Paper Dragons: China and the Next Crash 1786995964, 9781786995964

Table of contents :
Acknowledgements --
1. Introduction: will China be the epicentre of the next financial crisis? --
2. Crisis in Wall Street and the Keynesian response --
3. Europe: social democracy's Faustian pact with global finance --
4. Asia and finance capital: from the Japanese bubble to China's financial time bomb --
5. Reforming the global financial architecture: opportunities lost, 2008-18 --
6. How to rebottle the genie --
7. Conclusion: why financial reform is not enough --
Notes --
Glossary --
Index.

Citation preview

‘A stark warning about the vulnerable state of global financial markets from one of our most acute and prescient thinkers.’ Naomi Klein, author of This Changes Everything and  The Shock Doctrine ‘Startling, revelatory, brilliant! An astonishing exposé of the frightening economic details of this moment.’  Jerry Mander, author of The Capitalism Papers ‘Walden Bello, in this terrifying new book, explains that, if major changes are not taken, the same set of circumstances – unregulated shadow banking, runaway financial speculation and an overheated real estate bubble – are poised to take down China’s economy, and perhaps the world’s with it. A very important book for this political moment.  Maude Barlow, author of Blue Future and chairperson of the Council of Canadians ‘A tour de force of past and future financial crises by the globe’s most astute progressive political economist. Bello puts forward a comprehensive agenda to prevent the next crisis.’  Robin Broad, Guggenheim Fellow and Professor, American University ‘Walden Bello brilliantly explains how our global financial system still operates as a giant casino – with China now one of the most reckless gamblers. Read this book to learn how we can tame the global financial casino – before China and other reckless gamblers cause the next crash.’  Sarah Anderson, Global Economy Project Director

‘Crisply and clearly written, Paper Dragons demonstrates that: “Yes, it can happen here, again and again.” Politicians and lawmakers everywhere had better get a grip on finance, now. Or watch out, World!’   Susan George, President of the Transnational Institute and author of How the Other Half Dies ‘Walden Bello suggests that, while the next devastating crisis with global ramifications can strike any one of capitalism’s many nodes, the immediate threat comes from Asian giant, China. The lesson? Reform of capitalism may be the immediate call, but in the final analysis we must transform how the system works and we live our lives.’ C. P. Chandrasekhar, Professor of Economics, Jawaharlal Nehru University ‘Walden Bello shows how global capitalism remains structurally prone to financial crises. With clarity and conviction, Bello continues to explain reality lucidly and inspire progressive alternatives.’ Jayati Ghosh, Professor of Economics, Jawaharlal Nehru University ‘The question may not be if another crash will take place, but when and where it will start. Bello eschews pessimist fatalism, arguing for a broad programme of financial reforms integrated into a comprehensive programme of reforms of the real economy. Inspired and accessible … Wholeheartedly recommended!’ Heikki Patomäki, Professor of World Politics, University of Helsinki, author of The Great Eurozone Crisis

‘In 2008, a U.S. housing bubble careened out of control and plunged the world into a gruesome global financial crisis. Bello brilliantly lays out the case that – unless we put effective checks in place – the next financial crisis will likely erupt in China.’ John Cavanagh, Director, Institute for Policy Studies ‘In this volume, Walden Bello demonstrates that East and Southeast Asia has been the location of multiple financial crises, despite enjoying an international reputation as a group of successful globalizers.’  Manuel Montes, Senior Analyst, South Center, Geneva ‘Walden Bello is one of the rare truly global thinkers. A must-read for those seeking prevent the next financial meltdown. Superb.’ Cornelia Woll, Professor of Political Science; author of The Power of Inaction: Bank Bailouts in Comparison ‘Walden Bello is one of the foremost analysts of global economics and politics of our time. He shows that the global economy is a ticking time bomb. Erudite and eloquent, this book could not be timelier. This is a must read.’   William I. Robinson, Professor of Sociology, University of California ‘Walden Bello argues that fragility remains within the system and points to China as the potential source of the world’s next major economic crisis. He raises issues that citizens, policymakers, and financial players ignore at their peril.’ Dean Baker, Co-founder and Senior Economist, Center for Economic Policy Research

About the author Walden Bello is currently the International Adjunct Professor of Sociology at the State University of New York, Binghamton and an associate of the Transnational Institute in Amsterdam. He was formerly a member of the House of Representatives of the Philippines, and has previously held positions at the University of the Philippines, University of California at Berkeley, and University of California at Los Angeles. His previous books include Dilemmas of Domination: The Unmaking of the American Empire (Zed, 2005) and Capitalism’s Last Stand? Deglobalisation in the Age of Austerity (Zed, 2013). A noted critic of globalization, he is a recipient of the Right Livelihood Award (also known as the Alternative Nobel Prize).

China and the Next Crash Walden Bello

Paper Dragons: China and the Next Crash was first published in 2019 by Zed Books Ltd, The Foundry, 17 Oval Way, London SE11 5RR, UK. www.zedbooks.net Copyright © Walden Bello 2019 The right of Walden Bello to be identified as the author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. Typeset in Minion by seagulls.net Index by Rohan Bolton Cover design by James Jones All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying or otherwise, without the prior permission of Zed Books Ltd. A catalogue record for this book is available from the British Library ISBN 978-1-78699-596-4 hb ISBN 978-1-78699-598-8 pdf ISBN 978-1-78699-599-5 epub ISBN 978-1-78699-600-8 mobi

To Suranuch (‘Ko’) Thongsila (1963–2018) With deep gratitude, love, and loyalty

Contents

Acknowledgements

ix

1.

1

Introduction: will China be the epicentre of the next financial crisis?

2.

Crisis in Wall Street and the Keynesian response

21

3.

Europe: social democracy’s Faustian pact with

83

global finance 4.

Asia and finance capital: from the Japanese bubble

133

to China’s financial time bomb 5.

Reforming the global financial architecture:

195

opportunities lost, 2008–18 6.

How to rebottle the genie

239

7.

Conclusion: why financial reform is not enough

267

Notes

279

Glossary

300

Index

305

Acknowledgements

A number of colleagues contributed to the effort to get this book out. I am very grateful, in particular, to Nick Buxton, Fiona Dove, Pietje Vervest, and Satoko Kishimoto of the Transnational Institute (TNI). TNI commissioned this study and its staff provided valuable advice along the way. Part of the study was written while I was a senior research scholar at the Center for Southeast Asian Studies in Kyoto, Japan, in 2016 and 2017. For providing a research home as well as resources, I would like to extend my heartfelt thanks to the research and administrative staff of the Center, and in particular to Caroline Hau. Sections of the study were completed while I was teaching in 2017 and early 2018 at the sociology department of the State University of New York at Binghamton, which also served as a research base for me. Michael West, Joshua Price, Denise Spadine and Linda Zanrucha were unstinting in their encouragement and assistance, and for this I am very grateful. I would like to thank Henry Holt Co. for permission to use passages from my earlier book Dilemmas of Domination: The Unmaking of the American Empire. Kim Walker, my editor at Zed Books, was, as usual, very helpful and generous in providing advice and guidance. My beloved wife, Suranuch Thongsila, provided valuable intellectual and emotional assistance throughout the whole project. She passed away, however, a few months before it was completed. The last chapters of this book were written beneath the heavy weight xiii

of her loss, but her inspiration saw me through. To this wonderful, loving companion, I dedicate this book. Walden Bello Bangkok, 1 February 2019

1 Introduction Will China be the epicentre of the next financial crisis?

Conventional wisdom holds that China is on the ascent and the United States is in decline, that China’s economy is roaring with raw energy and that Beijing’s ‘Belt and Road’ mega-project of infrastructure building in Central, South and Southeast Asia is laying the basis for its global economic hegemony. Some question whether Beijing’s ambitions are sustainable. Inequality in China is approaching that in the United States, which portends rising domestic discontent, while China’s grave environmental problems may pose insurmountable limits to its economic expansion. Perhaps the greatest immediate threat to China’s rise to economic supremacy, however, is the same phenomenon that felled the US economy in 2008: financialization – the channelling of resources to the financial economy over the real economy. Indeed, there are three troubling signs that China is a prime candidate to be the site of the next financial crisis: overheating in its real-estate sector, a rollercoaster stock market, and a rapidly growing shadow banking sector. ’ China s real—estate bubble There is no doubt that China is already in the midst of a realestate bubble. As in the United States during the subprimemortgage bubble that culminated in the global financial crisis of 2007–08, the real-estate market has attracted too many wealthy 3

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and middle-class speculators, leading to a frenzy that has seen realestate prices climb sharply. Chinese real-estate prices soared in so-called Tier 1 cities such as Beijing and Shanghai from 2015 to 2017, pushing worried authorities there to take measures to pop the bubble. Major cities, including Beijing, imposed various measures: they increased down-payment requirements, tightened mortgage restrictions, banned the resale of property for several years, and limited the number of homes that people can buy.1 However, the Chinese authorities face a dilemma. On the one hand, workers complain that the bubble has placed owning and renting apartments beyond their reach, thus fuelling social instability. On the other hand, a sharp drop in real-estate prices could bring down the rest of the Chinese economy and – given China’s increasingly central role as a source of international demand – the rest of the global economy along with it. China’s real-estate sector accounts for an estimated 15 per cent of gross domestic product (GDP) and 20 per cent of the national demand for loans. Thus, according to Chinese banking experts Andrew Sheng and Ng Chow Soon, any slowdown would ‘adversely affect construction-related industries along the entire supply chain, including steel, cement, and other building materials’.2 The Shanghai casino Financial repression – keeping the interest rates on deposits low to subsidize China’s powerful alliance of export industries and governments in the coastal provinces – has been central in pushing investors into real-estate speculation. However, growing uncertainties in that sector have caused many middle-class investors to seek higher returns in the country’s poorly regulated stock market. The unfortunate result is that a good many Chinese have lost their 4

Introduction

fortunes as stock prices have fluctuated wildly. As early as 2001, Wu Jinglian, widely regarded as one of the country’s leading reform economists, characterized the corruption-ridden Shanghai and Shenzhen stock exchanges as ‘worse than a casino’ in which investors would inevitably lose money over the long run.3 At the peak of the Shanghai market, in June 2015, a Bloomberg analyst wrote that ‘[n]o other stock market has grown as much in dollar terms over a 12-month period’, noting that the previous year’s gain was greater ‘than the $5 trillion size of Japan’s entire stock market’.4 When the Shanghai index plunged 40 per cent later that summer, Chinese investors were hit with huge losses – debt they still grapple with today. Many lost all their savings – a significant personal tragedy (and a looming national crisis) in a country with such a poorly developed social-security system. Chinese stock markets, now the world’s second largest, according to some accounts, stabilized in 2017 and seemed to have recovered the trust of investors when they were struck by contagion from the global sell-off of stocks in February 2018, posting one of their biggest losses since the 2015 collapse. The Shanghai stock market was the world’s worst performer in 2017 and 2018.5 Shadow banking comes out of the shadows Another source of financial instability is the virtual monopoly on credit access held by export-oriented industries, state-owned enterprises and the local governments of favoured coastal regions. With the demand for credit from a multitude of private companies unmet by the official banking sector, the void has been rapidly filled by so-called shadow banks.6 The shadow banking sector is perhaps best defined as a network of financial intermediaries whose activities and products are 5

PAPER DRAGONS

outside the formal, government-regulated banking system. Many of the shadow banking system’s transactions are not reflected on the regular balance sheets of the country’s financial institutions. But when a liquidity crisis takes place, the fiction of an independent investment vehicle is ripped apart by creditors who factor these off-balance-sheet transactions into their financial assessments of the mother institution. The shadow banking system in China is not yet as sophisticated as its counterparts on Wall Street and in London, but it is getting there. Ballpark estimates of the trades carried out today in China’s shadow banking sector range from $10 trillion to more than $18 trillion per year. In 2013, according to one of the more authoritative studies, the scale of shadow banking risk assets – i.e. assets marked by great volatility, such as stocks and real estate – came to 53 per cent of China’s GDP.7 That might appear small when compared with the global average of about 120 per cent of GDP, but the reality is that many of these shadow banking creditors have raised their capital by borrowing from the formal banking sector. These loans are either registered on the books or ‘hidden’ in special off-balance-sheet vehicles. Should a shadow banking crisis ensue, it is estimated that up to half of the non-performing loans of the shadow banking sector could be ‘transferred’ to the formal banking sector, thus undermining it as well. In addition, the shadow banking sector is heavily invested in real-estate trusts. Thus, a sharp drop in property valuations would immediately have a negative impact on the shadow banking sector – creditors would be left running after bankrupt developers or holding massively depreciated real estate as collateral. Is China, in fact, still distant from a Lehman Brothers-style crisis? Interestingly, Sheng and Ng point out that, while ‘China’s shadow banking problem is still manageable … time is of the essence and a comprehensive policy package is urgently needed to preempt 6

Introduction

any escalation of shadow banking NPLs [non-performing loans], which could have contagion effects’.8 Beijing is now cracking down on the shadow banks, but these are elusive, and unless there is a fundamental reform in the country’s national credit system to end the virtual monopoly by the export-oriented economic complex of the banking system, there will always be a strong demand for these sub rosa entities. Finance is the Achilles’ heel of the Chinese economy. The negative synergy between an overheating real-estate sector, a volatile stock market and an uncontrolled shadow banking system could well be the cause of the next big crisis to hit the global economy, rivalling the severity of the Asian financial crisis of 1997–98 and the global financial implosion of 2008–09. Understanding global finance The dynamics of China’s financial sector will be explored more fully in Chapter 4, but I have started with one dimension of the sector to underline the fact that it remains vulnerable to speculative crises that may have a global impact. While most of the players in China’s stock markets and real-estate market may be mainly Chinese, a speculative earthquake there is likely to have a major impact on China’s vast holdings of US Treasury bills and on China’s real economy, which has become tightly integrated into the global economy. Thus, the major impact of such an event on the global economy would be inescapable. In 2008, China was not a significant buyer of Wall Street’s mortgage-backed securities and other complex derivatives. Yet, while escaping the direct impact of the collapse of these Wall Street instruments, it was nevertheless hit indirectly when the real economy of the US contracted, greatly reducing Chinese exports to the US and triggering a significant reduction in China’s GDP growth in 2008 and 2009. Today, 7

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with China being a major consumer of raw materials and agricultural products from developing countries and of agricultural and advanced technological imports from the US and Europe, much of the rest of the world would be negatively affected by a crash of China’s real economy triggered by a crisis in its financial sector. The gyrations of global finance continue to pose a threat to the world economy, and the continuing absence of effective regulation ensures that speculative bubbles may build up in different nodes of that economy. Today, the bubble could be building up in China. Tomorrow it could be in Germany. When bubbles grow and then interact with other economic factors – and even geopolitical ones – great uncertainty ensues, much like the anxiety that gripped the world when stock markets began spiralling downwards in February 2018, resulting in the loss of $4 trillion in paper wealth. The 2018 stock market turmoil passed, but the next one may not leave. Order of the book This book is an effort to understand the origins and dynamics of financial crises, examine their broader economic and political contexts, find out what reforms are needed to stabilize finance and make it a constructive force, and explain why these much-needed reforms remain largely stillborn, leaving the world vulnerable to another crash. My approach is largely that of political economy: that is, a perspective that sees economic phenomena such as financialization as stemming partly (though not wholly) from the struggle for advantage among antagonistic or competing social forces within a dynamic system of global capitalism, the basic engine of which is the search for profitability through market and non-market mechanisms. Chapter 2 begins with a theoretical exposition of the origins and dynamics of financial crises. Since the liberalization of capital 8

Introduction

markets began during the Margaret Thatcher–Ronald Reagan era in the early 1980s, there have been at least 12 major financial crises, the last one being the global financial crisis of 2007–08, which also provoked what is now known as the Great Recession from which most of the developed economies have not yet really recovered. Indeed, the global economy is now said to be in the throes of ‘secular stagnation’ or a period of prolonged low growth, one of the key causes of which was the recent financial implosion. The most distinctive process and feature of capitalism today is said to be financialization. Financialization has a number of dimensions. Perhaps, most generally, it means that finance – or the dynamics of the financial sector – has become the central force driving the economy. It means that movements in the production and prices of goods and services become increasingly conditioned not only by supply and demand in the real economy but by autonomous movements in the values or prices of financial instruments tracking goods and services. It means that speculative transactions overshadow the process of production as the source of profits, leading to a situation where the financial elite in the banking and shadow banking sectors eclipses the non-financial capitalist elites in both power and wealth. Although it accounted for only 8 per cent of the GDP of the US, the financial sector raked in 30 per cent of the profits in recent years, with some analysts saying the actual figure was 50 per cent.9 What accounts for the dominance of finance in contemporary capitalism? In the standard Economics 101 description of the financial system, it is the subsystem of the economy that channels money from those who have it (savers) to those who need it in order to invest in production (investors). This relationship is what has been lost or delinked in contemporary capitalism, with finance increasingly losing its relationship to production and becoming an end in itself. 9

PAPER DRAGONS

This delinking of the relationship between creditor and debtor, saver and investor, or financier and entrepreneur has been expressed in different though complementary ways by Marx and Keynes. In volume 3 of Capital, Marx talks about the normal production circuit of ‘M–C–M1’ (Money–Commodity–Money1) being occasionally displaced by the circuit ‘M–M1’ (Money–Money1). This occurs, he says, because: [to the possessor of money capital,] the process of production appears merely as an unavoidable intermediate link, as a necessary evil for the sake of money-making. All nations with a capitalist mode of production are therefore seized periodically by a feverish attempt to make money without the intervention of the process of production.10

