I.
Last week’s roller coaster on the world’s financial markets highlights the extreme volatility that characterizes the current economic system. Volatility is generated not just by uncertain prospects and a lack of trust in existing institutions and practices but also—and perhaps above all—by new forms of risk linked to complex financial instruments such as derivative trading.
Of course taking risk is integral to successful business, economic growth, and growing prosperity. But the sort of systemic risk that has been at the heart of finance for the past decades is fundamentally different from the calculable risk of individual businesses: it cannot be measured (inter alia, due to a lack of information), and its negative consequences cannot be insured against.
As a result, profits are privatized and losses are nationalized. With generous tax breaks and tax havens, corporate profits accrue to those who already have assets and do not trickle down via taxation. On the contrary, when speculating short-sellers help bring down corporations, it is central banks and national governments that have to bail them out with taxpayers’ money—something akin to socialism for the rich who hold the reigns of power.
To be sure, bailouts can hit CEOs, top management, and institutional shareholders hard, above all through loss of employment and loss of bonuses. But bailouts have economic and social costs that are not covered by the assets. And bailouts raise the question of moral hazard—the problem that people behave recklessly if they are not responsible for the consequences of their actions. Indeed, banks are allowed to fail whereas other financial institutions are rescued. Who decides on that and on what grounds?
Not to mention the ongoing concentration of assets: in the name of rationalization and consolidation, mortgage holders face a mountain of personal debt and sub-prime-induced repossessions, whereas multinational corporations take over their rivals’ assets at a faction of the real value—J.P. Morgan Chase buying up Bear Stearns and Lloyds TSB taking over Britain’s biggest mortgage lender, HBOS (itself the product of a merger between Halifax and Bank of Scotland).
Clearly, what the current crisis shows is that the predominant economic and political model privileges the concentration of wealth and the centralization of power. Thus, it is wrong to describe this as a confrontation between the centralized bureaucratic state and the unbridled free market. Instead, state and market have convergent interests: just as the state uses the market as its preferred delivery mechanism for “more efficient” public services (e.g., private contractors), the market depends on the state for deregulation, liberalization, and privatization.
In this, state and market have colluded at the expense of civil society and civic culture—intermediary institutions embedded in communities that have a shared, though contested, sense of social and political virtue. From Christopher Lasch’s book The Revolt of the Elites and the Betrayal of Democracy and from Paul Piccone’s work on the New Class, we know that this unholy alliance goes back to the 1960s, when the new elites eschewed organic cultures and a civic communitarianism in favor of technocratic bureaucracy and managerial politics. The specter of “possessive individualism” (C.B. MacPherson) and the advance of an acquisitive society (R.H. Tawney) came back to haunt America and Britain.
Traditional reciprocal bonds that bind people together were dissolved by a whole variety of factors. But in terms of the economy, nothing has been as destructive as the growth of financial services at the expense of manufacturing and industry and the rise of unrestrained speculation.
II.
Already last autumn, George Soros—the billionaire investor—warned that the financial turmoil following the collapse of the sub-prime mortgage market was no ordinary correction of market excesses. Instead, the parabolic shape of price curves and of the stock-market value indicates that massive speculation has been at work, a thesis he put forward in his book The New Paradigm for Financial Markets: The Credit Crisis of 2008.
The simultaneous onset of financial turmoil and soaring fuel and food prices was neither a freak accident nor an unfortunate coincidence. In large part, both were caused by unrestrained speculation that leads to a huge hike in asset and commodity prices and thereby creates trillions of dollars in fake wealth. In turn, this sustains the speculative frenzy—a phenomenon which the long-time Chairman of the U.S. Federal Reserve Alan Greenspan termed “irrational exuberance” but which he and consecutive administrations failed to act upon.
Nor are the consequences of speculative practices confined to finance. Derivative trading has massively expanded into oil and commodities. The oil price more than doubled in the twelve months from August 2007 to July 2008, soaring from about $71 to over $145. Since the mid-summer peak, the oil price has dropped by over 30%. With inventories largely unchanged, who would seriously argue that demand and supply factors can fully account for these movements?
Now that the credit crunch has burst the property bubble, the financial crisis is dragging the U.S. and the UK economy into recession. Economists call this “contagion,” the spread from Wall Street to Main Street. Western economies face a bigger economic storm than in the 1970s and the 1990s: they must confront a simultaneous house-price crash (perhaps equal to or worse than that of the early 1990s, with record monthly falls in July and August 2008 in the United States and Britain) and an oil shock that could be permanent (as opposed to the temporary price hikes in 1973 and 1979). The prospect is a decade of stagflation, permanently higher consumer prices and real wage decline. Indeed, in the United States, Britain, and elsewhere, consumers must face up to negative equity and permanently higher commodity prices—a real wage decline that will widen the asset gap.
Western economies are not alone. Far from de-coupling, the East is more integrated into the global economy than at any point since 1989. As the recent stock market collapse in China and Russia has demonstrated, Eastern economies are caught up in the mess. To be sure, there are specific factors such as the lower oil price, which is hurting Russia, and lower demand for commercial property, which is adversely affecting China. But the liquidity crisis is global, not because there is no money around (the Gulf states and Russia are awash with petro-dollars) but because investors are reluctant to part with their money. Hence the capital flight from financial assets to hard assets such as gold but also corn, a process that is driving up the price of primary commodities.
III.
