special article

the Great slump: What comes Next?

Robert H Wade

Given the half-hearted attempts at reform of the financial system in the past year and the new resolve of many west European governments and the Republican-controlled House of Representatives in the United States to push through fiscal austerity, one can make two sets of forecasts of the global economy: (1) The next several years will see slow and erratic economic growth in the US, much of Europe, and Japan, and quite possibly a widespread double dip recession. (2) The next decade will see at least one major financial crisis affecting a large part of the world economy, because (a) the effort to re-regulate the financial system has largely failed; (b) income distribution will continue to become more polarised, with the top 1% lifting further from the median; (c) global payments imbalances will continue at levels where the associated capital flows keep the level of financial fragility dangerously high.

he shortest explanation of the 2000s boom and bust is that people across much of the western world, especially in the United States (US), began to live out the dictum of Plautus, the Roman dramatist of the third century BC: I am a rich man, as long as I do not repay my creditors. The basic mechanism is very old. But the current coupling of debt crisis with First World rather than Third World is quite new, as also is the observation that some developing countries are leading the global recovery, such as it is. The abnormality of the times is caught in the quip, growth has gone South, debt has gone North. What comes next? I make two broad forecasts. I state them as certainties, in the spirit of, The future is fixed, but the past is always changing; but of course I am talking about probabilities. We should always remember J K Galbraiths dictum, Astrology was invented in order to make economic forecasting look good. All the more so when the outlook is unusually uncertain, in the phrase of Ben Bernanke, head of the US central bank, speaking in September 2010. (1) The next several years will see slow and erratic economic growth in the US, much of Europe, and Japan, and quite possibly a widespread double dip recession. (2) The next decade will see at least one major financial crisis affecting a large part of the world economy, because (a) the effort to re-regulate the financial system has largely failed; (b) income distribution will continue to become more polarised, with the top 1% lifting further from the median; (c) global payments imbalances will continue at levels where the associated capital flows keep the level of financial fragility dangerously high.

Forecast 1
The next several years will see slow and erratic economic growth in the US , much of Europe and Japan, and quite possibly a double dip recession. Think of the economy as a car. When households borrow they are stepping on the accelerator but at the same time loading up the car with more weight (debt). When they stop borrowing they take their foot off the accelerator and the car slows faster than otherwise because it is carrying more weight. This is the first dip. Then when households increase saving and repay debt they are stepping on the brake, so the car slows even faster than by just lifting the foot off the accelerator. This is the second dip. Replicated across the economy, braking the car repaying debt causes a multiplier process of lower spending, job losses, business failures, and bank failures (Palley 2009). The severity of the current slump is caught in Figure 1 (p 55), which shows the percentage fall in employment in the US in all the post-second world war recessions, each trend line starting at the peak. The current recession has produced a much deeper and
november 20, 2010 vol xlv no 47
EPW Economic & Political Weekly

Robert H Wade (R.Wade@lse.ac.uk) is at the London School of Economics.

54

special article

longer fall in jobs than previous ones and two and a half years on from the peak it showed little sign of a significant upturn. US unemployment is around 10%, and almost half of the unemployed have been so for more than six months. US Treasury Secretary Timothy Geithner said recently, were on the road to recovery; but if recovery is defined in terms of rising number of people in secure employment there is no US recovery as yet (Krugman 2010a). In most of Europe, too, a modest recovery in economic growth has been accompanied by little recovery of employment. This is surprising, because profits of banks and big non-financial corporations have bounced back to close to where they were before
Figure 1: Job losses in post-second World War recessions (%)
Job Losses Relative to Peak Employment Month (%) 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 -6.0 Current Employment Recession -7.0 Dotted Line ex-Census Hiring

cost of mortgages is at a record low, but low interest rates have lost their power to stimulate demand. In short, the US and Europe are mired in a liquidity trap. Big financial and non-financial companies are flush with cash, but unwilling to invest at home because uncertain about demand. They will not hire more people until they are confident that consumers will buy their products; consumers will not buy until they have secure incomes and have paid down some of their debt (Reich 2010). The circle is vicious, and it is difficult to see how it might turn the corner because there are no corners in a vicious circle. The prospect of the Japanese trap beckons. Figure 2 shows national disposable income of Japan since 1960. Note the long stagnation, lasting two decades after the Japanese bubble burst at the end of the 1980s. One of the main reasons is deflation; for
Figure 2: Japan National Disposable income (billion yen)
450000

350000

Real National Disposable Income

250000

150000

National Disposable Income

50000 0 1960 1966 1972 1978 1984 1990 1996 2002 2008

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 Number of Months after Peak Employment Source: cr4re.com/charts/charts.html

the crisis. The investment banks Goldman Sachs and Morgan Stanley have done particularly well, their share price up to within 10% of its peak before the Lehman collapse. You might think that higher corporate profits would lead to higher employment, but in fact, company profits have become substantially decoupled from jobs, for at least two reasons. One is that much of the profit comes from offshore operations (for example, General Motors now makes most of its cars in China, where it employs 32,000 hourly workers, as against only 52,000 hourly workers in the US, down from 4,68,000 in 1970). The second is that big US and European businesses have been investing heavily in labour-saving equipment, which boosts their profits but not their employment. The US housing market is one of the main sources of continued recession. Average house prices have already fallen from the peak by about 35%. But the US housing bubble over the 2000s grew much bigger than the housing bubbles in the five worst financial crises in the developed countries since the late 1970s, and in these other cases it took four to five years for house prices to fall to pre-bubble price levels relative to incomes. If the US housing market takes this long to deflate, prices would fall till late 2011 or 2012, continuing to destabilise the financial system; and since the US housing bubble was bigger the fall might well last longer (Reinhart and Rogoff 2008). As of September 2010 the volume of housing transactions relative to population was the lowest since late 1982. Half of all households now have less than 20% equity remaining in their homes, meaning they must have savings available to qualify for a government-insured loan. A large stock of foreclosed housing is on the market, and another large stock of likely to be foreclosed housing is ready to come on the market, depressing prices.1 The
Economic & Political Weekly EPW

