The Broken Machine: The Story of the Great Recession

The Broken Machine: The Story of the Great Recession

Wallace Katz: Broken Economy

FOR A year or so after the 2007-8 financial meltdown, the media gave it full focus. Everyone acknowledged that the financial crash had led to a deep recession almost as scary as the Great Depression. Rather quickly, however, President Obama and Ben Bernanke pronounced the recession over and, while admitting that jobs were scarce, described things as “getting better.” It was as if nothing much had happened or, more precisely, that the crisis had been an ordinary cyclical event, which with the proper policies would soon give way to good times.

One finds a less sanguine picture of the current situation in the works of Harold James, Robert Brenner, and Raghuram Rajan. Each of them, in his own way, sees the financial crash and the recession as a decisive break in the postwar system of global political economy. In The Creation and Destruction of Value, James identifies globalization as the culprit and warns that it is a process replete with risk and volatility. In two exhaustively detailed books, The Economics of Global Turbulence and The Boom and the Bubble, and in a recent essay, “What’s Good for Goldman Sachs is Good for America,” Robert Brenner describes how capitalist competition among advanced and newly developing nations resulted in overproduction of similar goods, leading to a fall in the rate of profit and what he calls “the long downturn” beginning in 1973. Rajan’s Fault Lines sees the crash and recession as originating in long-term global trade imbalances and in flawed government policies that promoted loose credit and irresponsible banking practices.

In The Creation and Destruction of Value, James quotes Alan Greenspan on the miraculous nature of the new economy of the early twenty-first century: “Dramatic advances in computer and telecommunications technologies have enabled a broad unbundling of risks through innovative financial engineering.” Everything James writes is meant to prove Greenspan wrong. James argues that there are inherent limits to financialization, and that even very sophisticated forms of debt securitization, which distribute risk among a wide array of investors, cannot prevent financial collapse. He sees the financial crisis abetted by these financial tools as marking the end of “the dream of global free market capitalism,” with the breakdown of globalization arriving in three key areas: flows of capital, trade, and movement of people.

One virtue of James’s book is the cogency with which he explains the “how” and “why” of the great financial crash. The vaunted globalization of the early twenty-first century is for him a “financial revolution” of capital flows across borders with “no historical parallel.” But the revolution went wrong, leading to “the buildup of debt on a global and personal level.” In the United States, debt of all kinds in 1980 amounted to 163 percent of GDP, but by 2007 the figure was 346 percent, with household debt increasing in the same period from 50 to 100 percent. The increase in debt was increasingly deregulated. Securitization allowed the debt to be broken into tranches or sections, allowing good debt to be pooled with bad debt. Credit agencies rated these sections, often vastly overstating their quality. This type of securitization revolutionized the real estate business and allowed real estate securities—mortgages—to be distributed around the world.

There was a second innovation: the riskiest parts of the standardized product—the bad debt—could be insured by insurance agencies like AIG and Swiss Re, so that further securities could be issued presumably without fear of default for investors. In 2008 these insured securities—in the form of credit default swaps—accounted for $58 trillion of global investment, more than the world GDP of $50 trillion. The ubiquity of these securities and their insured status made government regulation increasingly inefficacious or in some cases encouraged regulators not to regulate at all. This in turn allowed even big and solid bankers to believe that the securities they issued and themselves invested in were “the financial equivalent of a free lunch.”

A second virtue of James’s book is the historical context in which he sets the current crisis. He uses the crash of 1929 and the Great Depression that followed it to distinguish between financial crashes and ensuing long downturns. The former are easily handled by governments through regulation and the injection of funds into the economy by central banks; this was achieved after the 1929 crash and was accomplished by TARP in 2008 and 2009. But depressions and great recessions are not so easily managed. As Robert Reich has recently suggested, they often require redistributive structural changes—for example, in the thirties, Social Security and the full recognition of labor unions. And to the extent that depressions are international, involving many cross-border flows, they may resist state management. Moreover, once trade and commerce have broken down, individuals and corporations resume economic activity reluctantly because they still have old debts to pay.

