Report From an Unfolding Crisis, or What I Learned in Washington.
I was in Washington last week for meetings of economists from central trade union bodies, mainly from the OECD countries. While the main purpose of the meetings was to draft the annual union statement to the upcoming G-8 summit in Japan, we had a full day of meetings with researchers and senior officials from the International Monetary Fund, and also a half day mini conference on the unfolding economic crisis with progressive US economists, including Bob Kuttner, Robert Pollin, Bill Spriggs and Tom Palley.
With Bear Sterns collapsing just before we met and the US visibly headed into a potentially deep recession, the key theme of discussion and debate was, of course, the growing global financial and economic crisis, and what to do about it.
On the union and progressive economist side, the current crisis is seen as rooted in the current neo liberal global model, marked by a powerful, largely unregulated financial sector, by a global shift of power from labour to capital which has been depressing wages, and by unsustainable trade imbalances between major economic regions.
The IMF officials we met with hardly share this perspective but they were, to say the very least, deeply worried about where we are headed. Indeed, the extent of their concern was worrying in and of itself given that, until very recently, the IMF and central banks had tended to downplay if not dismiss concerns that financial de-regulation would lead to a major crisis.
The global economic outlook is currently being revised downwards, with, as the saying goes, pronounced risks on the downside, meaning that things could spin out of control. Key concerns expressed by and to the IMF from our group are that the US is in or near recession, which threatens to become deep and prolonged if the financial crisis turns into a credit crisis in which households and businesses are unable to borrow, and if housing prices continue to fall and destroy household wealth. Effective borrowing rates have not fallen despite recent deep cuts to policy interest rates by the US Federal Reserve, and risk spreads are now rising for even what would seem to be sound assets such as high grade corporate bonds. There is no indication when US housing markets will hit bottom, and more and more US households have seen their housing equity evaporate to nothing.
Growth in Europe could be slowing due to the knock-on effects of the financial crisis on their financial institutions and, as in Japan, the impacts of high oil prices. Some of the most worrying aspects of the financial crisis persist and are deepening. No one knows for sure who is holding the bad debts, what distressed assets will be worth if an when markets finds a bottom, and which institutions will survive and can be trusted not to renege on their own debts and deposits. Some of the distressed assets such as low grade sub prime mortgage securities may turn out to be worthless, and there is talk of eventual losses of 20% or more on even the highest grade, early vintage sub prime mortgage backed securities. Some of the highest risk securities such as the last tranches of sub prime mortgage debt may turn out to be almost worthless.
The current liquidity crisis – the difficulties banks and hedge funds face in finding cash – threatens to turn into a broader solvency crisis in which banks lack the capital to match any shortfall between their assets and liabilities. Clearly it was not just hedge funds which borrowed heavily to invest in what turned out to be very risky assets, but also major US and European banks which were supposed to be more closely regulated. To say the least, the collapse of Bear Stearns almost overnight shocked everyone, and will likely come to be seen as one of the defining events of this crisis.
On a more reassuring note, the anticipated slowdown is only just turning up in the hard data on production and jobs, meaning that something can be done about it in the US and elsewhere. Meanwhile, there are few signs to date of the crisis spreading in a major way to developing countries, which can still borrow, and where internal demand is still leading growth. That said, risk spreads on developing country debt are rising, and their stock markets have mainly been falling. If the US does go into recession, developing country exports and commodity prices will likely fall from current high speculation- fueled levels, further worsening the downturn.
What is interesting, to say the least, is that the IMF is concerned enough that they (now led by ex French Socialist Finance Minister Dominique Strauss- Kahn) have begun to tell governments with strong fiscal positions that they should provide some fiscal stimulus to global growth – a message that is being studiously ignored by the OECD and by most European governments.
