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International Socialism, Summer 2012

Brian O’Boyle

Book Review

Clutching at straws? Some mainstream
accounts of the crisis

From International Socialism 2 : 135, Summer 2012.
Copyright © International Socialism.
Copied with thanks from the International Socialism Website.
Marked up by Einde O’Callaghan for ETOL.

Gillian Tett
Fool’s Gold: How Unrestrained Greed Corrupted A Dream, Shattered Global Markets and Unleashed a Catastrophe
Abacus, 2009, £8.99

Paul Krugman
The Return of Depression Economics
Penguin, 2008, £9.99

Joseph Stiglitz
Freefall: Free Markets and the Sinking of the Global Economy
Penguin, 2010, £9.99

The crash of September 2008 was no ordinary event. [1] Within days financial markets crumbled as asset values plummeted and credit slowed to a virtual standstill. For a moment some feared that the global financial architecture might not survive. But the ruling classes soon steadied themselves for the job at hand. Aggressive interest rate cuts, forced nationalisations, blanket bank guarantees, ongoing recapitalisations and unlimited liquidity quickly became the hallmarks of monetary policy around the globe. The United States and China also synchronised fiscal packages to coincide with more modest measures from Britain and the European Union. [2] Collectively, the core capitalist states backstopped the financial sector to the tune of over $14 trillion, making it clear that this was far from the limit of their commitment. [3] These tactics staved off the immediate threat of financial catastrophe. However, they also accentuated a whole series of secondary difficulties – crises of sovereign debt, the fiscal system, investment and employment – while leaving the deeper causes of the crisis unresolved. Since then the system has been in virtual stagnation. What began as a financial crisis has now become the Great Recession of the 21st century.

As with any epoch-making event, accounts have varied, with commentators struggling to fit the new reality into the framework they previously espoused. The difficulties for economists who vigorously championed the superiority of the market are obvious. But for many of those with outlooks influenced by Keynesianism, this crisis has been a textbook case of financial hubris triumphing over the real economy. [4] John Maynard Keynes once remarked that “speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation”. [5] Speculative excess has undoubtedly been a feature of the current crisis, and each of the authors I consider here has, in their own way, attempted to situate the crash of 2008 in the “financialisation” of the past 30 years.

Gillian Tett is currently the US managing editor of the Financial Times, having previously spent time as the capital markets editor in London. Tett’s articles often give useful insights into the complex world of finance. Paul Krugman and Joseph Stiglitz both won Nobel Prizes in economics and both challenge the market fundamentalism of the mainstream. Krugman is a proponent of the “neoclassical synthesis”, meaning he marries a version of Keynesian macroeconomics with the microeconomic foundations of neoclassical theory. Historically this position was quite reactionary. [6] But within the stultified arena of US academic economics, Krugman now appears as a critic of the dominant paradigm. His weekly column in the New York Times has made him an influential commentator. Stiglitz originally made his name by challenging the informational assumptions underpinning general equilibrium theory. However, he is better known today as the “insider” who turned against the International Monetary Fund (IMF). Stiglitz, once the chief economist at the World Bank, produced a trenchant critique of his experiences of policymaking during the 1990s and has since further hardened his position. In a sense, Krugman and Stiglitz represent two attempts to rescue the market by humanising it.
 

Perspectives and approaches

Although each of the books under review attempts to grapple with similar material, there are differences in emphasis and perspective. Tett originally trained as an anthropologist and her approach adopts techniques she honed while studying marriage rituals in rural Tajikistan. Like other social systems, investment banking has its own language, mores and moral norms.

