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ISR Issue 58, March–April 2008

More than a recession: An economic model unravels

JOEL GEIER argues that this recession reflects a crisis of capitalism that goes deeper than the regular boom-bust cycle

WE ARE at an important turning point. The recession now unfolding marks the end of the 25-year long period of economic growth based on the neoliberal model—a model that was for years a great boon to capital but a great misery for the working class. Neoliberal measures were enacted a generation ago—after the long post–World War Two boom and the onset of crisis in the 1970s—to restore capitalist profitability. Those policies involved something called supply-side economics, which included tax cuts for the rich, economic deregulation and privatization, cuts in social welfare, union-busting, and wage-cutting. These policies led to a tremendous buildup of debt. Monetarism subsumed fiscal policy, and cheap credit came to be seen as the solution to economic downturns. These policies have now produced an economic disaster—first for working people, but now for the capitalist system itself. The destructive consequences of neoliberalism will require a reorganizing of the credit system and the banks, and a readjustment of the imbalances of the global trade system. This crisis is deeper than a standard business-cycle recession—it will entail long, painful years of crisis and restructuring. The capitalist program to carry this out is still undefined, but what is unmistakable is that we are entering a new period, economically and politically, which will reshape the balance of power between the world’s leading nations.

A year ago, it became clear the U.S. was headed for slowdown and recession. The business cycle peaked and the overproduction of housing produced stagnant and then declining home prices as the subprime housing market unravelled. This stil-ongoing collapse of the housing bubble initiated an equally slow unravelling of the credit bubble, what the Economist some years ago labeled the world’s greatest financial bubble. The impact of failing mortgages sent the first shock waves through the highly leveraged debt structure of the financial system. The massive losses on bad debt destroyed banks’ profits, constricted their ability to provide credit, and were clearly leading to a credit crisis and severe recession.

It was initially impossible to know how long it would take for this to work its way through the economy, although we assumed it would be one to two years. The world was still at the height of its biggest boom since the early 1970s. Profits were very high in the U.S., and banking profit rates were the best since the 1920s. Nor could we guess what actions the government would take to slow down the recessionary process or lessen its effects.

In 1998, when the Asian crisis spilled into the global financial system, Alan Greenspan, head of the Federal Reserve Bank, decided on the hitherto untried approach of stimulating an ongoing economic boom. Recession in the U.S. was successfully held back for over two years. The cost was high: The dot-com bubble led to a stock market implosion, and huge trade deficits and foreign debt built up as the U.S. became Asia’s “buyer of last resort.” Again when the recession finally hit the U.S. in 2001 with the biggest drop in profits since the 1930s, its full effects were cushioned by the largest stimulus package since World War Two. The $250 billion government budget surplus was transformed into a $300 billion deficit; $1 trillion in tax cuts for the rich and war spending were used to moderate the effects of the crisis. Interest rates were cut to between 1 and 2 percent for three years in order to lower business costs and restore profitability. The result was the weakest business recovery since World War Two, and the ultimate price was the housing and debt bubbles, whose collapse brought on the current crisis.

The economy is now in recession or entering one. As at every turning point, the economic indices still give off conflicting signals. Parts of the economy are visibly in recession; in construction, auto, finance, and retail, for example, job creation has stopped. Credit collapses have erupted in what were the most stable areas of the financial system. Yet some indices give the illusion that the economy is not in a recession, but only in a slowdown, or that the recession will be mild or short, with growth restored in six months’ time as lower interest rates and the $150 billion fiscal stimulus plan restore consumer spending. Some analysts predict that manufacturing tied to exports will keep the economy afloat. But exports, which had grown by 19 percent in the third quarter, only grew by 3.9 percent in the fourth quarter, despite the cheapness of the dollar. The slowdown in export growth is a sign of economic weakness spreading internationally.

