Responding to Jeff Madrick’s recent post on the US financial regulation legislation, Triple Crisis guest blogger Robert Wade argues for the need to consider “external” causes of the global financial crisis.
I agree with and admire the lucidity of Jeff Madrick’s post — as far as it goes. But (for understandable reasons) it keeps the spotlight trained on microeconomic financial regulation, as does most of the debate. My concern is that the focus on financial regulation obscures the important role of “external” causes in contributing to financial instability (external to national financial systems), and obscures the pressing need for policy reforms to curb these external causes. I highlight two external causes: (1) national income inequality; and (2) international payments imbalances. I argue that if high income inequality and large international payments imbalances are not curbed, we run a serious risk of repeat crises – because the microeconomic efforts to re-regulate and re-structure national financial systems will be eroded or swamped by the force of these more macroeconomic external causes.
On the role of income inequality, in the United States between 1976 and 2007 the top 1% of income recipients received almost 60% of every dollar of real income growth. The figure is even more stunning if one takes just the 2000s: the top 1% received more than 70% of the total increase. On the other hand, through the 1990s and 2000s incomes in the bottom half of the American income distribution have stagnated.
One channel by which this soaring inequality contributed to financial instability is reasonably well known. The great bulk of the population on stagnant or near-stagnant incomes tried to increase their consumption and investment by borrowing. With easy access to credit they provided a rising demand for non-prime mortgages, car loans and the like. Their demand pushed up house prices, which enabled them to borrow against the rising value of their houses – to reach levels of debt completely unsustainable out of their incomes in the event that house prices stopped rising. Thanks to their demand to borrow, the supply of many kinds of financial instruments proliferated, raising the ratio of financial products to “real” transactions (GDP), and raising the ratio of toxic assets to sound ones.
The other channel has received less attention, and it relates to the direct effect of the concentration of income and wealth at the very top. People at the top – high net worth individuals, investment funds, pension funds and the like – greatly increased the demand for complex financial products as they searched for ways to store their wealth. The proliferating billionaires around the world pressured organizations like Goldman Sachs and JP Morgan to supply them with complex financial securities. The investment banks generated huge fee and commission revenues by obliging, and neoliberal economic principles allowed the regulators to believe that the surging growth of complex financial instruments must be to the social benefit.
As long as this external pressure to supply complex financial securities for the super-rich to store their wealth continues, the financial system will remain prone to generate bubbles, followed by crashes. We know that modern capitalism can flourish with a much more equal distribution of income and wealth than in the United States, Britain and many other OECD countries. Reformers should use this argument to press for globally coordinated policy action to close down tax havens (to prevent tax avoidance), and to make the tax burden progressive rather than regressive, as it now tends to be, including capital gains.
The second deep external cause of financial instability is global payments imbalances. The key point is that the present system of international financial transactions is a prime cause of the present financial or money sector dominance of the industrial or real sector. It tends to make finance the “master” and the real sector its “servant”, both within and between national economies. This relationship is a key driver of financial crises, and the key policy question is how to make the real sector the master and the financial sector its servant.
For example, Iceland (from where I write) over the 2000s had a floating exchange rate and unrestricted capital inflows. The result was something which the economics textbooks said should not happen: the economy ran huge trade deficits and at the same time the krona appreciated in value against other currencies. According to the textbooks, the krona should have depreciated, so that Icelanders would find imports more expensive and foreigners would find Iceland’s exports cheaper and the trade deficit would go down. But it did not. The government allowed free inflows of capital, and capital surged in to take advantage of Iceland’s high interest rates compared to rates in Japan, Switzerland and elsewhere (the central bank set high interest rates to try to curb the inflationary pressure caused by the money inflow). The inflow of capital pushed up the value of the krona, and the government assured the people – quite wrongly — that the high value of the krona reflected international confidence in Iceland, including in its banks.
In our present international financial system a country can be flooded with capital inflows (like Iceland), and must then let its currency appreciate or (if the exchange rate is fixed) suffer inflation; or both. Either way the trade deficit will worsen as exports fall and imports increase. Hence capital flows become the master and the trade flows become the servant, rather than the other way around. The toxic effect is to make many economies around the world vulnerable to a sudden withdrawal of capital, as happened in East Asia in 1997-98 and in Iceland, the Baltics and east and central Europe in 2008-09.
Without reforms to curb both these causes of financial instability we will likely experience further serious crises over the next decade. The sheer magnitude of the demand for complex securities in which the swelling ranks of the super-rich can store their wealth will swamp efforts to keep banks within prudential limits; as also will the sheer magnitude of cross-border capital flows (which are also a function of high income and wealth inequality at the top). As governments respond to the crises by pumping in more liquidity, the supply of government bonds will expand even beyond the historically high levels of 2008-09 – and governments will have to offer higher returns to induce investors to buy them. The need to provide these higher returns to buyers of government bonds may be used to justify further cuts to government spending in health, education, infrastructure and other vital sectors, just what many conservatives wish to see. The question is how progressive forces can exercise countervailing pressure, and what policy and structural changes they should advocate. Progressive tax reform and restrictions on capital flows in unstable times (and at least blue sky discussion of how a mechanism of coordinating exchange rate changes might be established) should be high on the agenda.