PETER GOWAN
CRISIS
IN THE HEARTLAND
Consequences
of the New Wall Street System
The long credit crunch that began in the Atlantic world in August 2007 is
strange in its extraordinary scope and intensity. Mainstream discourse,
referring to a ‘sub-prime’ crisis, implies that the credit crunch has been
caused, rather than triggered, by a bubble in the real economy. This is at best
naïve: after all, the bursting of an equally large bubble in the Spanish
housing market led to no such blow-out in the domestic banking system. [1] The notion
that falling house prices could shut down half of all lending in the us economy within a matter of months—and not just
mortgages, but car loans, credit-card receivables, commercial paper, commercial
property and corporate debt—makes no sense. In quantitative terms this amounted
to a credit shrinkage of about $24 trillion dollars, nearly double usgdp. [2] Erstwhile
lenders were soon running not just from sub-prime securities but from the
supposedly safest debt of all, the ‘super senior’ category, whose price by the
end of 2007 was a tenth of what it had been just a year before. [3]
An understanding of the credit crunch requires us to transcend the
commonsense idea that changes in the so-called real economy drive outcomes in a
supposed financial superstructure. Making this ‘epistemological break’ is not
easy. One reason why so few economists saw a crisis coming, or failed to grasp
its scale even after it had hit, was that their models had assumed both that
financial systems ‘work’, in the sense of efficiently aiding the operations of
the real economy, and that financial trends themselves are of secondary
significance. [4] Thus the
assumption that the massive bubble in oil prices between the autumn of 2007 and
the summer of 2008 was caused by supply-and-demand factors, rather than by
financial operators who, reeling from the onset of the crisis, blew the price
from $70 a barrel to over $140 in less than a year, before letting the bubble
burst last June; a cycle with hugely negative ‘real economy’ effects. Similar
explanations were tendered for soaring commodity prices over the same period;
yet these were largely caused by institutional investors, money-market and
pension funds, fleeing from lending to the Wall Street banks, who poured
hundreds of billions of dollars into commodities indices, while hedge funds
with their backs against the wall pumped up bubbles in coffee and cocoa. [5]
Breaking with the orthodoxy that it was ‘real economy’ actors that caused
the crisis carries a political price: it means that blame can no longer be
pinned on mortgage borrowers for the credit crunch, on the Chinese for the
commodities bubble, or on restrictive Arab producers for the sudden soaring of
oil. Yet it may allow us to understand otherwise inexplicable features of the
crisis; not least, as we shall see, the extraordinary growth of sub-prime
itself. We will thus take as our starting point the need to explore the
structural transformation of the American financial system over the past
twenty-five years. I will argue that a New Wall Street System has emerged in
the us during this period, producing new actors,
new practices and new dynamics. The resulting financial structure-cum-agents
has been the driving force behind the present crisis. En route, it proved
spectacularly successful for the richest groups in the us:
the financial sector constituted by far the most profitable component of the
American and British economies and their most important ‘export’ earner. In
2006, no less than 40 per cent of American corporate profits accrued to the
financial sector. [6] But the new
structure necessarily produced the dynamics that led towards blow-out.
This analysis is not offered as a mono-causal explanation of the crisis. A
fundamental condition, creating the soil in which the New Wall Street System
could grow and flourish, was the project of the ‘fiat’ dollar system, the
privatization of exchange-rate risk and the sweeping away of exchange
controls—all euphemized as ‘financial globalization’. Furthermore, the system
could not have risen and flourished if it had not offered answers—however
ultimately pathological—to a range of deep-seated problems within American
capitalism overall. There is thus a rational, dialectical kernel in the
superficial distinction between financial superstructure and the ‘real’ us economy. In what follows, I will first sketch the
main elements of the New Wall Street System, and briefly show how its crisis
took such spectacular forms. I will then argue that, to understand the deeper
roots of the malaise, we do indeed need to probe into the overall
socio-economic and socio-political characteristics of American capitalism as it
has evolved over the past twenty-five years. I will raise the possibility of
systemic alternatives, including that of a public-utility credit and banking
model. Finally, I will consider the international dynamics unleashed by the
present crisis and their implications for what I have elsewhere described as
the Dollar–Wall Street Regime. [7]
i. the
new wall street system
The structure and dynamics of Wall Street banking changed dramatically in
the quarter of a century after the mid-1980s. The main features of the new
system include: (i) the rise of the lender-trader model; (ii) speculative
arbitrage and asset-price bubble-blowing; (iii) the drive for maximizing
leverage and balance-sheet expansion; (iv) the rise of the shadow banking
system, with its London arm, and associated ‘financial innovations’; (v) the
salience of the money markets and their transformation into funders of
speculative trading in asset bubbles; (vi) the new centrality of credit
derivatives. These changes mutually re-enforced each other, forming an
integrated and complex whole, which then disintegrated in the course of 2008.
We will briefly examine each of them in turn.
Trading models
For most of the post-war period, Wall Street investment banks engaged in
very little securities trading on their own account, as opposed to trading on
behalf of clients; while the big depository commercial banks shunned such
activity. But from the mid-1980s on, proprietary trading in financial and other
assets became an increasingly central activity for the investment banks, and
for many commercial banks, too. This turn was connected, firstly, to the new
volatility in foreign-exchange markets after the dismantling of Bretton Woods;
and then to the opportunities created by domestic financial liberalization,
above all the scrapping of capital controls and the opening of other national
financial systems to American operators. These changes offered opportunities
for a massive expansion of Wall Street trading activity, which would become a
crucial source of profits for the investment banks. [8] The turn
towards speculative proprietary trading was pioneered by Salomon Brothers,
whose Arbitrage Group was established in 1977 and acquired extraordinary
profitability under John Meriwether during the 1980s. [9]
As well as trading on their own account, the Wall Street banks became
increasingly involved in lending funds for other bodies to use in their trading
activities: hedge funds, so-called private equity groups (trading in
companies), or special investment vehicles (sivs)
and conduits, created by the investment banks themselves. [10]
Such lending, known in the jargon as prime brokerage, was also an extremely
profitable activity for the Wall Street banks: for many, their single greatest
earner. [11]
This turn to the lender-trader model did not mean that the investment banks
ceased their traditional activities in investment banking, broking, fund
management, etc. But these activities acquired a new significance in that they
provided the banks with vast amounts of real-time market information of great
value for their trading activity. [12]
Trading activity here does not mean long-term investment, Warren
Buffett-style, in this or that security, but buying and selling financial and
real assets to exploit—not least by generating—price differences and
price shifts. This type of ‘speculative arbitrage’ became a central focus, not
only for the investment banks but for commercial banks as well. [13]
So, too, did the related effort to generate asset-price bubbles. Time and time
again, Wall Street could enter a particular market, generate a price bubble
within it, make big speculative profits, then withdraw, bursting the bubble.
