the abcs of economic crisis

8/13/2019 The ABCs of Economic Crisis

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THE ABC s OF THE ECONOM IC CRISISWhat Working People Need to Know

by FRED MAGDOFF and MICHAEL D. YATES

IVRMONTHLY REVIEW PRESS

New York


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Copyright 2009 by Fred Magdof and Michael D. YatesAll righ ts reserved

Library of Congress Cataloging-in-Pub lication DataMagdof , Fred , 1942-The ABC's of the economic cisis i what working people need to know / byFred Magdof and Mich ael D. Yates.

p . cm .Includes bibliographica l references and index.ISBN 978-1-58367-195-5 (pbk.) - ISBN 978-1-58367-196-2 (clod i)I. United States-Economic policy--2001-2009 . 2 . Working class-UnitedStates-Economic conditions . 3. Financial cises-United States . L Yates,Michael, 1946-II . T ide.HC106 .83.M337 2009330.973-dc22

2009030676

Mondily Review Press146 West 29th Street, Su ite 6wNew York, NY 1000 1www.month lyreview.org

5 4 3 2 1

To a ll those who struggle for a better world


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AcknowledgmentsFirst, we want to thank our colleagues at Monthly Review-]o\mBellamy Foster, John Simon , John Mage, Brett Clark, ClaudeM isuk iewicz, Martin Padd io, and Scott Borchert-for their encour-agement and support. We also are grate ful to Carol Lambiase andStephanie Luce, who read the entire manuscript and made many help-ful comments and suggestions, as did Jan Schultz, who read an ea rlyversion of the manuscript. Thanks as well to Erin Clermon t for herexcellent copyediting.

Con ten ts

Preface 91. The Calm before the Storm 132. What Makes Capitalism Tick 213. Capitalist Economies Are Prone to Crises 274 . Mature Capitalism's Concentration of Production

and Slow Growth 335 . Can the Tendency to Slow Growth Be Overcome? 376 . Economic Stagnation Sets in Following the

Second World War 4 17. Neoliberalism 478 . The Financial Explosion : Introduction 559 . How Did it Happen? 5910. The Explosion ofDebt 7511 . The Great Unraveling 8312. The Government to the Rescue? 8913. Summary and Conclusions 105

A T imeline of the Financial Crisis anddie Great Recession 115A Brief Bibliographical Study Guide 133Notes 135Index 137


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PrefaceThis shot book aims to descibe and explain the The GreatRecession, the most severe economic cr isis since the G reatDepress ion , in straightforward and easy to understand language. Wehave wi tten it for wo rkers, students, and act ivists who are trying tograsp what is happening and who want to organize and do somethingabout it. We hope that readers will pass this book on and use ouranalysis to spread the wo rd that this is no ordinary recession but apo tentially deep and long-lasting down turn that could change ourlives and those of our children . If we understand its magnitude andcauses, we can position ourselves-pohtically and ideologically- tobegin building a better world.

Most of the book d iscusses even ts in the Un ited States. This isboth because th is is where we live and that the Un ited States is far andaway the most poweful and impo rtant capitalist country . The cisisbegan here and then spread to the rest of the world, a relection of thefact that U.S. economic, political, and military power have allowedeconomic ehtes here to penetrate the economies of every part of theglobe. What this means is tha t activists everywhere no t only need toigh t to reconstruct their own societies but also struggle to liberatethem from the onerous burden ofU.S. corporate interests. Those of usin the United States have the same duty, made more urgent by the hor-


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10 THE ABC i O F THE ECONOM IC CRISIS

rors that our nation has rained down upon the rest of the world, notjust the murderous bombs of war but the more mundane bu t no lessdeadly bombs of the economic policies promoted by the United Statesand eagerly embraced by those with power in so many coun ties.If you live outside the United States, this book will still be useful to

you. What has happened here has happened everywhere. Thespeciics dii Fer somewhat, but the fundamental truths are the same.The economic system in which almost al l of us are enmeshed is pro-found ly anti-human and irrational. Although a sign iicant portion ofthe world 's population-perhaps 20 to 30 percent- lives at a veryhigh standard of living , even for them it is a dead-end system, hell-benton trivializing our lives and destroying the planet, wh ile producingmisery for a huge number of people. We suffer its continuance at ourpeil .

WITCH 2 : Fillet of a fenny snake,In the cauldron boil and bake;Eye of newt, and toe of rog,Woo l of bat, and tongue of dog ,Adder's fork, and blind-worm's sting,Lizard's leg, and ow let's wing,For a charm of powerful trouble,Like a hell -broth boil and bubble.

ALL : Doub le, double toil and troub le;Fire burn, and cauldron bubble.

SHAKESPEARE , Ma cbeth


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1 . The Calm before the StormThe economic outlook continues to befavorable.HENRY PAU LSON , 2005

Just three years ago , in the spring of 2006 , things app eared very prom-ising . The home construction industry boomed, absorbing those look-ing for work and diose wai ting forjobs to open up and pusliing downthe rate of unemployment. For all of 2006, the oicial unemploymentrate was 4.7 percent, and in the spring of diat year it was abou t 4 .4 per-cent. Both numbers were low by U .S. stand ards. Wages were rising .The Bush administraion saw the numbers as jusifying its economicpolices: Today's strong report shows that our economy coninues toproduce steady, sustainable employment growth with strong wagegains for Americas workers. Average hou rly earnings for workersjumped 4 .2 percent in 2006 , the best 12-month showing since 2000 ,U.S. Secretary of Labo r Elaine L. Chao said in a pub lic statement onJanuary 5,2007 . This is hirther evidence that the president 's econom-ic policies are wo rking and producing strong wage gains for America'sworkers, and we should be cau tious of future policies that wou ld slowthese gains .1 Some of the money rom the real estate explosion foundits way into the stock market, and the most famous stock index, theDow Jones , hit an all-time high in October 2007 .


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14 THE ABC i OK THE ECONOM IC CRISIS

It should be expected tha t the president and his staf wou ld takegood economic numbers at face value and milk them for politicaladvantage. But economists and Knancial experts were no diferent.With few exceptions, they saw a bright future. There might be somebumps in the road , but severe downturns were diings of the past, ofonly historica l interest. They believed that money managers in theworlds financia l centers had harnessed the techn iques of advancedmathematics and statistics and learned how to hand le risk . Financialmarkets, so they to ld us, acted as stabilizers, prevent ing too mucheuphoria on the upside and too much pessimism on the downside. Ifan unexpected sequence of events occurred dia t threatened prosper-ity, the Federal Reserve could put things right by loosening or tight-ening the credit strings. Trust in the markets, said the econom istsand inanciers . And the Fed will take care of any market instabilitiesbefore they become crises. Pick an econom ist or inancial wizard.Maybe Alan Greenspan , chainnan of the Fed, who was wo rshipfu llyproclaimed to be bo th oracle and maes tro of the economy .Perhaps Robert Rubin, President Clinton's Secretary of the Treasuryand wise man ofWall Street. Or Lawrence Summers, wo rld-famouseconomist, another C linton Treasury secretary, president ofHarvard,and former chief econom ist at the World Bank . Were any of theseluminaries warning us that-as we all now know and as left-wingeconomists writing in the pages of journals far removed rom themainstream, like Monthly Review, were telling us for many years- thatthe floorboards of the economy were rotten? That housing pricescould no t continue to ise at a rate far surpassing the growth of theGross Domestic Product (GDP)? That it was not possib le for WallStreet to post oudandish returns year in and year out? That increas-ing levels of consumer, corporate, and governmen t debt- relative tothe underlying economy-couldn't go on forever? That the unimag-inable growth of speculation, using ever more comp lex and riskyways to gamble, was inherently destabilizing? That an eternallyexpanding economy was as much a myth as the foun tain of youth?Perhaps the most remarkable thing is that the housing bubble beganalmost immediately a ter the dot-com bubble burst. Yet few seemed

THE CALM BEFOR E TH E STORM

to wonder how it could be diat die new bubble wouldnt also burst,sooner or later.

Now , a few years later, we are living in desperate times . Every day,thousands ofworkers lose their jobs. In June 2009 , die United Statesoicial unemployment rate hit 9.5 percent, and it will ge t higher in themonth s to come.2 Housing pices are in free fall, and tens ofmillionsofhouseholds are choking on debt. The dtans ofWall Street have gonebankrupt or to Washington to beg for money. Colossal financial fraudshave come to light , in which psychopadis like Bernard Madof stolebillions of dollars from gullible clients who thought it was dieir igh tto make high rates of returns on dieir money. On Main Street, tales ofwoe abound . A woman over ninety years old was duped by a bank intotaking ou t a large mortgage she couldnt possibly aford . Now she maysoon be homeless, as will many od ier poor people, often minoi ties,who were swindled by unscrupulous lenders. Many home buyers mayhave made reckless decisions . They did not cause the cisis, however.As we will show , it was die often raudulent acdons of the banks andthe big W all Street irms that crea ted the financial mess in which wenow ind ourselves.