Tett works hard to break into this world and the results of this endeavour convey both the strengths and the weaknesses of her approach. On the positive side, Fool’s Gold is meticulous in its explanations of financial concepts that have been bandied about since the start of the crisis. By the end of the book complex terms such as collateralised debt obligations, securitisation, derivatives contracts and special purpose vehicles are significantly illuminated. [7] But the book’s narrow focus also leaves significant gaps. The first is in the broader economics of the crisis. Although Tett refers to bad corporate governance, loose monetary policy and lax regulation, she never explores any of these issues in great detail. [8] Instead the reader is left to infer the importance of these “background conditions”. The second gap is political. Tett’s eagerness to develop a narrative from the participants’ perspective means that she is extremely soft on them. The book follows the exploits of senior bankers at J.P. Morgan and, much like the feeling one gets when watching The Godfather, it is tempting to side with them. But this would be to forget the scale of the damage they caused. According to David Harvey, Wall Street banks colluded with the IMF and the US Treasury to thieve upwards of $4.6 trillion from some of the poorest in the world. [9]

Krugman made his name in the area of international trade and Depression Economics often reads like a primer in globalisation theory. Unlike Tett, Krugman is anxious to establish the credentials of his own perspective, and his book simultaneously tries to outline the policies he believes would stabilise the global economy. The book begins on a triumphant note, proclaiming that all of the really debilitating economic problems have effectively been solved. Policy mistakes during the Great Depression have now been largely corrected. Krugman argues, “Capitalism and its economists [have] made a deal with the public: it will be OK to have free markets from now on because we know enough to prevent any more Great Depressions”. [10] But while Krugman maintains that a dollop of “good old-fashioned demand-side macroeconomics still has a lot to offer in our current predicament”, he is also aware that something must have gone drastically wrong. [11] The title of his book is, after all, The Return of Depression Economics, and its central thesis is that the Keynesian compromise no longer holds in a globalised economy.

To make this case, the book considers the crises that have afflicted the global economy since the early 1980s. The analysis is cursory but relatively clear and gives a sense of the pattern of boom and bust that has accompanied global neoliberalism. [12] Concepts such as the balance of payments, current account deficits and exchange rates are interwoven into the narrative and some of the best parts of the book describe the tensions in simultaneously trying to maintain fixed exchange rates and discretionary monetary policy in the face of international capital movements. [13] However, Krugman massively overextends the analysis by pinning all the problems of the past 30 years on the policy constraints imposed by globalisation. Having filled in important gaps left by Tett, the book fails to identify the class dynamics of the neoliberal period. Indeed, Depression Economics never moves beyond the confines of technical policymaking.

Stiglitz’s book is far better in this regard. From the outset Freefall attacks the naked class abuse of the past 25 years. Instead of merely arguing for a novel set of economic policies, Stiglitz is looking for a new vision for the organisation of the economy. [14] Capitalism is now characterised by “economic colonialism”, “corporate welfare” and a massive increase in inequality. [15] He engages in a trenchant critique of the “ersatz capitalism” (neoliberalism) that has grown up since the 1980s. [16] Like Krugman, Stiglitz defends a form of Keynesian interventionism and he works hard to dissociate capitalism proper from financial interests. Stiglitz contextualises the 2008 crash in the bad governance, lax regulation, loose monetary policy and financial innovation of the period. [17] But his rejection of neoliberalism means that his analysis is generally fresh and interesting. Alan Greenspan’s monetary policies are described as responses to tax cuts by the Bush administration, deregulation is seen as the triumph of the bankers and financial innovation is, quite rightly, conceived as a predatory move to rob working people of their savings. [18] Stiglitz pulls no punches. His treatment of what he calls the “Great American Robbery” is, along with his critique of globalisation, a highlight of his book. Unfortunately, his critique is not matched by any of his solutions. Stiglitz believes we can establish a “new set of social contracts based on trust between all of the elements of our society”. [19] This is either hopelessly naive or just plain hopeless.
 

Neoliberal globalisation

The epicentre of the 2008 crash was so obviously in finance that even staunch neoliberals were momentarily forced onto the back foot. In considering the role of finance, it is best to start with the policy analysis in Depression Economics. According to Krugman, economic managers ideally want three things. The first is discretionary monetary policy to fight recessions and curb inflation. The second is stable exchange rates so that business is not faced with too much uncertainty. The third is international capital flows to allow the private sector to generate wealth. [20] Unfortunately all of these cannot be secured simultaneously. Fixing exchange rates automatically reduces discretion, while allowing capital flows is incompatible with strict management of the national economy. Previously countries imposed capital controls and/or gave up on discretionary monetary policy. But today the overwhelming policy consensus is that flexible exchange rates and free capital movements are the best combination for economic success:

