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Introduction: The Political Challenges of Hard Times
Terrence Casey
They called it the ‘Great Moderation’. While this specifically referred to a trend of reduced macro-economic volatility among the major advanced economies since the late 1980s, it encapsulated a wider political and economic meaning. It marked the extended period of economic growth from the early 1990s into the 2000s, growth that was attributed to an encouraging combination of free market economic policies at home and globalization abroad. In this view, post-war economic history began with the ‘Long Boom’, 30 years of full employment and unparalleled economic growth. The period also coincided with the widespread adoption of Keynesian macro-economic policies, intended to smooth the business cycle, and the social welfare state, serving to protect vulnerable workers and allowing them to become stable mass consumers. Yet by the late 1960s the model was already showing its contradictions, particularly a ‘spending ratchet’ (Crouch, 2009). Keynes called for the state to spend when the economy was in recession, but democratically elected governments found it difficult to take away the goodies when the boom years returned, as Keynes also advised. This fed into rising spending and higher prices, hindering productivity and profitability. Add in the cost-push of oil prices and the result was the rampant inflation and stagnant growth (‘stagflation’) of the 1970s. Attempts to restore the balance through even more spending only fed the inflationary spiral. Keynesianism was tested and found wanting, offering a political opening for leaders advocating a return to liberal economics; hence the label ‘neoliberalism’.
Both Margaret Thatcher’s Conservatives and Ronald Reagan’s Republicans rejected the verities of the ‘post-war consensus’. Rather than continuing state-centered economic governance, Reagan declared that ‘government was the problem’. The solution was simple: get the state out of the way. Although varied in application across governments, the basic rationale was that by shifting resources out of the government’s control – where political pressures led to economically inefficient decision-making – and into the private sector – where competition and market forces provided appropriate signals – these policies would remove the barriers to (private) investment, spur entrepreneurialism and innovation, and increase the trend growth rate of the economy. The initial shock therapy of extremely tight monetary policy and slashed budgets, intended to combat (as they saw it) the greater evil of inflation, produced sharp recessions in both economies. By the mid 1980s, however, prices were tamed and robust growth returned. Both leaders were rewarded for the economic turnaround with re-election, twice in Thatcher’s case (Reagan, of course, being constitutionally limited to two terms). Boom turned to bust, however, as overheating markets required the reapplication of monetary brakes, producing another recession in the early 1990s. For critics of neoliberalism, this was evidence that the program was a failure, unable to deliver stable growth. Yet the critics were premature, for that very moment saw a confluence of positive trends: the end of the Cold War, which provided not only a fiscal ‘peace dividend’ but the opening up of vast new capitalist markets; the expansion of other major developing markets, especially China and India; the realization of full cost advantages of globalized production; and development of a new wave of information technology, both creating new markets (such as mobile phones) and greatly enhancing productivity in existing industries (such as retail). The result in the 1990s was a heady period of strong economic growth, improved fiscal balances, and relative international stability, for Britain and America at least. To be sure, there were economic crises during this period, most notably in East Asia in 1997 and Russia in 1998. Yet all were contained without major impacts on global growth. In the minds of policymakers these were thus isolated and manageable events in countries on the periphery of the global economy.1 Problems hit home at the end of the decade when the overinflated expectations of new internet-based enterprises led to the ‘dot com bust’. Yet rapid action by the Federal Reserve limited the damage to a relatively short recession. Even with 9/11 and the two wars that followed, both America and Britain continued with strong growth and low unemployment – economic records envied by many of their competitors – into the middle of the 2000s. The Anglophone economies had been buffeted by recession and war, but with flexible financial markets and adroit monetary authorities, the business cycle was tamed. The Great Moderation appeared to be here to stay.
