The Hindu Business Line : Finance and the real economy

At a time when reports of losses resulting from the subprime crisis are on the rise, a paradoxical surge in global stock markets is inducing an element of complacency. The worst is over, argue observers. C. P. Chandrasekhar and Jayati Ghosh take a longer view, and examine evidence on growth and volatility in the age of finance that suggests that the worst is perhaps not behind us.

It is raining losses in the world of finance. When the subprime crisis broke, one of the first Wall Street banks to declare that it was affected was Bear Stearns, which found that two of the funds that it managed had mortgage-backed assets that were worthless. That set off fears of a liquidity crunch that could damage growth.

A couple of months down the line, Bear Stearns with losses of $700 million from the subprime episode almost seems a winner. Other players have declared much larger actual or predicted losses: Goldman Sachs ($1.5 billion), Morgan Stanley ($2.4 billion), Deutsche Bank ($3.1 billion), Citigroup ($3.3 billion), UBS ($3.4 billion) and Merrill Lynch ($5 billion), to name a few.

Paradoxical boom

However, paradoxically, as news of these losses resulting from the subprime mess proliferates, stock markets that had turned downwards in July have experienced a revival. In fact, on October 1, 2007, the Dow Jones industrial average closed at a record 14,087.55. That was even higher than the peak of 14,000.41 the index had touched at closing on July 19, 2007, when the subprime-crisis-induced market downturn had begun.

What is more, Citigroup’s share prices that had fallen 16 per cent this year, prior to the profit warning it issued, rose by 2.3 per cent to $47.42, immediately after that warning. Financial losses seem to be triggering a financial boom and not a slump.

This has induced an element of complacency in the minds of governments and market players, who seem to believe that the worst is behind us, because of a well-timed dose of government intervention. According to this view, the factor accounting for the recent boom in financial markets is the decision taken by leading developed country governments to reduce interest rates and pump liquidity into the system.

This is seen as having prevented the subprime slump from generating a liquidity crunch that could have precipitated a full-fledged financial crisis and resulted in a collapse in growth.

But complacency comes not just from the belief in the capability of governments. It is also because votaries of liberalised financial markets believe that the global economic system is characterised by a new resilience that comes from its late twentieth century transformation.

Capitalism is now seen as less crisis prone because financial deregulation and innovation are believed to have ensured that credit is accessible easily even in a downturn, because lenders are in a position to spread and share risk through securitisation. This according to The Economist (September 22, 2007), for example, breaks “the rigid link between income and spending”. Investment by firms is not restricted by their cash flow position, and spending by households is not limited by current incomes. As a result, any short-term fall in incomes does not trigger a downward spiral in economic activity. The net result is more stable and therefore “better” income growth, even if as we have seen that growth is much lower than recorded during much of the post-War period.

However the evidence to back this case for a new resilience stemming from financial deregulation and financial innovation is not easy to find. In fact, the increase in the volume of liquidity in the world economy and the sharp rise in the number of financial transactions occurring within and between countries that have liberalised their financial sectors appear to have increased rather than dampened financial volatility and, therefore, the volatility in real economic growth.

This is not to deny that the expansion in liquidity generated by the financial expansion and innovation of recent years has been crucial for whatever growth has occurred in the developed countries. Rather, it is to recognise that the financial explosion has also provided the base for financial speculation, leading to boom-bust cycles in financial markets. Associated with those fluctuations is the enhanced volatility of real economic growth.

Finance capital and growth

There are two important ways in which the expansion of finance capital has contributed to growth. To start with, this expansion has been responsible for speculative surges in asset markets that have, through the operation of the “wealth effect”, contributed to a consumption splurge.

Thus growth in the US during the 1990s, which was far better than in developed capitalist Europe and Japan, was seen as the result of a sharp increase in personal consumption expenditures led by expenditures on durable goods. This consumption fest in the US was not determined by real incomes.

What had been more crucial was the willingness of the average American to dip into potential savings to finance consumption, resulting in a gradual decline in the household savings rates in the US to negative levels. Credit, implying net dissaving, has been the trigger for the consumption boom that has driven growth.

This debt-financed consumer boom in the US was attributed to the wealth gains which American households had registered because of the boom in US stock markets. It is widely known that the US is unique in terms of the width and depth of the equity culture in the country.

