Postcapitalism

May 3, 2016

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Paul Mason. Postcapitalism: A Guide to Our Future. New York: Farrar, Straus and Giroux, 2016.

Paul Mason is a British freelance journalist and economics writer. He is a bold, creative thinker who challenges a lot of mainstream economic thinking. Here he has written an especially insightful and thought-provoking book, one that deserves serious attention and debate.

Mason’s title may make his book sound like a speculative, utopian work, but the future he envisions doesn’t drop out of the sky. It emerges naturally from his understanding of both the recent and earlier history of capitalism. For those who think that something as pervasive and entrenched as capitalism cannot possibly wind down, he offers this observation: “It is absurd that we are capable of witnessing a 40,000-year-old system of gender oppression begin to dissolve before our eyes, and yet still seeing the abolition of a 200-year-old economic system as an unrealistic utopia.”

Another stumbling block for readers may be Mason’s frankly Marxian perspective, although his is a revised version with no “dictatorship of the proletariat.” (Today he sees the educated and networked individual as the key agent of change.) I have some reservations about a few of his arguments, especially concerning the labor theory of value, but that hasn’t stopped me from agreeing with many of his conclusions about the future.

Capitalism’s bleak prospects

Mason begins his book by saying that “the long-term prospects for capitalism are bleak. According to the OECD, growth in the developed world will be ‘weak’ for the next fifty years. Inequality will rise by 40 per cent.”

If we keep going as we have been, we face two alternative futures, neither very pleasant:

  1. Economic globalization continues, but only the wealthy in the developed countries get much benefit from it; or
  2. Popular opposition to globalization grows, global cooperation breaks down, and more nationalist and authoritarian governments emerge, as in the 1930s. Each country tries to save itself at the expense of others, such as by putting up trade barriers to other country’s manufactured goods [See Trump, Donald].

And either way, things get worse in mid-century when the full effects of climate change and demographic change (the challenge of supporting larger and older populations) are felt.

New technologies yes, capitalism maybe not

Mason believes that a better alternative is to take advantage of the potential for new technologies to end capitalism as we know it. Economic problems such as over-reliance on fossil fuels and stagnating wages result from trying to perpetuate a system that no longer works very well. “Capitalism is a complex, adaptive system which has reached the limits of its capacity to adapt.” Although capitalism has a long history of generating technological change, it can no longer adapt to such change because it is now creating technologies that are ultimately incompatible with capitalism itself.

“Information is different from every previous technology,” Mason declares. “Its spontaneous tendency is to dissolve markets, destroy ownership and break down the relationship between work and wages.” Information is different because, unlike other means of production, it can be reproduced at near-zero cost. If I were to give you my car I would lose a car, but what have I lost if I give you an idea? It costs me nearly nothing to share these thoughts with you, so why should I expect you to pay for them? Why would people buy an encyclopedia when Wikipedia is free, or buy a newspaper when so much news is available online?

In addition to widely disseminating “information goods,” the information revolution also “adds a high information content to physical goods, sucking them into the same zero-price vortex….” In a fully automated production system, the key resource is the set of instructions for turning raw materials into finished products. “The knowledge content of products is becoming more valuable than the physical elements used to produce them.” Once the knowledge exists, many users can apply it with little additional cost.

A world of abundant information should also be a world of abundant things produced by automated, information-driven processes. That undermines capitalist markets, since “markets are based on scarcity while information is abundant.” As industrial robots proliferate, the need for paid human labor should diminish. Earlier technological innovations like the assembly line already shortened the work week while simultaneously raising living standards for workers. The more radical change Mason envisions now will free vast amounts of labor from paid employment. Much of that labor can go into voluntary but socially useful activity, whether it is caring for a loved one or making music. Consumers too should experience some liberation from capitalist markets, as more goods and services become available at little or no cost. “We are seeing the rise of non-market production: horizontally distributed peer-production networks that are not centrally managed, producing goods that are either completely free, or which…have very limited commercial value.”

Capitalists can impede this transition, but only by monopolizing information in order to restrict its free flow and maintain its artificial scarcity. Intellectual property rights will be a key issue. Society will have to balance the need to grant such rights in order to reward the producers of new knowledge, against the need to limit such rights in order to facilitate the free spread of information. In the end, Mason doesn’t think that capitalists will be able to own or control the intellectual means of production the way they have owned and controlled other means of production. “The main contradiction today is between the possibility of free, abundant goods and information and a system of monopolies, banks and governments trying to keep things private, scarce and commercial.”

