By Masoud Movahed
“The fate of the world economy is now totally dependent on the stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings.” Former Fed Chairman Paul Volcker.
Economists and analysts of the 2007-2009 financial meltdown usually take the domestic housing and securities markets as the point of departure in their prognoses of the crisis. While refusing to look beyond the apparent roots of the malaise, they continue to begrudge the decline in housing prices as the bedrock of the financial crunch. And, that, of course, makes perfect sense. With a housing bubble bursting by the end of 2006 that forced the prices of assets down, a deregulated credit market running on an unbridled debt explosion, and numerous banks plunging into failure and insolvency, the ground was rightly laid for the suspicion that the roots of the plague ought to be investigated in the housing and securities markets. But to accurately diagnose the origins of today’s economic depression, one should look beyond the U.S. financial and housing markets. The fundamental source of the crisis today—both in finance and beyond—is the declining economic vitality and dynamism of the advanced industrialized countries, especially the United States. Contrary to the mainstream account, the crisis is deep-rooted in the zero-sum game that the rapid development of some newly emerging economies abroad has entailed for the U.S. economy as well as the advanced world in general. Stemming from intensifying international competition, U.S. manufacturing firms had to struggle ever more with lower rates of profit, which led to system-wide economic distress. In what follows, I explain how the origins of the crunch should be probed in the intensifying competition in the global manufacturing market, which affected the financial sector at home.
It is no longer an esoteric reality that since the 1970s, the American economy has seen a reconstructing so fundamental that its magnitude is hard to overstate. We hear much about financialization of the economy, which has permitted the stratospheric ascent of finance. The “Old Economy” of complex machinery and laborious manufacturing has given its way to the “New Economy” of finance, software engineering and information technology. Quibbles among economists notwithstanding, the unmistakable broad trend is that the largest share of the aggregate profits in the economy—estimated to be roughly 40 percent of total profits—is generated in the financial sector (see Figure 1). This datum is often taken as the strongest evidence of the salience of finance in the U.S. economy. Financialization is defined in multiple ways, but Gerta Krippner’s definition as “a pattern accumulation in which profits accrue through financial channels rather than through trade and commodity production” seems to capture what has changed about investment and capital accumulation in our economy. Provision or transfer of liquid capital in expectation of future interest, dividends and capital gains are only a few of the many other stratagems of financial activities, in which investment bankers are the most adroit and innovative.
Naturally, such a tectonic economic change has invited a series of explanations aiming to explicate the roots of the phenomenon. There are those, for instance, who would attribute financialization to the natural progression of capitalist development where the productive sector, namely manufacturing, is subject to intensified international competition and witnesses an enormous reduction in profit rates. Thus, the ascent of finance is a natural response to the stagnating tendency of the manufacturing sector. In this vein, economists such as Paul Sweezy and Harry Magdoff argued that with decline of rates in manufacturing due to intensifying global competition, stagnation instead of dynamism and financialization instead of industrialization, become the twin trajectories of the advanced world. It should be noted, however, that financialization is not endemic to the U.S. economy alone. Finance, across the advanced world with the exception of Germany, has become a salient sector of the economy. Indeed, as I will show later in the essay, decline in the rates of profit in U.S. manufacturing has been the primary reason behind the massive explosion of finance worldwide, and the crisis of 2007 to 2009 by no means can be construed independent of the rise of finance.
There are also those who would take not only the decline in manufacturing profits, but also certain macroeconomic policies of the U.S. Federal Reserve as driving forces of financialization. This perspective has been led most notably by Robert Brenner of UCLA whose book The Economics of Global Turbulence demonstrated that the titanic fall in the rates of manufacturing profitability of the advanced economies has to do with the over-capacity in global manufacturing. The implication is that since the late 1960s, the manufacturers of consecutively newly emerging economic powers have been able to make use of the latest technology coupled with relatively lower wages of domestic labor markets to manufacture export goods that were already being produced, but can now be manufactured at a lower cost and offered for a lower price. Germany and Japan in the 1960s, the East Asian Tigers (e.g. South Korea and Taiwan) in the 1970s and 1980s, and the Chinese behemoth in the 1990s and 2000s have all been able to adroitly acquire significant market share in global manufacturing. For U.S. firms, however, to maintain the same market share that they had in the early 1950s to 1960s and to remain competitive globally, they have had to offer their output to the international market at lower prices, which translates to lower rates of profit on U.S. firms’ balance sheet. The upshot was, as Brenner accurately observes, oversupply for low global demand, which depressed not only prices, but also profits.
Hence, the reduction in manufacturing profitability meant that firms had smaller surpluses at their disposal, which itself dampened hiring and labor demand. This manifested itself conspicuously in the rapid decline of manufacturing employment in the U.S. economy. As a result, by the end of 2010, the sector had lost almost 50 percent of the 22 million jobs it had at its 1979 postwar peak (see Figure 2). Indeed, slower growth of the sector relative to services (namely finance and information technology), almost daily soaring trade deficits, record manufacturing job losses and factory closures, and massive outsourcing of manufacturing sites to labor-intensive economies (especially China), make it plausible to lament the decline of American manufacturing. Lower rates of profit in the productive sector of the economy, namely manufacturing, ushered in an era of financialization.