Such financial bubbles with real consequences are by no means exclusive to the neo-liberal dogma that has prevailed since the early 1980s. For example, in 1720 overheated speculation in the shares of the South Sea Company led to a stock-market crash that forced banks to default and left thousands of individual investors destitute. The case of the “South Sea Bubble” (and the subsequent collapse) is instructive because it highlights two characteristics of virtually all financial crises: they are international (with the end of similar bubbles in Amsterdam and Paris at that time), and they involve the collusion of central government and large corporations at the expense of small investors and independent businesses.
Indeed, the South Sea Company bought more than half of Britain’s national debt (financed by issuing new shares) in exchange for easy access to credit (made available by the King and Parliament) in order to finance the company’s expansion. This scheme relied on an unsustainable rise in share prices—the eventual collapse ruined small shareholders who had been misled.
Similar bubbles burst at the end of the nineteenth century and on Black Tuesday, October 29, 1929, triggering recessions from 1873 to 1896 and from 1929 to the mid-1930s, respectively. Each time, those who were left impoverished were ordinary citizens and small businesses.
Since the 1970s, the neo-liberal liberalization and deregulation of financial markets has promised to minimize the threat of recession and inflation and to maximize growth and price stability. Instead, it has given rise to a seemingly endless series of speculative booms and spectacular busts: in 1979, in the late 1980s and early 1990s, in 1994 in Mexico, in 1997 in East Asia, in 1998 in Russia, in 2000-1 in the United States and Britain (as well as Argentina), and now in 2007-8. A new and accelerating bubble cycle has supplanted the earlier business cycle.
The neo-liberal reforms abolished regulation and control, expanding capital mobility on an unprecedented scale. New complex instruments such as derivative-trading inflated the overall volume of capital in search of lucrative opportunities. With declining profit margins in industry and manufacturing, money switched to finance, insurance, and real estate—FIRE. The new economy was born. Reinforced by easy credit, the United States and Britain went on a collective, reckless speculation-drive and consumption-binge financed by a growing mountain of personal and public debt.
All of which led to artificially inflated and grossly overvalued asset prices: in the United States alone, the dot-com bubble of the 1990s built up $7 trillion in fictitious value and the recent housing bubble a staggering $12 trillion. At some point in 2008, derivative trading amounted to something like $70 trillion, more than three and a half times the value of the global economy.
Now that property and other asset prices are falling, wage earners can no longer service their mortgage and credit debts—a predicament that is exacerbated by stagnant or declining real wages for lower- and middle-income groups.
So the effect of neo-liberalism was to intensify and escalate some of the most destructive tendencies of finance capitalism: capital shifted from investment in productive activities to speculation in financial assets and commodities. The corporate imperative of quick profits put a premium on high-risk short-term speculative bets, injecting volatility into money markets and infecting the overall economic system. With private equity companies and hedge funds not just speculating in the financial sector but also in commodities, the price of oil, metals, and foodstuffs is soaring—to the detriment of producers and consumers. The ongoing global food crisis is of a piece with the current financial trouble.
IV.
As Soros has rightly remarked, the end of a speculative bubble does not mark the return to a historical trend but only a temporary correction before a new bubble and a new bust. Reverting to the bubble cycle should and could be averted.
First, national and international regulators need to ban and severely punish a number of dubious speculative practices, above all gambling with global commodity prices that hurts the world’s poorest most.
Both the Financial Services Authority (FSA) in Britain and the Securities and Exchange Commission (SEC) in the United States have finally acted to curb “short selling” (suspended until mid-January 2009), but this will not prevent a return to the inverse practice (betting on short-term increases in the stock-market value)—a phenomenon that led to the speculative bubble which began to burst last August.
Second, those who engage in derivative trading must be compelled to have larger equity capital in order to limit exposure and to reduce the ratio of loan to value. Such capital requirements must be the same across the entire financial system, independently of sector or class of risks.
Third, dodgy mortgage and credit schemes need to be abolished and lending diversified: the emerging monopoly of corporate banks must be diluted in favor of small building societies and cooperatives. Micro-credit could be adapted to advanced economies and extended to all those who are currently excluded from the formal banking system.
Finally, the overall incentive structure of the world economy must be reformed: investment in the production of goods and services and the enhancement of human and social capital must once more be privileged over and above short-term speculation. This requires a new ethical framework that imposes limits on financial markets and offers inducements that help direct economic activity towards the common good.
V.
The current crisis provides a window of opportunity for a new settlement. Politics and economics must once more be governed by a substantive account of justice, not just functional utility and the freedom of individual consumer choice. Proper justice blends individual well-being and communal welfare. As such, a just economy does not simply maximize corporate profits and fill the state’s coffers, but, more importantly, it provides public goods and sufficient revenue for the community. To achieve this, a different mix of regulations and incentives is needed in order to induce the market to set just prices that reflect the true value of goods and services and to pay just wages that represent the true value of labor.
Specifically, fair-trade prices and standards in agriculture and the food industry could be extended to other parts of the economy. Private-sector wage earners could be made stakeholders as part of successful shared ownership models, such as the British retailer John Lewis or the France-based banking cooperative Crédit Mutuel that also operates in other EU countries. Moreover, instead of inefficient state monopolies and expensive private contractors, public services and utilities could be delivered by “public interest companies” that are taxpayer-funded but operate independently and reinvest their profit.
The neo-liberal myths of free-market self-correction and self-regulation have been exposed. Nationalization and state capitalism do not provide the answer. In the short term, elected politicians and independent experts must once again intervene to frame and regulate economic activity. Over time, what is required is a new settlement that ties the economy more closely to locality and directs global financial transaction beyond private profits to public interest and the common good.