Since the end of the Second World War, the United States has been at the center of the world economy and has been responsible for its governance. James believes that the depth of American markets and U.S. political stability will sustain the United States in its position of global leadership. But he notes signs of trouble: the failure of America’s grand international strategy, its declining rate of growth, and the ever increasing deficit. If the United States should falter, it’s not clear who will take its place as the economic and financial center of the global economy. James rules out Europe as too divided between major economies such as Germany and France and the lesser economies of eastern and southern Europe. He describes China as “the America of the twenty-first century,” but wonders whether it is ready to assume the role played in the postwar period by the United States. Its savings rate of around 30 percent is spectacularly high, and it is home to the world’s three largest banks, in terms of market capitalization. But its economy is only partially entrepreneurial; it remains a classic “industrial policy state.” China could at some point resist an international role and fall back on its usual state-dominated and nationalist model.

FOR ROBERT Brenner, a sophisticated neo-Marxist, the problems of the postwar economy derive from one source: the falling rate of profit, a consequence of overproduction. Since 1973—and markedly in the last decade, which Brenner describes as the weakest business cycle in a half century—the world economy has experienced “a long downturn.” Things went well in the immediate postwar period, when the United States had little competition. But once Germany, Japan, and then the exporting nations of Asia, particularly China, came on board, overproduction of the same goods caused the rate of profit to decline. Instead of dealing with this issue, each nation attempted to sustain its market share. The problem was “papered over,” usually in two ways—by raising or lowering currency exchange rates and by loosening credit. Changes in the rate of currency exchange caused endless booms and busts: when the dollar was low the American economy experienced boom periods; when it was high the economy went bust. A lowered rate of profit also reduced investment in plants and wages and caused aggregate demand to fall. In order to maintain demand, credit was eased so that corporations could stay in business and individuals could sustain high living standards.

Keynesian counter-cyclical government expenditure worked in the immediate postwar period, but as time went on, we met the limits of its efficacy: more state spending produced less growth, and as new nations entered the fray, competition became a zero-sum game. This game linked international economics to international politics, with the United States torn between its role as the world’s leader and its national interest. The latter dictated low exchange rates so that American exports, especially in manufacturing, could thrive. But those focused on foreign policy often argued for high exchange rates, so as to satisfy the needs of our trading partners. This logic explains two key agreements: the Plaza Accord of 1985, which lowered the dollar exchange rate and led to the expansion of American manufacturing; and the reverse Plaza Accord of 1995, when the value of the dollar increased and imports and prices rose. The decline of manufacturing transformed the economy, with non-manufacturing sectors—in particular retail, construction, and financial services—moving center stage, and consumption (at least stateside) replacing investment.

With prices rising but profits and demand still falling, corporations were reluctant to invest. The economy over which Alan Greenspan presided was kept afloat by the radical reduction of interest rates to near or below one percent. Most of the extra cash was funneled into the stock market, where asset prices rose spectacularly, creating wealth out of nothing. Brenner underscores the fact that whereas increases in stock values usually follow innovation, in this case it was the stock market bubble itself that fueled the so-called “new economy” of the 1990s. He also identifies the key paradox that asset values rose as profits and productivity fell.

Because nothing was done to alter the underlying problem of overproduction, asset bubbles led to subsequent downturns (like the “dot.com” bubble of 2000), with each one met by the same strategy of eased credit. But the increase in the asset value of stocks was limited and had even declined in the early 2000s. The increase in the value of prime housing, or mortgages given to solid borrowers, was similarly constrained. To maintain economic expansion, the George W. Bush administration, the Federal Reserve, and banks played the dangerous game of promoting affordable housing via “non-conforming” or subprime mortgages. The terms of these mortgages seduced ordinary folk who saw this as an opportunity to attain the “American Dream” of home ownership. Greedy housing speculators also made use of these terms. Bankers considered the subprime mortgages relatively safe because they could be securitized, with risks shared. But the same banks also set up “off book” shadow divisions, precisely so that they, too, could buy these securities. By 2006, 40.1 percent of new mortgages were subprime. Of course, this bubble had to burst, creating in its wake a downward spiral in which consumer demand fell, banks refused to lend, and employment and investment declined. The key culprits here were not ordinary folk, but banks and mortgage brokers like Countrywide Financial.

