Skyrocketing oil prices, a falling dollar, and collapsing financial markets are the key ingredients in an economic brew that could end up in more than just an ordinary recession. The falling dollar and rising oil prices have been rattling the global economy for sometime. But it is the dramatic implosion of financial markets that is driving the financial elite to panic.
And panic there is. Even as it characterized Federal Reserve Board Chairman Ben Bernanke's deep cuts amounting to a 1.25 points off the prime rate in late January as a sign of panic, the Economist admitted that "there is no doubt that this is a frightening moment." The losses stemming from bad securities tied up with defaulted mortgage loans by "subprime" borrowers are now estimated to be in the range of about $400 billion. But as the Financial Times warned, "the big question is what else is out there" at a time that the global financial system "is wide open to a catastrophic failure." In the last few weeks, for instance, several Swiss, Japanese, and Korean banks have owned up to billions of dollars in subprime-related losses. The globalization of finance was, from the beginning, the cutting edge of the globalization process, and it was always an illusion to think that the subprime crisis could be confined to U.S. financial institutions, as some analysts had thought.
Some key movers and shakers sounded less panicky than resigned to some sort of apocalypse. At the global elite's annual week-long party at Davos in late January, George Soros sounded positively necrological, declaring to one and all that the world was witnessing "the end of an era." World Economic Forum host Klaus Schwab spoke of capitalism getting its just desserts, saying, "We have to pay for the sins of the past." He told the press, "It's not that the pendulum is now swinging back to Marxist socialism, but people are asking themselves, 'What are the boundaries of the capitalist system?' They think the market may not always be the best mechanism for providing solutions."
Ruined Reputations and Policy Failures
While some appear to have lost their nerve, others have seen the financial collapse diminish their stature.
As chairman of President Bush's Council of Economic Advisers in 2005, Ben Bernanke attributed the rise in U.S. housing prices to "strong economic fundamentals" instead of speculative activity. So is it any wonder why, as Federal Reserve chairman, he failed to anticipate the housing market's collapse stemming from the subprime mortgage crisis? His predecessor, Alan Greenspan, however, has suffered a bigger hit, moving from iconic status to villain in the eyes of some. They blame the bubble on his aggressively cutting the prime rate to get the United States out of recession in 2003 and restraining it at low levels for over a year. Others say he ignored warnings about aggressive and unscrupulous mortgage originators enticing "subprime" borrowers with mortgage deals they could never afford.
The scrutiny of Greenspan's record and the failure of Bernanke's rate cuts so far to reignite bank lending has raised serious doubts about the effectiveness of monetary policy in warding off a recession that is now seen as all but inevitable. Nor will fiscal policy or putting money into the hands of consumers do the trick, according to some weighty voices. The $156 billion stimulus package recently approved by the White House and Congress consists largely of tax rebates, and most of these, according to New York Times columnist Paul Krugman, will go to those who don't really need them. The tendency will thus be to save rather than spend the rebates in a period of uncertainty, defeating their purpose of stimulating the economy. The specter that now haunts the U.S. economy is Japan's experience of virtually zero annual growth and deflation despite a succession of stimulus packages after Tokyo's great housing bubble deflated in the late 1980s.
The Inevitable Bubble
Even with the finger-pointing in progress, many analysts remind us that if anything, the housing crisis should have been expected all along. The only question was when it would break. As progressive economist Dean Baker of the Center for Economic Policy Research noted in an analysis several years ago, "Like the stock bubble, the housing bubble will burst. Eventually, it must. When it does, the economy will be thrown into a severe recession, and tens of millions of homeowners, who never imagined that house prices could fall, likely will face serious hardship."
The subprime mortgage crisis was not a case of supply outrunning real demand. The "demand" was largely fabricated by speculative mania on the part of developers and financiers that wanted to make great profits from their access to foreign money that flooded the United States in the last decade. Big ticket mortgages were aggressively sold to millions who could not normally afford them by offering low "teaser" interest rates that would later be readjusted to jack up payments from the new homeowners. These assets were then "securitized" with other assets into complex derivative products called "collateralized debt obligations" (CDOs) by the mortgage originators working with different layers of middlemen who understated risk so as to offload them as quickly as possible to other banks and institutional investors. The shooting up of interest rates triggered a wave of defaults, and many of the big name banks and investors - including Merrill Lynch, Citigroup, and Wells Fargo - found themselves with billions of dollars worth of bad assets that had been given the green light by their risk assessment systems.
