CHAPTER
1
The Rise and Fall of the Finance-Driven Economy
Where We Are Today
Hegel remarks somewhere “all great world-historic facts … appear twice”; he forgot to add the first time as tragedy, the second time as farce.
—Karl Marx, The Eighteenth Brumaire of Louis Bonaparte (1852)
“Occupy Wall Street” does not quite seem credible as a revolution that can overthrow capitalism, at least not yet. However, the finance-driven economy that transformed America and the world between the early 1980s and the financial market meltdown appears irretrievably broken. The critical question for our economic and political future is whether or not the broken financial markets of today can be mended, by themselves or by the politicians. If they cannot be, we are likely to see a “world without finance” in our future with profound consequences for workers, savers, investors, and employers … in a word, all of us.
Some years ago, Queen Elizabeth voiced a question that no doubt occupied many minds: why did nobody in the economics profession see the global financial crisis coming? Of course, more than one professional economist did see disturbing trends in the data, but in general, history is often a better guide to understanding where events might take us. As Harvard historian Niall Ferguson once put it, “Yet a cat may look at a king, and sometimes a historian can challenge an economist.”
The lessons of history are constantly being revisited and debated by professional historians. This chapter is not a part of that debate. But even a layman can and should use history, which is after all our common memory as a society, to understand our present and make decisions about our future. So even a layman can thread together a narrative about how the current and continuing crisis will most likely play out.
The current crisis is not the first time the global financial system has effectively collapsed. Fortunately or unfortunately, the world has lived through the rise and fall of a finance-driven economy before. The real question is whether we have learned anything useful from the experience and whether we can avoid repeating the worst outcomes of the original tragedy.
It is somewhat surreal to think of how the leaders of global finance were Masters of the Universe only a few years ago. Today, bankers are demonized, and the very legitimacy and social usefulness of the financial markets and the firms and people that work in them is challenged from every quarter. In fact, “anti-capitalism” has reemerged from the dustbin of history.
Nobody who lived through the Cold War and marveled at the collapse of revolutionary socialism (i.e., communism) as a real-world alternative to capitalist democracy in 1989–1991 ever expected to see so many neo-Marxist slogans brandished by protesters “occupying Wall Street” just over 20 years later. Nor did it seem possible that seas of red flags with a hammer and sickle would flood the streets of Athens and Rome. But not only is the backlash against global finance capitalism very real, it is growing, and more than a few members of the political class and media are hoping it succeeds.
What Karl Can Teach Us
None of us should be surprised that anti-capitalism, even Marxism, is in the air again. Marx never entirely goes away, partially because he remains a great and original observer of how the world really works, including how politics follows economics. His critique of capitalism, a term he more or less defined, may be wrong. But it is not stupid. And he knew how to learn from history.
Marx’s world was shaped by two revolutions, one political and one economic. The French Revolution, which destroyed the old order in all of Europe, grew out of a deep economic crisis that was a direct result of France spending too much and borrowing too much, mostly to finance war. To Marx, the tragedy of the French Revolution was that after ten years it was hijacked by Napoleon (the first 18th Brumaire was Bonaparte’s seizure of power in 1799). The farce was his nephew Louis Bonaparte’s seizure of power 1851, shutting down the far less radical Revolution of 1848. Both men paid lip service to the ideals of the French Revolution, including equality. Both were opportunists who used crises to grab power. But only the original Bonaparte’s coup mattered enough to be tragic.
Perceptive as Marx could be about politics, his real project was making sense of the economic revolution that was unfolding before his eyes. This is not so much the so-called industrial revolution we learned about in school (presuming anyone is still taught history), but the rise of global finance capital. His big idea, grossly simplified, was that capital was a force unto itself, and a very destructive one. Basically, capital (today we talk about “wealth”) gets concentrated in fewer and fewer hands through market competition, capturing larger and larger portions of income and beggaring labor, the real source of value. Overproduction and speculation lead to ever more severe and frequent economic crises. The capitalist system’s contradictions lead to its own demise as the conditions of the masses become intolerable.
A key factor in this process, one that Marx took for granted as a resident of Victorian Britain, was that capital flowed freely around the world, ruthlessly seeking the highest returns. In other words, there was a global financial marketplace that allowed capital to become concentrated into fewer and fewer hands. Of course, today we call integration of markets for goods, services, and money “globalization,” and for much of the last decade we have debated whether it was a good thing or a bad thing. Actually, to the Victorians, including Marx, global markets were a fact of life, and barriers to moving capital were almost nonexistent. Between 1815 and 1914, especially in the second half of the period, the combination of a British Empire committed to free trade, the pound sterling backed by gold as anchor currency for the world, and London as the world’s money market allowed capital to go anywhere it could make a good return. Contemporaries called this system of free markets and the limited constitutional government that went with it liberalism, almost the opposite of how the word is used in America today.
Looking back, in this first great age of globalization, finance capital radiating out of London built the modern industrial world and ushered in the greatest rise in living standards in human history. It also ushered in a very wretched industrial working class. Looking at it up close from Marx’s perspective, and he was scarcely alone at the time or since, the old rhythms of agriculture and artisan production were replaced by an icy “cash nexus” where human beings were reduced to lumps of labor for capital to exploit. The gap between rich and poor was becoming intolerable, and financial booms and busts followed by deep downturns in the real economy more frequent and extreme. Surely the revolution would come … only it didn’t. Instead, the Great Powers, including liberal England, went to war with each other.
