Real Economy Roots of the Crisis
I’m pasting in below a listserv note from Frank Hoffer with the Bureau of Workers Activities at the International Labour Organization, followed by a piece from Walden Bello.
In these days of fianncial meltdown I do think we need to remind ourselves that this crisis is indeed rooted in the fact that “financialization” temporarily bridged the gap between the need for a stimulus to global demand, and the reality of severely repressed wage income around the world. A financial fix is needed, but growth moving forward will have to come from somewhere other than an increasingly indebted workign class.
From Frank Hoffer:
“Bello (see below) sees the deeper roots of the financial crisisÂ in
the development of the real economy over the last decades. The dysfunctional
wage/income development and growing inequality are seen as important explanatory
factors for the crisis. The declining wage share has resulted in a lack of
demand and hence profits were not directed towards real investment. Instead a
disproportional high share of profits flow into speculative financial assets,
where the illusion of high profitability was maintained through ever greater
From a labour perspective it looks to me that this point of view needs to be
elaborated much stronger. The current debate seems to be limited betweenÂ those
seeingÂ greed and irresponsible financial incentives for managers as the main
problem and those, who call for stronger state regulation of financial
institutions. Seeing the crisis more as a technical regulatory issue than an
expression of fundamentalÂ problems in the global economy. Hardly anyone argues
that the massive income redistribution towards the rich during the last 25 years
might be a root cause for the current problem.
The financial industry wants now a quick fix to avoid any discussion about
policy changes as long as the banking sector is under pressure.Â We are told
that all decisions have to be taken within days or hours. It is not clear to me
to what extent the need for urgent measures is abused for a pro-business
solution.Â “Wall Street has always been quick to overstate systemic risk”
(Stiglitz). Again the TINA (the is no alternative) approach is used to justify
the bail out. But why should we trust the Wall Street people in government that
there is no alternative?
There are huge political risks of being associated with or not opposingÂ a bad
deal. Any bail out will most likelyÂ be followed by a severe recession or even a
depression. This might open opportunities for labour, but also create a high
risk for a populist right wing backlash. This risk is particularly high, ifÂ the
labour movement and the left at large is seen as part of those who (out of
perceived responsibility for preventing a financial meltdown)Â endorse an
immediate bail out package that proofs to be deeply unfair.
If income inequality and dysfunctional wage developments are a major cause of
the problem, we shouldÂ articulate policy proposals that take this into account.
A call for better regulations, more transparency etc. needs to be specified with
ideas protectingÂ main street instead of saving Wall Street.Â Who pays the bill
will depend on the design of the package.
Here are some suggestions that might be part of a labour agenda:
a) Stabilizing credit markets by subsidizing mortgages for owners ofÂ modest
houses (below median house price).
b) nationalize the banks at market value. Governments should agree to bail out
banks not by taking just their toxic debts, but by buying them. Only those banks
that offer the lowest price (properly close to zero) and are hence in genuine
trouble should be bought. This would avoid that all banks are just offloading
their bad debts. It will weakens the vested interest of the private banks and
any profit from successful stabilization would go to those who bear the risk –
the taxpayer. It might also creates a publicly owned part of the financial
sector that allowsÂ futureÂ governments to use publicly owned banks to direct
credits towards real investment.
c) Government should create an emergency credit facility to provide enterprises
with access to credit for real investment.
d) Stabilising demand through additional investment in infrastructure, green
jobs, public health care, education etc.
e) Stabilising incomeÂ through affordable access to health care, minimum wages,
basic universal pension, universal child allowancesÂ and education grants for
low and lower middle class students)
f) Calling on governments to provide a conducive framewcentralized/coordinated collective bargaining to enable a functional wage
policy. Ensuring that real wages growth is in line with productivity gains.
f)Â progressive taxation and higher property taxes to reduce the tax burden on
average wage earners and increase their real net wages.