Such activity was very easy in so-called emerging market economies with small
stock or bond markets. The Wall Street banks gained a wealth of experience in
blowing such bubbles in the Polish, Czech or Russian stock markets in the 1990s
and then bursting them to great profit. The dot.com bubble in the us then showed how the same operation could be carried
through in the heartland without any significant loss to the Wall Street banks
(as opposed to some European operators, notably insurance companies, eager to
profit from the bubble but hit by the burst).
Both the Washington regulators and Wall Street evidently believed that
together they could manage bursts. [14]
This meant there was no need to prevent such bubbles from occurring: on the
contrary it is patently obvious that both regulators and operators actively
generated them, no doubt believing that one of the ways of managing bursts was
to blow another dynamic bubble in another sector: after dot.com, the housing
bubble; after that, an energy-price or emerging-market bubble, etc. This may
seem to imply a formidably centralized financial power operating at the heart
of these markets. Indeed: the New Wall Street System was dominated by just five
investment banks, holding over $4 trillion of assets, and able to call upon or
move literally trillions more dollars from the institutions behind them, such
as the commercial banks, the money-market funds, pension funds, and so on. The
system was a far cry from the decentralized market with thousands of players,
all slavish price-takers, depicted by neo-classical economics. Indeed, the
operational belief systems of what might be called the Greenspan-Rubin-Paulson
milieu seems to have been post-Minskian. They understood Minsky’s theory of
bubbles and blow-outs, but believed that they could use it strategically for
blowing bubbles, bursting them, and managing the fall-out by blowing some more.
Maximizing leverage
The process of arbitrage and bubble-blowing requires more of financial
operators than simply bringing together the maximum amount of information about
conditions across all markets; it also demands the capacity to mobilize huge
funds to throw into any particular arbitrage play, in order to shift market
dynamics in the speculator’s favour.
A striking feature of the New Wall
Street System business model was its relentless drive to expand balance sheets,
maximizing the asset and liabilities sides. The investment banks used their
leverage ratio as the target to be achieved at all times rather than as an
outer limit of risk to be reduced where possible by holding surplus capital. A
recent New York Federal Reserve report demonstrates how this approach proved
powerfully pro-cyclical in an asset-market bubble, driving the banks to expand
their borrowing as asset prices rose. [15]
In their illustration, the report’s authors, Tobias Adrian and Hyun Song Shin,
assume that the bank actively manages its balance sheet to maintain a constant
leverage ratio of 10. Suppose the initial balance sheet is as follows: the bank
holds 100 worth of securities, and has funded this holding with an equity of
10, plus debt worth 90.
The bank’s leverage ratio of security to equity is therefore 100/10 = 10.
Suppose the price of the securities then increases by 1 per cent, to 101.
The proportions will then be: securities 101, equity 11, debt 90. So its
leverage is now down to 101/11 = 9.2. If the bank still targets leverage of 10,
then it must take on additional debt (‘d’), to purchase d worth of securities
on the asset side, so that the ratio of assets/equity is: (101+d)/11 = 10, i.e.
d = 9.
The bank thus takes on additional debt
worth 9, and with this money purchases securities worth 9. After the purchase,
leverage is back up to 10. Thus, an increase in the price of the security of 1
leads to an increased holding worth 9: the demand curve is upward-sloping.
The mechanism works in reverse, too.
Suppose there is shock to the securities price, so that the value of security
holdings now falls to 109. On the liabilities side, it is equity that bears the
burden of adjustment, since the value of debt stays approximately constant.
But with securities at 109, equity at 10, debt at 99, leverage is now too
high: 109/10 = 10.9.
The bank can adjust down its leverage by selling securities worth 9, and
paying down 9 worth of debt. Thus, a fall in the price of securities leads to
sales of securities: the supply curve is downward-sloping.
A central mechanism through which the investment banks could respond to
asset-price rises was borrowing in the ‘repurchase agreement’—or ‘repo’—market.
Typically, the investment bank wishes to buy a security, but needs to borrow
funds to do so. On the settlement day, the bank receives the security, and then
uses it as collateral for the loan needed to pay for it. At the same time, it
promises the lender that it will repurchase the security at a given future
date. In that way, the bank will repay the loan and receive the security. But
typically, the funds for repurchasing the security from the lender are acquired
by selling the security to someone else. Thus, on the settlement day, the
original lender to the investment bank is paid off and hands over the security,
which is immediately passed on to the new buyer in exchange for cash. This kind
of repo funding operation presupposes an asset-price boom. It has accounted for
43 per cent of leverage growth amongst Wall Street banks, according to the same
New York Fed report. Repos have also been the largest form of debt on
investment banks’ balance sheets in 2007–08. [16]
The question arises as to why the Wall Street banks (followed by others)
pushed their borrowing to the leverage limit in such a systematic way. One
explanation is that they were doing this in line with the wishes of their
shareholders (once they had turned themselves into limited liability
companies). ‘Shareholder value’ capitalism allegedly requires the ratio of
assets to capital to be maximized. Surplus capital reduces the return on
shareholder equity and acts as a drag on earnings per share. [17]
But there is also another possible explanation for borrowing to the leverage
limit: the struggle for market share and for maximum pricing power in trading
activities. If you are a speculative arbitrageur or an asset-bubble blower,
financial operational scale is essential to moving markets, by shifting prices
in the direction you want them to go. In assessing which of these
pressures—shareholder power or pricing power—drove the process, we should note
how ready the Treasury, Fed and Wall Street executives have been to crush
shareholder interests during the credit crunch, yet how resolutely they sought
to protect the levels of leverage of the bulge-bracket banks during the bubble.