To Keynesians, the hegemony of finance stems from what Keynes saw as the contradictory functions of money as means of payment and exchange and money as a store of value. Uncertainty about the future leads savers to prefer keeping their wealth in liquid or monetary form rather than in immobile forms, a phenomenon he famously described as ‘liquidity preference’. Money as a store of value, say Keynesians Massimo Amato and Luca Fantacci, ‘makes it possible for saving to be unconnected with concrete goods and to take place rather through the constant and indefinite accumulation of abstract purchasing power’.11 This process of accumulation unconnected with production leads to a destabilizing expansion of liquidity that is made possible by the creation of multiple forms or instruments of credit that go far beyond the stock and bond markets to embrace the so-called innovations of financial engineering such as mortgage-backed securities (MBSs) and derivatives. With finance increasingly taking on autonomous dynamics of its own, becoming more and more delinked from 10

Introduction

the productive process, ‘the fundamental instability of capitalism’, argued the famous Keynesian Hyman Minsky, ‘is upward. After functioning well for a time, a capitalist economy develops a tendency to explode, to become “euphoric”.’12 The critical moment comes when there is widespread realization that the asset price bubble is about to burst and there is a rush towards liquidity and riskless assets before the value of financial assets collapses. This is the famous ‘Minsky moment’, a phenomenon that accelerates the destruction of values. Essentially, this is what happened in 2007–08. The chapter moves on to look at the roots of financialization. In Marx’s day, financialization as the key mechanism for creating profits was a periodic aberration. In recent years, however, it has become the dominant mode of extracting profit. How did this happen? Financialization stems essentially from the crisis of production that began in the late 1970s. This took the form of a crisis of overproduction that overtook the global capitalist economy after the so-called Trente Glorieuses or ‘Thirty Glorious Years’ of expansion after World War Two. Overproduction was rooted in the swift and successful economic reconstruction of Germany and Japan and the rapid growth of industrializing economies such as Brazil, Taiwan and South Korea. This added tremendous new productive capacity and increased global competition, while income inequality within countries and between countries limited the growth of purchasing power and effective demand. This classic crisis of overproduction – or underconsumption, to use Paul Sweezy’s formulation – led to a decline in profitability. There were three exits from the crisis of profitability that capital took: neoliberal restructuring, globalization and financialization. Neoliberal restructuring essentially meant redistributing income from the middle class to the rich to provide the rich with the incentive to invest in production. The globalization of production 11

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involved locating production facilities in low-wage countries to increase profitability. While these two strategies brought a rise in profitability in the short term, in the medium and long term they were self-defeating since they brought about a downturn in effective demand by cutting into or preventing the rise of workers’ wages. That left financialization. Financialization had a number of key aspects, but three must be stressed. First, financialization involved the massive creation of indebtedness in the population to substitute for stagnant incomes in order to create demand for goods and services. Much of this debt was financed by the infusion of borrowed money from Asian governments recycling cash to the US drawn from the trade surpluses they enjoyed with the latter. The main avenue debt creation took in the US was through the provision of so-called subprime housing loans to a huge swathe of the population. These were loans that were indiscriminately given to consumers with little capacity to repay them, so that they were essentially ticking time bombs. Second, financialization involved so-called innovations in financial engineering that would facilitate liquidity. One of the most important – and eventually most damaging – was securitization. Securitization involved making traditionally immobile contracts such as mortgages liquid or mobile and tradeable. With mortgages securitized, they could be traded, leading to the disappearance of the original creditor–debtor relationship. Furthermore, with mortgages securitized, financial engineering allowed the original subprime mortgage to be combined with higher-quality mortgages and sold as more complex securities. But even as MBSs were combined and recombined and traded from one institution to another, they could not escape their underlying quality, and when millions of owners of the original subprime mortgages could no longer service their payments owing to their low incomes, this development spread like a chain reaction to the trillions of mortgage-based securities being 12

Introduction

traded globally, impairing their quality and bankrupting those that held significant quantities of them, including the Wall Street investment bank Lehman Brothers. MBSs were just one example of the innovations of financial engineering, broadly known as ‘derivatives’, that were meant to facilitate liquidity but ended up encouraging massive indebtedness built on a frail foundation of equity or real wealth. Market participants marked by a high ratio of debt to equity were described as being ‘highly leveraged’. Maths experts hired by Wall Street firms formulated the most complex equations to foster the illusion of quality when, in fact, securities rested on assets of questionable value, a practice that provoked the legendary investor Warren Buffett to make his famous remark that derivatives were ‘weapons of mass destruction, carrying dangers that, while latent, are potentially lethal’.13 He emphatically ruled them out of his investment portfolio because he could not understand how they worked. That Buffett’s warning about derivatives was not exaggerated was underlined by the subprime mortgage crisis that hit the US economy in the mid-2000s. The third key feature of financialization was that many of the key actors, institutions and products that were at the cutting edge of the process were either unregulated or poorly regulated. Thus, there emerged the ‘shadow banking industry’ alongside the regulated traditional banking industry, with non-traditional financial institutions such as Goldman Sachs, Morgan Stanley and American International Group (AIG) serving as the leading wave of a tsunami that brought with it the introduction of securitization, financial engineering and novel products such as MBSs, collateralized debt obligations (CDOs) and credit default swaps (CDSs). The subprime implosion of 2007 revealed the essential dynamics of financialization as a motor of the economy: that is, that it rested on the creation and inflation of speculative bubbles. Profit making 13

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rested on the creation of massive debt with a very weak foundation in real value or equity. While the illusion of MBSs being solid securities persisted, Wall Street operated like a casino, with investors using different financial products to bet on the movements of the values of assets and their derivative products in order to make a killing. A killing meant buying securities at the right price at the right time, and then selling once their price had increased significantly and before they declined. Once events exposed the fragile foundations of high-flying securities, however, market participants panicked and ran for the exits, selling off their holdings as quickly as possible to salvage some value, a process that accelerated the plunge of values to negative territory. In 2008, capital markets froze and banks even refused to lend to each other, owing to fears that their prospective debtors might be loaded with toxic assets. Lehman Brothers, in fact, was loaded with worthless MBSs. When other banks refused to extend credit and Washington likewise withheld assistance, Lehman declared bankruptcy. Lehman’s bankruptcy pushed the financial system to the edge of collapse, and the government had to step in to restore confidence in the banking system. Washington bailed out the biggest financial players, with an initial rescue fund of over $700 billion, supplemented by additional financial support and guarantees over the next few years. The rationale of the government was that Citigroup, JPMorgan, Bank of America, Wells Fargo, Goldman Sachs and the US’s other top financial institutions were too-big-to fail – that is, allowing them to go bust would bring the whole global capitalist system down. The chapter ends with reflections on the Great Recession that followed the financial crisis. This was the second-biggest economic disaster to hit the US after the Great Depression. Unemployment rose from under 5 per cent in 2007 to 10 per cent in 2010. More than seven years later, in 2015, the number of unemployed was still above 14

Introduction

the 6.7 million mark at the officially designated start of the recession in 2007. More than 4 million homes were foreclosed and thousands were plunged into poverty and great uncertainty as the government prioritized saving the big banks instead of bankrupt homeowners.14 Keynesian economics – notably that associated with Hyman Minsky – illuminated the unstable dynamics of financialization that would inevitably lead to dangerous bubbles, but technocratic Keynesianism under the administration of President Barack Obama in the US was not up to the task of pulling the economy out of the recession that followed the implosion of the Wall Street bubble in 2008. This failure was essentially political in nature. First of all, the administration prioritized saving the banks instead of saving the hundreds of thousands of households that were drowning in the wake of the collapse of the subprime housing bubble. Second, it retreated from a decisive use of fiscal policy to trigger recovery and instead relied on the second-best option of monetary expansion, owing to a desire to conciliate the conservative Republican Party opposition. The result was a very weak recovery that became one of the factors that contributed to the election of Donald Trump as president in the elections of 2016. In Chapter 3, I trace the spread of the financial crisis to Europe, focusing on the dynamics of the crisis in the United Kingdom, Ireland and Greece. In the UK, the crisis followed the US pattern of high leveraging or the creation of massive indebtedness by private banks, the creation and exchange of massive amounts of subprime mortgage-based securities to absorb that debt, system failure owing to the destruction of bank balance sheets when these securities became toxic, and then the state stepping in to save the banking system. With Ireland and Greece, and especially with the latter, the second phase of the global financial crisis kicked in: the so-called sovereign debt crisis. Massive indebtedness of private banks and, in the case of Greece, the state itself to foreign banks forced the 15

PAPER DRAGONS

state to assume responsibility for paying back all debt, both private and public, due to tremendous pressure from the governments of the foreign banks. To save the highly exposed German and French banks, the European Union establishment and the International Monetary Fund (IMF) provided loans to the states in severe crisis that were then transformed into payments to the banks, with the condition that these states impose harsh austerity programmes that were ostensibly meant to cough up the resources to pay back the loans to the official lenders and nurse the afflicted economies back to health. The opposite occurred, however, as austerity measures cut the incomes that were supposed to drive recovery. The adoption of the euro by the affected economies provided a complicating factor that prevented them from devaluing their currencies to regain trade competitiveness, which would have contributed to their recovery. Examining more deeply the conditions that served as enabling factors for the emergence and spread of the crisis in Europe, the role of the Social Democratic parties is highlighted. Although the Conservative Margaret Thatcher is often the figure most associated with neoliberalism in Europe, financialization was, in fact, most actively promoted by Social Democratic governments. In Britain, Tony Blair and Gordon Brown’s ‘Third Way’ Labour government had as one of its key aims making London the world’s premier financial centre. On the continent, French socialists were the principal force pushing for the adoption of the common currency that eventually became a prison for the indebted members of the eurozone. In Germany, it was the Social Democratic Party government of Gerhard Schröder that forced through the neoliberal labour reforms that cut down on labour costs, making Germany super-competitive in its trade relations with its EU neighbours. Covering the resulting trade deficits was one of the key factors that led these countries to borrow heavily from German banks, paving the way for the sovereign debt crisis that afflicted them. 16

Introduction

Chapter 4 moves to a close examination of two financial crises that have occurred in Asia – the creation and implosion of Japan’s bubble economy in the 1990s and the Asian financial crisis of 1997–98 – and one that is brewing: that is, in China. Since the financial threat in China has already been touched on, this initial summary will focus on the Japanese bubble and the Asian financial crisis of 1997–98. In Japan, the crisis stemmed from the state’s strategy of encouraging a high savings rate in order to fuel a high investment rate. The strategy worked while local and global demand was dynamic and rising. But the rise in local demand was eventually constrained by people’s high level of savings, even as intensified international competition slowed the rate of growth of Japanese exports. Overproduction and overcapacity were the results, with the consequent downward spiral in profitability leading to an oversupply of capital meant for productive investment. This excess capital was then largely spent on unproductive investment, particularly in real estate, leading to the notorious Japanese real-estate bubble in the late 1980s, where the Imperial Palace East Gardens in Tokyo alone were valued at as much as all the property in the state of California, or in all of Canada. The inevitable collapse of the bubble led to a period of recession followed by stagnation from which Japan has been unable to emerge, despite different variations of technocratic demand–supply management. Japan’s speculative bubble was exported to East and Southeast Asia, with much surplus capital used to export excess industrial capacity to different countries in the region. In Southeast Asia, the Japanese direct investment-induced boom coupled with capital account liberalization triggered the inflow of speculative capital from Japan as well as from the US. This led to overinvestment in real estate, which imploded in the summer of 1997 when currency speculators attacked the Thai baht and other regional currencies 17

PAPER DRAGONS

in the expectation that the macroeconomic distortions caused by the property bubble would result in a drastic devaluation of these currencies. With investors panicking and their countries falling into recession, governments were forced to apply for emergency loans from the IMF. These loans, however, bailed out foreign speculators, although the IMF made a key condition the imposition of austerity programmes that were designed to generate the resources to pay back the Fund. Meanwhile, in South Korea, the liberalization of rules governing cross-border flows of capital mandated when South Korea joined the Organisation for Economic Co-operation and Development (OECD) encouraged Korean conglomerates to engage in a spree of borrowing from foreign banks that led to a massive foreign debt. This, in turn, led to a financial crisis followed by a recession when the lending banks and their governments deemed that the debt was unsustainable and collected on it, forcing South Korea into the arms of the IMF. As in the case with Southeast Asian governments, the IMF provided credit that went to rescuing foreign speculative investors on condition that the country be subjected to a tough austerity programme. Just as the Japanese bubble helped create the speculative bubble in Southeast Asia, so did the Asian financial crisis and its aftermath contribute to the development of the 2008 crisis in the US. To insulate themselves from further attacks from currency speculators, the economies of the region engaged in an export drive that netted them billions of dollars – a great part of which was cornered by the region’s central banks. East Asian reserves leapfrogged to $4 trillion in 2007. The central banks did not, however, keep all of these reserves in a state of hibernation. A large proportion was recycled back to developed economies through the purchase of assets such as US Treasury bills. Much of this debt was then re-lent to private financial institutions, which used it to create credit that 18

Introduction

financed US consumer spending, particularly in housing. While Asian money inflows were not the key element in the 2008 global financial crisis, they were certainly a contributing factor. Indeed, there have been major links between the financial crises of the last three decades. Chapter 5 examines efforts to reform national financial sectors and the global financial system following the 2008 crisis. I look closely at initiatives directed at addressing shadow banking, securitization, mortgage-backed securities, derivatives, leveraging, fractional reserve banking, executive pay, credit ratings agencies, international financial governance, international currency reform, central banks, and the crisis of the euro. The survey reveals a great gap between effective regulatory measures and the initiatives that have been implemented. The failure of reform is attributed mainly to two factors: the continuing power of finance capital and the shared neoliberal ideological perspective of both the regulated and their government regulators. Chapter 6 is devoted to a discussion of what ought to be, from a progressive perspective, the priority reforms and how they can be achieved. Reforms in the following institutional areas are proposed and detailed: hedge funds and tax havens, mortgage-backed securities and derivatives, 100 per cent reserve banking, nationalization, investment banking and retail banking, executive compensation, credit ratings agencies, global financial governance, development finance, global currency reform, central banks, and the euro. I clarify that the aforementioned reforms constitute a ‘minimum programme’: that is, a set of moves that strengthen the world’s defences against another financial crash while not eliminating the possibility of such an event. The basic problem is that capitalism is structurally prone to generate financial crises, and the programme outlined in this chapter assumes a global economic system that continues to function under the rules of capitalism. However, 19

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successfully achieving these reforms will be a giant step in a longer process of transformative change. The book ends with a discussion of why a longer-term solution to financial crises cannot be divorced from a more fundamental change in the way in which we organize our economic life, a need that has become urgent with the proliferating problems we face, from long-term stagnation and sharply rising inequality to environmental degradation. So long as the economic system is fundamentally driven by the engine of production for the sake of profit, finance will continually be distracted from what should be its fundamental role, which is to link those who wish to engage in production but lack capital with those who possess the capital necessary for production, in a cooperative enterprise for the common good.

20

2 Crisis in Wall Street and the Keynesian response

Ideology provides the intellectual and moral foundations of an economic order. From the late 1970s to the first decade of the twenty-first century, neoliberalism was the dominant ideology that legitimized the institutions of global capitalism. The principal tenet of neoliberalism was that, if there were less interference in the market, then there would be fewer distortions in the economy and the allocation and distribution of resources would be more efficient. According to neoliberalism, intervention by the state in any form – whether directly by producing goods or regulating the private sector’s own production and distribution of goods, or indirectly through fiscal or monetary policy – was the source of distortions or barriers to the efficient allocation of resources. Neoliberalism in retreat In finance, the two key pillars of neoliberal ideology were the efficient market hypothesis and the rational expectations hypothesis. Efficient market hypothesis held that, without government-induced distortions, financial markets are efficient since they reflect all information made available to market participants at any given time. It also maintained that all stocks are perfectly priced according to their inherent investment properties – and that all market participants possess equal knowledge of this and act on it as rational individuals maximizing their self-interest. Markets thus move towards equilibrium or stability where supply and demand for 23

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assets are perfectly matched.1 The rational expectations hypothesis provided the theoretical basis for the efficient market hypothesis with its assumption that ‘individual agents in the economy – be they individuals or businesses – operate on the basis of rational assessments of how the future economy will develop’.2 These two theories collapsed with the onset of the global financial crisis in 2007–08, when financial market players collectively lost faith in market valuations, panicked, and engaged in ‘irrational’ herd behaviour, bringing down not only the financial market but also the whole economy. This led to a discrediting of neoliberalism in general. Robert Lucas, one of the key proponents of the rational expectations hypothesis, probably best expressed the crisis of neoliberal theory when he paraphrased a well-known adage about atheism: ‘Everyone is a Keynesian in a foxhole.’3 This was the same Lucas who, in 1996, told a journalist: ‘One cannot find good, under-40 economists who identify themselves as Keynesian … people don’t take Keynesian theorizing seriously anymore: the audience start to whisper or giggle to one another.’4 Neoliberals never denied that a crisis could take place, but they were convinced that if one did, it would be the result of government intervention in the economy. However, with the cutbacks in government regulation of the financial sector that had taken place during the 25 years since the Reagan era, it was difficult for neoliberals to blame government for the financial crisis that broke out in 2008. Despite this, they were not short of prescriptions for dealing with the crisis – as bequeathed to them by neoliberal pioneers such as Friedrich Hayek or Ludwig von Mises of the Austrian School. Deficit and debt reduction was their answer. One Nordic Central Bank official had this pithy summary of Hayek’s approach: According to Hayek, measures should be focused on the underlying challenges, such as public debt, that had created the 24

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crisis. In Hayek’s opinion, higher public debt would inevitably end up funding unproductive investments and consumption in the public sector, which would lead to low growth. Instead, government budgets should be brought into balance and regulations hampering economic activity should be removed. In Hayek’s view, this would, over time, provide the basis for healthy, self-driven economic growth, even if the measures taken might deepen the crisis in the short term.5