Published on Friday, September 26, 2008 by Foreign Policy in Focus
Wall Street Meltdown Primer.
by Walden Bello
Many on Wall Street and the rest of us are still digesting the momentous
events of the last 10 days. Between one and three trillion dollars worth of
financial assets have evaporated. Wall Street has been effectively
nationalized. The Federal Reserve and the Treasury Department are making all
the major strategic decisions in the financial sector and, with the rescue
of the American International Group (AIG), the U.S. government now runs the
world’s biggest insurance company. At $700 billion, the biggest bailout
since the Great Depression is being desperately cobbled together to save the
global financial system.
The usual explanations no longer suffice. Extraordinary events demand
extraordinary explanations. But first…
Is the worst over?
No. If anything is clear from the contradictory moves of the last week –
allowing Lehman Brothers to collapse while taking over AIG, and engineering
Bank of America’s takeover of Merrill Lynch – there’s no strategy to deal
with the crisis, just tactical responses. It’s like the fire department’s
response to a conflagration.
The $700 billion buyout of banks’ bad mortgaged-backed securities is mainly
a desperate effort to shore up confidence in the system, preventing the
erosion of trust in the banks and other financial institutions and avoiding
a massive bank run such as the one that triggered the Great Depression of
Did greed cause the collapse of global capitalism’s nerve center?
Good old-fashioned greed certainly played a part. This is what Klaus Schwab,
the organizer of the World Economic Forum, the yearly global elite jamboree
in the Swiss Alps, meant when he said in an interview earlier this year: “We
have to pay for the sins of the past.”
Was this a case of Wall Street outsmarting itself?
Definitely. Financial speculators outsmarted themselves by creating more and
more complex financial contracts like derivatives that would securitize and
make money from all forms of risk – including such exotic futures
instruments as “credit default swaps” that enable investors to bet on the
odds that the banks’ own corporate borrowers would not be able to pay their
debts! This is the unregulated multi-trillion dollar trade that brought down
On December 17, 2005, when International Financing Review (IFR) announced
its 2005 Annual Awards – one of the securities industry’s most prestigious
awards programs – it had this to say: “[Lehman Brothers] not only maintained
its overall market presence, but also led the charge into the preferred
spaborrowers’ needs…Lehman Brothers is the most innovative in the preferred
space, just doing things you won’t see elsewhere.”
Was it lack of regulation?
Yes. Everyone acknowledges by now that Wall Street’s capacity to innovate
and turn out more and more sophisticated financial instruments had run far
ahead of government’s regulatory capability. This wasn’t because the
government was incapable of regulating but because the dominant neoliberal,
laissez-faire attitude prevented government from devising effective
But isn’t there something more that is happening?
We’re seeing the intensification of one of the central crises or
contradictions of global capitalism: the crisis of overproduction, also
known as overaccumulation or overcapacity.
In other words, capitalism has a tendency to build up tremendous productive
capacity that outruns the population’s capacity to consume owing to social
inequalities that limit popular purchasing power, thus eroding
But what does the crisis of overproduction have to do with recent events?
Plenty. But to understand the connections, we must go back in time to the
so-called Golden Age of Contemporary Capitalism, the period from 1945 to
This was a time of rapid growth both in the center economies and in the
underdeveloped economies – one that was partly triggered by the massive
reconstruction of Europe and East Asia after the devastation of World War
II, and partly by the new socio-economic arrangements institutionalized
under the new Keynesian state. Key among the latter were strong state
controls over market activity, aggressive use of fiscal and monetary policy
to minimize inflation and recession, and a regime of relatively high wages
to stimulate and maintain demand.
So what went wrong?
This period of high growth came to an end in the mid-1970s, when the center
economies were seized by stagflation, meaning the coexistence of low growth
with high inflation, which wasn’t supposed to happen under neoclassical
Stagflation, however, was but a symptom of a deeper cause: the
reconstruction of Germany and Japan and the rapid growth of industrializing
economies like Brazil, Taiwan, and South Korea added tremendous new
productive capacity and increased global competition. Meanwhile social
inequality within countries and between countries globally limited the
growth of purchasing power and demand, thus eroding profitability. The
massive increase in the price of oil aggravated this trend in the 1970s.