It all came crashing down in 2008, punctuated by one dramatic weekend in mid-September. Economic conditions had started to slip by the end of 2007. The Fed had pursued an expansionary monetary policy for most of the decade which, along with other incentives, fed especially into a booming housing market in the United States. With credit flowing freely and inflationary pressures building up, the Fed began to raise rates. With that the housing bubble began to deflate. Those who had taken out minimum down payment mortgages with high variable interest rates (the so-called ‘subprime mortgages’) now found themselves with huge debt on declining value assets. The economic damage of this might have been contained in the most overheated regional American markets except that these mortgages had been bundled together, securitized, and sold off to other investors all over the world. A dramatic downturn in the US housing market would thus send seismic shocks throughout the global financial system. (The details are examined in Chapters 3 and 4.)
That major financial firms were in crisis was evident in late 2007. Northern Rock first sought emergency cash from the Bank of England in September 2007. Gordon Brown’s government then spent the next four months seeking a private sector buyer for the bank until finally nationalizing Northern Rock in February 2008. In the same month the giant Swiss bank UBS announced $11.3 billion in losses for the fourth quarter, mainly from writing off US mortgages (James, 2009, p. 103). In March 2008 the Federal Reserve provided $29 billion in financing to allow JP Morgan to buy the struggling Bear Stearns, a deal quickly thrown together over a weekend of negotiations. The ‘conservatorship’ (effectively nationalization) of two major government-sponsored mortgage enterprises – Fannie Mae (short for the Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) followed in early September. Throughout the summer Lehman Brothers saw its profits and share value continue to slip. On 10 September they announced a $3.9 billion loss. By the evening of Friday 12 September Secretary of the Treasury Henry Paulson and Federal Reserve Bank of New York President Timothy Geithner called an emergency meeting of the leading financial figures on Wall Street to try and find a buyer for Lehman over that weekend, the same approach taken to deal with Bear Stearns. Both the Bank of America and Barclays emerged as potential buyers. Barclays took the lead, but British regulators raised objections and the British government was not willing to underwrite the sale unless matched by similar action from their US counterparts (James, 2009, p. 112). Whether by choice or by necessity – and this is still a point of controversy2 – no US government money was forthcoming. Lehman Brothers filed for bankruptcy on 15 September 2008.
The news exploded on the markets on that Monday morning and investors, already skittish, went into full-fledged panic. The financial dominoes started to fall quickly. Bank of America bought Merrill Lynch that day. American International Group (AIG) received an $85 billion bailout the following day from the Treasury in exchange for a roughly 80 percent equity stake in the company. Uncertainty fed the contagion. The international financial system was flooded with derivatives and securities sold by these failing institutions, obscuring any estimate of their real value and vastly enhancing the risks of counterparty default. The logical response was to stop lending, producing a ‘credit crunch’ that would be devastating to the real economy if not resolved quickly. Bernanke and Paulson thus sought more comprehensive legal authority to bail out banks for fear that inaction would lead to complete financial collapse and economic depression. The result was a $700 billion proposal to Congress for a Troubled Asset Relief Program (TARP), albeit without any clear guide
lines as to how the program would work,3 submitted on 20 September. The government seemed to be flailing, throwing around hundreds of billions of dollars but offering no clear indication of who would or would not be protected (Taylor, 2009, p. 29). Members of Congress, mainly Republican members in the House of Representatives, balked, expressing concerns with the size of the program, the means of implementation, and fundamentally whether the government should be providing such a massive bailout of the banks, a point which rankled their free market principles and raised problems of moral hazard. Days of tense negotiations followed between Congressional leaders, the White House, and Treasury officials, descending to the tragic-comic incident of Secretary Paulson getting down on one knee and begging Speaker of the House Nancy Pelosi to keep her Democratic members in support of TARP. Faced with the legislation being blocked, President Bush is said to have declared in private, ‘If money isn’t loosened up, this sucker could go down’ (New York Times, online edition, 26 September 2008). Despite the President’s urging, TARP was initially defeated in the House 205–228, with 133 Republicans and 95 Democrats voting against it. The market response was forceful and negative, with the Dow Jones Industrial Average experiencing its largest single-day point drop ever. Fear of economic Armageddon focused Congress’ attention. On 1 October the bill easily passed the Senate and was sent back to the House, where it passed on 3 October with a comfortable majority.4 Armageddon may have been averted, but enormous damage was already done. The ‘Great Moderation’ had collapsed into the ‘Great Recession’.
