Hyman Minsky, an American Economist, had written a book titled ‘Can It Happen Again’ with ‘it’ standing for the Great Depression of the 1930s, the biggest and the longest economic crisis in the history of capitalism. The answer to this question today seems to be in the affirmative if one takes a deeper look at the events that have unfolded in the financial markets in the United States and the other advanced countries over more than two years. The extent of this crisis, in particular in the US, has led the economic pundits to describe the present financial crisis as something similar to what happened during the 1930s. Despite all the signs of recovery, we believe it is too early and erroneous to assume that the crisis is over and that the government should withdraw the stimulus package.
Theoretical Overview
To place the issues in perspective, it is important to reflect upon the economic ideas that developed regarding growth and crisis under capitalism since the 1930s. In the aftermath of the Great Depression, John Maynard Keynes, a British economist and Michal Kalecki, a Polish economist, had written extensively on its causes as well as its remedies. Though their political orientation was very different (Kalecki was a Marxist while Keynes was not), both argued that it was the absence of direct intervention of the government in the working of the economy and financial markets that led to the Great Depression. The remedy that Keynes suggested was a categorical rebuttal of the principles of Laissez faire since he asked not only for a regulation of the financial markets but for a direct government intervention to boost the demand in the economy through positive fiscal stimulus. The fiscal management (1) on the lines of the Keynes-Kalecki produced the Golden Age of capitalism in the 1950s and the 1960s in the advanced capitalist countries which saw the longest period of booms in these countries and distribution of income moving partially in favour of the working class.
In the early 1970s, this model broke down and there was a resurrection of the old ideology of free market and finance. It is interesting to note the complete reversal in economic ideas as well as policies despite having learnt the lesson the hard way in the 1930s. It seems almost as if the Keynes-Kalecki were erased from history. But the real answer to this reversal comes out quite clearly in Kalecki’s writings. Kalecki, unlike Keynes, looked at capitalism as fundamentally an antagonistic system. Kalecki (1943) argued that even though it is theoreticallypossible to attain high levels of employment and growth through government spending, it cannot go on in the long run. He argued that a prolonged period of low unemployment increases the bargaining power of the workers due to the declining reserve army of labour. Why this would lead to problems in maintaining such a growth process is for the following reason,
“[T]o maintain the high level of employment. . . in the subsequent boom, a strong opposition of ‘business leaders’ is likely to be encountered. . . lasting full employment is not at all to their liking. The workers would ‘get out of hand’ and the ‘captains of industry’ would be anxious ‘to teach them a lesson’.
[U]nder a regime of permanent full employment, ‘the sack’ would cease to play its role as a disciplinary measure. The social position of the boss would be undermined and the self assurance and class consciousness of the working class would grow. Strikes for wage increases and improvements in conditions of work would create political tension. . . ‘discipline in the factories’ and ‘political stability’ are more appreciated by business leaders than profits. Their class interest tells them that lasting full employment is unsound from their point of view and that unemployment is an integral part of the normal capitalist system.”
So, the reserve army of labour is a necessity under capitalism to maintain the correlation of class forces in favour of the capitalists and rentiers. Accordingly, one could argue that the so-called golden age of capitalism was more of an aberration than a rule under capitalism. Seen in light of this argument, the present crisis, its severity notwithstanding, is actually not an exception but a rule under capitalism. We would like to argue, therefore, that this crisis should not be seen only in the light of the failure of the financial system for it could actually be just a signal of deeper malaise in the real economy. This distinction between real and financial crisis is very important because a sizeable majority in the academia and policy circles are arguing that if only the financial markets could be controlled, such crises would not take place. In other words, capitalism otherwise is a stable system provided the financial markets are regulated. Our argument is that crises of this nature can and do take place under capitalism independent of whether the latter were regulated or not. Unregulated financial markets add to the severity of the crisis.
Let us concentrate on the sources of malaise in the real economy. Unfettered development of capitalism leads to greater monopolisation by big business. Greater monopolisation of the market ensures a downward rigidity in prices and, therefore, a guaranteed profit margin. On the other hand, there are continuous efforts to improve labour productivity so as to keep the wage costs low. Downward rigidity in prices and continuous increase in labour productivity results in a tendency towards increasing profit share in the total output. While this strategy sounds good for an individual capitalist, it has seeds of its own destruction inbuilt into it.
A higher profit share for the economy as a whole leads to a decline in the domestic market. This is so because workers consume a higher proportion of their income than the capitalists and any shift of total income away from workers would ipso facto lead to a decline in overall consumption demand in the economy (2). Since private investment is the main source of growth under capitalism, such a signal of declining consumption in the market exerts a downward pressure on the rate of growth. This is the typical realisation crisis in Marxian terminology. This is an imminent tendency under capitalism because there is no spontaneous mechanism of coordination of investment decisions of the capitalists to avert such a crisis. The reasons for why the system is not underperpetual crisis but faces it only intermittently have to be found elsewhere but this tendency exists all the time. The factors which counter this tendency could be state intervention, export-led growth, capitalists’ consumption led growth. Each of these factors has different consequences on the trajectory of the growth process, some of which we would focus on later in this article.
Just as the pre-Golden Age, the current period is also not fundamentally different. Inequalities in income and wealth have been rising dramatically since the late 1970s across the world, except for the possible exception of France and Japan, creating conditions for realisation crisis. The genesis of the present crisis lies precisely in the factors which had kept the growth going even when such a tendency existed. Therefore, to understand the present crisis, we need to analyse the economic booms that the US has witnessed in the present decade and the previous one.
Growing Inequality
There has been a dramatic increase in inequality in the US since the early 1980s. What the US is witnessing today in terms of inequality has only one parallel in its history i.e., the period during the Great Depression (see fig 1). The inequality is such that the top 10 % of the population earns close to 40% of the total income. The inequality has increased in the US since the early 1980s primarily because of two reasons. On the one hand, the income of the poor has got squeezed due to a decline in the legal minimum wages, unionisation rates and increased globalisation, all of which have decreased their bargaining strength. On the other hand, the payrolls of the top executives, especially CEOs, has increased manifold in the absence of either the wage controls of the World War II or the social norms of the Golden Age period which restricted the growth of high-end wages.
The increase in equality is not restricted to income alone but there is a growth in wealth inequality too as shown in Table 1. While the top 1% of the population owned 33.8% of the total wealth of the economy, the bottom 40% of the population owned less than 1% of the total wealth in 1983. The wealth inequality increased by 1995 to such an extent that the top 1% owned close to 40% of the wealth while the bottom 40% owned a mere 0.2%.
A major part of the increase in the wealth of the rich during this period has been through the increase in the stock market prices of the financial assets that they own. Since the ownership of stock market assets itself is extremely skewed in favour of the rich, an increase in the prices of the shares has an asymmetric effect in favour of the wealth of the rich.
The Boom of the 1990s
From the point of view of classical political economy, such a growth in inequality should have led to stagnation in the economy instead of a boom as witnessed both in the late 90s and the present decade (prior to the current crisis). If that is the case, then why did the growth of inequality lead to an increase in the growth rate in the US in the late 90s and 2000s?