How did capitalism try to solve the crisis of overproduction?
Capital tried three escape routes from the conundrum of overproduction:
neoliberal restructuring, globalization, and financialization.
What was neoliberal restructuring all about?
Neoliberal restructuring took the form of Reaganism and Thatcherism in the
North and structural adjustment in the South. The aim was to invigorate
capital accumulation, and this was to be done by 1) removing state
constraints on the growth, use, and flow of capital and wealth; and 2)
redistributing income from the poor and middle classes to the rich on the
theory that the rich would then be motivated to invest and reignite economic
This formula redistributed income to the rich and gutted the incomes of the
poor and middle classes. It thus restricted demand while not necessarily
inducing the rich to invest more in production.
In fact, neoliberal restructuring, which was generalized in the North and
South during the 1980s and 1990s, had a poor record in terms of growth:
global growth averaged 1.1% in the 1990s and 1.4% in the 1980s, whereas it
averaged 3.5% in the 1960s and 2.4% in the 1970s, when state interventionist
policies were dominant. Neoliberal restructuring couldn’t shake off
How was globalization a response to the crisis?
The second escape route global capital took to counter stagnation was
“extensive accumulation” or globalization. This was the rapid integration of
semi-capitalmarket economy. Rosa Luxemburg, the famous German revolutionary economist,
saw this long ago as necessary to shore up the rate of profit in the
metropolitan economies: by gaining access to cheap labor, by gaining new,
albeit limited, markets, by gaining new sources of cheap agricultural and
raw material products, and by bringing into being new areas for investment
in infrastructure. Integration is accomplished via trade liberalization,
removing barriers to the mobility of global capital and abolishing barriers
to foreign investment.
China is, of course, the most prominent case of a non-capitalist area that
was integrated into the global capitalist economy over the last 25 years.
To counter their declining profits, many Fortune 500 corporations have moved
a significant part of their operations to China to take advantage of the
so-called “China Price” – the cost advantage of China’s seemingly
inexhaustible cheap labor. By the middle of the first decade of the 21st
century, roughly 40-50% of the profits of U.S. corporations were derived
from their operations and sales abroad, especially China.
Why didn’t globalization surmount the crisis?
This escape route from stagnation has exacerbated the problem of
overproduction because it adds to productive capacity. A tremendous amount
of manufacturing capacity has been added in China over the last 25 years,
and this has had a depressing effect on prices and profits. Not
surprisingly, by around 1997, the profits of U.S. corporations stopped
growing. According to one index, the profit rate of the Fortune 500 went
from 7.15% in 1960-69 to 5.3% in 1980-90 to 2.29% in 1990-99 to 1.32% in
What about financialization?
Given the limited gains in countering the depressive impact of
overproduction via neoliberal restructuring and globalization, the third
escape route became very critical for maintaining and raising profitability:
In the ideal world of neoclassical economics, the financial system is the
mechanism by which the savers or those with surplus funds are joined with
the entrepreneurs who have need of their funds to invest in production. In
the real world of late capitalism, with investment in industry and
agriculture yielding low profits owing to overcapacity, large amounts of
surplus funds are circulating and being invested and reinvested in the
financial sector. The financial sector has thus turned on itself.
The result is an increased bifurcation between a hyperactive financial
economy and a stagnant real economy. As one financial executive notes,
“there has been an increasing disconnect between the real and financial
economies in the last few years. The real economy has grown…but nothing
like that of the financial economy – until it imploded.”
What this observer doesn’t tell us is that the disconnect between the real
and the financial economy isn’t accidental. The financial economy has
exploded precisely to make up for the stagnation owing to overproduction of
the real economy.