Figure 3: Usa National Disposable income (billion $)

14000 12000 10000 8000 6000 4000 National Disposable Income 2000 0 1960 1966 1972 1978 1984 1990 1996 2002 2008 Real National Disposable Income

example, average salaries in Japan fell by 12% over the past decade. From an American perspective the question is whether the sharp downturn in US national income which began in 2007, shown in Figure 3, will take a similar trajectory to Japan after 1990, extending out to 2030. The Japanese case shows that large and highly developed economies can fall into a stagnation trap, not just in the 1930s but also today.

payments imbalances
Figure 4 (p 56) shows another of the bulldozer forces making for instability namely, the growth of huge payments imbalances over the 2000s, with the US running bigger and bigger deficits which were financed by capital flows mainly from east Asia, especially from Japan and from China in the second half of the past decade. These imbalances and associated capital flows were an important cause of the current crisis, for reasons explained below. They do not seem to be diminishing (Wade 2009a and 2009b). The specific problem is that Japan, Germany, and China are determined to rely on exports for their growth rather than

november 20, 2010

vol xlv no 47

55

special article

expand domestic demand and rely on others to expand their domestic demand, at the same time as many of those others
Figure 4: current account Balances, 1990-2006 (billions $)
400 200 0 -200 -400 -600 USA -800 -1000 1990 1992 1994 1996 1998 2000 2002 2004 * Emerging Asia includes the four ASEAN countries (Indonesia, Malaysia, Philippines and Thailand) and four NIEs (South Korea, Singapore, Hong Kong and Taiwan). Source: IFS and Asian Development Bank. 2006 Euro Area Japan Emerging Asia* China

(notably the US and UK) are trying to reduce huge external deficits by boosting their exports. This is a recipe for trade conflict. At the end of September 2010 the US House of Representatives passed legislation, by a large and rare bipartisan majority, authorising special tariffs on Chinese imports to counter Chinese currency manipulation (keeping the yuan undervalued).

cutters and stimulators

This brings us to the great debate for the past year between cutters and stimulators, between those who say that cutting fiscal deficits is the top priority and those who say that the top priority is to continue the existing fiscal stimulus until the recovery is assured. The cutters appeal emotionally to the popular misperception that governments are like households writ large. Just as a household with a cash flow problem has to tighten its belt, so must the government, they say. Financial markets are afraid that government debt is spiralling out of control; public deficit spending crowds out private spending (so when the government issues a lot of debt, private investment and output fall); and cutting the deficit will convince consumers and businesses that taxes will eventually be cut, encouraging them to spend more now. In short, the cutters argue that fiscal austerity supports rather than harms growth. John Cochrane, a University of Chicago economist and Cato Institute member, put it succinctly when he declared, The economy can recover very quickly from a credit crunch if left on its own (Cochrane 2010). The growth stimulators do not accept these arguments. They say, first, that when consumers and businesses see the deficit being cut they are unlikely to calculate that their taxes will eventually come down and will therefore increase their spending today; rather they will calculate that they may lose their job and will therefore tighten their belts, intensifying recession. They say, second, that if the cutters are right about the crowding out effect of government debt we would expect to see the yield on government debt high and rising, reflecting tightening competition for credit. In fact, real interest rates are close to zero, aside from extreme cases like Greece, Portugal, Ireland and Iceland. Markets are more worried about a growth slowdown than about unsustainable debt; afraid that a second dip to the recession would produce deflation, which would be difficult to escape from. As Martin Wolf, the Financial Times columnist, said about

the UK recently, the market is screaming its lack of concern about UK fiscal credibility, as indicated by very low yields on UK government bonds. He accused the UK deficit cutters of being terrified of a confidence bogey who is asleep (Wolf 2010a).2 The stimulators recommend that governments should withdraw stimulus and cut the fiscal deficit in step with the recovery of private business and consumer demand. For example, cutting might be calibrated to the rate of economic growth such that when growth remains at or below 2% deficit, spending or lowering taxes would be emphasised ahead of cutting; as growth rises above 2%, cutting could be accelerated. The key point is that if the stimulus is withdrawn before the recovery of private domestic demand, then recovery depends on exports, which shifts the burden of providing demand stimulus onto others (the German strategy). The stimulators say that much of the growth that occurred in the developed countries in the second half of 2009 and first half of 2010 (excluding the export-led economies like Germany and Japan) was due to inventory restocking after the collapse of 2008 and 2009, and inventory restocking is no basis for sustained growth. In current conditions, say the stimulators, the magnitude and speed of public spending cuts wanted by the cutters (the British coalition government has called for a departmental average 25% cut in UK public spending over the five-year term of the parliament) will cause a steep recession and higher deficits. Furthermore, the cuts will undermine the long-term rate of growth, because of the destructive effect of bankruptcies and long periods of unemployment on skills, motivation and social capital. So far, the cutters have won. Across Europe the biggest spending cuts since the 1930s are starting in October 2010; and the whole continent will probably be gripped by concerted fiscal austerity in 2011. The cutters have also prevailed in the European Central Bank, and in the consensus which the British and German governments got the G-20 leaders to endorse at the Toronto summit in June 2010 (against some resistance from the Obama administration). The new Republican majority in the US Congress after the November elections will block any further stimulus. The leader of the Republicans in the House of Representatives, John Boehner, wants sharp spending cuts, especially welfare payments, together with big tax cuts for the wealthy a recipe for bigger deficits and fewer jobs. Post-election he and his party have moved from obstructing the Obama administration to actually setting policy (Krugman 2010b). The US central bank is riding to the rescue by starting another round of quantitative easing (creating money to buy assets and add liquidity). It hopes to entice investment, raise asset prices and lower the price of the dollar as the way out of the crisis. Instead, it is likely to stimulate the stock market and the housing market (the interest-sensitive sectors), slow down the needed re-specialisation out of construction and finance and into export industries, and force appreciation of other countries currencies, including those of poor countries trying to build export industries. In short, the cutters victory means there is a high probability that much of the west will experience a multi-year stagnation, high unemployment and insecure employment as the debt mountain is wound down. It is as though the cutters are wilfully repeating the voyage of the Titanic, ignoring warnings of iceberg
november 20, 2010 vol xlv no 47
EPW Economic & Political Weekly