By all accounts, Citigroup’s turn to maximum balance-sheet and leverage
expansion for trading activities derived not from shareholder pressure, but
from the arrival there of Robert Rubin after his stint as us Treasury Secretary. [18]
Shadow banking
The drive for scale and for increasing leverage leads on to another basic
feature of the New Wall Street System: the drive to create and expand a
shadow-banking sector. Its most obvious features were the new, entirely
unregulated banks, above all the hedge funds. These have had no specific
functional role—they have simply been trader-banks free of any regulatory
control or transparency in their speculative arbitrage. Private equity groups
have also been, in essence, shadow trading banks, specializing in the buying
and selling of companies. Special Investment Vehicles (sivs)
and conduits are similarly part of this system. In the words of the director of
regulation at Spain’s central bank, these sivs and
conduits ‘were like banks but without capital or supervision’. Yet, as a Financial
Times report noted: ‘In the past two decades, most regulators have
encouraged banks to shift assets off their balance sheets into sivs and conduits.’ [19]
The shadow banking system was not in competition with the regulated system:
it was an outgrowth of it. The regulated commercial and investment banks acted
as the prime brokers of the shadow banking operators, thereby gaining very
large profits from their activities. This increasingly central feature of
official bank activity was, in reality, a way of massively expanding their
balance sheets and leverage. To tap the Wall Street banks for funding, the
hedge funds had to hand over collateral; but through a practice known as
rehypothecation, a proportion of these collateral assets could then be used by
the prime broker as its own collateral for raising itsown funds.
The result was the self-financing of hugely profitable prime brokerage
activities by the Wall Street banks, on a vast scale, without any extra
commitment of their own capital: an ingenious way of greatly enlarging their
leverage ratios. [20]
The debate about whether deregulation or reregulation in the financial sector
has been occurring since the 1980s seems to miss the point that there has been
a combination of a regulated and an unregulated shadow system, working
dynamically together.
Shadow banking refers not only to institutional agents, like hedge funds,
but also to the practices and products which allowed the investment banks to
expand their leverage. Since the late 1990s an increasingly important part of
this side of shadow banking has been the ‘over-the-counter’ credit derivatives
market, notably collateralized debt obligations (cdos)
and credit default swaps (cdss). The most obvious
attraction of these lay in the regulatory arbitrage they offered, enabling
banks to expand leverage. [21]
Traditionally banks had to insure their credit operations and such insurance entailed
supplying collateral. The beauty of cdss lay in
the fact that, as shadowy ‘over-the-counter’ products, they did not require the
commitment of appropriate tranches of capital as collateral, and thus
facilitated more leverage. cds expansion began on a
major scale after derivatives specialists from jp
Morgan Chase persuaded aig to start writing them
on cdos in 1998. [22]
cdos were also a clever solution to leverage problems. By acquiring large
quantities of securitized loans and thus greatly expanding their balance
sheets, banks should have expanded their equity base. But cdos famously bundled together dozens or hundreds of
such loans, of very varied quality, enabling the banks to increase their
leverage. The cdos were typically written by the
rating agencies, for a fee, and then given a Triple A rating by the same
agency, for a second fee. Such ratings allowed the banks’ equity commitments to
be minimized. These securitized loans—mainly from the housing market, but also
from credit-card debt and car loans—offered investors far higher rates of
return than they could get in the money markets. The crucial point about these
so-called ‘structured securities’ was not that they were securitized loans:
these could in principle be perfectly safe; after all, a bond is, in reality,
nothing but a securitized loan. But bonds have a clearly identifiable source,
in an economic operator whose credit-worthiness and cash-flow capacities can be
assessed; they also have clear prices in the secondary bond markets. The
products bundled in cdos, however, came from
hundreds of thousands of unidentifiable sources, whose credit-worthiness and
cash-flow capacity was not known; they were sold ‘over the counter’, without
any secondary market to determine prices, far less an organized market to
minimize counterparty risk. In short, they were at best extremely risky because
more or less totally opaque to those who bought them. At worst they proved a
scam, so that within a few months of late 2007 the supposedly super-safe
super-senior debt tranches within such cdos were
being downgraded to junk status.
Leverage restrictions were also removed through public policy. Hank Paulson
achieved a notable success in this area in 2004 when, as head of Goldman Sachs,
he led the Wall Street campaign to get the Securities and Exchange Commission
to agree to relax the so-called ‘net capital rule’, restricting leverage for
large investment banks. Henceforth, firms were effectively allowed to decide
their own leverage on the basis of their risk models. The result was a rapid
rise in the big banks’ leverage ratios. [23]
Importantly it enabled them to transfer their capital base to new activities,
such as collateralized debt obligations, which subsequently became such a
significant element in their trading activities.
London’s role
All these shifts are grouped under the euphemistic heading of ‘financial
innovation’—changes in institutional arrangements, products, oversight
structures, enabling Wall Street banks to escape regulatory restrictions and
expand their activities and profits. Dozens of shifts of this sort could be documented.
But one of the most fundamental was the construction of a large, new shadow
banking system in London, alongside the ‘official’ regulated sector. By the
early 1990s the American investment banks had wiped out their London
counterparts and dominated the Square Mile’s asset markets, with the City
acquiring an increasingly ‘wimbledonized’ role within the New Wall Street
System. [24]
Gordon Brown institutionalized the new relationship in 1997 by creating the
unified Financial Services Authority, which claimed to operate according to
‘principles’ rather than binding rules: one central principle was that the Wall
Street banks could regulate themselves. London thus became for New York
something akin to what Guantánamo Bay would become for Washington: the place
where you could do abroad what you could not do back home; in this instance, a
location for regulatory arbitrage.