Today we live in a world that has relearned the virtues of free markets, is suspicious of government intervention and is particularly aware that the more things are prohibited the greater the scope for bribery and cronyism ... [Globalisation has] removed hundreds of millions of people from abject poverty ... and ... capitalism could with considerable justification claim the credit ... Rapid development was possible after all – and it had been accomplished not through proud socialist isolation but precisely by becoming as integrated as possible with global capitalism. [21]

Capital flows allow developing economies to access resources that would otherwise be unattainable. However, they also bring attendant dangers in the form of currency speculation and increased volatility. Allowing hot money in necessitates allowing it back out again. And this makes individual economies vulnerable in the face of sudden shifts in mood. Krugman writes of the dangers posed by unscrupulous hedge funds and predatory speculators. [22] But by far the most severe concerns are those associated with capital movements under normal conditions. There are a number of prerequisites for economies to integrate into the global market. The first is liberalised capital markets, but there must also be secure property rights, labour market flexibility, privatisation and (frequently) a currency peg to guard against inflation.

Once these supports are in place, foreign capital can start to flow in, and Krugman highlights the centrality of mobile capital in initially fostering economic booms. One consequence of massive inflows of foreign capital is that the country begins to run a current account deficit. [23] This means that there are more resources flowing in than flowing out. This can be caused by foreigners investing, foreigners lending (to the government or private sector) or exports being less than the value of imports – or by some combination of these. In many of the most devastating crises it was the sheer volume of foreign investment that led to these current account deficits and, as far as Krugman is concerned, this suggests that “market sentiment” rather than “market fundamentals” eventually undermine peripheral economies. [24] In theory, investment from abroad should be viewed positively as it signals that private investors have confidence in a country. The problem though is that capital moves with a herd mentality and, having grabbed the lion’s share of the productivity increases, exuberant capital continues to spill in until a bubble begins to form. Price increases take over from rising productivity and eventually market participants judge the situation to be unsustainable. When this happens, the bubble bursts and capital rushes for the exits.

At this point governments should in theory use their monetary discretion to stimulate spending. This is what happened in the US in 1975, 1982 and 1991. [25] But in the face of recent crises in the developing world, the policies prescribed by the IMF and the US Treasury were diametrically opposed to those the US had previously devised for itself. The cynic might argue that the class interests of US capital were also opposed in the different cases. But for Krugman the key villain is the power of international capital in an era of deregulated globalisation. [26] Unlike the US, peripheral nations have to work extremely hard to win the confidence of the markets, and once a rush to the exits occurs it becomes imperative to slash the deficit no matter what the social costs. It doesn’t really matter whether a country has sound fundamentals. What matter are perceptions and the overriding market orthodoxy is that governments must engage in significant austerity coupled with raised interest rates to hold whatever capital remains. This causes widespread social misery while driving the economy further into recession. But such is the power of global investors that “governments have to show their seriousness by inflicting pain on themselves ... because only thus can they gain the trust of the markets”. [27] Once capital becomes global, national governments must trade economic sovereignty for economic development. Krugman is undoubtedly on to something when he highlights the advantages for mobile capital in a system framed around national priorities. But this still does not explain how capital gained so much power in the core of the system.
 

Financialisation in the US

To answer this question Depression Economics shifts from the periphery to the core. Krugman begins by recounting the godlike status that Greenspan enjoyed during his 18 years at the helm of the US Federal Reserve. [28] When markets were stagnating, Greenspan could rally them. When markets were booming, he wasn’t afraid to keep them booming, and “for investors the Greenspan years were heavenly as ... stock prices on average rose more than 10 percent a year”. [29] Greenspan’s philosophy was basically to “make hay while the sun shined”, cleaning up any problems after they arose. While the periphery was suffering a series of devastating crises, the US economy entered what Ben Bernanke, Greenspan’s successor, termed the “Great Moderation”. Unemployment fell to levels not seen since the 1960s, inflation remained persistently low and the two recessions that did occur were brief and relatively painless. But beneath the surface things were not as healthy as they first appeared. Countercyclical intervention in the economy allows policymakers to intervene when things are overheating. This is an important tool in the central banks’ armoury, and by refusing to use it Greenspan became the first chairman in Fed history to oversee two massive bubbles – first in stocks, then in housing.