56

special article

ahead. Even more remarkably they are doing so with the utmost certainty that they are right, despite the lesson from Japans experience after 1990 and the same lesson from the 1930s, that once deflation takes hold it is difficult to escape from. They ignore the reasons why the labour market is quite different from the market for potatoes (cuts in wages tend to make the oversupply problem worse rather than better, unlike cuts in the price of potatoes), and the reasons why the government budget must not be thought of as like a household budget writ large. But there is one small piece of good news. The Organisation for Economic Cooperation and Development (OECD), the wests leading economic think tank, has suddenly, in the first week of September 2010, done a U-turn over cuts. Having been urging the G-7 governments to give top priority to cutting fiscal deficits the OECD now urges G-7 governments to postpone fiscal austerity at least until it becomes clear whether the sharp slowdown in economic growth over the summer of 2010 is temporary or long-term (Elliott and Kollewe 2010). The OECDs change of heart might slow down the rush to cut fiscal deficits and thereby lower the probability that the developed world will experience a double dip recession. The US election that delivered the majority in the House of Representatives to the Republicans might even turn out to have an upside. Now the Republicans and the Tea Partyists have to unite, which may be difficult, and then give the people what they want. The last time they were in the same situation they closed down the federal government, and lost the next election. This time they may fall apart under the responsibility of governing. Obama may be able to use his veto to protect his existing achievements, and gain support as the fearful electorate becomes disillusioned with them.

Forecast 2a
The next decade will see at least one major financial crisis affecting a large part of the world economy, because the effort to re-regulate the financial system has largely failed. For the past two decades and more the banks have manoeuvered themselves into a position of super-profitability, where they are able to privatise oligopolistic profits and pass their losses to the public purse (the rationale being that governments are responsible for averting system-wide collapse). So on the one hand, senior employees in finance enjoy a magnificent remuneration premium compared to those in comparable professions. (A study (Goldin and Katz 2008) of Harvard graduates found that those who worked in finance received, over the 2000s, remuneration almost 200% higher than graduates from the same cohort who went into other professions like law, engineering and medicine, holding other things constant; whereas in 1950-80 finance received no premium.) On the other hand, families up and down the country are paying the bankers losses through rising taxes, shabbier public services and higher unemployment. The effort at a game-changing Great Re-regulation began in late 2008, intensified in 2009, and then further intensified into an attempt at the Great Revenge. From across the political spectrum from Gordon Brown and Barack Obama, from Angela Merkel and Nicolas Sarkozy, and from central banks and the International Monetary Fund (IMF) came calls for the banks to be reined in.
Economic & Political Weekly EPW

But by late 2010 it looks as though the Great Re-regulation and the Great Revenge have ushered in the Great Escape (Authers 2010); or as Howard Davies (2010) put it, the initial enthusiasm for global solutions [has] run into the sand. For the most part the banks have succeeded in blocking the imposition of significant constraints on their behaviour beyond those already in place before the crisis, at the same time as the investment banks and hedge funds have resumed making giant profits. The Financial Times columnist, Philip Stephens (2010a), concludes, three years on, things are much as they were except that most of us are poorer. The [financial] markets rule [again]. In the US the overhaul of financial regulations approved by the Senate in July 2010 did make some small improvements. These included requiring derivatives to be traded on exchanges, which makes the derivatives market more transparent and makes the job of the regulator easier; and mechanisms for winding up banks in trouble. The US Federal Reserve has issued broad guidelines on bankers bonuses, which include the radical recommendation that a portion of any bonus should be deferred and that guaranteed bonuses over several years should not be paid. But the new Republican majority in the House of Representatives will try to blunt some of the legislation approved before the November elections, will cut the budgets of supervisory agencies like the Securities Exchange Commission, and will block appointees whom the finance industry considers hostile, not only to the supervisory agencies but also to the Treasury. As the president of the Consumer Bankers Association said just before the election, At this juncture, gridlock is good. Its time we take a breather from all the excess of regulation and congressional legislation (Schwartz 2010). The EU has, finally, after months of haggling among member states and its different organisations, agreed on a new financial regulatory framework. The verdict of one expert (Briancon 2010) on the EUs new framework is: It should work slightly better [than the current one]. Maybe. Philip Stephens says about the changes to the US and European regulatory frameworks, Worthwhile as they are, such measures look like tinkering when set against the capacity of capital markets to wreak economic havoc. The key weakness of the US, the UK, and the EUs new regulations is that they do not tackle the most important issue of all, which is ensuring that banks do not again over-leverage and that regulators do have the tools to stop them. They kicked this critical issue up to the Basel Committee on Banking Supervision, which includes representatives of 27 countries.