As mentioned above, at least theoretically, there could be three ways which can help avert this tendency towards stagnation into becoming a reality. First, the government could prop up the domestic demand through fiscal management. But this route was practically unavailable given the right-wing dominance in the policy circles which wanted to restrict the role of the government in the real economy (3).
Second, the stress of growth could divert in favour of export-oriented strategy. Again to do that, one needs to be internationally competitive both in terms of technology as well as wage costs, neither of which was in favour of the US. The US had been left far behind in terms of technology by its European counterparts, especially Germany and Japan in Asia.
Third, consumption of the rich could more than compensate for the declining share of workers’ consumption through injection of consumption demand independent of the current stream of income, say through the wealth effect coming from the asset price markets. Furthermore, new methods of enticing even the workers to consume through credit financing could also act as a counter to this tendency. It is the third route which the US has adopted in the last two booms which we focus upon in the rest of the paper.
The way this third route worked is the following. Stock or housing market booms led to a growth in the ‘notional’ wealth of the rich which had a positive effect on the consumption of the rich, a phenomenon called the ‘wealth effect’. Increase in consumption due to wealth effect was an external injection of demand into the economy independent of the redistribution of income between the rich and the poor. Though the exact effect of an increase in wealth on consumption in the US has been estimated to be not more than 3 cents per dollar, i.e., out of every dollar increase in wealth only 3 cents are spent on consumption, the sheer magnitude of the wealth increase due to the stock market boom of the late 1990s was such that it had a huge impact on the overall consumption. The argument can be better understood if we look at the exact increase in the wealth of households which increased by 50 percent within a span of five years between 1995 and 2000. The increase in consumption as a proportion of GDP was close to 1.5 percent during these years. Therefore, this increase in wealth alone explains the increase in consumption of the household during this period.
A more interesting question, however, is not why the consumption increased but how was this consumptionfinanced? To understand that, we need to explain how the increase in the wealth was ‘notional’? It was purely ‘notional’ to the extent that its value had increased due to higher valuation in the stock market so that the increased wealth could not be realised from the stock market by all the stock holders at the same time. Any attempt to ‘realise’ the increased value of the wealth in the stock market by selling the stocks at their higher prices by all the investors at the same time would have meant a collapse in the stock market itself. Thus, the increase in wealth was merely notional. That being the case, any increase in expenditure on consumption based on this increase in wealth had to be financed by taking more debt based on the increased collateral in the form of enhanced value of wealth. It is here that the debt spiral began in the US. Therefore, the debt spiral became a necessity for the economy to compensate for the imbalances in the real economy.
During the 1990s, the household debt stood at 95.6 percent of the total disposable income of that sector (see table 2). In other words, the household debt was almost equivalent to the total income of the sector as a whole in the 1990s. Such high levels of debt-income ratio were ominous signs for the US but the Federal Reserve did not pay heed to the dangerous growth in the debt-income ratios, instead they were busy propagating the argument that the US economy had entered a new phase of ‘new economy’ where business cycles were a thing of past.
Such sleight of hand by the mainstream economics, however, had to face the reality when the economy witnessed the Dotcom bubble go burst in 2001. The business cycle was back as indeed it is a part of the working of any normal capitalist economy, contrary to the claims of the new economy enthusiasts. A decline in the stock market meant a decline in the wealth of the households too and the increased wealth effect was bound to reverse but the debt taken against the increased wealth earlier remained nonetheless.
The Mortgage Boom of the 2000s and the seeds of destruction
In the event of the stock market meltdown in 2000, the financial speculators moved away from the stock market to some other avenues where they could make a quick buck and the best opportunity they found was in the housing market. Such a huge diversion of funds from the Dotcom bubble to the housing market had a positive effect on the housing prices just as it had on the stock prices of the IT sector during the late 90s.
An increase in the housing prices made housing into a profitable venture for the household sector because in common perception it was thought to be a safer asset that the stocks, little was it known that it was merely a shifting of one bubble to another. As happens in the stock market, the increase in buyers of houses led to a further increase in prices of housing much beyond its cost of manufacture.
The policy of the government in the post-2001 phase was multi–pronged to provide a boost to the household demand (either in consumer durables or expenditure on housing) which had been responsible for the growth in the 1990s. First, there was a major tax cut by George W. Bush announced on June 7, 2001. Bush, in his remarks in Tax Cut Bill Signing Ceremony, argued that the magnitude of the tax cut that his administration was announcing can only be comparable to the Reagan Tax cut of the 80s or the Kennedy Tax cut of the 60s. This tax cut had a definite impact on increasing the consumption of the rich because they were the biggest beneficiary of the Bush Tax Cut. That is why despite the meltdown in the stock market which had driven the consumption during the 90s, consumption of the household did not decline as would be expected based on the wealth effect (after increasing for over two decades, the consumption share after 2001 remained stagnant instead of declining despite the meltdown in the stock market). The declining wealth effect was compensated to an extent by the easing tax effect during this period.
Second, after the stock market crash of 2000, which had its repercussions well into 2002, the Fed was looking for other ways of stimulating consumption demand because that had been the bedrock of growth in the late 90s. In the absence of another equity price bubble, the housing market provided an opportunity of such an alternative. The prices in the real estate market had been increasing since the mid–90s but it was still a sideshow to the stock market boom of the 90s. It was only in the early years of the present decade that they started picking up. The reason for this housing market run was quite obvious. The stock market crash led the investors to look for alternative measures of keeping their money and real estate seemed a good opportunity because its demand was going high so there was always a potential of making capital gains (p.92, Pollin (2005)). A Special Report (2005) of The Economist had the following to say about the magnitude of the housing market boom in the US or perhaps the entire developed world,
“[T]he total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries’ combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stock market bubble in the late 1990s (an increase over five years of 80% of GDP) or America’s stock market bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.” [Emphasis added]
The extent of speculation in the housing market can be measured by the ratio of the housing prices to the rental applicable to the houses. This is similar to the Price-equity (P/E) ratio of stocks because the income that can be imputed from owning a house comes from the rental that it would fetch in future. Let us see what happened to this ratio. Weller (2006) presents the data comparing the Housing Price Index to Rental and the CPI (see fig. 2).
While the ratio of HPI to rentals remained stable for more than two decades since 1975 (as shown by the dashed line in fig. 2), there was a sharp increase in it since 2000. This is further corroborated by the fact that in 2004, 23 percent of the homes bought were purely for investment purposes while 13 percent were bought as second homes. ‘Investors [were] prepared to buy houses they [would] rent out at a loss, just because they [thought] prices will keep rising–the very definition of a financial bubble.’ (Report (2005)). In Miami, nearly half of the original buyers resold their apartments in an attempt to make capital gains.
In such a situation of high speculation, the Fed pushed aggressively for an easy monetary policy which meant a drastic decline in the federal funds rate (short term interest rate set by the Fed) even below the rate of inflation resulting in negative real funds rate. The real federal funds rate remained negative from the mid-2002 to early 2006 which meant a real heavy dose of easy money for more than three years. This kind of monetary policy has not been seen in the recent past in the US. The household sector responded very positively to this easy credit policy because the mortgage rates also declined. They increased their expenditure on housing which further increased its prices and the spiral started building up. This was the other bubble building up as Pollin (2005) writes (p.92),
“As the upward price momentum continued through the middle of 2002, the Wall Street Journal, among other observers, began warning of the dangers of a housing “market bubble” in which “stretched buyers push mortgages to the limit.”