This ‘purging of past excesses’ approach, with its acknowledgement that it would be accompanied by high economic and social costs, was a suggestion no one wanted to hear in a collapsing economy. What most wanted to hear was the Keynesian solution that had been discredited more than two decades before, during the ‘stagflation’ crisis of the 1970s and early 1980s: massive government countercyclical action in the form of either a fiscal stimulus or an expansive monetary policy. Most economists of all stripes did not anticipate the severity of the financial crisis. Whatever schools of thought they belonged to, most appeared to believe that the ‘great moderation’ was not about to end so drastically and dramatically. Ironically, except perhaps for those who had taken seriously the work of Hyman Minsky (who was largely ignored by established economics during his lifetime), few Keynesians appeared to notice that the US economy had been propped up by what political economist Colin Crouch called a ‘privatized Keynesianism’, in which government and businesses were keeping consumers afloat with massive debt.6 When the crisis began, however, Keynesianism was in the best position to explain it, along with Marxism. And with Marxist economists relegated to the intellectual periphery, Keynesians or neo-Keynesians were also best positioned with the tools to manage the crisis. Intellectual leaders of this school included Paul Krugman, Joseph Stiglitz and 25

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Robert Shiller, who had drilled holes in neoliberal theory and practice before the crash. What united them was their scepticism about unfettered market forces, respect for the role of irrationality and imperfect information in the decisions of economic actors, fear that effective demand was being gutted by rising inequality, and advocacy of decisive government intervention to correct market failures. Keynesianism can be said to have made a vigorous comeback over the past few years; indeed, it has greatly eroded the neoliberal orthodoxy. It has come up with an explanation of the financial crisis based on Keynes’ concept of ‘liquidity preference’. It has deployed, with some success, the fiscal and monetary bazooka it rushed to the economic battle front. It has had a strong rationale for tougher regulations of finance and a set of solid prescriptions for adopting them. Despite all this, however, Keynesianism’s impact on policymaking has been limited and, in the case of financial reform, minimal. The aim of this chapter is to shed light on this paradox. Keynesianism returns The strength of Keynesianism (or neo-Keynesianism) lies in the conceptual toolkit and macroeconomic tools it provides for dealing with a crisis. For most Keynesians, analysis of financial crises begins with Keynes’ theory of money. Keynes’ theory rests on the distinctions he makes between the different functions of money in a capitalist economy. Money’s most fundamental function is to serve as a medium of exchange. Money is also capital, and as such it serves as an investment to get production going, in the form of credit extended to the entrepreneur. Money in the form of credit is essential to what is called the real economy. For production to begin, there must be credit advanced to the entrepreneur, which is repaid after what is produced is sold. 26

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But money is also a store of value, and it is this role that disrupts what would otherwise be a smooth circuit of credit from the creditor, to the entrepreneur who transforms it into capital, and back to the creditor as repayment with interest. During times of great uncertainty, the providers of credit may prefer to keep their wealth in liquid or monetary form, instead of lending it as capital to be invested in production. It is this contradiction between money as capital in the process of production and money as a store of value that its owners want to hold on to – Keynes’ famous ‘liquidity preference’ – that leads capitalism to instability rather than to equilibrium, as posited by neoclassical theory. Finance, in short, can become independent of the needs and dynamics of the real economy. As Massimo Amato and Luca Fantacci put it: the institution of money as a store of value makes it possible for saving to be entirely unconnected with concrete goods and to take place rather through the constant and indefinite accumulation of abstract purchasing power, in the precise sense of power being independent of the fact of being concretely exerted – so independent as to jeopardize the very possibility of its being exerted. It is the institution of money as liquidity, of which its function as a store of value constitutes one of the fundamental pillars, that makes crises of liquidity possible.7

Uncertainty plays a big role in capitalism. In real economic processes, there is always uncertainty – it is only the degree of uncertainty that varies. Uncertainty creates the contradiction at the heart of money and its competing uses as capital and as a store of value. The concrete expression of this contradiction is the interest rate. As Keynes put it: ‘The possession of actual money lulls our disquietude and the premium which we require to make us part with money is the measure of our disquietude.’8 Another way he 27

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expressed this was as follows: ‘The interest rate is the premium which has to be offered to induce people to hold wealth in some other form than hoarded money.’9 How uncertainty affects the degree of liquidity preference and impacts on the entrepreneurial investment activity that sustains the production process was underlined by Bill Lucarelli: money as a store of value depresses effective demand and delays the activation of idle resources. This only creates further uncertainty and postpones potential demand for goods and services. Entrepreneurs encounter problems in relation to their respective formation of future expectations and the timing of their investment expenditure … Under the conditions of unutilized excess capacity and rising unemployment, the state of uncertainty merely postpones planned investment and influences the expectations of wealth holders to hold their assets in a more liquid form.

Thus, high liquidity preference ‘will tend to divert real resources from being employed in the sphere of productive investment and leads inevitably to the existence of involuntary unemployment’.10 But creditors’ options include more than just high liquidity when investment in production does not produce attractive rates of return. For Keynes, there were two types of transaction associated with credit: credit used to purchase current goods and services in the process of production; and credit involving ‘speculative transactions in capital goods and commodities’ that ‘bear no definite relation to the rate of current production’.11 As Adair Turner noted, Keynes saw here a ‘potential disconnect’ between credit as investment for production and credit for speculation.12 Not only does the latter contribute less to GDP growth, it can also spiral out of control, generating a financial crisis and a finance-induced recession in the real economy. 28

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Keynes, then, saw money not as a passive element simply serving as a medium of exchange in the real economy or credit that is transformed into capital to get production going. ‘[M]oney and finance condition the real economy, not the other way around,’ as one commentator puts it, rather exaggeratedly.13 Indeed, as Keynes himself put it: money plays a part of its own and affects the motives and decisions and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted, either in the long period or the short, without knowledge of the behavior of money between the first state and the last.14

Money and, more comprehensively, the financial system actively shape the dynamics of capitalism, and they respond less to rationality than to what Keynes called ‘animal spirits’. The systemic instability stemming from speculative capital and animal spirits was posited in an interesting way by Keynes: Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic.15

In short, finance capital was the fly in the ointment of capitalism. ‘ ’ Minsky and his moment Hyman Minsky took Keynes’ insight into the dynamic behaviour of money and finance to paint a picture of capitalism as a system intrinsically geared towards instability and crisis rather than one 29

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that tended towards equilibrium. Minsky pointed out that Keynes’ propositions in his General Theory: center around the disequilibrating forces that operate in financial markets. These disequilibrating forces directly affect the valuation of capital assets relative to the price of current output, and this price ratio, along with financial conditions, determines investment activity … Once financial considerations are integrated into the investment decision, it is evident that capitalism as we know it is endogenously unstable … Contradictions and tensions associated with the accumulation of wealth come to the forefront of the analysis. Instability becomes normal rather than abnormal.16

Minsky used Keynes’ distinction (and conflict) between money as capital and money as a store of value to explore the reality behind the seemingly smooth functioning of the economy idealized by orthodox economics. The seeds of crisis are already in the ‘boom’, and, as Keynes’ and Minsky’s followers put it, lay even in such long periods of normalcy as the so-called ‘great moderation’. Minsky said: ‘The fundamental instability of capitalism is upward. After functioning well for a time, a capitalist economy develops a tendency to explode, to become “euphoric”.’17 In the neoclassical view, finance – or money – is a mechanism that passively reflects exchanges at the level of production and circulation in the real economy. For Keynes, finance and monetary flows and transactions were active processes that impacted on real economic processes. For Minsky, the key problem of orthodox theory was that it did not allow ‘activities that take place in Wall Street to have any impact upon the coordination or noncoordination of the economy’.18 In fact, financial processes achieved a dynamic of their own that began to destabilize the process of 30

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production. As the holders of money put a premium on extracting the highest value for their investments, banks and other financial agents began to compete feverishly to create financial products that would deliver the highest monetary returns. Thus, ‘financial innovation … tends to induce capital gains, increase investment, and increase profits: the economy will try to expand beyond any tranquil full-employment “state”’.19 As the profit rates in industry become less attractive relative to finance, more and more money is devoted to extracting higher returns in ever more complex financial products. Corporations themselves begin to borrow to engage in financial speculation, depending less on retained earnings as capital, and increasing their leverage and thus their profits if they make the right financial bets. Detailing Minsky’s dynamic picture of the processes unleashed by speculation, one commentator wrote: The economy therefore tends towards disequilibrium as these destabilizing financial forces assume ever more speculative forms. Asset price inflation during the peak of the boom will generate an increase in investment and consumption through the various channels of income and cash flows. When the price of capital assets exceeds the price of current output, excess investment is channeled into rising equity markets, which also encourages to increase their leverage. An implicit capital gain is realized, which merely serves to attract more investment. In other words, the rise in the price of capital assets relative to the price of current output could set in train quite perverse wealth effects, which amplify increases in consumption and investment.20

The critical moment comes when there is widespread realization that the asset price bubble is about to burst and there is a ‘rush 31

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towards liquidity and riskless assets’ before the value of financial assets collapses. That is the ‘Minsky moment’. The crisis of profitability and stagnation Finance played a central role in the ongoing economic crisis in that financial speculation instead of the productive process became the driving force of the economy, eventually destabilizing it. This essentially is what is meant by ‘financialization’. The dynamics of financialization, however, cannot be fully understood without exploring what triggered it. Here is where the Keynesian focus on macroeconomic trends and dynamics must be supplemented by a critical analysis of capitalism as a system driven forward by class conflict. The origins of the Great Recession, as it is now called, lie in the crisis that overtook Western capitalism in the late 1960s and 1970s. That crisis marked the end of what the French called the Trente Glorieuses (Thirty Glorious Years) from 1945 to 1975, when fiscal and monetary intervention, applied in a countercyclical Keynesian way, seemed to have eliminated the swings between frenzied booms and deep busts of capitalism, the most cataclysmic of which was the Great Depression. Stagflation (the coexistence of stagnation or low growth and high inflation, which was not supposed to occur under the Keynesian Phillips curve) squeezed the advanced capitalist economies, translating into a crisis of profitability. Stagflation was, however, a symptom of two related, profound developments in advanced capitalist economies. One was the problem of overproduction or over-accumulation. The other was the flaring up of the struggle between capital and labour over the fruits of the production process. The crisis of overproduction had its roots in the swift and successful economic reconstruction of Germany and Japan and the 32

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rapid growth of industrializing economies such as Brazil, Taiwan and South Korea. This added tremendous new productive capacity and increased global competition, while income inequality within countries and between countries limited the growth of purchasing power and effective demand. This classic crisis of overproduction – or underconsumption, to use Paul Sweezy’s formulation – led to a decline in profitability. The profit margins (share of profits in sales) of US non-financial corporations fell from slightly less than 20 per cent in 1967 to less than 10 per cent in 1974, before recovering slightly, then plunging to 8 per cent in 1980 and again in 1982.21 Indeed, the coexistence or direct correlation of stagnation and inflation was a symptom of the class struggle: a well organized labour force made it difficult for capital to get rid of workers and forced it to grant them relatively high wages and benefits packages. A pithy description of this process is provided by Radhika Desai: Western capitalism arrived at industrial maturity … and could enjoy the ‘golden age’ of growth thanks only to the stateorganized expansion of working class consumption made more urgent by the loss of colonies. It could only last as long as productivity increases permitted wages to rise without eating into profits. As soon as that limit was reached, further expansion of working class consumption proved intolerable.22

The crisis of profitability was eventually resolved by the adoption of neoliberal measures, but a necessary condition for the implementation of these measures was the political defeat of the working class. The most dramatic manifestations of this debacle were the defeat of striking air traffic controllers in the US by Ronald Reagan in 1982 and Margaret Thatcher’s crushing of the miners’ strike in Britain. As Paul Mason argues, although it has become commonplace to think that the triumph of globalization 33

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and neoliberalism was inevitable, it was not. It was predicated on labour’s political defeat: Neoliberalism was designed and implemented by visionary politicians: Pinochet in Chile; Thatcher and her ultraconservative circle in Britain; Reagan and the Cold Warriors who brought him to power. They’d faced massive resistance from organized labour and they had enough. In response, these pioneers of neoliberalism drew a conclusion that has shaped our age: that a modern economy cannot coexist with an organized working class. Consequently, they resolved to smash labour’s collective bargaining power, traditions, and social cohesion completely.23

While traditional conservatives or liberals sought to co-opt the working class, Mason argues that what the neoliberals wanted was its ‘atomization’: Because today’s generation sees only the outcome of neoliberalism, it is easy to miss the fact that this goal – the destruction of labour’s bargaining power – was the essence of the entire project: it was a means to all the other ends. Neoliberalism’s guiding principle is not free markets, nor fiscal discipline, nor sound money, nor privatization and offshoring – not even globalization. All these things were byproducts or weapons of its main endeavour: to remove organized labour from the equation.24

With organized labour defeated, global capitalism sought to resolve its crisis of profitability by doing away with the Keynesian or social democratic arrangements that had been the concrete expression of the social compromise with labour, and by reshaping the economic and social landscape. 34

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Escape routes from stagnation There were, broadly, three escape routes from the crisis of the 1970s. The first was neoliberal restructuring or removal of government barriers to the operation of market forces. In the global North, this involved breaking up unions that were accused of distorting labour markets; deregulation; privatization or re-privatization of government enterprises; and trade liberalization. In the global South, similar measures were adopted, along with the radical dismantling of the state as the leading agent of economic development. The second escape route was globalization, the most striking manifestations of which were the elimination of barriers to trade, investment and capital flows. The World Trade Organization (WTO) was created to break down such barriers, especially in developing countries. The IMF was harnessed to force capital account liberalization in the South. Transnational corporations shifted their operations to cheap labour areas in the South from the US and Europe. The third escape route was financialization, or the increasing use of the financial system, not as an intermediary between savers and investors, but as a mechanism to produce profit that would otherwise come from the production process. Using Marxian terms, this was a case of squeezing ‘value’ from value already created in the production process. Capitalism is incredibly contrary, so something that might appear to be a solution in fact deepens the same problem or creates new problems. Neoliberal restructuring The aim of neoliberal restructuring or structural adjustment, the first escape route, was to invigorate capital accumulation in two ways: first, by removing state constraints on the growth, use and 35

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flow of capital and wealth; and second, by redistributing income from the poor and middle classes to the rich according to the theory that the rich would then be motivated to invest and reignite economic growth. The problem with this formula was that, in redistributing income to the rich, it gutted the incomes of the poor and middle classes, thus restricting demand while not necessarily inducing the rich to invest more in production. In fact, it could be more profitable to invest in speculation. In the three decades prior to the crash of 2008, the wages of the typical American hardly increased – and, in fact, they dropped in the 2000s – as a result of neoliberal policies. A big part of the problem was the elimination of high-paying manufacturing jobs – an estimated 8 million of which vanished in the US between June 1979 and December 2009. One report describes the grim process of deindustrialization: ‘Long before the banking collapse of 2008, such important US industries as machine tools, consumer electronics, auto parts, appliances, furniture, telecommunications equipment, and many others that had once dominated the global marketplace suffered their own economic collapse.’25 Traditional manufacturing jobs were outsourced, and so were high-tech and related jobs that had been expected to make up for them. Apple’s case is paradigmatic. According to the report: Apple employs 43,000 in the United States and 20,000 overseas, a small fraction of the over 400,000 American workers at General Motors in the 1950s, or the hundreds of thousands at General Electric in the 1980s. Many more people work for Apple’s contractors: an additional 700,000 people engineer, build, and assemble iPads, iPhones, and Apple’s other products. But almost none of them work in the United States. Instead, they work for foreign companies in Asia, Europe, and 36

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elsewhere, at factories that almost all electronics engineers rely upon to build their wares.26

In relation to growth, neoliberal restructuring (which was generalized in the North and South during the 1980s and 1990s) had a poor record: global growth averaged 1.4 per cent in the 1980s and 1.1 per cent in the 1990s, whereas it averaged 3.5 per cent in the 1960s and 2.4 per cent in the 1970s, when state interventionist policies were dominant. Neoliberal restructuring could not shake off stagnation. Globalization The problem with globalization, the second escape route from stagnation, was that while it reduced the costs of labour, with the substitution of cheap labour in the global South for relatively costly labour in the global North, it also exacerbated the problem of overproduction or underconsumption. There was a lot of productive capacity added in places such as China but it was not matched by a significant corresponding rise in effective demand. True, some 1.7 billion new workers were estimated to have joined the labour force between 1980 and 2010,27 but, as Andrew Farlow points out: Those being employed in places like China were being paid a small proportion of the value they produced. The corporates that employed them were saving a high proportion of what they were generating. Hence those being employed were not contributing much to the global aggregate demand that would absorb what they produced. Meanwhile, the shift in production also put downward pressure on wages in richer countries, amongst those who might ordinarily have been thought of as the source of demand for the output … As firms chased insufficient demand, it seemed that one solution was for them to cut costs even more and further shift their activities offshore.28 37

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In their drive to regain profitability, US industry coupled offshoring activities with massive investment in labour-saving technology and information technology. As Deepankar Basu and Ramaa Vasudevan write: The pervasive adoption and growth of information technology would have almost certainly played an important role in shaping the particular evolution in the nineties when capital productivity showed an upward trend. New forms of managerial control and organization, including just-intime and lean production systems have been deployed to enforce increases in labour productivity since the 1980s. The phenomena of ‘speed-up’ and stretching of work have enabled the extraction of larger productivity gains per worker hour as evidenced by the faster growth of labour productivity after 1982. People have been working harder and faster. Information technology has facilitated the process. It enables greater surveillance and control of the worker, and also rationalization of production to ‘computerize’ and automate certain tasks.29