The housing bubble was, according to Krugman, actively encouraged. Immediately after the dotcom crash in 2001 Greenspan slashed interest rates, keeping them historically low for almost a decade. This made house-buying particularly attractive. [30] According to Krugman, “Greenspan had succeeded only by replacing the stock bubble with a housing bubble”. [31] But why had he allowed the dotcom bubble to originally emerge? Krugman never addresses this question. The obvious answer is a lack of a strong motor in the productive economy. If the second bubble was necessitated by a lack of any real alternatives, it stands to reason that the first bubble must have been necessitated for similar reasons. Greenspan’s monetary policy was thus a pragmatic response to a general malaise in the productive economy, and his easy money and deregulation were designed to facilitate the building up of asset bubbles.
 

Innovations in complex finance

Capitalism is the first economic system in history to be geared almost entirely towards the market. In previous times people generally produced to satisfy human needs, but under capitalism production is for profit and needs are satisfied through commodity exchange. Capitalists must purchase raw materials, machinery and human labour power before producing commodities. This obviously takes time and on occasion some of the accumulated profits can be held in reserve (savings). All of this makes a functioning financial system extremely important. Exchange can only be generalised through a universal medium, which the financial system provides through its supervision and distribution of the currency. Banks also promote exchange by allowing capitalists to buy and sell on credit. Producers give credit to wholesalers, wholesalers give credit to retailers and retailers give credit to consumers. Finally, the banking system facilitates economic growth by recycling resources that would otherwise lie idle.

Without these financial supports the flow of goods and services would grind to a halt, investment would be severely disrupted and mortgages would become all but impossible to obtain. These are just some of the reasons that financial institutions are often deemed to be too important to fail. And yet the irony is that banks can be the very institutions most likely to fail. Lending is a risky business, and doing so with other people’s resources makes it even more precarious. Banks create credit from the deposits they receive and this makes them more vulnerable than other capitalists to a crisis of confidence. Financial institutions face the possibility that some of their loans may eventually turn bad. This is exacerbated by the problem of “borrowing short” and “lending long”. Banks accept deposits and other liabilities on short time horizons. They must be able to return assets at a moment’s notice. But they can rarely impose this condition on the people to whom they lend. Banks traditionally gain their returns over many years. Even if loans are performing, there is still a mismatch between the liquidity of their liabilities and the liquidity of their assets.

These difficulties are inherent in banking. But what if innovative ways could be found of dealing with them, unleashing a wave of capital into the economy and making those who developed these innovations extremely wealthy? [32] This was the problem confronting the group of “cerebral young traders” at the heart of Fool’s Gold. Their first innovation was to take the idea of a derivative contract and apply it to corporate loans. Derivatives, as the name suggests, derive their value from the asset being insured and versions of derivative contracts have been around for centuries. [33] Key to the contracts is that those who buy and sell them are each making a bet on the future value of the asset. [34] If a commodity owner wants to guarantee her income, she may try to agree a future price for her commodity. Alternatively she may pay a nominal fee for the option to sell at some future date. There are numerous ways to configure these deals. But the essence of derivatives contracts is that they always allow commodity owners to trade the risk of a loss on their assets. The bankers at JP Morgan understood the benefits of derivatives, so why not create contracts allowing banks to trade the risk that a bond or corporate loan might go sour? [35] If ways could be found to insure against the threat of default, banks could reduce their capital reserves and risk could be matched up with those who were more willing to accept it.

Credit default swaps (CDSs), which pay out if a debtor defaults on a loan, helped to solve the problem of picking winners. These were joined by a novel way of increasing liquidity. The idea was known as “securitisation”. Thousands of potential sources of revenue (bonds, corporate loans, etc.) were bundled together before being “sliced and diced” and sold on to investors. This enabled the banks to solve their “maturity mismatch” by turning illiquid streams of revenue into immediately saleable commodities (collateralised debt obligations, CDOs). Those investing in these streams of debt could even be sold a CDS as well. As investment banks receive their fees from fixing contracts, there was a strong incentive to continually find parties to both CDO and CDS deals.

