateral damage to the economy, his successors, starting with Alan Greenspan, adopted a much more protective approach towards Wall Street and the consequences of its excesses. With little stomach for potential damage to the real economy from the implosion of over-extended creditors (and debtors), the US Fed panicked, flooring interest rates or flooding the market with money every time a bubble burst. And the more it repeated this behaviour, the more bankers and borrowers threw caution to the wind in the reassuring knowledge that the Fed would be there for them if things went wrong – thereby ensuring that things would indeed go wrong.
A credit binge (such as occurred between 1980 and 2007), during which debt increases faster than income thanks to falling interest rates, at some point becomes unsustainable because ever more monetary stimulation is needed after each cyclical bust. There is a limit to how far interest rates can fall without triggering inflation, either of the traditional kind or in assets such as equities, property, land or commodities, as everyone tries to get rid of zero-or negative-yielding (after inflation) cash by buying claims on real things that cannot be created at the click of a mouse. If the cost of money cannot fall further, then at some point credit growth relative to income has to cease, since the market runs out of Minsky’s ‘hedge’ borrowers (those that can service their loans from income rather than from capital gains on the levered asset they have bought) at current prices.
Although the lending machine can prolong the game by extending loans to borrowers whose only hope of servicing and repaying the debt is by selling the assets they have bought at a profit (Minsky’s ‘speculative economy’), at this point the system becomes totally unstable and fragile. Any slight hiccup, such as a rise in interest rates which renders some borrowers insolvent, brings down the entire house of cards as these borrowers are forced to sell, thereby interrupting the rise in prices needed to keep speculative high-risk borrowers solvent.
What was a virtuous circle of new debt pushing up asset prices, thus attracting new borrowing to buy assets, turns into a vicious circle of asset sales and debt liquidation and profits turning into losses for those borrowers and creditors who do not get repaid 100 per cent on their loans. Left to its own devices, this downward spiral can have catastrophic consequences; witness the events of the Great Depression in the 1930s, when the economy shrank, people lost their jobs, poverty increased and wealth was destroyed. No wonder central bankers will do whatever it takes to avoid such an end game.
What is ominous today is that the trauma of the last crisis has altered central banks’ behaviour. Alert and sensitive to the risk of raising interest rates to the point where the bloated credit structures collapse, they are now determined to hold off raising interest rates to a level that might trigger a recession, for fear of the consequences. In fact, they may never do so for a generation (as in Japan), so heavy is the debt burden and so anaemic the forces of growth. This means that debt levels continue to rise and are tolerated for fear of the consequences were the system to be reset. Global debt has climbed by $100 trillion since just before the GFC to $240 trillion.24 So much for learning its lessons.
The received wisdom is that we cannot purge the system of excessive debt through write-offs or bankruptcies for fear of severe collateral damage to the economy. But failure to purge encourages a further accumulation of debt, creating the conditions for a final catastrophic bust. In the first stage of debt bubble inflation the commercial banks were prisoners of their clients. In the terminal stage, which we have reached, the central banks are caught in a monetary catch-22. To purge the system of debt would create a crash, but not to purge it will create a crash because of the debt. They have lost control of the debt in the system, which has become a financial Frankenstein’s monster.
By now it should be obvious that the bursting of the US and European real estate and mortgage debt bubble in 2008 was not an isolated incident in time or geography. It was the dramatic apotheosis of a build-up of global debt over several decades and economic cycles. Japan holds the dubious distinction of leading the way, with the implosion of its real estate bubble in the 1990s, from which it has yet to recover fully. Western countries were eager to throw stones at Japan’s foolishness without noticing that they were living in a glass house which duly shattered.
Finance benefited on several fronts while the going was good. Falling rates raised the value of real estate, equities and bonds, igniting a bull market in tradable assets. As the croupiers in the casino, banks and brokers profited handsomely from all manner of fees and commissions. Initial public offerings from private companies, the privatisation of public enterprises on stock exchanges, corporate mergers and acquisitions and public debt issuance were just some of the services that provided rich pickings.
The real estate bubble of the noughties was the last straw that killed off once and for all the Western model of debt-fuelled growth, but credit growth had been outstripping the economy ever since deregulation became all the rage in the 1980s and interest rates embarked on their long downward trend. If they ran out of borrowers at home, lenders found willing takers for credit abroad. The credit creation machine found new victims for its wares, in excessive numbers, in each cycle. As one client base went bankrupt, it found other eager takers to sell to. And when each successive bubble burst, Western governments and central banks were willing to pick up the tab to prevent the unsavoury knock-on consequences for their economies as a whole.