Offshoring production to take advantage of cheap labour and eliminating jobs through labour-saving technology regained a measure of profitability for capital. During some years in the 1990s and 2000s, the profit rates for US non-financial corporations climbed to 10 to 14 per cent, although they never reached the dazzling 18 to 20 per cent rates of the late 1960s.30 But these methods also eventually deepened the crisis of overproduction. Labour productivity rose by 7 per cent a year in the late 1990s and early years of the twenty-first century, but wages plummeted and millions of manufacturing jobs were lost. Supply kept outstripping effective demand, with the result that by the end of the 1990s – with excess capacity in almost 38

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every industry – the gap between productive capacity and sales was the largest it had been since the Great Depression.31 The impact of overproduction on the rate of profit did not manifest itself immediately,32 but in the ten-year period before the Great Recession there was a marked decline in the productivity of capital, which foreshadowed the coming profitability crisis – a prospect underlined by the ‘dot.com’ recession of 2001–02. One way of staving this off was to intensify even more the exploitation of the working class by promoting regressive income distribution measures.33 There were, however, limits to this to avoid provoking social instability. Another attractive course was to increase income from investment in the financial sector, where profits dwarfed those that could be derived from industry: although it accounted for only 8 per cent of GDP, finance raked in 30 per cent of the profits, with some analysts saying the actual figure was 50 per cent.34 As we shall see, for capital, financialization provided the solution to both averting social instability and shoring up profitability. The financialization option Against a backdrop of uncertainty in relation to the productive process, capital sought ever greater rates of return by increasingly concentrating on speculation rather than production. Along lines sketched out by Keynes and Minsky, the financial sector began to move relatively independently of the production process, bringing increasing instability to the whole system. This situation was insightfully observed by Marx in a remarkable passage that could be said to anticipate twentieth- and twenty-first-century developments: [To the possessor of money capital,] the process of production appears merely as an unavoidable intermediate link, as a necessary evil for the sake of money-making. All nations with a capitalist mode of production are therefore seized periodically 39

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by a feverish attempt to make money without the intervention of the process of production.35

The profitability of finance stemmed from four developments. First was the abolition, during the Clinton administration, of the Glass–Steagall Act (1933), which had served as a firewall between commercial or retail banking and investment banking. This abolition was the result of tremendous pressure from the big banks, which felt left out of the boom in trading. Second was the expansive monetary policy promoted by the US Federal Reserve to counter the downturn following the piercing of the dot.com bubble in the first years of the new century. Third was government’s and business’s move to shore up effective demand by substituting household indebtedness for real wage increases. Fourth was the lifting of capital controls on the international flow of finance capital, following the post-war era of financial repression. These developments together produced a speculative boom in the housing and stock markets, and fed on each other to accelerate an economic nosedive during the ‘bust’ period that was to follow. Eliminating the 1933 Glass–Steagall Act The Glass–Steagall Act was perhaps the greatest factor in the relative stability of the financial sector until the late 1990s. It had been passed in the midst of the Great Depression, which had been blamed by many on the unrestricted speculative activities of the banks. The law separated commercial from investment banking on the grounds that conflicts of interest could develop if institutions that were granting credit were also investing or using credit. The law made retail banking predictable and unexciting, though not unprofitable. Over time, however, the commercial banks began to feel disadvantaged in relation to the investment banks, which were 40

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developing all sorts of financial innovations that were translating into high profits. The commercial banks’ lobbying resulted in the Gramm–Leach–Bliley Act of 1999, which repealed the Glass– Steagall Act and ‘paved the way for financial supermarkets – one-stop money shops taking deposits, making loans, providing advice, underwriting and trading securities, managing investments and providing insurance’.36 Banking no longer consisted of just taking deposits from people at a low rate of interest and lending to households, consumers and firms at a higher rate of interest, in the classical economic textbook model. It had become an increasingly torrid investment activity chasing higher and higher profits. Byron Dorgan, one of eight senators who voted against the bill, noted – presciently, in hindsight – that ‘this bill will, in my judgement, raise the likelihood of future massive taxpayer bailouts’.37 ’ Monetary Keynesianism

‘

Speculative activity in the late 1990s focused on high-tech stocks. This created the dot.com bubble through a demand for shares in high-tech corporations (including start-ups) that was rooted in a belief in the endless profitability of these investments. With the collapse of the bubble and the subsequent recession, Alan Greenspan, chairman of the Federal Reserve, reduced the federal funds rate (the Federal Reserve’s main policy instrument) from 6.5 per cent to 1 per cent – a 42-year record low – in a Herculean effort to counteract the strong recessive trends. Greenspan’s countercyclical monetary policy did indeed pull the US out of recession, with families spending on new homes, cars, home renovations and vacations, and it sent stock prices to new heights. Greenspan talked about ‘irrational exuberance’ as an extraordinary wave of consumer spending and financial speculation fuelled the recovery, owing partly to his expansive ‘Monetary 41

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Keynesian’. The cost of this, however, was the build-up of another bubble: this time in housing and real estate. Credit creation as class pacification Greenspan’s monetary stimulus would probably have been less effective had credit not been made easily available to the middle and working classes by government and the banks. Easy credit was a way of substituting for the share in the national income that capital had clawed back from labour via wage cuts, wage repression and other neoliberal measures. This was necessary not only to counter economic crisis but to promote political stability. As Daniel Alpert put it: Easy credit didn’t just prevent Americans from seeing inequality. It also helped obscure the fundamental ways in which a good swath of the public lost out under globalization … Under normal circumstances, the pain and dislocations caused by globalization would have triggered a massive backlash against the free trade regime embraced by both political parties … Yet easy credit helped salve the wounds of downwardly mobile Americans and silence dissent. Sure, the plants may be closed and the jobs shipped to China. But with adjustable rate mortgages at rock bottom rates and Home Depot offering no payments for a year on new kitchens, the good times could go on.38

Mortgage credit was the principal mechanism for creating effective demand in what political economist Colin Crouch called ‘privatized Keynesianism’.39 Cheap credit was initially made available to low-income groups via the mortgage finance giants Freddie Mac and Fannie Mae, two government-supported enterprises (GSEs).40 Then the private sector joined the party. As Raghuram Rajan wrote: ‘After all, they could do the math and they understood that the 42

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political compulsions behind government actions would not disappear quickly. With agency support, subprime mortgages would be liquid, and low-cost housing would increase in price. Low risk and high return – what more could the private sector desire?’41 Most of the debt was unsecured. Indeed, it was important to understate risk, perform no due diligence and throw responsibility to the winds if the consumer demand that was the basis of both profitability and political stability were to be maintained. As Crouch put it, that was the only way in which privatized Keynesianism could have the same countercyclical stimulant effect as state-directed, demand-management Keynesianism, since ‘prudential borrowing against specified collateral would not have helped the moderate-income groups who had to keep spending despite the insecurity of their labour market positions’. The illusion of prolonged, widespread unsecured debt that had little risk was in turn made possible through innovations in financial engineering, ‘innovations which for a long time had seemed to be an excellent example of how, left to themselves, market actors find creative solutions’.42 In 1990, US mortgage debt totalled $2.4 trillion. By 2000 it had risen to $4.8 trillion, and by 2004 it reached $7.8 trillion; by 2006, $9.8 trillion; and by 2007, $10.5 trillion. In addition, between 2000 and 2008 the amount of revolving debt held by consumers increased by nearly 50 per cent – from $675 billion to $976 billion. Outstanding student loans rose from $200 billion in 2000 to over $800 billion by 2010 – a stunning 400 per cent increase. As Alpert noted, ‘Never in history had individuals – in any country or at any time – borrowed so much money so quickly.’43 Liberalizing global capital flows Finally, as noted earlier, a key factor contributing to the financialization frenzy was the lifting of controls on global financial capital flows 43

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that had made the post-war period one of financial repression. This capital account liberalization took place against a backdrop of global monetary turmoil, including: a ‘haemorrhaging’ of dollars from the US to finance the war in Vietnam; an offshore financial centre evolving in London as a result of this outpouring of dollars and becoming a source of funds for investors; and the end of the Bretton Woods system of fixed currency values, giving way to floating values and creating opportunities for making money from currency arbitrage. This liberalization led to intense speculative activity globally as investors, aided by information technology, chased after profits in the rise in value of stocks, bonds and derivatives in different markets, leading to investment saturation, and to collapse. Not surprisingly, there have been around 12 major international financial crises since the early 1980s, followed by recessions. These recessions triggered by banking crises were more severe than normal, real-economy recessions.44 Perhaps the most severe after the Great Recession was the Asian financial crisis of 1998–2001, which saw $100 billion in speculative funds flow into Asia from 1994 to 1997, finding their way to real estate and causing overinvestment in this sector. This sparked a ‘rush for the exits’ that brought about the collapse of, and recession in, key Asian economies, including South Korea, Thailand, Indonesia and the Philippines. The Asian financial crisis was a key factor in the growth of the US speculative bubble that burst in 2007–08. When the Asian economies were destabilized by the panicky exit of foreign investors and the opportunistic actions of currency speculators – which together drastically weakened their currencies, leading to more expensive imports and an inability to service foreign debts – they were forced to go to the IMF. In turn, the IMF forced them to undertake contractionary policies that led to tremendous suffering. Asian technocrats said ‘never again’, and to protect themselves from future speculative attacks they geared up their export 44

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machines to earn dollars, mainly from goods sold in developed countries, the biggest of which was the US. Many of these dollars were then bought by Asian central banks with domestic currency. This fulfilled two objectives. First, it prevented the appreciation of the local currency, thus keeping Asian countries’ exports competitive in world markets. Second, it allowed central banks to build up their reserves to support their currencies with a ‘big bazooka’ and deter future speculative attacks. East Asian reserves – excluding Japan’s – went from less than $100 billion in 2000 to more than $4 trillion in 2007. The central banks did not, however, keep all of these reserves in a state of hibernation – after all, banks must use money to make money. A large part was recycled back to developed economies through the purchase of assets such as mortgage-backed securities (MBSs) from the private sector in the US, or US Treasury bills. The total issuance of private-sector securities in the US and Europe reached some $3 trillion in 2007. Close to half of this amount was purchased by foreign actors, principally emerging market central banking institutions from East Asia. As Atif Mian and Amir Sufi note: From 1990 to 2001, central banks bought around $100 billion annually. From 2001 to 2006, the rate of reserve accumulation just about sextupled. This led to a breathtaking jump in demand for new safe assets, and foreign central banks heaped money into US Treasuries. As foreign central banks built up their dollar war chests, money poured into the US economy. In theory, this flow did not have to end disastrously.45

But it did end disastrously, largely because so much of it ended up being re-lent to private financial institutions that used it to create the credit that financed US consumer spending, particularly in housing. 45

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Calling attention to the role of Asian savings in the US financial crisis does not mean endorsing former Federal Reserve chairman Ben Bernanke’s theory that it was the ‘savings glut’ in East Asia making its way to ‘savings deficit’ countries such as the US that was the central cause of the crisis. The US economy was not a passive receptacle for the Asian funds. They were being pulled in by the dynamics of the financialized US economy and the interventionist foreign policy of the US government. Chief Economist of the World Bank, Justin Lin, said Bernanke had the causal relationship wrong: The combination in the United States of financial deregulation (starting in the 1980s), which allowed higher leverage, and low interest rates (following the bursting of the housing bubble in 2001) led to a large increase in liquidity, which fed the housing bubble. The wealth effect from the housing bubble and innovative financial instruments supported excessive household consumption. The consumption surge and the fiscal deficits needed to finance the wars in Iraq and Afghanistan generated large US trade deficits and global imbalances. The United States was able to maintain these severe imbalances for as long as it did because of the dollar’s reserve currency status.46

In any event, the massive inflow of Asian funds interacted with US banking liberalization, the Federal Reserve’s expansive monetary policy, and the effort to prop up consumer demand through credit rather than wage rises. The result was a volatile brew that fuelled the subprime bubble. From the beginning of the bubble through the feeding frenzy that pushed it ever upwards to its bursting and to the recession that brought the economy to a standstill, the process unfolded in the way Minsky predicted. 46

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Creating and inflating the bubble The main mechanism through which credit was pumped into the system involved mortgages made to middle- and lower-class households – a great many of them representing credit risks that in normal times banks would have refused. Thus the term ‘subprime crisis’. Subprime and other mortgages served as the basis of the speculative bubble that grew in the 2001–07 period because they were transformed into securities that financial institutions, both US and foreign, bought in large quantities in the belief that they were relatively risk free and could only appreciate in value. Complementing and interacting with the frenzied trade in mortgage-based securities was credit going to corporate players that invested in stocks as well as in new instruments called ‘derivatives’, which also came to be regarded as risk free, thanks to the alchemy of financial engineering. The combination of very low interest rates on money borrowed from the Federal Reserve and the government and the seemingly unlimited supply of foreign money from China and the other East Asian countries that found its way to the private sector either directly or through official conduits led to the idea that ‘relatively risk-free’ speculation was where large profits were to be made, rather than in the productive sector. Getting leverage became the name of the game; this meant limiting one’s equity while using large amounts of borrowed money to make huge profits on a trade, from which the relatively low interest could later be paid. Nailing down huge profits through highly leveraged deals increased the valuation of a company, meaning that the value of shares escalated. Thus, raising ‘shareholder value’ became the Holy Grail sought by market players, leading them to make bigger and bigger bets with borrowed money, fortified by the belief that, even if trades did not go the way they expected, losses would be minimal in a bull market that seemed to be endless. In 47

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brief, these were the dynamics of the bubble economy that inflated rapidly, then burst in 2007–08. The subprime mortgage implosion As noted earlier, housing became a fertile field for speculation owing to the banks taking advantage of US government programmes to provide affordable housing to low-income groups. While the process of securitization of mortgages began with the GSEs, it was kept under control through underwriting standards; but when the private sector entered the scene, things got out of control. While the GSE’s Fannie Mae and Freddie Mac catered mainly to ‘conforming’ mortgages, or mortgages that met conventional lending standards, the new private-sector lenders went after subprime borrowers, thanks to the wonders of financial engineering.47 The wondrous formula went as follows: private lenders entering the scene borrowed the ‘originate to distribute’ model pioneered by Fannie Mae and Freddie Mac, which bought conforming mortgages from conforming or creditworthy individuals from banks that originated the mortgage, and paid for them by pooling the mortgages together and selling them as securities to financial institutions and other investors. What this model of securitization meant was that the originating bank no longer had to hold the mortgage until it was fully paid. Indeed, there was an incentive to sell the mortgage immediately to intermediary institutions and get the profit up front. What the non-GSE private securities specialists did was to create a market for non-prime mortgages through financial engineering devised to assure investors that buying the securities was almost risk free. Through pooling and tranching, prime and subprime mortgages were combined into ‘safe’ securities and sold to investors. These came to be known as collateralized debt obligations, or CDOs. This process of ‘slicing and dicing’ securities into lower-risk 48

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and higher-risk tranches based on the mortgage holder’s ability to pay quickly got out of hand. As two specialists on derivatives note: While securitization itself was a legitimate operation, further securitization (through CDOs) was probably not. When securitized mortgage loans were further securitized into CDOs with different risk categories, it resulted in a massive secondary market in these complex derivative securities. In some cases, there were CDOs which consisted of parcels of other CDOs (known as ‘CDO squared’). This led to a situation where the ultimate risk-bearer could often not be identified. In reality, there was no safe category any more in these instruments that were securitized multiple times over. Further, in effect, a mountain of leverage had been built on the original home mortgage; a progressively smaller and weaker foundation of equity supported a huge securitization superstructure.48

Moreover, since they had an incentive to get rid of mortgages immediately and make their money up front, originators became lax in their standards of lending; indeed, many deliberately passed off subprime borrowers as prime borrowers. Fraud was widespread. The idea was to make a sale quickly, get your money up front and make a tidy profit, while foisting the risk on others down the line – the hundreds of thousands of institutions and individual investors who bought the mortgage-tied securities. This was called ‘spreading the risk’, and it was actually seen as a good thing because it lightened the balance sheets of financial institutions, enabling them to engage in other lending activities. Keynes caught the essence of this behaviour when he wrote: ‘The actual, private object of the most skilled investor is “to bet the gun,” as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half crown to the other fellow.’49 49

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With such perverse incentives promoted by the ‘originate and distribute’ model, lenders piled into poor neighbourhoods, aggressively hooking poor residents into contracting mortgages. The consequences are detailed by Atif Mian and Amir Sufi: The expansion of credit to more and more borrowers who were likely to default ended disastrously. Lenders flooded low-credit neighborhoods with credit, despite no evidence of better income prospects. Investors buying the MBS fueling this expansion made simple mistakes in their models, and the arrangers of securitization pools exploited these mistakes. Fraudulent practices infected private-label securitization, and credit-rating agencies were either unaware of what was going on or were happy to look the other way … Eager to create and sell profitable securities, lenders extended credit to so many marginal borrowers that they reached a point at which they lent to borrowers so credit-unworthy that they defaulted immediately after the loan originated. Once the defaults began to rise, the entire game unraveled, and levered losses kicked in.50

It is estimated that, during the Great Recession, housing prices fell by $5.5 trillion, or by over a third of the US GDP of $14 trillion. The main victims were low-income households that had been aggressively baited into borrowing, although a significant number of middleclass and even upper-middle-class households registered losses. The impact went beyond households, however. With trillions of dollars’ worth of toxic assets purchased by investors, a virus was injected into the global financial network, driving financial institutions, corporations and individual investors to bankruptcy, among the most prominent being Lehman Brothers, Bear Stearns, the British bank Northern Rock, the Swiss bank UBS, and the German Bank IKB Deutsche Industriebank. Alan Greenspan himself provided the best 50

