Much of the analysis of the current crisis has focused on financial institutions, regulation and monetary policy. Although these were important in shaping the crisis, they are not at its root.
The truth is that the world economy has changed in ways that are likely to lead to periodic instability. These changes have not yet been recognised and assimilated by central bankers or politicians.
The freeing of capital movements in the 1980s combined with the collapse of communism, releasing billions of new workers into the world economy, has recreated a global reserve army of labour. That in turn has contributed to a rise in the share of world GDP accounted for by profits and an accompanying decline in the share accounted for by wages. Such a development easily leads either to over-investment by businesses or a shortfall of aggregate demand. When wages lag, spending can keep up with output only by an expansion of consumer debt.
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The Bretton Woods system ordained that the exchange rates of its members should be pegged to certain parities against the dollar (which was itself fixed to gold) and only permitted to fluctuate around those parities within narrow bands. Given controls on capital, these pegs were threatened mainly by trade imbalances. As trade deficits were less easily financed from abroad, rates of investment were limited by domestic saving.
This system was destroyed by inflation. The Polish economist Michael Kalecki, who anticipated much of the Keynesian revolution in the early 1930s, identified the difficulty of maintaining full employment. Ultimately workers would bid up wages and these extra costs to business would be passed on in prices. His conclusion was that governments would engineer periodic bouts of unemployment to maintain discipline and keep wages under control. Some countries evolved corporatist systems, such as incomes policies or centralised wage bargaining, to make the process less painful, but inflation began to creep up during the 1960s. Inflation differentials between countries led to the end of Bretton Woods in 1971 and floating of currencies in 1973.
Bretton Woods was unsuited to dealing with shocks that reduce national income. The oil shocks of the 1970s had exactly this effect, triggering a battle over whether profits or wages should bear the brunt, typically in the form of a wage-price spiral. When the Arab states suspended oil deliveries after the 1973 Yom Kippur war, a sharp rise in prices followed that cut national incomes in consuming countries, and raised both inflation and unemployment. This was used as a stick to beat Keynesian economics with, but it was simply the consequence of a deterioration in the terms of trade that both Keynes and Kalecki would have understood. A recession was needed to restore wage discipline. After the fall of the Shah triggered the second oil shock in 1979 and inflation soared again, many western countries voted in governments that followed restrictive policies, driving up unemployment until inflation fell.
This experience led to a change in the dominant view of how to manage the economy. It was increasingly accepted that there was a given rate of unemployment consistent with stable inflation and that the economy would automatically return to that "natural" rate if policy focused on inflation.
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By and large, central banks have continued to act as if we are still in the early 1980s. They saw their role as targeting inflation and letting the real economy look after itself. Most postwar recessions were triggered by inflation and the resulting policy response. But after 1980 most recessions, such as the US and Japanese downturns of the early 1990s, were caused by another mechanism, one to which governments and central banks have been blind.
When governments abolished exchange controls in the 1980s it allowed capital to flow freely to wherever it could find the highest profit. This weakened labour relative to capital, a change reflected in the relative share of profits and wages. From 1945 to 1980 the share of wages in GDP had either been stable, in countries such as the US, or had risen in others, such as Britain. Now it fell nearly everywhere and the share of profits rose. These developments accelerated after the collapse of the Soviet Union, which in turn accelerated economic liberalisation in China, India and other less-developed economies. That recreated what Marx called the reserve army of labour on a global scale. The potential growth rate of the global economy was raised and a period of rapid, inflation-free growth ensued, for which the current institutions of monetary policy—independent central banks, inflation targeting and so on—took credit. Another consequence was a further sharp rise in the share of profit in global GDP.
Since Keynes was unfashionable and Marx unmentionable, no one asked what this would mean for the level and pattern of demand. The first consequence was that investment rose as a share of GDP. This became evident in Asia, where rapidly growing economies benefiting from foreign investment saw profits and investment rise to very high proportions of GDP. Investment in China is 42 per cent of GDP.
Japan was the first to show where this could lead. In the 1980s the Japanese economy grew at 4 per cent a year in real terms and its profit share was as high as 40 per cent compared with 20 per cent or less in the west. While asset prices soared, there was no inflation and the Bank of Japan was undisturbed. In 1990 the stock market crashed, activity and prices began to fall. Falling prices—deflation—increased debt burdens and a persistent recession ensued.
Other Asian countries flirted with the same fate. Their investment-driven booms ended in 1997 with a succession of foreign exchange and stock-market crises. Under IMF pressure, they followed policies of austerity and devaluation. Since the rest of the world continued to grow, those policies enabled them to export their way out of trouble and get back to growth. But for that to be possible demand had to continue growing strongly in the west.
Yet here was the central problem with the globalised system. If profits and output rise persistently faster than wages, who will buy the output? A lack of effective demand, in Keynesian terms, is averted for a time but ultimately shows up in a problem of "the realisation of capital" in the language of Marxists.