What were the problems with financialization as an escape route?
The problem with investing in financial sector operations is that it is
tantamount to squeezing value out of already created value. It may create
profit, yes, but it doesn’t create new value. Only industry, agricultural,
trade, and services create new value. Because profit is not based on value
that is created, investment operations become very volatile and the prices
of stocks, bonds, and other forms of investment can depart very radically
from their real value. For instance, in the 1990s, prices of stock in
Internet startups skyrocketed, driven mainly by upwardly spiraling financial
valuations rooted in theoretical expectations of future profitability. Share
prices crashed in 2000 and 2001 when this strategy got completely out of
hand. Profits then depend on taking advantage of upward price departures
from the value of commodities, then selling before reality enforces a
“correction.” Corrections are really a return to more realistic varadical rise of asset prices far beyond any credible value is what what
fosters financial bubbles.
Why is financialization so volatile?
With profitability depending on speculative coups, it’s not surprising that
the finance sector lurches from one bubble to another, or from one
speculative mania to another.
And because it’s driven by speculative mania, finance-driven capitalism has
experienced scores of financial crises since capital markets were
deregulated and liberalized in the 1980s.
Prior to the current Wall Street meltdown, the most explosive of these were
the string of emerging markets crises and the U.S.tech stock bubble’s
implosion in 2000 and 2001. The emerging markets crises primarily included
the Mexican financial crisis of 1994-95, the Asian financial crisis of
1997-1998, the Russian financial crisis in 1998, and the Argentine financial
collapse that occurred in 2001 and 2002, but they also rocked other
countries including Brazil and Turkey.
One of President Bill Clinton’s Treasury Secretaries, Wall Streeter Robert
Rubin, predicted five years ago that “future financial crises are almost
surely inevitable and could be even more severe.”
How do bubbles form, grow, and burst?
Let’s first use the Asian financial crisis of 1997-98, as an example. First,
capital account and financial liberalization took place Thailand and other
countries at the urging of the International Monetary Fund (IMF) and the
U.S. Treasury Department. Then came the entry of foreign funds seeking quick
and high returns, meaning they went to real estate and the stock market.
This overinvestment made stock and real estate prices fall, leading to the
panicked withdrawal of funds. In 1997, $100 billion fled the East Asian
economies over the course of just a few weeks.
That capital flight led to an IMF bailout of foreign speculators. The
resulting collapse of the real economy produced a recession throughout East
Asia in 1998. Despite massive destabilization, international financial
institutions opposed efforts to impose both national and global regulation
of financial system on ideological grounds.
What about the current bubble? How did it form?
The current Wall Street collapse has its roots in the technology-stock
bubble of the late 1990s, when the price of the stocks of Internet startups
skyrocketed, then collapsed in 2000 and 2001, resulting in the loss of $7
trillion worth of assets and the recession of 2001-2002.
The Fed’s loose money policies under Alan Greenspan encouraged the
technology bubble. When it collapsed into a recession, Greenspan, to try to
counter a long recession, cut the prime rate to a 45-year low of one percent
in June 2003 and kept it there for over a year. This had the effect of
encouraging another bubble – in real estate.
As early as 2002, progressive economists such as Dean Baker of the Center
for Economic Policy Research were warning about the real estate bubble and
the predictable severity of its impending collapse. However, as late as
2005, then-Council of Economic Adviser Chairman and now Federal Reserve
Board Chairman Ben Bernanke attributed the rise in U.S. housing prices to
“strong economic fundamentals” instead of speculative activity. Is it any
wonder that he was caught completely off guard when the subprime mortgage
crisis broke in the summer of 2007?
And how did it grow?
According to investor and philanthropist George Soros: “Mortgage
institutions encouraged mortgage holders to refinance their mortgages and
withdraw their excess equity. They lowered their lending standards and
introduced new products, such as adjustable mortgages (ARMs),
?interest-only’ mortgages, and promotional teaser rates.” All this
encouraged speculation in residential housing units. House prices started to
rise in double-digit rates. This served to reinforce speculation, and the
rise in house prices made the owners feel rich; the result was a consumption
boom that has sustained the economy in recent years.”