Moreover, the IMF seem to generally approve the somewhat unorthodox actions of central banks, notably the US Federal Reserve, to provide credit to the banking system based on some rather risky and non traditional assets, and even to decisively intervene in the financial markets as in the brokered take-over of Bear Stearns by JP Morgan (partially financed by the Fed.) The scale of US Federal Reserve action in terms of lowering policy interest rates has been generally approved of, even though the US faces rising inflation. Officials even talk of the possible need for much more radical interventions by governments moving forward, such as buying up distressed mortgages and other assets to create a bottom to the housing market and to stop the slide in prices. There was also talk of forcing the banks to wipe bad loans off their balance sheets as quickly as possible. The big concern seems to be to learn from the lesson of Japanâ€™s decade long depression and to act decisively so as to stop the credit squeeze from worsening and becoming prolonged.
In terms of the underlying causes of the crisis, discussion on the trade union side and at the progressive economist meetings focused on three key, inter-related themes – financial deregulation, global economic imbalances, and the stagnation of working class living standards. It is clear that very lax regulation of banks and hedge funds played a major role in allowing a massive growth of very risky, complex debt in the US, which was in turn widely dispersed throughout the global financial system. Governments could and should have been limiting leverage, promoting greater transparency, and countering outright fraud and insider profiting which have jeopardised overall financial stability. But another key underlying factor has been the huge current account surpluses which fulled global liquidity, and generated massive amounts of low cost money, which the global banks deployed into risky loans of all kinds. The fact that wages have been stagnant in the US and much of Europe as a result of labour market de-regulation and financial pressures on firms to maximize returns to capital has meant that demand growth became unhealthily dependent on a continuing expansion of household debt, above all in the US.
In terms of policy response in the US, major concern was expressed about the fate of US working families, who have sustained consumption over a long period of stagnant wages growth by borrowing against their fast-eroding home equity. It is not just the sub prime borrowers who are in difficulty, but the many households who refinanced their mortgages over the past few years. Indeed it is very slow real wage growth which made US growth hostage to financial manipulations, stretching out an unsustainable growth of consumption based on ever-rising household debt.
Financialization of the real economy has also repressed wage growth by forcing companies to adopt short term profit maximization at the expense of long term investment. Hedge funds and private equity have further promoted a ruthless drive to cut wage costs, while doing nothing to raise the rate of real investment.
Those who lose their jobs in the US in the coming months will have little or no financial cushion or social safety net to fall back upon. Yet the modest tax rebate package just approved by Congress fails to even extend unemployment insurance benefits beyond the current maximum of 26 weeks. The majority of Democrats, including Hillary and Obama, are prepared to support modest public infrastructure investment/green jobs/alternative energy programs to create jobs, but are still not talking about re-regulation of Wall Street (source of half of all campaign funds) or about major government action to put a floor under house prices. Indeed the Democrats have been adamant, with the Republicans, that any fiscal stimulus must be very targeted and temporary, and not risk balanced budgets moving forward. A few progressive Democrats are now thinking about more radical actions, including a major shift to public investment financed in part by much higher taxes on corporations and the rich, and effective aid to highly indebted home-owners. The plan most likely to gain traction is for the US government to help refinance reduced mortgages, while taking some equity position in housing, combined with aid to banks in return for a share of equity.
In terms of global solutions the trade union and progressive economists are generally thinking along the same lines. China and other countries with large trade and current account surpluses must shift from export-led to internal demand driven growth. Europe and Japan should help the US administer a fiscal and monetary stimulus to global growth, with a tilt to investment in infrastructure and green jobs. The financial sector must be re-regulated, both nationally and globally, to reduce leverage and high risk lending, to end the perverse alignment of high insider compensation with highly risky and de-stabilizing financial practices. Wages and working class living standards must rise – at the expense of a growing profit share in all countries – to reduce reliance on financial sector driven growth, and to link wages with rising productivity.
We are at a moment when progressives will have to move from critique to prescription. As Naomi Klein argued in the Shock Doctrine, neo liberalism took advantage of past crises by having a set of coherent prescriptions ready to hand to advance to policy-makers. We are just beginning to define a new global agenda to replace the neo liberal prescription which has led into the current crisis.