Fourteen million, seven hundred thousand people were oiciallyunemployed in June 2009, and this does not include the nine millionworking part-Ume involuntarily (because their work hours were cutor part-Ume employment was all diey could ind) and the 2.2 millionpeop le marginally attached to the labor force (they were no t oi-cially unemployed but wanted a job and had searched for one in thepast year; of these , there were 793,000 discouraged workers, whohad stopped looking for work because they believed no jobs wereavailable). Adding these to the oicially out ofwork raises the unem-ployment rate to 16.5 percent. Very troubling is that long-term unem-ployment (those out of work for at least ifteen weeks) is now at itshighest level since the government began measuring it in 1948.3States are running ou t ofmoney for unemployment compensaUon. InJanuary 2009, 50,000 New Yorkers were scheduled to exhaus t theirunemployment beneits after receiving them for eleven months . ANew York Times reporter tells of Julio Ponce, a 55-year-old chef,


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[who ] has been using his weekly unemp loyment check to pay the renton his apartment in the Bushwick section of Brook lyn since he losthisjob at a center for the elderly more than a year ago . But he said hedid not know how he would cover the $800 monthly rent ater hisunemployment beneits lapsed this week . 'No one is helping me,saidMr. Ponce, who was faxing his resume to hotels and restaurants roman employment oice in Down town Brooklyn on Thursday. 'I'veapplied for public assistance, but I don t think I'm going to get it. 4Nationwide, by March of2009 , abou t one-quarter of the unemployedhad been ou t ofwork for at least six months and many were runningout of unemployment beneits, having gone through the twenty-sixweeks their states provide and more than thirty weeks of extendedbene its mandated by the federal government. One economist esti-mated that in the second half of the year, 700,000 people wouldexhaust their beneits.5

Making matters worse , our nation's unemployment compensadonsystem is much less generous than it used to be. A lower percentage ofworkers receive unemployment insurance payments-only 37 percentare eligible, compared to the 50 percent during the recess ion in themid-1970s. The maximum amount of time that people can rece iveunemployment payments has been reduced rom sixty-ive weeks to astandard of twenty-six weeks today, recently extended b y Congress foran extra thirteen weeks (and still further in the sdmu lus package enact-ed by Cong ress in February of 2009). Furthermore, employers havebecome more aggressive in challenging unemployment claims, andmany employee s have discovered that they canno t collect the beneitsto which they though t they were entided . To stave off hunger, recordnumbers of people are seeking food stamps. At the beginning ofApril2009 , a record 32.2 million persons were receiving food stamp ass is-tance, one in every ten Ainericans.i In pas t downturns they wouldhave sought public assistance as well . In the 1970s, over 80 percent ofthe poor were eligible to receive public as sistance through welfare pro-grams such as Aid to Families with Dependent Children. Now, afterthe welfare reformsof the Clinton era, only 40 percen t of the poorare eligible to receive assistance.7

THE CALM BEFORE THE STORM 17

Beneath the harsh stadsdcs, diligent journalists, social workers,police , and mental health counselors are witnessing more ominousresponses to the crisis . Increases in murders of coworkers and familymembers, suicides, thefts, bank robberies, arson, domesdc distur-bances, depression-all have been linked to the growing hard eco-nomic dmes in towns and cities in ev ery part of the count ry . The NewYork Times reports that anxiety and depression, triggered by the eco-nomic down turn , are on the ise, with more people seeking treatmentrom mental health professionals. In a Tit/CBS po ll, 70 percent ofrespondents were woried that a household member would be jobless .And as people become desperate ater losing theirjobs , robbeies havebecome more common . There have even been a rash of thefts inCalifon ia of the furnishings that companies place in houses to makethem easier to sell, and sometimes even plumbing and other ixturesare for sale on the black market.8

There is no doubt that we are in the most severe economic cisissince the Great Depress ion . In 1982, when we were in a deep reces-sion , unemployment was higher than it is now. But then the FederalReserve (the government agency that ties to influence economicactivity by making credit eas ier or more diicult to obta in) forcedinterest rates on loans to record-high levels in an efort to e liminateinfladon and scare the daylight s out ofworking men and women. H ighinterest rates were also bad for companies who needed to borrowmoney , and they responded in 1982 with mass layofs, further reduc-ing demand and also making it less likely that workers would insist onhigher wages in die near future. Once inladon was tamed , the FederalReserve pushed interest rates down and the federal governmentpumped money into the economy through its own spending . Within acouple of years, die economy began to recover. Today, however, theFederal Reserve has managed to ge t interes t rates as low as it can(some rates are near zero) yet still economic acdvity condnues todecline and w ill probably stabilize at a low level. We have to go backto the 1930 s for a precedent, or to Japan in the 1990 s-when noamount of government intervendon could ge t die economy rolling.Already our government has spent hundreds of billions ofdollars and


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committed trillions more to trying to get banks to open their lendingwindows and consumers and busines ses to start borrowing, bu t cred -it is still nearly rozen and spenders are retrenching . Mortgage ratesare near record lows and gasoline pices have dropp ed dramatically,yet houses are no t selling well and car sales have tanked to the pointthat even the world's premier auto company, Toyota, is losing gobs ofmoney and the weaker ones are essentially bankrupt-subsisting ongovernment handouts. Nothing seems to be working .

What in die world has happened? We will explain in som e detailwhat happened and why it happened. But for now, lets just take theexample of the housing market, mentioned above. Its true diat hous-ing pices were at record highs and seemed like they would continueto increase. But the explosion in home building and the dramaticincrease in hom e pices was partially a result of specula tive buying:people kept purchasing houses because they thought pices wouldalways ise. And as diey kept buying, prices did continue to ise. It waslike a Ponzi scheme in which someone prom ises large returns and paysthese ou t to the irst investors w ith die money husded rom laterones. Some hou se buyers, especially those involved early in die priceescalation, cashed out and made a lot ofmoney.

Every night on television you could tune in to a show in whichsavvy individuals bought houses, either ixed them up widi minima linvestment or not, and then lipped them for a much higher pice. Itlooked like anyone willing to put in a small effort could get ich in realestate. In hot markets like Las Vegas, Soudiem California, and parts ofFloida, hom e owners saw their houses double or even tiple in picein a year or so . Condom iniums sold two and diree times before any-one moved in to them. One ofus was in Key West, Floida, in 2005 andsaw shacks selling for a million dollars. And as house prices skyrock-eted, dieir owners borrowed money against the appreciated value andused the money to buy more property, make additional homeimprovements, or purchase all manner of goods and services-helpingto keep die economy going by using their homes as ATM machines.

But as we w ill see, die housing and mortgage market was truly ahouse of cards, built on low interest rates, easy money , the pushing of

THE CALM BEFORE THE STORM

purchases on people whocou ldnt afford them,speculative fever, and theuse of raudulent tacticsand misleading mo rtgagetenns. And once a signif-ican t number of peoplewere unab le to maketheir mortgage pay-ments, it became clearthere was a prob lem .Homes offered for salestarted to swamp pur-chases and prices fell .The falling pices forcedthe more indebted homeowners and some specu -lators to sell , pushingpices down further. Thebubble burst. And thiswas only one of the manysymp toms that a majorcisis that was brewing .

Today, in the spingof2009 , after more than a

Ilic cmw was caused by the largcmlevelled asset bubble and credit bub-ble in die history of humanity, whereoccessive leveraging and bubble* weremil limited to housing in the UnitedStates but also to housing in many odiercountries and excessive borrowing byfnuncial institutions and some segiiiriiUiofdie corpo rate sector and of the publicsector in many and diferent economics :a housing bubble, a mortgage bubble, ane(|uity bubble, a bond bubble, a creditbubble, a commodity bubble, a pr ivateequ ity bubble, a hedge fund* bubble arcall now bursting at once in die biggestreal sector and inancial sector delever-aging since the (> iTat Depression .RGEMonitor NrwtUttn ,

Oct. 10,2008

Note: RC.E MpHilor is an economicanalysis website (www.rgeinonitor .com)founded by a group of economic andpolitical experts.

year of cataclysm ic eco-nom ic occurrences , those who should know still dont have a clue asto what actually happened or why it occurred. In congressional hear-ings on October 23, 2008 , Representadve Henry Waxman asked M r.Greenspan, In other words, you found that your view of the world ,your ideology was not right. It was not working. The maestro replied, Precisely. That's precisely the reason 1 was shocked, because I hadbeen going for forty years or more with very considerable evidencetha t it was working exceptionally well. .. . I still do no t fully under-stand why it [the cisis] happened. 9


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Economist Jef Madick, a sharp critic of his mainstream col-leagues, attended the December 2008 annual meeting of die AmericanEconomic Association in San Francisco and found that no one tookany blame for failing to foresee what was happen ing. No one suggest-ed that something must be wrong with a discipline that had no ideathat a very severe recession , or a possible depression , was striking , fas tand without mercy.10 T he irony is that some of the very same peoplewhose heads were in the sand-except when diey were up and aboutsnifing for easy money to be made-are now in charge of the govern-ments unprecedented bailout. No wonder the people are up in arms.

So, then , we iiave an economy sailing along, poised, it seemed, foreven better things to come, and all of a sudden the wheels fall of thebus. The econom ists and financiers can't tell us what happened orwhy it happened . Their training doesnt seem to have prepared themfor diis. If ever there was a time when the emperor had no clothes ,it is now. What are we to do in such circumstances ? Was it all a bigaccident? Were evil men and women conspiring to ruin the economy,wh ile diey enriched themse lves? Was it Bushs fault? Clintons?Greenspan's? Here are some good starting suggestions for those ofyou who want to ind out . Ignore wha t you see on television . Don't lis-ten to or read the commentaies ofmainstream economists. Hide yourwalle t when bankers or Wa ll Stree t bigwigs put forth their two cents.Assume that when government spokespersons are at die podium diatthey are eidier lying or ignorant of the truth . And most important,Read on

2 . What Makes Capitalism Tick?AccumulateAccumulatt Ihat is Moses and the Prophets.