The First World War almost put an end to liberal order and the first great age of global finance capital, but its immediate effect was to kill off the reactionary empires of Europe, Russia, Austria-Hungary, Germany, and Turkey. Revolution, where it did come, was the product of military defeat, not the revolt of “the 99 percent.” The great goal of the war’s victors, especially the United States, who got in late and came out rich and powerful, was to get back to what Warren Harding famously called “normalcy.” It seemed obvious that the global financial system that had been in place before the war could and should be put back together. This meant that countries that had moved off the gold standard during the conflict would get back on it as quickly as possible, and that means would be found to work off the mountains of government debt the war had generated. The big difference was that it was New York, not London, that held the keys of the global financial system. Having been a destination of global finance capital for a century, America became the world’s creditor as well as the biggest industrial economy. For a while it worked: global capital flows were eventually rejiggered, so the Americans loaned money to the Germans so the Germans could pay enough in reparations to the French and British to service the huge sums they had borrowed in New York during the war. Of course, nobody was really paying what was owed, but a booming Wall Street kept the money flowing.
And Wall Street did boom, partially in response to pro-business policies in Washington, but mainly in response to a whole wave of new technologies being transformed into mass consumption goods such as automobiles and radios. A new type of credit, consumer finance, emerged to make the new goods affordable. Stocks seemed to only go in one direction, up. So did paper wealth, at least among those fortunate enough to have the money to play the market. Real estate prices followed stocks up. America was awash in money.
Beneath the Wall Street froth, however, all was not well on Main Street. Leveraging new technologies and methods of doing work, such as the assembly line, industrial productivity (the hours of labor needed to produce something) was outstripping wages and purchasing power. Farms and small-town banks failed in droves during the Roaring Twenties. Few noticed, but the economy was being driven by an “asset bubble” in common stocks inflated by easy money, especially loans to purchase shares—so-called margin credit—and unbounded optimism.
A boom, or bubble, economy supported by borrowing against inflated assets can be sustained for long periods as long as everyone believes prices will continue to rise. The dot-com bubble of the 1990s was a classic case of this. To be fair, at least the stock market darlings of the 1920s were real companies, such as RCA and Studebaker, making real products and real profits.
Financial history tells us that all bubbles end in busts, often very nasty ones, but these are usually limited to one country and only rarely compromise the global economy. Even the catastrophic bursting of the Japanese bubble economy in 1989, despite its lingering effects even now after 20 years, had very limited consequences for global markets.
What made the bursting of the Wall Street bubble in October of 1929 and the events that followed unique was not just the depth and duration of the economic pain in the United States, but that the market collapse was global in scope. The events of the 1930s are a source of endless fascination and controversy because so many narratives can be constructed around its causes and effects.
Wall Street had seen dramatic busts before, such as the Panic of 1907, but they were neither global nor long lasting in their consequences. In 1929, however, the initial market crash was followed by an avalanche of disasters, many of them self-inflicted by policy makers, which effectively destroyed the liberal order and the global financial system that made it work. The Great Depression not only set the stage for a global war of unparalleled destructiveness, but it vastly expanded the role and power of government in shaping the economy and society itself—a profound break with the classical liberal tradition.
Are we about to repeat the trauma of the Great Depression? We have much better analytical and policy tools at our disposal today than were available in the 1930s, plus the great advantage of having lessons of what went wrong in the 1930s to guide us. Moreover, the world was still mending from a devastating general war in 1929 and was far, far poorer than it is today. This does not mean, however, that we should dismiss the idea of a replay.
The Current Movie
History never quite repeats itself, but, as Mark Twain paraphrased Marx, it does rhyme. We can think through our investment, public policy, and business strategy options (we always have options, even when they are all bad) by understanding the “movie” or narrative of how financial crises unfold and how things turn out in the final reel. Besides the Great Depression, we have the benefit of several smaller B movies—banking implosions limited to one country. (The biggest headliner is the Japanese financial crisis of the 1990s.) Finally, we have the most recent version, the financial market meltdown of 2008, though the shooting is not yet complete.
The plot summary goes like this.
Scene One
Low interest rates and easy money encourage overinvestment and speculation that gradually builds into a boom or mania. Usually this is led by one investment type or asset class, such as common stock in the 1920s. But as optimism spreads through the economy, all asset prices go up. There are no bad investments in a boom. There are also very few bad loans or deals that cannot get done, so the financial sector does very, very well compared to other industries, and the share of wealth and income captured by bankers explodes.
Scene Two
An event—often a key bank revealing unexpected weakness or a central bank raising rates to “cool” overexuberence—causes a sudden break in the upward trajectory of asset prices, or they simply stop rising due to overinvestment, just as US house prices did in 2006. This breaks the spell of universal optimism and makes markets, especially overnight interbank funding markets, nervous about which financial institutions are holding bad assets.