As far back as 1998, the probability that an individual between the age of 35 and 64 owned some shares stood at above 50 per cent, with the figure rising to 62.4 per cent in the 35 to 44 age group. During the years of the stock market boom, which began at the end of 1994 and lasted till the end of 1990s (with one major glitch at the time of the financial crises of 1997-98), this wide prevalence of stock ownership resulted in a substantial increase in the wealth of American citizens. The consequent “wealth-effect”, which encouraged individuals to spend because they saw their “accumulated” wealth as being adequate to finance their retirement plans, was seen as a major factor underlying the consumer boom and the fall in household savings to zero or negative levels.

The end of the stock market boom in 2000, in the wake of the dotcom bust, was expected to reverse this process. It initially did, forcing the Fed to intervene by reducing interest rates. But these reduced interest rates and the persistence of excess liquidity triggered in time the housing boom.

People borrowed to invest in housing, pushed up house prices and used the equity that ownership of more expensive houses provided to borrow more to spend. In this manner, the easy money that financed the housing boom has been crucial to the economic recovery since 2001.

According to one estimate, housing has contributed over 40 per cent of employment growth between 2001 and 2005. And housing expansion plus real estate inflation are estimated to have accounted for 70 per cent of the increase in household wealth over this period. With the value of their housing assets having risen individuals found that their net worth had increased substantially. This too triggered a splurge in consumption.

What we now know is that the easy liquidity and low interest rates that triggered and sustained the housing boom also created the conditions that led up to the subprime crisis.

That crisis has revived fears of a liquidity and credit crunch that would contract consumption and investment and precipitate a recession.

The world’s leading capitalist economies, led by the US, are gripped by fears of an imminent economic crisis, triggered by financial uncertainty. If a recession does ensue, this would be the third instance of an economic downturn within a decade, coming after the recessions that followed the East Asian financial crisis in 1997 and the dotcom bust of 2000 (Chart 1).

As in those instances, this time too, the proximate cause of the crisis would be a speculative surge in the activities of poorly-regulated, profit-hungry financial firms and entities that have come to dominate the global economic landscape in the neo-liberal era.

This proneness to periodic crisis is of special significance because it occurs in a global situation where booms of large amplitude are increasingly rare. An abiding feature of capitalism over the last three quarters of a century is a near continuous decline in its long term rate of growth.

Keynesian policies rejected

The “Golden Age” of post-War capitalism — or the years of boom that followed the end of the Second World War — had come to end by the late 1960s. With it waned the belief in the ability of state-expenditure-led, Keynesian demand management policies to stall the periodic crisis that afflicts capitalism as a system.

What is not emphasised, however, is that the rejection of Keynesian policies resulted in a continuous decline in the average rate of growth of the world economy. According to the World Bank’s annual analyses of Global Economic Prospects, world economic growth that stood at 5.2 per cent between the mid-1960s and 1973 (prior to the first oil shock) declined to 3 per cent during 1974-1990 and further to 2.3 per cent recorded during the years (1991-1997) preceding the East Asian financial crisis (Chart 2).

What is more, if we compare the world economy’s growth performance during the 1970s, 1980s, 1990s, and the first half of this decade, we observe a continuous decline in the rate of growth, leading up to a situation where growth of even 2.5 per cent per annum is considered creditable (Chart 3).

Thus medium-term trends point to slowing of growth in the developed countries. One consequence of the process of financial expansion and globalisation is that the policy space available to governments is substantially reduced. If the government in any one country chooses to accelerate employment and output growth by expanding expenditures, any inflation that this might spur would, by worsening the trade deficit and eroding the value of financial assets, result in an outflow of capital and trigger a collapse of the currency.

As a result governments learn to limit their expenditures and curtail their deficits, resulting in chronic deflation and slow growth. Whatever growth occurs is triggered by private expenditures which are increasingly financed by the excess liquidity that financial deregulation and openness deliver.

As we have seen above, this dependence on debt-financed consumption, investment or housing booms, besides limiting the rate of growth, makes economies prone to crises resulting from speculation. As a result, relatively slower growth is accompanied by greater volatility. The subprime crisis and its aftermath is an example of such volatility.

In recent times, however, periodic crises have been followed by early recoveries. But there is no guarantee that such recoveries would always occur within a short period of time. In fact the fear today is that if the uncertainties generated by the subprime housing loan crisis were to persist, the dollar could collapse and the global economy could be faced with a prolonged crisis. It is for this reason that there is much talk of the need to ensure a soft-landing of the dollar.

The liquidity-induced paradoxical boom in the stock markets should not lead to complacency on this count.

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