The “limits” to which the buyers were “pushed” can be estimated by the growth in the Financial Obligation Ratio (FOR) and the Debt Service Ratio (DSR) of the household sector during this period. Debt Service Ratio (DSR) is the ratio of debt payments on outstanding mortgages and consumer debt to the disposable income of the household sector. We also present data of a more inclusive concept of the debt obligation that the household sector holds. This measure is called the Financial Obligation Ratio (FOR) which, apart from the repayment of interest charges on outstanding mortgage and consumer debt, includes the automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments.
Some important conclusions can be drawn about the financial condition of the household sector based on these two ratios. In panel (a) of fig. 3, it clearly shows that both DSR and FOR have been rising since the early to mid–1990s. If we differentiate between the debt payments on account of home mortgages and consumer durables, we get panel (b), which tells us another interesting story behind this debt growth. As expected, for the 1990s, which is characterized by stock market boom, it is the consumer durables debt payments that play a central role in driving the FOR up whereas the home mortgage debt payments were declining for that decade. After 2000, however, when the real estate boom replaced the stock market boom, it is the home mortgage payments which determine the FOR for the households.
The Federal Reserve during this period had its priorities chalked out pretty well which was to give a boost to the housing prices, just as in the 90s, it was most interested in maintaining the stock market boom. This can be seen from the minutes of the Federal Open market Committee (FOMC) meeting of this period. Minutes of the FOMC (2004) meeting held in June say,
“The members continued to report a high level of housing demand in numerous parts of the country, with housing construction described as a notably robust sector in many regional economies. The strong performance of the housing industry continued to be attributed in large measure to the lowest mortgage interest rates in several decades.” [Emphasis added]
Third, given that the growth of the economy now was driven by the growth in residential investment financed primarily by debt, there was an increasing tendency by the lenders to indulge in predatory lending practices. The norms of lending were broken at will to keep the real estate boom alive and the Fed, despite being aware of the precariousness of the situation, allowed it to happen under its nose just as it did not intervene during the speculative run in the stock market boom of the 90s.
Lending norms were twisted in myriad ways, especially in the Sub-prime mortgage market (4). First, the norm of mortgage was changed for rich borrowers who could use up to 50 percent of their income for their mortgage payment whereas earlier the norm was only 28–32 percent (p.92, Pollin (2005)). Second, new forms of loans were introduced which had no requirement for down payments. As high as 42 percent of the first time borrowers and 25 percent of all borrowers were exempted from making any down payment (Report (2005)). Third, a new form of financing was introduced which was the Adjustable Rate of Mortgage (ARMs), according to which the overall interest payment could be spread over years so that the initial interest payments might seem very low but the debt burden would increase as you go further into future. This was used to sell loans with ‘hidden costs’. Fourth, the borrowers could get up to 105 percent of the buying cost as loan and no documentation of borrower’s income or employment was required (Report (2005)). Fifth, the borrowers were allowed to pay only a part of the interest amount due while their unpaid interest amount and the principal get added as debt, a form of loan which has been termed as ‘negative amortization loans’. One third of the total loans in the US in 2002 were either interest–only loans or negative amortization loans (Report (2005)).
The housing market boom had a logic of its own which was in some ways similar to a stock market boom. Since the housing prices were increasing, it provided a good opportunity to make money at the margin by buying low and selling high, just as in the case of equities. Moreover, increasing prices of houses also increase the net worth of the owners of the houses which further increases their capacity to borrow and hence to speculate even more, which was reflected in people buying more than one house. But since all the buy is financed through debt, it puts the household sector on a knife–edge position. On the one hand, if the prices of the houses declined then the value of their collateral declines and further borrowing becomes less likely. In the worst situation, if the prices fell drastically, even the possibility of repaying the debt by selling the house might itself disappear leading to foreclosures. On the other hand, if the interest rates increase eventually, they would increase the debt burden in future, especially if the loans have been taken under the ARM scheme. In effect, it is the real mortgage rate that matters which is the difference between the nominal mortgage rate and the capital gain through a housing price rise (Weller (2006)).
Even though it was obvious that the housing prices were primarily speculative in nature, Alan Greenspan, the then Chairman of the Federal Reserve, while addressing the Joint Economic Committee on June 9, 2005, had rubbished all claims about the housing boom being a speculative bubble by arguing that,
“[T]here can be little doubt that exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding and home turnover, and especially in the steep climb in home prices. Although a “bubble” in home prices for the nation as a whole doesnot appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels…
Transactions in second homes … suggest that speculative activity may have had a greater role in generating the recent price increases than it has customarily had in the past.
The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increases in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace.
The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. In part, this is explained by an underlying uptrend in home prices…
Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications.” [Emphasis added]
It would be really surprising to note that the same Greenspan had an altogether different take on the Depression of the 1930s. Greenspan (1966) wrote,
“When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage… The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed.” [Emphasis added]
If we say that ‘the excess credit which the Fed pumped into the economy spilled over into the housing market–triggering a fantastic speculative boom’, then how different would that be from what his argument is? If not, then it sounds puzzling as to why he did not apply his own argument about the Great Depression to the policy of the Fed under his chairmanship. Whitney (2005) writes the following about the policy of the Fed and its former chairman,
“Greenspan knows all about “irrational exuberance”; he’s its primary champion. The Fed seduces the public with cheap money, so that credit spending increases and, then, “presto”, millions of Americans slip inexorably into indentured servitude.”
Given the delicate balance that the household sector was maintaining vis-à-vis the housing market, it was obvious that any meltdown in these markets would be disastrous not only for the US economy but for the world economy as well. This possibility was further precipitated by the fact that dual pressure fell on the borrowers. On the one hand, the Fed decided to increase the federal fund rate, which increased the interest burdens especially for consumers who had opted for ARMs or negatively amortized loans. On the other hand, decline in housing prices decreased the value of their collateral and thus increased the possibility of bankruptcy which indeed were quite high in this period. This would especially have serious consequences for the US economy, as can be seen today, because 90 percent of the growth witnessed during 2001-05 was due to increased consumption and residential investment of the households.
Till now we have presented a macroeconomic picture of the housing market but it is obvious that such a market has the potential of having an asymmetric effect on households depending on their income category. For the poorer households, the effect of an increase in the real mortgage rate would be more severe than a richer household.
Some broad pattern can be drawn about the different categories of households (see table 3). First, the bottom quintile was not a part of the recent run in the housing market since 2001. The value of home as a proportion of income increases the most for the middle quintile. Second, contrary to the general perception, the main customers of ARMs appear to be the richest households and not the poorer ones. This could be because of the fact that the rich were buying the house only for the purposes of selling it later and were financing it through ARMs. A housing market meltdown would, thus, have an asymmetric effect on these categories depending on their relative exposure to the credit market.
The fact that the growth process in the last two decades was dependent on asset price markets can be substantiated if we plot the movements in economic activity with respect to these markets. We attempt to plot the business cycle of the 1990s and 2000s against the cycle in the stock market and the housing marker respectively in figure 4.