As would be expected, there has been plenty of finger-pointing in the aftermath of the disaster, and economic Cassandras such as Peter Schiff, Nassim Taleb, and Noriel Roubini now seeming amazingly prescient. Explanations for the crisis have largely broken down along ideological lines. On the one side are those who see this as a failure of markets or, more precisely, the decades of deregulation that allowed the financial system to develop unchecked and devolve into an inherently unstable sort of ‘casino capitalism’ (for example, see Cassidy, 2009; Posner, 2009; Stiglitz, 2010). Banks made increasingly risky bets on an asset bubble and governments stood by and let them do it. When it all went bust, taxpayers were left holding the bill – a system of privatized profits and socialized risk. In counterpoint are scholars who see the crisis manifesting from government policies and regulations that encouraged misguided economic decisions, such as excessively loose monetary policy encouraging subprime lending (see Taylor, 2009; Brooks, 2010; Wallison, 2009; Jablecki and Machaj, 2009; Freidman, 2009). Even the official report of US Financial Crisis Inquiry Commission was reduced to battling opinions from the Democratic and Republican appointed members (FCIC, 2011). Suffice it to say that those who want to boil the crisis down to either ‘too little regulation’ or ‘too much government’ will find the facts wanting. Or, more accurately, there is an element of truth in both arguments. It may provide moral or political comfort to identify a sole culprit, be it greedy bankers, economic theorists, short-sighted politicians, misguided regulators, or irresponsible homeowners. Reality though is closer to the plot of Agatha Christie’s Murder on the Orient Express, where everyone was guilty.
The United States and Britain were the exemplars of the free market revolution that swept the globe at the end of the twenty-first century. The financial crisis was incubated within these economies before infecting global markets. The damage, moreover, was as bad (or worse) in the host economies than in many other states. The Legacy of the Crash explores how the financial crisis of 2008 changed the economics and politics of both the United States and Britain. First and foremost it is important to understand the causes and consequences of the economic crisis. Even to informed observers, the causes of the crash remain uncertain. How did this crisis happen? More precisely, how did a downturn in the US housing market mutate into a crisis that nearly brought down the global financial system? There is certainly no dearth of published narratives as to how this disaster befell us, although as indicated above there is very little consensus on the matter. This is hardly surprising; scholars still argue vehemently over the causes of the Great Depression after all. Terrence Casey (Chapter 3) and David Coates and Kara Dickstein (Chapter 4) offer explanations of the current crisis which, while overlapping in much of their analysis, place different emphases in terms of causation. For Coates and Dickstein, the crisis was more of a systemic problem of the Anglo-American economic model. The neoliberal era saw a marked decline in manufacturing and an increased reliance on financial services as a driver of growth. Yet that growth was founded on the accumulation of private debt, leaving the American and British economies dangerously exposed once the credit crunch hit. Casey’s perspective is that the crisis stemmed from the interaction of economic policy, especially an expansionary monetary policy, and specific financial regulations, coupled with the incentives firms faced to create innovative and hence profitable investment opportunities in integrated and flexible financial markets. That is, a permissive policy and regulatory environment provided the economic space in which private actors then took excessive risks.
The contrast between these arguments highlights a fundamental question: did this crisis result from specific policy failures, or was this a systemic crisis of the neoliberal growth model? The issue is first taken up by Wyn Grant (Chapter 2), who explores the similarities and differences between the British and American political economies. For many scholars, particularly those writing in the ‘varieties of capitalism’ mode (Hall and Soskice, 2001), the US and UK were treated as undifferentiated archetypes of the Anglo-Saxon model. Grant makes clear that while there are many similarities between the two systems, there were always substantial differences, particularly in the prevalence of alternatives. International position, ideological predispositions, and the sclerotic nature of the US policy-making created a political barrier to the adoption of more interventionist economic policies. British policy-makers have long seen the more state-directed continental economies as alternatives to their market-oriented model, a position reinforced by their membership in the European Union. The potential to opt for industrial policies is what he dubs the ‘dirigiste temptation’. Even if done grudgingly, choices made in the immediate aftermath of the crisis seemed to confirm that both Washington and London had given in to temptation. Banks were bailed out or nationalized, controlling stakes were purchased in automakers, and both governments passed substantial stimulus packages in an attempt to kick-start growth. Policies in the interim, however, suggest that this renewed burst of statism may be short-lived. Grant notes that the policies of the Cameron government represent a return to ‘business as usual’ and an implicit acceptance of the continued utility of neoliberal economic governance. That is hardly a surprise; that President Obama’s approach is little different is rather unexpected. This is much by default as by design, as Casey observes in Chapter 3. A fully articulated alternative economic model that has the backing of electorally viable groups has yet to emerge in either country. Despite what for some was incontrovertible evidence that the neoliberal model was inherently flawed, it remains alive and well in both Britain and America.
