by Norman Lowe
(a) The American economic model
The US economic system evolved out of American traditions of freedom and the sanctity of property. The American right-wing attitude was that the law of private property and the freedom from government interference should be supreme. This was why the USA came into existence in the first place; people emigrated to the USA so that they could enjoy that freedom. It followed that the US federal government should interfere with people’s lives as little as possible, its main function being to safeguard national security.
On the question of social welfare – to what extent the state should be responsible for the care of the poor and helpless – attitudes were divided. The right-wing or conservative attitude was based on ‘rugged individualism’ and self-help. Taxation was viewed as an invasion of private property, and government regulations were seen as restraints on freedom and prosperity. The liberal attitude was that ‘rugged individualism’ should be tempered by the idea of a ‘social contract’. This held that the state should provide basic welfare in return for the respect and obedience of its citizens. Hence Roosevelt’s New Deal and Johnson’s Great Society – programmes introduced by Democrat administrations, which included large elements of social reform. For 16 out of the 24 years preceding 2005, the US had Republican governments which favoured the right-wing approach.
Both schools of thought had their supporters and champions in the USA. For example John Rawls, in his book A Theory of Justice (Oxford University Press, 1973), put forward a theory of ‘justice as fairness’. He argued in favour of equality and claimed that it was the duty of government to provide welfare and some redistribution of wealth through taxation. In reply, Robert Nozick, in his book Anarchy, State and Utopia (Harvard University Press, 1974), argued that property rights should be strictly upheld, that there should be minimal government intervention, minimal taxation and minimal welfare and redistribution. Nozick’s theories had a great influence on the New Right and were taken up by the neo-conservative branch of the Republican party. They were seen in action during the Reagan administration (1981–9), and even more so under George W. Bush (2001–9), when both taxes and welfare programmes were reduced. With neo-conservatism in the ascendant in the USA, it was only to be expected that, as the USA assumed the role of world leadership, the same principles would be extended to American international dealings; hence American reluctance to become involved in initiatives to help the Third World – on issues such as debt relief, international trade and global warming. There was no denying that the American economic system in its different variants had achieved remarkable success over the years. However, in the early twenty-first century the New Right approach was clearly faltering (see Section 23.6(d)); many liberal Americans were looking towards the European model as a potentially better way of providing a just economic and social order.
(b) The European economic model
The economic and social systems of western, democratic Europe, which took shape after the Second World War, varied from country to country. But they all shared certain basic characteristics – provision of social welfare and public services, particularly education and health, and a reduction in inequality. It was expected that the state would take an active role in regulating business and society and in operating a tax system that redistributed income more fairly and provided the revenue to finance education and healthcare. There was also the assumption that big business had a part in the social contract – it had responsibilities to society and so must function in a socially acceptable way, looking after its employees, paying fair wages and taking care of the environment. Whereas in the USA the interests of shareholders were paramount, in most parts of Europe the perception was that the interests of the entire business must come first; dividends were kept relatively low so that high investment was not neglected. Trade unions were stronger than in the USA, but on the whole they operated responsibly. This system produced highly successful companies and relatively fair and just societies.
Outstanding examples of successful European companies include the German car and truck manufacturer Volkswagen: some 20 per cent of the company’s shares are owned by the state government of Lower Saxony, shareholders’ voting rights are limited to 20 per cent and the company pays only 16 per cent of its profits as dividends – none of which would be allowed to happen in the USA. Michelin, the French tyre manufacturer, and the Finnish company Nokia, the world’s largest manufacturer of mobile phones, are high-performance organizations run on similar lines to Volkswagen. Another European success story is the joint German, French and British Airbus, which can claim to be the world’s most successful aircraft manufacturer, surpassing even the USA’s Boeing company. Western European states have generous welfare systems financed by a combination of taxation and social security contributions, and a high standard of public health and education. Even in Italy, Spain, Greece and Portugal, with their history of fascism and military dictatorships, the social contract exists, and unemployment insurance is the highest in Europe.