The logic of the rise of finance—as the most thriving and profit-generating sector of the economy—can be explained by the following simple economic rationale. For any given industry to bourgeon, there has to be sufficient demand for the output of that industry. The level of demand—the volume of spending and investment—for a specific industry determines the growth rate of that industry. That is to say, no sector in an economy—be it in manufacturing or services— can grow if there is no demand for it. For instance, the IT industry has witnessed an unrivaled growth rate in the past two decades simply because of the growing demand for software and high-speed IT infrastructure, which has invited a mammoth investment in the sector. Little wonder why! Now in such a depressing economic climate, where the global manufacturing market suffers from over-capacity and as a result reduced profit rates, which by itself disincentives firms from hiring more labor and generating more employment, the economy continues to show signs of enfeeblement. As Brenner explains, since firms were ever more reluctant to hire labor or raise wages as a result of lower rates of profit, there was no way for the economy to generate demand—or to encourage spending—other than by way of ever greater borrowing, which meant running the economy on credit. This was essentially dependent upon banks. To boost private spending, the Fed lowered the short-term interest rate in the 1990s, which made highly risky credit available to households, many of which were unqualified.
As a matter of fact, because of the stagnant growth of wages, many of those households had ever higher debts compared to their incomes. In attempt to pinpoint origins of the housing bubble prior to 2006, two economists at the University of Chicago Atif Mian and Amir Sufi argued that there exists a statistically causal relationship between the massive supply of mortgages and the rapid rise of housing prices which led to the bubble by the end of 2006. Surprisingly enough, they find that the period between 2001 and 2005 is the only one in recent U.S. history where housing prices increased in zip codes that had negative income growth. This is strong evidence that credit was in one way or another supplied in an extraordinarily risky way to ever more unqualified borrowers. In an economy that had already demonstrated sluggish growth rates by the mid 1990s, injections of risky credit by way of lowering short-term interest rates offered a way out of the predicament (see Figure 4). This massive injection of credit became the benchmark economic policy that laid the ground work for the spectacular ascent of finance.
I mentioned earlier that since the 1980s, manufacturing firms have been enfeebled by the decline of profit rates, as were households by the wage stagnation. Corporations along with households were thus enabled to increase their borrowing. Speculative run-ups in asset prices in both the housing and securities markets enabled huge, largely fictitious increases in the wealth of corporations and households. Nurtured by easy credit and deregulation policies of the Federal Reserve Banks, there was a massive run-up in the housing prices between 2000 and 2006. Whenever the run-ups in financial markets led to trouble, the Fed would not hesitate to reduce the short-term interest rates so as to incentivize financial investors to step up their borrowing in order to correspondingly increase their purchases of housing and financial assets.
Credit Market Explosion and Bubblenomics
The key to the complete explosion of the credit market was the Fed’s policy of maintaining low short-term interest rates. For banks, that was a license to make money with very little risk, particularly since they can get people to open savings accounts that pay close to nothing. The low short-term rates meant easy access to cheap credit for borrowers who then invested enormously in the stock and securities market. Indeed, what is good for banks is not good for the economy. The incessantly low short-term interest rates in the past two decades thus created an environment conducive to financialization. The flood of easy credit to the stock and housing markets paved the path for the historic run-ups of equity and land prices that ensued during the second half of the decade and provided the increase in paper wealth that was required to enable both corporations and households to step up their borrowing, raise investment and consumption, and keep the economy expanding. The low interest rates of the 1990s and early 2000s created conditions under which firms and households could borrow easily, invest in the housing and stock markets, and push up their prices. So banks took it upon themselves to stimulate growth by enabling corporations and households to increase their borrowing, which precipitated a significant increase in housing and securities prices. With credit made so cheap, and profit-making on lending rendered so easy, banks and non-bank financial institutions could not resist opening the floodgates and advancing funds without limit.
In short, the crisis of 2007 to 2009 was one of the most disastrous financial meltdowns since the Great Depression. While there is a pervasive tendency among economists to look at the financial and securities market to understand the roots of the crunch, a few have departed from them. Viewed against what the mainstream economists put forward, those who differ often argue that the origins of the crisis ought to be investigated in the context of the lower rates of profits as a result of intensifying international competition. Decline in the rates of manufacturing profits and certain macroeconomic policies of the Federal Reserve Bank are seen to have provided the impetus towards the financialization of the economy as well as the recent crisis in the financial sector. The decline of U.S. manufacturing profitability posed serious threats to economic dynamism and vitality as firms were ever more reluctant to hire labor or raise wages. For the Fed to continue generating growth, it had to enable both the public and private sectors—both households and the government—to increase their borrowing. This process was entirely dependent on banks. With the policy of low interest rates that provided cheap credit to borrowers, households that struggled with stagnant wages and runaway debt, and housing prices that fell day by day after the bubble burst in 2006, the Fed along with banks continued to stimulate the economy by expanding the credit market. Running the economy on deficit spending in both public and private resulted in the devastating crunch of 2007 to 2009.
Masoud Movahed is a doctoral candidate at the University of Wisconsin-Madison. Previously, he was a Research Associate in Development Economics at New York University. He contributes to, among others, Harvard International Review, Foreign Affairs,Yale Journal of International Affairs, World Economic Forum and Aljazeera English.