1
From financial crisis to turning point
How the US “subprime crisis” turned into a worldwide one and is to change the global economy.
Jacques SAPIR[1]
The current financial crisis, born from the US mortgage industry, and creeping into a global financial disorder since summer 2007[2], has known a new stage of acceleration and development during early Fall 2008. Ongoing stock market crashes and bank emergencies have been the worse since 1929.
This crisis has been labelled as a “financial” one. There is some truth here as the securitization process definitely had a hand in the whole process. However roots of the crisis are far to be purely financial. We are witnessing the collapse of a specific model of capitalism, and the collapse of the post-Bretton Woods international monetary order as well. Stakes are obviously high and this crisis is to be seen as a major turning point in the XXIth century.
- What is this crisis about?
The current crisis is actually a three-tiered process embedded in a context. We have witnessed a spectacular liquidity crisis from September 20th, 2008 up to October 12th, which was a textbook case of Keyes “absolute preference for liquidity” and motivated massive State intervention[3]. The liquidity crisis was the result of a global crisis of the financial system focusing on general uncertainty on sophisticated debt instruments developed during the last ten years through the securitization process. But, this global financial crisis has its roots in the credit overextension, which developed in the United States and also in UK, Spain and Ireland).
This credit expansion was the result of structural changes in income repartition seen both in the US economy but also in the UK since mid-80’s. They describes the “neo-liberal” capitalist model[4]. Wages share declined and profits surged as income distribution became in the USA as unequal it has been just before the 1929 depression[5]. If the average wage increased significantly till 2006, the median wage didn’t moved at all. It even went down in several “old-industry” US states[6].
This would have led to economic stagnation with a constrained demand, but for credit expansion. Then, it can be argued that the financial crisis was the result of model of capitalism, which went too far.
The crisis global context.
The three different levels of the crisis developed in a specific context: the dismantling of all residual Bretton Woods principles, ending into a massive international monetary non-order.
Actually, one can even begin from here to a better understanding of the crisis (see Graph 1). The monetary non-order, epitomized by the complete freedom of capital circulation, led to the 1998 crisis in most emerging countries. The inability of surviving BW originated institutions, IMF and World Bank, to check or just manage the crisis[7], led emerging countries, mostly Asian ones to feel that only a massive Foreign currencies reserve could protect them. In turn this logically led these countries to implement FOREX accumulation policies based on undervaluation of the national currency and competitive deflation. Restraining sharply their internal market they turned toward an export-led growth model at a time when WTO fostered a new free-trade regime, which enabled Asian emerging countries to implement mercantilist policies.
This export led growth went toward high saving rates and investment-attracting policy helped emerging countries to enjoy a high rate of labour productivity growth not emulated by workers direct or indirect incomes. As the quality of exports began to rise (Table 1), they exerted a deep wage-led deflation effect on developed economies and particularly on the US one[8].
Table 1
Export Similarity Index with OECD countries. Evolution 1972-2005
1972 / 1983 / 1994 / 2005Taiwan / 0,14 / 0,17 / 0,22 / 0,22
Hong Kong / 0,11 / 0,13 / 0,17 / 0,15
Korea / 0,11 / 0,18 / 0,25 / 0,33
Singapore / 0,06 / 0,13 / 0,16 / 0,15
China / 0,05 / 0,08 / 0,15 / 0,21
India / 0,05 / 0,07 / 0,09 / 0,16
Source: P.K. Schott, “The relative sophistication of Chinese exports”, Economic Policy, n°55, January 2008, pp. 7-40, p. 26.
The US unsustainable growth.
The US economy maintained a high rate of growth by substituting credit (mostly mortgage credit and the now notorious home equity extraction mechanism) to labour income. This was helped by a highly pro-active monetary policy but also by the securitization process. In a largely deregulated financial environment[9], securitization helped banks and mortgage brokers to lower interest rates on high-risk mortgages[10]. The cut-throat competition in the mortgage industry has been a strong impetus to extend the securitisation process to the mortgage industry (with mortgage-backed securities)[11].
Mortgage displaced progressively other consumption-credit systems and the US household debt reached GDP 93% by 2006. However, without the home equity extraction a constant increase in home prices from 1990 till 2007 made possible, the US growth would have been much lower than it was. Of course, cheap credit helped to boost demand and home prices to increase, and then even if household savings reached an unseen disposable income 0.4% in 2007, household solvency was not questioned before prices began to turn down. This was nothing less than a massive Ponzi finance mechanism in the US economy. By 2007, US total savings struck a record low of GDP 13.6%, when they reached 23.8% in Germany and 20.3% in France (not to mention Asian countries).
The consumption-led growth it generated, at a time labour productivity went down, explained the huge current-account deficit USA had from 2000 on. Asia countries used their own surplus to massively buy US debts. This double disequilibrium has been unfortunately called the “Bretton Woods II”, but was intrinsically unstable as it was grounded on an unsustainable debt-expansion system.
European divergence.