The term ‘Wall Street’ should therefore be understood to include London, as
a satellite for these American operators. [25]
Together London and New York dominate the issue of new shares and bonds. They
are the centre of the foreign-exchange markets. Most significantly they have
dominated the sale of over-the-counter derivatives, which make up the
overwhelming bulk of derivatives sales. [26]
In 2007, the uk had a global share of 42.5 per
cent of derivatives based on interest rates and currencies, with the us handling 24 per cent. In terms of credit-derivatives
trading, the us handled 40 per cent in 2006, while
London handled 37 per cent (down from 51 per cent in 2002).
Funding speculation
The enormous expansion in the activities of the Wall Street banks and their
shadow system required ever-larger amounts of funding. Such funding was
classically supplied by the recycling of retail savings sitting in deposit
accounts and, even more importantly, by the commercial banks creating large
supplies of credit money. But in post-1980s America such retail savings were
minuscule—a point to which we will return—and credit money from the commercial
banks, though significant, was soon hopelessly inadequate. In these
circumstances the trader banks turned to the wholesale money markets. At the
heart of such markets were the inter-bank markets, with interest rates on, or
just a few basis points above, the Fed’s policy rates. Historically these
markets were used to ensure that the banks were able to clear smoothly on a
daily basis, rather than as a source of new, large-scale funding, let alone
funding of a speculative nature. There was also the commercial-paper market,
typically used by the big corporations for short-term funding, again
principally to smooth their operations.
But in the New Wall Street System, these money markets were transformed.
They remained centres of short-term lending, but they were increasingly funding
speculative trading activity. On the supply side, the funds available for
lending to Wall Street were expanding rapidly, especially through the expansion
of pension funds during the 1980s and 1990s. In rather typical American style,
a small change in the tax code through amendment 401K in 1980 opened the door
to this development. This amendment gave a tax break to employees and employers
if they put money into pension plans; the result was a massive flow of employee
income into these plans, totalling nearly $400 billion by the end of the 1980s.
By the late 1990s it had climbed to almost $2 trillion. [27]
At the same time as becoming key sources for the liabilities of the
investment banks through short-term lending to them, the mutual funds, pension
funds and so forth also became increasingly important targets for Wall Street’s
efforts to sell asset-backed securities, and in particular collateralized debt
obligations. Thus the New Wall Street System attempted to draw the fund
managers into speculative bubble activity on both the funding (liability) side
and on the asset side, enabling ever-larger balance-sheet expansion.
ii. the
causes of the crisis
It might, in principle, have been the case that the cluster of mutually
re-inforcing innovations which we have called the New Wall Street System, were responses
to the emergence of a housing-market bubble in the us
from 2001. If so, we would have had a classic Minskian crisis linked to
housing. In fact, all the key innovations were set in place before the onset of
the bubble. Indeed there is ample evidence that the Wall Street banks quite
deliberately planned a house-price bubble, and spent billions of dollars on
advertising campaigns to persuade Americans to increase their mortgage-related
debt. Citigroup ran a billion-dollar campaign with the theme ‘Live Richly’ in
the 1990s, designed to get home owners to take out second mortgages to spend on
whatever they liked. Other Wall Street banks acted in a similar fashion, with a
great deal of success: debt in second mortgages climbed to over $1 trillion in
a decade.
But the bubble that generated the credit crunch of 2007 lay not only—or
even mainly—in the housing market, but in the financial system itself. The
crisis was triggered not only by the scale of the debt bubble, but by its
forms. In a normal over-lending crisis, when banks have ended up with
non-performing loans (as in Japan in the 1990s), both the location and scale of
the problems can be identified without much difficulty. But in 2007 the debt
bubble within the financial system was concentrated in over-the-counter
derivatives, in the form of individual cdos that
had no market price or pricing mechanism—beyond the say-so of the ratings
agencies—and which were distributed in their tens of thousands between the
institutions at the summit of the financial system, as well as their satellite
bodies such as sivs. Once this set of
debt-accumulation arrangements was shown to be junk, in the two Paribas cases
in August 2007, the suppliers of credit funding, such as money-market and
pension funds, grasped that they had no way of knowing how much of the rest of
the cdo mountain was also worthless. So they fled.
Their refusal to keep supplying the handful of opaque Wall Street investment
banks and their spin-offs with the necessary funds to keep the cdo market afloat was what produced the credit crunch.
The investment banks had initially spread the word that the effect of their
securitization of debt had been to disperse risk widely across a multitude of
bodies. But this seems to have been false: the Wall Street summit institutions
themselves had been holding on to the so-called super-senior debt tranches, in
tens of thousands of cdos. [28]
They had been borrowing billions in the money markets to buy these instruments,
gaining an interest rate on them some 10 basis points above their money-market
borrowing costs. To continue to turn that profit they had to keep going back to
the money markets to roll over their debts. Yet now the money markets were
shutting down. [29]
When investors in the money markets fled the recycling of short-term borrowing
in the summer of 2007, the entire pyramid centred on the cdos
began to crumble. When the Wall Street banks tried to off-load their cdos, they found there was no market for them. The
insurance companies that had insured the cdos with
cdss found their market collapsing, too.
Much remains obscure about the precise mechanisms through which the credit
crunch acquired its scope and depth in 2007–08, mainly because the main Wall
Street operators themselves sought to obfuscate both the nature of their plight
and their survival tactics. But it is possible to trace a number of phases
through which the crisis has passed. First, the attempt by the Fed and Treasury
to defend the investment-bank model as the summit of the system, by acting as
its lender of last resort. Second, with the fall of Lehman Brothers, the
collapse of this effort and disappearance of the investment-bank model,
producing a drive to consolidate a universal-bank model in which the trading
activities of the investment banks would occur within, and protected by, the
depository universal bank. In this phase, the Fed essentially substituted
itself for the creditor institutions of the credit system, supplying loans,
‘money-market’ and ‘commercial-paper market’ funding for the banks. Between
April and October 2008 this massive Central Bank funding operation involved
about $5 trillion of credit from the Fed, the ecb
and the Bank of England—equivalent to about 14 per cent of global gdp. Insofar as this state funding can continue without
raising serious sovereign credit-worthiness problems, the most difficult and
dangerous phase of the response to the crisis can get under way in a serious
fashion. This will involve the deleveraging of the biggest banks, now in the
context of negative feedback loops from deepening recessions. How and when this
is achieved will give us a sense of the overall contours of the credit crunch.