The Failure of Self-Regulation
The housing bubble is only the latest of some 100 financial crises that have swiftly followed one another ever since the lifting of Depression-era capital controls at the onset of the neoliberal era in the early 1980s. The calls now coming from some quarters for curbs on speculative capital have an air of dÃƒ©jÃƒÂ vu. After the Asian Financial Crisis of 1997, in particular, there was a strong clamor for capital controls, for a "new global financial architecture." The more radical of these called for currency transactions taxes such as the famed Tobin Tax, which would have slowed down capital movements, or for the creation of some kind of global financial authority that would, among other things, regulate relations between northern creditors and indebted developing countries.
Global finance capital, however, resisted any return to state regulation. Nothing came of the proposals for Tobin taxes. The banks killed even a relatively weak "sovereign debt restructuring mechanism" akin to the U.S. Chapter Eleven to provide some maneuvering room to developing countries undergoing debt repayment problems, even though the proposal came from Ann Krueger, the conservative American deputy managing director of the IMF. Instead, finance capital promoted what came to be known as the Basel II process, described by political economist Robert Wade as steps toward global economic standardization that "maximize [global financial firms'] freedom of geographical and sectoral maneuver while setting collective constraints on their competitive strategies." The emphasis was on private sector self-surveillance and self-policing aimed at greater transparency of financial operations and new standards for capital. Despite the fact that it was finance capital from the industrialized countries that triggered the Asian crisis, the Basel process focused on making developing country financial institutions and processes transparent and standardized along the lines of what Wade calls the "Anglo-American" financial model.
Calls to regulate the proliferation of these new, sophisticated financial instruments, such as derivatives placed on the market by developed country financial institutions, went nowhere. Assessment and regulation of derivatives were left to market players who had access to sophisticated quantitative "risk assessment" models.
Focused on disciplining developing countries, the Basel II process accomplished so little in the way of self-regulation of global financial from the North that even Wall Street banker Robert Rubin, former secretary of treasury under President Clinton, warned in 2003 that "future financial crises are almost surely inevitable and could be even more severe."
As for risk assessment of derivatives such as the "collaterized debt obligations" (CDOs) and "structured investment vehicles" (SIVs) - the cutting edge of what the Financial Times has described as "the vastly increased complexity of hyperfinance" - the process collapsed almost completely. The most sophisticated quantitative risk models were left in the dust. The sellers of securities priced risk by one rule only: underestimate the real risk and pass it on to the suckers down the line. In the end, it was difficult to distinguish what was fraudulent, what was poor judgment, what was plain foolish, and what was out of anybody's control. "The U.S. subprime mortgage market was marked by poor underwriting standards and 'some fraudulent practices,'" as one report on the conclusions of a recent meeting of the Group of Seven's Financial Stability Forum put it. "Investors didn't carry out sufficient due diligence when they bought mortgage-backed securities. Banks and other firms managed their financial risks poorly and failed to disclose to the public the dangers on and off their balance sheets. Credit-rating companies did an inadequate job of evaluating the risk of complex securities. And the financial institutions compensated their employees in ways that encouraged excessive risk-taking and insufficient regard to long-term risks."
The Specter of Overproduction
It is not surprising that the G-7 report sounded very much like the post-mortems of the Asian financial crisis and the dot.com bubble. One financial corporation chief writing in the Financial Times captured the basic problem running through these speculative manias, perhaps unwittingly, when he claimed that "there has been an increasing disconnection between the real and financial economies in the past few years. The real economy has grown...but nothing like that of the financial economy, which grew even more rapidly - until it imploded." What his statement does not tell us is that the disconnect between the real and the financial is not accidental, that the financial economy expanded precisely to make up for the stagnation of the real economy.
The stagnation of the real economy stems is related to the condition of overproduction or over-accumulation that has plagued the international economy since the mid-1970s. Stemming from global productive capacity outstripping global demand as a result of deep inequalities, this condition has eroded profitability in the industrial sector. One escape route from this crisis has been "financialization," or the channeling of investment toward financial speculation, where greater profits could be had. This was, however, illusory in the long run since, unlike industry, speculative finance boiled down to an effort to squeeze out more "value" from already created value instead of creating new value.