Dramatic changes, conflicts and crises have been common in the history of capitalism. As profit-making opportunities have declined in old industries, capital has repeatedly sought out new markets and new technologies. Always, however, the assumption of industrial capitalism was that people would depend on the owners of centralized means of production for both employment and products. What makes the current crisis different is that knowledge is so easily decentralized, and networked individuals can create so much of value on their own. Global corporations continue to make their profits for now, but they do so increasingly by squeezing the workers and damaging the environment. New technologies that could produce more freedom and abundance for all while better protecting the planet are not yet allowed to do so.

Mason’s argument that abundance will reduce market activity and expand non-market activity makes a lot of sense to me, but I’m not sure how far to take it. The most obvious example is the displacement of human labor from manufacturing production as automation takes control. Many low-skill service jobs could also be automated, although the availability of cheap labor reduces the incentive to make the transition. But I would expect there to be a continuing market for skilled services because not everyone will be willing or able to provide them. A lot of free legal information is available online, but that doesn’t mean that everyone is comfortable being their own lawyer. And although an abundance of goods and services may make them cheaper, only if they become entirely free will the need for money and marketplace exchanges disappear entirely. While some people, especially the more educated, may experience a reduction in paid work hours as a blessing, others may experience it as the curse of unemployment or poverty. Mason’s postcapitalist world will require massive investments in human capital and a stronger safety net for the economically displaced.

The limits of neoliberalism

Standing against Mason’s vision of the future is the set of ideas and policies known as neoliberalism. That is the most recent incarnation of the free-market economics that was considered liberal in the eighteenth and nineteenth centuries, but is associated with conservatism today. Mason defines it as a commitment to uncontrolled markets, the pursuit of self-interest through the market, the small state, and a high tolerance for financial speculation and inequality. On the one hand, he credits neoliberalism for unleashing the information revolution and promoting economic development, especially in poorer countries. On the other hand, he blames the uncontrolled pursuit of profit for aggravating economic inequality and endangering the global environment.

Although neoliberal policies have brought capitalism to a crisis point, neoliberal theory is poorly equipped to understand crisis or radical transformation. Neoliberals believe that markets are essentially rational and self-correcting. If left to their own devices, they tend toward equilibrium, not crisis. For neoliberals, capitalism is just the normal state of affairs, a “continuous present.” Writing with more than a little sarcasm, Mason says that neoliberal economics has a “brilliant model for understanding forms of capitalism that do not change, mutate or die. Unfortunately these do not exist.”

Neoliberal policy and practice has kept capitalism as we know it limping along by relying on loose monetary policy, dramatic growth of the financial sector, and global imbalances between creditor and debtor nations. Specifically:

  1. “Fiat money,” which is money that a state can create freely as long as people have confidence in it, has allowed central banks to counteract stock market drops by pumping cheap money into the economy. When this money inflates the prices of stocks and other assets beyond realistic earnings prospects, boom becomes bust.
  2. As real wages have stagnated, consumer spending has been sustained more by credit and borrowing. By the time of the 2008 financial crisis, 40 percent of corporate profits were coming from the financial sector. Profits must eventually fall if they depend too much on the accumulation of debt.
  3. Neoliberal policies have created debtor countries as well as indebted consumers. “For countries that smashed organized labor, offshored large parts of their productive industries and fueled consumption with rising credit, the outcome was always going to be trade deficits, high government debts and instability in the financial sector.” Debtor nations like the United States require other countries, such as China, Germany and Japan, to be creditor countries. When the burden of debt becomes too great to sustain, countries resist and the system breaks down.

Since the recent financial crisis, neoliberal policy has turned toward imposing austerity on the debtors, while not addressing the reasons for the expansion of debt in the first place. Mason regards the economic recovery as only a temporary fix, since the underlying weaknesses have not been corrected. The real existential crisis of capitalism itself is only beginning.

The most important limit on the neoliberal system is information technology, which is put to the service of the existing capitalist system in the short run, but undermines it in the long run.

And that’s just the introduction and Chapter 1! My next post will look at the historical part of Mason’s argument, his interpretation of the “long cycles” in capitalist history.

Continued


The Shifts and the Shocks (part 3)

December 19, 2014

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The last part of Martin Wolf’s book deals with solutions to financial instability and the sluggish economic recovery. This is the hardest part to summarize, since Wolf discusses a great many ideas, organizes them rather loosely, provides little in the way of prioritization, and conveys little confidence that some of the more promising ideas will actually be adopted. In keeping with Wolf’s interest in underlying macroeconomic causes of financial crisis, I will highlight the solutions that would address those causes.

