Hyman Minsky, an American Economist, had written a book titled ‘Can It Happen Again’ with ‘it’ standing for the Great Depression of the 1930s, the biggest and the longest economic crisis in the history of capitalism. The answer to this question today seems to be in the affirmative if one takes a deeper look at the events unfolding in the financial markets in the United States over the past few months, in particular the last few weeks. The collapse of the five biggest investment banks in the US within a span of few days has left the US economy in a lurch with economic pundits in the US describing the present financial crisis as something similar to what happened during the 1930s. What we have seen so far seems to be only the tip of the iceberg as this financial crisis is already having a debilitating impact on the rest of the world too.
In the aftermath of the Great Depression, John Maynard Keynes, a British economist and Michal Kalecki, a Polish economist, had written extensively on its causes as well as its remedies. They argued that it was the absence of direct intervention of the government in the working of the economy in general and financial markets in particular that led to the Great Depression. The remedy that Keynes suggested was a categorical rebuttal of the principles of Laissez faire since he asked not only for a regulation of the financial markets but for a direct government intervention to boost the demand in the economy through positive fiscal stimulus. The fiscal management on the lines of the Keynes-Kalecki produced the Golden Age of capitalism in the 1950s and the 1960s in the advanced capitalist countries which saw the longest period of booms in these countries. However, as the events unfolded with the capitalist world getting engulfed in another crisis in the 1970s, there was a resurrection of the ideology of free market which argued for withdrawal of the state from intervening in the natural process of the economy. The essays here argue that it is this resurgence of the ideology of the Laissez Faire which has produced the economic crisis of today’s magnitude.
To understand the present crisis, we need to analyse the economic booms that the US has witnessed in the present decade and the previous one because the seeds of destruction were laid down precisely during these booms.
There has been a dramatic growth in inequality in the US since the early 1980s. What the US is witnessing today in terms of inequality has only one parallel in its history i.e. the period during the Great Depression (see fig 1). The inequality is such that the top 10 % of the population earns close to 40% of the total income. The inequality has increased in the US since the early 1980s primarily because of two reasons. On the one hand, the income of the poor has got squeezed due to a decline both in the legal minimum wages as well as the unionisation rates. On the other hand, the payrolls of the top executives, especially CEOs, has increased manifold in the absence of either the wage controls of the World War II or the social norms of the Golden Age period which restricted the growth of high-end wages.
The increase in equality is not restricted to income alone but there is a growth in wealth inequality too as shown in Table 1. While the top 1% of the population owned 33.8% of the total wealth of the economy, the bottom 40% of the population owned less than 1% of the total wealth in 1983. The wealth inequality increased by 1995 to such an extent that the top 1% owned close to 40% of the wealth while the bottom 40% owned a mere 0.2%.
|Top 1%||Top 20%||2nd 20%||3rd 20%||Bottom 40%|
|Mean Wealth(in 000, ’95 Dollars)|
A major part of the increase in the wealth of the rich during this period has been through the increase in the stock market prices of the financial assets that they own. Since the ownership of stock market assets itself is very skewed in favour of the rich, an increase in the prices of the shares has an asymmetric effect on the wealth of the rich.
The Boom of the 1990s
From the point of view of classical political economy, such a growth in inequality should have led to stagnation in the economy instead of a boom as witnessed both in the late 90s and the present decade (prior to the current crisis). The argument underlying the negative linkage between growth and inequality can be found even in Marx when he talks about the underconsumption crisis. Josef Steindl, Paul Baran, Paul Sweezy and even Kalecki were the new proponents of this view, according to which, any income distribution in favour of the rich has a negative effect on the overall consumption in the economy because the rich consume less than the poor as a proportion to their respective incomes. Such a decline in the overall consumption of the economy leads to a decline in demand in the economy, which in a demand constrained system, has a negative effect on the growth of the economy.
