Credit crunch (book extract)

In this extract from his book, The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis, economist Graham Turner argues that in the current financial turmoil, the omens are not encouraging for remedying the inherent flaws that will tip us in to debt deflation

November 24, 2008
20 min read

The US is embroiled in economic crisis. The housing market is suffering its biggest slump since the 1930s. Across the US, house prices were falling by an annualised rate of 17.5 per cent in the fi nal three months of 2007. Distressed sellers have seen property prices tumble by up to 50 per cent in some areas of the US. Record defaults and the prospect that more than two million families may lose their home in 2008 alone, signals capitalism’s biggest test in the post-war era. The credit shock is reverberating across the industrialised world. Ten years of growth financed by record borrowing are starting to unravel in the UK. Property markets are imploding in Spain, Ireland and across Euroland. And the world’s third largest economy, Japan, shows no sign of winning its long, tortuous 18-year battle with deflation.

Globalisation predicated on unfettered markets is going awry. The housing bubbles were not an accident, spawned simply by careless regulatory oversight. They were a necessary component of the incessant drive to expand free trade at all costs. Dominant corporate power became the primary driving force for economic expansion. Profits were allowed to soar. A growing share of the national income was absorbed by companies at the expense of workers. And the record borrowing provided a short term panacea, to bridge the yawning wage gap that ineluctably followed. Governments fostered housing bubbles to stay in power. Consumers were encouraged to borrow, to ensure there would be enough economic growth.

With the US housing market in freefall and the UK suffering its first bank run since 1878, the mainstream financial press has been turning in on itself, searching for scapegoats. Regulators, central banks and management at the more reckless banks have been selectively targeted and criticised for their lack of due diligence. The opprobrium heaped on chosen culprits sanctifies and provides redemption for those that failed to spot the inherent dangers in allowing economic growth to be financed by untrammelled borrowing.

But there is no mention of the underlying causes of this explosion in debt. These commentators dare not venture there, out of fear that the contradictions and flaws with the economic philosophy they have espoused will be exposed. Greed is good, but some just got a little carried away. Rap a few knuckles, offer a few sacrificial lambs and let the party recommence.

Financial markets have been bailed out before, there is no reason to stop and take a hard look at how we arrived here. That would be too painful and would force recognition of the brutal truth: such an uneven society breeds asset bubbles. Rising inequality explicitly leads to extreme house price cycles. If we want to get off this destructive rollercoaster, the limits to unbridled trade need to be acknowledged. The case for a more even distribution of income has to be accepted too.

In a bid to preserve a status quo, few meaningful policy changes of substance have been mooted or advocated, far less promoted. The collapse of the dotcom bubble saw a mere tweaking of regulation, a few token limited fines, and the next wave of speculation was fermented to drive economic growth. Under government sanction, central banks stepped back from the plate and facilitated a cataclysmic accumulation of debt.

With companies given such free rein to drive wage costs down, creating property inflation became a necessary stimulus for economic growth in the industrialised west. After the precipitous meltdown in high-tech share prices during the early part of this decade, few governments complained when strong consumer borrowing and a proliferation of debt provided the fuel for economic recovery. And few objected as an explosion in credit trading buried in a blizzard of abbreviations – MBS (mortgage-backed securities), CDOs (collateralised debt obligations), CDS (credit default swaps) or SIVs (structured investment vehicles) – allowed banks to conceal the inevitable risks from an unsuspecting and pliant public.

Money illusion

Indeed, rising house prices became symbolic, a modern era indicator of wealth and success. House prices were soaring, we must all be better off. Never mind that debt was rising too. Never mind that house price inflation is a zero sum game. Society as a whole does not benefit from a rise in house prices. Those already on the ladder can only gain at the expense of a growing number unable to reach the first rung.

In the short run, housing bubbles can provide a stimulus to economic growth if they hoodwink people into believing they are wealthier. And governments that have been promoting the free trade and profi ts fi rst agenda are content to foster the delusion. Indeed, governments rely upon money illusion, hoping homeowners will take a myopic view of their record debts. Witness New Labour’s boast – ‘ten years of GDP growth, the longest for 300 years’. Growth was everything, it told the electorate. Runaway house prices were a function of the strong economy and a shortage of properties. A similar refrain was widely uttered in Japan during the late 1980s. Record debt levels did not matter, it was claimed, because property prices were soaring. Just focus on the asset side of the balance sheet. Eighteen years on, Japan is still suffering from that disastrous miscalculation.

Therein lie the dangers facing governments today. Japan struggled to defy the march of asset deflation, slashing interest rates to zero, pushing all the fiscal levers available and running up record budget deficits. For more than a decade, it did not work. Finally, the Bank of Japan resorted to extreme measures, printing money and buying government debt in one last desperate bid to reflate. It succeeded for a short while, but only because Japan was able to ride the crest of a boom in China and other emerging market economies.