The case for a mild recession is based on the expectation that profits will quickly recover. While profits declined dramatically in the fourth quarter—down 20 percent from the year before—the decline was due to the large write-offs in the banking system, which will continue. In the rest of the economy profits seemed to be holding up, particularly in oil, raw materials, and high tech, all benefiting from the world boom. Profits for the S&P 500—the 500 largest public corporations—grew 11 percent for the year. But a majority of those profits came from international operations. There are not yet reliable figures on profits from domestic operations, which have been weakening for a year.

Every day there is new data of economic distress. The biggest shock was the staggering collapse of the service economy (the Institute for Supply Management reported its index of service sector business activity declined to 41.9 in January from 54.4 in December—below 50 indicates a recession). Meanwhile, despite massive injections of liquidity—central banks pouring money into the banks to prevent a paralyzing credit crunch—new areas of credit become dysfunctional. The Wall Street Journal recently reported that “credit-card pinch leads to pullback in spending,” and it indicates that 7.6 percent of credit card loans were either at least sixty days in default or in foreclosure. The failure of “auction-rated” debt, supposedly the safest of credits, has pushed up municipal interest rates. Credit for student loans is drying up, and credit-tightening for business as well as for consumers intensifies.

Global dimensions

The downturn is now becoming global. The recession began and is centered in the United States, but there is a slowdown throughout Europe and in Japan. Italy seems to be in recession. The housing bubble has burst in Britain, Ireland, and Spain, with others, including China, expected to follow. European banks have begun to report similar difficulties as the American banks. In January, there was an international stock market crash, during the three-week period from January 2 to 23, affecting the United States, Canada, Japan, Britain, France, and Germany, as well as the emerging markets (Brazil, Russia, India, and China). Stock markets plunged between 15 percent and 20 percent. More than $7 trillion of stock values were wiped out. The theory that the world economy had decoupled from the United States, that the world boom would continue in the face of an American recession, collapsed in an international stock market panic.

The U.S. share of the world economy has declined dramatically in the last few years, from 30 percent to under 25 percent of world GDP, but it is still the center of the international capitalist system. Fifty-five percent of all goods produced in Asia are exported, two-thirds of them to the United States and the other advanced industrial countries. The consumer market in the U.S. is $9.5 trillion. In China and India together it’s $1.6 trillion. Asian manufacturers are dependant upon the American market for the sale of their commodities—without it they have a crisis of overproduction. Therefore as the U.S. market goes into decline, it will have a dire impact on the rest of the world economy.

Increasingly it looks as though the whole world may enter recession together. There has not been a coordinated international recession since 1973. Since then, when some countries were in recession, others were booming—maintaining export markets to ease the downturn for countries in recession. If all go into crisis together, export markets constrict everywhere, deepening the recession even further.

This slump is also a crisis of finance capital, beginning in the U.S. but spreading to the banking system internationally. The banking system is both key to capitalist production and distribution, which cannot function without credit—and also one of the main ways in which American imperialism has dominated the world, through its international banking system.

A year ago when the slowdown began, most aspects of the credit system were hidden from public view. There was no public knowledge of structural investment vehicles (SIVs), of conduits, of collateralized debt obligations, of collateralized loan obligations, or asset-backed commercial paper, etc.—all the off-the-book operations used to keep capital reserves down and inflate profits—and of the massive fraud, corruption, and toxic debt at the center of the financial system.

The banks are being crippled by losses originating in the housing bubble. So far they have taken $160 billion in write-offs from subprime mortgages (a third of that at just three banks—Citicorp, Merrill Lynch, and UBS), and they’re expected to take a total hit of $300 billion to $400 billion on subprime mortgages. The housing market has not yet bottomed out—and if house prices decline further (they have dropped 10 percent and are expected to fall another 10 to 20 percent in the next few years), the banks will have even bigger losses. Homeowners will lose between $4 trillion and $6 trillion, with a third of households saddled with mortgages greater than the value of their homes.
Losses sustained in the subprime market are leading to the contraction of $2 trillion worth of credit. Total credit contraction may eventually be much greater. Commercial real estate markets, in boom a few months ago, are now collapsing. Their estimated losses may be as large as subprime losses. Other credit problems are growing, too, from commercialized loan obligations backed by credit card debt and auto loans to corporate mergers and buyouts financed by junk bonds.

