The Trillion Dollar Meltdown: easy money, high rollers and the great credit crash
by Charles R. Morris
Public Affairs £13.99
The Credit Crunch: housing bubbles, globalization and the worldwide economic crisis
by Graham Turner
Pluto Press. Paperback. £14.99
The Conscience of a Liberal: reclaiming America from the Right
By Paul Krugman
Allen Lane. £20.
Common Wealth: economics for a crowded planet
By Jeffrey Sachs
386pp. Penguin. £22.
New Frontiers in Free Trade: Globalization’s future and Asia’s rising role
By Razeen Sally
Cato Institute. $18.95
The Economists’ Voice: Top economists take on today’s problems
By Joseph E. Stiglitz, Aaron S. Edlin and J. Bradford DeLong. editors
Columbia University Press. £14.95
Of the six books under review, all published this year, only the two by non–economists, Charles R. Morris and Graham Turner, have an inkling of the economic blizzard in store. This reflects the fact that the crisis, at least in its severity, came as a complete surprise to professional economists. The eminent Nobel Prize-winners Paul Krugman, Jeffrey Sachs and Joseph E. Stiglitz, all represented here, have written as though the outstanding fault of the present capitalist system lies not in its instability, but in its distributional effect – both domestic and global. Even now it is not clear how far economists have started to question the economic assumptions that underlie the large–scale collapse we are living through.
Morris, an American lawyer and investment banker, seems to have anticipated the present credit crunch for some years. His book, The Trillion Dollar Meltdown, is the best account I have read of its genesis, written before the crunch had become global. In part, it is the story of financial innovation carried to self–destructive excess. At the same time, Morris unwittingly exposes the flaw in the financial system: it was too complicated for anyone but a professional investor to understand. This is also a problem with his book. Though it is excellently written, and full of arresting thoughts and phrases (“Intellectuals are reliable lagging indicators, near–infallible guides to what used to be true”), the world of financial legerdemain which it reveals is simply too opaque for the averagely well–educated reader to understand.
The credit crunch, originating in the American subprime mortgage crisis of 2007 and then spreading out to the global banking system, had its origins in a gigantic credit bubble. How did this arise? Morris identifies three enabling conditions. The first was the coming to power of the Chicago School of economists, with its deregulating philosophy. A key deregulating move was the repeal in 1999 of the Glass–Steagall Act of 1933, which aimed to separate retail from investment banking. “While Keynesians prayed to the idol of the quasi–omniscient technocrat, the Friedmanite religion enshrined the untrammelled workings of free market capitalism”. The second condition was what he calls the “Greenspan put”. Denouncing a “new paradigm of active credit management”, Alan Greenspan, Chairman of the Federal Reserve from 1987 to 2006, held the Federal funds rate down to 1 per cent from 2003 to 2005 as the economy went into overdrive. His message to the market was: no matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles. The third condition was what Morris calls a “tsunami of dollars” – the result of America’s huge trade deficits, financed largely by East Asia. It was Chinese savings invested in US Treasuries which enabled Greenspan to keep the interest rate at 1 per cent for thirty months. “America’s housing and debt binge was made in China.”
It was in this regime of deregulated markets, cheap money and Asian–financed consumption demand that leveraged (debt–dependent) finance took off. The stages in the rake’s progress were the junk bond explosion of the 1980s, the development of mortgage–backed securities or “pass throughs”, the creation of portfolio insurance to “manage” the extra risk, and the sprouting of hedge funds to buy up the riskiest debt and sell it to wealthy speculators. Credit agencies fed the bubble by giving bonds containing “toxic waste” triple–A ratings. Morris does not decry the value of all this financial engineering. But the new investment instruments, while hugely enlarging credit facilities by spreading risk, suffered from dangerous flaws only revealed in moments of stress. A small number of institutions – global banks, investment banks, hedge funds – built an unstable tower of debt on a tiny base of real assets. So long as a cheap–money regime forestalled defaults, the tower might wobble but stay erect. A rise in interest rates from 2005 onwards brought it crashing down. Morris comments tartly: “Very big, very complex, very opaque structures built on extremely rickety foundations are a recipe for collapse”. His forecast of a “true shock–and–awe surge of asset write downs through most of 2008” proved to be all too accurate.
What needs to be done? The key requirement is to restore effective oversight of the financial services industry. Morris makes the excellent point that banks make high profits by taking large risks, but their losses are partly socialized. Banks cannot be both public utilities and risk–taking institutions. If the taxpayer is to be liable for losses, through deposit insurance or bail–outs, then risk–taking by banks must be severely limited. This points towards restoring some version of the old Glass–Steagall Act.