Prevailing theories
Much of the mainstream debate on the causes of the crisis takes the form of
an ‘accidents’ theory, explaining the debâcle as the result of contingent
actions by, say, Greenspan’s Federal Reserve, the banks, the regulators or the
rating agencies. We have argued against this, proposing rather that a
relatively coherent structure which we have called the New Wall Street System
should be understood as having generated the crisis. But in addition to the
argument above, we should note another striking feature of the last twenty
years: the extraordinary harmony between Wall Street operators and Washington
regulators. Typically in American history there have been phases of great
tension, not only between Wall Street and Congress but also between Wall Street
and the executive branch. This was true, for example, in much of the 1970s and
early 1980s. Yet there has been a clear convergence over the last quarter of a
century, the sign of a rather well-integrated project. [30]
An alternative explanation, much favoured in social-democratic circles,
argues that both Wall Street and Washington were gripped by a false
‘neo-liberal’ or ‘free-market’ ideology, which led them astray. An ingenious
right-wing twist on this suggests that the problematic ideology was
‘laissez-faire’—that is, no regulation—while what is needed is ‘free-market
thinking’, which implies some regulation. The consequence of either version is
usually a rather rudderless discussion of ‘how much’ and ‘what kind’ of
regulation would set matters straight. [31]
The problem with this explanation is that, while the New Wall Street System was
legitimated by free-market, laissez-faire or neo-liberal outlooks, these
do not seem to have been operative ideologies for its practitioners,
whether in Wall Street or in Washington. Philip Augar’s detailed study of the
Wall Street investment banks, The Greed Merchants, cited above, argues
that they have actually operated in large part as a conscious cartel—the
opposite of a free market. It is evident that neither Greenspan nor the bank
chiefs believed in the serious version of this creed: neo-classical financial
economics. Greenspan has not argued that financial markets are efficient or
transparent; he has fully accepted that they can tend towards bubbles and
blow-outs. He and his colleagues have been well aware of the risk of serious
financial crisis, in which the American state would have to throw huge amounts
of tax-payers’ money into saving the system. They also grasped that all the
various risk models used by the Wall Street banks were flawed, and were bound
to be, since they presupposed a general context of financial market stability,
within which one bank, in one market sector, might face a sudden threat; their
solutions were in essence about diversification of risk across markets. The
models therefore assumed away the systemic threat that Greenspan and others
were well aware of: namely, a sudden negative turn across all markets. [32]
Greenspan’s two main claims were rather different. The first was that,
between blow-outs, the best way for the financial sector to make large amounts
of money is to sweep away restrictions on what private actors get up to; a
heavily regulated sector will make far less. This claim is surely true. His
second claim has been that, when bubbles burst and blow-outs occur, the banks,
strongly aided by the actions of the state authorities, can cope with the
consequences. As William White of the bis has
pointed out, this was also an article of faith for Bernanke. [33]
iii.
systemic options
The real debate over the organization of financial systems in capitalist
economies is not about methods and modes of regulation. It is a debate between
systemic options, at two levels.
A
public-utility credit and banking system, geared to capital accumulation in the
productive sector versus a capitalist credit and banking system, subordinating
all other economic activities to its own profit drives.
An
international financial and monetary system under national-multilateral
co-operative control versus a system of imperial character, dominated by the
Atlantic banks and states working in tandem.
We can briefly look at each of these in turn.
A public-utility model?
All modern economic systems, capitalist or not, need credit institutions to
smooth exchanges and transactions; they need banks to produce credit money and
clearance systems to smooth the payment of debts. These are vital public
services, like a health service. They are also inherently unstable: the essence
of a bank, after all, is that it does not hold enough funds to cover all the
claims of its depositors at any one time. Ensuring the safety of the system
requires that competition between banks should be suppressed. Furthermore,
policy questions as to where credit should be channelled are issues of great
economic, social and political moment. Thus public ownership of the credit and
banking system is rational and, indeed, necessary, along with democratic
control. A public-utility model along these lines can, in principle, operate
within capitalism. Even now the bulk of the German banking system remains in
public hands, through savings banks and Landesbanken. The Chinese
financial system is overwhelmingly centred on a handful of huge, publicly owned
banks and the Chinese government does indeed steer the credit strategies of
these banks. It is possible to envisage such a public-utility model operating
with privatized banks. The post-war Japanese banking system could be held to
have had this character, with all its banks strictly subordinated to the Bank
of Japan’s policy control via the ‘window-guidance system’. The post-war
British commercial bank cartel could also be viewed as broadly operating within
that framework, albeit raking off excessive profits from its customers.
But a private capitalist credit system, centred on banks, would operate
under the logic of money capital—in Marx’s formula, m-m':
advancing money to others to make more money. Once this principle is accepted
as the alpha and omega of the banking system, the functional
logic points towards the Greenspan apotheosis. This has been the model adopted
in the us and the uk
since the 1980s: making money-capital king. It entails the total subordination
of the credit system’s public functions to the self-expansion of money capital.
Indeed, the entire spectrum of capitalist activity is drawn under the sway of
money capital, in that the latter absorbs an expanding share of the profits
generated across all other sectors. This has been the model that has risen to
dominance as what we have called the New Wall Street System. It has been a
generator of extraordinary wealth within the financial system and has actually
transformed the process of class formation in the Anglo-Saxon economies. This
model is now in deep crisis.
The second debate centres around the underwriting of financial systems.
Whether public or private, banking and credit systems are inherently unstable
in any system where output is validated after production, in the market-place. [34]
In such circumstances, these systems must be underwritten and controlled by
public authorities with tax-raising capacities and currency-printing presses.
Insofar as they are minimally public bodies—not utterly captured by the private
interests of money capital—these authorities will aim to prevent crises by
trying to bring the behaviour of the financial system roughly into line with
broad (micro as well as macro) economic goals. At present, only states have the
capacity to play this role. Rule books like Basel I or II cannot do it; neither
can the eu Commission or the ecb.