If that is the case, then why did the growth of inequality lead to an increase in the growth rate in the US in the late 90s and 2000s? The answer to this question lies in the stock market booms that led to a growth in the ‘notional’ wealth of the rich. This notional increase in their wealth had a positive effect on the consumption of the rich, a phenomenon called the ‘wealth effect’. Increase in consumption due to wealth effect was an external injection of demand into the economy independent of the redistribution of income between the rich and the poor. Therefore, the wealth effect had the potential of countering the tendency of underconsumption that existed in the economy. Though the exact effect of an increase in wealth on consumption in the US has been estimated to be not more than 3 cents per dollar i.e. for every dollar increase in wealth there is a 3 cents increase in consumption, the sheer magnitude of the wealth increase due to the stock market boom of the late 1990s was such that it had a huge impact on the overall consumption. The argument can be better understood if we look at the exact increase in the wealth of households which increased by 50 percent within a span of five years between 1995 and 2000. The increase in consumption as a proportion of GDP was close to 1.5 percent during these years. Therefore, this increase in wealth alone explains the increase in consumption of the household during this period.
A more interesting question, however, is not why the consumption increased but how was this consumption financed? To understand that, we need to explain how the increase in the wealth was ‘notional’? It was purely ‘notional’ to the extent that its value had increased due to higher valuation in the stock market so that the increased wealth could not be realised from the stock market by all the stock holders at the same time. Any attempt to ‘realise’ the increased value of the wealth in the stock market by selling the stocks at their higher prices by all the investors at the same time would have meant a collapse in the stock market itself. Thus, the increase in wealth was merely notional. That being the case, any increase in expenditure on consumption based on this increase in wealth had to be financed by taking more debt based on the increased collateral in the form of enhanced value of wealth. It is here that the debt spiral began in the US. During the 1990s, the household debt stood at 95.6 percent of the total disposable income of that sector (see table 2). In other words, the household debt was almost equivalent to the total income of the sector as a whole in the 1990s. Such high levels of debt-income ratio were ominous signs for the US but the Federal Reserve did not pay heed to the dangerous growth in the debt-income ratios, instead they were busy propagating the argument that the US economy had entered a new phase of ‘new economy’ where business cycles were a thing of past.
|S&P 500 real average annual growth rate||4.6||-5.9||8.3||14.5||2.28|
|S&P 500 real growth minus GDP real growth||0.2||-9.2||5.4||11.3||-0.4|
|Total HH Debt/ Disp Pers Income||67.3||67.6||77.2||95.6||130.08|
|Total HH Debt/ Financial assets||17.5||20.5||23.1||22.8||30.32|
|HH bank deposits+govt. sec/Financial assets||23||25.9||26.7||18.8||15.96|
Source: First Four Columns from p.228, Pollin (2005) and last column author’s calculation from the Flow of Funds Accounts of the Fed
Such sleight of hand by the mainstream economics, however, had to face the reality when the economy witnessed the Dotcom bubble go burst in 2001. The business cycle was back as indeed it is a part of the working of any normal capitalist economy, contrary to the claims of the new economy enthusiasts. A decline in the stock market meant a decline in the wealth of the households too and the increased wealth effect was bound to reverse but the debt taken against the increased wealth earlier remained nonetheless.
The Mortgage Boom of the 2000s and the seeds of destruction
In the event of the stock market meltdown in 2000, the financial speculators moved away from the stock market to some other avenues where they could make a quick buck and the best opportunity they found was in the housing market. Such a huge diversion of funds from the Dotcom bubble to the housing market had a positive effect on the housing prices just as it had on the stock prices of the IT sector during the late 90s.
An increase in the housing prices made housing into a profitable venture for the household sector because in common perception it was thought to be a safer asset that the stocks, little was it known that it was merely a shifting of one bubble to another. As happens in the stock market, the increase in buyers of houses led to a further increase in prices of housing much beyond its cost of manufacture.