Scene Three
Every major financial center revolves around a “money market” where, in normal market conditions, banks with surplus deposits lend them to other banks that are short funds overnight and for longer terms. In scene three, such interbank lending dries up and interbank loan spreads spike as institutions try to protect themselves from each other. Banks hoard their surplus funds (those that they have no immediate need of) in central banks such as the European Central Bank (ECB) and the US Federal Reserve in a rush toward safety and liquidity. Asset prices tumble as credit required to finance investment activity evaporates.
As the flow of bank credit to households and businesses dries up, the “authorities” (central banks and national treasuries) try to pump liquidity into the money market. (Any country that issues a currency can create infinite amounts of it through its central bank. This is also known as “printing money.”) Pumping money into the market also drives down its price (in other words, interest rates). This part of the plot was not really tried in the 1930s version, and often blamed for the worst of the slump. Since the 1940s it has become part of almost every remake.
Scene Five
If it looks like banks are going to fall over like dominos, central banks and treasuries will resort to making asset purchases and even direct capital injections into the banks. Shotgun weddings putting weak or walking-dead banks together into larger players are encouraged or compelled. Once this could be done with private capital, as when J. P. Morgan singlehandedly stopped the Panic of 1907. Now the banking sector is so large and interwoven that many individual banks are “too big to fail,” which in practice means the government (i.e., the taxpayers) has to save them from collapse. Although so-called bailouts are politically toxic, not doing them risks total economic collapse. Thus, sooner or later, they get into the story line.
Scene Six
More subtly, the authorities try to restore banks to profitability so they can go back to lending to businesses and households. The easiest way to do this is by providing essentially free money to the banks so they can “earn” a spread on government bonds, or even by hoarding money at the central bank. These artificially created bank earnings are meant to rebuild confidence and stability in the financial markets and a restoration of “normal” credit conditions.
Scene Seven
In this scene, nothing that is supposed to happen actually does. First, there is limited demand for borrowing in the real economy, the actual exchange of goods and services, which remains in shock from the destruction of wealth caused by the collapse of asset prices (over $13 trillion was wiped off the balance sheet of the US household sector during 2008–2009). Anybody who actually needs money faces a credit crunch caused by the restoration of prudent (or hyper-prudent) lending standards. Banks are terrified of lending into a falling economy.
Scene Eight
Regulation is greatly expanded and tightened, setting off more adverse consequences on credit availability. Banks become political and legal targets of opportunity. The 1933 Pecora hearings in Congress featured the ritual humiliation of J. P. Morgan himself, but the Banking Act of 1933 (aka the Glass-Steagall Act which barred banks from the investment business) was based on a vaguely coherent view that bank fed speculation led to the Crash of 1929. The Dodd-Frank act, which was jammed through Congress before the completion of a congressional report, was arguably more a compromise between long-held political objectives, such as enhanced regulation of consumer financial services, and pushback by lobbyists than an attempt to address root causes like excessive extension of credit to consumers (more on this in Chapter 2).
Scene Nine
Sovereign debt vastly increases due to financial sector bailouts and depressed tax receipts from the shrinking real economy, rising unemployment, and associated social safety net spending. States with weak public finances lose debt market access and veer toward default (with Greece being the poster boy this time around). Meanwhile, regulatory capital rules—as well as risk aversion to the real economy and lack of loan demand by shell-shocked enterprises and households—have stuffed bank balance sheets with sovereign bonds. Central bank balance sheets are whole multiples of pre-crisis levels due to bad asset purchases and “quantitative easing”—central banks creating money to buy debt securities.
Scene Ten
The finance crisis seems contained, and states and banks hope for a return to something resembling pre-crisis conditions or recovery while they continue to patch over difficulties ad hoc (e.g., Greece, Ireland, US house prices). Recovery in the real economy and meaningful reductions in unemployment remain elusive. Markets swing wildly from hope (risk-on) to fear (risk-off) on political or corporate-earnings news.
An unanticipated shock delivers the system a blow that it has no remaining resources, tools, or will to withstand. The financial system collapses for a second time to the point that it has to be restarted more or less from scratch under new rules, with most of the power being transferred from the markets to the state that provided the resources, essentially a far more radical version of what happened in the US after the Bank Holiday of 1933.
Scene Twelve
The aftermath of financial crisis rarely leads to the state simply recapitalizing the banks and exiting the business, though something very like this happened in Sweden in the 1990s. Most often, crises are followed by the systematic imposition of “financial repression”—a regime in which the state systematically suppresses market forces in finance—especially interest rates—in order to direct credit for political ends and hold down its own funding costs. This regime leaves itself open to democratic crony capitalism at best. At worst, it leads to socialism or “corporatism”—the organization of society into collective interest groups such as big business and labor, all subordinate to the state (as with Italy and Germany and even some aspects of the New Deal). Financial repression is how banking works in China today, and once in place, it is very hard to change.
The Banking Act of 1933 ushered in an age of financial repression (and so-called utility banking) in the United States that lasted almost 40 years, until the rise of the euromarkets in London during the 1960s and 1970s allowed US banks and their corporate customers to create a parallel unregulated dollar market outside of US jurisdiction. The much-maligned deregulation of US financial markets only took place much later (the final demise of Glass-Steagall took place on President Bill Clinton’s watch), after the repression was no longer effective. And deregulation has proved remarkably easy to throw into reverse. The Dodd-Frank Act, the new Basel III international bank capital regime, and the policies of the European Central Bank make up the new financial repression regime on the hoof, a regime that will likely last for a generation or two. The result will be far slower growth than the finance-driven economy produced from 1983 to 2007. The impact of this will be felt globally because fast-growing export economies and commodity producers in developing markets rely on growth and consumption in the developed economies. There is far less decoupling of the fates of individual countries in a global economy than is often thought or hoped. The ability to offset depressed US and European growth with emerging market dynamism will likely prove a delusion.