Corporate bonds were financed in packages similar to the subprime mess. Bonds were divided into slices and sold as tiers; the worst, riskiest parts had the highest interest rates. In this pyramid scheme, if one part defaults, it devalues the rest. Moreover, bonds of heavily indebted corporations were popular because holders could buy insurance against default in the form of credit derivative swaps. Swaps are a totally unregulated market of $45 trillion, with lax lending standards; they are constantly traded, so no one knows who holds the insurance and whether they have the resources to make good on defaulted bonds. What is certain is that with credit tightening and recession, a large number of corporations will not have the cash flow to make payments on high levels of debt. They will go bankrupt and default, a process only just starting, and which will pick up momentum in the next two years. Due to the lack of transparency and swindle involved, there is no hard information on how big this problem can become.

A neoliberal crisis

This mounting debt debacle results from neoliberal policies of bank deregulation that began with Reagan’s “free market reforms” of the 1980s, including allowing the banks to set up off-balance-sheet operations, à la Enron. Banks could leverage their loan books to increase their profits by taking on enormous risk, without putting up capital reserves if the loans turned bad. Clinton and Bush tax laws encouraged off-the-book operations by taxing bank salaries and profits from them as “carried interest,” a tax loophole for the capitalist class to keep their highest tax rate at 15 percent, which Congressional Democrats still preserve.
Under Clinton the neoliberal gift to the banks was the repeal of the Depression-era Glass-Steagall banking law, ending the separation of investment and commercial banking. It was the investment banks that originated the corporate debt packages. The bond rating agencies (Moody’s, Standard & Poor’s, Fitch) were paid by bond originators to provide AAA ratings so that they could be held by pension funds and insurance companies. Goldman Sachs, the largest originator of this lethal debt, made large fees selling these bonds to its clients, while at the same time making billions by speculating against these bonds they understood were headed for default and bankruptcy. There are some winners amid the misery—the “smart money,” or “sophisticated investors”—inside traders and swindlers.

Behind the financial crisis of the banking systems stands the consumer debt crisis. The principal reason for the explosion of bad consumer debt is the enormous class inequality fueled by neoliberal free-market union-busting policies. The U.S. economy has almost tripled since 1973, but all the growth has gone to capital, to the employers, to the owners, none to labor. Real wages are lower today than they were in 1973, thirty-five years ago. The only way to keep up living standards was through working longer hours, and two-income families. Even that wasn’t enough; real family income is lower today than what it was ten years ago. To maintain their standard of living, working people fell deeper into debt. The last, and worst debt was to borrow against their only savings, the rise in the value of their houses. From 2004 through the first half of 2007, homeowners took $800 billion a year through refinancing their housing loans and through home equity loans. Thirty-four-million American households—almost a third of the population—borrowed against their houses. Together, they had a net savings rate last year of minus 13 percent. They were literally living off their homes.

When the housing bubble popped and mortgage rates went up, large numbers of workers couldn’t make their housing payments, contributing to the spiraling decline of housing values, and precipitating the banking crisis. It has also effectively put a stop to consumer spending based on people borrowing against the rise in the value of their homes. This in turn is producing a squeeze on producers of consumer products, especially the makers of “big-ticket” items like cars and appliances, and is now radiating throughout retail. Naturally, since the U.S. became after the 1997 Asian crisis the “buyer of last resort,” this collapse of consumer spending will have an international impact on countries that depend on the U.S. as a key export market.

