FROM CLAIMS ON PROFIT TO CLAIMS ON CLAIMS
Commercial banks seem literally to have been given a licence to print money, through their ability to create money in the process of lending it, and to lend it at higher interest rates than they borrow. But such lending remains a risky source of profit, if those they lend to don’t pay back. And because they can only lend if a household or business wants to borrow, it’s a highly cyclical source of profit, rising and falling with the scale of investment activity. So from the start, commercial bankers have sought to do more with the money they create – and the additional funds they take in from depositors – than just lend it to prospective borrowers. They’ve eyed the lucrative world of financial markets – dealing in shares and bonds, on behalf of clients and on their own account – as an additional source of profit. That’s why the Glass–Steagall Act and its counterparts elsewhere, forcing banks to choose between taking customer deposits or playing the markets, was so unpopular in banking circles, and why they celebrated its repeal at the turn of the twenty-first century.
The move into investment banking was made more attractive by other aspects of financial deregulation. It enabled investment banks to poach some of the commercial banks’ most profitable clients: large businesses which could finance investment by issuing bonds rather than taking bank loans, and high-net-worth individuals seeking private wealth management. And it opened up a range of new financial markets for investment banks to gamble on, trading instruments which had long been known about but which past regulations had effectively banned.
Two classes of financial instrument in particular were made available to investors by deregulation from the 1970s onwards, and were central to the subsequent massive growth in financial transactions and profitability. These were derivatives, contracts on the future delivery of a financial instrument or commodity which allowed investors to make bets on their price movement; and securitizations, bundles of income-yielding instruments that turned these into tradable securities (and enabled their inclusion in derivative contracts). Commercial banks made a particular breakthrough in the early 2000s when they began to ‘securitize’ past lending to finance new lending. Home mortgages were the initial focus, enabling banks like the UK’s Northern Rock to grow their loans at unprecedented speed, and win political praise for making these loans available to households previously dismissed as too poor to borrow. After the 2008 financial crash – triggered in part by debt securitizations rendered worthless by default on the underlying mortgages – attention turned to securitizing other forms of obligation, among them ‘personal contract plans’ and other car loans, student loans and residential rents.
Political leaders and financial experts praised financial markets for helping goods and services markets to work more efficiently and grease the wheels of capitalism. In his ‘The Great Moderation’ speech in 2004, Ben Bernanke, who later became the Chairman of the US Federal Reserve, said: ‘The increased depth and sophistication of financial markets, deregulation in many industries, the shift away from manufacturing toward services, and increased openness to trade and international capital flows are other examples of structural changes that may have increased macroeconomic flexibility and stability.’35 Spectacular growth in the volume of derivatives – which can be traded even if the underlying assets were never delivered or deliverable – was viewed as helping to reduce systemic risks and ‘get prices right’. The often enormous profits were dressed up as fulfilling the worthy social objective of spreading and managing risk so that the previously unbankable and uncreditworthy could be brought in from the cold and sold products – especially homes – that the more affluent took for granted.
As we saw in Chapter 3, banks mark up borrowers’ interest rates as an indication of value added (FISIM): an obvious example of fictitious financial value. But this is only the tip of the iceberg. Today, leading investment banks like Goldman Sachs and J. P. Morgan don’t attribute their employees’ vast salaries to success in ordinary borrowing and lending. The great bulk of these banks’ profits comes from activities such as underwriting the initial public offerings (IPOs) of corporate bonds and shares, financing mergers and acquisitions, writing futures and options contracts that take over risk from non-financial businesses, and trading in these and other financial instruments for capital gain.