Given the complexity of this system an example might be useful. Suppose IBM wants to borrow $100 million from Bank of America (BOA). BOA is happy to lend the money, but knows this will tie up resources for years and that it will not receive a big return. So BOA writes a derivatives contract moving the risk of default onto a third party, say American Insurance Group (AIG). This would then allow it to hold less capital in reserve, freeing up money. In addition BOA could bundle the $100 million loan up with other such loans and create assets out of them. If the total value of the loans is $40 billion BOA may try to sell them on for around $41 billion. Instead of receiving a steady stream of payments they have sold this stream to an investor. This investor now assumes both the risk of default and the longer time horizon, in exchange for the extra revenue that gradually comes in. BOA may finally arrange with AIG to give insurance to the investor to guard against the threat of default. This will be done for a fee (both for AIG and BOA) and it supposedly lets everyone assume the levels of risk they are comfortable with. If AIG started to worry about its level of exposure, it could simply write another contract with Barclays Investment Bank to offload some of the risk. Anyone can buy a derivative, and pretty soon these contracts can be so far removed from the original asset that both the complexity and the ability to gamble have massively increased.

Writing in his 2002 Annual Report for Berkshire Hathaway the investor Warren Buffet described derivatives as “financial weapons of mass destruction”. The shift that proved him correct was the application of both securitisation and derivatives contracts to mortgage markets. Mortgages are notoriously difficult to assess for risk. Those taking out a mortgage are unlikely to have a track record in repayments and the problems were compounded by the explosion of the “subprime” mortgage market. By 2005 over 50 percent of US mortgages were to people with a poor credit history and a lack of sufficient resources. [36] To make matters worse, the conveyor belt of home loans that developed left nobody with any incentive to reduce the risk of these mortgages defaulting. Brokers granted mortgages that they never intended to hold. Investment banks bundled these mortgages into CDOs before getting them rated for risk, creating CDSs against them, and selling them on to unwitting investors. Investors assumed that any product rated as “triple A” by rating companies could never turn sour. [37] At every stage the incentive was to maximise the quantity of mortgages, while assuming property prices would continue to rise. When house prices began to fall, all hell broke loose.
 

Problems of effective demand

Any underlying weaknesses in the economy were masked but only so long as financial innovations were driving the economy. Financial innovation was extremely lucrative for the capitalist banks. [38] But it was the cheap credit that they helped to unleash that really sustained the Greenspan mirage. For example, according to Tett: “In 2005 US households extracted no less than $750 billion of funds against the values of their homes ... of which two-thirds was spent on personal consumption, home improvements and credit card debt”. [39] Stiglitz argues that it was closer to $1 trillion. [40] As a Keynesian, Stiglitz is highly attuned to the problem of “effective demand”, and at a number of points informs readers of the rising inequality that has accompanied financialisation. [41]

America like much of the rest of the world faces growing income inequality, but in America it has reached levels not seen for three quarters of a century ... the global economy needed ever-increasing consumption to grow, but how could this continue when the incomes of many Americans had been stagnating for so long? Americans came up with an ingenious solution: borrow and consume as if their incomes were growing ... [This then led to] an unsustainable bubble. Without the bubble, aggregate demand ... would have been weak, partly because of the growing inequality ... which shifted money from those who would have spent it to those who didn’t. [42]

Cheap credit essentially replaced falling real wages. Without the innovations the economy would have stagnated. If Stiglitz is correct: “Many Americans have wound up paying 40-50 percent of their incomes to the banks”. [43] This conveys an important truth about the latest round of financial products missing from Fool’s Gold – they were never about improving services but about robbing as much as was possible. Useful innovations should reduce what economists call “transaction costs” at the same time as providing products that consumers can rely on. Instead, Wall Street ramped up the transaction costs (their own fees), while preying on vulnerable customers with all manner of teaser loans, Ponzi schemes and predatory lending.
 