Basel 3
The committee issued guidelines, known as Basel 3, which say that banks should be required to raise the amount of high-quality capital (their own shares and retained earnings) they hold in reserves relative to their risk-adjusted assets from the current 2% (under Basel 2 guidelines) to 4.5%; and also hold an additional buffer of 2.5% of risk-adjusted assets, such that banks whose capital falls within this buffer should face restrictions on paying dividends and discretionary bonuses.3 In the negotiations between the Basel Committee member-states the US, the UK and Switzerland homes of the largest developed

november 20, 2010

vol xlv no 47

57

special article

country banks and the countries with most to loose if another crisis hits wanted tougher capital standards. But opposition from many European governments and the Japanese government ensured that the rules are not nearly as tough as they should be. The Financial Times Martin Wolf summarises the result:
To celebrate the second anniversary of the fall of Lehman, the mountain of Basel has laboured mightily and brought forth a mouse. Needless to say, the banking industry will insist the mouse is a tiger about to gobble up the world economy. Such special pleading of which this pampered industry is a master should be ignored: withdrawing incentives for reckless behaviour is not a cost to society; it is costly to the beneficiaries. The latter must not be confused with the former. The world needs a smaller and safer banking industry. The defect of the new rules is that they will fail to deliver this (Wolf 2010c).

What are the main problems? First, the new capital ratio is still so low that most banks can easily meet it already (including about 45 of the 50 biggest European banks). Incredibly enough, it was set by looking at the losses banks experienced in the current crisis yet those losses were kept artificially low by massive taxpayer bailouts. So the new ratio is safe only if investors are confident that governments will bail out creditors in a crisis. It allows banks again to become so highly leveraged that it would not take much of a disaster to bring them close enough to insolvency to panic uninsured creditors. To quote Martin Wolf, We might think of the new requirements as a capital inadequacy ratio. Second, the target ratios do not have to be met until 2019, in order to give the banks lots and lots of time to adjust. Yet if a bank is undercapitalised now it should be put on a much faster timetable. Third, the new rules do not ensure that banks have sufficient liquidity resources that can be quickly converted into cash, even in a panic. The liquidity requirements remain to be defined. Fourth, the rules say banks should build up capital in good times, so it would be available as a cushion in bad times; but the Basel Committee could reach no agreement on something more precise.

plenty of signs that some banks are still ignoring the spirit of the new rules and again paying giant bonuses circumventing the ban on multi-year guaranteed bonuses by, for example, offering employees loans that would be forgiven if they stayed with the firm for several more years (Thallarsen 2010). If it is not hard to guess why the banks have been so opposed to re-regulation, the slightly harder question is why the banks have been so successful in blocking re-regulation in converting the Great Re-regulation into the Great Escape? First, the banking industry has raised lots of fears about the consequences of tougher regulation. Fears of dire effects on growth and employment; fears of regulatory arbitrage in the form of moving headquarters to another country; fears of regulatory arbitrage in the form of moving financial activity out of regulated banks and into unregulated shadow banks, as in the upswing of the past cycle. The second reason for the banks success is that the banking lobby is one of the most powerful lobby groups in the US. There are five registered bank lobbyists for every member of Congress, more than for any other sector. Congress men and women depend heavily on payments from the financial sector for their re-election campaigns, and they know it is generally a bad idea to go against the banks or rather, a bad idea to act against the banks, as distinct from talk against the banks. Third, US politics has become extremely polarised along party lines, such that Republican members of Congress almost never support a Democratic Party proposal, and vice versa. During the Obama administration the Republicans have mounted a particularly effective blockade under the slogan, Hell, no, one of whose consequences is that the financial regulations were continually watered down as they proceeded through Congress.

Hayeks revenge
The Republican blockage rests on a resurgence of anti-government, especially anti-federal government sentiment in the US. One of its strangest aspects is the return to right wing favour of Friedrich Hayeks book, The Road to Serfdom. As of early 2010 the book stood at number 241 on the Amazon best-sellers list: not bad for a book first published in 1944. Hayek warned that infringements of economic freedom-to-do, such as the Beveridge welfare state, put the UK on the slippery slope to political serfdom. The books current popularity stems from boosts by conservative thinkers like Glen Beck and Rush Limbaugh, who tell their listeners that The Road to Serfdom is a road map to what the Obama administration is doing. They say that Obamas healthcare reform, the bank bailouts, and just about everything else the administration has tried to do (excepting military adventures) constitute rising government intervention in the economy; and the resulting curbing of economic freedom leads on to the curbing of political freedom. In Rush Limbaughs words,
Friedrich von Hayek brilliantly laid it right out. Its all about power. Its all about control, and thats what Obamas about (Farrant and McPhail 2010).

Financial industry Fightback

The financial industry the most subsidised industry in the world by far, thanks to its almost unlimited access to public revenues in bad times is mounting determined resistance even to many of the measures which Philip Stephens calls tinkering. Its representatives argue that the industry has already made the necessary changes to stabilise its firms; and that the only way to ensure recovery is for regulators not to impose tougher rules. Further regulatory tightening would cut 3% off economic growth over the next five years across the US, the euro zone and Japan, and cost 10 million jobs, they say. So more regulation is neither needed nor desirable. Every dollar of [required] capital is one less dollar working in the economy, according to the Financial Services Roundtable, an organisation of large US financial organisations (cited in Norris 2010). It is not hard to guess why the banks have been so opposed to lower ceilings on leverage and significant increases in their capital reserves, and why they are keen to have us forget that their undercapitalisation got us into the boom-and-bust cycle in the first place. Making sure that banks do not over-leverage and do hold more capital in reserve, and that regulators have the tools to govern them, would cut bank profits during the next good times. Even today, with some banks again making big profits, there are

The fact that the Beck-Limbaugh version of Hayek fails just about every empirical test one can think of has not stopped many millions of Americans from believing the argument and using it to fuel up the McCarthyite tendencies of the Tea Party movement and the Republican right.
november 20, 2010 vol xlv no 47
EPW Economic & Political Weekly

58

special article

The bottom line is that the opportunity to stamp on the practices that led to the crisis has been lost, for the most part. The postcrisis financial reforms in the US and UK the main international financial centres seem to have done little to reduce vulnerability to another euphoric bout of This time is different. We meaning most western governments, the European regulatory bodies, the IMF are in the position of having had a bad crash due to a badly designed car, and are now climbing into a repaired version of the same vehicle for another drive (Blyth forthcoming). However, the Basel committee guidelines have been submitted to the G20 leaders meeting in Seoul in November 2010, and it is possible but unlikely that the leaders will recommend tougher measures.