The subtle yet fundamental change in the way that the banking sector’s productivity has been redefined over the last two decades or so has corresponded with its increasing capture of the economy’s surplus. The massive and disproportionate growth of the financial sector (and with it the origins of the global financial crisis) can be traced back to the early 2000s, when banks began increasingly to lend to other financial institutions via wholesale markets, making loans not matched by deposits. In the UK the ‘customer funding gap’ between loans advanced and deposits from households (traditionally viewed as the most stable form of bank financing) widened from zero in 2001 to more than £900 billion ($1,300 billion) in 2008, before the crisis cut it to less than £300 billion in 2011.36 Banks and other lenders found that wholesale funds could be raised much more cheaply than deposits from retail or business customers, especially by using their customers’ existing loans, such as mortgages, as security for more borrowing. These lenders benefited from a seemingly virtuous circle in which additional lending raised financial asset prices, which strengthened their balance sheets, giving them the scope to borrow and lend more within existing minimum capital ratios, the amount of capital banks had to retain relative to their lending.
As well as lending more to one another and to retail clients, over the past three decades banks began to target their loans at riskier prospects offering higher rates of return. This is the part of the story that most people now understand, having been well covered in the media and popular culture, in books and films such as Inside Job, Margin Call and The Big Short. Banks felt they needed to take more risks because, with governments trying to balance budgets and reduce public borrowing requirements, the yields on low-risk assets (such as US and European government debt) had fallen very low. Banks also believed that they had become much better at handling risk: by configuring the right portfolio, insuring themselves against it (especially through credit default swaps – CDSs – that would pay out if a borrower didn’t pay back), or selling it on to other investors with a greater risk appetite. Investment banks lent to hedge funds and private equity firms and developed and traded exotic instruments based on assets like subprime mortgages, because the returns were higher than lending to industry or government.
When channelling short-term deposits into long-term loans, banks traditionally took a risk – especially when the loans went to borrowers who would need a windfall gain (a business that took off, a house price that rose) to pay back their loans. Ostensibly, that risk disappeared in the 1990s and early 2000s, when securitization turned a bundle of subprime mortgages or other loans into a bond with a prime (even triple-A) credit rating in the shape of a mortgage-backed security (MBS).
Securitization can and does play a valuable role in diversifying risk and increasing liquidity in the financial system. In 2006 Alan Greenspan, then Chairman of the US Federal Reserve, and Tim Geithner, the former President of the Federal Reserve Bank of New York, claimed that derivatives were a stabilizing factor because they spread the risk among the financial institutions best equipped to deal with it.37 Greenspan had, a decade before the crisis struck, vetoed a proposal to regulate over-the-counter (OTC) derivatives, claiming that on the contrary ‘the fact that OTC markets function so effectively without the benefits of the Commodity Exchange Act [CEA] provides a strong argument for development of a less burdensome regulatory regime for financial derivatives traded on futures exchanges’. Passed in 1936, the CEA requires all futures contracts for physical commodities to be traded on an organized exchange. As was spectacularly shown in 2008, derivatives’ capacity to transfer and defray risk really exists only at the individual level. At the aggregate level, the individual risk
is merely transferred to other intermediaries in the form of counter-party risk. Its disappearance from the balance sheets of the original holders, and the frequent lack of clarity about who has taken it over, makes the market situation even more precarious.38
Securitization was also abused, sometimes in ways that bordered on fraudulence, and that abuse certainly influenced regulators in the years following the financial crisis. The transformation of relatively low-quality loans into triple-A-rated securities occurred largely because credit-rating agencies routinely gave high valuations to securitizations of low-grade debt, underestimating the likelihood of default, especially on residential mortgages. To be doubly sure that their high returns were sheltered from a comparably high risk, banks ‘transferred’ their risk by assigning the securitized debt to ‘special purpose vehicles’ (SPVs), whose liabilities did not show up on the banks’ own balance sheets. When lower-income borrowers began struggling to repay their debts after 2005, the securitized bonds turned out to be much less safe than their triple-A rating suggested, and the SPVs bounced back onto the banks’ balance sheets. The golden combination of high return and low risk turned out to be a statistical illusion, but one that national accounting had promoted just as enthusiastically as had banks’ pre-2008 corporate accounts.