But the curse of deflation soon returned, led by another onslaught on the incomes of Japanese workers. Wages started to contract again – in both nominal and real terms – even as company profits soared to record highs. Japan had tried to model itself on the Anglo-Saxon way of doing business, restructuring, rationalising and putting the pursuit of profits first. However, that simply pushed the economy back into the deflation quagmire, which first snared Japan following the stock market peak on 31 December 1989. Even the Bank of Japan now admits globalisation and competition from low-cost foreign producers has broken the transmission mechanism, with profits rising but wages falling.

Growing income inequalities are an affliction for the entire industrialised world, not just Japan. But Japan’s experience should be salutary. Successive Japanese governments have responded to deflation by introducing aggressive pro-market policies, and the country has become more competitive. Labour costs have now fallen for eight consecutive years and its exports have soared. But it has still failed to shake off deflation as consumer confidence plummeted again in 2007, threatening to send the economy back into recession.

US – heading into a debt trap?

For the US, the stakes are already high. A two-and-a-half year downturn in the housing market is in danger of spiralling out of control despite the Federal Reserve’s belated decision to cut interest rates in the autumn of 2007. The US authorities lost valuable time. Federal Reserve officials were sidetracked by numerous voices claiming inflation would continue to accelerate.

Inflation is not the primary issue, precisely because of the free market policies that feed and nourish property bubbles in the first place. Just as Japan overestimated inflation pressures at the top of its housing boom in the late 1980s, the US and UK are also exaggerating the risks. The same downward pressure on wages, the income inequalities and the rise in profit ratios that have driven asset prices, will ensure that any pick-up in inflation will be constrained.

Oil and food are a problem. Climate change and peak oil constitute fundamental costs that will have to be borne by producers and consumers alike. Nevertheless, a closer examination of the consumer prices indices suggests that by the beginning of 2008, the underlying inflation rate was running at little more than 2 per cent in the US and 1 per cent in the UK. In Euroland, it was just over 1.5 per cent. The bigger secular threat for all these industrialised nations imitating Japan may well prove to be one of falling asset prices leading to a debt trap – or debt deflation. And the theory of debt deflation, first put forward by US economist Irving Fisher in response to the depression of the 1930s, now provides a key template for the risks facing all industrialised economies. An aggressive free market response to a debt crisis could easily serve to make the problem worse and any collapse in asset prices more entrenched. Many of the same commentators who underestimated the debt risks now claim ‘markets will have to clear’. This, they argue, can only happen by allowing lenders to fail. Miscreants have to go under, to teach others a lesson. Capitalism purges itself by the economic equivalent of natural selection.

But a policy of tough love only works if central banks are alert to the dangers. Too often these voices drown out the counter arguments predicated on historical experience. And they illustrate the folly of allowing the market to operate unchecked. Attempts to dispose of bad debts and repossess properties may lead to more deflation and push more lenders into trouble. The debt burden may go up in real terms, not down. And the cycle may just repeat itself until such point that a systemic financial crisis signals the need for a change of policy. Even then critics will claim there is no other way, arguing that one more round of bank failures will soon bring the debt trap to a close. Instead, it may simply prolong the fallout.

Japan’s experience also highlights the dangers that many economies in the Industrialised West may yet slip into a Keynesian liquidity trap. The attempts to reflate may not succeed if investors take fright at a perceived inflation threat. The economist John Maynard Keynes was quite clear in his prognosis: interest rates had to come down quickly in a housing bust. If that did not work then there would be a clear case for government intervention to correct the market’s failings.

If the authorities bail out lenders too early, mistakes will be repeated. It is a fine line between going too early and leaving it too late – the moral hazard argument. In the UK, the housing market started slowing sharply from the summer of 2004 onwards. At the turn of 2005, fears of a property crash were widespread. But just one rate cut by the Monetary Policy Committee in August of that year was enough to convince legions of buy-to-let ‘investors’ and other speculators that property remained a one-way bet to riches. A new wave of landlords succeeded in crowding out first-time buyers and driving homeownership down.

In a similar vein, cutting interest rates to 1 per cent in 2003 has widely been cited as the primary cause of the US housing bubble. But the Federal Reserve had little choice. Recent housing bubbles have not been the fault of central banks per se, but of governments allowing corporate power to exploit wage differentials in the pursuit of higher profit margins. As a result, overinvestment in high technology during the dotcom boom was quickly followed by a precipitous decline in pricing power that threatened deflation and a steep recession. Unemployment was heading up, and as it was, the jobless total still climbed by nearly four million even with the deep rate cuts.