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description of the virus-like spread of securities based on subprime mortgages: ‘The roots of this crisis are global and geopolitical … the actual trigger is securitized American subprime mortgages which became toxic and essentially proliferated around the world.’51 Derivatives drive the crisis Greenspan noted, however, that had it not been subprime-based securities, ‘something else would have triggered it’.52 He probably had in mind derivatives, which were the other big contributor to the crisis. Because of their role, the financial guru Warren Buffett labelled derivatives ‘weapons of mass destruction’. Derivatives are financial products that are not the assets themselves but are priced on the likely movement of those assets. One buys or sells derivatives depending on one’s sense of the likely direction of the underlying asset, making or losing money on this ‘bet’. The best-known derivative to emerge during the financial crisis was the ‘credit default swap’ (CDS), which was in fact a form of insurance that was termed a ‘swap’ to avoid the federal regulation to which other forms of insurance were subject. CDSs were originally contracts that holders of credit default obligations (CDOs) took out to insure themselves against losses if their CDOs turned sour in the event of a downturn in the real-estate market. However, since CDSs, being outside government regulation, did not require an insurable interest, speculators bought CDSs in the expectation that the growing risk of default would raise the price of the CDSs they purchased, and they could make a neat profit from the sale. As two derivatives specialists put it: Many institutions acquired CDS on the secondary market as investments without any interest in the original credit. If so much money is at stake on a disaster happening (credit default), then perhaps there is a perverse incentive to make the risk 51

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materialize rather than prevent it from happening. Thus, there is moral hazard written all over the credit default swap industry.53

Not surprisingly, the market in CDSs exploded, as speculators took out CDSs not only on CDOs but on price movements of different commodities, as well as on risks including crop failures or natural disasters such as climate change. Prior to 2007, such bets on credit defaults made up a $45 trillion market that was entirely unregulated. It amounted to more than five times the total of the US government bond market. When the subprime bubble exploded and investors and speculators rushed to convert their CDSs into cash to make up for their losses, the American International Group (AIG) was felled by its massive exposure in CDO insurance. AIG lost billions of dollars on these swaps, and it was Washington’s fear that its bankruptcy would infect the whole CDS market and cause it to implode – bringing the whole financial system with it – that made Washington go to its rescue after it allowed Lehman Brothers to collapse in the fateful autumn of 2008. The trade in derivatives was completely unregulated, taking place in what was called a ‘shadow banking system’ where most trades were done ‘over the counter’; this meant that there was no public record of these exchanges, which would have existed had they taken place in official exchanges. Further, these transactions were not entered into the balance sheets of many of the corporations engaging in trades, but into ‘special purpose vehicles’ (SPVs) set up to avoid regulation and to take advantage of loopholes in the law. SPVs allowed banks to present healthy balance sheets when in fact their SPVs showed losses in trades. Once a bank was rumoured to have a liquidity or solvency problem, however, market players ripped apart the fiction of SPVs and held the parent bank accountable for paying back credit it had extended to its subsidiaries, as 52

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they did to Lehman Brothers and other big Wall Street institutions during the panic of 2008. ‘ ’ ‘ ’ Financial tail wags industrial dog Financialization reshaped the corporate landscape, and perhaps the most telling evidence of this was how corporate stalwarts in industry were transformed into organizations where the financial tail ended up wagging the industrial dog. General Electric exemplified this transformation. One of the US’s most successful industrial corporations, GE found its profits shrinking amidst the fragile state of US industry in the late 1980s and 1990s. A conglomerate, its mature industrial businesses were not growing and its profits were not expanding as desired, to the disappointment of shareholders who believed in the new doctrine of the financial era: a constantly rising share value was a good indication of good management. To counteract the poor performance of its traditional industrial units, GE set up a financial arm, GE Capital, to aggressively play the financial markets, diverting earnings from its old industrial units to it. By the early 2000s, GE was ‘leveraged around 10 times; $10 of borrowings, much of it short term, for every $1 share of capital’.54 It also went on a buying spree of financial businesses, from whose investment and trading operations the conglomerate was eventually drawing half of its growth earnings. Industrial operations were subordinated to financial operations, and the aim of those financial operations was to constantly enhance their return on equity, earnings and share price. Eventually, GE became extremely fragile, and the advent of the financial crisis in 2008 revealed just how overextended and indebted it was, leading to a corporate meltdown. This was not surprising since meeting financial targets had replaced the production of goods as the prime corporate concern.55 53

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GE and many other industrial corporations were in the vortex of a speculative frenzy, where the Wall Street financial establishment was calling the shots. The irrationality of the bubble was evident in the fact that the total volume of traded derivative financial instruments came to $740 trillion, compared with the world GDP of $70 trillion. The most common derivatives were MBSs, CDOs and CDSs, although there were more exotic varieties. Some $640 trillion of these were traded over the counter, meaning that there was little transparency, little indication of how healthy these derivatives were, and little knowledge of how many were owned by whom. Not surprisingly, credit ratings agencies failed to price these instruments properly, often taking the word of the investment banks that created them and the financial institutions that bought them as to the value of these instruments and the health of their holders. ‘ ’ Fear of the unknowns With so many unknowns, when news of widespread subprime mortgage failures spread in 2007, panic quickly followed, leading to radical downgrading of all MBSs, and, by contagion, almost all other derivative products too. Not knowing each other’s toxic securities holdings, banks practically stopped lending to each other. The rating agencies that had been caught napping at the wheel sprang to life, ‘downgrading hundreds of issues of securities and thus accelerating the crisis’.56 So exposed were the top financial institutions to toxic and downgraded securities that the federal government had to undertake massive rescue operations in 2008–09, which injected direct investments in preferred and common stock to the tune of billions of dollars. Others urged nationalization. The banks were considered too-big-to-fail, and with this rationale, some $20 billion was invested 54

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in Bank of America and another $20 billion in Citigroup. The banks were saved, but households were left to fend for themselves. The impact of the crisis As the bubble economy burst, the financial system froze, with interbank lending grinding to a halt along with bank lending to corporations on overnight, fortnightly, short-term or long-term bases. The impact on the real economy was devastating. Governments in the US and Europe went into motion – not to prevent or mitigate spreading unemployment, but to save the big banks that had brought on the crisis, on the assumption that failure on their part would trigger the collapse of the real economy. The Great Recession was the biggest economic disaster to hit the US since the Great Depression. Unemployment rose from under 5 per cent in 2007 to 10 per cent in 2010 and around 8.6 million jobs were lost between March 2007 and October 2009. More than six years later, in 2015, the number of unemployed was still about 2 million above the 6.7 million unemployed at the start of the recession in 2007.57 While employment started to rise in December 2009, it nevertheless took until 2014 to reach the pre-crisis peak of 138 million employed workers.58 Moreover, the fall in the unemployment rate was driven less by improved labour market conditions than by a falling participation rate, as discouraged workers withdrew from the labour force. As far as growth was concerned, the recovery was tepid, with average GDP growth barely 2 per cent per annum between 2011 and 2013 – less than half the pace of typical post-World War Two expansion.59 In terms of inequality, the statistics were clear: 95 per cent of income gains from 2009 to 2012 went to the top 1 per cent; median income was $4,000 lower in 2014 than in 2000; concentration of financial assets increased after 2009, with the four largest banks 55

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owning assets that came to nearly 50 per cent of GDP. An Economic Policy Institute study summed up the trends: ‘[T]he gains of the top 1 percent have vastly outpaced the gains for the bottom 99 percent as the economy has recovered.’60 At the individual and household level, the economic consequences of being laid off were devastating, with one study finding that workers laid off during recessions ‘lose on average three full years of lifetime income potential’.61 One estimate showed that the income of the US would have been $2 trillion higher had there been no crisis, or $17,000 per household.62 More than 4 million homes were foreclosed.63 Lower-income homeowners – the main victims of aggressive mortgage sharks – suffered most. Since they were highly leveraged, meaning that their debt-to-equity ratio was quite high, their net worth plunged from $30,000 to almost zero between 2007 and 2010. This decline in net worth, according to Mian and Sufi, ‘completely erased the gains from 1992 to 2007’.64 Keynesianism to the rescue The unfolding of the crisis brought Keynesian economics to the forefront, with neoliberalism beating a hasty retreat in its immediate aftermath. A few Keynesian economists may have anticipated the crisis, but even they were probably surprised by its severity. But it was not the correctness of their financial analysis for which their expertise was sought – but rather for the policy tools they offered for dealing with the unfolding crisis. As noted earlier, the neoliberal par excellence, Robert Lucas, said: ‘Everyone is a Keynesian in a foxhole.’ Even before Obama won the 2008 election, George W. Bush’s administration had discarded the hands-off approach to the financial sector and had brought recalcitrant proponents of the free market in Congress to endorse the massive rescue of the banks via 56

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the $700 billion Troubled Assets Rescue Program, which was set up to purchase the toxic securities of the top commercial and investment banks under the doctrine that the banks were too-big-to-fail. This was in addition to the Federal Reserve’s infusion of credit via SPVs to two troubled financial players, Bear Stearns and AIG. Government action also forced two investment banks, Goldman Sachs and Morgan Stanley, to convert themselves into holding companies of the big banks. But Keynesianism’s rise to prominence really took place during the Obama presidency. Government fiscal intervention and regulation of the banks were seen by the incoming administration and its advisers as the central instruments in stabilizing an unravelling system. Failure on the fiscal front ‘Stimulus’ was the byword of 2009, with governments in the North running deficits of up to 10 per cent of their GDP to counteract the economic downturn. The Group of 20 (G20), meeting in Pittsburgh in September 2009, appeared to give the imprimatur to a new era of fiscal activism by urging the adoption and maintenance of stimulus programmes as the key solution to the crisis. Another key G20 resolution was the creation of a new regulatory framework for the financial sector at both the national and international level. While everyone agreed on financial reform, the devil was in the detail, with some governments favouring the banning of derivatives and the imposition of some kind of financial transactions tax, and some (like the US) not willing to go that far. The move on the fiscal front was, however, disappointing. Christina Romer, the head of Barack Obama’s Council of Economic Advisers, estimated that it would take $1.8 trillion to reverse the recession. Obama approved less than half, or only $787 billion, 57

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supported by the more conservative members of his economic team, leaving Romer isolated. Relatively speaking, this package was smaller than the $585 billion stimulus the Chinese government injected into its own economy. For many Keynesians, such as Richard Koo, the US had only to look to Japan for an example of the importance of massive fiscal stimulus. Despite much scepticism in policy and academic circles, noted Koo, the 140 trillion yen spent by the Japanese government to counter the country’s Great Recession in the 1990s prevented economic collapse: In reality, it was only because the government increased fiscal expenditures to the extent it did that the nation’s standard of living did not plummet. Indeed, it is nothing less than a miracle that Japan’s GDP remained at above peak bubble-era levels despite the loss of 1,500 trillion yen in national wealth and corporate demand equal to 20 per cent of GDP, and it was government spending that made this miracle possible.65

What makes President Obama’s restraint even less understandable is that the neoliberals were still in disarray, with a number of their leading lights supporting Obama’s stimulus spending. One was Nobel Prize laureate Robert Lucas, unofficial dean of US neoliberalism. Another was John Cochrane, also a University of Chicago neoliberal luminary, who stated his position in a way that Paul Krugman would have approved: Let’s be clear what this issue is not about. Governments should run deficits in recessions, and pay off the resulting debt in good times. Tax revenues fall temporarily in recessions. Governments should borrow (or dip into savings), to keep spending relatively steady. Moreover, many of the things government spends money on, like helping the unfortunate, naturally rise in 58

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recessions, justifying even larger deficits. Recessions are also a good time to build needed infrastructure or engage in other good investments, properly funded by borrowing. For all these reasons, it is good economics to see deficits in recessions – and surpluses in booms … We can argue whether the overall level of spending is too high; whether particular kinds of recession-related spending are useful or not; whether particular infrastructure really is needed; and we certainly face a structural deficit problem. But those are not the issue either.66

Obama’s apparent motive in halving Romer’s proposed stimulus was not economic but political: to signal to the right in Congress that he was someone with whom they could talk business. According to Krugman and other Keynesians, this Solomonic decision may have prevented the economy from tanking but it prolonged the stagnation, with GDP growth not rising above 2.25 per cent and unemployment not going below 7 per cent from 2009 to 2013.67 The limits of monetary policy With the Obama administration unwilling to put into effect an aggressive stimulus programme for fear of triggering a neoliberal backlash, the one Keynesian mechanism that was left to stop the downward spiral was an expansive monetary policy. Here, the Federal Reserve under Ben Bernanke did act aggressively, radically bringing down the rate at which banks could borrow – from 2.5 per cent to effectively zero. A wide range of channels opened to pump liquidity into the economy and radically raise effective demand. As Atif Mian and Amir Sufi say: The Fed also expanded the definition of who could borrow and what classified as acceptable collateral. An entire alphabet 59

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soup of new programs was initiated. There was the $150 billion Term Auction Facility (TAF); $50 billion in swap lines for foreign central banks; the $200 billion Term Securities Lending Facility (TSLF); the $20 billion Primary Dealer Credit Facility (PDCF); the $700 billion Commercial Paper Funding Facility (CPFF); and the $1 trillion Term Asset-Backed Securities Loan Facility (TALF).68

The biggest and longest-lasting Federal Reserve programme was the Large Scale Asset Purchase (LSAP) programme – informally known as ‘quantitative easing’. This involved the Federal Reserve buying long-term assets from the banks, including agency debt, MBSs, and long-term Treasury bills. This programme was massive, with the Federal Reserve’s balance sheet leaping from $800 billion in 2007 to $3.3 trillion by 2013.69 The idea was that these purchases would enable the banks to make loans to companies and households, which would then spend, add to aggregate demand, and jump-start the economy. The slow pace of recovery and continuing high unemployment showed that this second-best Keynesian method for overcoming recession was disappointing in its results, although it did not trigger the inflation that the hard-line neoliberals and neoliberal press (such as the Wall Street Journal) predicted. Again, there was a Keynesian explanation for this, and this time it was not the size of the programme. Drawing from his experience in Japan during the 1990s, Richard Koo explained this by saying that the response of indebted corporations and households would be to pay off their debts or ‘deleverage’ rather than contracting new debt. The private sector began paying down debt after the debtfinanced asset bubble collapsed, leaving only debt in its wake. This was both responsible and correct behavior for individual 60

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businesses and households, but as a result of their actions the economy as a whole experienced what are known as fallacyof-composition problems. A fallacy of composition refers to a situation in which behavior that is correct for individuals or companies has undesirable consequences when everyone engages in it.70

This means that when corporations stop borrowing money (even at zero interest rates) because they are deleveraging, funds supplied to financial institutions by the central bank remain stuck within the financial system. The same disappointing results that met expansive monetary policy in Japan in the 1990s also greeted the dramatic expansion of the monetary base post-Lehman in the US. The key implication here, writes Koo, is that ‘the effectiveness of monetary policy diminishes dramatically as the private sector switches from maximizing profit to minimizing debt’.71 In the US, the infusion of money by the Federal Reserve into the banks or ‘bank reserves’ rose from under $1 trillion in 2009 to $3 trillion in 2013, while currency in circulation – reflecting money released by the banks through loans to corporations and households – rose only from $500 billion to less than $1 trillion. Far more effective in the Keynesian view is monetary stimulus that puts as much money – as directly as possible – into the hands of households that have a significant propensity to spend, meaning poor households. Atif Mian and Amir Sufi say, perhaps exaggeratedly, that: A better approach would [have been] to allow central banks to directly inject cash into the economy, bypassing the banking system altogether. The most extreme image that comes to mind is the chairman of the Federal Reserve drops of cash. The idea of directly injecting cash into the economy may at 61

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first seem crazy, but reputable economists and commentators have suggested exactly such a policy during severe economic downturns. Ben Bernanke, only a few years before he was chairman of the Fed, suggested helicopter drops for Japanese central bankers in the 1990s, earning the nickname ‘Helicopter Ben’. Financial Times columnist Martin Wolf wrote in February 2013 that ‘the view that it is never right to respond to a financial crisis with monetary financing of a consciously expanded fiscal deficit – helicopter money, in brief – is wrong. It simply has to be in the tool kit.’ Willem Buiter used rigorous modeling to show that such helicopter drops would in fact help an economy trapped at the zero lower bound nominal interest rates. It would be best if the helicopters targeted indebted areas of the country to drop cash.72

’ The banking reform that wasn t The most dismal failure of the Keynesian effort, however, occurred in the area of financial reform. When the financial crisis broke, there was one thing on which there was a virtual national consensus, and this was urgent reform of the financial system so the crisis would not happen again. There were widespread expectations that, with Barack Obama taking over as president in the depths of the crisis and the Democrats winning control of the House and Senate, banking reform was just around the corner. The new president captured the mood of the country when he warned Wall Street: ‘My administration is the only thing that stands between you and the pitchforks.’73 Reform of the US financial system was not just the concern of Keynesian and progressive economists. Many economists and policymakers of a strong free market bent were, in fact, also supporters of tough penalties and robust rules for the big banks. What is 62

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amazing is that despite a common front uniting the vast majority of the public, economic policymakers and economists, practically no real reforms have seen the light of day ten years after the outbreak of the financial crisis. The first reason is that – excluding outright fraudsters such as Bernie Madoff, whose criminal wrongdoing began way before the crisis – no Wall Street senior executives have been jailed for the myriad white-collar crimes involved in the MBS and derivatives business, including ‘well documented illegal acts, such as authorizing document forging, misleading investors, and obstructing justice’.74 Failure to prosecute people at the top has contributed to a continuing lack of accountability among top executives, resulting in scandals such as the recent Wells Fargo fraud involving bank personnel creating false accounts in unwitting customers’ names. Next, there’s the question of executive pay. Despite opprobrium visited on AIG officials for pocketing bailout money from the government in 2009, executive pay has remained relatively unrestrained. Caps on the pay of top executives of the banks that were bailed out while they were indebted to government were one of the reasons why they rushed to pay back the government. This way, they were able to take advantage of tax loopholes including the CEO bonus based on ‘performance’. This loophole, as many have noted, had been one of the reasons for the irresponsible executive behaviour that led to the crisis. With the loophole ban lifted: Between 2010 and 2015, the top executives at the 20 leading US banks pocketed nearly $800 million in stock-based ‘performance’ pay – before the value of their company’s stock had returned to pre-crisis levels. In other words, with shareholders who had held on to their stock still in the red, executives were reaping massive rewards that their banks could then deduct off their taxes.75 63