The disconnect between the real economy and the virtual economy of finance was evident in the dot.com bubble of the 1990s. With profits in the real economy stagnating, the smart money flocked to the financial sector. The workings of this virtual economy were exemplified by the rapid rise in the stock values of Internet firms that, like Amazon.com, had yet to turn a profit. The dot.com phenomenon probably extended the boom of the 1990s by about two years. "Never before in U.S. history," Robert Brenner wrote, "had the stock market played such a direct, and decisive, role in financing non-financial corporations, thereby powering the growth of capital expenditures and in this way the real economy. Never before had a US economic expansion become so dependent upon the stock market's ascent." But the divergence between momentary financial indicators like stock prices and real values could only proceed to a point before reality bit back and enforced a "correction." And the correction came savagely in the dot.com collapse of 2002, which wiped out $7 trillion in investor wealth.
A long recession was avoided, but only because another bubble, the housing bubble, took the place of the dot.com bubble. Here, Greenspan played a key role by cutting the prime rate to a 45-year low of one percent in June 2003, holding it there for a year, then raising it only gradually, in quarter-percentage-increments. As Dean Baker put it, "an unprecedented run-up in the stock market propelled the U.S. economy in the late nineties and now an unprecedented run-up in house prices is propelling the current recovery."
The result was that real estate prices rose by 50% in real terms, with the run-ups, according to Baker, being close to 80% in the key bubble areas of the West Coast, the East Coast north of Washington, DC, and Florida. Baker estimates that the run-up in house prices "created more than $5 trillion in real estate wealth compared to a scenario where prices follow their normal trend growth path. The wealth effect from house prices is conventionally estimated at five cents to the dollar, which means that annual consumption is approximately $250 billion (2 per cent of gross domestic product [GDP]) higher than it would be in the absence of the housing bubble."
The China Factor
The housing bubble fueled U.S. growth, which was exceptional given the stagnation that has gripped most of the global economy in the last few years. During this period, the global economy has been marked by underinvestment and persistent tendencies toward stagnation in most key economic regions apart from the United States, China, India, and a few other places. Weak growth has marked most other regions, notably Japan, which was locked until very recently into a one percent GDP growth rate, and Europe, which grew annually by 1.45% in the last few years.
With stagnation in most other areas, the United States has pulled in some 70% of all global capital flows. A great deal of this has come from China. Indeed, what marks this current bubble period is the role of China as a source not only of goods for the U.S. market but also capital for speculation. The relationship between the United States and Chinese economies is what I have characterized elsewhere as chain-gang economics. On the one hand, China's economic growth has increasingly depended on the ability of American consumers to continue their debt-financed spending spree to absorb much of the output of China's production. On the other hand, this relationship depends on a massive financial reality: the dependence of U.S. consumption on China's lending the U.S. Treasury and private sector dollars from the reserves it accumulated from its yawning trade surplus with the United States: one trillion dollars so far, according to some estimates. Indeed, a great deal of the tremendous sums China - and other Asian countries - lent to American institutions went to finance middle-class spending on housing and other goods and services, prolonging the fragile U.S. economic growth but only by raising consumer indebtedness to dangerous, record heights.
The China-U.S. coupling has had major consequences for the global economy. The massive new productive capacity by American and other foreign investors moving to China has aggravated the persistent problem of overcapacity and overproduction. One indicator of persistent stagnation in the real economy is the aggregate annual global growth rate, which averaged 1.4% in the 1980s and 1.1% in the 1990s, compared to 3.5% in the 1960s and 2.4% in the 1970s. Moving to China to take advantage of low wages may shore up profit rates in the short term. But as it adds to overcapacity in a world where a rise in global purchasing power is constrained by growing inequalities, such capital flight erodes profits in the long term. And indeed, the profit rate of the largest 500 U.S. transnational corporations fell drastically from 4.9% from 1954-59, to 2.04% from 1960-69, to -5.30% from 1989-89, to -2.64% from 1990-92, and to -1.92% from 2000-2002. Behind these figures, notes Philip O'Hara, was the specter of overproduction: "Oversupply of commodities and inadequate demand are the principal corporate anomalies inhibiting performance in the global economy."
The succession of speculative manias in the United States has had the function of absorbing investment that did not find profitable returns in the real economy and thus not only artificially propping up the U.S. economy but also "holding up the world economy," as one IMF document put it. Thus, with the bursting of the housing bubble and the seizing up of credit in almost the whole financial sector, the threat of a global downturn is very real.
Decoupling Chain-Gang Economics?