Intriguingly, the Atlantic projects grouped under the name of ‘economic
globalization’—the fiat dollar system, ending of capital controls, free entry
and exit of big Atlantic operators in other financial systems—have ensured that
most states have been deprived of the capacity to underwrite and control their
own financial systems: hence the endless financial blow-outs in the South over
the last thirty years. Atlantic business interests benefited from these crises,
not only because their losses were fully covered by imf
insurance—paid for later by poor people in the countries hit—but also because
they were used as occasions to sweep open the product and labour markets of
these countries to Atlantic penetration. But now the blow-outs have hit the
metropolitan heartland itself. Obviously the Atlantic economies will want to
keep this system going: the practices covered by ‘financial globalization’
constitute their most profitable export sector. But it is not so clear that the
rest of the world will buy a formula for more of the same. The alternative would
be some return to public control, along with public underwriting. This could
only be achieved by individual national states regaining effective control, via
new multilateral co-operative systems comparable to those that existed before
1971, implemented on a regional if not fully international scale.
Here, however, we will focus on the question of why the financial model
centred on the New Wall Street System has achieved such complete hegemony
within American capitalism over the past few decades. This takes us, finally,
back out of the financial sphere into the wider field of socio-economic and
socio-political relations in the us since the
1970s. Within this broader context, we can begin to understand how the New Wall
Street System’s rise to dominance within the us
could have been seen as a strategic idea for tackling the problems of the
American economy.
Financial dominance as national strategy
From the 1970s through to the early 1980s, the American state waged a
vigorous battle to revive the industrial economy, partly through a mercantilist
turn in external trade policy, but above all through a domestic confrontation
with labour to reduce its share of national income. This was the vision of such
leaders as Paul Volcker; it was assumed that these measures would return
American industry to world dominance. Yet the hoped-for broad-based industrial
revival did not take place. By the mid-1980s, non-financial corporate America
was falling under the sway of short-term financial engineering tactics, geared
towards the goal of enhancing immediate ‘shareholder value’. What followed was
wave after wave of mergers and acquisitions and buy-outs by financial
operators, encouraged by Wall Street investment banks who profited handsomely
from such operations. The legitimating argument that this was ‘enhancing
industrial efficiency’ seems scarcely credible. A more convincing case would be
that these trends were driven by the new centrality of the financial sector
within the structure of American capitalism. [35]
A full explanation of this development is, I think, not yet available. But
the trend produced some structural features of American capitalism that have
been present ever since. On the one hand, a protected military-industrial
sector remains intact, funded from federal and state budgets. Some high-tech
sectors, especially in ict, were also strongly
supported by state subsidies in the 1980s and 90s, and have involved real new
industrial investment, without as yet playing a transformative role in the
overall economy: the main impact of ict has been
in the financial sector and retail. But the bulk of the American economy, on
which growth depends, has been marked by stagnant or even declining incomes
amongst the mass of the population and no growth motor from new investment,
whether public or private. With the partial exception of ict
investment in the late 90s, gdp growth in the us has not been driven by new investment at all. As is
widely recognized, it has come to depend upon the stimulus of consumer demand;
yet such household consumption was itself inhibited by stagnant mass incomes.
This circle was famously squared in two ways. First and most important, the
problem of stimulating consumer demand was tackled through the sustained supply
of credit from the financial system. Secondly, cheap commodities could be
bought on an endless basis from abroad—especially from China—since dollar
dominance enabled the us to run up huge
current-account deficits, as other countries allowed their exports to the us to be paid for in dollars. The supply of credit from
the financial system to the mass of consumers through the usual mechanisms of
credit card, car debt and other loans and mortgages was, however, supplemented
by the distinctive mechanism of asset-price bubbles, which generated so-called
wealth effects among a relatively broad layer. The stock-market bubble of the
1990s raised the paper value of the private pensions of the mass of Americans, thus
giving them a sense that they were becoming richer and could spend (and indebt
themselves) more. The housing bubble had a double effect: it not only made
American consumers feel confident that the value of their house was rising,
enabling them to spend more; it was reinforced by a strong campaign from the
banks, as we have seen, urging them to take out second mortgages and use the
new money for consumption spending.
Thus the New Wall Street System directly fuelled the 1995–2008 consumer-led
American boom, which ensured that the us continued
to be the major driver of the world economy. This was backed by a global
campaign to the effect that the us boom was not
the result of debt-fed growth aided by highly destructive trends in the
financial system, but of American free-market institutions. Here, then, was the
basis in the broader social relations of American capitalism for the rise to
dominance of the New Wall Street System: it played the central role in ensuring
debt-fed growth. This Anglo-Saxon model was based upon the accumulation of
consumer debt: it was growth today, paid for by hoped-for growth tomorrow. It
was not based upon strengthening the means of value-generation in the economies
concerned. In short, it was a bluff, buttressed by some creative national
accounting practices which exaggerated the extent of the American boom and
productivity gains in the us economy. [36]
The role of China and other Asian exporting economies in this growth model
extended beyond their large export surpluses of consumer goods to the us. These export surpluses were recycled back into the
American financial system via the purchasing of us
financial assets, thus cheapening the costs of debt by massively expanding
‘liquidity’ within the financial system. The results of these trends can be
summarized in the following figures. Aggregate us
debt as a percentage of gdp rose from 163 per cent
in 1980 to 346 per cent in 2007. The two sectors which account for this rise
were household debt and internal financial-sector debt. Household debt rose
from 50 per cent of gdp in 1980 to 100 per cent of
gdp in 2007. But the really dramatic rise in
indebtedness occurred within the financial sector itself: from 21 per cent of gdp in 1980 to 83 per cent in 2000 and 116 per cent in
2007. [37]
iv.
implications
The ideological effects of the crisis will be significant, though of course
far less significant than imagined by those who believe financial regimes are
the product of intellectual paradigms rather than power relations. Yet the cant
dished out in the past by the us Treasury and imf is over. American-style financial-system models are
now grasped as being dangerous. No less risky is the eu
banking and financial-system framework, which the crisis has shown to be a
house of cards, even if still standing at the time of writing. The eu’s guiding notion is that banking systems are secured
by good rules rather than by authoritative states with tax-raising powers. This
has been shown to be a dangerous joke. The whole eu–emu project has encouraged banks to grow too big for
their national states to save them, while offering no alternative at eu or even Eurozone level. Absurdly, the Single Market
and Competition rules in the financial sector insist on free competition
between banks at all costs, and proscribe any state aid for them; while if the
stability criteria were respected, any full-blown credit crisis would
necessarily be transformed into a 1930s-style depression. Obviously these rules
are for the birds, yet they are simultaneously the principal planks of the eu political economy. [38]
This crisis of the American and European set-ups will no doubt have two
intellectual effects. Firstly, to raise the credibility of the Chinese model of
a state-owned, bank-centred financial system. This is the serious alternative
to the credit models of the Atlantic world. The maintenance of capital controls
and a non-convertible currency—which China has—are essential for the security
of this system. Secondly, as the crisis unfolds, broader discussion of the
public-utility model seems likely to return to political life, re-opening a
debate that has been silenced since 1991.