KARL MARX, 1867A working person toiling away on an automobile assembly line or in ares taurant kitchen must have found it dificult to understand how diebankers and brokers who have brought the economy to its knees madeso much money simply by selling pieces of paper. If workers makecars, houses, or meals or teach children, and wh en farmers producefood , they are producing something that people need and can use.But those who sell complex financial instruments don't produce any-thing tangible at all . Something doesnt seem right abou t makingmoney without producing a useful good or service. And indeed, nosociety can survive if the only economic activity-or even the domi-nant acivity- is lending and borrowing money . The same can be saidfor buying already-made things at one pice and se lling them at a high-er pr ice. If the only economic activity is merchant trade , everyone willsoon die because nothing is being produced. A t its most fundamentallevel, an economy is a system ofproduction of at least some useful out-puts. When so much labor is devoted to the buying and selling ofpieces of paper, with the sole aim of convering money into mon ey,something profoundly irrational is taking place.


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som e old ways) ofmaking money w ithout bodiering with producdon .Capitalist economies are money economies; they revo lve around buy-ing and selling . Once they begin to mature, the importance increasesof all sorts of businesses that make money by purely inancial transac-tions: banks, insurance companies , stock and bond brokerages,exchanges for buying and selling foreign currencies, and so forth.Alongside the real economy of product ion , ainancial economy a is-es and begins to take on a life of its own , not always connected to theworld of production. The independent development of the financia leconomy adds, as we shall see, new layers of irrationality to the sys-tem . What happens in inance can adversely affect the rea l economy,and crises in the latter can lead to changes in finance that reverberateback to die world of producion with disastrous consequences.

We must make an impo rtant po int here : There is a close connectionbetween politics and the drive to accumulate capital . The owners of thelarges t businesse s have come to exert great poliical inluence. This isnot surpising, given the importance of the producion they controland the wealth this bings them . Poliicians need large sums ofmoneyto run for and stay in ofice, and this alone makes them beholden totho se who have it- the owners of large industial corporations, banks,and other big irms. The owners use their inluence w ith die govern-ment to keep workers in line (the Bi tish government once made join-ing a union a crime, and in the United States, the law, courts, andpoliicians have put many obstacles in the way of union organizing)and remove any bariers to accumula tion , including, most citically,impediments put in place by weaker counties that limit foreign invest-ment and resource removal.The history of accumulaion has been rom its beginn ing about the

penetration of Afica, Lain Ameica, and Asia by the irst capitalistnaions: England, Holland, France, Belgium , Italy, Germany, and dieUnited States. (Som e counties, such as Spain, were impo rtan t andbru tal colonizers, but they were no t capitalist until much later. Muchof the wealth they stole rom their colonies went to pay debts toEngland. O ther naion s, notably Japan, joined the impeialist clublater.) The theft of peasant lands and mineral wealth, along with the

WHAT MAKES CAPITALISM TICK ? 25

slave trade and plantation ag iculture , gready s timulated the iniialcapital accumulaion and made poss ible the full loweing of early cap-italism . Today ich coun ties continue to dominate poor ones, thoughthe ways in which they do so are more indirect than in the colonial era,re lying on local poli tica l elites to see to it that wages are kept low andthat favorable trade agreements are negoiated . Poor counties arepo litically independen t bu t economically subservien t to their ichcounterparts. The relaionship betwee n Mexico and the United Statesis a case in po int.

Anyone who doub ts the close and corrupting connection betweenbusiness interests and the poli tical process should read SimonJohn sons The Quiet Coup, in the May 2009 issue of The AtlanticMonth ly. Johnson , a professor at MIT and former chief economist atthe Inte n aional Monetary Fund, has described the depth of the cor-ruption inherent in the cozy connecion between the fabulouslywealthy and the government, and the consequences for the economyand society:

The great wealth that the financia l sector created and concentated gavebankers enormo us politica l we ight-a weight no t seen in the U.S. sincethe era of J. P. Morgan (the man), fn that peiod, the banking panic of1907 could be stopped only by coordination among private-sectorbankers: nogovernment entity was able to ofer an efective response. Butthat irst age of banking oligarchs came to an end with the passage of s ig-niicant banking regulation in response to the Great Depression ; thereemergence of an Ameican financial oligarchy is quite recent.


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3 . Capitalist Economies Are Prone to CrisesCapitalism 's im tabilih is systemic.RICHARD WOLFF , 2008

As we noted in the last chapter, capitalist economies are defined by diefollow ing characteristics:. Most of society's productive resou rces- land, raw materials,

machinery, factory buildings-are owned by a small percentage ofdie population.

. Most people have no way to live but to sell their capacity to work-their labor power- to the highest bidder .

. Relendes s proit seeking by business owners.

. Reliance by most people on wage work in order to ive.Although there is much planning within individual capitalist cor-

porations , capitalist economies as a whole are unplanned. What hap-pens with respect to the mix ofproducts produced and the amount ofunutilized labo r, for example, is the result of decisions made by mil-


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capacity-amount ing to about 50 percent-bo th in the Un itedStates and globally.)It should com e as no surprise that recess ions, depressions, andcrises occur in an economic system in which businesses follow their

own inancial interes ts without coord inadon or plann ing for society'sneeds. What we might call ord inary business cycles occur when, dur-ing boom years, companies expand employmen t and producdon tokeep up with increa sing demand , bu t, not anticipadng any slowdown ,end up with an overabundance of stuf to sell. They dieu decrease pro-ducdon and lay of workers , setdng of a recess ion . When producdonand demand come back in balance, the process repeats itse lf.There are also other ways in which accumuladon can be interrup t-ed. Mainstream economists believe tha t deep recession s and evendepressions are always caused by some traumadc event or se t of eventsthat strike the economy rom the outside.11 Although we be lieve theopposite, tha t capitalist economies are by their nature prone to crises,outside forces can ce rtainly generate economic dificuldes. If a largebank suddenly and unexpectedly fails, its reladonships with borrow -ers could cause problems signiicant enough to negatively afect theendre economy . No doubt the swit 2008 invasion of the Repub lic ofGeorgia by Russia slowed down accumulation in Georgia. The devas-tating eardiquakes and tsunami that struck Indonesia in 2004 retard-ed that nations economic grow th . If speculators attack a countryscurrency so that its value falls in reladon to odier currencies, the risein the price of imports that this brings abou t (if, for example, it takesmore dollars to buy yen, then Japanese goods w ill be more expensivein the United States ) could lower the rate of capital accunm ladon .That is, the growth of the economy will slow down .

However, we do not think that unexpected events originatingexternally are the main danger as far as capita l accumuladon is con-cerned . We con tend diat the very process of capital accumulationitself, naturally and w ithout fail, brings along w ith it long-term andintractable barriers to the generadon of proits and capital growth.There are several possibilides here. As businesses replace workerswith mach ines, producdon becomes ever more capital intensive.

CAPITALIST ECONO M IES AR E PRONE TO CRISES

The purpose of automation is to make it poss ible to produce morewith less labor. Ater one company makes a breakthrough in subsdtut-ing machines for labor, lowering the cost to produce something, othercompanies making the same commodity must do the same if they areto remain in business . In an economy characterized by free comped -don as in the nineteenth centu ry, companies making similar goods orproviding die same services are in a compeddon for people to buywhat dey sell. Compeddon to se ll a greater supply pushes pricesdown. This means that, over dme, there is less labor per unit ofmachinery to exploit, and at the same ime prices are falling. It followsthat the rate of pro it on the invested capital falls as well . DecUningproits decrease capital accumula tion, because employers will be lesslikely to invest in making more of the same product when proits arelower. During a recession, when it becomes harder to sell products,some inns w ill go under, in e fect destroying capita l and restoringhigher proitability or die remaining businesses when the economyrebounds.

A second possibility , and the one we want to emphasize, is theresult of the interaction between two tendencies of mature capitalisteconomies: the tendency for producion to be dominated by relaive-ly few companies and the tendency for insuficient investment oppor-tunities in producion of goods or services . We think that this barrierto accumulation is signiicant enough to warrant a separate chapter.