It can be seen that in both the cycles the movement of GDP is closely linked to the movement in these markets. In fact, the GDP cycle follows the asset price cycles. This gives us some empirical evidence on the theoretical proposition made above. In Keynes’ words, the growth processes had become ‘bubble in the whirlpool of speculation’.
Is ‘it’ over?
A lot is being written about the end of the crisis or at least ‘the worst is over’. But we believe, given the magnitude of the crisis, it is premature to think so. When we say the crisis, we do not mean the subprime crisisper se. By end of the crisis, we mean the delinking of the growth process’ dependence on the speculative booms in the asset price markets. It is very possible that in the short term we have another asset price bubble which will provide some respite to the economy but only to aggravate the systemic problem in the long run.
Let us first examine the economic variables which can tell us about the present recovery process. To examine the extent of recovery, we have to first examine the components of the recovery. Since the US economy is facing a crisis of inadequate aggregate demand in the economy, the path of recovery has to somehow solve this problem. Its failure to do so would not only prolong the crisis but any premature withdrawal of the government stimulus would further aggravate the very problem it is seeking to address. Aggregate demand in any economy comprises of the consumption of the household sector, investment made by the household sector (residential investment), investment made by the corporations (non-residential investment), government expenditure and net exports (trade surplus).
Not only has the residential market plummeted seriously, there has been a decline in the share of consumption too in the present crisis for reasons well known. Together they form a deadly combination of declining investment and the income multiplier. Therefore, the path to recovery has to be dependent on the last three components of aggregate demand, i.e., non-residential investment, government expenditure and trade surplus. Let us look at what is happening to these three factors at present (see figure 5).
Non-residential investment or the corporate investment in ‘real’ capital continues to decline as a proportion of GDP, which itself is serious because it means a lower rate of growth in investment than the GDP. But this is a general trend during the periods of crisis. In any crisis, the first factor that is affected is the corporate investment precisely because of the crisis of confidence of the capitalists. So, this by itself is not novel to this crisis, especially if we see it in the light of the magnitude of the present crisis.
The stimulus package that Obama administration has injected into the economy has led to increase in the second factor mentioned above, i.e., government expenditure. This automatically has the effect of propping up demand and thus, the GDP. But its magnitude is crucial, especially in crises like these. First, it has to compensate for the decline both in residential and non-residential investment. Second, even if that is taken care of, the net effect of that increase would be dampened if the income multiplier is decreasing as a result of declining share of consumption (as explained above). Therefore, the increase in government expenditure has to take care of both these factors which demands far more than what President Obama has announced so far.
Finally, the third factor, i.e., the trade balance, can also play a role in the recovery. In fact, as we will see below, the most crucial factor contributing to whatever little recovery that the US is witnessing today is directly linked to what is happening in their current account. Though it might seem contrary to common perception that current account balance in the US, which has been running record deficits for the last two decades, could actually be a catalyst to recovery. But if one looks carefully, if the rate of increase of trade deficit is low compared to the rate of decline in growth of GDP, it could actually play a positive role in recovery. In other words, if the ‘leakage’ of income from the economy in the form of net imports declines during the crisis, it will put less downward pressure on the rate of growth. This is what seems to be happening in the US. The share of trade deficit in the GDP has declined during the period of the crisis giving a positive impetus to an otherwise declining rate of growth.
A decline in the trade deficits could happen if there is an increase in the share of exports in the GDP or a decline in the share of imports or both. Or, at least the decrease in the share of exports in the GDP is lower than that of imports if both are decreasing. Declining trade deficit has taken place during this period in the US due to a sharper rate of decline in imports than exports. Further categorization of imports reveals that two factors, namely, industrial supplies and materials (except petroleum and products) and automotive vehicles, engines, and parts together have accounted for more than half the decline in imports in these quarters. This nature of decline in the share of imports in the GDP seems more to be of a short term character than a policy response by the US to increasing trade deficits, which makes this component of recovery even for a medium term suspect.
After analysing various components of demand and their behaviour during the ‘recovery period’, we can say that the increased government expenditure in the US through the fiscal package has still not been able to stimulate the economy to the extent of alleviating the problem at hand. On the one hand, consumption has stagnated, thereby, terminating the route to recovery through an increase in the multiplier. On the other hand, neither the residential investment nor the non-residential investment is showing any sign of recovery, especially, since the level of confidence of the corporations to invest is still quite bleak. Therefore, to withdraw the stimulus package now would be far from prudent. The lessons of the Great Depression remind us that the decision to withdraw the stimulus, on the basis of initial signs of recovery, ended up prolonging the crisis to almost a decade.
Conclusion
We have argued in this paper that growth in the US economy in the recent past has entirely been driven by either consumption spending or residential investment. Both of these were driven by asset price inflation of one kind or the other. While consumption was driven by the stock market boom of the 90s, residential investment was driven by the housing price boom. Such a growth path, however, has serious problems as already being witnessed in the US. First, it would require asset price inflation of one or the other kind to sustain the wealth driven growth. Second, it would be a highly volatile growth path because it would be dependent on the vagaries of these asset price markets. Third, it would invariably force the government to act in the interests of the finance capital because they hold the key to growth in the economy as happened in the bailout package endorsed by the US Congress earlier. The monetary as well as fiscal policy would have to be tethered to the developments in the asset price markets.
The current economic crisis that capitalism is faced with is of far greater magnitude than was envisaged even a few months back precisely because of the extent to which the machinations of the globalized finance capital has spread across the world. This is the time to categorically reject ‘there is no alternative’ (TINA) paradigm of the neo-liberalism and reassert alternative policy prescriptions which would be beneficial to common people.
Notes:
(1) It is another matter that the nature of state intervention was militarist in nature. Therefore, it would be simplistic to argue that the state intervention was primarily pro-people. In fact, the initial reversal in the economic activity after the prolonged period of Great Depression came after the World War II started. This led to increased fiscal expenditure on part of the government, which pushed the growth up. It is important to note that this growth was purely militaristic in nature. But post-1950s, there was an attempt to pop up the growth and employment by what was later came to be known as ‘welfare capitalism’. It is of course a contentious issue as to how much of the growth even in this period was welfare oriented.
(2) The argument underlying the negative linkage between growth and inequality can be found even in Marx when he talks about the underconsumption crisis. Josef Steindl, Baran and Sweezy and Kalecki revived this view in the field of Economics.
(3)This policy response was best exemplified by Ronald Reagan in the US and Margaret Thatcher in the UK where they proposed small governments to allow free markets to functions uninhibitedly. It should be kept in mind, however, that despite the opposition to government intervention in social sectors, they did not have any problems with burgeoning military expenditure. So, the argument effectively was to keep the ‘unnecessary’ government expenditure under check.
(4) With every passing day results of the investigations into the financial sector are getting murkier. A recent example of this is the recent case against the Golman Sachs (NY Times Editorial, 17 April 2010). Goldman Sachs Group Inc has been charged with fraud by the U.S. Securities and Exchange Commission over its marketing of a subprime mortgage product. It argued that Goldman Sachs was involved in malicious practice of creating and selling mortgage-backed investments and then placing financial bets that those investments would fail.
References
FOMC (2004): “Meeting of the Federal Open Market Committee,” Discussion paper, Board of the Governors of the Federal Reserve System.