Some predict much more sweeping short-term changes, such as the replacement
of the dollar as the global currency or the collapse of Western leadership
institutions within the world economy. A complete debauching of the dollar by
the Obama Administration could, perhaps, lead to a stampede to dump it
globally, along with a retreat into regional or narrow imperial trading blocs. [39]
But no less likely could be a temporary strengthening of the use of the dollar
over the next decade: a long stagnation in the us
may well be combined with very low interest rates and a low dollar. This could
produce a new dollar carry trade, in which everybody borrows in dollars to take
them across the exchanges into higher value assets. This would produce a strong
trend towards a decoupling of other exchange rates from the dollar, but it
would not necessarily undermine the central element in dollar dominance: the
readiness of other states to accept payments for their goods and credits in
greenbacks.
We are also likely to see the intensification of the two basic structural
trends in long-term credit-debt relations in the world economy. First, the
creditor relations between the Atlantic world and its traditional South in
Latin America, Africa and elsewhere, historically policed by the imf. This relationship weakened over the last decade but
is likely to be re-inforced in the present crisis. Second, the contrary debtor
relations between the United States and the East Asian New Growth Centre
economies, which are also likely to deepen and tighten, particularly between
China and the us. This is a power relationship in
which China (and other creditors) can exercise real political leverage over
Washington. We have seen this operating in both the timing and the form of the
renationalization of Fannie Mae and Freddie Mac. [40]
We will see it again as the us Treasury seeks
buyers of its large new tranches of debt in 2009. The East Asian economies,
above all China, will likely become ever more critical to global macro-economic
trends, while the erstwhile centrality of the us
will weaken during its long stagnation. The strengthened financial clout of
China and other East Asian states could impinge upon the old imperial
credit-debt relationships between the Atlantic world and the South, by offering
the latter alternative sources of financial support. This threat is already
prompting warnings in the Atlantic world for Washington to soften the predatory
conditions it has traditionally imposed on Africa, Latin America and elsewhere. [41]
But whether this will mean that East Asia will start to build new market
institutional arrangements for the world economy, challenging those of the
Anglo-American world, remains unclear, for two reasons: first, the internal
divisions within East Asia; and second, the question of China’s strategic
priorities at the present time. Thus, East Asia has an obvious rational
collective interest in building its own, centralized commodity and oil markets
and promoting them to world leadership, ending the dominance of London and
Chicago. Such new market frameworks have sprung up, but they are divided: one
in Hong Kong, one in Japan and one in Singapore. As for China, it is currently
overwhelmingly concentrated on maintaining domestic growth and carrying through
the leap of dynamic capital accumulation from the coast to the interior. At
present, it is showing not the slightest interest in challenging the Americans
for leadership in shaping the institutions of the world economy. Thus the us has some breathing space. But such is the social and
political strength of Wall Street, and the weakness of social forces that might
push for an industrial revival there, that it would seem most likely that the
American capitalist class will squander its chance. If so, it will enjoy
another round of debt-fed gdp growth funded by
China and others while the us becomes ever less
central to the world economy, ever less able to shape its rules and
increasingly caught in long-term debt subordination to the East Asian credit
matrix.
[1] Leslie Crawford and Gillian Tett, ‘Spain spared because
it learnt lesson the hard way’, Financial Times, 5 February 2008.
[2] The total debt owed by financial and non-financial
private sectors in the us in 2008 has been
calculated at $48 trillion. George Magnus, ‘Important to curb destructive power
of deleveraging’, ft, 30 September 2008.
[3] David Patterson, ‘Central Banks must find or become
buyers of system risk’, ft, 5 February
2008.
[4] For a useful survey of why most economists were
completely incapable of grasping the crisis, see Chris Giles, ‘The Vision
Thing’, ft, 26 November 2008.
[5] Javier Blas, ‘Commodities have proved a saving grace for
investors’, ft, 6 March 2008; Chris Flood,
‘Speculators give a stir to coffee and cocoa prices’ ft,
5 February 2008. That these financial operators were able to build and burst
such bubbles derived, of course, from the fact that the markets for oil and
commodities are organized in London, New York and Chicago, with rules made to
match the interests of American and British capital. As Jeff Sprecher, ceo of Intercontinental Exchange (ice),
the London-based market whose rules enabled blowing the oil bubble, explained
to the Financial Times, the market’s organizers could not understand why
members of Congress should want to give up control over this sector by closing ice down. ‘View from the Top’, ft,
6 August 2008.
[6] Lawrence Summers, ‘The pendulum swings towards
regulation’, ft, 27 October 2008. The
figure of 40 per cent actually understates the share of profits accruing to the
financial sector, since these are in part concealed by being transformed into
huge employee bonuses, to reduce headline profits data; one reason for the
bonus system that is often overlooked.
[8] The bread-and-butter of Wall Street investment bank
income had been fixed (cartelized) fees for trading securities on behalf of
clients until 1975, when a change in the law limited such fees. At the start of
the 1980s, this fee income was still greater for the investment banks than
profits from trading on their own account. But from the mid-1980s, these banks
plunged seriously into proprietary trading. By the end of the 1990s, trading
income was a third bigger than income from commissions for trading on behalf of
others. And some of the biggest banks earned over half their profits from such
trading. See John Gapper, ‘The last gasp of the broker-dealer’, ft, 16 September 2008.