A DEBT IN THE FAMILY
Since the 1970s, the growing inequality of wealth and income has profoundly shaped the way in which finance has developed. The growth of finance has also fed the growth of inequality, not least by adding to the influence and lobbying power of financiers who tend to favour reduction of taxes and social expenditures, and promoting the financial-market volatility that boosts the fortunes of those who serially buy low and sell high.
Following deregulation, the enormous increase in finance available to households was the main reason for the rise in banks’ profits. Commercial banks profited from direct loans for anything from cars to homes to holidays, and from credit cards. Investment banks made money by securitizing commercial-bank ‘products’ and trading the derivatives they ‘manufactured’. Legislators allowed financial intermediaries to regulate themselves, or imposed only minimal regulation because their operations were too complex to be understood. Markets (following the marginalists) were considered to be ‘efficient’ – healthy competition would deter financial intermediaries from reckless behaviour.
As previously prudent banks bombarded customers with offers of credit – the age of tempting credit card promotions dropping almost daily through millions of letter boxes had arrived – household borrowing began to rise inexorably. Across the financial sector more broadly, the relaxation of controls on mortgage lending became another source of profit and also fuelled the increased household borrowing. Whereas in the 1970s mortgages had been rationed in the UK, by the early 2000s house buyers could borrow 100 per cent or even more of the value of a property. By 2016, total cumulative household borrowing in the UK had reached £1.5 trillion – about 83 per cent of national output, and equivalent to nearly £30,000 for each adult in the land – well above average earnings.39
Governments rejoiced when banks offered mortgages to low-paid, marginally employed home buyers on the assumption that their debt could be ‘securitized’ and quickly resold to other investors. It seemed less a reckless gamble and more a social innovation, helping to broaden property ownership and boosting the ‘property-owning democracy’, while increasing the flow of income to an already buoyant investor class. Greater revenue from financial-sector incomes and associated high-end purchases even pushed the US and UK government budgets into rare surpluses around the turn of the twenty-first century.40
Loosening the availability of credit to sustain consumption is not in itself a bad thing. But there are dangers. One is cost. It seemed to make sense to relax controls on lending when interest rates were low or falling. It makes less sense if borrowers, lulled into a sense of false security, are caught out when interest rates rise. Another fundamental danger is the tendency of the system to overexpand: for credit to become too readily available, as the Bank for International Settlements has recently recognized.41 The system is stable when the growth in debt is matched by the growth in the value of assets whose purchase is financed by that debt. As soon as people begin to have doubts about the assets’ value, however, the cracks appear. That is what happened when US property prices collapsed after the crash of 2008. Home owners may find themselves in negative equity and even have their property repossessed, although not before lenders have extracted rent in interest and loan repayments. But banks can always choose to provide other services than loans. When uncertainty about the future is high, they can even decide to hoard cash rather than invest it – often a sound decision, as high interest rates are associated with a high risk of not obtaining enough for the investment.
The rise in private debt in the US and UK has resulted in household savings falling as a percentage of disposable income – income minus taxes – especially in periods of sustained economic growth (during the 1980s, the late 1990s and the beginning of the 2000s). Simultaneously, household consumption expenditure has been buoyant. It has outpaced any rise in disposable income, and its contribution to GDP has grown.42
Income inequality has been on the rise in most advanced economies, especially in the US and in the UK, over the past four decades. Increasing inequality in the US has taken three complementary forms.43 First, real wages have fallen or stagnated for many low- and middle-income households. For instance, OECD data on the US economy indicate that the annual real minimum wage (in 2015 US dollars) fell from $19,237 in 1975 to $13,000 in 2005 (in 2016 it was $14,892). Second, in almost every OECD country wage shares have declined by several percentage points in favour of rising profit shares, even when real employee compensation has gone up.44 As Figure 9 below shows, this was the result of average productivity growth rising faster than average or median real-wage growth in many countries, especially in the US.