To review some of the main themes, Wolf describes a global economy in the aftermath of a great credit boom and bust. Underlying the financial crisis was a global savings glut that was really an excess of saving over investment. When an economy generates more income than is spent on current consumption, the surplus should sustain economic activity through investment in future production and consumption. Also, some people’s savings can go to finance other people’s consumption, as long as the loans are sound and the debtors can repay them out of future earnings. But in the global economy prior to the crisis, not enough of the world’s savings was used for either sound investment or sound consumer borrowing, and too much was used to finance high-risk consumer loans and asset bubbles, especially in housing.

The world became more divided into creditors and debtors: creditor and debtor countries (such as Germany in relation to peripheral Europe and China in relation to the US), creditor and debtor economic classes (increasingly unequal households, especially in the US), and creditor and debtor economic sectors (the corporate sector with surplus income and the government and household sectors running deficits). When the credit boom got too far out of hand, some debtors defaulted, some creditors stopped lending, and the system crashed.

The challenge for the future is then to tighten financial rules to discourage credit excesses, but also to reform the system to make better use of economic resources. It isn’t enough just to stop creditors from making risky loans and force debtors to pay down debt. If something else isn’t done to put excess savings to good use–in either investment or consumption–austerity will only weaken economic demand, increase surplus savings and produce long-term economic stagnation. That is what Wolf fears:

Far more likely [than adequate reform] is an enduring slump in high-income countries, at least relative to pre-crisis expectations. That would impose huge costs – of investments unmade, of businesses not started, of skills atrophied and of hopes destroyed. Should that fate be avoided, another temporary credit-driven boom might emerge, followed by another and still bigger crash.

Wolf argues that the long-term costs of failing to sustain high economic output are greater than the costs of wars, and also greater than the costs of inflation (relevant because fighting inflation has often been such a high priority of economic theorists and policymakers).

Banking reform

Throughout his discussion of solutions, Wolf is willing to entertain more radical reforms than have been adopted so far, although he acknowledges the difficulties of implementing them. For example, he would like to make fundamental changes in the way bankers do business:

So the business model of contemporary banking is this: employ as much implicitly or explicitly guaranteed debt as possible; employ as little equity as one can; invest in high-risk assets; promise a high return on equity, unadjusted for risk; link bonuses to the achievement of this return target in the short term; ensure that as little as possible of those rewards are clawed back in the event of catastrophe; and become rich. This is a wonderful business model for bankers….For everybody else, it was a disaster.

The solution seems clear: force banks to fund themselves with equity to a far greater extent than they do today.

Before the crisis, the median ratio of debt to equity in UK banks was 50:1. That meant that a mere 2% drop in the value of the typical band’s assets would make it insolvent. Wolf would like to see a maximum ratio of 10:1.

Wolf also devotes considerable space to a discussion of the even more radical “Chicago Plan,” which would eliminate the role of bank lending in the creation of money and dramatically increase the government’s control over the money supply. But he acknowledges that this would be too disruptive, and that more moderate reforms should be tried first.

Macroeconomic reforms

The deeper problem is how to stimulate demand and put savings to constructive use, so that excessive credit is not needed to maintain economic activity.

Wolf deplores the almost exclusive reliance on monetary policy (low interest rates and bond purchases by central banks) to bring about economic recovery. At least in the short run, increases in government spending would have accomplished more in a shorter time. “The decision to withdraw fiscal support for the recovery, taken at the G – 20 Summit of June 2010, delivered a longer and deeper slump than necessary….It has also meant relying on a more uncertain tool – that of unconventional monetary policy – and abandoning a less uncertain one – that of fiscal policy.” The notion that government borrowing and spending interferes with private investing lives on, although it made more sense when capital was scarce and expensive than it does now, when capital is abundant and cheap.

In the longer run, total economic demand must be increased by reducing the excess savings of creditors and increasing the income of debtors. High-saving, high-export countries like China and Germany need to stimulate domestic demand by allowing their workers to consume more, while debtor countries need to stimulate foreign demand by becoming more globally competitive and earning more income abroad. Corporations should be discouraged from accumulating excess savings, but encouraged by changes in corporate governance and taxation to distribute profits not needed for investment. Government should have the tax revenue it needs to create needed social goods. Low-income households should get a larger share of income through higher wages or progressive taxation, so they can maintain consumption without relying so heavily on debt.