Morris’s book provokes an obvious reflection. The financial system should never be allowed to take on a life of its own. It provides a service to the public and should never be beyond the understanding of the public or at least of those who regulate it on the public’s behalf. In other words, it should be simple to understand. Banks should be banks, not speculators: insurance companies should insure real assets, not toxic waste: prudential rules should limit debt–to–equity ratios. There would then be less demand for the service of high–powered mathematicians to invent instruments which bamboozle the rest of us. Yes, there will be less credit available, conceivably a slower rate of economic growth. But most people will feel more secure, less stressed, and more in control of the machine that disposes of their future.
The economic consultant Graham Turner may also claim to have read the runes. The Credit Crunch: Housing bubbles, globalization and the worldwide economic crisis fills an important gap in Morris’s story, by relating recent credit bubbles to the changing structure of the real economy. We often forget that since the financial system was deregulated in the 1980s, we have had nine major financial collapses in different parts of the world, plus major stock exchange collapses. Turner’s thesis, in brief, is that globalization has resulted in a global shift in world GDP shares from wages to profits. The result has been a crisis of “realization” – over–investment in relation to worker demand. In the face of wage stagnation in the United States, American consumption demand could be kept going only by the expansion of debt. In other words, if you are a worker you don’t get your productivity gains but are encouraged to borrow at a cheaper rate. The housing bubbles in the West were deliberately created to mask the damage inflicted by American companies transferring jobs to China and East Asia to boost profits. Western governments acquiesced in job exports because this fitted their strategy of promoting free trade. The real requirement is to rebalance power in the American economy between “omnipotent capital and weak labour”. This rebalancing requires, among other things, protection of American jobs.
It is good to see the venerable under–consumptionist story wheeled out to explain the present credit crunch. There is a problem, though, which Paul Krugman points out in The Conscience of a Liberal: Reclaiming America from the Right: the numbers don’t add up. True enough, “income inequality is as high as it was in the 1920s”. But this is not due to globalization. Globalization might explain the rising gap between skilled and unskilled workers. It does not explain the gains of the super–rich, the main winners of recent years. In the 1970s CEOs at 102 major companies were paid $1.2 million on average in today’s money. This was only a bit more than in the 1930s and only forty times that of the pay of the average full– worker. By the early 2000s CEOs in the same companies were paid over 9 million a year, 367 times the pay of the average worker, whose benefits, additionally, had been greatly reduced. The explanation for this “great decompression”, as Krugman calls it, lies in politics. From the 1980s, American politics was captured by “a vast right wing conspiracy” which set about dismantling the protective structures of the New Deal by creating “distractions”. The chief of these was race. Race, in particular, duped the white voter into neglecting his material interests. Race is the main explanation for America’s lack of universal health–care: whites did not want integrated hospitals. But Krugman is hopeful that the neoconservative domination is coming to an end. The last part of the book explains his plan for creating “guaranteed universal health care” for all Americans.
Krugman provides a brisk romp through twentieth–century American history from a Democratic point of view. As he tells it, this history traces two great arcs. The first, political economy arc is from high inequality in the “gilded age” – the late nineteenth century to the 1920s – to relative equality in the middle years, and back again from Ronald Reagan onwards. The second, political arc parallels it from extreme polarization to bipartisanship and back. The reality of the first arc is readily attested by the statistics of income distribution, though Krugman provides no real explanation for these swings: why, for example, did arguments for financial deregulation and lower taxation gain such traction in the 1980s, having earlier been successfully resisted? However, the political arc doesn’t do the work Krugman wants it to. It is true that American politics became polarized again the 1980s, after a period of bipartisanship. But any change of governing philosophy is likely to start life as partisan. Krugman forgets that FDR’s New Deal was highly divisive too. Nor is there anything bipartisan about Krugman’s own history. The Republicans, in his view, were acceptable when they acted like Democrats; when they did not, they were trying to roll back the twentieth century.
What Krugman offers is a social democratic account of history’s trajectory, which is occasionally derailed by the antediluvian forces of fundamentalist religion and racist bigotry. But any historian knows that material progress is not history’s only storyline, and that religious and tribal feelings are not just “distractions” from humanity’s rational goals, but are as constitutive of human nature as is the desire for “more for less”. There was an ideological, programmatic aspect to Democratic politics in the 1960s which Krugman intermittently acknowledges – indeed he espouses it today – but which plays no part in his explanation of why the bipartisanship of the mid century broke up. He conveniently forgets that the Democrats excoriated the complacent Eisenhower years which he now loves. A combination of Barack Obama and the excesses of neo–conservative economics will probably give America the chance to “complete the New Deal”. But Krugman should remember that it was the limitations of the first New Deal that made it acceptable to Republican America.