Greenspan, A. (1966): “Gold and Economic Freedom,” The Objectivist.
Kalecki, M. (1943): “Political Aspects of Full Employment” in Selected Essays on the Dynamics of The Capitalist Economy, Cambridge University Press, 1971
Piketty, T., and E. Saez (2003): “Income Inequality in the United States, 1913-1998,” Quarterly Journal of Economics, 118, 1–39.
Pollin, Robert (2005): Contours of Descent: US Economic Fractures and the Landscape of Global Austerity. Verso.
Report (2005): “In Come the Waves: The Global Housing Boom,” The Economist.
Weller, C. E. (2006): “The End of the Great American Housing Boom: What it Means for You, Me and the U.S. Economy,” Discussion paper, Center for American Progress.
Whitney, M. (2005): “Pop Goes the Weasel: Greenspan and the Housing Bubble,” Monthly Review.
Radical Notes
Is ‘It’ Over? A Look at the Current Economic Crisis
Rohit
Hyman Minsky, an American Economist, had written a book titled ‘Can It Happen Again’ with ‘it’ standing for the Great Depression of the 1930s, the biggest and the longest economic crisis in the history of capitalism. The answer to this question today seems to be in the affirmative if one takes a deeper look at the events that have unfolded in the financial markets in the United States and the other advanced countries over more than two years. The extent of this crisis, in particular in the US, has led the economic pundits to describe the present financial crisis as something similar to what happened during the 1930s. Despite all the signs of recovery, we believe it is too early and erroneous to assume that the crisis is over and that the government should withdraw the stimulus package.
Theoretical Overview
To place the issues in perspective, it is important to reflect upon the economic ideas that developed regarding growth and crisis under capitalism since the 1930s. In the aftermath of the Great Depression, John Maynard Keynes, a British economist and Michal Kalecki, a Polish economist, had written extensively on its causes as well as its remedies. Though their political orientation was very different (Kalecki was a Marxist while Keynes was not), both argued that it was the absence of direct intervention of the government in the working of the economy and financial markets that led to the Great Depression. The remedy that Keynes suggested was a categorical rebuttal of the principles of Laissez faire since he asked not only for a regulation of the financial markets but for a direct government intervention to boost the demand in the economy through positive fiscal stimulus. The fiscal management (1) on the lines of the Keynes-Kalecki produced the Golden Age of capitalism in the 1950s and the 1960s in the advanced capitalist countries which saw the longest period of booms in these countries and distribution of income moving partially in favour of the working class.
In the early 1970s, this model broke down and there was a resurrection of the old ideology of free market and finance. It is interesting to note the complete reversal in economic ideas as well as policies despite having learnt the lesson the hard way in the 1930s. It seems almost as if the Keynes-Kalecki were erased from history. But the real answer to this reversal comes out quite clearly in Kalecki’s writings. Kalecki, unlike Keynes, looked at capitalism as fundamentally an antagonistic system. Kalecki (1943) argued that even though it is theoreticallypossible to attain high levels of employment and growth through government spending, it cannot go on in the long run. He argued that a prolonged period of low unemployment increases the bargaining power of the workers due to the declining reserve army of labour. Why this would lead to problems in maintaining such a growth process is for the following reason,
So, the reserve army of labour is a necessity under capitalism to maintain the correlation of class forces in favour of the capitalists and rentiers. Accordingly, one could argue that the so-called golden age of capitalism was more of an aberration than a rule under capitalism. Seen in light of this argument, the present crisis, its severity notwithstanding, is actually not an exception but a rule under capitalism. We would like to argue, therefore, that this crisis should not be seen only in the light of the failure of the financial system for it could actually be just a signal of deeper malaise in the real economy. This distinction between real and financial crisis is very important because a sizeable majority in the academia and policy circles are arguing that if only the financial markets could be controlled, such crises would not take place. In other words, capitalism otherwise is a stable system provided the financial markets are regulated. Our argument is that crises of this nature can and do take place under capitalism independent of whether the latter were regulated or not. Unregulated financial markets add to the severity of the crisis.
Let us concentrate on the sources of malaise in the real economy. Unfettered development of capitalism leads to greater monopolisation by big business. Greater monopolisation of the market ensures a downward rigidity in prices and, therefore, a guaranteed profit margin. On the other hand, there are continuous efforts to improve labour productivity so as to keep the wage costs low. Downward rigidity in prices and continuous increase in labour productivity results in a tendency towards increasing profit share in the total output. While this strategy sounds good for an individual capitalist, it has seeds of its own destruction inbuilt into it.
A higher profit share for the economy as a whole leads to a decline in the domestic market. This is so because workers consume a higher proportion of their income than the capitalists and any shift of total income away from workers would ipso facto lead to a decline in overall consumption demand in the economy (2). Since private investment is the main source of growth under capitalism, such a signal of declining consumption in the market exerts a downward pressure on the rate of growth. This is the typical realisation crisis in Marxian terminology. This is an imminent tendency under capitalism because there is no spontaneous mechanism of coordination of investment decisions of the capitalists to avert such a crisis. The reasons for why the system is not underperpetual crisis but faces it only intermittently have to be found elsewhere but this tendency exists all the time. The factors which counter this tendency could be state intervention, export-led growth, capitalists’ consumption led growth. Each of these factors has different consequences on the trajectory of the growth process, some of which we would focus on later in this article.
Just as the pre-Golden Age, the current period is also not fundamentally different. Inequalities in income and wealth have been rising dramatically since the late 1970s across the world, except for the possible exception of France and Japan, creating conditions for realisation crisis. The genesis of the present crisis lies precisely in the factors which had kept the growth going even when such a tendency existed. Therefore, to understand the present crisis, we need to analyse the economic booms that the US has witnessed in the present decade and the previous one.
Growing Inequality
There has been a dramatic increase in inequality in the US since the early 1980s. What the US is witnessing today in terms of inequality has only one parallel in its history i.e., the period during the Great Depression (see fig 1). The inequality is such that the top 10 % of the population earns close to 40% of the total income. The inequality has increased in the US since the early 1980s primarily because of two reasons. On the one hand, the income of the poor has got squeezed due to a decline in the legal minimum wages, unionisation rates and increased globalisation, all of which have decreased their bargaining strength. On the other hand, the payrolls of the top executives, especially CEOs, has increased manifold in the absence of either the wage controls of the World War II or the social norms of the Golden Age period which restricted the growth of high-end wages.
The increase in equality is not restricted to income alone but there is a growth in wealth inequality too as shown in Table 1. While the top 1% of the population owned 33.8% of the total wealth of the economy, the bottom 40% of the population owned less than 1% of the total wealth in 1983. The wealth inequality increased by 1995 to such an extent that the top 1% owned close to 40% of the wealth while the bottom 40% owned a mere 0.2%.
A major part of the increase in the wealth of the rich during this period has been through the increase in the stock market prices of the financial assets that they own. Since the ownership of stock market assets itself is extremely skewed in favour of the rich, an increase in the prices of the shares has an asymmetric effect in favour of the wealth of the rich.
The Boom of the 1990s
From the point of view of classical political economy, such a growth in inequality should have led to stagnation in the economy instead of a boom as witnessed both in the late 90s and the present decade (prior to the current crisis). If that is the case, then why did the growth of inequality lead to an increase in the growth rate in the US in the late 90s and 2000s?
