The subprime mortgage crisis has revealed to many people that the "strength" of the U.S. economy, isn't. As the crisis proceeds, more and more people will feel devastating effects, and what might be thought politically impossible today, will become common topics of policy discussions. Right now, the big banks, investment houses, and hedge funds, have a stranglehold on the policy process, but just like the financial system itself, that stranglehold will crack as the crisis proceeds to build. We must be prepared with progressive policy proposals when the time comes.
The underlying problem is a financial system that has run wild, with no heed paid whatsoever of the effects of financial flows and gyrations on the underlying, real economy, in which 95 percent or so of us mere mortals have to live our everyday lives. There must be a way to force those financial flows back into subservience to the real economy. At the same time, we need to avoid crippling the financial markets to such an extent that they can no longer serve their proper function of allocating capital within an economy.
As I have searched for solutions, I have recently come across an economist I would like to introduce you to, Thomas I. Palley, formerly Assistant Director of Public Policy at the AFL-CIO. He is now working on his own project, Economics for Democratic & Open Societies, to stimulate public discussion about what kinds of economic arrangements and conditions are needed to promote democracy and open society. In 1998, his book, Plenty of Nothing: The Downsizing of the American Dream and the Case for Structural Keynesianism, was published by Princeton University Press.
(Some people will undoubtedly find much of what follows too dry and academic. Palley is an economist, not a polemicist. I have received permission via email, dated December 14, 2007, from Dr. Palley to quote his work extensively.)
In the autumn of 2002, Palley published a paper in the Journal of Post Keynesian Economics entitled, "Economic contradictions coming home to roost? does the U.S. economy face a long-term aggregate demand generation problem?" in which he argues that the
U.S. economy confronts deeper seated problems concerning the aggregate demand generation process. For two decades, these problems have been obscured by a range of demand compensation mechanisms -- rising consumer debt, a stock market boom, and rising profit rates. Now, these mechanisms are exhausted. Fiscal policy adjustments and dollar depreciation are the only stable exits from this impasse, but they must be accompanied by measures rectifying the income distribution imbalances at the root of the problem. Absent this, deficient demand will reassert itself.
As I have pointed out two weeks ago, We’ve Been Here Before, and it is Not Good. Marriner S. Eccles, who served as Franklin Roosevelt’s Chairman of the Federal Reserve from November, 1934 to February, 1948, wrote in his memoirs that the income and wealth inequality of the 1920s resulted in a deficiency of demand that caused in the Great Depression.
In another paper in March 2006, Palley quite accurately forecast the bursting of the U.S. housing bubble -- which we are witnessing now -- as part of a larger effort to address the increasingly dangerous imbalances in the world financial system. In that paper, which is entitled "The Fallacy of the Revised Bretton Woods Hypothesis: Why Today’s System is Unsustainable and Suggestions for a Replacement."
Palley warns that there are fundamental differences between the U.S. trade deficit of today, and the trade deficit of four decades ago:
There are three significant differences between today’s system and the earlier system. First, today’s trade deficits are the result of on export-led growth predicated upon under-valued exchange rates, yet the purpose of Bretton Woods was to prevent "beggar-thy-neighbor" trade based on competitive devaluation such as had afflicted the international economy in the Great Depression era. Though Germany’s exchange rate alignment in the old Bretton Woods system came to be significantly under-valued, that was not the case for the United Kingdom. Moreover, the Bretton Woods system had formal provisions whereby countries with structural trade deficits could devalue.
Second, the current period has multi-national corporations shifting to China to establish state of the art export platforms whose production is intended for export back to the center (the U.S.). This contrasts with the 1950s and 1960s when American multi-nationals established production facilities in Europe for purposes of supplying the European market. Companies such as Ford, General Motors and IBM produced in Europe for Europe, not for export back to the United States. Likewise, European capital accumulation was primarily intended for European markets.
Third, the growing U.S. trade deficits in the 1960s were driven by full employment in the United States, along with higher wages, a growing manufacturing sector, and increasing manufacturing employment. These deficits contrast with current U.S. trade deficits, which are driven by debt-financed consumption spending (supported by a housing price bubble), and imports are displacing U.S. manufacturing. Whereas U.S. trade deficits in the 1960s were consistent with the generation of robust and stable aggregate demand, the current financial system is undermining the structure of the income and aggregate demand process and eroding manufacturing capacity.
Thus, in a nutshell, it is the over-stretched U.S. consumer that is the fatal weakness of the current world financial system. Since the East Asian economies are being used to arbitrage labor costs, (as well as regulatory costs, and environmental effects), there is not sufficient demand in those economies to absorb their own production, and they MUST export.