Underpinning everything was the dominant faith in deregulation and a market-knows-best philosophy. It is no coincidence that the first market earthquake since 1929 – the Wall Street crash of 1987 – occurred so soon after the red-blooded no-holds-barred free market ideology had taken hold, nor that it was followed in 1990 by the US Savings and Loan crisis, when the authorities were forced to bail out the financial system for the first time in generations. Far from the market disciplining itself, as it should have done according to idealised economic theory, the demand for credit tested the market’s resilience to destruction every few years in a series of rolling credit crises triggered by repeating cycles of credit expansion, albeit targeted at different areas each time.
While there was nothing new about credit crises, the frequency of the crises, their increasing severity and the ever more desperate and extreme measures taken to prevent the consequences of them was of an entirely different order. Moreover, in complete contradiction to the market fundamentalism of the times, governments cut off the downside of each crisis by pouring huge sums of money into the system to shore up both debtors and creditors when defaults threatened to plunge the real economy into depression. This encouraged massive and irresponsible risk-taking by creditors and investors, who knew that ‘Heads I win, tails you lose.’ The building into the economy of such complacency, politely termed ‘moral hazard’, or more cynically ‘the Greenspan put’, sowed the seeds of the next crisis. More importantly, it was the transmission mechanism for a reverse Robin Hood effect: robbing the poor to give to the rich.
The simple fact is this: financial markets have no track record of exercising self-restraint. Once they latch on to a profit opportunity, they will pursue it to destruction.
The Great Financial Crisis (GFC) of 2008 was the financial crisis to end all financial crises, or so it seemed. The financial equivalent of the First World War, it nearly blew up the world economy. Just as the assassination of Archduke Ferdinand in Sarajevo is often referred to as the spark that led to the conflagration of the First World War, a small, apparently localised financial accident set off a chain reaction that led to the effective bankruptcy of the global financial system. Only a massive taxpayer-led bail-out of banks and the printing of gargantuan sums of money by the major central banks saved the global economy from disaster.
As we have seen, after the technology bubble burst in 2002, the Greenspan Fed was desperate to avert an economic downside by slashing interest rates to 1 per cent and encouraging a re-leveraging of the economy. Having all but blown up the corporate sector, banks switched their attention to households and the housing market. With interest rates at new lows, they easily found eager borrowers who could now afford mortgages to get on to the property ladder. The phrase ‘as safe as houses’ did not exist for nothing, and it was well known that house prices always rise, at least in nominal terms.
Finance for house purchases was deemed safe given increasing property prices brought about by more freely available credit. While each mortgage decision may have been carefully considered in the early days of the expansion, credit growth that far exceeded economic growth necessarily meant that the quality of loans had to deteriorate at some point. But to each lender this was not obvious: the collective effect of ever more credit was house price inflation that validated the creditworthiness of even marginal borrowers. But for house prices to continue to rise at a rate required to justify the solvency of the related debt, ever more borrowers had to be found.
For Hyman Minsky, pro-cyclical behaviour is characteristic of lenders and borrowers, such that instability is baked into the free market system.
Whenever full employment is achieved and sustained, businessmen and bankers, heartened by success, tend to accept larger doses of debt financing … profit seeking financial institutions invent and reinvent ‘new’ forms of money … and financing techniques … this results in higher prices of assets, which, in turn, raises the demand price for current investment, and increases the finance available for investment … An investment boom leads to a financial structure that is conducive to financial crises.25
As we’ve already seen, this infernal mechanism in effect turned into a giant Ponzi scheme in several countries. New buyers on credit had to be sucked into the housing market by the promise of capital gains in order to validate the assumptions of the rising prices needed to support the creditworthiness of many existing debtors and support the prices of mortgage-backed securities that had been sold to investors. Doped on debt, new home sales in the US rocketed from around 600,000 per year on average to more than double that after 2000.
At some point all this was bound to blow up, either because the market ran out of buyers and borrowers, because rising bad loans started to impact lenders and investors in mortgage-related securities, or because interest rates rose.
Home ownership peaked in the US at 69 per cent in 2006.26 Interest rates had been rising slowly since the last cyclical low in 2003. Oblivious of the dangers and the mounting instability of the system it had condoned, the Fed continued to raise interest rates into 2007. Rising rates cause a triple whammy on the property market by increasing the cost of purchase, reducing demand and damaging the creditworthiness of existing marginal borrowers who had come into the market at lower rates and needed to refinance themselves at higher rates.
The system reached a tipping point in 2007, surprising everyone, as interest rates had topped out just over 5 per cent, lower than the peak of the previous cycle, and the credit creation machine abruptly went into reverse. Delinquent borrowers and their creditors were forced to sell the properties held as security. Property prices fell, forcing the next layer of borrowers into distress as the value of their debts exceeded that of their assets.