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Interestingly, the biggest beneficiary of the bonus was John Stumpf, CEO of Wells Fargo, who received tax-deductible bonus pay between 2012 and 2015 to the tune of $155 million.76 As noted above, Wells Fargo is the focus of the most recent Wall Street scandal, which has resulted in Stumpf ’s resignation. Nationalization of troubled banks such as Citi and Bank of America, which were propped up by over $800 billion from the government at the start of the financial crisis, was one of the measures in the toolkit of Keynesians such as Paul Krugman and Joseph Stiglitz. As Krugman put it: To end their zombiehood, the banks need more capital. But they can’t raise more capital from private investors. So the government has to supply the necessary funds … But here’s the thing: the funds needed to bring these banks fully back to life would greatly exceed what they’re currently worth. Citi and BofA [Bank of America] have a combined market value of less than $30 billion, and even that value is mainly if not entirely based on the hope that stockholders will get a piece of a government handout. And if it’s basically putting up all the money, the government should get ownership in return.77

Again, economic rationality was not the reason why the Obama administration took a different route to that chosen by other governments in Europe. It was ideology. The Obama administration, said White House spokesman Robert Gibbs, believed ‘that a privately held banking system is the correct way to go’.78 Bank nationalization, even temporary nationalization, was said to be ‘anathema to large segments of the American public, not to mention to the banking lobby’.79 In any event, what eventually resulted was the government charade of giving the banks ‘stress tests’ in order to declare them healthy – even if some of them were insolvent or 64

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bordered on insolvency – so they could raise the capital that would bring them back to good health. As Barry Eichengreen writes: A less happy interpretation is that the Good Housekeeping Seal of Approval conferred by the tests was tantamount to a colossal government guarantee. The nineteen biggest banks received special attention. Treasury asserted that they were solvent. Nine of them, starting with Goldman Sachs and JPMorgan Chase, required no additional capital. Citigroup, Bank of America, and eight of their less pristine competitors would be adequately capitalized if they raised only an additional $75 billion of capital, or so the government averred. If they then got into trouble, it stood to reason that this would be due to events not of their own making, and that the authorities, having attested to their soundness, would bail them out.80

The total cost to taxpayers of bailing out the banks in 2008 and 2009 came to $2.2 trillion – $900 billion through the US Treasury and $1.3 trillion through the Federal Reserve. The paradoxical result is that the big banks have become even bigger and more profitable, and have continued to engage in many of the practices that led the financial crisis. Derivatives trading that violated federal law led to JPMorgan paying $920 million in fines in 2013, and the bank continues to be the object of wide-ranging criminal charges that it misrepresented the quality of the mortgages it was packaging into bonds and selling to investors. Wells Fargo, for its part, has admitted to creating millions of false accounts in unwitting clients’ names. Meanwhile, CEOs of the two corporations – Jamie Dimon of JPMorgan and John Stumpf of Wells Fargo – received pay packages totalling $27 million and $19 million respectively in 2015.81 Given these developments, it is hard to argue that nationalization was not the better option. 65

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Keynesian economists and policymakers also favoured having the financial institutions bear part of the costs of the subprime crisis, instead of laying them at the doors of bankrupt homeowners. This would have involved the government forcing banks to forgive the mortgages of indebted homeowners, and making the banks take the hit. The rationale for sharing the financial consequences of the housing crisis was that, since both homeowners and creditors were responsible for driving the housing boom, it was only fair to have a ‘more even distribution of losses between debtors and creditors’.82 Such an arrangement would also make macroeconomic sense, because the lack of effective demand could be partly addressed by reducing the indebtedness of households in trouble. Indeed, top economists who met President Obama and Vice President Joe Biden said that Obama ‘could have significantly accelerated the slow economic recovery if he had better addressed the overhang of mortgage debt left when housing prices collapsed’.83 The problem again was ideological: the banks had to be saved at all costs – and having them bear part of the cost of the mess they created by forcing them to write down mortgages would have harmed their recovery. In the measured judgement of Atif Mian and Amir Sufi: When a financial crisis erupts, lawmakers and regulators must address problems in the banking system. They must work to prevent runs and preserve liquidity. But policy makers have gone further, behaving as if the preservation of the bank creditor and shareholder value is the only goal. The bank-lending view has become so powerful that efforts to help home owners are immediately seen in an unfavorable light. This is unacceptable. The dramatic loss in wealth of indebted home owners is the key driver of severe recessions. Saving the banks won’t save 66

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the economy. Instead, bolstering the economy by attacking the levered-losses problem directly would save the banks.84

Ideological predisposition was very pronounced among economists, who ignored the fact that the banks were no longer in severe stress after the bailout of 2008 and 2009. ‘The banklending view,’ according to Mian and Sufi, ‘enjoys tremendous support among some in the economics profession, and they help lodge it in the public discourse of policies in severe recessions. The entire discourse becomes focused on the banking crisis, and potential solutions to the household-debt crisis are ignored.’85 In fact, not only was the plight of households ignored; the administration deliberately sabotaged the passage of measures to assist them: [A] policy that implied large losses for the lenders would have undermined Treasury’s strategy for rehabilitating the financial system, which was based on the banks’ earning their way back to health. Secretary Geithner opposed any form of intervention that meant losses for the banks. The Senate was quietly told that bankruptcy reform was not a priority of the Treasury, and legislation aimed at revising the [law] died a quick death.86

Of course, ideological predilection was greased by money. Research by Mian and Sufi found that ‘campaign contributions by financial firms led congressional representatives to be more likely to vote for bank bailout legislation … Some members of Congress desperate to get campaign funds have clearly been bought off by the financial industry.’87 Another badly needed reform was to have banks increase their equity relative to the debt, thus decreasing the leverage and their willingness to take the risks that had contributed to the financial crisis. And when banks get distressed, if they have more equity they 67

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are less susceptible to insolvency. Moreover, as Anat Admati and Martin Hellwig point out: If solvency risk is reduced, the likelihood of liquidity problems and runs is also reduced because depositors and other creditors are less nervous about their money. Moreover, beyond the bank’s own ability to absorb losses without becoming distressed, the fraction of assets that a bank may have to sell after losses in order to recover its equity is smaller if it has more equity. Therefore, the contagion caused through asset sales and interconnectedness is weaker when banks have more equity. Increasing banks’ ability to absorb losses through equity thus attacks fragility most effectively and in multiple ways.88

When the financial crisis began in 2007, the equity of some major financial institutions was 2 to 3 per cent of their assets, and these thin safety margins had a critical role in bringing about the crisis. The Basel I and II Accords that government bank regulators put together to regulate capital did little to prevent the crisis. Basel III, which regulators agreed after the outbreak of the crisis, failed to address the basic problem that banks can easily ‘game’ the regulation, with the agreement still permitting banks’ equity to be as low as 3 per cent of their total assets.89 ‘The weakness of Basel III,’ note Admati and Hellwig, ‘was the result of an intense lobbying campaign mounted by the bankers against any major change in regulation. This campaign has continued since. By now even the full implementation of Basel III is in doubt.’90 The most ambitious effort at financial reform was the so-called Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. Authored by Senator Chris Dodd and Representative Barney Frank, this piece of legislation came to 848 pages, which, as one authority has noted, ‘easily surpasses the 32 pages of the Federal 68

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Reserve Act of 1913 and the 37 pages of the Glass–Steagall Act of 1933, the earlier major pieces of banking legislation’.91 Upon its being signed into law, President Obama said: ‘The American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more taxpayer-funded bailouts. Period.’92 It is fair to say, however, that this monumental and exceedingly complex and detailed law gave birth to a mouse. On this, both the right and the left agreed. One of the main objectives of the law was to eliminate moral hazard, especially that which came under the rubric of too-big-tofail institutions. Yet, by declaring that every banking organization worth more than $50 billion was ‘systemically important’, assure the big banks that they were too-big-to-fail was exactly what the legislation did. As Peter Wallison and Cornelius Hurley assert: ‘Prior to the financial crisis, the policy option of government intervening was called “constructive ambiguity”. It provided creditors with just enough uncertainty to keep the biggest banks from being subsidized. But the financial crisis and the Dodd– Frank response have turned government intervention into a perceived entitlement.’93 Given their central role in triggering the financial crisis, there was a strong call for the banning or very strict control of derivatives. Dodd–Frank did nothing of the sort. Instead, it permitted investment banks: to create innovative (toxic) derivative products (such as ‘CDO-cube’ or synthetic CDs) that defy analysis by ratings agencies as well as by investors, with no required approval by the Securities and Exchange Commission or the new Consumer Financial Protection Bureau within the Federal Reserve as long as the products are sold only to professional investors.94 69

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It left out regulation of cross-border derivatives trading, a process that contributed to the crisis. Even the minimum demand of the reformers that derivatives trading must take place on electronic exchanges where it could be better monitored and put on public record did not make it. Following the financial crisis, there were calls to bring back the separation of retail banking and investment banking as laid out in the Glass–Steagall Act, the abolition of which during the Clinton administration had led the banks to engage in risky trades in search of high profits. This was not taken up by Dodd–Frank. Instead, the final version of the legislation adopted what came to be known as the Volcker Rule, which, in its original formulation, would have banned banks from engaging in proprietary trading or using depositors’ money to trade on the banks’ own accounts and from owning or investing in a hedge fund or private equity fund, and would have set limits on the liabilities that the largest banks could hold. In fact, the Volcker Rule was watered down: rather than banning proprietary trading, banks could still invest up to 3 per cent of their equity in speculative trading. How the banks could twist the weak version of the Volcker Rule that became law was illustrated by the $6.2 billion lost by JPMorgan in speculative trading by an agent known as ‘London Whale’ in 2012. The bank initially claimed that this was within the parameters of the Volcker Rule, but it eventually admitted violating securities laws and agreed to pay fines of more than $1 billion.95 Why Keynesianism failed Banking reform in the US was a case of the regulated capturing the regulators. In spite of their severe crisis of legitimacy, the financial elite was able to resist reform. Despite a national consensus for radical reform of banking, Keynesian reforms were stopped dead in their tracks. 70

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Finance capital and its allies were able to wage skilled defensive warfare from their entrenched positions in the US economic and political power structure. This structural power had developed over the nearly 30 years of neoliberal hegemony, during which the balance of power in government–business relations had shifted decisively in the direction of business. The first thing the deployment of this ‘structural power’ by the banks achieved was to get the government to rescue them from the financial mess they themselves had created. The banks flatly refused Washington’s pressure on them to mount a collective defence with their own resources. The banks simply told government that they were responsible only for their own balance sheets and not for dealing with any systemic threat. This is what Cornelia Woll so aptly called the ‘power of inaction’, or the power to influence developments by not acting.96 Even when Lehman Brothers was about to go under in the autumn of 2008, the banks did not budge. Revealing the banks’ sense of their strong bargaining position vis-à-vis government, Merrill Lynch CEO John Thain remarked that, in hindsight, the only thing he regretted in the tense days of negotiations leading up to the collapse of Lehman Brothers was that the bankers did not ‘grab [the government representatives] and shake them to say that they can’t let this happen’.97 It was up to government to come up with the resources to save the banks and save the system, not the banks themselves. The banks calculated right. The Bush administration pressured Congress to approve the $787 billion Troubled Asset Relief Program (TARP) and used this to recapitalize the banks, with the dividend for the government shares so low that Vikram Pandit, CEO of Citigroup, the most troubled Wall Street giant, exclaimed, ‘This is really cheap capital.’98 Accepting the banks’ implicit position that ‘they were too-big-to-fail’, Treasury and Federal Reserve funds that went to the banks through various conduits, either as 71

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capital for recapitalization or as guarantees, eventually came to $3 trillion. Government action – and taxpayers’ money – saved the day, but the banks also calculated correctly that, despite pressures from Keynesian economists such as Paul Krugman and Joseph Stiglitz, nationalization was out of the question since it was ‘not the American way’. So generous (or intimidated) was Washington that what should have been standard operating procedure – the firing of top management and the shake-up of the board of what were essentially insolvent institutions – was not even seriously considered. To the power of inaction, however, must be added the power of action – the second element of the banks’ structural power. As shown in the various cases cited above – the debates over burden sharing between the banks and indebted homeowners, bank equity levels, Dodd–Frank – Wall Street deployed massive lobbying, and the cash to accompany it. Indicative of the banks’ lobbying firepower was the $344 million the industry spent lobbying the US Congress in the first nine months of 2009, when legislators were taking up financial reform. Senator Chris Dodd, the chairman of the Senate Banking Committee, alone received $2.8 million in contributions from Wall Street in 2007–08. The result of the lobbying offensive was summed up by Cornell University’s Jonathan Kirshner: [The] Dodd–Frank regulatory reforms, and provisions such as the Volcker Rule, designed to restrict the types of risky investments that banks would be allowed to engage in, have … been watered down (or at least waterboarded into submission) by a cascade of exceptions, exemptions, qualifications, and vague language … And what few teeth remain are utterly dependent for application on the (very suspect) will of regulators.99 72

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The third element of the structural power of the banks was ideological: the sharing of their perspectives with key government personnel about the centrality of finance, and about how the good health of the financial system was key to the good health of the whole economy, including the government. Some analysts called this the ‘bank-lending’ point of view. Others called it the Wall Street–Washington connection. Cornelia Woll characterizes this as ‘productive power’ – the joint production of world views, meanings and interpretations that emerge from shared perspectives.100 The perspective in question developed from the thorough discrediting of government interventionist approaches (not least through the stagflation of the 1970s and 1980s) and their yielding primacy to the supposed superior efficacy of private-sector initiatives. It was a central part of the neoliberal revolution. Through education and close interaction, regulators and bankers had come to internalize the common dictum that finance, to do its work successfully, must be governed with a ‘light touch’. By the late 1990s, according to Simon Johnson and James Kwak, this process had created a Washington elite world view ‘that what was good for Wall Street was good for America’.101 Neoliberalism may have gone on the defensive with the financial crisis, but it was not without influence within the Obama administration, especially in the years 2009 to 2012, when the administration was forging its strategy to deal with the fallout from the financial crisis. The new regime’s core economic technocrats had a healthy respect for Wall Street, notably Treasury Secretary Tim Geithner and Council of Economic Advisers’ head Larry Summers. Both had served as close associates of Robert Rubin, who had successive incarnations as co-chairman of Goldman Sachs, Bill Clinton’s Treasury chief, and chairman and senior counsellor of Citigroup. More than anyone else, Rubin, over the last two decades, has symbolized the Wall Street–Washington connection 73

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that dismantled the New Deal controls on finance capital and paved the way for the 2008 implosion. Over a period of nearly 20 years, Wall Street had consolidated its control over the US Treasury Department, and the appointment of individuals who had served in Goldman Sachs (the most aggressive investment bank on Wall Street) to high positions became the most visible display of the structural power of finance capital. Robert Rubin and George W. Bush’s Secretary of the Treasury, Hank Paulson, were merely the tip of the Goldman Sachs iceberg at the centre of Washington politics. Wall Street was afforded an opportunity to make an ideological counter-offensive when the financial crisis entered its second phase, which was dominated by Greece’s sovereign debt crisis. During the debate on the fiscal stimulus, which would involve the government going into deficit spending and increasing the national debt, and even as they enjoyed tremendous monetary support from the Federal Reserve and the Treasury, the banks and their Republican allies in Congress were able to change the narrative from one of ‘irresponsible banks’ to one of ‘the profligate state’. Greece was painted as the future of the US. In the words of one Wall Street economist: As federal and state debt mounts up, the US credit rating will continue to be downgraded, and investors will become reluctant to hold US bonds without receiving much higher interest rates. As in Greece, high interest rates on government debt will drive federal and state governments into insolvency, or the Federal Reserve will have to print money to buy government bonds and hyperinflation will result. Calamity would result, either way.102

Wall Street’s hijacking of the crisis discourse and shifting the blame for the continuing slowdown on government convinced some sectors of the population that it was the Obama administration’s 74

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pallid Keynesian policies that were responsible for the continuing stagnation, and this contributed to putting the administration on the defensive and going slow on bank reform. Cornelia Woll’s conclusion is that: ‘For the administration and Congress, the main lesson from the financial crisis in 2008 and 2009 was that they had only very limited means to pressure the financial industry into behavior that appeared urgently necessary for the survival of the entire sector and the economy as a whole.’103 The structural power of Wall Street certainly contributed to making Obama less aggressive in pushing banking reform and taking state action that would decisively end the recession. But Woll’s analysis is too deterministic an explanation for failure. The presidency is a very powerful position, and from 2009 to 2011, the Democrats also controlled the House and the Senate, which put them in a position of pushing decisive measures for recovery. Moreover, no other office can compare in terms of mobilizing the citizenry in support of reform. In other words, if power could be productive on the side of Wall Street, it could also be productive on the side of the administration. Here, the contrast between Obama and Franklin Delano Roosevelt is stark. Whereas Roosevelt used the presidency as a bully pulpit to rally the population, setting in motion the massive organizing drive of labour that became a key pillar of the New Deal, Obama adopted a technocratic approach that demobilized the base that had carried him to the White House to the Wall Street-biased prescriptions of the conservative wing of his economic team. This pallid, pragmatic Keynesianism was precisely what people were not looking for in period of deep uncertainty and crisis. Building a mass base for reform would, of course, have necessitated an inspiring comprehensive alternative vision to the discredited neoliberal one. Perhaps it was precisely articulating such an agenda that Obama, with his pragmatic instincts, feared, 75