Many American analysts were critical of the European system, since during the 1990s unemployment rose in Europe, while the USA enjoyed an economic boom. The Americans claimed that European problems were caused by high taxation, over-generous welfare systems, the activities of trade unions and too much regulation. Europeans blamed their difficulties on the need to keep inflation under control so that they would be able to join the single currency launched in 1999. Europeans were confident that once that hurdle had been surmounted, economic growth and job creation would recover. European confidence in their system received a boost during the Bush administration, when it was observed that all was not well with the US economy.
(c) The American system in action
Even during the Clinton administration, the USA extended its economic principles into its global dealings. American interests usually came first, so much so that many people complained that globalization meant Americanization. Some examples were:
During the 1990s the USA gained control of the International Monetary Fund (IMF), which meant that the Americans could decide which countries should receive aid, and could insist that governments adopted policies of which the USA approved. This happened to many Latin American countries as well as Korea, Indonesia and Thailand. Often the conditions imposed made recovery harder instead of easier. In 1995, when the World Bank suggested that debt relief was vital for some poor countries, it met stiff opposition from the USA, and its chief economist felt compelled to resign. Basically these developments meant that the USA could control the world’s financial system.
In 1994 the USA used the General Agreement on Tariffs and Trade (GATT) to force the EU to open all its voice communications (post, telephone and telegraphs) to international competition. In 1997 the World Trade Organization (WTO), which succeeded GATT in 1995, agreed that 70 countries should be opened up to US telecoms companies on American terms. By 2002 there were 180 commercial satellites orbiting in space, and 174 of them were American. The USA all but controlled the world’s communications systems. It was to counter this that the EU insisted on launching its own Galileo space satellite system (see Section 10.8(d)).
In March 2002 the Bush administration imposed import duties on foreign steel in order to protect the American steel industry. This brought bitter protests from the EU, since the function of the WTO was to encourage free trade. The USA resisted the pressure until December 2003; then, faced with threats of retaliatory duties on a wide range of American goods, President Bush cancelled the steel tariffs. In the same month, however, the US announced new tariffs on imports of textiles and television sets from China.
In 2003 there was one positive step which benefited poorer countries: responding to worldwide protests from states suffering the worst ravages of HIV/AIDS, President Bush agreed that the patents controlling the necessary drugs should be overridden, allowing far cheaper versions to be produced for sale in the worst affected states. There was an ulterior motive, however: in return, the Americans were hoping
to gain access to African oil and to set up military bases in strategic parts of the continent.
There was a long way to go before globalization produced a fair and just world in which wealth was more evenly distributed. Some observers believed that the way forward was in a reinvigorated and strengthened UN; others saw the newly enlarged EU as the best hope. The participation of the USA – the world’s richest nation – was still thought to be vital. As Will Hutton put it: ‘We badly need the better America back – the liberal, outward-looking and generous US that won World War II and constructed a liberal world order that in many respects has sustained us to this day.’ South African president Thabo Mbeki summed up the world situation admirably in July 2003 when he wrote: ‘The progressive politicians must demonstrate whether they have the courage to define themselves as progressive, recovering their historic character as champions of the poor, and break the icy ideological grip of right-wing politics. The African masses are watching and waiting.’ Sadly, what happened next can hardly have been more disappointing for them. The participation of the USA was still very much in evidence, but not quite in the way the commentators hoped for.
27.7 CAPITALISM IN CRISIS
(a) Meltdown – the Great Crash of 2008
On 15 June 2007 Ben S. Bernanke, chairman of the American Federal Reserve Bank, made a long speech in which he extolled the virtues of the American financial system:
In the United States, a deep and liquid financial system has promoted growth by effectively allocating capital, and has increased economic resilience by increasing our ability to share and diversify risks both domestically and globally.