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4 . Mature Capitalism 's Concentrationof Production and Slow G row th

Tht normal lendmn of capitalism in its monopo ly stage [ is] mu of economicstagnation due to the inabili ty to absorb the enormous actual and potentialsurplus at its disposal Given a tendrnty to stagnation in monopoly capital-ism, what need[sj to be explained [ is] not stagnation as much as prosperi ty .JOHN BELLAMY FOSTER,2005

In mature capitalist economies, such as those of the United States ,Japan, and Germany, capital accumulation involves a rising concentra-tion ofproduction, that is, a tendency for production and markets to bedom inated by a relatively small number of very large irms. Businessowners are always trying to eliminate rivals , both to increase their shareofdie market and to increase their power to raise prices w ithout the fea rthat consumers will go elsewhere .Only the strong survive , as the say-ing goes . How many automobile companies are there worldw ide? Steelcorporations? Phannaceuticai bu sinesses? When a large number ofsmall irms has been winnowed down to a much smaller number ofgiant corpo rations, we say that markets can be described by the wordoligopo ly (the preix oli means a ew ). Such inns are said to have con-siderable monopoly power so it is also possible to call them quasi-monopolies or even monopoly capital . Steep recessions and depres-


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411 TH E ABC S OF TH E ECONOM IC CRISIS

the government will on ly do thing s that maintain the curren t systemand its relationships , and in the end this will tend to keep surplus(profits) high relative to investment outlets, perpetuating the stagna-tion problem .When investm ents in the real economy are not proitable enough

to justify themselves, capitalists have tied to deal with the predica-ment of stagnation by developing new ways to utilize the surplus andmake money, especially doing so without making any produc t or pro-viding any service. But, as we will see, this quest has led to one calami-ty after another: stock market crashes, bursting bubbles , recessions,and depressions. The current cisis that started in 2007 was set off bythe fall of housing prices after the growth of a huge real estate bubble . 6 . Econom ic Stagnation Sets in Follow ing

the Second World War

Let me.. . point out that thefat t that the overaU performance of the economy inrecent years has not hern much xuorse than it actually has been, or as bad as itwas in the 1930s, is la rge ly owing to three causes: (I) the much grrater role ofgBi'emment spending and government deficits; (2) the enormous grow th of con-sumer debt, including residential mortgage debt, especially during the 1970s;and (3) the ballooning of thefinancial sector of the economy , which, apartfromthe grow th ofdeb t as such, includes an exp losion ofall kinds ofspeculation , oldand new, which in turn generates more than a mere trickle-down ofpurchasingpower in to the real economy, most ly in theform of increased demand for lux-ury goods . These are importantforces counteracting stagnation as long as th eylast, but there is always the danger that if carried too far they will erupt in anoldfashioned panic ofa kind we haven V seen since the 1929-33 period .PAUL SWEEZY , 1982

We can illustrate ou r arguments concretely by looking a t some mod-em U.S. economic history . Our analysis tells us that a peiod of veryhigh growth must be due to some extraordinary source of investmentdemand , one that fully counteracts the tendency toward stagnation .One such peiod was the Second World War. Duing the war therewere three years (1941,1942, and 1943) when the annual real growth


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THE A BC i OF THE EC ONOMIC CR ISIS

of the economy exceeded 16 percent, and grow th exceeded 8 percentin three other years (1939, 1940 , and 1944) . The enormous gove n -ment spending for the war effort ign ited and maintained this rapidgrow th , for the military needed everyth ing-rom clothes to food toguns and ammun ition to jeeps and trucks and tanks, to temporaryhousing, airplanes, ships, and so on. The long depression of the 1930 smelted away in the face of such tremendous investment. But it tookextraordinary circumstances, a mass ive war efort, with unprecedent -ed government spending financed by borrow ing, for this to happen .Widiout these, the economy would have continued to stagnate, w ithvery high unemployment and low growth .The U.S. economy grew less rapidly after the war but still at a fairly

high clip. GDP grow th s lowed to around 4 percent in the 1950s and1960s, low by 1940 s standards but still respectably high . (See Table 1for decade-by-decade growdi ra tes.) These relatively high growth ratesoccurred for a number of reasons. There was considerable pent-updemand because during die war many consumer goods, including auto-mob iles, were no t available or were sharply rationed. This mean t dialhouseholds were forced to save money, and this created pent-updemand that could only be realized after die war. The United States wasthe only major participant in the war whose physical capital was notdestroyed or damaged . As counties rebuilt dieir economies, they wereforced to buy every conceivable good and resource rom die UnitedStates , leading to an export boom . In addiion, the automobile had itsgreatest e fect on the economy duing this peiod, as suburbs were built,the extensive interstate highway system constructed, and hotels, restau-rants, gas stations, auto repair shops, and the like were built to meet theneeds and des ires of a more mobile population . Govenment spendingwas not cut back to prewar levels , and in ee t, led by ising defensespending, grew steadily , add ing to total demand. It also funded pro-grams that subsidized home ownership and college educaion, leadingto investments in these important sectors. There were also innovationsin consumer credit, and household debt helped to prop up demand. So,unique forces were at work ater the war, as diere were during it, to helpmaintain liigh demand and growth rates. This provided capitalists out-

ECONOM IC STAGNATION 9

lets for their invest-ments in the economyof real goods and serv -ices. The prob lem wasthat these forces couldnot be sus tained indef-initely .The rapid capitalaccumulation of thewar and the irst twopostwar decades be-gan to run into obsta-cles, as all such accu-mulaion must, in the1970s. The worldwas now lush withfactoies, too ls, and machinery, all the end products of the investmentsmade during the boom . Thus proitable investment opportuniiesbecame harder to ind. At die same time, U.S . corporations werebeginning to face seious compeition rom Japan and Germany, bodiofwhich had rebuilt and enlarged their productive capacity widi themost technologically ef icient capital. These counties also spent verylittle on de fense,while the United States was waging a cold war againstthe Soviet Un ion and a ho t one in Vietnam . Organized labor hadgrown, widi some power both in manufacturing workplaces and in thepi>litical sphe re . The United States did not have a European-sty le wel-ere state , bu t it had increased social welfare spending enough to makeworkers more secure than they had ever been. There was now unem-ployment compensation. Social Secui ty, Medicare and Medicaid,food stamps, low-cost and ree lunches for children at school, morepublic housing , and other forms of direct public ass istance .

Slower growth has been the rule ever since, as Table 1 clearlyshows. GDP increa sed by 3.3 percent per year in the 1970s, 3.1 per-. ent in the 1980s and 19908 , and 2.2 percent from 2000 to 2008 .Another sign of protracted slow growth has been the decline in

TABLE 1 : Growth in rral GDP 1930-2008(correctedfor inlation)

Average annual percen tgrowth in real GDP1930 s 1.31940s 5.91950s 4.11960s 4 .41970s 3.31980s 311990s 3.12000-2008 2.2


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44 THK ABC OF TH E ECO NOMIC CRISIS

capacity utiliza tion in manufacturing. During the early 1970s, thepercent of industrial capacity actually used for production wasaround 85 percent. By 1984 , this was down to abou t 78 percent, anddespite an increase starting in the mid-1990s, decreased consistent-ly in the late 1990s and in the 2000s, and returned to about 78 per-cent in 2007. The rate of manufacturing capacity utilization as thisis being written is 66 percent, the lowes t since records started beingkept in 1948.18

A seious problem was diat the power of the automobile industryto drive the accumulation process began to wane, as the advanced cap-italist countries started to become saturated with cars and trucks andthe world's poor nations did not have a mass market large enough totak e up the slack . Huge excess capacity in the industry in the UnitedSlates, fueled in part by intense competition from Japanese produce rswho began to locate p lants here, forced the closing of plants. The carcompanies have for years had die capacity to turn out close to 50 per-cent more cars than they did have. And today, of course , the U.S. autocompanies arc on government-spon sored life support as are most ofthose in Europe and Japan .Another indication of the slowing of the economy is diat following

each post-Second Wo rld War recession there has been a deinite trendof inc reasing tim e to recoup the jobs lost duing the recession (secTab le 2). Even when a hug e percentage of jobs are not lost, as in the2001 recess ion , it is taking the economy increasingly longer to pro-duce enough jobs to make up for those lost in the downtun- fouryears for that one. Some states, such as Massachusetts , never didrecover the job s lost .The trouble was that no other epoch-making innovation-great

enough to propel die economy to prolonged high rates of growth-arose to replace the automobile . From the time in which the economybegan to slow down in the mid-1970s, no technology or other forcehas come along with die transformative efect of stimulaing growthlike the railroads in the nineteenth century, the Second World War inthe 1940s, or the automobile in the immediate postwar era. Even thewidespread use of computers has not stimulated the economy to the

CONOM IC STAGNATION 45

ABLE 2 . Jobs lost during post-Second World War recessionsand time to regain lostjobs following end ofdmmtum.Date recession ended Job s lost as percen tage Mon ths neededof number employed to regain lost job sat start of recess ionOct. 1945 7.9 18Oct. 1949 5.0 21Apr. 1958 4.0 2 1Mar. 1975 1.6 26Apr. 1982 3.1 29Mar. 1991 l.l 32Nov. 2001 1-7 4820- ? 4.8 (throun lijune 2009)

extent that the automob ile once did. Although the manufacture ofchips and computers uses factories and labor, diere have been nonoticeable spin-ofs diat increased the growth of the rest of the econo-my. In many cases, such as die use of computers and robots in factoryproduction, the elec tron ic revolu tion simply enhanced die eiciencyof the system and decreased labor needs .Nor did the U.S . wars against Afghan istan and Iraq take up theslack, although the massive resources, including the workersemployed in war production and in carrying out the wars, have cer-tainly he lped keep the economy going . However, these have no t stim -ulated economic grow th anywhere close to what occurred in theSecon d World War, during which the mobilizaion of peop le and pro-duction was many times more massive.As we argued above, slow growth reduces proits and this is whathappened in die 1970s. Proits, as a percentage of die economy , beganto decline. In the 1950s and 1960s, proits were in the range of 8 toover 10 percent of the Gross Domestic Product.18 But the trend afterthis was downward, averaging a litde over 5 percent for the irst yearsof the 1980s.