The subprime mortgage crisis wasn’t a case of suppThe “demand” was largely fabricated by speculative mania on the part of
developers and financiers that wanted to make great profits from their
access to foreign money that has flooded the United States in the last
decade. Big-ticket mortgages were aggressively sold to millions who could
not normally afford them by offering low “teaser” interest rates that would
later be readjusted to jack up payments from the new homeowners.
But how could subprime mortgages going sour turn into such a big problem?
Because these assets were then “securitized” with other assets into complex
derivative products called “collateralized debt obligations” (CDOs). The
mortgage originators worked with different layers of middlemen who
understated risk so as to offload them as quickly as possible to other banks
and institutional investors. These institutions in turn offloaded these
securities onto other banks and foreign financial institutions.
When the interest rates were raised on the subprime loans, adjustable
mortgage, and other housing loans, the game was up. There are about six
million subprime mortgages outstanding, 40% of which will likely go into
default in the next two years, Soros estimates.
And five million more defaults from adjustable rate mortgages and other
“flexible loans” will occur over the next several years. These securities,
the value of which run into the trillions of dollars, have already been
injected, like virus, into the global financial system.
But how could Wall Street titans collapse like a house of cards?
For Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, and Bear
Stearns, the losses represented by these toxic securities simply overwhelmed
their reserves and brought them down. And more are likely to fall once their
books – since lots of these holdings are recorded “off the balance sheet” –
are corrected to reflect their actual holdings.
And many others will join them as other speculative operations such as
credit cards and different varieties of risk insurance seize up. The
American International Group (AIG) was felled by its massive exposure in the
unregulated area of credit default swaps, derivatives that make it possible
for investors to bet on the possibility that companies will default on
repaying loans. According to Soros, such bets on credit defaults now make up
a $45 trillion market that is entirely unregulated. It amounts to more than
five times the total of the U.S. government bond market. The huge size of
the assets that could go bad if AIG collapsed made Washington change its
mind and intervene after it let Lehman Brothers collapse.
What’s going to happen now?
There will be more bankruptcies and government takeovers. Wall Street’s
collapse will deepen and prolong the U.S. recession. This recession will
translate into an Asian recession. After all, China’s main foreign market is
the United States, and China in turn imports raw materials and intermediate
goods that it uses for its U.S. exports from Japan, Korea, and Southeast
Asia. Globalization has made “decoupling” impossible. The United States,
China, and East Asia in general are like three prisoners bound together in a
In a nutshell…?
The Wall Street meltdown is not only due to greed and to the lack of
government regulation of a hyperactive sector. This collapse stems
ultimately from the crisis of overproduction that has plagued global
capitalism since the mid-1970s.
The financialization of investment activity has been one of the escape
routes from stagnation, the other two being neoliberal restructuring and
globalization. With neoliberal restructuring and globalization providing
limited relief, financialization became attractive as a mechanism to shore
up profitability. But financialization has proven to be a dangerous road. It
has led to speculative bubbles that produce temporary prosperity for a few
but ultimately end up in corporate collapse and in recession in the real
The key questions now are: How deep and long will this recessionthe U.S. economy need another speculative bubble to drag itself out of this
recession? And if it does, where will the next bubble form? Some people say
the military-industrial complex or the “disaster capitalism complex” that
Naomi Klein writes about will be the next bubble. But that’s another story.
Copyright Â© 2008, Institute for Policy Studies
Walden Bello, a Foreign Policy In Focus columnist, is professor of sociology
at the University of the Philippines and senior analyst at the Bangkok-based
research and advocacy institute Focus on the Global South. He is the author
of, among other books, Dilemmas of Domination: The Unmaking of the American
Empire (New York: Henry Holt, 2005).
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