Many people remain stunned that the vast and powerful American economy could have experienced such profound and enduring setbacks over the last five years. How could this have happened? Who is to blame? And could it happen again?
The New Economics Institute is thrilled to present the first paper of "New Economy Viewpoints," a series of position papers meant to inspire dialogue around policies and solutions that could promote a just and sustainable economy.
John M. Balder offers his take on how we got here, and points to some of the changes in the financial industry that will need to accompany our progress towards a more just and sustainable economy. We hope that you will participate in the conversation in the comments section.
One of the most disturbing questions that has emerged from the Great Recession is why our financial markets keep collapsing. The structural problems go much deeper than the last five years – indeed they goes back a generation. Though the social and economic damage (rising unemployment, increased bankruptcies, and greater income inequality) has been extensive, there is still too little understanding and too little action to address the root causes of this turbulence.
We must remember that 2007 was not the first crisis. We have endured a long reckless era in which the more highly regulated and stable financial system that facilitated global recovery in the postwar period was steadily dismantled. From 1945 to 1970, banks and financial firms dutifully helped foster global economic recovery. This period is sometimes referred to as the “Golden Age” of capitalism. Productivity grew steadily. Rising profits for business meant increasing real wages for workers, profitable businesses and declining income inequality.
However, as economic volatility increased in the 1970s, productivity growth slowed and manufacturing jobs disappeared. Median wages since the early 1970s have been flat in inflation-adjusted terms. By the early 1980s, policy makers, enamored with the concept of free markets, pushed for deregulation in various sectors, including finance. From 1980 to 2007, debt ratios and asset prices soared relative to incomes. The financial sector’s share of overall corporate profits increased dramatically from 10% in 1980 to 40% in 2001, a classic sign of the tail wagging the dog. And financial volatility accelerated, as crises became increasingly commonplace. Policy makers responded by rescuing the financial system each time, setting the stage for the next crisis. Finally, the crisis in 2007 proved so severe that U.S. Government and Federal Reserve System had no choice but to intervene on a massive scale to stabilize what otherwise would have been a full-fledged disaster.
The irony is that many on Wall Street and in policy making circles believed and argued that financial innovations – ranging from hedging strategies to credit default swaps – would make the financial system more resilient. Instead, these products nearly caused the entire financial and economic system to melt down. Given the magnitude of this particular crisis, one might have thought that lessons would have been learned and that serious steps would have been taken to address the underlying causes. However, judging by the results, little has changed.
The Origins of Boom-Bust Cycles
Several tectonic structural changes across global financial markets over the past generation fueled the growth in the severity and frequency of financial crises.
- First, financial market liberalization and deregulation liberated financial firms from regulatory restrictions that had been imposed during the Great Depression. These events created new financial players, technologies, and instruments (such as securitization and derivatives) that fueled rapid expansion in asset valuations and leverage. As household memories of the Great Depression faded, American families and business borrowed more. This rising debt caused asset prices to increase, which in turn prompted the creation of still more debt. Over time, debt and asset valuations spurred each other on both at an explosive pace, eventually imperiling financial stability.
- Second, policy officials neither understood nor reacted well to the increasingly volatile structure of financial markets. Like generals who fight the last war, the officials in charge of monetary policy remembered the high inflation of previous decades and remained focused on managing price pressures in goods and services. While doing so, they ignored growing signs of monetary excess, including excessive debt and inflated asset prices. Their apparent success in meeting the narrow inflation mandate led to longer economic cycles, which created the illusion that all was well. Although little productive wealth was actually created in this era of financialization, people rejoiced at the illusion of prosperity.
For more than 25 years, these imbalances steadily intensified. Debt growth easily outstripped income growth (see chart below). Household debt doubled while lending between financial firms increased by more than 500%. How could this house of cards keep rising? Primarily due to excessive debt creation, overvalued assets and low interest rates. It took more than $4 in debt to spur an additional dollar of income from 2000-2007 versus less than $2 from 1950-1980. In fact, debt creation in the latter era was largely allocated to speculative purposes and had little to do with capital formation and real economic growth.
U.S. Debt Ratios Relative to Incomes: Q1 1952 to Q4 2007
(Source: Federal Reserve Flow of Funds)
These structural changes led to the decoupling of debt-induced growth in the financial sector from the erosion that was occurring elsewhere in the real economy. Credit located its own mission (“finance finances mostly finance”). Fostered by rising indebtedness, inflation effectively shifted from goods and services to asset prices. Financial market liberalization changed the rules of the game, elevating the importance of financial stability relative to inflation, yet policy makers failed to adapt. In retrospect, the success of the so-called Great Moderation, as this period was known, was an illusion that obscured the buildup of new, more severe sources of instability that were increasing like underground pressure beneath a volcano.