Since the panic of 1907 and the creation of the Federal Reserve system in 1913, this is the third American financial crisis. The first was in the 1930s when the interimperialist relations that led to the First and Second World Wars produced between the wars the international banking collapse that made the 1930s Depression intractable. In that period there was no deposit insurance, and the crisis led to a run on the banks, as people tried to withdraw their savings. The resulting panic led to the failure of thousands of banks. The second financial disaster was the savings and loan crisis in the 1980s confined to mortgage lenders. It was a $180 billion loss that was socialized through a taxpayer bailout, with the assets sold by the Resolution Trust Company at fire-sale prices for enormous profit to investors. There was a credit squeeze, but it was not intense enough to impact most of the economy for long.

This third crisis is much deeper than the second; in its opening stage it is already outstripping the size of the S&L crisis. There is still no accurate picture of how bad it will be. Yet the banks are being crippled even with just a part of the subprime mortgage loss. They had to raise capital by selling parts of banks to Abu Dhabi, Singapore, and various other sovereign wealth funds—in effect to be partially controlled by foreign governments.

When Japan’s housing and stock market bubbles collapsed in 1990, the Japanese banks that held the debt were crippled by bad loans. Japan suffered more than a decadelong period of recession and stagnation, despite interest rates that were cut to almost zero. Japan was only recently pulled out of recession by the Asian boom. This banking crisis could very well be worse than Japan’s, because of the number of banks all over the world that the creation of the unregulated credit derivatives markets and off-book banking has affected. Its global impact will be greater because unlike the American banks, the Japanese banks were not at the center of the world financial system.

Accumulated contradictions

This financial crisis is potentially more dangerous because it comes up against the profound contradictions of the neoliberal period. The global trade system took a peculiar form after the 1997–8 Asian crisis and the Greenspan Fed’s response to that crisis. The U.S. became the buyer of last resort, importing cheaper Asian goods, as well as outsourcing manufacturing facilities to Asia, particularly China. The U.S. lost its competitive position on the world market. The U.S. trade deficit ballooned to $700 billion to $800 billion annually in recent years, paid for through $3.5 trillion of foreign borrowing—80 percent of world savings financed this deficit. In this business cycle the American corporations have not invested in the creation of new plant and equipment, i.e., in expanding the means of production. There are fewer factories in the U.S. today than there were at the start of the recovery six years ago. There are three million fewer industrial workers than there were five years ago. Meanwhile U.S. corporations have invested heavily in new factories in China and Southeast Asia, the majority of whose production goes to exports, in circular fashion, much of it to the United States.

This global trading system, with huge U.S. trade deficits financed by the Asian central banks, could not be sustained. Yet it went on for so long that it became an accepted part of global trade and finance. But the trade deficit becomes unsustainable as it comes up against the credit/debt crisis and the declining value of the dollar. The U.S., now the world’s largest debtor, borrowed $3.5 trillion from foreigners, and then refused to defend its currency. It allowed (and encouraged for export reasons) the dollar to be devalued by 30 percent since 2000. The foreign holders of U.S. debt have as a result lost $1 trillion by the dollar’s decline, the greatest debt default in history. There is therefore a greater reluctance on the part of foreign banks and investors to continue to finance the U.S. debt by increasing their dollar reserves, as the dollar continues to decline because of debt problems, interest-rate cuts, weak American profits, and the trade and government budget deficits.

The painful restructuring of the American economy includes a painful international trade readjustment. Countries dependent on exporting to the U.S. market will be caught up in this crisis. Chinese domestic consumption is only 35 percent of GDP; with slumping exports, China is faced with overproduction in most industries. Chinese overproduction has been floated by trade-debt relations that have now become increasingly untenable. The Chinese government holds $1.5 trillion in foreign currency reserves, the bulk of which is in American government debt. Unsustainable conditions, even if they go on for years, eventually are not sustained. This crisis will bring that to a head.

The war economy also increases the depth of this crisis. In 2000, military spending was $299 billion; now it is over $800 billion—having grown by half a trillion dollars in seven years. From the end of the Vietnam War until 2007, arms spending was 3 to 4 percent of the economy, except for a few years of the Reagan second Cold War arms buildup.
The right wing is demanding that the military be expanded and that arms spending be raised—they claim it’s 4 percent of GNP, using the figure of $515 billion. When the supplements for Iraq and Afghanistan are included, as well as homeland security, the CIA, the nuclear weapons part of the energy budget, and additional veterans’ health costs, it is well over $800 billion, or 6 percent of GNP.

