Masoud Movahed is a researcher in development economics at New York University. He contributes to, among others, the Harvard International Review, the Yale Journal of International Affairs, and Al-Jazeera English.
“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 what seems to be the roots of the malaise, they continue to begrudge the decline in the housing prices as the bedrock of 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, with a deregulated credit market running on an unbridled debt explosion, and with 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. Unlike 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. as well as the advanced world in general. Stemmed from intensifying international competition, the U.S. manufacturing firms had to ever tussle more with lower rates of profit, which led to a systemwide 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 way to the “New Economy” of finance, software engineering and information technology. Quibbles among economists notwithstanding, the broad trend is unmistakable that the largest share of the aggregate profits in the economy—estimated roughly 40 percent of the total profits—is generated in the financial sector (See Figure 1). This datum is often taken as the biggest evidence for 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 have captured 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 among many other stratagems of financial activities, at 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 impute financialization to the natural progression of the capitalist development where the productive sector namely, manufacturing, subject to intensified international competition, witnesses an enormous diminution in profit rates. Thus, the ascent of finance is a natural response to the stagnationary tendency of the manufacturing sector. In this vein, economists such as Paul Sweezy and Harry Magdoff argued that with decline of rates in manufacturing as a result of intensifying global competition-stagnation instead of dynamism, 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 the 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 20072009 by no means can be construed independent of the rise of finance.
There are also those who would not only take the decline in the manufacturing profits as the driving force towards financialization, but also certain macroeconomic policies of the U.S. Federal Reserve Bank. 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 the global manufacturing. Essentially what that means is that since the late 1960s, the manufacturers of one after another newly emerging economic powers have been able to make use of the latest technology and with relatively lower wages of domestic labor market to manufacture for export goods that were already being produced, but at both a lower cost and a lower price . Germany and Japan in the 1960s, the East Asian Tigers (i.e. South Korea and Taiwan) in the 1970s and 1980s, and the Chinese behemoth in the 1990s and 2000s; all have been able to adeptly acquire significant shares in the global manufacturing market. For the U.S. firms, however, to maintain the same market shares that they had in the early 1950s1960s and to remain competitive globally, they had to offer their outputs to the international market with lower p rices , which means lower rates of profit on U.S. firms’ balance sheet. The upshot was, as Brenner accurately observes, too much of supply for low global demand, which forced not only the prices down, but also the profits .
Hence, the reduction in manufacturing profitability meant that firms had smaller surpluses at their disposal, which itself dampens hiring of additional labors. This manifested itself quite 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 number of manufacturing job losses and factory closures, as well as massive outsourcing of manufacturing sites to labor-intensive economies especially to China make it plausible to eulogize the American manufacturing. Lower rates of profit in the productive sector of the economy, namely manufacturing, ushered a lapse into financialization.
The logic of the rise of finance—as the most thriving and profit-generating sector of the economy—can be explained by a simple economic rationale. For any given industry in the economy to bourgeon, there has to be sufficient demand for 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 rates 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 under such a depressing economic climate, where the global manufacturing market suffers from overcapacity making for reduced profit rates, which by itself disincentivizes firms to hire more labor and to generate more employment, the economy continues to show signs of enfeeblement. As Brenner explained, since firms are ever more reluctant to hire laborers or raise wages as a result of lower rates of profits, there was no way for the economy to generate demand or to encourage spending but by way of ever greater borrowing, which means running the economy on credits. 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 (See Figure 3).
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 the origins of the housing bubble prior to 2006, two economists at the University of Chicago, Atif Mian and Amir Sufi, argued a statistically causal relationship between the massive supply mortgages and the rapid rise of housing prices which led to the bubble by the end of 2006. Surprisingly enough, they find the period between 2001 and 2005 is the only one in recent U.S. history where housing prices increase in zip codes that have had negative income growth. This is evidence that credit in one way or another was supplied in extraordinarily risky to ever more unqualified borrowers. In an economy that had already demonstrated sluggish growth rates by the mid 1990s, injections of risky credit by ways of lowering short-term interest rates offered a way out of the quagmire (See Figure 4). This massive injection of credit became the benchmark economic policy that laid out the ground for the spectacular ascent of finance.
I mentioned earlier that since the 1980s manufacturing firms have been enfeebled by the decline of profit rates, and so were the households by the wage stagnation. Corporations along with households were thus enabled to step up their borrowing and in that way induce massive speculative run-ups in asset prices in both housing and securities markets. Nurtured by easy credit and deregulation policies of Federal Reserve Banks, there was an increase in the prices of housing between 2000-2006. So whenever the run-ups in financial markets ran into 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.
The key to the whole explosion of credit market was the Fed’s policy of maintaining low short-term interest rate. This is particularly so as the low rates are accompanied by somewhat higher longer-term rates. For banks, that is a license to make money with very little risk, particularly since they can get people to open savings accounts that pay close to nothing. For borrowers, it was an easy access to cheap credit who then invested enormously in the stock and securities market. Indeed, what is good for banks is not good for the economy. The incessant low short-term interest rates in the past two decades thus provided a climate conducive to financialization. The flood of easy credit to the stock and housing markets paved the path for the historic spike 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 by itself 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 2007-2009 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 origins of the crisis ought be investigated in 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 fall of the U.S. manufacturing profitability posed serious threats to economic dynamism and vitality as firms were ever more reluctant to hire laborers or to raise wages. For the Fed to continue generating growth, it had to enable both the public and private sectors—or both households and government expenditures—to step up their borrowing. This process was entirely dependent on banks. With the policy of low interest rates that provided cheap credit to borrowers, and with households struggling with stagnant wages and runaway debts, 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 2007-2009.