In July 2007 Wall Street investment bank Bear Stearns announced that two of its hedge funds had imploded because of the fall in the value of their investments in mortgage-backed securities – securities sold to investors which consist of bundles of mortgages offloaded by the banks. Economist Mark Zandi wrote that this 2007 event was arguably ‘the proximate catalyst’ for the financial market disruption that followed.27
The news had a ripple effect through the financial system. The price of similar securities fell, which in turn impacted lenders unable to refinance their holdings of such securities. House prices tumbled as cheap mortgage finance packaged into securities dried up through lack of buyers. Lower property values in turn affected the collateral value of other mortgages, reducing their credit quality and hence the ability of leveraged investors to refinance their positions, causing another downward turn in the financial death spiral. This was the mirror image of the upward spiral of credit creation that had been prescribed to save the economy from the bursting of the technology bubble.
Unlike previous financial crises, which had been largely confined to the banks of a few countries, the shock waves of the imploding US housing market not only threatened to drag the US banking system into insolvency, but quickly spread to Europe and Asia. Not only had financial globalisation reached such an advanced stage that banks and insurance companies across the globe had become intertwined, financing and guaranteeing each other’s assets, but many had also participated in the rapid creation of credit in their respective countries. The high degree of leverage that had built up across the global financial system eroded any margin of safety that would have previously existed in regions with lower leverage. As investors saw how interdependent the banks and the loans they had made to households for house purchases were, confidence eroded. One by one, banks failed, and with no end in sight to this dynamic, panic set in.
Out of the blue, in September 2007 Northern Rock, a second-tier UK mortgage bank, suffered a run, as it could no longer finance its mortgage book in the wholesale money markets. It was taken over by the British government.
The chain reaction of failures in the financial markets gathered pace as money market funds, essentially pooled cash funds that retail investors thought were safe, ‘broke the buck’ – fell below 100 per cent of the value of the cash paid in. These funds held securities of banks or finance houses that had exposure to some of the mortgage-related securities falling in value. As nervous investors in these funds tried to get their cash out, the funds could not buy any more mortgage-backed securities, so fewer new mortgages could be created. House prices came under more pressure, and marginal debtors were unable to service their debts or refinance because the value of their properties had fallen below the value of their loans. The dominoes were falling.
By March 2008, the crisis has found its way back to its origins, Bear Stearns, as rumours spread about its inability to fund a balance sheet that was leveraged thirty-six times with many unsaleable illiquid assets. Banks are a confidence trick. Lack of confidence becomes self-fulfilling. The New York Fed arranged for the bank to be sold for $10 a share (down from $172 in January 2007) to JPMorgan. Famously, Bear Stearns CEO James Cayne was at a bridge tournament during the final days of the bank, clearly failing to grasp the enormity of the situation.
Other banks began to eye each other, wondering what suspect securities they might own. In a classic case of the pernicious effects of the generalisation principle in markets, what appeared a rational decision by each bank individually – to reduce risk by reducing its credit exposure to other banks – became catastrophic when all the banks made the same decision, as no banks could finance themselves adequately. The system was on the edge of collapse with the real danger over the weekend of 18 September 2008 that customers in the UK would not be able to take cash out of ATMs.
The finance industry had manufactured an inordinate amount of credit. It had also transformed part of this into complicated and opaque structures that could be bought, sold and distributed across the world to every type of investor. From retail savers in money market funds to large insurance companies such as AIG in the US, who ‘guaranteed’ the creditworthiness of these securities for other financial institutions, nearly everyone stood to lose once the weakest link snapped and the music stopped as investors tried to pass the parcel. The contagion was inevitable and unprecedented. This was a truly global crisis, whose repercussions continue to constrain the global economy and undermine faith in democracy and its institutions to this very day.
The seeds of the GFC were planted by an uncritical espousal of the deregulated market – including the finance industry, with all its perverse incentives and destabilising tendencies – by the central banks and the political elite. But it was the impunity with which bankers and brokers operated – in the knowledge that the authorities would bail them out – coupled with the refusal to limit credit creation, that was a major cause of the disaster. The political system of the West had malfunctioned because its power had been usurped by the finance industry.
The implicit social contract of democracy, whereby the people freely elect a government that will represent their interests nationally, no longer held. In thrall to the markets, governments and central bankers failed to check changes that undermined their citizens’ incomes and welfare. Not only were good jobs lost, but national infrastructure was eroded as public bodies ran short of funds. This became glaringly obvious in the case of public services: underfunded and stretched health services, relegation down international league tables of educational attainment, the inability to fund university education or maintain a good road and bridge network. The list goes on.
The second cause of the crisis was collateral damage resulting from the massive transfer of good-quality manufacturing capacity and jobs to low-cost developing countries such as Mexico, Thailand and above all China. This is globalisation under cover of the free market principle, and was sold to a population not well schooled in the principles of economics as a means to benefit from the availability of cheaper goods. However, as the growth in real wages of Western labour was eaten away, even cheap goods were not enough to sustain a rising standard of living for many, leading to a growing demand for credit.