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for it could run out of his control. But such are the risks that must be taken by serious reformers. The opportunity that presented itself and the way in which it was wasted are well described by Barry Eichengreen: An administration and a president convinced of the merits of a larger stimulus would have campaigned for it. Obama could have invested the political capital he possessed as a result of his recent electoral victory. He could have appealed to GOP senators from swing states like Maine and Pennsylvania. Going over the heads of Congress, he could have appealed to the public. But Obama’s instinct was to weight the options, not to campaign for his program. It was to compromise, not confront.104

The derailment of progressive Keynesianism by Obama’s conservative, technocratic Keynesianism resulted in a protracted recovery, continuing high unemployment, millions of foreclosed or bankrupt households fending for themselves, and more scandals in a Wall Street where nothing had changed. Obama did not pay for this tragic outcome in 2012, but Hillary Clinton did in 2016. The political consequences of economic failure If one certainty emerged in the 2016 elections it was that Hillary Clinton’s unexpected defeat stemmed from her loss of four ‘Rust Belt’ states: Wisconsin, Michigan and Pennsylvania (which had previously been Democratic strongholds), and Ohio, a swing state that had twice supported Barack Obama. The 64 Electoral College votes of those states, most of which hadn’t even been considered battlegrounds, put Donald Trump over the line. Trump’s numbers, it is now clear, were produced by a combination of an enthusiastic turnout of the Republican base; his 76

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picking up significant numbers of traditionally Democratic voters; and large numbers of Democrats staying home. But this wasn’t a defeat by default. On the economic issues that motivate many of these voters, Trump had a message: the economic recovery was a mirage, people were hurt by the Democrats’ policies, and they had more pain to look forward to should the Democrats retain control of the White House. The problem for Clinton was that the opportunistic message of this demagogue rang true to the middle-class and working-class voters in these states, even if the messenger himself was quite flawed. These four states reflected, on the ground, the worst consequences of the interlocking problems of high unemployment and deindustrialization that had stalked the whole country for over two decades as a result of the flight of industrial corporations to Asia and elsewhere. Combined with the financial collapse of 2007–08 and the widespread foreclosure of the homes of millions of middleclass and poor people who had been enticed by the banks to go into massive debt, the region was becoming a powder keg of resentment. True, these working-class voters going over to Trump or boycotting the polls were mainly white. But then these were the same people who had placed their faith in Obama in 2008, when they favoured him by large margin over Republican John McCain. And they stuck with him in 2012, although his margins of victory were for the most part narrower. By 2016, however, they had had enough, and they would no longer buy the Democrats’ blaming George W. Bush for the continuing stagnation of the economy. Clinton bore the brunt of their backlash, since she made the strategic mistake of running on Obama’s legacy – which, to the voters, was one of failing to deliver the economic relief and return to prosperity that he had promised eight years earlier, when he took over (from Bush) a country falling into a deep recession. Failed policies have massive political consequences.105 77

Keynesianism and the Great Recession Interview with Walden Bello,

Transnational Institute, 1 March 2017

What were the main ways in which neoliberalism created the Great Recession? Neoliberalism sought to remove the regulatory constraints that the state was forced to impose on capitalist profitability owing to the pressure of the working-class movement. But it had to legitimize this ideologically. Thus it came out with two very influential theories, the so-called efficient market hypothesis (EMH) and rational expectations hypothesis (REH). EMH held that, without government-induced distortions, financial markets are efficient because they reflect all the available information available to all market participants at any given time. In essence, EMH said that it is best to leave financial markets alone since they are self-regulating. REH provided the theoretical basis for EMH with its assumption that individuals operate on the basis of rational assessments of economic trends. These theories provided the ideological cover for the deregulation or ‘light-touch’ regulation of the financial sector that took place in the 1980s and 1990s. Due to a common neoliberal education and close interaction, bankers and regulators shared the assumptions of this ideology. This resulted in the loosening of regulation of the banks, the absence of any regulation, and very limited monitoring of the so-called ‘shadow banking’ sector, where all sorts of financial instruments were created and traded among parties. 78

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With so little regulation, there was nothing to check the creation and trading of questionable securities such as subprime mortgagebased securities. And with no effective monitoring, there were no constraints on banks’ build-up of unsustainable balance sheets with high debt-to-equity ratios. Without adult supervision, as it were, a financial sector that was already inherently unstable went wild. When the subprime assets were found to be toxic, since they were based on mortgages on which borrowers had defaulted, highly indebted or leveraged banks that had bought these now valueless securities had little equity to repay their creditors or depositors who now came after them. This quickly led to their bankruptcy, as in the case of Lehman Brothers, or to their being bailed out by government, as was the case with most of the biggest banks. The finance sector froze up, resulting in a recession – a big one – in the real economy. So how did these banks get to be so big and powerful? What drove the ‘financialization boom’ that triggered the recession? Financialization, or an increasing preference for speculative activity instead of production as a source of profit, was driven by four developments. The first was the abolition, during the Clinton administration, of the Glass–Steagall Act, which had served as a Chinese wall between commercial or retail banking and investment banking, as a result of tremendous pressure from the big banks that felt left out of the boom in trading. The second was the expansive monetary policy promoted by the Federal Reserve to counter the downturn following the piercing of the dot.com bubble in the first years of the new century. Third was the government’s and business’s move to shore up effective demand by substituting household indebtedness for real wage increases. Fourth was the lifting of capital controls on the international flow of finance capital, following the era of financial repression during the post-war period. These developments acted in synergy, first to produce a speculative boom in the housing and stock markets, and then feeding on one another to accelerate an economic nosedive during the bust. 79

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What was the worst impact of the crisis, and upon whom? With unemployment hitting 10 per cent in 2010, working people suffered the most. Although the unemployment rate was down to 5 per cent in 2017, that fall has been driven less by improved labour market conditions as by a falling rate of participation, as discouraged workers withdrew from the labour force. More than 4 million homes were foreclosed. Lower-income households, the main victims of aggressive loan sharks, suffered most. As far as growth was concerned, the recovery was tepid, with average GDP growth barely 2 per cent per annum between 2011 and 2013, less than half the pace of the typical post-World War Two expansion. In terms of inequality, the statistics were clear: 95 per cent of income gains from 2009 to 2012 went to the top 1 per cent; median income was $4,000 lower in 2014 than in 2000; concentration of financial assets increased after 2009, with the four largest banks owning assets that came to nearly 50 per cent of GDP. An Economic Policy Institute study summed up the trends: ‘[T]he gains of the top 1 percent have vastly outpaced the gains for the bottom 99 percent as the economy has recovered.’ At the individual and household level, the economic consequences of being laid off were devastating, with one study finding that workers laid off during recessions ‘lose on average three full years of lifetime income potential’. One estimate showed that the income of the United States would have been $2 trillion higher had there been no crisis, or $17,000 per household. What did Keynesianism offer as a way of responding to the crisis? Keynesianism offered two major weapons for overcoming the crisis. The first and most important was a fiscal stimulus, or deficit spending by government. The second was monetary expansion. Essentially, these were forms of government intervention designed to revive the economy after a collapse of investment on the part of the private sector. They are called ‘countercyclical’ since they are designed to counter the recessionary pressures brought about by the crisis of the private sector. 80

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How were Keynesian policies and strategies applied in the wake of the onset of the recession? The Keynesian interventions were in the right direction. Unfortunately, they were applied half-heartedly by the Obama administration. For instance, the size of the fiscal stimulus – $787 billion – might have been enough to prevent the recession from getting worse, but it was not enough to trigger an early recovery, which would have demanded at least $1.8 trillion, according to Christina Romer, the head of Obama’s Council of Economic Advisers. Expansive monetary policy was always a second-best solution and was not as effective as a fiscal stimulus. Yes, cutting interests to zero and quantitative easing – or providing banks with infusions of money – did have some impact, but this was rather small, since, for the most part, individuals and corporations did not want to go further into debt but wanted to focus on lessening their debt. What three things could have been done, ‘truer’ to the spirit of Keynesianism, that would have reduced the recession? First of all, there should have been a much bigger stimulus, one along the lines of Christina Romer’s proposal of $1.8 trillion. Second, instead of focusing on saving the banks, the government should have devoted resources to assisting the millions of troubled homeowners, a move which would have raised effective demand. Third, the insolvent banks should have been taken over or nationalized, and the billions spent on recapitalizing them or guaranteeing their borrowing should have been devoted to creating jobs to absorb the unemployed. Is financialization still a threat? Yes, even conservative analysts say that the so-called Dodd–Frank reform encourages moral hazard or reckless behaviour by banks owing to their belief that, when they get into trouble, the government will bail them out. Derivatives – which Warren Buffett called ‘weapons of mass destruction’ – are still virtually unregulated. And so is the shadow banking sector. 81

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The non-transparent derivatives market is now estimated to total $707 trillion, or significantly higher than the $548 billion in 2008. As one analyst puts it: ‘The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour. Its size and potential influence are difficult just to comprehend, let alone assess.’ Former US Securities and Exchange Commission chairman Arthur Levitt says that none of the post-2008 reforms have ‘significantly diminished the likelihood of financial crises’. In what ways do we need to go beyond Keynesianism to address current economic and ecological problems? I think Keynesianism has valuable insights into how a capitalist economy operates and can be steadied so its inherent instability and contradictions can be mitigated. But, as Minsky says, these solutions do not address the inherent instability of the system. A new equilibrium contains the seeds of disequilibrium. With its focus on growth propelled by effective demand, Keynesianism also has difficulty addressing the problem of ecological disequilibrium brought about by growth. The real issue is capitalism’s incessant search for profit, which severely destabilizes both society and the environment. I think there is no longer any illusion, even among its defenders, that capitalism is prone to crises, and these days these are crises that stem not only from the dynamics of production but from the dynamics of finance. We need to work towards a post-capitalist system that aims at promoting equality, enhances instead of destroys the environment, is based on cooperation, and is engaged in planning to achieve shortterm, medium-term and long-term goals. In this scheme, finance would function to link savings to investment and savers to investors, instead of becoming an autonomous force whose dynamics destabilize the real economy. A post-capitalist society does not mean the elimination of the market. But it does mean making use of the market to achieve democratically decided social goals rather than having the market drive society in an anarchic fashion. 82

3 Europe ’ Social democracy s Faustian pact with global finance

From Wall Street, the financial panic radiated outwards, mainly towards Europe. The liberalization of financial flows promoted by neoliberal policies ensured that the rise in defaults on US subprime mortgages would have a global impact. American-made mortgaged-based securities spread through the global financial system like a virus, leading it to the edge of collapse. As British analyst Hugh Pym put it: The US subprime disaster had such a huge impact on financial markets because exposure to vulnerable American borrowers was so widely spread around the international banking system. US lenders sliced and diced the mortgages and packaged them up as sophisticated instruments with names like ‘collateralized debt obligations’ and ‘asset-backed securities’. They were created, sold and resold, and ended up in the balance sheets of US, Asian and European banks. When house prices started to fall and defaults rose, the music in this global financial game stopped. Suddenly everyone wanted out. They scrambled to cut their losses on the subprime mortgages.1

British banks were among those most exposed, owing to their close relationship with US banks. And there was no bank more exposed than Royal Bank of Scotland (RBS). RBS had grown from a regional bank to the world’s second-largest bank through a wave of acquisitions, many of them financial institutions whose assets 85

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were overloaded with US-originated subprime-based securities. When the US real-estate market plunged and subprime mortgage owners began to default, RBS found itself with practically valueless assets, unable to repay the lenders and depositors who had financed its acquisitions. The British government had to step in to inject billions of pounds’ worth of capital into RBS, since its going under would have brought down the country’s entire banking system.2 British banks were not unique in their exposure to toxic securities from the other side of the Atlantic. At the beginning of the financial crisis, German Chancellor Angela Merkel said she regarded the banking crisis ‘as an Anglo Saxon problem, born in the United States and compounded by the US’ failings’.3 Her advisers were probably late in briefing her, since continental, and notably German, banks had been big buyers of those mortgage-based securities. These included Société Générale SA, Deutsche Bank AG, BNP Paribas, Crédit Agricole SA, Dresdner Kleinwort Securities, the German bank IKB, several German Landesbanken or regional development banks, and UBS Securities. Neoliberalism, finance and crisis in Britain Exposure to questionable US bank securities was, however, probably not as decisive as the adoption of financial reforms that neoliberal economists had promoted both in the US and in Europe. This paved the way for the explosive meeting between unfettered finance and scarce real estate. In Britain, liberalization of the banking sector began with what is now known as Big Bang day, 27 October 1986, when Prime Minister Margaret Thatcher deregulated the London Stock Exchange. Financial market deregulation was aimed at making the City of London a competitive global financial hub on a par with New York. Finance became the cutting edge of economic activity, 86

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and its so-called ‘social value’ became the lynchpin of a new ideological consensus. As Manchester University’s Centre for Research on Socio-Cultural Change put it: In the United Kingdom, after the late 1980s, finance became a domain of high politics where agendas were set by industry leaders, sympathetic technocrats and supportive elite political sponsors. If political participation narrowed, so did intellectual debate as two mystifications supplied what Wright Mills once called the ‘vocabulary of motivation’ for elite economic and political practices in finance. The first mystification was a variation on the venerable laissez-faire narrative about selfregulation that helped legitimize a particular regulatory order by conferring financial markets the right to run their own affairs. The second mystification was a more contemporary narrative about the social and economic value of finance in the wider economy. That narrative helped to politically empower finance as a sector by emphasizing the importance of an economic regime and a ‘light touch’ regulatory regime tailored to the needs of financial markets.4

When New Labour came to power in the mid-1990s, a view of finance as productive became part of Tony Blair and Gordon Brown’s ‘Third Way’. As the Manchester University study points out: ‘The City was viewed by the New Labour government as both a tax cash cow and as an engine of growth, job creation and innovation in the UK economy.’5 Gordon Brown bought into the ideology of ‘light-touch’ regulation, and was vocal about his intention to make London a financial centre outstripping New York.6 As in New York and Washington, the efficient market hypothesis, which posited that the market price of an asset was the synthesis of all available information and thus constituted its true value, 87

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came to govern the thinking of bankers and regulators alike in London. As one study pointed out: ‘Financial markets had come to be regarded as inherently stable and financial institutions as just another commercial undertaking, so that no more than light-touch monitoring and intervention was thought necessary to ensure system integrity and dynamic stability.’7 The precise configuration of reforms differed from country to country, but as Adair Turner notes, whether in Japan, Spain, London or Scandinavia, liberalization had the following commonalities:

• removal of restrictions on the quantity of lending in the whole economy or specific sectors;

• elimination of the distinctions between retail, corporate and investment banking, and between banking and non-banking activities; and

• use of interest rates as the only policy lever to manage the economic cycle, with the overwhelming focus on maintaining a low and stable rate of inflation.8 As in the US, by the 1990s traditional lending activities to corporations and banks were matched or overshadowed by the activities of the financial market – or, in the American parlance, ‘shadow banking’ – with institutions that adapted to the new regime, including RBS, becoming the most dynamic players. This cult of innovation resulted in the proliferation of derivatives produced by allegedly sophisticated financial engineering. Most prominent were mortgage-backed securities, which were similar to subprime securities. As in the US, mortgage-backed securities were created amidst – and helped to create – a frenzied property bubble, which saw residential property prices double between 1997 and 2007.9 As in the US, a mortgage-backed security was based on a package of mortgages bundled together and sold off 88

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to investors, a move designed to lift the credit risk from the originating bank and transfer it to the buyer. While the securitization of mortgages in the UK was not as widespread as in the US, it was nevertheless a very significant development, with mortgage-backed securities rising from practically nothing in 1995 to over 25 per cent of mortgage lending by 2005.10 British banks and the mortgage-backed securities crash Northern Rock was one of the more aggressive issuers of mortgagebacked securities, securitizing 50 per cent of the loans that it made. Particularly popular was its ‘Together Loan’, which was the British equivalent of the subprime loan. This loan covered an amazing 125 per cent of the value of a new home and six times the income of a household, compared with the two and a half to three times income that was usual practice. Some 30 per cent of the bank’s mortgage book consisted of ‘Together Loans’. Not surprisingly, when realestate prices began to plunge in 2007, these loans accounted for 50 per cent of loans in default and 57 per cent of foreclosures.11 When the defaults became news, Northern Rock became the victim of a classic bank run, with television footage showing depositors queuing at bank branches throughout Britain. The Bank of England tried to rescue Northern Rock with an unprecedented package of £55 billion in liquidity assistance and guarantees, but this did not stem the crisis, pushing the government to eventually nationalize it, with the full bill to taxpayers coming to £37 billion.12 But it was soon clear that British banks’ problems related not only to their exposure to US-based subprime mortgage securities or their home-grown counterparts. The bigger problem, again encouraged by neoliberal ‘hands-off ’ or light-touch ‘regulation’, was a banking model that combined the traditional bank formula of ‘borrowing short and lending long’ – that is, borrowing short term at low rates of interest and lending long term at high rates – 89

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with the practice of leveraging, or maintaining a high ratio of credit to one’s equity or capital. To Mervyn King, the Governor of the Bank of England at the time, this process was tantamount to trying to turn metal into gold. Taking riskless, low-interest bank deposits and loans and transforming them into risky long-term investments on the promise of high profits is always a precarious proposition, and the risk increases exponentially when high leverage, or a high ratio of loans to equity, is glorified because standard accounting allows a bank to show it as proof of profitability. This irreducible gap between riskless deposit and risky investment is the source of the financial sector’s instability, and one which cannot be eliminated by derivatives that purport to remove or radically reduce risk. As King puts it: For all the clever innovation in the world of finance, its vulnerability was, and remains, the extraordinary levels of leverage. Pretending that deposits are safe when they are invested in long-term risky assets is an illusion. Without a sufficiently large cushion of equity capital available to absorb losses, or the implicit support of the taxpayer, deposits are inherently risky. The attempt to transform risky assets into riskless liabilities is indeed a form of alchemy.13

