Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Learning from Lehman, we’ve reinflated the bubble

The global economy appears structured to lurch from crisis to crisis, with bubbles in between

Mumbai: Back in 1936, after the searing experience of the Great Depression, the economist John Maynard Keynes wrote, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done." More than seven decades later, what Keynes said pithily sums up the backdrop for the crash of 2008.

Why did the meltdown occur?

Economists rarely agree on anything and that’s true for their theories of the crisis as well. Some of them look no further than Wall Street. It is in that hotbed of greed, so goes the accusation, that the worst excesses were committed. They blame Wall Street for selling toxic financial products to gullible investors. This is an age-old tale of financial chicanery and human cupidity. Jail a few bankers, say proponents of this view and everything will be set right. This morality play version of events is popular, but it’s hardly an explanation.

Many blame the regulators. Alan Greenspan, the erstwhile chief of the US Federal Reserve, kept interest rates too low for too long, thus lowering the price of risk and inflating the biggest financial bubble in history. Once hailed as the maestro of monetary policy, he quickly became the villain. To be sure, lax regulation aided and abetted the building of the bubble, but it wasn’t the underlying reason for it.

Keynesians pin the blame for the crisis squarely on the climate of de-regulation fostered by the political right from Ronald Reagan and Margaret Thatcher onwards—the so-called neo-liberal revolution. In the same tradition is Hyman Minsky, a heterodox economist carefully ignored until the crisis unearthed his perceptive work. His now-famous ‘financial instability hypothesis’ summed it up: “over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system."

Another set of finger-pointers put the blame squarely on the intellectual progenitors of bogus economic and financial models, those who served as apologists for Wall Street. Nassim Nicholas Taleb, the man who made the term ‘black swan’ so popular, puts it succinctly, “Six Nobel prizes were handed out to people whose work was nothing but BS. They convinced the financial world that it had nothing to fear." This theory gives too much weight to the outpourings of economists—many of them merely serve their masters.

What is common to all these theories? As the philosopher Slavoj Zizek has said, their main task is to spin a narrative that avoids putting the blame for the meltdown on the system, but instead blames its deviations—errors of policy, bad theory, lax regulation, bad incentives, corruption, greed, human nature and other such convenient scapegoats.

The origins of the crisis

The crisis erupted in 2008, but we have to delve into history to uncover the underlying forces that caused it. The answer, of course, lies in political economy.

In the 1970s, the free world was in deep crisis. Labour unions had grown too strong, the share of profits in the western economies had gone down and the political system was being questioned by all kinds of radical movements. The social compact in the developed countries between capital and labour had broken down. A sharp rise in oil prices at that time led to stagflation and proved to be the final straw that broke the old system.

The Empire of Capital saw an opportunity to strike back. Within the next few years, it re-asserted its power. The trades union were crushed, barriers to the free flow of capital were dismantled and slowly but surely, industry was relocated to low-cost centres. The demise of the Soviet Union, China’s open-door policy and liberalization in India resulted in the addition of vast pools of labour to global production, keeping wage costs down. Profits as a share of national income went up substantially. As social scientist David Harvey put it, it was a project “to re-establish the conditions for capital accumulation and to restore the power of economic elites".

But with production shifting to the East and with falling real wages, how would consumption in the developed countries be maintained? One, cheap imports from low-cost countries, especially China, helped. Two, the de-linking of the US dollar from gold allowed the US to run up huge current account deficits but also flooded the world with dollars, fanning asset bubbles. Three, the absence of wage pressures and cheap imports lowered inflation, allowed the US Federal Reserve to pat itself on the back for ushering in what was called ‘The Great Moderation’ and for keeping interest rates low. Needless to add, these low rates resulted in a sharp rise in debt. Real wages may fall, but the masses could be kept quiet by cheap and easy credit.

All this also led to the increasing role of finance in the advanced economies and set the stage for what was to become the sub-prime mortgage crisis in the US. The unravelling of that debt, spread throughout the financial system by a web of opaque financial products that sliced, diced and sold these mortgages, was the financial crisis of 2008. You could call the new system Asset Market Keynesianism—relying on easy credit to pump up asset values and using the inflated assets as collateral for further rounds of borrowing.

Capitalism has gone through several avatars in the last hundred years. The Keynesian revolution of the nineteen-thirties was hailed as a solution to the contradictions engendered by the earlier era of near-laissez-faire. It resulted in capital controls, a partnership between labour and capital in the West and in the welfare state. When that solution was found to impede the demands of capital accumulation, a new system, one of capital mobility, financialization and globalization, came into being. The financial crisis laid bare the flaws in that new system.

Serial financial bubbles

The freeing up of capital movement and the increasing financialization of the global economy has spawned a series of credit and asset bubbles. Some trace it all the way back to the oil price rise of the 1970s, when the Gulf oil producers accumulated vast surpluses, most of which were funnelled to US banks. That led to a big rise in money supply in the US, setting the stage for a heady bout of lending by mortgage companies, which culminated in the savings and loan disaster of the 1980s.