Final Scene and Fade to Credits
Global financial markets will not long remain broken and dormant, as human ingenuity and the desire to make money will always find new ways to connect borrowers and investors. The entrenched, too-big-to-fail institutions left standing by the second leg of the crisis, as well as the most heavily regulated financial centers, will increasingly be bypassed as capital, talent, and customers go elsewhere. Money, like water, always finds a way around efforts to dam it. Innovation trumps regulation over time. In the final scene, global finance reinvents itself in unregulated spaces in developed countries and the dynamic markets of East Asia and beyond. Gradually, the dead hand of the state gives way, and the global financial markets regain their freedom … again driving rapid economic growth, until the next catastrophic financial bubble that nobody saw building up explodes.
Where We Are Now
We are teetering on the cusp of scenes ten and eleven. We might still avoid the final tragedy through skill (or dumb luck). We are not passive actors in this movie, and it doesn’t have to end in tragedy if we understand where we are in plot and what options are still available to us.
And we must not forget that the market collapse of the 1930s led directly to political tragedy and a global war that killed at least 50 million human beings and that nearly destroyed civilization. Compared to this, the loss of the liberal economic order and the gold standard of the 1920s were small potatoes. The current financial crisis, with any luck, will only destroy the delusions that laws and regulation can make finance safe, but will leave the foundations of economic growth and social stability untouched. We can still reasonably hope that the second great global financial crisis is more farce than tragedy.
The Magic and Poison of Financial Leverage
The size of the financial system relative to the real economy ought to be pretty constant over time, because money is basically just something we use as a convenience or shorthand in exchanging what we have (time, labor, goods, property) for what we want (production, other goods, leisure, status).
Capitalism is not really an ideology, much less a system. At most it describes what happens when the prices of what we have and what we want are set by market bargain, not by custom or authority. The problem is that market bargains are never perfect, much less fair, because the two parties in the transaction are rarely equal in knowledge and power. People make as many bad decisions as good, so the clever and lucky end up with more than their “fair” share of the fruits of production and more money than they have immediate need for.
The financial economy is where this extra money, savings, and investment derived from the real economy gets stored and put to work making more money. Usually this is a benign activity. For example, when a banker gives me a loan for six months so I can plant, harvest, and sell a crop, he is essentially giving me the stuff I need today (tools, labor, seed) to make the money to pay him back tomorrow. The same works for manufacturing and most other forms of commerce. It is called working capital, and when it is in short supply, the whole economy grinds to snail’s pace. This is why countries without working financial systems (and they are the vast majority) have trouble growing their economies.
The problems that led to our current unhappy state arise when the financial economy becomes disconnected from the real economy. When that happens, the stocks of financial assets, which are just claims on someone’s future production, come to be much larger than the production itself. For example, before the current crisis, the total stock of financial assets, debt, and equity in the United States was $84.3 trillion (year-end 2007) while GDP, the most common measure of production, was only $14 trillion. For the United Kingdom, where the totals are distorted by the activity of non-British firms, the balance sheet of the banking system was five times the size of the real economy.
This disparity between the financial economy and the real economy is stark enough measured as a stock or lump sum of claims. Trading in financial assets dwarfs the real economy’s annual turnover by a degree that defies comprehension. Remember, GDP is only a snapshot of final output, so the first sale of a new car gets into the GDP total, but subsequent sale of the same car and many supplier transactions do not. As a result, central bank data compiled by the Bank for International Settlements shows that it took about $500 trillion in real economy payment transactions in 2010 to produce a global GDP of only around $65 to $70 trillion. $500 trillion sounds like a huge number until you compare it with the turnover in purely financial assets traded among banks and other market players around the world, 24 hours a day. Interbank payments settled in the United States alone (around one-third of the global total) amounted to $1,157 trillion in 2007, equities in US depository accounts turned over to the tune of $210 trillion, and US bond transactions came to $671 trillion.
The largest single source of interbank payments is foreign exchange trading. While obtaining foreign exchange is necessary for persons and firms engaged cross-border business and travel, such transactions are a small percentage of turnover, perhaps as little as 1 percent. What accounts for the other $1,000 trillion? The answer is called professional or proprietary trading if you are a banker, but raw speculation or gambling if you are almost anyone else.
Going back to our movie, remember that this vast disparity between the financial economy and the real economy is essentially new—a product of financial innovation on one hand and the severing of the last constraints on money creation on the other. The 1920s bubble economy was based on stock prices vastly outpacing any realistic future productions and profits by the companies involved. These inflated stock price values were multiplied by excessive borrowing against them, both for speculative purchase of more stock on credit (so-called margin loans by stock brokers) and for consumption and real estate investment. Another word for this disparity is leverage. As long as the banking system is solvent—that is, it can continue to make loans—leverage is pure magic. Essentially, it means more economic activity takes place and more wealth gets generated. If I have to finance expansion of my business out of retained profits, it might take me years to do so. If a bank gives me the money, I can do it immediately. The same goes for a consumer buying a car or major appliance—access to borrowed money makes it happen sooner and often at higher sticker prices. A finance-driven economy, managed prudently, is a dynamic economy.