Jeffrey Sachs’s Common Wealth: Economics for a crowded planet is also a cry for action. Its main idea is that human activity has now become so extensive that it has thrown every life–sustaining system on the planet out of kilter. If Sachs is troubled by the thought that humanity is on the wrong treadmill, he does not allow it to cloud his optimism. He comes to the reader not as a philosopher, but as a doctor offering readily available cures for the main planetary diseases he diagnoses: human pressure on the ecosystem leading to dangerous climate change, population pressure on scarce resources, and the extreme poverty of one–sixth of the world’s population. With only a modest investment, we can achieve sustainable development, stabilize the world’s population at 8 billion (it is now 6.6 billion), and end extreme poverty. All “we” need is the necessary political will”.
Sachs displays a disappointingly uncritical attitude towards the science he adduces in support of his plans. To some extent he is the victim of his own multidisciplinary approach. Working at the Earth Institute at Columbia University has been to him an “unalloyed gift”. And his range of knowledge is impressive. But he inevitably has to take a huge amount on trust, and it shows. This is not a book of scholarship but an executive summary of hundreds of reports of blue ribbon commissions, research papers, convergences and UN declarations. The bullet points roll off the assembly line of his prose, with scarcely a hint of doubts, still less self–doubt.
Sachs presents himself as an economist of the toolkit, but in fact, he is a moralist who believes it his mission to save the planet. With such an attitude, it is almost impossible for the scientist not to become a preacher. Like his fellow moralist Paul Krugman. Sachs presents a one–sided dossier in support of his cause. A reader who knows at least something about the subjects being discussed, without fully sharing the passion of the author, is bound to deplore his lack of attention to opposing arguments, whether on climate change, population or the utility of aid for economic development.
Sachs’s uncritical attitude to science is matched by his naivety about politics. He seems to believe that the main reason for government failure to tackle global problems with the required vigour is organization deficiencies (for example, failure to mobilize available knowledge), forgetting that governments – and more generally politics – have not been set up to solve global problems but to protect their countries against domestic disorder and external attack. While berating Western governments for their failure to shape up to their planetary tasks, he pays surprisingly little attention to what it is now usual to call the problem of “governance” in the poorest countries. African countries fail to live up to their “convergence potential” because they lack basic levels of infrastructure, health, education “and governance”. But for many development economists, “governance” is not something to be added to a list of infrastructural projects financed by the World Bank. It is what makes such projects possible. And the quality of “governance” is embedded in the habits and customs of the people. Sachs never faces up to the issue of how much “governance” will have to be imported from elsewhere to realize the millennium goal of poverty elimination, or how this is to be done.
Global networks, he thinks, may be the answer. “A wonderful new project, e–Parliament”, he enthuses, “aims to knit together the world’s parliaments and assemblies by video conferencing and the Internet to forge a new kind of hybrid democratic institution at the transnational and even global scale”. National Parliaments could mobilize the best brains through simultaneous teleconferences. He ends up by proposing a billionaires’ foundation to eradicate world poverty. I have no doubt that it will be established. No one else need apply for the post of director.
Despite the book’s deficiencies, Sachs’s main thrust is convincing: the problems he identifies can be solved, by the methods he outlines. His fault is that he is much too impatient and optimistic. Societies progress at their own pace. They can be tweaked a little by scientists. More likely, they will be jolted out of stagnation by disaster. There will be many of those to come, and many regressions as well, before Sachs’s dreams are realized. It is naive to imagine that it can be otherwise.
Razeen Sally is a wide–ranging historian of economic thought, and his clearly written monograph New Frontiers in Free Trade has been heavily influenced by his studies in the Scottish Enlightenment foundations of classical liberalism. He is an unqualified advocate of free trade and globalization, but points out that, historically, free trade was only one element in the Victorian political–economy package, which included domestic laissez–faire, low balanced budgets, and the gold standard. The international liberal order of the nineteenth century was not constructed by international organizations, but emerged as a by–product of acts of domestic liberalization. This unity between external and domestic liberalism broke down after 1945 when “[Adam] Smith abroad” had to be reconciled with “Keynes at home”. The post–1945 theory of commercial policy developed by James Meade, Harry Johnson and Jagdish Bhagwati uncoupled free trade from laissez–faire by advocating targeted subsidies instead of protection for infant industries. The case for free trade came to be argued in purely technical terms. But social democracy at home was ideologically inconsistent with free trade abroad. This made free trade vulnerable to attacks by anti–globalizers.