Regardless of the causes, the depth of the crisis demanded a considerable response, reviewed in detail in Chapters 3–5. Following the triage of the bank bailouts, regulators in both the US and UK had to reconfigure the rules and regulations of the financial system to prevent a future crash. With no consensus on the causes of the crisis, the paths of regulatory reform were and are riddled with partisan barricades. Nevertheless, as epitomized by the Oscar award-winning documentary Inside Job, the image in the popular mind is of a finance industry dominated by greedy rogues who used the misguided analysis of free market academics to convince ideologically-blinded politicians in Washington, themselves backed Wall Street money, to cut the regulatory coils and let them run wild. In this atmosphere the major institutions took out enormous and increasingly risky bets that spectacularly went bust. Being ‘too big to fail’, however, the taxpayer was handed the
bill. One would expect democratic politics to translate this perspective into serious financial market reforms. The details are discussed below, but given the intensity of the crisis, what is most surprising5 is how modest those reforms have been. Both governments have implemented some limits on the type and scale of financial bets that firms can make, created more effective means to deal with troubled banks, and put in place systemic monitoring facilities. Yet financial institutions are even more concentrated than before the crash and the new regulations do not fundamentally prevent markets from developing new and risky financial instruments. The fact that Wall Street and the City of London offered only trifling resistance to these new regulations indicates their confidence that these rules will not hinder their profitability. Market trends seem to have proven them right so far; as Coates and Dickstein record, profitability has already returned to the banking sector as a whole.
The rest of the economy was another matter. Both governments sought to reinvigorate growth by implementing stimulus packages on a scale not seen since the 1970s. London and Washington took different approaches to fiscal stimulus, as Edward Ashbee explores in Chapter 5. The Obama administration passed a much larger package (as a percentage of gross domestic product, GDP) than that pushed by Brown in the UK. There was equally a difference in timing: the British stimulus was largely frontloaded to 2009, whereas the bulk of American spending would not kick in until 2010 or later. Fiscal policies have converged somewhat since then, with a budget-cutting Conservative-led Coalition government in the UK, and more fiscally conservative Republicans winning seats in the 2010 congressional elections. Nevertheless, Ashbee attributes the variations in fiscal response more to the institutional architecture of the two states rather than the ideological preferences of those in power. The more fluid and open nature of policy-making in the US allowed politically well-connected economic interests, particularly in high-tech sectors, to push for greater spending, a difficult strategy in the more cloistered world of Whitehall. The more important question is the impact of these policies. Debates continue to swirl among economists on this point.6 Paul Krugman, for example, argues Obama has been too timid; the stimulus should be much greater and directed at public works projects. Others, especially Robert Barro question the evidence of the ‘multiplier effect’7 that underpins Krugman’s support for Keynesian stimulus (Barro, 2009). Regardless of who has the better of the argument, the key political facts are that the recovery to date has been both modest and insecure while government balances have gone increasingly into the red. Whether or not fiscal policy is sufficient to the scale of the problem is now somewhat beside the point; the political winds are blowing in favor of fiscal retrenchment, not further stimulus. The great challenge for both economies through the rest of the decade is to master the delicate task of getting the books in order without squashing economic revival.8
The Legacy of the Crash Page 2