The policy of the government in the post-2001 phase was multi–pronged to provide a boost to consumption demand (either in consumer durables or expenditure on housing) which had been responsible for the growth in the 1990s. First, there was a major tax cut by George W. Bush announced on June 7, 2001. Bush, in his remarks in Tax Cut Bill Signing Ceremony, argued that the magnitude of the tax cut that his administration was announcing can only be comparable to the Reagan Tax cut of the 80s or the Kennedy Tax cut of the 60s. This tax cut had a definite impact on increasing the consumption of the rich because they were the biggest beneficiary of the Bush Tax Cut. That is why despite the meltdown in the stock market which had driven the consumption during the 90s, consumption of the household did not decline as would be expected based on the wealth effect (after increasing for over two decades, the consumption share after 2001 remained stagnant instead of declining despite the meltdown in the stock market). The declining wealth effect was compensated to an extent by the easing tax effect during this period.
Second, after the stock market crash of 2000, which had its repercussions well into 2002, the Fed was looking for other ways of stimulating consumption demand because that had been the rock–solid basis for growth in the late 90s. In the absence of another equity price bubble, the housing market provided an opportunity of such an alternative. The prices in the real estate market had been increasing since the mid–90s but it was still a sideshow to the stock market boom of the 90s. It was only in the early years of the present decade that they started picking up. The reason for this housing market run was quite obvious. The stock market crash led the investors to look for alternative measures of keeping their money and real estate seemed a good opportunity because its demand was going high so there was always a potential of making capital gains (p.92, Pollin (2005)). A Special Report (2005) of The Economist had the following to say about the magnitude of the housing market boom in the US or perhaps the entire developed world,
[T]he total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries’ combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stock market bubble in the late 1990s (an increase over five years of 80% of GDP) or America’s stock market bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history. [Emphasis added]
The extent of speculation in the housing market can be measured by the ratio of the housing prices to the rental applicable to the houses. This is similar to the Price-equity (P/E) ratio of stocks because the income that can be imputed from owning a house comes from the rental that it would fetch in future. Let us see what happened to this ratio. Weller (2006) presents the data comparing the Housing Price Index to Rental and the CPI (see fig. 2).
While the ratio of HPI to rentals remained stable for more than two decades since 1975 (as shown by the dashed line in fig. 2), there was a sharp increase in it since 2000. This is further corroborated by the fact that in 2004, 23 percent of the homes bought were purely for investment purposes while 13 percent were bought as second homes. ‘Investors [were] prepared to buy houses they [would] rent out at a loss, just because they [thought] prices will keep rising–the very definition of a financial bubble.’ (Report (2005)). In Miami, nearly half of the original buyers resold their apartments in an attempt to make capital gains.
In such a situation of high speculation, the Fed pushed aggressively for an easy monetary policy which meant a drastic decline in the federal funds rate (short term interest rate set by the Fed) even below the rate of inflation resulting in negative real funds rate. The real federal funds rate remained negative from the mid-2002 to early 2006 which meant a real heavy dose of easy money for more than three years. This kind of monetary policy has not been seen in the recent past in the US. The household sector responded very positively to this easy credit policy because the mortgage rates also declined. They increased their expenditure on housing which further increased its prices and the spiral started building up. This was the other bubble building up as Pollin (2005) writes (p.92),
As the upward price momentum continued through the middle of 2002, the Wall Street Journal, among other observers, began warning of the dangers of a housing “market bubble” in which “stretched buyers push mortgages to the limit.”
The “limits” to which the buyers were “pushed” can be estimated by the growth in the Financial Obligation Ratio (FOR) and the Debt Service Ratio (DSR) of the household sector during this period. Debt Service Ratio (DSR) is the ratio of debt payments on outstanding mortgages and consumer debt to the disposable income of the household sector. We also present data of a more inclusive concept of the debt obligation that the household sector holds. This measure is called the Financial Obligation Ratio (FOR) which, apart from the repayment of interest charges on outstanding mortgage and consumer debt, includes the automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments.