European countries too were affected by the wage-led deflation induced by Asian mercantilist policies but also by EU “new entrants” in some case. They had however to face a much more rigid monetary policy induced by the ECB, which explained the low-growth situation we had in the Euro-zone.
The single currency principle was quite problematic for heterogeneous countries with widely diverging inflation to growth relations[12], and without something like a large “federal” budget[13]. By the way, economic theory has proven that inflation can be too low[14]. The Zero-inflation ECB has been targeting had disastrous effects on European economies. Overvaluation of the Euro has been computed to cost between GDP 0.6% to 1% a year to the French economy[15]. The ECB policy contributed too to the international monetary disorder leading to the current crisis[16].
Some European countries (UK, Spain and Ireland) responded to regional depressed economic climate by emulating the US “neo-liberal” capitalist model, with a highly developed mortgage system and a finance-led economy. Household indebtedness soared as savings plummeted down. They are now among countries worst hit by the crisis. Germany cheated the wage-led deflation by adopting what can be called a neo-mercantilist model. In the industrial process, sub-assembly production was delocalized in EU “new entrants” countries. The famed Made in Germany was progressively replaced by Made by Germany enabling Germany to maintain a huge trade surplus. However, industrial employment went down and household indebtedness increased, which is now part of the problem German banks are facing. France and Italy tried to maintain the “classical” European capitalist model through a relatively expansive public policy but at the cost of a raising public debt.
However, when it comes to total indebtedness (including household, enterprise and public debt) countries belonging to the “classical” model have not necessarily been the worst-off.
Table 2
Total indebtedness in GDP %, 2006
France / Germany / Spain / United Kingdom / ItalyHousehold debt / 45% / 68% / 84% / 107% / 39%
Enterprise debt / 73% / 57% / 104% / 88% / 63%
Total household+enterprise / 118% / 125% / 188% / 185% / 102%
Public debt / 63% / 67% / 39% / 39% / 106%
Total / 181% / 192% / 227% / 224% / 208%
Source: INSEE, ECB and UK national accounting system.
Note: Household debt reached GDP 112% in Spain by Fall 2007.
Global unsustainability?
The current crisis shows multiple failure lines.
The US credit-induced growth was not sustainable, but mercantilist policies implemented in response to the 1998 financial crisis neither were. The US economy could not indefinitely increase its current account deficit and for Asian emerging economies accumulating FOREX reserves, which had to be sterilized to prevent an exchange rate increase, had a cost without impact on the investment process[17].
In the same time, the ECB followed a policy in direct contradiction to the claimed target of fostering European integration as it actually fostered structural divergence.
Last but not least the neo-liberal ideology promoting widespread deregulation in banking and finance had created a system plagued with endogen instability, a result forecasted by a long string of theoretical works[18].
Table 3
Yearly current account positions in USD billionsDeveloped countries / Of which
USA / Japan / Emerging countries / Of which
China
1999 / -107,9 / -299,8 / 114,5 / 37,8 / 21,1
2005 / -431,6 / -759,9 / 165,7 / 518,0 / 160,8
2006 / -508,8 / -811,5 / 170,4 / 681,6 / 250,0
2007 / -499,8 / -784,3 / 195,9 / 684,2 / 380,0
FMI, World Economic Outlook, Washington, DC, October 2007
Highly competitive markets are not necessarily the best coordination tool we need and fostering more competition could be efficiency destructive. Even the IMF in the end acknowledged that financial innovation has increased risk without tangible improvements in the investment process[19].
We can then point to three important facts in the current crisis process making it really global.
The first one is the key position of the wage-led deflation process induced by the combination of Asian mercantilist policies (and to some extent the German neo-mercantilist policy backed by ECB anti-inflation bias) and WTO sponsored free trade. This process significantly weakened household solvency. Even Paul Krugman, 2008 Nobel Prize, has acknowledged the negative impact of Free Trade on income distribution in the current context[20].
The second important fact is the deregulation of international finance. This certainly has been a second key factor, helping the credit overhang to develop and in the same time allowing the US economy to contaminate the world. However, even if neo-liberal ideology played an important role here it is to be understood that when credit looks as the only way to maintain growth, deregulating finance to help credit expansion is nearly unavoidable. As a matter of fact current French President Mr. Sarkozy advocated a US-patterned mortgage system for France before being elected[21].
The third key fact is the process of structural divergence developing inside the EU and even inside the Euro Zone. It is raising serious concerns about the survival of the Euro as a single common currency.
- What are possible responses to the crisis.
There is no doubt this crisis is to have a deep impact on developed economies. Recession has already begun before the September-October 2008 liquidity crisis and stock-market crash. It will worsen and spread at the very least till Summer 2009 and probably till the end of 2009. Decline of the real-sector activity is to have a feedback effect on the financial one. The current crisis is then to be the worst developed economies have known since the end of World War 2 and is to force governments to alter their economic policy to a considerable extent helping to shape the global economy, with or without any cooperative attempt to rebuild a better and more efficient international monetary order.