Forecast 2b
The next decade will see at least one major financial crisis affecting a large part of the world economy, because income distribution will continue to become more polarised, with the top 1% lifting further from the median. Income polarisation raises the level of financial fragility and the probability of financial crisis. The discussion so far has identified problems in the re-regulation of finance as one of the sources of the next big financial crash. But we should be careful of following the standard diagnosis that the root causes of financial crisis lie in the structure and regulation of finance. When Jean Claude Trichet, the president of the European Central Bank says that the root cause of the crisis was a widespread undervaluation of risk, he begs the question of why financial organisations undervalued risk (Trichet 2008). To answer that question takes us away from the structure and regulation of finance, to the structure of income and wealth. The extraordinary growth over the past two decades of ordinary debt securities like mortgages and of complex securities like Collateralised Debt Obligations cannot be explained from within the financial sector. Rather, their growth can be explained by the high and rising polarisation of income in many countries. Organisations like Goldman Sachs created a large supply of securities (which later turned out to be toxic) because they were responding to soaring demand for them. The demand came, first, from those at the top of increasingly concentrated national income distributions looking for ways to store and multiply their wealth; and second, from the mass of the population on stagnant incomes looking for ways to increase their consumption through borrowing (in the spirit of Plautus). In other words, the financial system produced toxic securities not just because regulation was poor, but because of strong external demand pressure on it coming from income polarisation. The US trends in income polarisation are dramatic, and the same trends occurred more weakly in other developed countries. The share of the top 1% of US households in national disposable income rose through the 1920s to hit a peak of 22-23% in 1929, then fell through the Great Depression, the second world war, the Great Society era, until it bottomed out at around 8-9% in the mid-1970s. Then it began to soar, to reach 22-23% in 2006 (including capital gains), the same as the previous peak in 1929. This is not a misprint. During the Clinton administration of the 1990s the top 1% received about 45% of the increase in US disposable income; and during the George W Bush administration of
Economic & Political Weekly EPW

the 2000s the top 1% received about 73% of the increase (Palma 2009; Wade 2009b). On the other hand, the real income of the median household increased by less than 10% between 1990 and 2010, when GDP grew by 60%. Over the 2000s between a quarter and a third of American children have been living with one or no parents, in chaotic neighbourhoods with failing schools. The lesson is clear. Strengthening financial regulation, making the financial system more transparent and more accountable and other good things, will not protect us from more big financial crises as long as there are powerful external pressures on it to create complex securities with high yield and high ratings. Those pressures come from very unequal national and international income and wealth distributions. They will continue to swamp regulatory systems until they are made more equal. But US politics has become so intensely polarised that agreement on ways to do this is extremely unlikely. The current political polarisation is not just a Tea Party-type reaction to the Obama administration; it is driven by structural features of US society, particularly income and wealth polarisation, such that income polarisation and political polarisation reinforce each other (McCarty et al 2006). Political polarisation makes it unlikely that the US will take a lead in introducing financial regulation that would effectively curb the banks.

Forecast 2c
The next decade will see at least one major financial crisis affecting a large part of the world economy, because global payments imbalances will continue at levels where the associated capital flows keep the level of financial fragility dangerously high. Payments imbalances, such as built up over the 2000s between China and the US, can break the financial system in at least two ways. First, the external credit-debt recycling system ruptures as the debtor country builds up such large obligations to foreign creditors that at a certain point someone shouts fire in the theatre and the debtors currency crashes, multiplying its foreign debt obligations. Second, the debtors domestic credit-debt recycling system, the counterpart of the external debt, ruptures as domestic debtors build up unsustainable debt. Many commentators expected a dollar crash as US foreign debt accumulated through the 2000s (to the point where the US external deficit in 2006 was about equal to Indias GDP). In the event, the rupture came in the domestic creditdebt system, beginning in the sub-prime mortgage market and rippling out into the rest of the economy as holders of complex securities panicked at what they might contain (Wade 2009a). The most serious gap in the international financial system is a mechanism for curbing payments imbalances without putting all the adjustment pressure on the deficit countries. The market for foreign exchange is barely fulfilling this function. It is driven more by speculative capital flows than by trade flows, and it moves exchange rates in crazy directions, like drunken air traffic controllers. Countries running large deficits and high inflation may experience currency appreciation, as carry trade investors seek to profit from both the high interest rates and the prospect of further currency appreciation (the story in much of eastern Europe and especially Iceland, see Wade and Sigurgeirsdottir 2010). Meanwhile, some governments peg their exchange rate to

november 20, 2010

vol xlv no 47

59

special article

that of their main export market, even as they accumulate large external surpluses and large reserves, partly as a substitute for WTO-prohibited tariffs, quantitative restrictions, and other industrial policies. In contrast to trade, in which governments have shared sovereignty to create trade rules and a WTO dispute settlement mechanism, governments jealously protect their currency market from external discipline. The US, in particular, shows no interest in sponsoring a switch from the US dollar as the main reserve currency to an accounting currency linked to a basket of all the major currencies, in which countries would accumulate reserves. Without some major institutional change of this kind, the world economy will continue to experience large external deficits and surpluses and destabilising capital flows.