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7 . NeoliberalismThere is no alternative.MARGARET THATCH ER, early 1980 s

Capitalists (here we are speaking of large stockholders and the offi-cers of our largest corporations, those tha t wield the mos t economicand political power) are intoleran t of any slowdown in growth thatcuts into their proits, and as soon as these were noted in the 1970sand 1980s, capitalists began an aggress ive campaign to maintain andeven expand their proit margins-even if the economy as a who lewas doing worse, and even if this would compound the economicprob lems. The state also got into the act on the behalf of capital andthe rich, redistribu ting income and wealth from the poor to the rich ,what Jesse Jackson was to call Rob in Hood in Reverse.All of thiswas justiied as the way to get the economy going again . The imme-diate goal of course was to cut labor costs, but the long-term planwas to undo the New Deal programs and restore to the owners ofcapital greater control of the economy and enhance their ability toga in as much proit as poss ible. A primary weapon was ideological.Businesses and wealthy individual capitalists funded th ink tankssuch as the Heritage Foundation and the American EnterpriseInstitute to wage a war of ideas against the welfare state, labor


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48 TH E ABC i OF THE ECONOM IC CR ISIS

un ions , big government, and any and all public regulation of busi-nesses . According to the employers, these were the causes of theproit dec line . Corporate America also consolidated and expandedits political operations, hiring lobbyists by the busload and fillingthe campaign coffers of politicians of both parties to push the newagenda in Congress, eventually accepted by liberals as well as con-servatives . These efforts coalesced into what is b lown as neoliberal-ism , the politics offree market economics, wh ich is a program tha tconsists of these elements:19

. E liminating all barriers to the movement of both physical andmoney capital, w ithin a coun try and among all coun tries.

. Privatizing as much public enterprise as poss ible . The govern-ment is asserted to be inherently ineficient. Public employeesare considered parasitic, earning high wages while do ing littlework .

. Tightening requirements for rece iving any kind of assistance forthe poor from the government, or ending welfare programs alto-gether, and at the same time making it easier for businesses to getmoney rom governments.

. Cutting taxes on businesses, capita l gains , and die incomes of therich. This must be done because businesses and wealthy individu-als are the sources of investment, econom ic growth, andjobs. Onlyif they prosper will the rest ofus do okay .

. Making it more dificult for workers to form un ion s and bargainwidi employers. Union s are said to make markets less competitiveand to encourage less work effo t .

. Seeing in flation as a public scourge and making sure dirough diemonetary policies of die central bank (the Federa l Reserve in theUnite d S tates) that inlation is kept at bay .

EOLIBERALISM

Neoliberalism hit full stride w ith the election of Ronald Reagan.He fired striking air trafic controllers, signaling to employe rs tiiat thegovernment would not stand in their way as they waged war on unionsand workers. He illed worker-protecdon and civil rights agencies w ithreactionaries who made rulings contradicting the very purposes of thelaws and regulaions they were supposed to enforce. Over die twenty-cight-year period rom 1980 to 2008 ,we have seen a relentless proces-sion of anti-labor trade agreements, deregulation of one industry afteranother, priva tizations, re fusals to regulate new eni ties like hedgefunds and complex inancia l instruments , and the shredding of thesocial safety net.

Three consequences of neoliberalism deserve mention at thispoint in our argument. First, as neoliberalism took hold, workers weresqueezed, and squeezed hard . For already existing businesses , slash-ing costs became a primary way to enhanc e proits. Although busi-nesses have always been forced to reduce costs as competitors usedcost-saving procedures such as new and more eicient machines ,there was an added need to do so after the m id-1970s because of sloweconomic growdi. And one of the ways to become more eicientwas to force workers to work harder for less . Reagans an ti-labor mes-sage told businesses that it was now politically acceptable to use hard-bal l tacics to break unions and bust their strikes . So successful wereemployers (and so inept were die unions) tha t union membershipdeclined from 23.5 percent in 1970 to 15.5 percent in 1990 and 12.4percent in 2008-widi much of die remaining union strengdi amonggovernment employees. W al-Mart, the largest employer in the country,with 1.2 m illion workers, has made a special effort to stay union-ree .Since union workers earn more money and have more and better ben-eits than do non-union employees , the successful corporate campaignagainst unions lowered business costs and increased proits. 20With the power ofworkers in decline, employers were able to attackkey beneit costs, such as pensions and hea lth care. They began to ridthemselves of expens ive deined pension plans (with speciic amountsprom ised to retirees) and to replace them with deined contributionplans, which do not guarantee a speciic pension payout and to which


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M THE ABC i OF THE ECONOMIC CRISIS

workers had to contibute some of their wages. Workers were also forcedto pay for more of the costs of their health insurance. New employeesoten found themselves with neither a pension nor a hea lth care plan.

As the power of capita lists grew at the expense of labor, the aver-age wage stopped ising. When corrected for inlation, the averagewage in 2006 was about 8 percent less than the peak reached in 1972and about the same as it was in die late 1960s. Greater amounts ofcompany income were directed toward profits (or as tronomically largesa laies for top management) instead ofwage s , resulting in wag es andsalaies becom ing smaller relative to the economy (GDP). This led toa much greater inequality of income-by 2006 the top 1 percent ofhouseholds received close to a quarter of all income and the top 10percent got 50 percent of the income pie . In 2006, th e 400 ichestAmericans had a collective net worth of $1.6 tillion , more than thecombined wealth of the bottom 150 million people. This degree ofincome and wealth inequality was las t seen just before the beginningof the Grea t Depression.2 1

Ano ther way that busines s owners sought to divert more incomeinto pro its was to make do widi fewer workers. The new managementmantra became do more with less,or what worker advocates called management by stress. The success of th is strategy was part of tiiereason for the weak job growth duing the recovery from the 2001recession . But doing more with fewer workers just means that theremaining workers mu st work harder. During this pe iod, rom 2000through 2007 , as the volume ofmanufactuing products increased, thenumber of manufactuing workers declined by some diree million.22This indicates gready increased labor productivity . But the beneits ofthis ising productivity went mainly to management and busines sowners and no t to wo rkers. It was also duing this peiod that manyjobs were transferred to other coun ties-mainly in Asia-as outsourc-ing of manufacturing and services accelera ted. As public afairs jour-nalist Bill Moyers wrote about the worsening condidons of labo r inthe ea rly 2000s: Our business and polidcal class owes us better thanthis. Ater all, it was they who declared class war twenty years ago, andit was they who won . They're on top.23

NEOLIBE RALISM SI

As workers found themselves less secure, with stagnant wages andgrea t inancial burdens, two things happened . They became more sus-ceptible to the nodon that each person is responsible for his or herown inancial secui ty . This seemed reasonable to many peop le whenthere was prospei ty . In the late 1990s, when the stock marke t was ona rampage , wo rkers followed the market and counted dieir newfoiiiidwealth in rapidly appreciating 401(k)s . A decade later, they did thesame thing w ith their houses. However, money insecuity also led torap id increases in household debt, as workers used credit cards tomaintain their standards of living, including their health . They alsoborrowed against dieir homes . Financial insdtutions made mountainsof cash loaning money to working men and women. In efect, those atthe top extracted income rom those below and dien loaned some ofthis money back to diose with lower incomes. On the one hand , debtallowed consumption to remain high and this added to die growth ofthe GDP . On the other hand , ising debt coidd not be sustained forev-er when die income that allowed the debt to be serviced (paying inter-est and pr incipal) was not also ising .

A second efect of neoliberalism-spread through much of theworld-was a rap id expansion in internadonal trade and capital lows.Trade agreements (such as the North American Free TradeAgreement) and dereguladon of global markets led to an increase ininternadonal financial transacdons. Foreign currencies have to bebought and sold du ring trade transacdons and investment. If a corpo-raion in the United States wants to operate in Europe , it will needeuros. Th is, in turn , will make U.S . businesses think abou t changes inthe dollar-euro exchange rate ; if the euros they now hold diminish invalue compared to the dollar, diey will get fewer dollars when theyseek to convert foreign ean ings back into dollars- that is, exchangeforeign money for dollars that can be brought back and spent in theUnited States . This kind of thinking led to the creadon ofmarkets forinancial instruments that allow die ho lder to hedge against harmfulexchange-rate movements . Similar instruments were crea ted to pro-tect the holders against adverse changes in interest rates in diferentcoun tries . As neoliberalism was embraced by governments around the


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sa THE ABC. O F THE EC ONOM IC CR ISIS

world , capitalists saw pro fit opportunities in die so-caUed emergingmarkets, such as Brazil,Thailand, and Indonesia . Investments in thesecountries required special attention to risk, both political (suddenchanges in governments) and econom ic (speculators rapid ly selling ofa currency in anticipadon of political turmoil, for example) . So, asglobal trade and busines s operations grew, financial transactionsbegan to grow rapidly. The banks and odier inanc ial organizationstha t oversaw such transactions profited from diese and began to seethe possibility ofmaking a lot more money .