A crisis and its consequences.
The financial crisis is to impact the economy real sector through different channels. The credit-crunch has been so far the most discussed, as it is the most spectacular. However it is far to be the only channel. In many countries asset prices (stocks and real-estate) have fallen to a considerable extent. This is to have a important impact through the wealth effect. Where economies have followed the US neo-liberal model the sheer necessity to rebuild savings is also to constrain severely household consumptions in quarters to come.
The combined effect of the end of the home equity extraction and of a massive negative wealth effect triggered by the downward plunge of asset prices is to considerably harm consumption in the US economy. The home equity extraction was amounting to 3% of the real disposable consumer income by 2005/2006. The sharp fall of home prices erased this source of consumption and the stock market crash has created a huge problem for retirement pension funds making mandatory an increase of the outrageously low household saving rate. The US GDP is then to fall by -2.5% / -3.5% for at least three quarters and possibly five.
The Euro Zone too is now entering recession. GDP will fall by at least -1.5% till summer 2009 at best, with some countries looking particularly vulnerable (Spain and Italy). Even the German neo-mercantilist model is now deeply challenged. In the rest of the EU, Great-Britain is to suffer a shock pretty similar to the US one and “new entrants” are to know a deep recession (Baltic states, Hungary, Romania, Czech Republic and Poland). Mediterranean countries linked to the EU (Morocco and Tunisia) are also to suffer from the recession impact.
The deep contraction of consumer demand, already obvious on the car market and in house building, is to increase the number of enterprises going bankrupt. Unemployment figures, which already have increased fast in Spain and USA, are to soar all across the board, increasing household insolvency when and where unemployment benefits are too low or too restricted in scope.
Enterprises failures are to create new “toxic” debt chains inside the banking sector and the recession, induced by the financial crisis, is to open a new stage of bank and insurance difficulties during winter and early spring 2009.
Facing increasing economic hardship governments are to respond by increasing budget deficit. The most impressive move is to be the US one and one can expect FY-2009 budget deficit to reach or even surpass GDP 10%. If we add up all probable budget deficit sources, we can find USD 930-950 billions to be added to the USD 439 billions planned deficit. The total US deficit for FY-2009 could well be pushed up to 1,370-1,400 billions or close to GDP 11%.
In the EU too budget deficit is to significantly increase through the combination of government support to the embattled bank sector and activity-boosting measures. By early November 2008 there was a strong opposition led by Germany and Luxemburg to have a coordinated anti-recession plan at the Euro Zone level. This is to have very unfortunate consequences.
Budget deficit however is not to be contained to 2009. As the credit-expansion mechanism looks durably disabled and economic activity to be depressed for a significant time, public spending is to be the only possibility to avoid the current recession to develop into a full-fledged depression. A quick estimate of financing needs shows that the US economy would need between GDP 20% to 25% till 2011 and Euro Zone economies between GDP 12% to 15%. If we add non-financial enterprises borrowing needs, we could reach GDP 28% to 35% for the US economy and GDP 16% to 21% for the Euro Zone.
To any extent this is a massive increase of the total debt. As interest rates are not to be increased (this could definitely kill the bank sector) funding such a debt increase is to be impossible without a significant increase of inflation levels. This, combined to the fact there is a strong asymmetry in borrowing needs among countries is to induce wild fluctuations of currency exchange rates in the next 24 months. If the USD improved it position toward the Euro during Summer and early Fall 2008, one can expect a strong reversal of this trend once the debt issue is to come to the forefront[22].
Direct and indirect crisis consequences are to be of such magnitude that significant changes are to happen in economic policies and institutions.
The financial markets re-regulation process.
One of the most obvious changes is certainly a trend toward a re-regulation of financial markets. Few voices are now openly opposing such a move and defending the old neo-liberal credo. This trend is to have two distinct consequences.
The first one is a strengthening of prudential regulations for banks and financial institutions. This is certainly a needed move, but it would be a deep mistake to take it for a complete cure. Prudential regulations are designed against known risks. However would risk be fully knowledgeable it could be rationally expected and then prudential regulations would not be needed. What defines the best risk is the surprise a totally unexpected event, as the late G.L.S. Shackle would have put it[23], could imply.
Taking risk seriously means that we are in a world probabilities can’t fully describe. Then, prudential regulations are necessarily incomplete and imperfect when facing an event not expected by the regulator. If the regulator could have expected all events this would have meant a fully probabilistic world where regulations would not have been needed. Beyond this logical paradox undermining the value of any prudential regulation one has to add the effect of preference reversals, a well-known and established fact[24].
Prudential regulations are usually grounded on incentives. They assume a given structure of individual player preferences. However if we are to face a “framing effect” when an unexpected event is to happen[25], then the preference structure is to change making prudential regulations sometimes useless when they are the most needed. As a matter of fact prudential regulations never prevented financial market players to be caught in a frenzy during bubbles…