There was, he said, no possibility of a financial crisis in America. Yet, little over a year later the American system and the whole global economy seemed to be on the verge of total collapse. In fact some experts had been predicting collapse for some years, but had been proved wrong. However, in March 2008 the unthinkable happened – it was revealed that one of the oldest and most respected Wall Street investment banks, Bear Stearns, was in serious trouble. It had lost $1.6 billion when some affiliated hedge funds collapsed, but much worse, it had a problem with bad debts estimated at $220 billion. Reluctantly, US treasury secretary, Henry Paulson, decided that Bear Stearns could not be allowed to collapse, since that might inconvenience or even ruin many of the rich citizens who had entrusted their wealth to the bank. There was a rule that the US government should never bail out an investment bank, so it was arranged that another bank, J. P. Morgan, should be provided with Federal Reserve funds to enable it to take over Bear Stearns. This indirect Federal Reserve bailout of Bear Stearns saved the system from collapsing. Unfortunately, it also left the impression that any other bank that got itself into difficulties would always be able to rely on a government bailout. In financial circles this was described as ‘moral hazard’ – the idea that there are some investors who believe that they are ‘too big to fail’, and who therefore take reckless risks.
The fourth largest bank on Wall Street, Lehman Brothers, had been struggling for over a year with problems of bad debts and a shortage of capital. In August 2008 it too was on the verge of bankruptcy and no other bank was willing to bail it out. In September its European branch based in London was put into administration, but there was wide expectation in the USA that the government would come to the rescue with a Bear Stearns-type deal. But this time there was to be no bailout – Tim Geithner of the Federal Reserve of New York state announced that there was ‘no political will’ for a Federal rescue. Lehman Brothers was allowed to go bankrupt; it was the largest US company until then ever to go bust. The collapse sent shock waves around the world, and share prices plummeted. Why was Lehman Brothers allowed to collapse? Government and state financial bosses like Paulson and Geithner were determined that there should be no such thing as ‘moral hazard’ – state takeovers should not become a habit, because it was seen as state capitalism. In a country that almost worshipped free-market capitalism, the idea that private companies and banks should be subsidized or taken over by the government was sacrilege. One leading financier remarked: ‘I just think it is disgusting; this is not American.’
Unfortunately, the crisis worsened rapidly and the government found it impossible to maintain its free-market stance. Another struggling investment bank, Merrill Lynch, was taken over by the Bank of America (BOA). Then came the biggest sensation so far: a giant insurance company, American International Group (AIG), asked the government for a loan of $40 billion to stave off bankruptcy. Like the failing investment banks, AIG had too many bad or ‘toxic’ debts, as they were now being called. The government was in a dilemma: AIG was so big and had done so much business with most of the major financial institutions worldwide, that if it were allowed to collapse the repercussions would be catastrophic. Consequently it was decided that AIG should be bailed out with a government loan of $85 billion, although the state took an 80 per cent stake in the company. In effect, the US government had nationalized AIG, though the word itself was never used.
The UK banking system was already in trouble before the US crisis began, mainly because the Bank of England was reluctant to pump money into the system and failed to reduce interest rates on borrowing. The UK mortgage bank, Northern Rock, which had been forced to reduce its lending because of its own dependence on short-term borrowing (see below (b)3), collapsed in September 2007. It was eventually nationalized at a cost of some £100 billion. In September 2008 Halifax Bank of Scotland (HBOS) was saved from collapse when it was taken over by Lloyds TSB for £12 billion in a deal arranged by British prime minister Gordon Brown. However, its share price fell rapidly, so that only a few weeks later its value had slumped to £4 billion. This brought Lloyds TSB to its knees as well and it too had to be rescued by the government. Royal Bank of Scotland (RBS) was partly nationalized, so that it became 83 per cent taxpayer-owned. Shares in European banks followed suit; Fortis, the huge Dutch–Belgian bank, lost almost half its value in just a few days and was taken into joint ownership by the two governments. In Germany, France, the Irish Republic and Iceland similar bailouts were taking place. And most of this happened in just a few days in September 2008. The situation was exacerbated by millions of ordinary depositors rushing to withdraw their funds from the banks. Lending between banks had more or less dried up because the inter-bank lending rates (known as LIBOR) were prohibitive.