As mentioned above, at least theoretically, there could be three ways which can help avert this tendency towards stagnation into becoming a reality. First, the government could prop up the domestic demand through fiscal management. But this route was practically unavailable given the right-wing dominance in the policy circles which wanted to restrict the role of the government in the real economy (3).
Second, the stress of growth could divert in favour of export-oriented strategy. Again to do that, one needs to be internationally competitive both in terms of technology as well as wage costs, neither of which was in favour of the US. The US had been left far behind in terms of technology by its European counterparts, especially Germany and Japan in Asia.
Third, consumption of the rich could more than compensate for the declining share of workers’ consumption through injection of consumption demand independent of the current stream of income, say through the wealth effect coming from the asset price markets. Furthermore, new methods of enticing even the workers to consume through credit financing could also act as a counter to this tendency. It is the third route which the US has adopted in the last two booms which we focus upon in the rest of the paper.
The way this third route worked is the following. Stock or housing market booms led to a growth in the ‘notional’ wealth of the rich which had a positive effect on the consumption of the rich, a phenomenon called the ‘wealth effect’. Increase in consumption due to wealth effect was an external injection of demand into the economy independent of the redistribution of income between the rich and the poor. Though the exact effect of an increase in wealth on consumption in the US has been estimated to be not more than 3 cents per dollar, i.e., out of every dollar increase in wealth only 3 cents are spent on consumption, the sheer magnitude of the wealth increase due to the stock market boom of the late 1990s was such that it had a huge impact on the overall consumption. The argument can be better understood if we look at the exact increase in the wealth of households which increased by 50 percent within a span of five years between 1995 and 2000. The increase in consumption as a proportion of GDP was close to 1.5 percent during these years. Therefore, this increase in wealth alone explains the increase in consumption of the household during this period.
A more interesting question, however, is not why the consumption increased but how was this consumptionfinanced? To understand that, we need to explain how the increase in the wealth was ‘notional’? It was purely ‘notional’ to the extent that its value had increased due to higher valuation in the stock market so that the increased wealth could not be realised from the stock market by all the stock holders at the same time. Any attempt to ‘realise’ the increased value of the wealth in the stock market by selling the stocks at their higher prices by all the investors at the same time would have meant a collapse in the stock market itself. Thus, the increase in wealth was merely notional. That being the case, any increase in expenditure on consumption based on this increase in wealth had to be financed by taking more debt based on the increased collateral in the form of enhanced value of wealth. It is here that the debt spiral began in the US. Therefore, the debt spiral became a necessity for the economy to compensate for the imbalances in the real economy.
During the 1990s, the household debt stood at 95.6 percent of the total disposable income of that sector (see table 2). In other words, the household debt was almost equivalent to the total income of the sector as a whole in the 1990s. Such high levels of debt-income ratio were ominous signs for the US but the Federal Reserve did not pay heed to the dangerous growth in the debt-income ratios, instead they were busy propagating the argument that the US economy had entered a new phase of ‘new economy’ where business cycles were a thing of past.
Such sleight of hand by the mainstream economics, however, had to face the reality when the economy witnessed the Dotcom bubble go burst in 2001. The business cycle was back as indeed it is a part of the working of any normal capitalist economy, contrary to the claims of the new economy enthusiasts. A decline in the stock market meant a decline in the wealth of the households too and the increased wealth effect was bound to reverse but the debt taken against the increased wealth earlier remained nonetheless.
The Mortgage Boom of the 2000s and the seeds of destruction
In the event of the stock market meltdown in 2000, the financial speculators moved away from the stock market to some other avenues where they could make a quick buck and the best opportunity they found was in the housing market. Such a huge diversion of funds from the Dotcom bubble to the housing market had a positive effect on the housing prices just as it had on the stock prices of the IT sector during the late 90s.
An increase in the housing prices made housing into a profitable venture for the household sector because in common perception it was thought to be a safer asset that the stocks, little was it known that it was merely a shifting of one bubble to another. As happens in the stock market, the increase in buyers of houses led to a further increase in prices of housing much beyond its cost of manufacture.
The policy of the government in the post-2001 phase was multi–pronged to provide a boost to the household demand (either in consumer durables or expenditure on housing) which had been responsible for the growth in the 1990s. First, there was a major tax cut by George W. Bush announced on June 7, 2001. Bush, in his remarks in Tax Cut Bill Signing Ceremony, argued that the magnitude of the tax cut that his administration was announcing can only be comparable to the Reagan Tax cut of the 80s or the Kennedy Tax cut of the 60s. This tax cut had a definite impact on increasing the consumption of the rich because they were the biggest beneficiary of the Bush Tax Cut. That is why despite the meltdown in the stock market which had driven the consumption during the 90s, consumption of the household did not decline as would be expected based on the wealth effect (after increasing for over two decades, the consumption share after 2001 remained stagnant instead of declining despite the meltdown in the stock market). The declining wealth effect was compensated to an extent by the easing tax effect during this period.
Second, after the stock market crash of 2000, which had its repercussions well into 2002, the Fed was looking for other ways of stimulating consumption demand because that had been the bedrock of growth in the late 90s. In the absence of another equity price bubble, the housing market provided an opportunity of such an alternative. The prices in the real estate market had been increasing since the mid–90s but it was still a sideshow to the stock market boom of the 90s. It was only in the early years of the present decade that they started picking up. The reason for this housing market run was quite obvious. The stock market crash led the investors to look for alternative measures of keeping their money and real estate seemed a good opportunity because its demand was going high so there was always a potential of making capital gains (p.92, Pollin (2005)). A Special Report (2005) of The Economist had the following to say about the magnitude of the housing market boom in the US or perhaps the entire developed world,
The extent of speculation in the housing market can be measured by the ratio of the housing prices to the rental applicable to the houses. This is similar to the Price-equity (P/E) ratio of stocks because the income that can be imputed from owning a house comes from the rental that it would fetch in future. Let us see what happened to this ratio. Weller (2006) presents the data comparing the Housing Price Index to Rental and the CPI (see fig. 2).
While the ratio of HPI to rentals remained stable for more than two decades since 1975 (as shown by the dashed line in fig. 2), there was a sharp increase in it since 2000. This is further corroborated by the fact that in 2004, 23 percent of the homes bought were purely for investment purposes while 13 percent were bought as second homes. ‘Investors [were] prepared to buy houses they [would] rent out at a loss, just because they [thought] prices will keep rising–the very definition of a financial bubble.’ (Report (2005)). In Miami, nearly half of the original buyers resold their apartments in an attempt to make capital gains.
In such a situation of high speculation, the Fed pushed aggressively for an easy monetary policy which meant a drastic decline in the federal funds rate (short term interest rate set by the Fed) even below the rate of inflation resulting in negative real funds rate. The real federal funds rate remained negative from the mid-2002 to early 2006 which meant a real heavy dose of easy money for more than three years. This kind of monetary policy has not been seen in the recent past in the US. The household sector responded very positively to this easy credit policy because the mortgage rates also declined. They increased their expenditure on housing which further increased its prices and the spiral started building up. This was the other bubble building up as Pollin (2005) writes (p.92),
The “limits” to which the buyers were “pushed” can be estimated by the growth in the Financial Obligation Ratio (FOR) and the Debt Service Ratio (DSR) of the household sector during this period. Debt Service Ratio (DSR) is the ratio of debt payments on outstanding mortgages and consumer debt to the disposable income of the household sector. We also present data of a more inclusive concept of the debt obligation that the household sector holds. This measure is called the Financial Obligation Ratio (FOR) which, apart from the repayment of interest charges on outstanding mortgage and consumer debt, includes the automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments.