Stiglitz’s challenge to Krugman’s analysis

Krugman’s Depression Economics would leave the reader assuming that capital, while far from virtuous, is basically benign. When it comes to the IMF’s role, Krugman writes:

Because speculative attacks can be self-justifying following an economic policy that makes sense in terms of fundamentals is not enough ... Now, consider the situation from the point of view of those clever economists who were making policy in Washington. They found themselves dealing with countries whose hold on investor confidence was fragile ... the overriding policy objective must therefore be to mollify market sentiment ... It became an exercise in amateur psychology in which the IMF and the Treasury Department tried to persuade countries to do things they hoped would be perceived by the market as favourable. [44]

In stark contrast to Krugman’s apologetics, Stiglitz charges those who run the economic system with being far more interested in protecting the interests of Western banks than with protecting the lives of the people of the Global South. [45] The Washington Consensus (liberalisation, privatisation, stabilisation) was designed to open vulnerable countries to a host of disastrous measures. Stiglitz writes of a central banker who told him that “the country would have to be on its deathbed before ever returning to the IMF” and in many parts of the developing world the Bretton Woods institutions came to be seen as instruments of post-colonial control. [46] Structural adjustment was little more than a ruse to increase exploitation and, for Stiglitz, it is once again the particular brand of neoliberal capitalism that has left the poor so dangerously exposed:

In the end the programmes of the “Chicago boys” didn’t bring the promised results. Incomes stagnated. Where there was growth, the wealth went to those at the top ... Free market ideology turned out to be an excuse for new forms of exploitation. “Privatisation” meant that foreigners could buy mines and oilfields in developing countries at low prices. It also meant they could reap large profits from monopolies and quasi-monopolies, such as in telecoms. “Financial and capital market liberalisation” meant that foreign banks could get high returns on their loans, and when the loans went bad, the IMF forced the socialisation of the losses meaning the screws were put on entire populations to pay the foreign banks back. [47]

These insights show how disillusioned Stiglitz has become with neoliberal capitalism. The extent to which the Federal Reserve has been at the forefront of the corporate bonanza poses, for Stiglitz, serious questions about the nature of American democracy:

One of the reasons why the Fed was able to get away with what it did was that it ... didn’t need to get congressional permission for putting at risk hundreds of billions of taxpayer dollars. Indeed, that was one of the reasons why the administrations turned to the Fed; they were trying to circumvent democratic processes knowing they had little support. [48]
 

The impossibility of the Keynesian compact

Stiglitz’s conclusion is that “the current crisis has uncovered fundamental flaws in the capitalist system, or at least, the peculiar version of capitalism that emerged in the latter part of the 20th century”. [49] This makes his account far superior to Krugman’s. But while the strengths of Stiglitz’s book flow from his challenge to neoliberalism, his unwillingness to break with capitalism more generally means that there are also significant weaknesses. Perhaps the most glaring is the mismatch between the book’s critique and its prescriptions. Stiglitz’s call for a “New Capitalist Order” is both utopian and uninspiring. [50] Like Krugman, Stiglitz champions a reversion to a traditional form of Keynesian interventionism. But Krugman’s “Keynesian compromise” is decisively undermined by the twin realities of globalisation and the easy money policies of the Fed. Despite all the requisite know-how, peripheral governments are unable to intervene, while the US government has no interest in intervening, unless it can be squared with saving the banks. Nowhere is income redistribution on the cards. The idea that we can somehow revert to a more caring version of capitalism is extremely implausible.

Contrary to popular myth, the global restructuring associated with neoliberalism was never about replacing a benign state with the vicissitudes of the market. Rather it was about reorienting the state to support the new requirements for capital to accumulate. From a high point in the 1950s, profit rates fell steadily until the early 1980s [51], and this necessitated a new form of state intervention. How is the system now to be remoulded? Elites have, after all, used the crisis to reassert their political dominance. Far from compromise, ruling classes have increased their attacks, and as the system continues to degenerate it is extremely unlikely that wealth can be redistributed without massive working class resistance.

There is another, more basic reason why it is problematic to argue for a more caring version of capitalist society. Put simply, there can be no compromise with the class of exploiters. Rather than arguing for some form of “capitalist utopia”, the real message of the crisis should be the need to emancipate ourselves from every form of class exploitation. Stiglitz never gets close to asserting this. But unlike Fool’s Gold and Depression Economics, it would be hard to finish his book without realising that some form of social(ist) transformation is exactly what is needed.

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