Saving the Eurozone

Wolf minces no words in his discussion of the European Monetary Union; he regards it as a “bad marriage,” since it created a unified currency without first creating a unified state. “Proponents thought that creating a currency union would bring the peoples of the Eurozone closer together. Crises divided them into contemptuous creditors and resentful debtors instead. This has been a march of folly.”

As I discussed in the first post, the common currency made it easier for strong economies to export and weaker ones to borrow. But when the credit bubble burst, there was no central state to help repair the damage. Wolf notes that in the United States, some states are economically weaker than others, but their citizens participate in a federal safety net and their bank deposits are federally insured. The European Central Bank was very slow to intervene to maintain liquidity in the countries hardest hit by the financial crisis. Wolf maintains that since “the creditor countries bear a full share of the responsibility for the mess, they should expect to bear a full share in its resolution as well,” by refinancing some debt with lower interest rates and longer terms. Wolf also wants to see a strengthening of the central bank, with stronger powers to regulate banks and issue eurobonds “for which the Eurozone states are jointly and severally liable.”

From a macroeconomic perspective, the Eurozone will suffer from weak demand if Germany continues to rely for its prosperity on its high level of exports while weaker economies import less in order to pay down debt. If all of Europe is trying to consume less than it produces, that will in turn aggravate the problem of weak demand in the global economy. Austerity may work for some countries, but it cannot work for all.

The implications of the attempt to force the Eurozone to mimic the path to adjustment taken by Germany in the 2000s are profound. For the Eurozone it makes prolonged stagnation, particularly in the crisis-hit countries, probable….Not least, the shift of the Eurozone into surplus is a contractionary shock for the world economy.

Wolf thinks that the chances are good that many European countries will suffer from economic stagnation for a long time, putting an economic drag on the entire European and global economies.

Secular stagnation?

Clearly Wolf regards many of our economic problems as secular (long-term) rather than just cyclical (tied to phases of expansion and contraction). He believes that developed countries with aging populations can expect to experience slower economic growth from now on. “Not only will the labour force shrink absolutely in many countries, as the population falls, but the proportion of it that is young, flexible and innovative will decline further.”

I’m not entirely convinced of that, especially the part about innovation. Age may be related to innovation, but so are education and occupation; consider Richard Florida’s The Rise of the Creative Class. Slower population growth does reduce one obvious reason for new investment–the need to expand the quantity of existing goods and services–but there can still be innovations in type and quality. And even if businesses do find it harder to come up with things to invest in–which I gather is Wolf’s point–a thriving economy remains possible as long as enough income finds its way into the hands of those who will use it for something useful. These could be working families trying to raise children, or governments trying to fund improvements in infrastructure or education. They certainly don’t have to be wealthy financiers squandering the world’s income on risky loans.

Neither economic evil–stagnation on the one hand or credit binge on the other–is inevitable. Wolf helps us understand how we might avoid them, if we have the wisdom and the will. However, the author himself is not sure that we do.


The Shifts and the Shocks (part 2)

December 17, 2014

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The second part of Martin’s Wolf’s The Shifts and the Shocks examines the deeper economic causes of the financial crisis. “This crisis was the product not just of easily fixable failings in the financial sector….It was also the product of failings of the global economic system….Moreover, both are among the consequences of fundamental shifts in the world economy.”

Wolf’s interest in looking for deeper causes sets his book apart from more superficial treatments that just blame the crisis on easy credit, foolish borrowing, and loose monetary policy by the Federal Reserve. Wolf regards these as symptoms rather than underlying causes. Returning to full employment and high economic output may be harder than most people realize, since it will require addressing some fundamental economic problems.

This part of the book is divided into two chapters: “How Finance Became Fragile” and “How the World Economy Shifted.” Again, his approach is to examine financial effects before economic causes, so the reader must follow the argument all the way through to arrive at the key conclusions.

How finance became fragile

Financial crises have been endemic to capitalism. The financial system often fluctuates between phases of boom and bust, optimism and pessimism, credit expansion and credit contraction. Wolf summarizes Hyman Minsky’s description of five stages in a financial bubble:

‘displacement’ – a trigger event, such as a new technology or falling interest rates; ‘boom’ – when asset prices start rising; ‘euphoria’ – when investors’ caution is thrown to the wind; ‘profit-taking’ – when intelligent investors start taking profits; and ‘panic’ – a period of collapsing asset prices and mass bankruptcy.