By the time the crisis passed, the US Treasury had acquired stakes in several more major financial institutions, including Goldman Sachs, Morgan Stanley, J. P. Morgan Chase, and two mortgage underwriters, Freddie Mac and Fannie Mae. The function of these last two institutions was not to provide mortgages directly to house-buyers, but to act as an insurance by underwriting mortgages given by other banks. Much of the help was provided under the Bush administration’s Troubled Asset Relief Program (TARP) and later by the Obama administration’s Public–Private Investment Program. According to an official report in July 2009, TARP had saddled the taxpayers of the USA with a debt of $27.3 trillion. By that time the crisis had developed into a global recession. The whole bailout operation was extremely controversial. President Bush was accused of being un-American and of introducing socialism. To get the TARP approved by Congress it was necessary to attach several conditions: limits on executive pay, a cap on dividends and the right of the government to take stakes in the ailing banks.
(b) What were the causes of the great crash?
Paul Mason, economics editor of the BBC Newsnight programme, sums up the causes of the crisis neatly in his book Meltdown (2010):
If you exalt the money-changers, exhort them to make more money and hail the ascendancy of speculative finance as a ‘golden age’, this is what you get. The responsibility for what happened must lie, as well as with any banker found to have broken the law, with regulators, politicians and the media who failed to hold them up to scrutiny.
He argues that the system known as neo-liberalism that had been in operation for the last quarter of a century was
mainly responsible for the catastrophe. In the words of Sir Keith Joseph, a UK Conservative supporter of the free-market system, neo-liberalism involved ‘the strict and unflinching control of money supply, substantial cuts in tax and public spending and bold incentives and encouragements to the wealth creators’.
Beginning in the last decade of the twentieth century, globalization played an important role, as national economies became interlinked as never before. In the 20 years after 1990 the world’s labour force doubled and with the increase in migration, became global. China and the former Soviet bloc joined the world economy. The greater availability of labour brought a fall in real wages in the leading western economies, including the USA, Japan and Germany. Yet consumption grew, made possible by a massive increase in credit and the heyday of the credit-card era. The credit boom seemed sustainable at first but after 2000 the debts began to run out of control. At the same time capital flowed around as western financiers began to invest abroad more than ever before, and this caused a huge rise in global imbalances. For example, China’s foreign currency reserves grew from $150 billion in 1999 to $2.85 trillion in 2010; but between 1989 and 2007 the US deficit increased from $99 billion to $800 billion. So long as the US housing boom continued, the situation was just about sustainable, but once house prices began to falter, chaos was unleashed as the amount of toxic debts soared. To look at the steps towards meltdown in more detail:
1 The deregulation of the US banking industry in 1999–2000
In November 1999 the US Congress passed an act designed to promote economic growth through competition and freedom. This cancelled the regulation, dating from the Depression of the 1930s, that prevented investment banks from handling the savings and deposits of the general public, and meant that they now had access to far larger funds. Banks were also allowed to act as insurance companies. A year later futures and all other derivatives were exempted from being classified as gambling and all attempts to regulate the derivatives market were declared illegal. Probably the most common type of derivatives are futures; a future is a contract in which you agree to buy something at a future date, but at a price decided on now. The hope is that in the meantime the price will go up, enabling you to sell it again at a profit. The actual contract between the two parties can itself be sold and resold several times before the agreed date. However, there is a risk involved: in the meantime the price might fall, but you still have to pay the agreed price. Another type of derivative develops when observers start betting among themselves on whether the original contract will be fulfilled. The option derivative is similar to a future except that you simply agree the option to buy, rather than actually buying the commodity itself.