So it proved. Although investment in the more developed countries never reached Asian levels, it rose. In the 1990s the share of business investment in US GDP rose from 9 per cent to 14 per cent. (Since the US did not save, extra investment involved borrowing from abroad and hence a large current account deficit.) Much of this investment was in computers and it was accompanied by a big rise in stocks connected with information technology. By 2000, however, the over-investment became evident and the stock market fell, embarking on a three-year decline. Unlike Japan, however, the US experienced only a shallow and short-lived recession. Nothing fateful seemed to have happened.
But it had begun to dawn on some people that the fluctuations in economic activity since 1980 were different from earlier ones. They were not obviously triggered by wage-price spirals or by terms-of-trade shocks. What the Japanese, Asian and US recessions all had in common were debt-fuelled booms in asset prices and investment that eventually popped.
*** Hyman Minsky, another renegade economist ignored in the academies and largely forgotten, had predicted this sort of development, claiming that it was the inevitable pattern in a capitalist economy with liberalised financial markets. His basic idea was that success breeds excess. As the economy grows and profits are made, institutions realise more money can be made if they borrow to "gear up" their investments. Institutions pass from being hedgers, when their liabilities can be covered by their assets, to being speculators who cannot cover their liabilities but who can service them from income. Some then pass from being speculators to operating a "Ponzi scheme," in which they can only service liabilities by raising more debt. The system is then vulnerable to the smallest setback. A small hesitation in the path of rising asset values forces sales which trigger an asset price collapse—bankruptcies and dislocation ensue. It sounds like a description of the current crisis. Yet Minsky was writing long before the invention of modern derivatives or the growth of the subprime mortgage market. The precise mechanisms of folly will differ each time but that sort of folly is a recurrent feature of the system, he believed.
After the bursting of the dotcom bubble, the US seemed to reach the point of contraction. Excess capacity meant US companies would not continue to invest as they had in the 1990s. Asia was tightening its belt and growing by saving and exporting. Consumers in the west were not earning enough to take up the slack. But if they could be induced to borrow they could buy the goods that they otherwise could not afford. Growth could continue. In the 19th century no one would have considered lending to the workers on easy terms so they could maintain demand, they would not have been considered creditworthy. But today the workers often have assets, and the most important is their house.
For various reasons, house prices have risen for half a century in many economies, particularly in the English-speaking countries where owner-occupation is an important individual and political aspiration. Such a long period of rising prices, as Minsky knew, is sure to create the expectation of indefinite further increase. When interest rates were cut to ease the recession of 2000-01 it triggered a boom in borrowing to fuel house purchase in many countries. Because house prices were rising household balance sheets appeared to be perfectly sound: debts were rising rapidly but so were assets. Thus did debt in Britain rise from 90 per cent to 160 per cent of annual household income with only slightly less extreme developments in the US, Spain, Australia, Denmark, New Zealand and Ireland.
Eventually this process had to reach a limit. The over-indebted had to sell or be foreclosed. Prices tumbled. It was a classic Minsky process, which ended by taking down the banks and other financial institutions that had borrowed and lent too much money on an inadequate capital base.
Marx observed that all business cycles appear to be credit cycles, but credit is the symptom not the cause. That is too polar a view but it contains some truth. The underlying problem facing the world economy is one of defective demand caused by profits outstripping wages in a world of excess labour. It has been made worse because Asia, having suffered an investment boom and bust, was able to emerge by beggar-my-neighbour policies of domestic deflation and devaluation. Those policies can work for one country or region but not for the whole system.
It is easy to blame western central banks for running too loose a policy after 2002 but we forget that there was a widespread fear of deflation—a fear that might have been realised had not consumer borrowing come to the rescue. It is now clear that we do not live in a world where the sole purpose of central banks is to avoid a domestic wage-price spiral. They have to pay attention to asset prices. And in a globalised economy someone must also pay attention to the rate of credit creation. The old IMF or OECD consultation committees must be revived so that pressure can be applied to countries whose policies threaten to unbalance the system. China should be encouraged to use foreign exchange reserves to meet domestic demand, not to subsidise exports—as it is perhaps now recognising.
International agreements on financial regulation and capital taxes are also urgently required. If capital is free to chase the cheapest labour around the world, it should not also be free to chase tax concessions, inducing a race to the bottom in capital taxation. Governments must shift more of the tax burden on to capital to offset the effects of a rising profit share. That is, again, impossible for one country but can be done by concerted action.
Capitalism is the only system that can produce a sustained rise in living standards. But voting is still organised on national lines and, after the death of socialism, nationalism will be seen as the only force able to protect people from capitalism's instability. To preserve it in a form that offers stability and hope to the poor of the world requires state intervention. This also means recreating the habit of co-operation between states that existed in the third quarter of the 20th century. The alternative is repeated crises leading to political and economic upheavals.