The lesson that Sally draws from all this is that globalization today should be pursued by unilateral action rather than by complicated multilateral negotiations through the World Trade Organization. Attempts to secure common minimum standards as a condition for lowering trade barriers will lead to regulatory overload. Pressures to harmonize labour, environmental, food–safety, and other product standards will have a chilling effect on labour–intensive exports. An increasingly politicized WTO will have to bear the brunt of the anti–globalization backlash and NGO pressure. Sally points out that in Asia, unilateral dismantling of trade barriers has been the rule, with China as its driving force. This challenges the consensus that trade liberalization must be based on reciprocity. Welfare gains result directly from import liberalization, regardless of anyone else’s concession. The WTO could be retained as a useful auxiliary to “national market–based reforms”.
Sally’s case for unilateral liberalization – for instance, dismantling American and EU farm subsidies without waiting for another trade round – is persuasive, but it has little chance of gaining a hearing in the West today. The problem, which he admits, is that globalization threatens the living standards not just of unskilled and skilled workers, but of the Western middle class as a whole. “The political challenge”, he writes, “is to keep borders open and extend market–based reforms, while containing inevitable protectionist pressures”. But he does not tell us how this is to be done.
In The Economists’ Voice: Top economists take on today’s problems, “more than thirty of the world’s top economists offer innovative policy ideas and insightful commentary on our most pressing economics issues”. The book is divided into nine sections ranging from climate change – now the obligatory problem number one – to the pros and cons of the death penalty. Each section consists of two or more short non–technical essays, helpfully prefaced by a summary of the essays it contains. Although three essays warn of the coming collapse of the housing bubble, there is no sense of the scale of the impending crisis. For example, Robert Schiller writes that while homeowners face a “substantial risk of much lower prices”, fortunately “derivative products, notably a futures market, are being developed [so] that they will soon be able to insure against this risk”.
The collection illustrates the power and limits of economics. Economics is the most inventive of the social sciences in its ability to suggest how incentives might be rearranged so as to secure desirable outcomes at least cost in money, bureaucracy and liberty. But it lacks a realistic account of politics, the arena in which what is desirable can be made to happen. Joseph Stiglitz illustrates both features in his missionary essay on climate change: “The well–being of our entire planet is at stake. We know what needs to be done. We have the tools to hand. We only need the political resolve” – which to many will mean that we don’t have the tools to hand, since political resolve is a tool too, which Stiglitz doesn’t tell us how to invent.
The same lack of political understanding is apparent in the discussion of the costs of the Iraq war. From the economists’ point of view, the editors ask, “could not [the money] have been better spent on fighting global climate change, on providing vaccine commitments to fight tropical disease, on brokering Israeli–Palestine peace, or on giving ten million children in the United States or abroad each a $100,000 scholarship”? The answer is yes, but the economists cannot explain why these alternatives were not adopted.
The book is full of excellent cut and thrust. In his essay on international capital mobility, J. Bradford DeLong discusses how events have denied his faith in its untrammelled operation. Fifteen years ago, he supported capital mobility unreservedly. But now he believes that too many external costs are associated with financial crises. Capital also seems to want to flow, not from but to where it is already abundant – the United States has become a giant vacuum cleaner sucking in capital from all round the world – and even when efficient, capital flows benefit rich people from poor countries, not the poor. However, DeLong cannot abandon his neoliberalism; “in the end we may have to tolerate the equality–lessening reverse flow of capital in order to promote the equality–increasing and wealth–increasing diminution of corruption.” At least he is honest enough to admit the dilemma.
The cumulative impression left by these six books is that we are on the cusp of one of those periodic changes in political economy caused by a crisis of the existing order. The end of the liberal/social democratic era lauded by Paul Krugman was brought about by the crisis of inflation and permissiveness. The succeeding neoconservative era supported by Razeen Sally is likely to end in a crisis of financial excess. Keynesianism and socialism, only recently proclaimed dead, are risen from their graves. The last Soviet leader, Mikhail Gorbachev, recently remarked that, what with all the bail–outs of banks and corporations going on, we now seem to have capitalism for the poor and Communism for the rich. This is a neat easy way of saying that we stand on the threshold of uncharted territory.
Robert Skidelsky 