For the most recent episode of credit boom and bust, Wolf identifies five factors that contributed to financial fragility:

  • a trend toward financial liberalization and weakening of financial regulations
  • globalization of banking, lending and holdings of assets
  • financial innovations such as derivatives and shadow banking (trading of asset-backed securities)
  • leveraging (holding more debt relative to equity, magnifying returns on the upside but also losses on the downside)
  • incentive systems that rewarded risk-taking and short-term success

He also identifies three failures of policymakers:

  • underestimating the need for regulation
  • focusing monetary policy on controlling inflation, while overlooking other sources of instability
  • not intervening in the banking collapse soon enough (specifically, letting Lehman Brothers fail)

How the world economy shifted

Once again, Wolf emphasizes that despite all of these financial weaknesses, “the failure does not lie only or even mainly within the financial system or with financial regulators. The crisis had wider economic causes–and consequences.” In particular, the boom in easy credit and excessive lending depended on what Ben Bernanke called–even before the crisis–a “global savings glut.” Wolf argues that this should also be thought of as an “investment dearth,” or a problem of balancing savings and investment. The issue is sustaining economic activity by using the money not spent on consumption for investments in future production.

To a degree, investment adjusts to savings through fluctuations in interest rates. If the desire to save is greater than the desire to invest in the means of production, interest rates fall, capital becomes cheap, and balance is restored by discouraging saving (through low return) and encouraging investment (through low cost). But in an economic slump, this balancing mechanism can fail to put capital to productive use. People may choose to sit on cash, neither spending it nor buying low-interest bonds, and businesses may refrain from investing in production because the demand for products is so weak. “In brief, Mr. Bernanke’s global savings glut would be visible in a combination of two phenomena: weak economies and/or low interest rates. Today, this combination is precisely what we see in the high-income countries.”

What caused the global savings glut was primarily a shift in many emerging economies, especially China, from being net importers of capital to being net exporters of capital. Although it has been common for investors in developed countries to find investment opportunities in less developed ones, some of the latter prefer to avoid dependence on foreign capital. They choose to strengthen their economies by encouraging saving over spending, financing their own industries, emphasizing exports over domestic consumption and running trade surpluses. At the same time, some developed countries, especially Germany and Japan, were also becoming net exporters of goods and capital, partly because their aging, slow-growing populations required less investment in new infrastructure and capital equipment at home. In the words of Raghuram Rajan, “So long as large countries like Germany and Japan are structurally inclined–indeed required–to export, global supply washes around the world looking for countries that have the weakest policies or the least discipline, tempting them to spend until they simply cannot afford it and succumb to crisis.”

The largest of such countries was, of course, the United States, whose own industries were threatened by the ease with which American consumers could buy foreign goods. Making that situation worse was the strong American dollar–still the world’s most popular currency for holding cash reserves–which made American products more expensive and foreign products cheaper. However, the glut of foreign savings seeking investment opportunity brought interest rates down, discouraging saving and making it easier for Americans to buy expensive things on credit, especially housing. Investors who were reluctant to invest in faltering American manufacturing could invest in mortgage loans, including very shaky ones, which were packaged in clever ways to disguise the risks. So there was a credit boom that took multiple forms: creditor countries like China and Germany lending to debtor countries like the United States and Greece, an exploding finance industry lending to consumers within the United States, and rich investors around the world financing the US government deficit.

For most of the years leading up to the financial crisis, US business remained highly profitable, and contributed to the savings glut by running large surpluses. “With rising profits and a weak desire to invest, the non-financial corporate sector became a net supplier of savings to the rest of the economy.” The only way to keep the economy humming was for households and government to absorb excess savings by running deficits. “Persuading the household sector to spend consistently more than its income is quite hard,” Wolf says, but it was managed with easy credit. I would add that getting a Republican administration to accept large deficits ought to be hard too, but it was managed with tax cuts and wars.

One additional contributor to the savings glut and credit boom was rising economic inequality. “Finally, there was a huge shift in the distribution of income inside many economies, notably including high-income countries, from wages to profits, and, within wages, from those at the middle and bottom towards the top, partly due to globalization, partly due to technology, partly due to financial liberalization, and partly due to changes in social norms, particularly corporate governance.” While those with higher incomes could afford to save more, those with lower incomes relied more on credit to sustain consumption.

In the end, the global savings glut resulted in a massive waste of economic resources, as too little capital was put to productive use. “Instead, the resources were wasted in building unneeded and unaffordable houses or in fiscal deficits caused by unfunded wars, unfunded entitlement spending and unfunded tax cuts. The capital imported by the US, in particular, was wasted on a colossal scale.”

The final post on Wolf’s book will deal with ideas for putting the global economy on a more sustainable footing.