The problem arises when financial leverage outstrips the ability of firms and households to generate income (or worse, becomes a substitute for income). This is very much what happened in the US domestic economy between the 1980s and the market meltdown of 2008. Leverage helped America create jobs and economic growth at a pace that more financially conservative Europe could not match. But what looked like magic in the rosy days of the Clinton boom was actually a mounting level of poison in the economic bloodstream. Essentially, leverage became a substitute for real income growth among the vast majority of Americans. At the same time, the United States became, to an extraordinary degree, dependent on consumer spending rather than production. Over a 20-year period, consumer debt went from about half of household assets to over 120 percent. In addition, real inflation-adjusted wages stagnated or fell, as almost all income gains flowed to holders of financial assets.
The Financialization of Wealth
This “financialization” of wealth is not entirely new. The finance capital Marx focused on was much the same in principle. So was the wealth that concentrated itself in the hands of common-stock owners in the Roaring Twenties. What was new was its sheer scale and its sources. The financialized wealth of the 1982–2007 boom was concentrated in two types of people: the beneficiaries of stock-based compensation granted by public companies—itself a result of efforts to curb the cash compensation of executives—and participants in the financial services industry itself, especially investment bankers. This wealth, unlike the finance capital of Marx’s day that built the industries of America and railroads around the world, got recycled into more financial trading and risk taking to an extraordinary extent. Partners’ funds accumulated in investment banks fed ever more sophisticated proprietary trading operations. Hedge funds—essentially private investment clubs betting on the skills or connections of a stock manager—became real forces in the capital markets. Even conservative long-term investors such as pension funds, insurance companies, and university endowments put money into these vehicles, despite the utter lack of transparency and the high fees charged by their managers at the height of the bubble. The share of corporate profits—which of course excludes the hedge funds—generated by the financial services industry (broadly defined) hit 22 percent.
The key to this was less genius than it was leverage. Investment banks, once partnerships trading on their own capital, became public companies. They used the capital raised in the market to increase their leverage by issuing debt. Hedge funds became some of the largest borrowers from the leading commercial banks. The game only worked if the value of financial assets and companies kept going up.
Two things were necessary to make this happen. First, companies themselves had to bend all their efforts to meet the quarterly profit expectations of the professional investors. This meant that, unless they were so-called growth stocks in new technologies, they needed to cut costs relentlessly where and when so-called top-line growth failed to meet profit targets. The burden of this fell directly on labor, which because of the emergence of technology-driven breakthroughs in efficiency and companies’ ability to source low-cost production and services in China, India, and other emerging markets found itself competing with what Marx called “the reserve army of labor” on a global basis. Outrage over “shipping jobs overseas,”—aka outsourcing—was of no practical benefit, because low-cost labor was of less significance than investment in productivity-enhancing technologies. Productivity gains over the long run tend to raise living standards, but a very large share of these gains was captured in corporate profits and by workers overseas.
Second, corporate profits themselves could be manipulated by management. Stock-based compensation was intended to align the interests of the owners of a company, the shareholders, with those of executive management. When the company did well, management did well, because the stock price should rise and reward both. This was a neat solution to the so-called agency problem, in which the interest of the hired help (as JP Morgan explicitly viewed the executives of companies he owned) and the owners conflict. In practice, managers know all the ins and outs of a company, and through timing expenditures and the recognition of losses can to a degree manufacture the quarterly numbers the stock market wants to see. Owners have no such insight, even when boards of directors are not hand-picked by top management, which is usually the case.
Since the basic yardstick of a public company’s performance is return on equity, leverage—that is, replacing equity with borrowed money—is a simple means of boosting stock price. So is returning capital directly to the shareholders by buying back stock. Expense reductions, whether by reengineering to eliminate jobs, outsourcing to low-wage markets, or ending so-called defined-benefit pension plans and other benefits, are also levers management can push to increase profits. So-called top-line growth—that is, actually selling more goods and services—is a lot tougher, especially in a mature economy like the United States. However, top-line growth can be bought by acquiring other public companies, keeping most of their customers and revenue, and getting rid of as many costs (and jobs) as possible. The ability to borrow large sums of money—again, leverage—was central to the ability of many “serial acquirers” to grow profits in this way. The mergers-and-acquisitions game also brought enormous fees to the investment banks who negotiated the deals, adding to the concentration of income in the financial industry.
The Rise of the CEO Class
The net result of all these developments was the largest transfer of wealth in history to what we might call the CEO class. This new class is not like the much maligned “robber barons” who actually built whole industries and created million of jobs. A few entrepreneurial heroes stand out—above all, the sainted Steve Jobs—but the CEO class is mainly a technocratic elite of professional managers of established public companies. Its ability to capture as much as a fifth of total corporate profits is a matter of positional power and the tolerance of the institutions that hold their shares.