We have known for more than a century that financial cycles are deeply embedded in the fabric of the capitalist system. Credit can foster productive growth, as it did in the global recovery after World War II, but it also has an unproductive side, especially when closely linked with asset price speculation. Credit can be a tool for real growth, as when an owner borrows money to build a factory. It can also fuel speculative tendencies, as it did from the mid-1990s until 2007 – everyone become drunk on buying and flipping homes, mortgages, and other assets. We need to better understand what credit does in the economy, especially as conditions for its creation are eased. At the end of the day, there is a need for policy makers to monitor and manage the credit cycle. They need to “take away the punch bowl” and not leave the credit creation process to market forces alone.
Policy Responses: Finding a New Balance
Throughout the past thirty years, policy makers believed that low and stable inflation alone would lead to the promised land of financial and macroeconomic stability. They left markets alone as credit and asset prices bubbles accelerated. However, when conditions reversed and instability flared, central bankers (especially after 1998) responded by lowering short-term interest rates and (as needed) injecting credit to stabilize conditions. This asymmetric policy (also known as the “Greenspan Put”) helped prompt recoveries from successive crises, including the stock market crash in 1987, the thrift crisis in 1990-1991, the Asian financial crisis in 1997, the near-collapse of LTCM and Russia in 1998 and the tech bubble in 2000-2001. Each intervention helped stabilize the system during that particular crisis. However, these short-term successes had a negative long-term effect, leading to more speculative borrowing, inflated assets, and frequent disruptions. Each illusory achievement of stability reflected policies that were doomed in the end, creating a series of asset bubbles, each bigger than the last, waiting to burst.
These forces in combination triggered a super-debt cycle that came to a dramatic close in 2007. The events that precipitated the bust were miniscule, akin to the grain of sand that when added to the pile, causes an avalanche. Once the reversal begins, the self-reinforcing feedbacks (again between credit growth and asset valuations) take over, and a rush occurs out of assets and into money. The money-like quality of various assets (such as supposedly “high quality” AAA-rated mortgage backed securities or Greek Government debt) quickly disappears as these assets cannot attract buyers. All the forces that turned in one direction to create the illusion of profit suddenly reverse direction and rapidly destroy value. People have to dump whatever they own — even if the price is falling — to pay what they owe. This abrupt process of deleveraging then leads to devastating consequences for financial and macroeconomic stability that especially hurt the poor and middle classes.
What was missed in all of this is that financial markets often do not operate according to rules we learned in microeconomic theory 101. Liberalizing these markets without proper oversight and enforcement threatens financial stability. The key distinction is to be found in the link between debt and asset prices in the financial markets. Non-financial markets tend to find a natural balance. An increase in the price of a good tends to depress demand. In financial markets, however, an increase in the price of an asset spurs people to borrow more, which in turn causes prices to rise further. Boom-bust cycles are an inherent tendency in liberalized financial markets. This was one of the most important lessons from the 1920s. And policy makers, ever-confident that the “Greenspan Put” was working well, failed to pay heed to the rising imbalances that evolved alongside the Great Moderation until it was much too late.
What is to be done? One of two paths makes sense. The first path is for regulators and monetary officials to focus aggressively on moderating credit growth and systemic risk. There are several policies that can be marshaled in this regard, including policies to constrain the growth in credit and systemic risk (macroprudential policies), monetary policy and more forward-looking supervision that monitors and takes action against financial excesses. All of these policies were available to policy makers prior to the 2007 crisis, yet none was used. Will this time be any different?
If we can absorb critical lessons from the crisis of 2007, perhaps it will. The Dodd-Frank law, signed by President Obama in 2010, created the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR) with the explicit objective of monitoring and, if need be, managing systemic risks. Time will tell as to whether these newly created bodies meet their mandate and effectively address systemic risks. Political economic pressures from bank lobbyists and members of Congress make this task more difficult, especially since credit appears so attractive in a boom (and the pain does not arrive until much later). Education of the public and of politicians is absolutely essential as we move forward in this brave new world.
Another major crisis will likely push us rapidly toward the second path of reregulating financial markets. We must define limits on finance so that it will once again focus on capital formation, job growth and genuine economic activity. Wall Street should serve the needs of the real economy on Main Street. Although the political system today still resists these common sense reforms, it is essential to build a new financial system in which the dog wags its tail, rather than the other way around. The power of unrestrained financial markets have generated enormous downside consequences that will remain with us for many years. By committing to a pathway of reform, we can address the core questions that will shape the 21st century world – what should finance do and whose interests should it serve?
About the author: John Balder teaches at the International Business School at Brandeis University, and has had an exceptional career working for both the public and private and sector, including work at Grantham, Mayo, Van Otterloo and SSgA as well as staff positions on the Committee on Financial Services in the US House of Representatives, the Housing Banking Committee, the Federal Reserve Bank of NY, and the Department of the Treasury.