Continued


The Shifts and the Shocks

December 15, 2014

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Martin Wolf. The Shifts and the Shocks: What we’ve learned–and have still to learn–from the financial crisis. London: Penguin, 2014.

British economic journalist Martin Wolf provides a comprehensive account of the global financial crisis and its aftermath. The story unfolds slowly and covers a lot of ground, so the reader needs to read the entire book carefully to get the full picture.

Wolf’s own policy perspective is fairly moderate. He supported much of the economic liberalization and limitation of state power under Margaret Thatcher and Ronald Reagan, but he now believes that liberalization got out of hand and became a major cause of the financial crisis. “The financial driven capitalism that emerged after the market-oriented counter-revolution has proved too much of a good thing. That is what I have learned from the crisis.” He also faults naïve economists for exaggerating the efficiency of free markets and overlooking the signs of increasing instability, thus condoning the risky behaviors that led up to the financial meltdown.

The title of the book refers to Wolf’s distinction between the underlying shifts in the global economy that made financial markets less stable, and the actual financial shocks that caused a sharp contraction of economic activity and created a need for government intervention. In organizing the book, Wolf chose to cover the shocks in Part I and the shifts in Part II. I thought that made the book’s argument harder to follow, reversing the chronological order of events and putting the financial cart before the economic horse that was pulling it. Wolf describes the financial crisis in Chapter 1, but doesn’t discuss the reasons for financial instability until Chapter 4. He only sets the scene briefly by describing four features of an ultimately unsustainable global situation: “huge balance-of-payments imbalances; a surge in house prices and house building in a number of high-income countries, notably the US; rapid growth in the scale and profitability of a liberalized financial sector; and soaring private debt in a number of high-income countries, notably the US, but also the UK and Spain.”

When investors lost confidence in the value of the loans they had made and the assets they had helped inflate, major investment banks failed and credit dried up. That forced governments to intervene, very likely bringing to an end the era of financial liberalization. The US government took over the biggest mortgage lenders, injected capital into failing businesses, lent money to banks at zero or near-zero interest rates, and held down longer-term rates by purchasing private bonds.

Post-crisis recovery and its limitations

Judging from the size of the banks that failed, the financial crisis was even worse than the crash of 1929, but the rapid policy response kept the economic situation from becoming as bad as the Great Depression. Nevertheless, the success of the recovery has been limited by the failure of government to be even more aggressive. Wolf’s verdict is that it rescued the world economy “fairly successfully, but not successfully enough, largely because the fiscal stimulus was both too small and prematurely abandoned.”

The post-crisis recovery has been weak for many reasons: Borrowers reduced borrowing and spending and turned to paying down debt. Investors also pulled back as a reaction against previous overinvestment, especially in housing that buyers couldn’t really afford. Financial institutions became more reluctant to lend, and borrowers could no longer count on inflation to increase the price of their assets while reducing the real value of their debts. The result was a general state of economic “malaise” in which low consumer demand and low investment reinforced each other.

Wolf also discusses “sectoral balances,” the balance of income and spending within the household, corporate, government and foreign sectors of economic activity. When US households and corporations reduced spending and started generating large surpluses, the economy required deficit spending by government to avoid protracted recession. This turned on its head the old idea that government spending crowds out private spending by borrowing money that could be put to better use by business. With the central bank lending money for practically nothing and corporations failing to invest much of it anyway, Wolf argues that “the private-sector cutbacks crowded in the fiscal deficit.” He believes that if the government had followed the advice of conservatives and slashed the deficit, that would have caused an economic depression.

Nevertheless, world economic leaders became so concerned about fiscal deficits that they pledged to cut them in half at the Toronto Summit of 2010. In the US, ideological opposition to government intervention remained strong, heightened by Republican opposition to the Obama presidency:

In the US, for both electoral and ideological reasons, the Republican Party was irrevocably opposed to the idea that the government could do anything useful about the economy except by leaving it alone, and so could not tolerate the possibility that the Obama administration might prove the opposite in the aftermath of the biggest economic crisis for eighty years. It therefore dedicated itself in Congress to preventing the administration from doing anything that might improve economic performance.

The crisis in the Eurozone

While the United States was starting to recover from the financial crisis, “the epicenter of the crisis moved inside the Eurozone, where it subsequently remained.” The contraction of credit exposed weaknesses in European national economies that had been masked by the adoption of a common currency.