Third, personal distribution of income and wealth has become more and more unequal. In both the US and the UK, and in many other OECD countries, those with the highest incomes have enjoyed an increasing share of total national income ever since the 1970s, as can been seen in Figure 10. Furthermore, income distribution is extremely skewed towards very high incomes, not just the top 10 per cent and 1 per cent, but especially the top 0.1 per cent.45 Wealth distribution reveals a similar pattern. A 2017 Oxfam report, An Economy for the 99%, found that in 2016 eight men own the same wealth as the poorest half of the world’s population. In a report published a year earlier, An Economy for the 1%, Oxfam calculated that the club of the wealthiest 1 per cent of individuals globally shrank from 388 members in 2010 to just sixty-two in 2015; in other words, the very richest were getting even richer relative to others who were also by any sensible standard very rich. The wealth of the sixty-two very richest individuals increased by 45 per cent in the five years to 2015, a jump of more than half a trillion dollars in total. Over the same period, the wealth of the bottom half fell by just over a trillion dollars – a drop of 38 per cent.48
Figure 9. Labour productivity and wages in the US since 1974 (left) and the UK since 1972 (right)46
Figure 10. Income inequality in the US and the UK, 1960–201047
The upshot of growing inequality of income and wealth was that, to maintain the living standards they had enjoyed from the Second World War to the 1980s, workers had to shoulder an increasing debt burden from the 1980s onwards. Looking at the broader economic picture, without growing household debt, demand might have been weaker and sales by businesses lower. Finance bridged the gap, in the form of new forms of credit whose resultant interest flows and charges underpinned the sector’s expansion.
As a result, private debt, and particularly household debt, increased substantially as a percentage of disposable income. Figure 11 below shows that total household debt as a percentage of net disposable income grew by 42 per cent in the US and by 53 per cent in the UK from 1995 to 2005.
Figur
e 11. Household debt and income in the US and the UK, 1995–200549
In the US, mortgage loans were a principal cause of rising household indebtedness (Figure 12), partially a reflection of households’ propensity to extract equity from the rising value of their houses.50
In 2007, the US Congressional Budget Office lent weight to the argument that the increased value of real estate represented a typical ‘wealth effect’: the assumption that as people’s assets such as their houses go up in value, they are psychologically more disposed to spend. The rise in US real-estate prices translated into higher rates of mortgage-equity withdrawal and ultimately boosted consumer spending.51
The Survey of Consumer Finances produced by the US Federal Reserve shows that the poorer a family is, the more heavily indebted it is likely to be. Using data for the 2004 (pre-crisis) period, Figure 13 is based on all families whose ratio of debt payments relative to their disposable income is greater than 40 per cent. The families are broken down into groups according to their income bands (measured as percentiles) and levels of indebtedness. In the group with the lowest income, the poorest 20 per cent of the income distribution, 27 per cent of families were ‘heavily indebted’. Among the richest 10 per cent, it was only 1.8 per cent. This means that poorer families were much more indebted than richer ones in relative terms. The stagnation or outright decline in real incomes of the poorest group forced them to borrow to finance current consumption.
Figure 12. Household debt as a percentage of disposable personal income52
Figure 13. Indebtedness and family income (2004)53
Sustaining economic growth through household borrowing has been aptly defined as ‘privatized Keynesianism’,54 because ‘instead of governments taking on debt to stimulate the economy, individuals did so’.55 But it was an unsustainable solution to the lack of wage-led demand growth. Aided and abetted by government policy, central banks, instead of being the lenders of last resort, became the lenders of first resort to the financial sector, cutting interest rates to avert financial crises. But this policy drove up the price of assets such as shares and houses and further encouraged households to borrow. The result was that households were enrolled in an indirect – if not in fact ‘private’ – management of effective demand, through highly financialized consumption that left many ever more impoverished and indebted.
The Value of Everything (UK) Page 16