A dii rd result of neoliberalism derived rom its attention to infla-tion , which included die suppres sion ofwages and benefits. This cre-ated the kind ofmarket stability in die United States conducive to thepurchase of securities (stocks and bonds). The longest bull market inU .S . history took of in the middle of the 1980s, lasting until the tech-no logy stock bubble burst in 2000 . Stocks provided a repository forthe growing surplus taken from workers by capitalists as pension andworker 401(k ) plans invested heavily . There were breaks in dieupward movement of stock prices, some seious, especially the recordfall in the Dowjones index on October 19,1987 , bu t overall the trendwas up , up, and up. Such a long bull market inevitably gives rise tonotions that stock prices cannot fall , or if they do sufer a downward corr ection , Uiey w ill ise again soon . This in turn encourage s nas -cent entrepreneurs, with the help of investment banks, to issue stocksfor new enterpises. People, including leading economists, believedtiiat a new economy had arisen- immune to major setbacks . In a peri-od of stock market eupho ria , va iou s kinds of swindles also crop up.A get rich quick mentality seeps into the peop le's con sciousness,and we w ill believe almost anything . A cottag e industry of books, web-sites, advisors, and the like develops. When die compu ter techno logyrevoluion hit full stide in the 1990s , with rea l impact on the way inwhich business is conduc ted , die stock markets were ready for anaccelerated bull market . The stock p ices ofmany tech companies sky-rocketed , even when the corporations had not ye t made a proit. It wassaid that the pices relected future proits, but since these areunknowable, what was really happening was mass delusion . A popu-

NEOLIBE RALISM 53

lar book of the time was tided Dow 36,000 : die authors predicted asteady ise in the Dow to an astronomically high 36,000 . This seemsludicrous today when die Dow has been well below 10,000 for manymon ths.The explosion of inancial markets , to which we now turn, has a

dual character. On the one hand, the grow ing prominence of suchmarke ts is due to the reassertion of slow growth or stagna tion tenden-cies in the 1970s . Wh ile grow ing trade , foreign investment, and pur-chases of foreign stocks and bonds requ ired an expansion of inance,inancial markets also provided a convenient and profitable repositoryfor the growing hoards ofmoney that could not ind proitable out letsin the real economy, tha t is, in investment in productive capacity andservices.

On the odier hand, the financial explosion helped to prop updemand and employment in the real economy . The inlation in stockprices gave rise to a wealth efect. As household wealth rose (as a resultof higher stock prices), consumers were icher, at least on paper, dianthey had been and there for e felt they could save less and spend more .What is more, stocks can be borrowed against . And die perception ofgreater wea lth can make households more willing to take on debt.During the housing bubble, the same things happened . So , consump-ion spurs the production of output, whedier of luxury automobilesand yachts or housing construction materials . The trouble is that thisprocess w ill go into reverse when asset prices stop ising .One inal point: inancial institutions , whether they be ordinarycommercial banks, investment banks, brokerages, hedge funds, equ itycapita l funds, or the inancing arms of automobile companies, all se llproducts-mortgages, stocks, bonds, auto loans, and so forth . Tomake more money and to compete efectively, financial inn s mustconstandy market their products and invent new ones . Much of thework in inance is selling, and the salesperson here isjust as connivingas the guy wh o tries to se ll you a car Or the broker who wants you tobuy that house. The point of new inancial instruments is invaiably toget people to take on more isk by buying speculative products thatpromise high yields while at die same time suggesting dial these are


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54 THE ABC . OF THE ECONOMIC CRISIS

relatively risk-free. Deception is as common at a big brokerage as it isat your local auto dealer or real estate agency. History tells us, howev-er, that the hard sell works, especially when markets are robust.

8 . The Financial Explosion: IntroductionIn every stockjobbing swindle everyone knows that some time or other the crashmust come, but everyone hopes that it mayfa ll on the head ofhis neighbor, at erhe himse lf has caught the shower of gold and placed it in safety. Apris mo i lecc luge is the watchword of every capitalist and of every capitalist nation .Hence Capital is reckless of the health or length of life of the laborer, unlessunde r compulsionfrom soc ie ty. KARL MARX , 1867

Even before capitalism existed , there were people who made moneywithou t making a product.24 More than two thousand years ago ,A istode referred to die making ofmoney with money (buying a prod-uct and se lling it for a higher price or loaning money in return for pay-ment of interest as well as the original amount ofprincipal) as unna t-ural . This is now, of course , considered to be very natural, andretail merchants, banks , and other inancial bu sinesses are all respect-ed and important parts of capitalist economies.The inancial system used to be a relative ly small, diough impor-

tant, sector of the capitalist economy . It helped economic growth byloaning money to businesses for expansion , new operations, and foroperating capital . The creation of stock certiicates helped businessesto a ise money by allowing the ownership of companies to be divided

56 THE ABCi O F THE ECONOMIC CR ISIS E FINANCIAL EXPLOSION 57


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up and sold. Insurance was sold to protect businesses and individualsfrom catastroph ic losses. But what occurred in the last few decades, ascapitalists were trying to find new ways to make proits, was theextraordinary expansion of the inancial system , which absorbed ahuge amount of capital (cash) that could have been spent on new busi-nesses that produced goods or services but was no t because of lowpro it expectations. Making money w ithout actually making some-thing turned out to be the large st growth sec tor of the U.S. economyrom the early 1980s to the present crisis.The explosive grow th of inance did lead to increased employ-

ment. But employment in finance did no t grow nearly as fast as itseffect on the economy. In 2006, the financ ia l sector employed about 6percent of workers but produced 40 percent of all the proi ts ofdomesdc industries. In 1960, by contrast, the FIRE sector of theeconomy (wh ich includes strictly inancia l irms, insurance compa-nies, and real estate) accounted for about 15 percent of the pro its ofall domestic irms. (In New York C ity between 2003 and 2007 thesecurities industry accounted for 59 percent of the grow th in wagesand salaries though composed of just 6 percent of pivate sectoremployment.)25The grow th of inance was gready aided by the dereguladon of

global markets, referred to above . Through political negotiations thatoccurred in the late 1980s , the worlds ichest nations developed aframewo rk for opening up the wo rld to the inancial companies of dieleading capitalist counties, something no t inevitably decreed by themarketp lace but done so the wealthy could make still more money .The Wo rld Trade Organization 's Understanding on Commitmentsin Financial Services made it much easier to make money with mon eyabroad and to bing proits back to the home coun try as desired. TheWTO did diis primai ly by proh ibiting member nations rom regulat-ing inancial transactions. All of the complex and uldmately lethalinancial instruments discussed below could be sold anywhere,immune rom government regula tion. Companies like Citibank-which exempliied this global expansion , with 1,400 branch oices inforty-seven count ies, including ten in Latin Ameica, twenty-two in

Paciic Asia, and one inAfrica (Egypt)- tookadvantage of the newtrade agreements by sell-ing toxic assets whereverii d luld, making as muchmoney as it could as fastas possible, all the whilefree of worry that a gov-nunent would investi-gate and regulate what itwas doing .

The global opera-nous of multinationalcorporations, whetherthey involved the out-sourcing of domesticproducdon to low -wagecounties or more purelyinancial transactions,were citical to their bot-f/Otn lines . Prof its rompe foreign operations ofU .S. irms representedabout 6 percent of totalliin lits in the 1960s bu taveraged 17 percentI i 1990 to 2006 . Athird of all imports intoiIn United States arerom ailiates of U.S .nuil tinationals.During this explo-

sion of inance, compa-nies we dont usually

THE OR IG IN O FFINANCIAL PROFITS

How have (uumcial companies been ableto reap such high proits? They made aportion of the ir profits rom workers(through investments of 401(k) plans.state worker pension funds, etc .) or bycreating and selling products to peoplewho luil obtained profits in the realeconomy. Thus what happened was notdie creadon of new value or wealth butrather a redistribution ofwealth as work-ers incomes and industrial and servicecapitalists profits becmnc targets ofpotential profit growth by the inancialsystem . Buying companies and loadingthem up with debt and dicn reselling thecompanies-a perfecdy legal stain-wasbehind the wave of leveraged buyouf1acqu isidon s by pivate capital . And, aslong as pices for companies , stocks,houses, and the like kept going up , itseemed as though people in the inancialsector (as well as private investors orspeculators) could hardly not make abundle. But die creation of diese ''prof-itswas similar to a Poni scheme-aslong as increasing amoun ts of moneykep t com ing in to die system, diving upprices, it was possible for many investorsto get back theit investincnl plus proits .Bu t once the inilow of money dies up abit--watch out .

58 THE ABC i OF THE ECONOM IC CR ISIS


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think of as inancial, such as insurance corpo rations, also engaged inmany practices sim ilar to those ofbanks and investment irms . In add i-tion, non-inancial companies, such as farm machinery manu facturerJohn Deere, General Moto rs, General Electic, and many retailers,made signiicant income rom their inancial divisions, so the impor-tance of inance to the economy as a whole grew even larger than indi-cated by the proits of inancial irms.Many of the inancial division s of corporations, which providedmuch of their proits before the crisis se t in du ing 2007/2008, arenow in trouble because they generated the high proits by the samedubious and dangerous practices followed by sticdy inancial irms.The rise of the inancial system to such prominence in the economywas assisted by an era of deregulation at home and abroad, and some-times there was no regulation at all .