[9] On Salomon Brothers and the subsequent career of John
Meriwether’s team in the 1990s, when they constructed ltcm
under the sponsorship of Merrill Lynch, see Roger Lowenstein, When Genius
Failed, London 2001.
[10] After the Enron scandal, sivs
and conduits were initially not allowed to engage in active trading on their
own account, but this restriction was soon lifted.
[11] James Mackintosh, ‘Collapse of Lehman leaves prime
broker model in question’, ft, 25 September 2008.
[12] Philip Augar gives a vivid account of how key such
informational centralization from all the main markets was in giving the
investment banks a decisive competitive edge over their smaller or
non-investment banking rivals. See his The Greed Merchants: How the
Investment Banks Played the Free Market Game, London 2006.
[15] Tobias Adrian and Hyun Song Shin, ‘Liquidity and
Leverage’, Staff Report no. 328, Federal Reserve Bank of New York, May 2008.
The term ‘leverage’ refers to the relationship between a bank’s ‘equity’ or
‘capital’ and its assets—the sum that it has lent out. It is usually expressed
as a ratio, so that if we say that Lehman’s leverage at the time of its
collapse was 25, this means that for every one dollar of capital the bank had
25 dollars of assets. But this figure of 25 also means that for every one
dollar of capital, Lehman had 24 dollars worth of borrowings—i.e. liabilities.
[17] The rewards of senior bank executives were often linked
to changing earnings per share. See John Kay, ‘Surplus capital is not for wimps
after all’, ft, 22 October 2008.
[19] Leslie Crawford and Gillian Tett, ‘Spain spared because
it learnt lesson the hard way’, ft, 5 February
2008.
[20] James Mackintosh, ‘Collapse of Lehman leaves prime
broker model in question’, ft, 25 September 2008.
[21] Christina Bannier and Dennis Hänsel, ‘Determinants of
European Banks’ Engagement in Loan Securitization’, Deutsche Bundesbank
Discussion Paper Series 2: Banking and Financial Studies no. 10/2008.
[22] Gretchen Morgenson, ‘Behind crisis at aig, a fragile web of risks. Tiny London unit set
decline in motion’, International Herald Tribune, 29 September 2008.
[23] Stephen Labaton, ‘How sec
opened path for storm in 55 minutes’, International Herald Tribune, 4/5
October 2008. In a classic manoeuvre, this was dressed up as a turn by the sec towards more regulation of the investment
banks. From a formal point of view this was right: the sec
acquired regulatory jurisdiction over them; but it simultaneously removed basic
capital-base restrictions. Furthermore, from 2004 onwards the sec had seven staff to supervise the big five investment
banks, which had combined assets of over $4 trillion by 2007.
[24] The annual tennis tournament in Wimbledon is widely
considered, at least in the uk, to be the greatest
in the world; yet for decades there has been no British finalist.
[25] There are some very large British commercial banks, but
these should be distinguished from the City of London because, while some have
participated heavily in the New Wall Street System, others such as the Hongkong
and Shanghai Banking Corporation (hsbc), by some
measures the largest bank in the world, and the Standard Chartered Bank, have
been heavily focused on activities in East Asia.
[27] Roger Lowenstein, Origins of the Crash, New York
2004, pp. 24–5. This expansion of bank funding for speculative trading through
the transformation of the ‘wholesale’ markets intersected, of course, with the
ending of capital controls, enabling the growth of international wholesale
borrowing by banks and the rise of ‘carry trade’ operations, such as that based
on the yen: banks borrowing in yen, at 0.5 per cent or less, and taking the
funds into the Icelandic krona, at 18 per cent. The funding of British
commercial banks, overwhelmingly domestic at the start of the 1990s, had become
largely based on overseas wholesale lending, to the tune of about £650bn, by
2007.
[29] For a useful mainstream (and apologetic) account of the
risks involved in cdos and over-the-counter
derivatives like cdss, see the imf publication by Garry Schinasi, Safeguarding
Financial Stability: Theory and Practice, Washington, dc 2006.
[30] There were tensions between Wall Street and New York
state regulator Eliot Spitzer after the dot.com bubble burst, but this simply
highlighted how strong was the consensus at a higher level.
[31] References to these kinds of debates can be found in
Andrew Baker et al., Governing Financial Globalization, London 2005.
[32] See Greenspan, ‘We will never have a perfect model of
risk’; Alan Beattie and James Politi, ‘Greenspan admits he made a mistake’, ft, 24 October 2008.
[33] Cited in John Cassidy, ‘Anatomy of a Meltdown: Ben
Bernanke and the Financial Crisis’, New Yorker, 1 December 2008.
[35] This is not to say that American industrial production
disappeared: it remained large, notably in the defence-budget related sector as
well as in cars, aerospace, ict and
pharmaceuticals.
[36] A series of changes in us
national accounting rules from 1995 onwards exaggerated both growth and
productivity figures. Notable here was the use of so-called ‘hedonic
indicators’.
[37] Martin Wolf, ‘Why Paulson’s Plan was not a true solution
to the crisis’, ft, 24 September 2008.
[38] In addition, Western eu
states made an unstated but real precondition for Eastern enlargement that the
new entrants hand over the bulk of their commercial banks to their Western
counterparts; a remarkable imperial move. These Western banks will now wish to
starve the Eastern eu members of credit, as they
seek every trick to deleverage and survive. Will the eu
political authorities intervene in the market to block this? If so, how?
[39] A trend in this direction is evident in the us decision to give special treatment to Mexico, Brazil,
Singapore and South Korea in terms of dollar-funding support.
[40] The Financial Times reported that us Treasury Secretary Paulson confronted the fact that
‘the Bank of China had cut its exposure to agency debt over the summer’ and
thus: ‘found himself with a fait accompli. The federal government had to
give reassurance to foreign investors in agency debt if it wanted to avoid
chaos in financial markets and a run on the dollar. It smacks of debt crises
past in Latin American countries, where the ultimate pressure for a bail-out
came from foreign investors.’ John Gapper, ‘A us
government bail-out of foreign investors’, ft, 8
September 2008.
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