The oil surpluses were also lent by the banks to governments in Latin America. Later on in the 1980s, when interest rates rose and the dollar appreciated, these loans turned bad and led these countries into a debt trap. The eighties became a “lost decade" for Latin America. In the US, the rise in interest rates led to the bust in the savings and loan associations.

About that time, worried by the continuous rise in the value of the dollar and the loss of competitiveness to Japan, the US forced the Plaza Accord down Japan’s throat, forcing it to let the yen appreciate. That led to a fall in the value of the dollar, capital repatriation to Japan and a lowering of interest rates there to rock bottom to keep exports going. It created the mother of all bubbles in Japan, with the Nikkei rocketing up and real estate values going through the roof.

But all bubbles have a nasty habit of popping. When the Japanese bubble burst, it sent the country into a prolonged slump from which it is yet to recover. After the bust in Japan, the Asian tigers became the next bubble, with capital flowing like water to these emerging markets. When that huge bubble burst during the Asian crisis, the money hotfooted back to the US, where the tech bubble was waiting to happen.

We all know how that ended and how Alan Greenspan’s rate cuts, in an effort to keep US growth going, fed the housing bubble in the US which ultimately led to the Global Financial Crisis (GFC).

World 10 years after the GFC

Massive monetary stimulus by the central banks of the advanced economies has finally engineered a rebound in global growth. But have the reasons that led to the financial crisis been addressed?

To be sure, there has been some tightening of oversight—banks now have higher capital ratios and market reforms have included standardization of contracts, expanded reporting requirements, mandatory central clearing and margin requirements for a wide range of derivatives. But that has merely pushed some activities to the so-called shadow banking sector. Gillian Tett of the Financial Times says the size of the shadow banking sector is up from $28 trillion in 2010 to $45 trillion now and it accounts for 13% of the world’s financial assets.

What’s more, overall debt is now higher than it was in 2007, as Chart 2 shows. In the US, in particular, corporate leverage today is at its highest level since the beginning of the millennium and similar to that prevailing after the leveraged buyout boom of the late 1980s. The Bank for International Settlements has identified several risks to the financial system and it says that “the combination of a non-inflationary expansion and low interest rates would be likely to encourage the further, gradual build-up of financial imbalances and debt accumulation more generally, creating the conditions for a more costly contraction further down the road." The global bankers’ bank also points to the imbalances in the Chinese economy that continue to fester and to the rising risks from protectionism.

Perhaps the biggest challenge has come from the backlash against globalization, which has injected a huge dose of uncertainty into the global economy. With the opium of household debt no longer easily available, the masses in the advanced economies have woken up to their plight. Neo-fascist forces across the world have lost no time in tapping into the disruption and resentment caused by the financial crisis. It’s an eerie reminder of what happened in the nineteen thirties.

That apocalyptic scenario is unlikely to happen. But many questions remain about the quality of the current recovery, not the least of which is uncertainty about what will happen once the unprecedentedly loose financial conditions are tightened. Chart 3 shows that the Chicago Fed National Financial Conditions Index is currently at its lowest since the early 1990s, despite the Fed raising interest rates. The fundamental question remains: Is the global economy going to lurch from crisis to crisis as it has done since the nineties, with bubbles in between? Is it going to be business as usual then till the next crisis? And finally, given the continual rise in debt, will the next crisis be even worse than the last one?


The lingering aftermath of Lehman Brothers in India

In the initial stages of the crisis, when it was thought to be just a sub-prime mortgage crisis in the US, there was a lot of talk about India being unaffected, thanks to its economy based on domestic consumption, its state-owned banks and its lack of foreign borrowing. But the optimists had not reckoned with the impact of the crisis in global financial markets and the relentless selling by foreign portfolio investors, which soon revealed that de-coupling of the Indian economy was a pipe dream. The crisis laid bare the fact that the much-vaunted growth of the Indian economy during boom years of 2004-08 was simply the result of a tsunami of foreign money.

Once it realized that growth would be affected, however, the Indian establishment lost no time in putting into effect a massive fiscal and monetary stimulus to the economy. In the short-run, this huge stimulus boosted gross domestic product growth, which reached double digits in 2010-11. But the reprieve was short-lived. As oil prices climbed globally, the large fiscal deficit soon morphed into a current account crisis, reaching its nadir with India being labelled a member of the Fragile Five group of countries in 2013.

While we recovered from that crisis, thanks to some deft footwork by the Reserve Bank of India and by a reduction of the fiscal deficit, some effects of the artificially-induced boom during the financial crisis are still with us. The excess capacity created during those years is still an overhang on the economy and the effects of the debt piled up during those years linger on in some sectors of the economy. Most importantly, the banking sector is yet to recover from the hangover of its lending binge during the crisis years.