Vestergaard 2010). This might fortify the principle of subsidiarity and dilute the assumption that regulatory harmonisation on a global scale is optimal (Rottier and Veron 2010; Wade 2008).

the titanic analogy

But these are too slender threads with which to dispel the Titanic analogy. What is especially alarming about the current situation is that the consensus around spending cuts constitutes not ignorance but unlearning of key ideas of Keynesian economics. You might expect that the key neoliberal ideas which have shaped economic policy in the west for more than two decades would have crash-landed on facts and common sense about the current crisis; but the signs are that they retain much of their addictive hold over policymakers and the economics profession, only slightly softened at the edges.4 This is a surprise, on the face of it. Centre-left champions can produce ample evidence with which to debunk key ideas of the centre-right (not to mention mainstream economics) like the efficient financial markets hypothesis, the idea that free capital movement is a good rule for all, and the belief that anyone who worries about income polarisation is merely practising the politics of envy. This debunking should have mass appeal, because voters have just lived through the worst crisis in western capitalism in the 70 years since the 1930s, they are enraged at the bankers, and they are angry at governments for the rush to fiscal austerity when the austerity hits education, health and defence. Meanwhile, centre-right governments in Europe are in a mess: in Italy Berlusconis right wing coalition has split; in Germany A ngela Merkels Christian Democrats are adrift; in France Nicolas Sarkozy is driving all over the road. Yet in the US, Canada, the UK and continental Europe, progressive politics has been in retreat, unable to seize the advantage. Fringe parties on right and left have made electoral gains. America is rife with wild and crazy sentiments, such as the belief that the belief that Jews were responsible for the financial crisis, affirmed by 32% of registered Democrats; that President Obama is secretly a Muslim, affirmed by nearly 20% of respondents in national polls; and that it is definitely true or probably true that Barack Obama sympathises with the goals of Islamic fundamentalists who want to impose Islamic law around the world, affirmed by 52% of Republicans in a recent Newsweek poll (Douthat 2010). Political parties are stoking up voters fears with the same logic as the Salem witchcraft trials.

conclusions
I have suggested, first, that the west is likely to experience several more years of slow and erratic growth; and second, that another big financial crisis within a decade is quite possible. The first forecast rests particularly on the determination of European governments, now joined by the US government under the influence of the new Congress, to press full steam ahead into fiscal austerity all saying they will rely on export growth to offset the fall in domestic demand, as though they had not heard of the fallacy of composition. The second forecast rests on the failure to push through reforms to finance which would stamp on the practices that produced the current crisis; and on factors beyond the financial sector. The latter include high top end income and wealth inequality, which generates a high and rising demand for these practices (in the form of complex financial instruments in which the holders of burgeoning wealth can store and multiple their wealth). And they include persistent payments imbalances and destabilising capital flows. The combination of income concentration at the top and large payments imbalances is likely to swamp the stabilising efforts of regulatory bulwarks. And as if these forces were not enough, there is also the looming prospect of the disintegration of the euro zone, as repeated rescues of the peripheral countries fail and as Germany and the IMF impose impossibly severe fiscal policies on the periphery (an immediate fiscal tightening in Greece of 7% of GDP, for example). Some qualifications are needed. First, the OECDs abrupt U-turn in early September 2010 in favour of sustaining the fiscal stimulus may help to persuade governments to moderate their cutting plans. Second, the Basel Committees recommendations on higher global capital standards, also announced in early September, may help to curb bank profits and make asset bubbles less likely provided regulators make sure that the rules are implemented swiftly. But as Martin Wolf suggests, the new capital adequacy standards will help only a little, as compared with equity requirements of 20% to 30% which Wolf considers should be aimed at. Indeed, one can argue that banks will only be safe when they raise most of their capital from equity, not debt, and that anything short of this is an invitation to crisis and taxpayer-financed bailouts. Third, the dysfunctions of global organisations like the G-20 and the imf Committee may induce the growth of compensating regional governance mechanisms like the Chiang Mai Initiative (Wade and

protection from Uncertainty versus Fear of Government intervention

Behind these trends in western politics we can see the collision of two powerful impulses (Stephens 2010b). First, voters want government to protect them from physical, economic and identity uncertainties. Even in 2007, well before the onset of the current crisis, a FT/Harris poll across the western world found that citizens were looking to government to cushion the blows they perceived to come from the liberalisation of their economies to trade with developing countries. In the US, the UK, France and Spain respondents were three times more likely to say globalisation was having a negative rather than positive effect on their
november 20, 2010 vol xlv no 47
EPW Economic & Political Weekly

60

special article

countries. The country with the smallest majority against globalisation was Germany, with its large export base (Giles 2007). The second impulse, however, is that voters are suspicious of government intervention. Slogans like over-mighty government, or in Prime Minister David Camerons language, big society, not big government, elicit mass support. In US the visceral, primitive form of free-market populism now rooted in the conservative movement has emboldened Republicans to say hell, no to just about every Obama proposal.

plutocratic politics
The causes of these two opposed impulses in the western mass public are less clear. But they are surely related to the widening class gap between a plutocracy and the rest, and to the responsiveness of democratic politics and the media to the preferences of those in the top few percentiles of the income distribution. The US financial industry, having been rescued by Obamas policies, is determined to unseat the government, cut taxes, and roll back financial regulation and healthcare reform, and boost its own remuneration still more as in the case of AIG, the reckless insurance giant, which having been saved by Treasury loans proceeded to pay out $165 in executive bonuses and funnel millions of dollars to the Republican party (Egan 2010). The conservative populist movement is being promoted with funding, organisation and ideas by super-elites like the billionaire Koch brothers, who seek to use it to secure legislative support for less tax and less regulation. They persuade its supporters that the movement is fighting elite power, in what must be the biggest exercise in false consciousness the western world has ever seen (Monbiot 2010). They supply the masses with a narrative of a conspiracy against the American way of life, into which is slotted public healthcare, efforts to forestall climate change, support for the United Nations, and many other government interventions. This is of course an oversimplification, and it may be dismissed as too close to conspiracy theory. But pay attention to the following quote from Alan Budd, a long-serving UK Treasury official who became Margaret Thatchers chief economic advisor:
The Thatcher government never believed for a moment that [monetarism] was the correct way to bring down inflation. They did however see that this would be a very good way to raise unemployment. And raising unemployment was an extremely desirable way of reducing the strength of the working classes.. What was engineered in Marxist terms was a crisis of capitalism which re-created the reserve army of labour, and has allowed the capitalists to make high profits ever since (cited in Cohen 2003).