Free and easy credit was widely held responsible for Japan’s property bubble and subsequent collapse. Frustrated by the rising trade imbalance between the two countries and a subsequent slide in the dollar, the US administration put pressure on the Japanese Ministry of Finance and Bank of Japan to slash borrowing costs. During the summer of 1987, interest rates fell to an unthinkable 2.5 per cent. But at this early stage, Japan was already gripped by endemic overinvestment and a squeeze on wages that would consume the rest of the West two decades later. That was the fundamental imbalance which led inexorably to Japan’s housing bubble.

Unbalanced globalisation

Cutting interest rates aggressively during an economic downturn triggered by a housing collapse is never a complete solution. An easier monetary policy does not cure the roots of a speculative mania. That way lies a revaluation of the political economy that begets asset inflation in the first place. Indeed, should central banks get their timing right and succeed in reflating the economy, that may simply allow governments to deflect any searching examination of the inequities that presaged overinvestment and excessive borrowing in the first place.

And one of the key inequities that must be addressed is the galloping pace of globalisation with inadequate checks and balances to corporate power. The rapid growth in world trade has been trumpeted as one of the key economic triumphs of a free market. It seems churlish to quibble when world GDP growth has been unrelentingly strong over the past four years.

But dig a little below the surface and the picture is not quite so benign. The systematic tearing down of trade barriers in the absence of appropriate protection and rights for ordinary workers accelerated a two-decade trend towards higher profit ratios in the west. That was unsustainable. Profit ratios can only continue to rise at the expense of a further decline in the share of national income taken by labour income, or wages. And such a divergence will increase the tendency and political pressure for consumer borrowing and house price inflation to fill the gap, between overinvestment and inadequate demand.

And this dichotomy will ultimately trigger a financial crisis that will lead to a sudden reversal in profit margins. Ironically, and perhaps unwittingly, the point was made eloquently by the current Federal Reserve chairman, Ben Bernanke, in January 2004. He endorsed a key tenet from overinvestment theories, the ‘tendency of the rate of profit to fall’, which explains much of the lurch from boom to bust in today’s deregulated markets. By deduction, profit ratios can only increase ad infinitum by heightening the long-term threat of debt deflation.

We should draw a distinction between rising profit ratios and high profit levels. The latter may occur in a more sustainable direction if free trade is matched by appropriate labour rights, so that consumption can rise without governments having to foster asset inflation as a substitute for economic growth. Hence, it is in the long term interests of free trade advocates to allow a greater share of the spoils to accrue to workers. It is also in their interest to permit a more even distribution of wages given the clear differences in marginal propensity to consume between income groups.

Relocation, relocation

But emboldened by their success in pushing profit ratios up to a four-decade high, they remain unwilling to temper their unquenchable enthusiasm for raw, free trade. Each and every company has the incentive to push the boundary of globalisation to its limit. If my competitor can relocate from low-cost China to an even cheaper Vietnam, so should I. Indeed, if I do not, my competitor will drive me out of business. Out of a naked self-interest, companies will never voluntarily agree to partake in a less uneven and destabilising mode of globalisation.

Similarly, left to their own devices, multinational corporations will have little incentive to prevent global warming, inflicting irreparable damage upon the climate. Food shortages are already appearing and prices are climbing. Climate change may ostensibly appear to heighten the risks of inflation. But instead, it will aggravate the threat of debt deflation in the west due to the very dominance companies enjoy over workers. Debt deflation – a cycle of falling asset prices pushing up the real debt burden and defaults – can and will coexist with persistently high headline inflation. Indeed, the inability of workers to match rising food prices with higher wages implies climate change will simply squeeze real incomes, making it harder for consumers to spend on other goods and services.

But that is not for companies to fret over. If they pay any more than lip service to the damage their trading practices inflict on the environment, in today’s global economy they will suffer a competitive disadvantage. The only resolution can come from governments acting in unity to ensure an orderly rebalancing of worker and environmental rights vis-à-vis the all pervading dominance of corporations. It can not happen in isolation. France has tried it with attempts to limit the working week, but its efforts were undercut by European neighbours and other competitors, who remained engaged in a race to drive down labour costs. Real wage rates in Germany have experienced their longest period of contraction in modern times, and they are still going down. Their export industries may have outperformed their French counterparts. But wage growth across Euroland has been too weak in the past five years to sustain domestic growth. And consumer spending has slumped, both in Germany and countries that had ridden high on housing bubbles. The collapse of the property market was hitting the once high-flying Spanish economy hard, with a vicious downturn in consumption.