When each nation has its own currency, the strength of that currency can reflect the competitiveness of its economy. Weak demand for its products on world markets will usually weaken demand for its currency, and the low buying power of its currency should keep it from buying more than it produces and trades. Investors from stronger economies can lend to weaker ones, but usually at high interest rates to reward lenders for taking more risk. The common European currency papered over these national differences and encouraged an excessive flow of goods and credit from the stronger economies, especially Germany, to the weaker economies of Southern Europe, such as Spain. The fiction that every euro was worth the same made it too easy for the Spanish, Greeks, Italians and others to borrow from German banks and buy German goods. The various economies appeared to be thriving together, but only until the end of the credit boom brought the game to an end.

The credit crunch put the poorer countries in the position of either defaulting on their debts or adopting austerity measures that threw their economies into recession:

Given their difficulty in borrowing and their lack of access to central-bank financing, the crisis-hit countries could not offset these deep recessions, indeed true depressions, with fiscal or monetary stimulus, at least without external support. That was not to be forthcoming on any significant scale. This was partly because Germany, supported by other creditor countries and the European Commission, argued that necessary structural reforms would not occur without remorseless economic pressure and, for that reason, regarded greater external support as counter-productive.

Wolf criticizes Germany for refusing to accept any responsibility for the crisis:

Germany’s focus on the alleged fiscal crimes of countries now in crisis was an effort at self-exculpation: as the Eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis. As Bagehot indicates, excess borrowing by fools would have been impossible without excess lending by fools: creditors and debtors are joined at the hip. A country that chooses to run current-account surpluses, indeed, one that has built its economy around generating improved competitiveness and increased external surpluses, has to finance the counterpart deficits and must, accordingly, bear responsibility for the wastage of funds.

Wolf thinks it is misleading to blame the European economic crisis on government deficits in particular. What the troubled economies had in common before the crisis were not government deficits but balance-of-trade deficits, which were a consequence of policies in both creditor and debtor countries. After the crisis, private spending declined, but government deficits increased due to falling tax revenues and counter-recessionary spending. Fiscal austerity alone, without any other economic reforms, is a recipe for continued recession.

Emerging economies

Emerging economies in Asia and Latin America generally grew at a faster rate both before and after the financial crisis. Most of them managed to avoid credit booms that would leave them as heavily indebted as the United States or Southern European countries. On the contrary, some of them, especially China, ran large surpluses by exporting more than they imported and investing heavily in other countries. Although this has been a successful growth strategy in the short run, Wolf questions its sustainability. Again, if countries like Germany and China run surpluses, others must run deficits; and if too many countries embrace austerity at the same time, global output must fall. Like Michael Pettis, Wolf thinks it is silly to treat austerity and lending as moral goods, while treating spending and borrowing as moral evils. At the macroeconomic level, the problem is finding a balance, for example by having creditor countries increase domestic demand and debtor countries increase their exports.

My next post will deal with the global economic shifts to which Wolf attributes the financial crisis in the first place.

Continued


Political Bubbles (part 2)

November 13, 2014

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Having described how political ideologies, interests and institutions help inflate dangerous financial bubbles, McCarty, Poole and Rosenthal turn their attention to what happens after a bubble bursts.

In the case of the bubble that burst in 2008, the political response was hampered for many reasons. Although the voters elected a moderate Democrat as President, the ideological positions within Congress changed very little. In fact, while the new Democrats elected in 2008 were mostly moderate candidates running in swing states, the new Republicans elected in 2010 were more often extreme conservatives from “red” states. After 2010, free market conservatism was even better represented in Congress than it had been before the crisis.

Although some large financial institutions failed, mergers and acquisitions–many of them arranged by government–created even larger ones that were truly “too big to fail,” giving them a kind of license to engage in risky behavior. The power of the financial industry to influence elections and shape legislation remained unchecked.

The institutional arrangements that make change difficult, such as the Senate filibuster, remained in place, and the number of bills that couldn’t be brought to a vote reached record proportions. By undoing some of the previous campaign finance reforms, the Supreme Court enhanced the political influence of powerful financial interests.

Responses to “pops” in American History

The difficulty of financial reform after the bubble popped in 2008 is fairly consistent with the historical experience. The authors draw four lessons from government responses in similar situations:

  1. Legislative responses to financial crises and economic downturns have generally been limited and delayed.
  2. The response often awaits a transition in political power. This partisan delay reflects the idea that the cause of the crisis is generally rooted in the ideology of the incumbent party.
  3. Future change in political power often reverses the initial legislative response. The reversal contributes to the next crisis. This point is central to the inevitability of future financial crises.
  4. Short-term reelection concerns undermine the search for longer-term solutions.