At the end of the permanent arms economy with the U.S. defeat in Vietnam, the U.S. could no longer afford a level of military spending of 6 percent or more of GNP. It was only affordable when the U.S. totally dominated the world market. Once the U.S. had competitors by the end of the 1960s—rebuilt Germany and Japan—it could not maintain a permanent arms economy of that size. History repeats itself. With weak American competitiveness on the world market, an enormous trade deficit, and now dependency on foreign borrowing, the U.S. has problems affording the levels of war spending necessary to maintain its position as the world’s superpower. Weakened by its unending military and political disaster in Iraq and Afghanistan, American imperialism now has huge economic problems undermining its power and changing the balance of power internationally.

The government budget deficit this year will range upwards from $4 billion to $500 billion, much of it borrowed from the rest of the world. The Democrats will blame it on the Bush tax cuts and overlook the $500 billion rise in war spending that they voted for.

For the reasons enumerated above, what we are witnessing now is more than the onset of a recession, but a turning point similar to when the postwar boom ended in 1970–73. At that time, the contradictions of the permanent arms economy—the U.S. losing its competitive edge on the world economy—led to a deep crisis of profitability, followed by a major restructuring of American capitalism. In the twelve years from 1970 to 1982 there were four recessions. The United States was forced to abandon the Bretton-Woods Agreement, end fixed currencies, and float the dollar. In the 1970s the U.S. still had the highest wages and lowest productivity compared to its chief competitors. By the end of the 1980s it had lower wages and higher productivity than its main rivals.

This enormous restructuring was accomplished under the ideological rubric of neoliberalism. Keynesianism had been the accepted capitalist economic orthodoxy since the 1930s depression. Keynesian stimulus spending, aimed at boosting consumer demand to fight downturns, was held responsible for inflation, and it had no answers for the 1970s stagflation crisis of simultaneous inflation and slow growth.

The new economic model of neoliberalism marked a return to “free market” conditions before the 1930s rise of unions, the welfare state, and government regulation. The mantra was that the privatization and deregulation of industry would restore competition, lower costs, and curb inflation. Neoliberals also championed “supply-side economics”: replacing state spending aimed at boosting consumer demand with tax cuts for capitalists who, the theory went, would invest it back into the economy, thus boosting growth. The argument was that handing money to the capitalists would lead to a “trickle-down” effect benefiting all sectors of society. In the first years of the 1970s crisis, the working class Left was on the rise internationally; by the end there was a total rout of the working class. The balance of class forces here and internationally shifted. Capital and its conservative right-wing coalition won. Its total victory in the 1990s was aided by the collapse of Stalinism, giving rise to the ideological triumphalism of the free market as the only alternative.

What we are now coming up against are the limits of neoliberalism. Mortgage and banking deregulation cannot be allowed to produce another crisis like this anytime soon. The banks are going to be re-regulated. Northern Rock Bank in England, a casualty of the mortgage crisis, was just nationalized, the first such nationalization in decades. Further tax cuts for the rich, the unifying idea of the Republican Party, can no longer be afforded; top marginal tax rates will be raised no matter who is elected. The bipartisan $150 billion stimulus program, however inadequate, already repudiates neoliberalism. It is in essence a Keynesian package aimed at stimulating consumer demand. It is limited to people expected to spend it, to people who make less than $150,000 a year. Call it what you will, but it is not tax cuts for the rich.

Neoliberalism has now exhausted itself as an economic strategy for capital. It was always a failure for workers. But whereas in 1982 the stock market was at 750, in 2007 it peaked at 14,000, reflecting the success of the model in restoring profits on the back of the working class. Capitalists loved neoliberalism because it made them fantastically rich; they are reluctant to give it up and will fight to keep as much of it as possible. Neoliberalism will not disappear until the ruling class replaces it with an alternative strategy, but what has changed is that the capitalist class has to confront and solve the failures of its own neoliberal policies, and this will not occur without political struggle and ideological crisis brought on by the failures of the free market.