However, this arrangement is inherently unstable, because East Asia’s overwhelming need to export outweighs policy prescriptions required by prudent economic and financial considerations.
The price that the developing periphery must pay, however, is exports to the center. This arrangement explains why savings flow north from poor to rich countries, rather than from rich to poor countries, as predicted by conventional, intertemporal, consumption-smoothing models of the international economy. Since international competitiveness is the key to export-led growth, countries actively pursue policies aimed at maintaining undervalued exchange rates. This explains why China has refused to revalue its exchange rate despite a massive and growing trade surplus, and why there is an accumulation of dollar-denominated official reserves throughout East Asia. . . .
East Asia benefits from exporting to the United States, as its factories are fully employed. Export success spurs domestic investment and FDI [foreign direct investment] in manufacturing, which fuels further growth and development. These benefits are especially important to China, which needs to create jobs rapidly in order to absorb rural migration to its cities; if jobs are not forthcoming, social and political unrest could erupt to threaten Communist Party rule. The benefits mean that East Asian governments are willing to continue accumulating U.S. financial assets, thus ensuring a steady stream of financing for the U.S. trade deficit at current interest and exchange rates. For East Asian countries, portfolio risk and return are not the driving force of financial investment decisions. The driving force is economic growth. (Emphasis mine)
Which makes the U.S. consumer, as has been widely noted, "the buyer of last resort.
Turning to examine where the fault line thus lies -- the United States -- Palley points out what is obvious to everyone except journalists, central bankers, conservatives, and Republican politicians: the "boom" of the Bush years has been based on an unsustainable consumption boom -- unsustainable because it is financed by debt, and
the housing price bubble may be topping out, thereby eliminating future gains to borrow against and even possibly imposing losses. A second reason is that U.S. households face adverse wage and income pressures generated by international outsourcing. These pressures have been spreading from the manufacturing sector to the larger service sector.
Moreover, Palley predicts – almost two years ago -- exactly what we are seeing now.
. . . the constraint will lie in U.S. goods markets and domestic credit markets, and East Asian economies can do nothing to force those transactions by providing credit to banks. It is the borrower and local bank that must seal that deal. The bottom line is that the system is vulnerable to a crash that originates within the U.S., and about which East Asian economies can do little. Indeed, the competitive pressures unleashed by export-led growth and outsourcing, are part of the constellation of forces making for such a crash. . .
The U.S. is also likely to find it difficult to escape a consumer-led recession. The previous recession was escaped by the combination of a budget U-turn from surplus to massive deficit, a significant reduction in interest rates that spurred mortgage refinancing that re-liquified household balance sheets, and by consumer borrowing collateralized by a house price bubble. Today, these options are no longer available, and the only significant space for policy stimulus is for the Fed to reverse itself and cut rates. However, such rate cuts will likely be much less effective than previously. One reason is the stock of high interest mortgages has already been depleted and refinanced. The second reason is that lenders will be less inclined to lend given households’ more financially stretched positions. A third reason is that house prices have already risen and are more likely to go down than up.
Palley next lays the foundation for understanding his suggested solutions by describing how the present global financial architecture has been shaped by the East Asian financial crisis of 1997, when the Asian countries decided to amass huge foreign exchange reserves as a bulwark against future financial panics. Palley does not mention it, but of course this created more artificial demand for the U.S. dollar as a reserve currency, thereby hiding the fundamental weakness of the U.S. economy for another decade.
There are several important points that follow from this. First, the accumulation of official reserves has not been driven by a desire to accumulate collateral to underwrite [foreign direct investment]. It has been driven by a desire to protect against the possibility of future capital flight. Second, the system is an accidental product, the result of state policy responses to unwelcome market developments. Viewing the system as the product of optimizing markets is the disease of modern economists who interpret everything in this light. Third, the system is globally problematic . . . it promotes global deflation through its excessive emphasis on exports, which hollows out the income and aggregate demand generation process in the U.S. via de-industrialization and out-sourcing.
Palley then lists a small number of scholars who have proposed various solutions for governing and regulating capital flows, including:
Improved prudential regulation
Chilean-style or Indonesian-style "speed bumps" that implicitly tax short-term inflows
Currency transaction taxes
http://www.currencytax.org/
http://www.globalpolicy.org/...
http://www.ceedweb.org/...
Domestically imposed reserve requirements on lenders
Obligations for lenders to hedge foreign currency lending on behalf of borrowers.
Some further reading on these measures can be found in:
Blecker, R.A., Taming Global Finance: A Better Architecture for Growth and Equity, Economic Policy Institute, Washington, DC, 1999.