Some important conclusions can be drawn about the financial condition of the household sector based on these two ratios. In panel (a) of fig. 3, it clearly shows that both DSR and FOR have been rising since the early to mid–1990s. If we differentiate between the debt payments on account of home mortgages and consumer durables, we get panel (b), which tells us another interesting story behind this debt growth. As expected, for the 1990s, which is characterized by stock market boom, it is the consumer durables debt payments that play a central role in driving the FOR up whereas the home mortgage debt payments were declining for that decade. After 2000, however, when the real estate boom replaced the stock market boom, it is the home mortgage payments which determine the FOR for the households.
The Federal Reserve during this period had its priorities chalked out pretty well which was to give a boost to the housing prices, just as in the 90s, it was most interested in maintaining the stock market boom. This can be seen from the minutes of the Federal Open market Committee (FOMC) meeting of this period. Minutes of the FOMC (2004) meeting held in June say,
Third, given that the growth of the economy now was driven by the growth in residential investment financed primarily by debt, there was an increasing tendency by the lenders to indulge in predatory lending practices. The norms of lending were broken at will to keep the real estate boom alive and the Fed, despite being aware of the precariousness of the situation, allowed it to happen under its nose just as it did not intervene during the speculative run in the stock market boom of the 90s.
Lending norms were twisted in myriad ways, especially in the Sub-prime mortgage market (4). First, the norm of mortgage was changed for rich borrowers who could use up to 50 percent of their income for their mortgage payment whereas earlier the norm was only 28–32 percent (p.92, Pollin (2005)). Second, new forms of loans were introduced which had no requirement for down payments. As high as 42 percent of the first time borrowers and 25 percent of all borrowers were exempted from making any down payment (Report (2005)). Third, a new form of financing was introduced which was the Adjustable Rate of Mortgage (ARMs), according to which the overall interest payment could be spread over years so that the initial interest payments might seem very low but the debt burden would increase as you go further into future. This was used to sell loans with ‘hidden costs’. Fourth, the borrowers could get up to 105 percent of the buying cost as loan and no documentation of borrower’s income or employment was required (Report (2005)). Fifth, the borrowers were allowed to pay only a part of the interest amount due while their unpaid interest amount and the principal get added as debt, a form of loan which has been termed as ‘negative amortization loans’. One third of the total loans in the US in 2002 were either interest–only loans or negative amortization loans (Report (2005)).
The housing market boom had a logic of its own which was in some ways similar to a stock market boom. Since the housing prices were increasing, it provided a good opportunity to make money at the margin by buying low and selling high, just as in the case of equities. Moreover, increasing prices of houses also increase the net worth of the owners of the houses which further increases their capacity to borrow and hence to speculate even more, which was reflected in people buying more than one house. But since all the buy is financed through debt, it puts the household sector on a knife–edge position. On the one hand, if the prices of the houses declined then the value of their collateral declines and further borrowing becomes less likely. In the worst situation, if the prices fell drastically, even the possibility of repaying the debt by selling the house might itself disappear leading to foreclosures. On the other hand, if the interest rates increase eventually, they would increase the debt burden in future, especially if the loans have been taken under the ARM scheme. In effect, it is the real mortgage rate that matters which is the difference between the nominal mortgage rate and the capital gain through a housing price rise (Weller (2006)).
Even though it was obvious that the housing prices were primarily speculative in nature, Alan Greenspan, the then Chairman of the Federal Reserve, while addressing the Joint Economic Committee on June 9, 2005, had rubbished all claims about the housing boom being a speculative bubble by arguing that,
It would be really surprising to note that the same Greenspan had an altogether different take on the Depression of the 1930s. Greenspan (1966) wrote,
If we say that ‘the excess credit which the Fed pumped into the economy spilled over into the housing market–triggering a fantastic speculative boom’, then how different would that be from what his argument is? If not, then it sounds puzzling as to why he did not apply his own argument about the Great Depression to the policy of the Fed under his chairmanship. Whitney (2005) writes the following about the policy of the Fed and its former chairman,
Given the delicate balance that the household sector was maintaining vis-à-vis the housing market, it was obvious that any meltdown in these markets would be disastrous not only for the US economy but for the world economy as well. This possibility was further precipitated by the fact that dual pressure fell on the borrowers. On the one hand, the Fed decided to increase the federal fund rate, which increased the interest burdens especially for consumers who had opted for ARMs or negatively amortized loans. On the other hand, decline in housing prices decreased the value of their collateral and thus increased the possibility of bankruptcy which indeed were quite high in this period. This would especially have serious consequences for the US economy, as can be seen today, because 90 percent of the growth witnessed during 2001-05 was due to increased consumption and residential investment of the households.
Till now we have presented a macroeconomic picture of the housing market but it is obvious that such a market has the potential of having an asymmetric effect on households depending on their income category. For the poorer households, the effect of an increase in the real mortgage rate would be more severe than a richer household.
Some broad pattern can be drawn about the different categories of households (see table 3). First, the bottom quintile was not a part of the recent run in the housing market since 2001. The value of home as a proportion of income increases the most for the middle quintile. Second, contrary to the general perception, the main customers of ARMs appear to be the richest households and not the poorer ones. This could be because of the fact that the rich were buying the house only for the purposes of selling it later and were financing it through ARMs. A housing market meltdown would, thus, have an asymmetric effect on these categories depending on their relative exposure to the credit market.
The fact that the growth process in the last two decades was dependent on asset price markets can be substantiated if we plot the movements in economic activity with respect to these markets. We attempt to plot the business cycle of the 1990s and 2000s against the cycle in the stock market and the housing marker respectively in figure 4.
It can be seen that in both the cycles the movement of GDP is closely linked to the movement in these markets. In fact, the GDP cycle follows the asset price cycles. This gives us some empirical evidence on the theoretical proposition made above. In Keynes’ words, the growth processes had become ‘bubble in the whirlpool of speculation’.
Is ‘it’ over?
A lot is being written about the end of the crisis or at least ‘the worst is over’. But we believe, given the magnitude of the crisis, it is premature to think so. When we say the crisis, we do not mean the subprime crisisper se. By end of the crisis, we mean the delinking of the growth process’ dependence on the speculative booms in the asset price markets. It is very possible that in the short term we have another asset price bubble which will provide some respite to the economy but only to aggravate the systemic problem in the long run.
Let us first examine the economic variables which can tell us about the present recovery process. To examine the extent of recovery, we have to first examine the components of the recovery. Since the US economy is facing a crisis of inadequate aggregate demand in the economy, the path of recovery has to somehow solve this problem. Its failure to do so would not only prolong the crisis but any premature withdrawal of the government stimulus would further aggravate the very problem it is seeking to address. Aggregate demand in any economy comprises of the consumption of the household sector, investment made by the household sector (residential investment), investment made by the corporations (non-residential investment), government expenditure and net exports (trade surplus).