of institutional changes which lower the relative price of labour and hold wage growth below productivity growth. Unemployment rates have remained much higher than before. Some of the reasons are related to technological change and globalisation, which brought intensified competition between many more national labour forces; and some to the increased participation of women in the labour force. But the class project described by Budd, of breaking the social compact and shifting the distribution of power and income upwards towards the top end, is also an important part of the story. It worked brilliantly to keep income flowing disproportionately to the top in the US and UK. (In the year to June 2010 average directors remuneration in FTSE 100 companies increased by 55%, the median by 23%, while average earnings for the rest of the population increased by 1.5%.) At the same time, the US and UK have the lowest rates of intergenerational social mobility of the continental European and north American societies; they are moving from class societies towards caste.

the Wests Fear and chinas swagger

If the widening and solidifying gap between the plutocracy and the rest is one main cause of the opposing impulses in western politics, another is the gnawing fear in the west that its best days are over, that we are at the beginning of a long decline in western primacy in industry, technology and scientific innovation, and a parallel decline in western dominance of international politics. The fear strikes at a bedrock of western identity ever since the Enlightenment and the Industrial Revolution, that agents of western civilisation should rule the world and bring the rest of the world into harmony with their values. This is the fear. At the same time, the resurgent American conservatives are united around belief in the USs exceptional virtue and uniquely benign role in world. The belief encourages the presumption that America should enjoy the benefits that flow from others adherence to the rules without the inconvenience of having to abide by those rules itself; the presumption that America should not accept the constraints on its power posed by the rise of new centers of power. With Republicans back in control of the House of Representatives, US foreign policy is likely to be pushed back towards the aggressive, self-righteous, self-pitying foreign policy of the George W Bush administration, based on coalitions of the willing. Meanwhile, the Chinese government responds increasingly haughtily to suggestions from other states that it should behave differently (on currency, human rights, and most issues in-between) in the same manner as the British government during its imperial hayday. This US-China combination is not a promising basis for forging multilateral agreements on global issues, whether about financial regulation, internal rebalancing of savings and demand, or external rebalancing of payments. As social scientists we can at least identify key questions whose answers will shape how these contrary impulses play out. Can the west retain its concentration of the high value-added parts of global production chains, perhaps by continuing to rig the world trade regime in its favour? (Wade 2003) Can the west retain its privileged access to the best sites for oil and minerals (including Iraq and Afghanistan)? Will the US manage to correct its Great Misallocation into construction and finance, and develop new

In the post-war decades up to the 1970s, when the idea of a social compact made sense and income distribution was substantially more equal than in the 1920s or in the 1980s and beyond, governments gave high priority to full-employment, and used fiscal, monetary and occasionally even incomes policies to pursue this objective, such that average wages increased in line with productivity. Aggregate demand remained high, unemployment remained low. This whole complex was broken in the 1980s and has remained broken ever since: governments have prioritised keeping inflation very low and redirected fiscal and monetary policy to this end, and have sought to make labour markets flexible by means
Economic & Political Weekly EPW

november 20, 2010

vol xlv no 47

61

special article

export industries? Will the American Right be able to keep goading the population into hatred of some enemy terrorists, China, Muslims, liberals, Black Muslim Socialist President Obama to the point where more warfare becomes electorally acceptable, even to the point of knocking out the financial claims and productive capacities of US rivals in the hope of preparing the ground for another period of fast US economic growth? Will the plutocracy be able to sustain its position of concentrated and largely unaccountable power and use it to obtain deeper public spending cuts and more divisive policies (Wedel 2009); or will more populist forces succeed in engineering a radical devaluation of monetary assets, including those of the plutocracy, by a bout of high inflation? How can social democrats mobilise enough support to secure public office against the efforts of the Right to bring people out into the streets where visceral simplifications reign? How can
Notes
1 Disinterest rates, Lex, Financial Times, 16 September 2010, p 18. Foreclosure has far-reaching effects. When even a few houses are foreclosed other households in the area may try to sell to escape the reputation effect, putting downward pressure on all house prices and putting more mortgage holders under water. Martin Wolf (2010a). The UK government argues that borrowing costs have been contained only because of its plans for tough spending cuts. Not so. The spreads on UK government debt over German bunds stabilised in February 2010 and have fallen only 0.2 percentage points since the election, which suggests that the governments strong fiscal stance has brought only modest credibility gains. See Martin Wolf (2010b). For the deep politics behind the Basel Committee see Ranjit Lall (2010). If polls were taken of policymakers and economists in, say, 2007 and 2010 they would probably show a fall between those years in the proportion of respondents agreeing with little qualification to propositions about the virtues of free capital movements and the self-regulating tendencies of financial markets. As told by the Financial Times Lex column, For much of the past decade, emerging market policymakers were relatively relaxed about the movement of capital across borders. They would cheerily send capital on its way so long as the entry or exit papers were in order. The authorities are now a lot more guarded. The 2008-09 crisis was a reminder of the fickleness of foreign investment. Violent currency swings showed the difficulty of dealing with more or less unchecked flows. Central banks have to fight exchange-rate appreciation on the way in, depreciation on the way out There is growing evidence that judicious controls can tame volatility without threatening the broader economy. Take Taiwan. Late last year the central bank governor, making clear his distaste for unbridled international capital flows, clamped down on foreign portfolio investors. So far this year, net inflows into equities are down almost 90%. But this has not had a catastrophic effect on stock prices Moreover, it seems to have stabilised the Taiwan dollar. And investors enthusiasm for the cross-straight growth story is apparently undimmed. Other emerging countries will have to take note. Capital is heading Asias way, whether it wants it or not. Investors should realise that when it comes to curbing excess, authorities would rather be too successful than not successful enough. Lex, Capital Mobility, Financial Times, 19 September 2010, emphasis added.