9 . How Did it Happ en?I 'd never taken an accoun ting course, never run a business, never even hadsavings of my own to managr. I stumb led into a job at Salomon Brothers in1985 and stumbled out much richer three years later...the whole thing stillstrikes me as prepos terous.../ thought I was writing a period piece [in Liar's Poker/ about the 1980s in

America . Notfor a moment d id I suspect that thefinancial 1980s would lasttwofull decades longer or that the d iference in degree between Wall Street andordinary l ife would swell into a d if erence in kind. 1 expected readers of thefutu re to be outraged that back in 1986, the C .E.O. ofSalomon Brothers, JohnGutfreund, was paid $3.1 million; I expected them to gape in horror when Ireported that one of our traders, Howie Rubin, had moved to Merrill Lynch,where he lost $250 million; I assumed they 'd be shocked to learn that a WallStreet C.E.O. had only the vaguest idea of the risks his traders were running .What I didn't expect was that any future reader would look on my experienceand say, How quaint.'' M ICHAEL LEW IS,2008

Something fo r nothing . It never loses its charm,'' as Michae l Lewisputs it . But how did inancial irms make money out ofmoney , with noreal tangible product and how did die signiicance of these companiesto the economy (along with their proits) grow so rapidly? In the face

THE ABC i O F THE ECONOM IC CRISIS HOW D ID IT HAPP EN ? (. 1


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of huge quantities of money looking for investment opportunities ,inancial companies expanded dramatically . Here are the most impor -tant ways that they did so. They did all of these at the same time, bu tfor clarity, let us look at each one separately.Financialfirms loaned increasing amoun ts ofmoney to tin publii

(main ly for homes, cars, and credit card debt) .In order to maintain or enhance their standard of living when conront-ed with stagna ting wages , peop le responded in a number of ways-wo rking longer hou rs, do ing mo re than one job, and taking on debt.Total household debt in the United States increased rom around 40percent of the GDP in the early 1960s to 100 percent of the GDP in2007. So , people were notjust taking on debt, they were doing so wayout of proportion to the growth of the economy. In addition, no t onlyd id consumer debt increase relative to the GDP, i t also increased rela-tive to people's incomes-doubling rom 1975 to 2005 , to 127 percentof disposable income . There fore , people were paying an ever largerportion of their disposable income just to service their debt-mo rethan 14 percen t by 2007 . Much of this debt stimulated the economy,because people made purchases they wouldn 't otherwise have beenable to afford. In eet, household spendin g increased rom around 62percent of the GDP in the early 1980s to around 70 percent in 2007-providing a major underpinning for the economic growth.

Financialfirms speculated and developed and peddled increasing lycomp lexinancial gimm icks as a primary means ofmaking money.A profusion ofinancial products (also called inancial instruments)were created and then sold, mainly to wealdiy individu als and to institu-ional investors such as pension funds . Most of these instrumentsinvo lved what were, in reality, types of bets-some simple, some just alitde convoluted, and others highly complex. These products weremo sdy derivatives- that is, dieir value derived rom the value of some-thing e lse , such as a particular interes t rate, the value of a currency rela-

tive to another currency, astock market index , diespread in pr ices of someproduct over two months,and so forth . Some ofthese securities were ce-ated to oload loans ontoothers. For example,banks used to keep diemortgage loans theymade, and, as die loanswere paid off, they wouldreceive the agreed-uponinteres t and also get backthe principal. However,beginning in die 1970s,banks and then inde-pendent mortgage origi-nating companies-beganto sell off their loans toothers in the so-calledsecondary market. Thenex t innovationwas the securitization of loans.This involved packagingtogether loans of va iou squalities; packages withhigher-quality loans(meaning they had a highprobability of being paidback) had lower interestrates , and packag es w ith lower-quality loans caried higher interes trates . Mortgage s of vaious qualities were also packaged togedier, andthen these were some timessliced and diced and rearranged into pack-ages of vaious sizes and estimated qualities and sold to investors.

THE REAL ECONOM Y VERSUSTH E PHANTOM ECONOMY

Economists often talk about the realeconomy where something rea l ismade and sold and services a e provid-ed-as opposed to the inancial econo-my, where paper changes hands forother paper (or diese exchanges occure lcclronically). The real economy is theone in wh ich we dwell as we gu abou tour daily lives, working at a job. buyinggroceies, and paying elec tic bills. The phantom economy of inance becameso large and, to a significant extent,divorced from die real economy that itlook on a life of its own . However, thefinancia l system is stil l linked, some-times in only indirect and diicnlt-lo-discover ways, to the real conomy.nTims when the financial system beginsto falter, it (Uies afect die real economy .When the toxic assets on bank balancesheets proved nearly worthless, thebanks cou ld no longer lend ou t monc toconsumers and businesses that neededloans to pu rchase real goods and servic -es. like cars, hou ses, rerigerators, tool .r(|iiipinciit. and buildings.

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No one rea lly understood die value of these complex securides (or tranches) of different quality mortgages. By 2005 , inancial compa-n ies,wh ich in 1980 got 80 percent of their income from interest on theloans they created, were obtaining only 58 percent of their incomerom interest, while 42 percent came rom fees ob tained when theyoriginated or packaged and sold loans. The income-generatingmachine that developed as mortgage loans were made, packaged as

FINANCIAL INSTRUMEN T ALPHABET SOUP

i of financial instruiiiciits and (cxhniquc s are fam iliar topeople-such as stocks , honds, and certiicates oCdcposit . But a denyingarray of products and strategies is available nowadays. Here are someexamples of the major categories (there are many different possibilitieswithin each one):

ABCP Asset Backed Commercial Paper. IVpically 90- to 180-day loans issued by banks and odier inancial institu-uons. They ae backed by actual assets of tlte institu tion.There is also commercial pa|Kr dial is not backed by anyassetsjust die prom ise to pay .Collatealized Debt Obligation. Secu ities backed by apool of bonds, loans, or od ier assets. CDOs arc divid -ed into tranchc-sbased on die assumed level of isk,w ith higher-risk tranches ofering higher interest.Syn thetic CDOs invest in CDSs (see be low) oranother type of ixed income asset. These arc alsodivided into tranches. There are also CDO stquajfod CDOs backed by CDOs Mortgages werepackaged into CDOs and sold of in various forms tolarge investors . The packages were designed to havediferen t levels of isk , with the potentially prob lematic

on es prom ising higher interest rates . The spread farand wide ofCDOs of dubious c|uality has gready lit icians want to regu late these funds, but so far theyhave not l>een very success ful.Leveraged Buyout. This occurs when venture cap iists purchase a company and as part of the deal thecompany takes on debt tha t is then used to pay feesand other returns to the new owners. Stock in theecompanies, now loaded with new debt, is then sold to

SIV

IM ELOAN S

companies may then close down tsions that ae not suiciendy proitable, wliich will raisethe comiwuy's short-term proi t margin and cause thestock pice to ise by signaling to slock buyers diat thebusiness is liecom ing more eicient. Inevitably, masslayof s ofworkers accompany leveraged buyouts.Structured Invcslment Veliicle. A teclmique wheein - aliank lends long tenn to get liigher interest ates and Imr-ruws short tenn at lower inteest rates l>y issuing asset-backed commercial paper (ABCP). However, if short-temiinteest rates incease, a lot of money can Ijc lost in dieprocess . The lianks shoit-tenn loans liave to be continual-ly paid back, but money from the bank's customers comesback to the bank only in the futue . SIVs wee mainly uoir-balance sheet, meaning they wee hidden rom view andwee not reported as part of inancial statemenLs.Mortgage loan s mad e to people with poor cedit hisries or low income . Some subpriines wee issued widi-out any down payment and required the borrower topay only the interest for a peiod . When this |)e iod wasover, the loan got reset at a higher rate of interest, andpeop le wee no longer able make suicient payments.H ie ultimate subpr ime loan was a ninja ,' granted w ith No veriicaiiipn ol Income, job status or Assets.

coliateralized debt obligations (CDOs- for an exp lanation, see the Financial Instruments Alphabet Soup box above), and inally sold offtuned into a renzy of activity. The renzy of activity was acceleratingeven as the whole housing pyramid was beg inn ing to topp le:

The Wal l Steet machine cranked out CDO s iil l tilt rom 2005 to 2007.It was a race aga inst time as accelerating delinquencies ate away at the

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value ofmortgage-backed secui ties that se rved as collateral for many ofthe deals . No one was trying to contain the eros ion ; rather, the playershad every incentive to get the secuities that backed the deals ou t of theirinventoies, so they created as many CDOs as possible.In just two months (February and March of 2007), one of the wo rld 's

biggest CDO dea lers, Meri ll Lynch , sold nearly $29 billion of die secu-i ties, 60 percent more than in any previous two-mon th peiod, accord -ing to data from Thomson Reuters. Go ldman Sachs sold $10 billion thatMarch , more than double any previous mondi . Citigroup sold $9 billion ,one-third more than in February, itself a record month.26

Most of the financ ial products were backed by a real asset-no tjustdie promise of a home owner to pay the mor tgage but ultimately, if diemo rtgage wasnt paid, by the house itself. However, many types ofinancial products were not backed by any asset. Secuides were solddial were based on package s of credit card debt, stud en t loans, or cor-porate loans. These were backed by the promise of the borrower topay interest and princ ipal on the loan . There were also other instru-ments in which die seller or originator agreed to pay the buyer undercertain circum stances-that is, if certain events happ ened. The num-ber of these types of products was literally endles s-you could bet ona change in prices, a difference between prices, or on almost anything .These were sold under an array of acronyms, including SIVs andCDS. Credit default swaps (CDSs), were made legal and not sub jectto regulation as part of the so-ca lled Commodity FuturesModem izadon Act, rushed through Congress w ithout debate andsigned by Presiden t Cl inton at the end of 2000.Some inancial products were just bets on such things as whether apaticular currency, in terest rate, or stock index would go up or down-you could bet either way . Then there was the carry trade, where largequandties ofJapanese yen were borrowed at close to no interest- foryears Japan had interest rates close to zero-and invested in countriesthat had rela tively high interest rates such as Iceland,Australia, and NewZea land . This assumed that the relative value of the currencies wou ldremain fairly stable. When the crisis set in during 2008 and the yen

appreciated aga inst manyother currencies, thecarry trade disintegrated .Iceland, a country dialbased a good pat of its new economy on itsbanks borrowing mon eycheaply abroad and dienIciuling it ou t inside andoutside the country,found itself bank rup t indie fall of 2008 .