If, then, most of the increase in American incomes (and wealth, which is harder to measure) was captured by 1 percent of the top 1 percent of earners over the last 25 years, what was the fate of everybody else? The relative income position of the “1 percent” that Occupy Wall Street complains about is distorted by the CEO class and their financiers. The income spread between CEOs and other top executives (the so-called C-Suite, since their titles all seem to start with “Chief”) on one hand and line management on the other exploded. Once it was common for a bank’s senior vice president or a division head in a company to make a sizable fraction of what the top boss got paid—say $100,000 as opposed to $1,000,000. Now the C-suite and line management live on different planets. Business executives, lawyers, physicians, and other professionals no longer belong to a single broad socioeconomic class, as they had for generations.
For the broad working class that American politicians persist in calling the middle class, things got dramatically worse. Their real incomes have been stagnant or falling for a generation, and whole communities have been stripped of places of employment. Marx would have predicted that the working class would revolt against the CEO class if only out of desperation at their financial predicament. But the remarkable thing, much to the befuddlement of many academic and media observers, is that the middle class became more conservative. Indeed, the union movement—traditional vehicles for workers to push back against capital—has largely collapsed over the last generation. Most union members today are in the public sector. The reasons behind this are complex and controversial but, yet again, financial leverage played a role.
Role of Consumer Debt
The same financial markets that facilitated the financialization of wealth and the rise of the CEO class also managed to turn consumer debt into a viable substitute for income. As historian Louis Hyman points out in Debtor Nation (Princeton University Press, 2011), the United States virtually invented consumer credit, and it has profound effects on our economy, politics, and culture. Hyman finds these effects disturbing on many levels, but the fact remains that after World War II the United States became the first country in history to create a dynamic consumer-driven economy on borrowed money. I briefly discuss the mechanics of this in Chapter 2 of this book and in my other book, Financial Market Meltdown (Praeger, 2009), though I would urge you to delve into Debtor Nation or Hyman’s Borrow (Random House, 2012) for a fuller critique of the American debt culture and its consequences. The point is that for good or ill, American households were able to continue spending in the face of falling real incomes and negative savings for nearly a generation. As long as consumer debt could be transformed into securities by the Wall Street leverage machine, and Wall Street could sell those securities to institutional investors, including the Chinese, Americans could continue to consume well beyond their earning power. The consumer banking industry would provide households spending money with little or no regard for their ability to repay. Some of this, about $1 trillion, was unsecured revolving credit, mostly provided by a small group of commercial banks.
However, the main driver of consumer debt was $10.5 trillion in mortgage credit, mostly government guaranteed, that allowed nearly 70 percent of US households to “own” a home by 2007. The last few point gains in home ownership was accomplished by a material loosening of lending practices that placed millions of marginal borrowers in houses in which they had made almost no up-front investment and could only afford through loans featuring low “teaser rates.” This was partially a product of politics—home ownership for everyone, regardless of means, had appeal to both major parties—and of the Wall Street leverage machine, where mortgage-backed securities drove an inordinate amount of activity and profits. When consumers maxed out their credit cards, they could pay off the balance through refinancing those homes because, of course, house prices only moved in one direction: up. They could take out “excess” equity through so-called HELOCs (home equity lines of credit). People’s homes became their ATM, their savings account, and even their pension plan as long as house prices went up and refinancing was easy. The question is not so much why this all came tumbling down in 2008 as it is, “How did this house of cards stay up so long”? The short answer is cheap money over a long period of time.
The Great Moderation
The term Great Moderation was coined to describe the 25 years between 1983 and 2008 when inflation remained in check, the value of financial assets rose, and free market capitalism was in the ascendant position it had not occupied since the 1920s. Of course, unless you were sad to see the demise of Marxist-inspired state socialism, times were good with the exception of a few short recessions and a few special cases like Japan. It would be wrong, however, to attribute the Great Moderation to the inherent virtues of a finance-driven global economy where the market rewarded good investments and punished bad ones. For example, the taming of inflation was an heroic one-off accomplishment of Paul Volcker at the Federal Reserve. However, the market reforms during this period in China, and later India, coupled with much improved communications and logistics, greatly expanded the global labor market and lowered the cost of goods that everyday Americans bought. This was no substitute for good central banking, but it certainly made it easier to hold inflation in check. As Asian exports to the United States exploded in volume, the dollar earnings of China and the rest got invested in United States government bonds, including those of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which both guaranteed trillions of dollars in consumer mortgages but bought huge amounts of securitized mortgages. These purchases held down interest rates, making consumer debt more affordable. This allowed China, of course, to export more stuff and buy more bonds. Low and stable long-term interest rates allowed housing prices to rise and more people to afford houses.
None of this was due to the genius of policymakers, though a reputed “maestro,” Alan Greenspan, occupied the chairmanship of the Board of Governors of the Federal Reserve System for 17 of the 25 years of the Great Moderation. Where the central bank and US Treasury policy was decisive during the Great Moderation was in protecting the financial economy from its own mistakes and excesses. On one level, this made sense, because the sheer scale of the financial economy relative to the real economy made the consequences of a market panic too scary to contemplate in terms of damage to real output and production.