Not only has the residential market plummeted seriously, there has been a decline in the share of consumption too in the present crisis for reasons well known. Together they form a deadly combination of declining investment and the income multiplier. Therefore, the path to recovery has to be dependent on the last three components of aggregate demand, i.e., non-residential investment, government expenditure and trade surplus. Let us look at what is happening to these three factors at present (see figure 5).
Non-residential investment or the corporate investment in ‘real’ capital continues to decline as a proportion of GDP, which itself is serious because it means a lower rate of growth in investment than the GDP. But this is a general trend during the periods of crisis. In any crisis, the first factor that is affected is the corporate investment precisely because of the crisis of confidence of the capitalists. So, this by itself is not novel to this crisis, especially if we see it in the light of the magnitude of the present crisis.
The stimulus package that Obama administration has injected into the economy has led to increase in the second factor mentioned above, i.e., government expenditure. This automatically has the effect of propping up demand and thus, the GDP. But its magnitude is crucial, especially in crises like these. First, it has to compensate for the decline both in residential and non-residential investment. Second, even if that is taken care of, the net effect of that increase would be dampened if the income multiplier is decreasing as a result of declining share of consumption (as explained above). Therefore, the increase in government expenditure has to take care of both these factors which demands far more than what President Obama has announced so far.
Finally, the third factor, i.e., the trade balance, can also play a role in the recovery. In fact, as we will see below, the most crucial factor contributing to whatever little recovery that the US is witnessing today is directly linked to what is happening in their current account. Though it might seem contrary to common perception that current account balance in the US, which has been running record deficits for the last two decades, could actually be a catalyst to recovery. But if one looks carefully, if the rate of increase of trade deficit is low compared to the rate of decline in growth of GDP, it could actually play a positive role in recovery. In other words, if the ‘leakage’ of income from the economy in the form of net imports declines during the crisis, it will put less downward pressure on the rate of growth. This is what seems to be happening in the US. The share of trade deficit in the GDP has declined during the period of the crisis giving a positive impetus to an otherwise declining rate of growth.
A decline in the trade deficits could happen if there is an increase in the share of exports in the GDP or a decline in the share of imports or both. Or, at least the decrease in the share of exports in the GDP is lower than that of imports if both are decreasing. Declining trade deficit has taken place during this period in the US due to a sharper rate of decline in imports than exports. Further categorization of imports reveals that two factors, namely, industrial supplies and materials (except petroleum and products) and automotive vehicles, engines, and parts together have accounted for more than half the decline in imports in these quarters. This nature of decline in the share of imports in the GDP seems more to be of a short term character than a policy response by the US to increasing trade deficits, which makes this component of recovery even for a medium term suspect.
After analysing various components of demand and their behaviour during the ‘recovery period’, we can say that the increased government expenditure in the US through the fiscal package has still not been able to stimulate the economy to the extent of alleviating the problem at hand. On the one hand, consumption has stagnated, thereby, terminating the route to recovery through an increase in the multiplier. On the other hand, neither the residential investment nor the non-residential investment is showing any sign of recovery, especially, since the level of confidence of the corporations to invest is still quite bleak. Therefore, to withdraw the stimulus package now would be far from prudent. The lessons of the Great Depression remind us that the decision to withdraw the stimulus, on the basis of initial signs of recovery, ended up prolonging the crisis to almost a decade.
Conclusion
We have argued in this paper that growth in the US economy in the recent past has entirely been driven by either consumption spending or residential investment. Both of these were driven by asset price inflation of one kind or the other. While consumption was driven by the stock market boom of the 90s, residential investment was driven by the housing price boom. Such a growth path, however, has serious problems as already being witnessed in the US. First, it would require asset price inflation of one or the other kind to sustain the wealth driven growth. Second, it would be a highly volatile growth path because it would be dependent on the vagaries of these asset price markets. Third, it would invariably force the government to act in the interests of the finance capital because they hold the key to growth in the economy as happened in the bailout package endorsed by the US Congress earlier. The monetary as well as fiscal policy would have to be tethered to the developments in the asset price markets.
The current economic crisis that capitalism is faced with is of far greater magnitude than was envisaged even a few months back precisely because of the extent to which the machinations of the globalized finance capital has spread across the world. This is the time to categorically reject ‘there is no alternative’ (TINA) paradigm of the neo-liberalism and reassert alternative policy prescriptions which would be beneficial to common people.
Notes:
(1) It is another matter that the nature of state intervention was militarist in nature. Therefore, it would be simplistic to argue that the state intervention was primarily pro-people. In fact, the initial reversal in the economic activity after the prolonged period of Great Depression came after the World War II started. This led to increased fiscal expenditure on part of the government, which pushed the growth up. It is important to note that this growth was purely militaristic in nature. But post-1950s, there was an attempt to pop up the growth and employment by what was later came to be known as ‘welfare capitalism’. It is of course a contentious issue as to how much of the growth even in this period was welfare oriented.
(2) The argument underlying the negative linkage between growth and inequality can be found even in Marx when he talks about the underconsumption crisis. Josef Steindl, Baran and Sweezy and Kalecki revived this view in the field of Economics.
(3)This policy response was best exemplified by Ronald Reagan in the US and Margaret Thatcher in the UK where they proposed small governments to allow free markets to functions uninhibitedly. It should be kept in mind, however, that despite the opposition to government intervention in social sectors, they did not have any problems with burgeoning military expenditure. So, the argument effectively was to keep the ‘unnecessary’ government expenditure under check.
(4) With every passing day results of the investigations into the financial sector are getting murkier. A recent example of this is the recent case against the Golman Sachs (NY Times Editorial, 17 April 2010). Goldman Sachs Group Inc has been charged with fraud by the U.S. Securities and Exchange Commission over its marketing of a subprime mortgage product. It argued that Goldman Sachs was involved in malicious practice of creating and selling mortgage-backed investments and then placing financial bets that those investments would fail.
References
FOMC (2004): “Meeting of the Federal Open Market Committee,” Discussion paper, Board of the Governors of the Federal Reserve System.
Greenspan, A. (1966): “Gold and Economic Freedom,” The Objectivist.
Kalecki, M. (1943): “Political Aspects of Full Employment” in Selected Essays on the Dynamics of The Capitalist Economy, Cambridge University Press, 1971
New York Times Editorial: “Watch This Case”, April 16, 2010 available at http://www.nytimes.com/2010/04/17/opinion/17sat2.html?hp, accessed on April 17, 2010
Piketty, T., and E. Saez (2003): “Income Inequality in the United States, 1913-1998,” Quarterly Journal of Economics, 118, 1–39.
Pollin, Robert (2005): Contours of Descent: US Economic Fractures and the Landscape of Global Austerity. Verso.
Report (2005): “In Come the Waves: The Global Housing Boom,” The Economist.
Weller, C. E. (2006): “The End of the Great American Housing Boom: What it Means for You, Me and the U.S. Economy,” Discussion paper, Center for American Progress.
Whitney, M. (2005): “Pop Goes the Weasel: Greenspan and the Housing Bubble,” Monthly Review.
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