There have to be new economic policies developed. This won’t happen over night. At the beginning of the crisis of the 1970s, the conservative Nixon said, “We’re all Keynesians.” By the end, there weren’t even many liberals defending Keynesianism. The ruling class hasn’t yet devised a new strategy; it has no game plan. It is still in denial, hoping the world boom will save it, narrowly focused on immediate bailouts. There will be attempts to soften the spiraling of mortgage defaults, to retain municipal bond insurance, to keep student loans afloat. But at this stage only piecemeal efforts are being proposed, not a new economic strategy. It should also be clear that any new strategy, whatever name it is given, will involve a continued, if not intensified, offensive by the ruling classes to cut wages and benefits and increase productivity.

Yet no new strategies

“Politics is concentrated economics,” Lenin was fond of saying. This economic crisis will produce new political programs and remedies. Neoliberalism is destined to follow neoconservative foreign policy into the ideological wilderness. Defeat clarifies the mind; failures force new options to develop. But consciousness lags behind experience. The Right is in disarray and retreat, correctly held responsible for the mounting military and economic mess, condemned for its blindness, incompetence, and corruption. But the Right is too strong, too tied to capital to disappear. The right wing program will change; it can no longer credibly hope to win on tax cuts for the rich, deregulation, and small government by cutting social welfare. There will be a different Right, perhaps along the lines of Lou Dobbs—a right-wing populism that attacks immigrants and supports protectionism—or conceivably an even nastier right wing. Perhaps a major electoral defeat in the upcoming elections will start the process of conservative readjustment, but the ideas for a new capitalist Right are still too inchoate and reactive to predict their longer-term coherence.

As the economic crisis has unfolded over the last few months the liberals, however hesitantly, have shifted leftward, if only in rhetoric. The mass response to Obama’s vague call for change has indicated to them the popular appeal of leftward motion, and a bidding war between Obama and Hillary Clinton over working-class support has characterized the primaries from Iowa onward.

In December John Edwards came out with a stimulus plan of $70 billion; and in January Clinton came out for $110 billion; Obama said $120 billion, yet even Bush topped them at $150 billion. Beyond these immediate responses, more important is how liberalism will define itself for the new period ahead. There will be various attempts to raise Keynesian or regulatory ideas, to present a mortgage bailout and foreclosure relief by the government, since private capital is proving incapable of solving its own problems. But there is yet no fundamental liberal program to deal with American capitalism’s crisis—only immediate, narrow responses to constantly moving targets.

In recent months, the Democrats have made many promises—mostly vague; but they have raised people’s expectations and hopes for improvements in their lives. The Democrats have their best chance in decades to sweep the elections. The Right has been discredited. How the liberals handle the problems of both war and recession, and how they handle the disillusionment with them when they fail to carry through on many of their promises, will shape the political context of the next period.

We have gone through thirty years of reaction, of the politics of the neoliberal free market, and of the ideology of TINA (There Is No Alternative), which most people have more or less accepted. Even the Left after 1991 came to the conclusion that a planned economy doesn’t work and that the free market is the only efficient way for the economy to function.

What has held back the development of the socialist movement is the general acceptance of the free market as the only alternative, coupled to the idea that the working class can’t change society. The ideological crisis born of the failures of the free market do not automatically lead to a rejection of it. But from believing that the free market was a positive good, there can develop, out of its impact on workers, the belief that the free market and its workings have horrible consequences.

Though we cannot yet predict the impact the crisis will have on levels of working-class struggle, we can say that the accompanying ideological crisis of neoliberalism creates bigger openings for winning people to the necessity of an alternative to capitalism.

Joel Geier is associate editor of the ISR. This is a revised version of a speech he delivered to a conference of the International Socialist Organization in February 2008.
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