The bottom line was a massive transfer of wealth from West to East and a considerable widening in the US and UK trade deficits, as consumers had to buy goods now made abroad on credit provided by industrious and thrifty workers in developing countries. Putting it more crudely, the Chinese (principally) embarked on a massive vendor-financing scheme, reinvesting their trade surplus and savings from their new-found industrial jobs into Western financial markets, thereby providing money for their impoverished customers to borrow to buy their goods.
Last but not least, none of this would have occurred had elected governments not been seduced by business. Instead of protecting the long-term interests of constituents and consumers, politicians were lobbied by, and accepted campaign funds from, companies. In many cases corporations pushed for unregulated globalisation in order to maximise their profits – manufacturing cheaply abroad and selling this output expensively back home. As usual, where the US led, others were happy to follow. Corporate titans stuffed each other’s remuneration committees with their executives who awarded themselves generous stock options and bonuses tied to company earnings per share. Globalisation turbocharged company earnings growth, top executive income sky-rocketed relative to that of their workers, and inequality widened to levels not seen since the 1920s.
While this functioned for a while, it was doomed to collapse under the basic contradiction that domestic consumers could not continue to buy goods at expensive Western prices if they were no longer earning high wages from Western-based production. Plugging the gap with debt could only work for so long.
The GFC was no isolated accident, but the latest, and greatest, in a series of crises that have recurred every five to eight years with the threat of increasingly dire consequences for the global economy. It was the culmination of a prolonged and inexorable build-up of debt in Western countries through several economic cycles. This excessive debt created bubbles of overvalued assets and liabilities that could no longer be serviced when the interest rate cycle turned up. That these bubbles were allowed to inflate time after time reflected the free-market fundamentalism of the epoch, famously expressed by Fed chairman Greenspan’s extraordinary dogma that bubbles could not be spotted in advance.
Even today it is impossible to quantify the cost of the GFC, not only in money but in human suffering, of hopes and lives wrecked. In the US the cost of just one of several government assistance programmes – the Troubled Assets Relief Program (TARP) – amounted to $700 billion. The government also bailed out General Motors and the giant insurer AIG. Central banks spent trillions of dollars buying government and other bonds to provide cash for the system and lower the cost of credit by reducing bond yields.
While the US government claims that it has recouped more money than it provided under TARP and so made a profit for taxpayers, this is a misleading picture of the current state of affairs.28 According to a study published in August 2018 by the Federal Reserve Bank of San Francisco, the GFC will have cost the average American around $70,000 in lifetime income. In the UK, according to the National Audit Office, total support for the banks during the GFC amounted to over half of the size of one year’s production by the economy (GNP) – over £1 trillion. In the UK, as we have seen, the average worker has suffered years of lower real earnings.
What we do know is that the cost of saving the economic and political system can be measured in terms of the vast transfer of debt from the private to the public sector (taxpayers present and future). In other words, most Western governments took on massive amounts of debt as they spent to bail out banks and other large companies that would have gone under, and on unemployment benefits and other safety nets for those who lost their jobs or homes due to the crisis.
US public debt ballooned from around 31 per cent of GDP in the early 1980s to an estimated 106 per cent of GDP in 2017 with a leap of 30 per cent during the crisis years of 2007–10.29 A similar pattern occurred in the UK, with national debt rising from less than 40 per cent of GDP in 2007 to nearly 90 per cent by 2018. Although UK public debt was higher relative to the economy after the Second World War, this was quickly brought under control by decent growth in the 1950s and 1960s. Today, this does not appear likely to recur.30
The massive rise in government debt has mortgaged the future of entire nations. Not only are the UK and US governments so much in debt they will not be able to help out should another crisis come along, but the debt inhibits them from investing in education, public services and infrastructure.
But government bail-outs were not enough on their own to prevent a collapse of the system. Central banks also had to print money and spend it on buying government and private-sector bonds. As a consequence, the Bank of England’s balance sheet, bloated by the purchase of debt, rocketed from around £77 billion in 2007 to £359.3 billion in October 2018. This is paltry compared to the Eurozone and the US, where central bankers have printed around €3.6 trillion and $3.7 trillion respectively since 2007.31 These are colossal sums disbursed by public institutions to save the banks, and in so doing have jacked up the value of stock markets and property.
The winners in the West have been the well-to-do, who only suffered a brief flutter of anxiety. Everyone else remains trapped in a web of low or no-growth wages, decaying public services and rising social and political disenchantment and violence. Political institutions have fallen into disrepute, unable to quell growing disaffection with current economic and political systems. It is to politics that we now turn in Part Three.