Prior to the marketcrash of 2008, one of thelargest single losses takenby a lit iige fundoccurred in 2006, whena broker at Amaranth

lanks used tomore conservative , says Dan iO Conncll . chief executive of Vcs iCapital Partners, a major pivate equitylinn . Now they encourage us to brow more. The banks arc moesive because they rarely kee p the lojthey make. Instead , they sell them toothers, who d icn repackage, or securi-tizc. the loans and sell them to investorsas exo tic-sounding vehicles such asCLOs, or coUatcralizcd-loan ob liga-tions. Every week b ings announce-ments of billions of do llars in newCLOs, created by traditional moncy-inana cnR iit .ind hedge funds, whichthen sell them to other investors. Inmany cases, they may keep some slicesof these complicated secuities,27

lidtar

Advisors lost a $6 billionbet that the pice spread between natural gaspices rom one month to ano ther the following spring wou ld move ina certain direction . You can bet on die future pices of commod itiesand can even be t on the d ifference in the pice of whea t betweenKansas City and Chicago. You can construct a deivaive that places abet on literally anydiing or any combination of things . Mathematiciansand physicists, nicknamed quants, flocked to Wall Street and werepaid large sums of mon ey to use their computational skills to deviseand value new inancial instruments. Many are unemployed today.

Financial irms took on huge amounts of debt in order tomake more money on tlu ir own invest?nen ts.

In other words, when inancial irms bought some investment theywould use $3 or $20 or $30 or more ofborrowed money for every dollar

68 THE ABC i O F THE ECONO M IC CR ISIS HO W DID IT HAPPEN?


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they conunitted of their own-a practice called leveraging. Leveragingatios of over 100 to 1 were common among currency speculators.H ighly leveraged bets can be enormously proitable when returns are cal-culated as a percent of your own money or tha t of your client. Let's sayyou borrow $2,000 and use $200 of your own (for a leverage of 10 to 1)and diis $2,200 is invested in some way that earns a rate of retun of 8percent in three months-$176 (see Table 3). Of course , you have to payfor the use of the borrowed $2,000, perhaps 5 percent a year. But youonly had the money for one-quarter of a year: youll need to pay interestof $25 (or 0.25 x 0 .05 x 2,000), plus die original $2,000 , for a total of$2 ,025 . So, you have made $176 - 25 = $151, w liich works out to a ra teof retun of 76 percent on the original inves tment of $200 of your own(or you r client s) money , instead ofjust 8 percent ifno leverage was used .The potendal for enormous profits was the reason that so manyleveraged transactions occurred. (However, as we wil l see in the nextchapter, when leveraged bets go sour, the losses can also be enor-mous.) The entire financial system's debt grew fas ter than any othersector-household , non-financial business , and government debt-rom just over 20 percent in 1980 to over 115 percent of die GDP bythe end of 2007.TABLE 3: Example ofIncreasing Proits Us ing Leverag e

Investment :Borrowed money $2,000 Income @ 8% = $ 160Own money $200 Income @ 8% = $ 16

TOTAL INVESTMENT $2,200 $176Cost of borrowed money(for 3 month s @ 5% per year) $25Net Pro it $151TOTA L RETURN

ON OWN MONEY $100* ($151/200) 76%

Hedge funds wereconsidered to be finan-cial engines, eventhough pension plans,mutual funds, and insur-ance companies hadmore assets. T his wasbecause these companiestraded their holdingsrapidly, in 2006 account-ing for 30 to 60 percentof all trading in theUnited States and UnitedKingdom stock markets.They were the biggestplayers in some of themore risky types of investments, such asderivatives and dis-tressed debt. In the fallof2008,hedge funds had

STOCKS AND C t RKKNClES

In 197 .') , 19 million stock shares tradedaily on the New York Slock Kxchangc .By 1985 . the volume had reached 109million , and by 2006. 1,600 millionshares , with a value of ove r $60 billion .In June of 2007, 5.2 billion shares weretaded, and in October 2008 close to 9billion were traded in a single day. Evenlarser is the daily trading on the worldcurrency markets , which has gone from$18 billion a day in 1977 to over $;i tril-lion a day in 2007. That means thatevery twenty days, the do llar volume ofcurrency trading; e(|ualcd the entireworlds annual GDP . Currency specula-tion is especially attractive- you cantrade twenty-lour hours a day . and itseasy to ge t in and get out quickly .a bit less dian $2 tril lion

under management, bu twere leveraged a t 3:1 or higher, and so their total invesunents (bets)were around $6 trillion . Many university endowments and pensionfunds inves ted in hedge funds and venture capital because of the high-er rates of retu n . During the good times , money flowed reely to thefavored few, including the top manage rs of these funds . Now, collegeand university endowments have lost so much money that austerityhas become the watchword on our campuses, with salary and hiringreezes , layoffs , and mandatory and unpaid leaves . Of course , thosehurt most will no t be those wh o made all the money.The practice ofusing large leveraging ratios became common once

owners of private inves tment firms sold their companies by goingpublic tha t is , selling stock shares. A 20- or 30-to-I (or greater)

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leverage then made sense because a lot ofmoney and bonuses cou ldbe made if the bet went your way . Bu t it would be owners of the com-panys stock diat would take the brunt of any damage if bets wentsouth. In Apr il 2004, the ive main large investment banking irms(including Goldman Sachs , whose CEO , Henry Paulson , became theBush administration's Treasury Secretary in 2006) convinced theSecurity and Exchange Commiss ion tha t because their ma thematicalrisk models could predict how much leverage they could safely use,diey should be free of the 12-to-1 SEC limit on the amount of debtthey could take on . Leverage rose dramatically following diis agree -ment, with Bear Steam s going up to 33 to 1.The economist Herman Daly has written , Financial assetshave grown by a large multiple of the real economy-paperexchanging for paper is now 20 times greater than exchanges ofpaper for real comm odities. 29 The inancial economy, sometimesreferred to as a shadow bank ing system, greatly overshadows therea l economy in wh ich actual physica l products are produced andsold and rea l services provided. This increasingly importan t sectorfor generating proits was built on a base of rising levels of debtand the invention of new ways to gamble. It became a highly lever-aged giant casino.

Behind every great forlnne lies a p eal crime .HONORe DE BALZACere can he little doubt tha t mitriglil fraud am i shady dea lings penthe tinancial Hyslcin . W illiam K. Black , a senior government regula-

ir during the savings and loan debacle of the 19808, told Bill Moycrsthat the current financial crisis was driven by fraud. H e said that hank sknowingly lent money to people they knew could not pay . They thenpackaged these subprime loans, knowing that they were selling secuitiesf dubious worth. The companies that then sliced and diced the pack-ges and then resold them knew the same thing . So did the rating agen-

i bogus inancia l instrumcntjih igh-i|ii.i Fhe

whole diing was one gigantic fraud, shot throu gh wi th dishon esty Gmn dbeginning . Mr. Black said . Our (inancial system became a Poim scheme.Ev erybody was buymg die pig in the poke. But they were buying die pig itdie poke widi a pretty pink ribbon , anil the pink ribbon said . .Triple-A .

Bodi political parlies helped create the environment tliat allowtwidespread fraud to occur. Clinton favored deregulation as muchBush. What is more , the people President Obatna ls put in chargeixing the mess are, for die most part, the very same persons who peqitratcd the fraud . They arc doling out money to the same banks and liuaic ial companies who were dieir partners in cime .

Some peiiietrator s have gon e to p ison . Several Enron execu tnspent time in jail, and the most infamous crim inal. Bernard MadoB (a for-me r Nasdaq stock exchange oicial), created a Ponzi scheme in which avariety of wealdiy people we re defrauded of an estimated $50 billion),and will probably die in prison . Many more arc yet to be caught, aldioughmost wilt escape the jus tice system . When so much money is at slake andch ang ing hands rapidly, fortunes seem to appear out of diin air . lliosc inCongress who pushed deregulation of inancial ins titutions and agenciesstu l i as Moodys that rated the quality of invesUnents sold whateverethics they had for hard cash. The insti tutions that crea ted suhpimemortgages and peddled them to people who were clearly not going to beable to keep up payments are also to blame .Hmv evrr, die underlying prob lem was no t corruption , bx oversight,or deregulation-these arc only symptoms of a sick economy and socie-ty-but rather an economic system that was responding to stagnation ofdie real economy , b a society that pays to the money gods, corruptionis unavoidable after die discovery ofmagica l new ways to turn money intoin ,1 . moae) without produc ing any thing .50

Thefinancial compan ies encouraged (Urepdeition and oftenengaged inf raud or at the least lax business practices.

IThere is no doubt that the explosive growth of the inancial systemwas ass isted by deregulation in the 1990s and 2000s, the lack of reg-


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10. The Explosion of DebtAb, it '.s not Las Vtgas or Atlantic Ci ty. It s thf U.S . inancial system . The vol-ume of transactions has boomed far beyoTid anything needed lo support theeconomy. Borrowing-polite ly called leverage- is getting out of hand . Andfutures enable people to play the market without owning a share of stock. Theresult: the system is liltingfrom investment to speculation .BUSINESS WEEK, Scplember 16 , 1985

The exp losion of debt was direcdy related to , and encou raged by, thegrowth of the importance of inancia l institutions in the economy.High levels of debt (leverage) were used to enhance the proit-makingpotential of various bets. One of

the abcs of economic crisis

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