RAGHURAM RAJAN argues that the current crisis is the result of three “fault lines,” or systemic flaws in the global economy. Government encouragement of home ownership through loose credit is one such flaw; trade imbalances between importing nations like the United States and exporting nations like China constitute another. The third flaw is the discrepancies between countries like Great Britain and the United States, which have “transparent” and contractual financial systems, and other countries, often newly developing nations, which lack “transparent” systems.

Rajan overemphasizes government responsibility for the financial crash. The policies that maintained low interest rates and that promoted “the ownership society” doubtless contributed to the crisis. Easy credit, combined with the banks’ understanding that, should they fail, government would bail them out, allowed financiers to act irresponsibly. But as Rajan himself notes, the reward structure in the financial industry provided the greatest incentive to irresponsibility: risk takers who played the game and won made millions and were admired and promoted (and those that lost often kept their jobs). Another factor contributing to the crash, however, was the global capital glut. Much of the cash that was invested in subprime mortgages came from nations with high savings rates. With so much cash available, bankers had ample incentive to make loans to almost anyone who walked in the door.

Rather than criticizing Americans for living high on credit, Rajan believes that because so many nations focused on exports in order to grow, the United States simply did its duty and assumed responsibility for the world economy by becoming its major consumer. He is probably right that trade imbalances are bad for the global economy and also harm “late developing” nations dependent on exports. “Managed capitalism” favors producers over consumers. Certain industries and firms are protected and subsidized, encouraging innovation for export trade, while other industries—often local agriculture—are subsidized with little regard to productivity. Wage earners are badly paid, heavily taxed, and the goods they buy—unlike the goods exported—are expensive. All of the above, however, represents a curious defense of American consumer capitalism and omits mention of any of the following: the failure to revive American manufacturing via industrial policy in the 1970s; the rush by American global corporations to export manufacturing abroad in search of cheap labor; and, finally, the acquiescence of ordinary Americans in a Catch-22 situation that allowed them to buy inexpensive goods made elsewhere in exchange for declining wages and an increasingly inegalitarian society.

Rajan sets forth a reform agenda that confusedly affirms aspects of social democracy while being rooted in free market liberalism. He hopes to eliminate or alleviate global “fault lines.” He proposes that the United States institute a more substantial safety net, with unemployment and pensions modeled on more generous European systems. But while he acknowledges inequality, he accepts a jobless recovery as a market outcome, which means that his interest in a more ample safety net implicitly sanctions ever-increasing class and income disparity. To keep newly developing nations from seeking bad loans, he suggests that they refrain from borrowing by reducing investment in infrastructure. He would also expunge from law and finance all incentives that encourage risk-taking by bankers. But nowhere does Rajan offer a politics, either national or global, to implement any of his ideas for reform.

One might do well to answer the question posed by Brenner: “what comes next?” Regrettably, neither James nor Brenner, two world-class historians, provide a long-term answer to this question. The global economy is now in shambles, with the future unclear. The timidity of current policy amounts to using the same old machine even though it has long since broken. The idea that growth would be a means to stability and prosperity dominated the postwar era in America; build it and we will all thrive. As James, Brenner, and, to an extent, Rajan make clear, the growth fueled by thirty years of financial speculation and the export of manufacturing production abroad has resulted in inequality and unemployment or underemployment for ordinary people, whether middle class or “working class.” Recent Wall Street bonuses show that the age of booms and bubbles has not yet abated; but those won’t work in the future any better than they did in the past.

Wallace Katz is an associate editor and the book review editor of Globality Studies Journal. He is currently a visiting scholar and fellow of the Center for Global and Local History at SUNY-Stony Brook and has taught at CUNY, Wesleyan University, and the University of the South. For twenty-two years, he worked in Washington, D.C. in urban and public policy.