In this regard, talk about a process of "decoupling" regional economies, especially the Asian economic region, from the United States has been without substance. True, most of the other economies in East and Southeast Asia have been pulled along by the Chinese locomotive. In the case of Japan, for instance, a decade-long stagnation was broken in 2003 by the country's first sustained recovery, fueled by exports to slake China's thirst for capital and technology-intensive goods. Exports shot up by a record 44%, or $60 billion. Indeed, China became the main destination for Asia's exports, accounting for 31% while Japan's share dropped from 20 to 10%. As one account in the Strait Times in 2004 pointed out, "In country-by-country profiles, China is now the overwhelming driver of export growth in Taiwan and the Philippines, and the majority buyer of products from Japan, South Korea, Malaysia, and Australia."
However, as research by C.P. Chandrasekhar and Jayati Ghosh and has underlined, China is indeed importing intermediate goods and parts from these countries but only to put them together mainly for export as finished goods to the United States and Europe, not for its domestic market. Thus, "if demand for Chinese exports from the United States and the EU slow down, as will be likely with a U.S. recession, this will not only affect Chinese manufacturing production, but also Chinese demand for imports from these Asian developing countries." Perhaps the more accurate image is that of a chain gang linking not only China and the United States but a host of other satellite economies whose fates are all tied up with the now-deflating balloon of debt-financed middle-class spending in the United States.
New Bubbles to the Rescue?
Do not overestimate the resiliency of capitalism. After the collapse of the dot.com boom and the housing boom, a third line of defense against stagnation owing to overcapacity may yet emerge. For instance, the U.S. government might pull the economy out of the jaws of recession through military spending. And, indeed, the military economy did play a role in bringing the United States out of the 2002 recession, with defense spending in 2003 accounting for 14% of GDP growth while representing only 4% of the overall U.S. GDP. According to estimates cited by Chalmers Johnson, defense-related expenditures will exceed $1 trillion for the first time in history in 2008.
Stimulus could also come from the related "disaster capitalism complex" so well studied by Naomi Klein: the "full fledged new economy in home land security, privatized war and disaster reconstruction tasked with nothing less than building and running a privatized security state both at home and abroad." Klein says that, in fact, "the economic stimulus of this sweeping initiative proved enough to pick up the slack where globalization and the dot.com booms had left off. Just as the Internet had launched the dot.-com bubble, 9/11 launched the disaster capitalism bubble." This subsidiary bubble to the real-estate bubble appears to have been relatively unharmed so far by the collapse of the latter.
It is not easy to track the sums circulating in the disaster capitalism complex. But one indication of the sums involved is that InVision, a General Electric affiliate producing high-tech bomb-detection devises used in airports and other public spaces, received an astounding $15 billion in Homeland Security contracts between 2001 and 2006.
Whether or not "military Keynesianism" and the disaster capitalism complex can in fact fill the role played by financial bubbles is open to question. To feed them, at least during the Republican administrations, has meant reducing social expenditures. A Dean Baker study cited by Johnson found that after an initial demand stimulus, by about the sixth year, the effect of increased military spending turns negative. After 10 years of increased defense spending, there would be 464,000 fewer jobs than in a scenario of lower defense spending.
An more important limit to military Keynesianism and disaster capitalism is that the military engagements to which they are bound to lead are likely to create quagmires such as Iraq and Afghanistan. And these disasters could trigger a backlash both abroad and at home. Such a backlash would eventually erode the legitimacy of these enterprises, reduce their access to tax dollars, and erode their viability as sources of economic expansion in a contracting economy. Yes, global capitalism may be resilient. But it looks like its options are increasingly limited. The forces making for the long-term stagnation of the global capitalist economy are now too heavy to be easily shaken off by the economic equivalent of mouth-to-mouth resuscitation.
Dean Baker, "The Menace of an Unchecked Housing Bubble," in Joseph Stiglitz, Aaron Edlin, and J. Bradford DeLong, eds., The Economists' Voice (New York: Columbia University Press, 2008)
Robert Brenner, The Boom and the Bubble (New York: Verso, 2002.)
"China: the Locomotive," Strait Times, February 23, 2004.
Naomi Klein, The Shock Doctrine (New York: Metropolitan Books, 2007).
Philip Anthony O'Hara, "The Contradictory Dynamics of Globalization," in B.N. Ghosh and Halil Guven, eds., Globalization and the Third World (Basingstoke: Palgrave Macmillan, 2006).
Robert Rubin and Jacob Weisberg, In an Uncertain World (New York: Random House, 2003).
Robert Wade, "The Aftermath of the Asian Financial Crisis," in Bhumika Muchhala, ed., Ten Years After: Revisiting the Asian Financial Crisis (Washington, DC: Woodrow Wilson International Center for Scholars, 2007)