Some important conclusions can be drawn about the financial condition of the household sector based on these two ratios. In panel (a) of fig. 3, it clearly shows that both DSR and FOR have been rising since the early to mid–1990s. If we differentiate between the debt payments on account of home mortgages and consumer durables, we get panel (b), which tells us another interesting story behind this debt growth. As expected, for the 1990s, which is characterized by stock market boom, it is the consumer durables debt payments that play a central role in driving the FOR up whereas the home mortgage debt payments were declining for that decade. After 2000, however, when the real estate boom replaced the stock market boom, it is the home mortgage payments which determine the FOR for the households.
The Federal Reserve during this period had its priorities chalked out pretty well which was to give a boost to the housing prices, just as in the 90s, it was most interested in maintaining the stock market boom. This can be seen from the minutes of the Federal Open market Committee (FOMC) meeting of this period. Minutes of the FOMC (2004) meeting held in June say,
The members continued to report a high level of housing demand in numerous parts of the country, with housing construction described as a notably robust sector in many regional economies. The strong performance of the housing industry continued to be attributed in large measure to the lowest mortgage interest rates in several decades. [Emphasis added]
Third, given that the growth of the economy now was driven by the growth in residential investment financed primarily by debt, there was an increasing tendency by the lenders to indulge in predatory lending practices. The norms of lending were broken at will to keep the real estate boom alive and the Fed, despite being aware of the precariousness of the situation, allowed it to happen under its nose just as it did not intervene during the speculative run in the stock market boom of the 90s. Lending norms were twisted in myriad ways, especially in the Sub-prime mortgage market. First, the norm of mortgage was changed for rich borrowers who could use up to 50 percent of their income for their mortgage payment whereas earlier the norm was only 28–32 percent (p.92, Pollin (2005)). Second, new forms of loans were introduced which had no requirement for down payments. As high as 42 percent of the first time borrowers and 25 percent of all borrowers were exempted from making any down payment (Report (2005)). Third, a new form of financing was introduced which was the Adjustable Rate of Mortgage (ARMs), according to which the overall interest payment could be spread over years so that the initial interest payments might seem very low but the debt burden would increase as you go further into future. This was used to sell loans with ‘hidden costs’. Fourth, the borrowers could get up to 105 percent of the buying cost as loan and no documentation of borrower’s income or employment was required (Report (2005)). Fifth, the borrowers were allowed to pay only a part of the interest amount due while their unpaid interest amount and the principal get added as debt, a form of loan which has been termed as ‘negative amortization loans’. One third of the total loans in the US in 2002 were either interest–only loans or negative amortization loans (Report (2005)).
The housing market boom had a logic of its own which was in some ways similar to a stock market boom. Since the housing prices were increasing, it provided a good opportunity to make money at the margin by buying low and selling high, just as in the case of equities. Moreover, increasing prices of houses also increase the net worth of the owners of the houses which further increases their capacity to borrow and hence to speculate even more, which was reflected in people buying more than one house. But since all the buy is financed through debt, it puts the household sector on a knife–edge position. On the one hand, if the prices of the houses declined then the value of their collateral declines and further borrowing becomes less likely. In the worst situation, if the prices fell drastically, even the possibility of repaying the debt by selling the house might itself disappear leading to foreclosures. On the other hand, if the interest rates increase eventually, they would increase the debt burden in future, especially if the loans have been taken under the ARM scheme. In effect, it is the real mortgage rate that matters which is the difference between the nominal mortgage rate and the capital gain through a housing price rise (Weller (2006)).
Even though it was obvious that the housing prices were primarily speculative in nature, Alan Greenspan, the then Chairman of the Federal Reserve, while addressing the Joint Economic Committee on June 9, 2005, had rubbished all claims about the housing boom being a speculative bubble by arguing that,
[T]here can be little doubt that exceptionally low interest rates on ten-year Treasury notes, and hence on home mortgages, have been a major factor in the recent surge of homebuilding and home turnover, and especially in the steep climb in home prices. Although a “bubble” in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels...
Transactions in second homes ... suggest that speculative activity may have had a greater role in generating the recent price increases than it has customarily had in the past.
The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increases in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace.
The U.S. economy has weathered such episodes before without experiencing significant declines in the national average level of home prices. In part, this is explained by an underlying uptrend in home prices...
Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. [Emphasis added]
It would be really surprising to note that the same Greenspan had an altogether different take on the Depression of the 1930s. Greenspan (1966) wrote,
When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage... The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. [Emphasis added]
If we say that ‘the excess credit which the Fed pumped into the economy spilled over into the housing market–triggering a fantastic speculative boom’, then how different would that be from what his argument is? If not, then it sounds puzzling as to why he did not apply his own argument about the Great Depression to the policy of the Fed under his chairmanship. Whitney (2005) writes the following about the policy of the Fed and its former chairman,
Greenspan knows all about “irrational exuberance”; he’s its primary champion. The Fed seduces the public with cheap money, so that credit spending increases and, then, “presto”, millions of Americans slip inexorably into indentured servitude.
Given the delicate balance that the household sector was maintaining vis-à-vis the housing market, it was obvious that any meltdown in these markets would be disastrous not only for the US economy but for the world economy as well. This possibility was further precipitated by the fact that dual pressure fell on the borrowers. On the one hand, the Fed decided to increase the federal fund rate, which increased the interest burdens especially for consumers who had opted for ARMs or negatively amortized loans. On the other hand, decline in housing prices decreased the value of their collateral and thus increased the possibility of bankruptcy which indeed were quite high in this period. This would especially have serious consequences for the US economy, as can be seen today, because 90 percent of the growth witnessed during 2001-05 was due to increased consumption and residential investment of the households.
Till now we have presented a macroeconomic picture of the housing market but it is obvious that such a market has the potential of having an asymmetric effect on households depending on their income category. For the poorer households, the effect of an increase in the real mortgage rate would be more severe than a richer household.
Some broad pattern can be drawn about the different categories of households (see table 3). First, the bottom quintile was not a part of the recent run in the housing market since 2001. The value of home as a proportion of income increases the most for the middle quintile. Second, contrary to the general perception, the main customers of ARMs appear to be the richest households and not the poorer ones. This could be because of the fact that the rich were buying the house only for the purposes of selling it later and were financing it through ARMs. A housing market meltdown would, thus, have an asymmetric effect on these categories depending on their relative exposure to the credit market.
The growth in the US economy in the recent past has entirely been driven by either consumption spending or residential investment. Both of these were driven by asset price inflation of one kind or the other. While consumption was driven by the stock market boom of the 90s, residential investment was driven by the housing price boom. Such a growth path, however, has a few problems as already being witnessed in the US. First, it would require asset price inflation of one or the other kind to sustain the wealth driven growth. Second, it would be a highly volatile growth path because the growth path would be dependent on the vagaries of the stock market or some asset price market. Third, it would invariably force the government to act in the interests of the finance capital because they hold the key to growth in the economy as happened in the bailout package recently endorsed by the US Congress. The monetary as well as fiscal policy would have to be tethered to the developments in the asset price markets.
The current economic crisis that capitalism is faced with is of far greater magnitude than was envisaged even a few months back precisely because of the extent to which the machinations of the globalized finance capital has spread across the world. This is the time to categorically reject the ‘there is no alternative’ (TINA) paradigm of the neo-liberalism and reassert alternative policy prescriptions which would be beneficial to our own people.
FOMC (2004): “Meeting of the Federal Open Market Committee,” Discussion paper, Board of the Governors of the Federal Reserve System.
Greenspan, A. (1966): “Gold and Economic Freedom,” The Objectivist.
Piketty, T., and E. Saez (2003): “Income Inequality in the United States, 1913-1998,” Quarterly Journal of Economics, 118, 1–39.
Pollin, Robert (2005): Contours of Descent: US Economic Fractures and the Landscape of Global Austerity. Verso.
Report (2005): “In Come the Waves: The Global Housing Boom,” The Economist.
Weller, C. E. (2006): “The End of the Great American Housing Boom: What it Means for You, Me and the U.S. Economy,” Discussion paper, Center for American Progress.
Whitney, M. (2005): “Pop Goes the Weasel: Greenspan and the Housing Bubble,” Monthly Review.