Here again, governments have thus resorted to house price bubbles to drive economic recovery and bring unemployment down. The strategy has not worked in the US, and it is coming unhinged in Euroland as well as the UK. Indeed, governments today behave no differently from the typical self-interested multinational corporation, vying for the most competitive edge – not just on labour rights but also on taxes and the environment – in a short term bid for growth. But they have only secured growth by deliberately creating credit booms.

Cross-border labour unions are an obvious riposte to overarching corporations. But here again, the real impact of globalisation is thrown into stark relief. Even if unions in the steel sector, for example, were to unite across a hundred countries – a tall order indeed – there would still be many more countries where producers could choose to relocate. Companies that are now bigger than many small and medium countries can play one off against the other. Wal-Mart is now China’s eighth biggest trading partner. And it is the threat of relocation that proves just as powerful as the reality of a transfer somewhere cheaper. Accept more flexible terms, or we will walk. This is arguably the overriding and most significant point of globalisation that led to rising profit ratios and housing bubbles. It is the stick for companies to beat workers into accepting a smaller share of the national income pie.

Free trade falls short

Proponents of free trade claim the growth of emerging markets and the rise in demand for ‘high value exports’ from the industrialised west will more than compensate for the loss of lower skilled jobs. However, the argument is falling short on two counts. For the two-way transfer to succeed, exchange rates have to be allowed to reflect the new equilibrium offered by reduced barriers and increased trade flows. A failure of this rebalancing to occur anywhere near enough has accentuated the risks of debt deflation in the west.

China is a key example. Chinese workers are not necessarily more productive than their western counterparts. They are just cheaper, more abundant and receive fewer labour rights. Their average incomes may have risen over the past decade, but not enough to compensate for the loss of earnings in the west. As a result, China over-invests and under-consumes, and at current exchange rates, there can be no realignment of supply and demand. Chinese import demand will remain woefully inadequate, precisely because the economy is deliberately structured to underpin the corporate-led model driving the industrialised west. Exchange rates will have to adjust sharply, but in the short run, that may aggravate the fallout.

The accumulation of trade surpluses in emerging markets and huge foreign exchange reserves mirrored the explosion of consumer debt in the west. Governments in industrialised economies have appeased the process, because it fits neatly with their avowed strategy of promoting free trade irrespective of the costs. And the asset bubbles that fill the gap in demand allow them to deceive their citizens into believing that globalisation in its current format works. Developing countries hardly dare challenge the rules of the game, lest it should jeopardise their place at the world trading table. Western companies are not in a rush to challenge the status quo either. They benefit from the increased leverage over workers in their domestic markets, but profit from their overseas operations too. Hence, China is now a major profit source for many western companies. A growing share of UK and US companies’ profits are derived from abroad. As these returns flow to shareholders, that further exacerbates income inequalities at home.

This is only one part of the story. The free trade argument falls down in its current guise because it makes no allowance for the increased income inequality that it drives intra-country, i.e., between a nation’s citizens. Trade flows may have flourished since the creation of the World Trade Organisation in 1995. That is not in dispute. The argument is not about reactivating trade barriers per se, but creating a more even balance of power between omnipotent capital and weak labour, and not just in the industrialised west.

China is growing rapidly, not through its own innovation, but simply because it provides multinationals with the opportunity to cut costs, and with huge consequences for the environment and income distribution. Even supporters of free trade have looked on in horror, as the growth of multi-billionaires in developing economies and plutocracy endangers the legitimacy of globalisation. There are other ways to foster free trade that do not depend simply upon driving profit ratios up and labour incomes down, with the attendant fallout for debt and inequality. But a rebalancing of corporate versus labour rights can also be achieved by reversing policies that have allowed companies to become dominant.

The easy lending fostered by western governments has fuelled mergers, takeovers and acquisitions by private equity funds that concentrates corporate power, underpinning the fundamental forces that create asset bubbles. Tighter lending restrictions are critical to restoring the imbalance between corporate and labour power. Mergers that create corporate monoliths and increase market dominance need to be resisted. More appropriate tariffs and constraints need to be applied to trade in goods and services where the price mechanism fails to reflect the environmental costs. And such a tariff may be necessary where increased trade is no longer a reflection of any comparative advantage, but simply a means to exploit wage differentials.

Only time will tell whether governments and central banks can prevent the inherent flaws of rising profit ratios and over accumulation of capital tipping countries into debt deflation. The omens are not encouraging. The US is certainly the major, pivotal risk in the decade-long experiment with corporate-led globalisation. The US authorities are running out of time. A backlash against the shortcomings of today’s unregulated free trade model is gathering momentum. And the country is sinking deeper into a Japanese-style debt trap that could take years to unwind.

Extract from The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis by Graham Turner, published by Pluto Press (20 Jun 2008)

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