Griffith-Jones, S., and J. Kimmis, "Stabilizing Capital Flows to Developing Countries," in Michie and Grieve Smith (eds.), Global Instability: The Political Economy of World Economic Governance, Routledge: London, 1999.
"International Finance and Global deflation: There is an alternative," in Michie and Grieve Smith (eds.), Global Instability: The Political Economy of World Economic Governance, Routledge: London, 1999.
Palley suggests a scheme of crawling band target zones to replace the complete, unregulated chaos we have today in foreign exchange markets.
Such a system involves choice of a number of parameters that would need to be negotiated by participants. First, there is choice of the target exchange rate. Second, there is the choice of size of the band in which the exchange rate could fluctuate. Third, there is a choice whether the band would be hard or soft. A hard band is automatically and decisively defended; a soft band is one that allows for marginal temporary deviations outside the band, while retaining a commitment to bring the exchange rate back within the band when market conditions are most conducive. Fourth, there is the choice of the rate of crawl. This involves determining the rules governing the adjustment of the target and band. Issues here concern the periodicity of adjustment, and the rule governing adjustment of the nominal exchange rate. . . .
Finally, rules of intervention to protect the target exchange rate need to be agreed upon. Historically, the onus of defending the exchange rate has fallen on the country whose exchange rate is weakening. This requires the country to sell foreign exchange reserves to protect the exchange rate. Such a system is fundamentally flawed because countries have limited reserves, and the market knows it. This gives speculators an incentive to try and "break the bank" by shorting the weak currency, and they have a good shot at success given the scale of low cost leverage that financial markets can muster. Recognizing this, the onus of exchange rate intervention needs to be reversed so that the strong currency country (the central bank whose exchange rate is appreciating) is responsible for preventing appreciation, rather than the weak currency country being responsible for preventing depreciation. Since the strong currency bank has unlimited amounts of its own currency for sale, it can never be beaten by the market. Consequently, once this rule of intervention is credibly adopted, speculators will back off, making the target exchange rate viable. Such a procedure recognizes and addresses the fundamental asymmetry between defending weak and strong currencies.
Palley ends by assailing the "mentality of policy passivity" induced in American policy makers by the belief that "markets know best." This belief is unfounded, and
is at odds with reason and the evidence. There are many theoretical reasons for believing that foreign exchange markets are prone to herd behavior. There is also strong empirical evidence that exchange rates depart from their theoretically warranted equilibrium levels. . .
Obviously, I believe that Palley has put forward excellent proposals. He implicitly recognizes that there would be massive and unacceptable damage done to the underlying economies by such rash and unreasoned proposals as a gold standard. At the same time, he clearly see that the present system not only is unsustainable, but is being pulled apart by inherent instabilities that cannot be reconciled.
However, I believe that Palley unfortunately overlooks the importance of beginning to constrain foreign exchange trading and capital flows. Palley clearly recognizes that wages and earnings in the U.S. have been sinking under the pressures of the present system, but does not see that foreign exchange trading and capital flows are in fact some of the primary mechanisms by which those pressures are generated. Trading of financial instruments, including stocks, bonds, futures, and other derivatives, as well as foreign exchange, is now more than fifty times annual GDP.
If just one fifth of one percent of those financial flows are taken out as management fees, trading profits, and so on, by banks, hedge funds, and other financial actors, that amounts to ten percent of GDP. And that is how you get a situation where the combined bonuses awarded by just five Wall Street firms for just one year are more than double the increase of real annual earnings from given in five years to 93 million production and nonsupervisory workers.
John Bogle, founder and retired CEO of The Vanguard Group of mutual funds, who has been warning that the financial system has overwhelmed the productive system, has estimated that the financial system is taking around $500 billion in value out of the productive system. Bogle’s estimate of $500 billion is a bit less than one third of the ten percent of GDP noted above, but Bogle is not trying to measure the entire "take" of the financial system, only what he considers an unnecessary imposition on the real economy.
If you have read this far, I know you are interested in these issues. I hope you also realize it is going to be extremely difficult, politically, to implement these types of policies. The banks and financial houses and hedge funds have more money than anyone else, and pretty much have almost the entire Congress in their back pocket. But I believe that the subprime mortgage crisis will continue to spread throughout the financial system and into the real economy. Indeed, we already see a massive slowdown of real economic activity because of the collapse of the housing boom. But I think most Americans won’t actually start feeling the pain until sometime in the middle of next year. And that pain will be so severe, that many things that look politically impossible today, will become common topics of policy discussions. We must be ready for when that time comes.