In the case of the most famous financial crisis, the crash of 1929, the legislative response was delayed until the election of 1932. By then, the economic damage was severe enough to generate a massive shift in ideology and voting, which gave Roosevelt large majorities of pro-intervention Democrats in both houses of Congress. In addition, the Republican Party included more moderates in those days, as a result of a progressive reaction against Gilded Age inequalities that had been building for some time. As a result, “FDR was able to do business with practical, compromising politicians. In contrast…Obama is faced with a pack of ideologues.”

As an example of the difference, the Roosevelt administration was able to provide debt relief to millions of farms and homeowners, with massive approval from the general public. The Obama administration’s efforts to restructure failing mortgages were not only hampered by a lack of cooperation from lenders, but attacked as a subsidy for irresponsible borrowers, a reaction that launched the Tea Party movement.

Legislative responses

Because of Congressional polarization and strong conservative opposition, the Obama administration’s major pieces of legislation–the economic stimulus package, the Dodd-Frank financial reform, and the Affordable Care Act–had to be carefully crafted to achieve a majority in the House and a filibuster-proof majority in the Senate. In all three cases, votes split along clear ideological and party lines, with only just enough votes to win. The bills couldn’t include anything unacceptable to their least enthusiastic supporters.

The authors regard Dodd-Frank as a very limited financial reform. It makes few hard-and-fast rules, instead leaving a great deal to the discretion of regulatory agencies, mostly the same agencies that have demonstrated low regulatory capacity and over-dependence on industry in the past. It didn’t bode well that the agencies missed most of their deadlines for issuing the new regulations required by the law. Dodd-Frank did little to eliminate the problem of “too big to fail,” or change the executive compensation practices that led to excessive risk taking, or regulate risky financial derivatives.

Another political response to the crisis, the Troubled Assets Relief Program (TARP) had a different political dynamic. It was proposed by the Bush administration as an emergency response to the banking crisis. The vote did not split neatly along liberal/conservative lines, since opposition came both from conservatives opposed to government intervention and some liberals opposed to government generosity toward big banks. It may have been necessary, but it wasn’t very popular at either end of the political spectrum.

Public opinion

The authors explore some of the nuances of political populism. In general, it “arises from mistrust of elites and the institutions they govern,” but it takes many forms. One populist current in American history is “distrust of big business, finance, and concentrated economic power.” Even stronger currents, however, are distrust of government and of cultural elites like intellectuals. Before the 1970s and the Watergate scandal, most people said they trusted their government to do the right thing most of the time, but in 2007 only about 20% still thought so.

When the financial crisis hit in 2008, the public generally supported government interventions such as more financial regulation and assistance to homeowners. Given the general mistrust of government, however, that support was hard to sustain in the face of limited and mixed results. Many people couldn’t see how the government was helping them, even as they heard about bailouts for big banks and low-income homeowners. In the face of relentless attack from the well-mobilized right, especially the Tea Party, public support for change withered. Meanwhile, the Occupy Wall Street movement was trying to mobilize opposition to financial elites and extreme inequality, but they suffered from an inability to agree on an agenda, disengagement with party politics, and hostility to any hierarchical organization.

I find it ironic that the economic failures of government–large deficits, wasteful wars, lax financial regulation–are clearly bipartisan accomplishments, and yet the resulting mistrust of government seems to benefit mostly Republicans as the most overtly anti-government party. Low expectations of government easily become a self-fulfilling prophecy.

Recommendations

McCarty, Poole and Rosenthal would like to see the political response to financial crises strengthened in these ways:

  • “Use simple regulatory rules,” such as a simple “Volcker rule” that commercial banks cannot trade securities on their own account. Dodd-Frank let regulators write a several hundred page rule that is much harder to interpret and enforce.
  • “Set rules that account for political risk,” for example that are strong enough to be useful even if total compliance cannot be achieved
  • “Limit the activities of taxpayer-insured financial firms,” since federal deposit insurance gives taxpayers a stake in the financial outcomes
  • “Reform compensation practices,” so that financial executives cannot receive large bonuses for making bad bets with other people’s money
  • “Prevent ‘Too Big to Fail'” by actually limiting the size and power of financial institutions
  • “Increase regulatory and prosecutorial capacity,” making regulators less dependent on the knowledge and talent of the industry they regulate

In order for reforms like this to occur, the authors see the need for a major shift of ideology, such as occurred during the Progressive Era around the turn of the previous century. Although Americans are generally agreed that the country is on the wrong track, they seem unable to define a more constructive role for government in setting a new direction. I suspect that a new generation will have to be heard from before this will happen.