More controversially, the argument can be made that the financialization of wealth had created a new relationship between finance and government. Financial wealth was not reactionary or conservative wealth, but just as likely to be progressive in character. Both Tony Blair’s New Labour Party and the Democratic Party under both Bill Clinton and Barack Obama enjoyed the political largesse of financialized wealth, more so than their Tory or Republican opponents. It is no surprise that using the resources of the US Treasury to pull Goldman Sachs’s fat out of fire seemed the simple pursuit of national interest. The markets and the largest investment-banking operations increasingly came to believe that the authorities would step in to prevent any reckoning for financial bets gone wrong. In this sense, the Great Moderation was at least as much a product of governments as it was of markets, something that pains the heart of free-market fundamentalists.
The problem is that in a free market, everyone is free to fail. Indeed, something that Joseph Schumpeter called “creative destruction” is essential to economic progress. The Great Moderation was largely a one-way bet for market participants. Financial crises of one sort or another, which affected companies ranging from Japanese and Swedish banks to Long Term Capital, an American hedge fund, continued to occur. In fact, they became more frequent. However, the US Federal Reserve and Treasury were always quick to flood the market with money and slash interest rates in order to limit the damage to the financial economy. Except for the collapse of the dot-com stock market bubble, large-scale destruction of financialized wealth was a thing of the past.
Another problem, of course, is that markets are reflections of human nature, balanced on a knife’s edge between fear and greed. To remove fear is to open the floodgates of greed. The problem with greed, whatever the Occupy Wall Street gang might think, is not that it is bad. There is bad and greed in all of us. The problem with greed is that it is careless and often delusional. Fear, specifically fear of losing everything, has always been a healthy antidote to excessive optimism and greed. This is why, in real market capitalism, failure is allowed and even panics have their uses. They purge excess from the system and foster prudence. Individuals and institutions learn from their losses. During the Great Moderation, individuals and institutions learned that the market was back-stopped by the state, their profits were theirs to keep, and their losses would be picked up by the taxpayer.
The Great Panic: Cause and Effect
Much 20/20 hindsight lavished on the financial market meltdown revolves around the collapse of Lehman Brothers and the market freefall that ensued. What made the event so shocking was that the Great Moderation had taught the global financial economy that a large market player with huge obligations to and from other key players would somehow be saved. Certainly Lehman’s management must have made this assumption. After all, Bear Stearns, a far less important house with more to answer for in the mortgage securities bubble, had been rescued. Surely, the authorities could see the domino effect that would occur if they let Lehman go down?
Economists use the term moral hazard to describe what happens when the consequences of bad decisions are eliminated. For example, deposit insurance means you don’t have to evaluate the soundness of your bank. Uncle Sam will always make you whole if it goes bust. What would happen if deposit insurance was abolished overnight during a market panic? There would be a run on the banks as people rushed to turn their deposits into cash before the cash ran out. The failure of one bank would accelerate the failure of others, and soon there would be no banking system aside from the institutions visibly propped up by government.
The deeper causes of the 2008 Great Panic are rehashed in a vast output of books, including my own effort, but the practical effect of letting Lehman fail was to place every institution in the global financial economy in the position of an uninsured depositor to every other institution. Banks that once lent excess funds freely to one another suddenly trusted nobody except central banks. The whole global credit market seized up as banks were reluctant to do much with the funds that central banks were pumping into the system beyond buying government bonds and building up cash in their reserve accounts at the central banks. I’ll discuss how regulators and financial uncertainty, especially in Europe, have made this worse, in Chapter 2. The practical effect of a Great Panic was to throw a wrench into the great Wall Street leverage machine.
The Agony of the Household Sector
Up to 2008, with no significant financial wealth, debts in excess of their income—which was in any case stagnant—and diminished employment security, the great American “middle class” continued to drive the economy. Up until 2008, personal consumption accounted for 70 percent of US GDP. The largest positive item on the US household balance sheet was the value of residential property, and the largest negative item was mortgage debt. As long as house prices rose faster than consumer debt, household spending would continue to grow. But that depended on the great Wall Street leverage machine continuing to turn consumer credit into investments. When it became clear that it had gone too far and the machine seized up, so did demand for houses, and therefore their prices fell, especially in the most overheated and overbuilt real estate markets, such as California, Nevada, and Florida.
Since homeowners had been aggressively extracting equity from their houses (in other words, borrowing the difference between the appraised value of the house and the nominal amount owed on the mortgage) for years and many had purchased homes at the top of the bubble, often with little or no down payment, a correction in house prices spelled catastrophe for millions. The net worth of households fell by $7 trillion between 2008 and 2009, excluding gyrations in the price of financial assets. That is the equivalent of all wages and salaries for an entire year simply disappearing. Millions of households—more than one in five mortgage borrowers—woke up to find their houses worth less than the face value of their loans. Since the house-price escalator was the savings retirement plan for the broad middle class—indeed, their only route to financial security—the reality of falling prices was almost impossible to accept. Consumers began to stop paying underwater mortgages and walk away from their houses, sending the keys to the bank in so-called jingle-mail. The stigma of defaulting on a mortgage became replaced with a sense of victimization. The time-honored truism that consumers in difficulty would always pay their mortgage first and their credit card last was turned on its head. Households needed credit cards to buy everyday necessities like gas.