policies of embedded liberalism regain legitimacy? Will a more legitimate successor to the current G-20 emerge as a steering committee for the world economy? Will it or some other body be able to engineer the crucial move from the US dollar as the main reserve currency to an accounting currency based on a basket of major currencies, and couple it with penalties on both surpluses and deficits? How will the various dysfunctions in the established western powers, added to rapid ageing of their populations, affect the opportunities for rising powers like China, India and Brazil to substantially lower the gap in income, technology and human capabilities between them and the west? Will China become old before it has become rich, with the result that most of its economy remains locked in a semi-peripheral role in the world economy, punctuated with islands of hi-tech opulence (cathedrals in the desert)? Will this be Indias fate too?
Palley, Thomas (2009): A Second Great Depression Is Still Possible, ft.com, 11 October. Palma, Gabriel (2009): The Revenge of the Market on the Rentiers, Cambridge J Economics, 33, 4, July, 829-69. Reich, Robert (2010): More Profits, Fewer Jobs, International Herald Tribune, 30 July. Reinhart, Carmen and K Rogoff (2008): Is the 2007 Sub-Prime Crisis So Different? An International Historical Perspective, American Economic Review, 98, 2, May. Rottier, Stephane and Nicolas Veron (2010): Global Financial Integration Goes into Reverse, Financial Times, 10 September, p 13. Schwartz, Nelson (2010): Financial Industry Awaits a Washington Power Shift, International Herald Tribune, 3 November. Stephens, Philip (2010a): Three Years On, the Markets Are Masters Again, Financial Times, 29 July. (2010b): Blairs Telling Lessons for the Left in Its Era of Retreat, Financial Times, 3 September, p 11. Thallarsen, Peter (2010): Inconsistent Bank Rules Could Hurt Reform, Reuters Breaking Views, International Herald Tribune, 6 September, p 18. Trichet, Jean Claude (2008): Macroeconomic Policy Is Essential to Stability, Financial Times, 13 November. Wade, Robert (2003): What Strategies Are Viable for Developing Countries Today? The WTO and the Shrinking of Development Space, Review of International Political Economy, 10, 4. (2008): Financial Regime Change?, New Left Review, 53, September-October, pp 5-21. (2009a): The Global Slump: Deeper Causes and Harder Lessons, Challenge, September-October. (2009b): From Global Imbalances to Global Reorganisations, Cambridge J Economics, 33, 4, pp 539-62. Wade, Robert and Silla Sigurgeirsdottir (2010): Lessons from Iceland, New Left Review, SeptemberOctober. Wade, Robert and Jakob Vestergaard (2010): Overhaul the G20 for the Sake of the G172, Financial Times, 22 October. Wedel, Janine (2009): The Shadow Elite: How the Worlds New Power Brokers Undermine Democracy, Government, and the Free Market (New York: Basic Books). Wolf, Martin (2010a): Why the Balls Critique Is Correct, Financial Times, 3 September, p 11. (2010b): The Risks of Premature Tightening, Financial Times, 17 September. (2010c): Basel: The Mouse That Did Not Roar, Financial Times, 19 September, p 13, emphasis added.
vol xlv no 47
EPW Economic & Political Weekly

References
Authers, John (2010): The Great Re-regulation Turns into Great Escape, Financial Times, 17-18 July. Blyth, Mark (forthcoming): This Time It Really Is Different: Europe, the Financial Crisis, and Staying on Top in the Twenty-First Century in D Breznitz and J Zysman, Can the Rich Countries Stay Rich? Briancon, Pierre (2010): EC Plugs a Hole in Regulating Banks, Reuters Breaking views, International Herald Tribune, 6 September, p 18. Cochrane, John (2010): One Year Later, Stimulus Appears to Yield Mixed Results, PBS Newshour, 17 February, at www.pbs.org/newshour/bb/business.jan-jun10/stimulus_02-17.html. Cohen, N (2003): Gambling with Our Future, New Statesman, 13 January. Davies, Howard (2010): Finance: Dont Bank on Global Reform, Prospect, September, 21. Douthat, Ross (2010): Paranoid About Paranoia, International Herald Tribune, 10 September. Egan, Timothy (2010): How, To His Cost, Obama Saved Capitalism, International Herald Tribune, 5 November. Elliott, Larry and Julia Kollewe (2010): OECD Makes U-turn Over Cuts as Global Slowdown Continues, Guardian, 10 September. Farrant, Andrew and Edward McPhail (2010): Does F A Hayeks Road to Serfdom Deserve to Make a Comeback?, Challenge, 53, 4, July-August, pp 96-120. Giles, Chris (2007): Poll Reveals Backlash in Wealthy Countries against Globalisation, Financial Times, 23 July. Goldin, Claudia and L Katz (2008): Transitions: Career and Family Life Cycles of the Educational Elite, American Economic Review, 98, 2, pp 363-69. Krugman, Paul (2010a): This Is Not a Recovery, International Herald Tribune, 8-9 August. (2010b): Things Could Be Worse, International Herald Tribune, 11 Sep 2010, p 7. Lall, Ranjit (2010): Reforming Global Banking Rules: Back to the Future, DIIS Working Paper, Danish Institute of International Studies. McCarty, Nolan, Keith T Poole and Rosenthal, Howard (2006): Polarised America: The Dance of Ideology and Unequal Riches (Cambridge: MIT Press). Monbiot, George (2010): The Tea Party: A Deluded Grassroots Movement Inspired by Billionaires, Guardian, 26 October, 31. Norris, Floyd (2010): Bank Rules? Dont Hold Your Breath, International Herald Tribune, 17 September, p 19.

3 4

62

november 20, 2010