After a generation of debt-fueled consumption, households began to cut back their spending in 2009, and the savings rate turned positive. Household debt levels, having more than doubled in a decade, began to reverse themselves in a process called deleveraging, though much of the reduction in household debt was really due to banks writing off loans as uncollectable. In early 2012, there was actually an uptick in consumer credit, which remains at troubling levels. Putting the household balance sheet on a sustainable footing looks to be a long and bumpy road.
Corporate America Chugs Ahead
Unlike households, American businesses had pretty strong balance sheets going into the market meltdown. A generation of escalating global competition and unforgiving financial markets had taught them how to do more with less and adjust swiftly to changes in demand. Moreover, the largest American corporations were getting ever-larger shares of their sales and profits from the fast-growing emerging markets. They were also basing more of their production and development in places like China, India, and Brazil, which were relatively insulated from the collapse of the US housing bubble. As a result, US industry could react to a crisis in the banking system and consumer confidence by swiftly shedding costs, especially employees, while actually increasing output. Unlike the companies during the crisis of the 1930s, in which profits and employment in large companies fell in tandem, this generation’s US companies overall met or exceeded expected earnings in the wake of the initial stock market swoon set off by Lehman’s collapse. But they kept their powder dry, hoarding cash and cutting costs where possible.
The real hammer-blow to employment came from the construction industry, which alone accounts for 10 percent of jobs in the US, and businesses dependent on domestic consumer spending, such as retailers and car dealers. Small businesses especially found that banks were no longer willing to lend to them. These sectors also shed jobs, many of them for low-skilled, low-income workers. As such, one of the key predictors of unemployment became educational attainment.
A key vulnerability of a finance-driven economy is that the leverage machine is every bit as powerful when thrown into reverse as it is in forward gear. Spiking unemployment drives defaults on mortgages and credit cards, harming the balance sheets and income statement of the banks, causing them to tighten credit standards, which reduces the ability of consumers to spend on houses and products. This in turn leads to more layoffs and business failure, and hence more unemployment.
The notion that people have a reasonable expectation of a steady job, usually with hourly pay or salary plus non-cash benefits, is deeply entrenched in our thinking. In our political discourse, there is a central (yet factually unfounded) notion that “creating jobs” is a function of government, or that rich people are somehow “job creators.”
The harsh truth of the matter is that the very notion of employment—and its opposite, unemployment—is a product of the rise of big public companies around 1890 or so. Before that, labor was mostly casual, and hands were hired by the day or even the shift. By their very nature, big public companies are essentially bureaucracies, not much different than government bureaus, and are mainly concerned with coordinating activities and resources, including labor. Modern war gave rise to bureaucratic government in the 18th century, and for generations, government service—whether civil or military—was the only full-time employment. Everyone else was self-employed or a hired hand. The reason big public companies like industrial firms and railroads followed the state bureaucratic model was that they needed reliable workers for complicated processes, such as running an automobile assembly line or driving a train. It was more efficient to contract with full-time employees than to fund the workers required as the need arose. Eventually, workers organized into unions that negotiated contracts covering all the workers in a company or industry. This system reached its peak in the 1950s when big business, big labor, and as a referee, big government, presided over what was still an industrial economy.
This system of employment began to fall apart in the 1980s, less than a century after it began, and all the current crisis is really doing is speeding up the process that I call the end of employment. Less and less of the economy is engaged in manufacturing, and more is concentrated in services and self-employment. Manufacturing itself has become globalized, so jobs can be readily relocated because of cost or skill factors. Above all, outsourcing and temporary employment have become organized, increasingly efficient markets that provide cheaper ways to contract than the old model of employment.
The finance-driven economy influenced these developments in two important ways. First, financial markets demanded relentless growth in profits, which effectively forced corporations to minimize high-cost, full-time employment in high-wage countries. Second, the buoyant capital markets of the Great Moderation, ever hungry for the next big thing, brought a remarkable number of startup companies to market (Microsoft, Google, Apple, Starbucks, etc.). The ability of a small enterprise to create jobs is limited until it gets the financing to gain scale and grow rapidly. The 1990s capital markets were almost unique in their ability to launch new companies into a growth phase.
The reason we have a jobs crisis, as the chattering class unanimously agrees is the crux of the next election, is not that large, mature firms are not hiring. They rarely do, given global competition. It is that we have ceased to create new enterprises and grow them aggressively.
No Safe Havens
Compounding our problem is the fact that the investor class—the minority of the population with stock portfolios of any size—has become traumatized by the events of 2008 and has largely fled the market or gone into wait-and-see mode. That leaves only professional investors, institutional fund managers, and hedge funds, that have to be in the market. The whole market shifts to risk-on when it seems safe to buy equities, and then gallops over to risk-off when equities seem overbought. Sovereign debt (government bonds) used to be safe harbor, but with the euro zone in chronic debt crisis and the United States downgraded on its inability to address its runaway deficit spending, even that refuge seems questionable.
The markets truly are broken. In the following two chapters I will drill down on two key issues that are widely misunderstood by both commentators and the general public. Chapter 2 explains why banking lost its way and became (and in crucial respects remains) dangerous to the general economy, and how many steps taken in the wake of the crisis not only fail to address the core problems but add to them in unintended ways. Chapter 3 spells out the real-life impact of these unintended consequences on the real economy and the man in the street.