For King, the illusion of eliminating risk from investment that promised high returns, financed by low-interest deposits and loans, was a central factor leading banks to both overborrow and overinvest, becoming larger and larger in the process. And as they grew larger, the more indispensable they became to the system, and the more governments could not allow them to fail. What was perceived as an implicit government guarantee that it would cover their deposits in turn encouraged people and creditors to place their money in 90

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or lend it to the banks, giving the banks an unfair advantage over other institutions, such as non-financial corporations. All three cases of spectacular UK bank failure – Northern Rock, Royal Bank of Scotland and the Halifax Bank of Scotland – were essentially felled by this model when the market soured on their long-term investments, and their short-term depositors came after them in a panic to retrieve their money. They were overexposed to commercial and residential property, and when its price plunged, they found panicked depositors and creditors demanding their cash. But they were unable to supply the money since their equity or capital was extremely limited, having been dependent on borrowing to make their acquisitions. Bailing out the banks became a massive problem for the state, since the size of the banking sector had increased to the stage, as King points out, ‘where it was beyond the ability of the state to provide bailouts without damaging its own financial reputation – for example in Iceland and Ireland – and it proved to be a near thing in Switzerland and the UK’.14 That the state itself could have gone under financially in the UK is an extraordinary admission for the former Governor of the Bank of England to make, but it was not surprising if one considers that the size of the banks’ balance sheets had grown to five times the country’s GDP.15 The UK government’s bailout packages for the ailing banks included equity injections, guarantees and liquidity support from the Bank of England, all of which raised public debt from 44 per cent in 2007 to 92 per cent in 2013. While the government bought huge chunks of shares in the troubled banks, in only two of them – Northern Rock and a smaller mortgage lender, Bradford & Bingley – was the nationalization option exercised, owing to fears that the business establishment would see the Labour government, then headed by Gordon Brown, as going back to its old, ‘socialist’ ways. Direct monetary support was provided to banks across the board through ‘quantitative easing’, which was supposed to 91

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promote lending and stimulate and raise effective demand, but the bulk of it remained within the vaults of the banks.16 Most likely, the issue was the same as the one quantitative easing faced in the US: corporations and consumers chose not to borrow during the crisis, preferring instead to reduce their debt. The British government engaged in stimulus spending, with the fiscal deficit rising from 2.9 per cent to 11.3 per cent of GDP between 2007 and 2009, but, as in the US, there was reluctance to go full speed ahead to reverse the recession that came on the heels of the financial crisis. What Adair Turner describes as ‘unnecessarily aggressive fiscal consolidation’ appears to have depressed growth.17 Interestingly, both Turner, who headed up the Financial Services Authority during the crisis, and Bank of England Governor King might be said to agree with Minsky that the financial sector is inherently unstable. For King, banks are ‘inherently fragile’, meaning unstable, and the source of instability lies in their propensity to engage in the impossible task of financial alchemy, of making longterm investment from safe deposits equally safe. For Turner, the instability lies in ‘the interaction between the infinite capacity of banks to create new credit, money and purchasing power, and the scarce supply of irreproducible urban land. Self-reinforcing credit and asset price cycles of boom and bust are the inevitable result.’18 Both King and Turner favoured the nationalization option for the troubled banks in the midst of the crisis.19 But when it comes to the key lessons of the crisis, Turner pushes for tighter and more comprehensive regulation by government, even flirting with the idea of abolishing the banks, while King flies off to abstract recommendations such as a ‘move to a new equilibrium’ that will enable economies to regain their pre-crisis path of productivity.20 With these views coming from two of the top regulators of the UK finance industry, it is not surprising that the outcome for the banks – nationalization of two banks and virtual state control of 92

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another two, along with the dismantling of their top management – was harsher (relatively, that is) in the UK than in the US, where the troubled banks were not only bailed out on very generous terms but their management was allowed to stay in place. As one foreign observer commented: ‘The crisis was a terrible blow to the British Bankers’ Association, because they ended up being nationalized … The entire liberal reasoning was ripped apart … We never see them taking a stance at international meetings any more.’21 A change in government from Labour to the Conservatives in 2010 brought accelerated re-privatization of the troubled banks to the agenda, but so poor was the state of RBS that it found no serious buyers for the government’s huge stake in it. The entire system remained saddled with the effects of the implosion eight years after it had taken place, leading to this judgement by one of its most assiduous chroniclers, Hugh Pym: The untold story of the banking crisis has no ending. It is a story that matters to borrowers, savers and taxpayers. Future generations should be grateful to the politicians, regulators and advisers of 2008 for preventing a cataclysm, which would have crippled the UK economy for years. But they will not thank them for leaving debts and liabilities that could take decades to settle.22

Talk about the social value of finance and good words about lighttouch regulation went up in smoke after the crash. But neoliberalism plodded on in the form of the Cameron government’s austerity programme – cutting government spending – which was essentially a way of making the public pay for the excesses of the era of financialization. Anger simmered in the electorate and revolt came in the form of the Brexit vote in 2016, which can be interpreted not only as a rejection of the European Union, but also as a repudiation 93

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of both the Conservative Party and Labour Party elites who were responsible for eight years of crisis, austerity and stagnation. Ireland: from development miracle to financial nightmare

The marriage of real estate and dodgy finance spelled disaster for British banks. In the case of Ireland, it was a love triangle of real estate, dodgy finance and the euro. It was not too long ago that Ireland was regarded as the site of an economic miracle, something that was supposed to be an East Asian copyright. How did the so-called Celtic Tiger lose its way and collapse into the financial hole from which it is still digging itself? Interestingly, the reason is pretty much the same as why the East Asian tigers were brought low by the Asian financial crisis: financialization. The ‘Celtic Tiger’ The Ireland that drew the admiration of a whole generation of neoliberal economists and technocrats successfully rode the wave of globalization to become Europe’s fastest-growing economy from the 1990s to the middle of this decade. In 1988, The Economist described Ireland as ‘the poorest of the rich’.23 By 1997, it pitched Ireland’s transformation as ‘dazzling’.24 By 2005, the country’s per capita GDP was the second highest in the EU, after Luxembourg’s. After the Asian financial crisis brought down Asia’s tiger economies in the late 1990s, Ireland remained, along with China, the stars of export-oriented growth, seen by orthodox economists as the road to prosperity in the era of globalization. China learned the lessons of the Asian financial crisis and kept its financial sector on a tight leash. Ireland did not, and paid the price when the Western financial system unravelled in 2007. 94

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Like South Korea and the Southeast Asian tiger economies, the Irish economy passed through two phases. In the first phase of export-oriented growth Ireland experienced real growth, especially in manufacturing and services. The growth was driven by foreign investment, particularly in high-tech. The country became a premier international location for US investment in information technology, with Intel leading the pack with 5,000 employees, Dell with 4,300, IBM with 3,500, Hewlett-Packard with 2,500, and Microsoft with 1,200. By the mid-2000s, tiny Ireland, whose population was no more than 4.5 million, had become the world’s leading exporter of computer software and the source of a third of all personal computers sold in Europe.25 Much of what has been written about the Celtic Tiger – a sobriquet thought up by an investment agent with the Wall Street firm Morgan Stanley – was hype. But not all. By the turn of the century, the boom in the real economy had brought down the country’s chronically high unemployment rate to 5 per cent, and the poverty rate to the same figure. At that fateful conjuncture in the late 1990s, upgrading the real economy via technological innovation owing to rising costs was the obvious priority.26 But the challenge went beyond just improving productivity. According to journalist Fintan O’Toole: [The Irish] had an opportunity that was unique in Irish history. They had the resources to invest in the creation of a decent society, one that would be economically, socially and environmentally sustainable. They had a population that was optimistic, self-confident and ready for a challenge. They had incredibly favourable global conditions.27

Fifteen years earlier the export-led economies of East Asia, then at their apogee, were at a similar crossroads … and took the wrong 95

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turn. Tempted by foreign speculative capital knocking at the door of the ‘East Asian Miracle’, the economies of the region liberalized their financial sectors. Hot money came flooding in, for investment not in industry or agriculture, but in real estate and the stock market. Overinvestment in real estate led to a collapse in property prices, which led to dislocations in the rest of the economy, which in turn led to panicky flight by foreign investors. In the summer of 1997, some $100 billion that had flowed into East Asian economies in the period 1994–97 flowed out of the region. The end result of this toxic cocktail of hot money and volatile property was a threeyear recession that brought an end to the East Asian Miracle. Wrong turn Had Ireland’s leaders paid attention to the East Asian tragedy of the late 1990s, they would have been more mindful of the dangers associated with financial liberalization and property development. They also would have avoided the second phase of the Asian growth process – paper prosperity. The conjunction of the international recession of 2001 and Ireland’s adoption of the euro appeared to bring the Irish elite to a new conclusion: that there was an easier way to prosperity than expanding the real economy and raising productivity. That was the route of financialization, in which the creation of the euro and its adoption by Ireland played a central role. In adopting the euro, which was backed by Germany (Europe’s strongest economy), Ireland, like other eurozone countries, found itself regarded by international markets as having a creditworthiness matching that of Germany, a fact that was reflected in the convergence of its sovereign bond yields with German levels. ‘With the euro,’ as Financial Times journalist Martin Sandbu writes, ‘other countries saw Germany’s credibility rub off on themselves.’28 The US and Britain showed the Irish capitalist class that real estate was where profitability was highest, leading to an unholy 96

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alliance between global funds, Irish banks such as Anglo Irish that aggressively tapped them, and local developers such as the Seán Quinn family. The hothouse atmosphere of the early 2000s was described by The New York Times thus: Before Ireland joined the euro, its banks tended to do business the old-fashioned way, financing their lending through the deposits they took in. Once in the eurozone, banks were suddenly able to borrow huge sums of money inexpensively on international markets with nearly no exchange rate risk, an activity that was barely regulated by policy-makers. With easy access to these funds, banks such as Anglo Irish lent huge amounts to prominent Irish developers, leading to a frenzy of overdevelopment.29

To use Adair Turner’s image, the encounter of finite land with the infinite ability to produce money and credit resulted in a real-estate bubble that seemed to go on inflating indefinitely. The crisis In the five years from 2003 to 2008, net foreign borrowing by Irish banks increased from 10 per cent to 60 per cent of GDP. Lending standards were driven down to entice prospective homeowners, many with low or no credit history – much like the subprime phenomenon in the United States. And, as in the US, regulators stood on the sidelines, unwilling to take away the punch bowl, probably because so many of the top figures of the ruling party, Fianna Fáil, were tied to bankers and developers. Corruption, it seems, was central to the Irish financial model and – particularly when it came to relations between politicians, the banks and developers – it went well with the neoliberal prescription of light-touch regulation, since that provided a justification for regulators not to look too closely at dealings among these key actors.30 97

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Ireland’s finances were already rotten when the global financial crisis blew in from Wall Street in 2007–08. The crisis simply exposed the decay. With Ireland’s lenders becoming jittery, the country’s finance minister guaranteed all debt and deposits in the six main Irish banks and financial institutions, effectively nationalizing the debt and bailing out the country’s banking elites. It was a case, however, of David carrying Goliath, since the banks’ liabilities totalled €440 billion, a sum that was nearly three times the country’s GDP.31 The government ended up nationalizing the notorious Anglo Irish Bank and Irish Nationwide Building Society, and injected massive amounts of capital into Allied Irish Bank and the Bank of Ireland. The total cost of restructuring and capitalizing these entities was enormous, and when the budget deficit needed to prop up Ireland’s sinking economy was added, it became clear that things had gone beyond the capacity of the government. This led to the government applying for – and getting – an €85 billion loan from the European Commission, European Central Bank (ECB) and IMF, the so-called Troika. The loans did not, however, come without significant costs. First, the government lost control over the process of restructuring. Before going to the Troika, it had entertained the possibility of having senior holders of the nationalized banks take a ‘haircut’ on their investments as a penalty for irresponsible lending. The ECB, however, vetoed this, fearing the outrage this would cause among the global financial elite. To show it meant business, the Bank’s head, Jean-Claude Trichet, warned the Irish finance minister that a ‘bomb’ would go off if Ireland insisted on the haircut.32 This meant that the costs of the bailout would be shouldered wholly by Irish taxpayers. Second, to repay the Troika, the government imposed an austerity programme that severely cut government social expenditures, deepening the recession that swamped the country following the 98

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2008 financial collapse. The New York Times characterized the quid pro quo for the bailout as the ‘toughest austerity programme in Europe’, involving ‘the loss of about 25,000 public-sector jobs, equivalent to 10 percent of the government work force, as well as a four-year, $20 billion program of tax increases and spending cuts like sharp reductions in state pensions and minimum wage’.33 Austerity bites ‘Having surrendered sovereignty in 2010,’ three of Ireland’s top economists assert with little exaggeration, ‘the Irish state remained in effect a protectorate of the Troika until the end of 2013.’34 The country went through a two-year recession in 2008 and 2009, followed by several years of stagnation until 2014. The unemployment rate rose from 6.4 per cent in 2008 to 13 per cent in 2013.35 Especially hard hit were the young, with development NGO Oxfam reporting that, as of February 2013, 30.8 per cent of the country’s under-25s were unemployed, and those in chronic longterm unemployment accounted for close to 62 per cent of the total number of those out of work. Inequality was also on the rise, with those with the lowest incomes seeing them fall by more than 26 per cent, while those with the highest saw theirs rise by more than 8 per cent. Ireland, noted Oxfam, ‘is likely to see rising inequality over the coming years, as it struggles to maintain the redistributive mechanisms in place prior to the financial crisis’.36 Some 610,000 people left the island between 2008 and 2015, or close to 13 per cent of the country’s population of 4.58 million. The bailout of the private sector transformed the Irish government from one with a relatively good ratio of public debt to GDP of 25 per cent in 2008 to one with a sovereign debt problem – with the ratio climbing to 123.7 per cent in 2014. In its transformation from a commendable practitioner of budgetary restraint to a government with a sovereign debt problem, owing to the state 99

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assuming the liabilities of its failed banks and taking on new debt from official agencies to settle these, the Irish case was similar to that of Spain and Iceland, underlining political economist Mark Blyth’s sardonic observation that ‘sovereign debt crises are almost always “credit booms gone bust”. They develop in the private sector and end up in the public sector. The causation is clear. Banking bubbles and busts cause sovereign debt crises. Period.’37 Plus ça change, plus c’est la même chose Ireland exited the ECB-imposed austerity programme in 2013, with a chorus of technocrats led by IMF Managing Director Christine Lagarde painting it as the ‘poster child’ of austerity. There were, however, doubts that this was the case, or that one could even call what had transpired a success. Unemployment stood at a high 8.5 per cent in 2016. Ireland was the second most indebted industrial country in the world, with a per capita debt of over €43,500. Servicing that debt would absorb a significant volume of financial resources over the next few years, depriving the country’s underresourced public services of much-needed investment.38 Moreover, in the years after Ireland exited austerity, it seemed that the financialization dragon had not been slain, leading Seán Ó Riain to assert that what happened was a ‘recovery without transformation’ and that a process of ‘refinancialization’ was taking place: Ireland’s ability to move forward is threatened by the same trends that contributed to the crash. While banks are not lending as recklessly as they once did, they have provided little credit to productive businesses … Both finance and property are once again being boosted as growth sectors, and rising rents and prices are putting pressure on households and small businesses.39

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Greece: the unending tragedy Greece’s case differs from Ireland in that the massive borrowing financed real-estate speculation in the former and government spending in the latter. But they had a common denominator: lenders who were eager to lend. Missing in the equation By most standard accounts, the Greek crisis was triggered by the revelation in 2009 that the government had been cooking the books. Greek accounting had previously been viewed with suspicion by the EU’s statistical agency, Eurostat. The Hellenic Statistical Authority had initially reported a projected budget deficit of 3.7 per cent GDP. Then, successively, the estimates ran to 7.8 per cent of GDP, then 9.8 per cent, then 11.0 per cent, and finally 12.7 per cent. It was at this point that further lending to Greece practically ceased, since lenders realized that the debt-to-GDP ratio was more than the reported 110 per cent – and actually clocked in at 148 per cent. In April 2009, ratings agency Standard & Poor’s, which had previously rubberstamped Greek bonds with high ratings, now demoted them to junk bond status, making Greece the first eurozone country to suffer this fate. Just two months later, the agency pushed it over the cliff by giving it a CCC, the lowest rating in the world.40 But what is missing in the standard account is that, as economist Joseph Stiglitz puts it, ‘if there is an irresponsible borrower, it means at a minimum that there is an irresponsible lender, who has not done due diligence’.41 Indeed, by 2007, two years before the statistics scandal, the tango of frenzied lending and addictive borrowing had already pushed Greece’s debt to €290 billion, which was equivalent to 107 per cent of GDP. Why was the fact that half the blame rested with the banks not given even the briefest recognition? The most likely answer is 101

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because it was banks from the two pillars of the eurozone, France and Germany, that were most exposed in Greece. German and French private banks held some 70 per cent of the country’s €90 billion debt at the beginning of the crisis. Among foreign buyers of Greek bonds, French banks had over €20 billion in claims and more than €80 billion at stake in the Greek economy overall.42 German banks, as noted earlier, had been great buyers of toxic subprime assets from US financial institutions, and they applied the same enthusiasm to buying Greek government bonds. Led by Commerzbank, they held some €17 billion of Greek debt. Indeed, the exposure of the German private sector, including pension funds, insurance firms and individual investors, came to as much as €25 billion. Martin Wolf of the Financial Times was on target when he asserted: ‘Germany’s focus on the alleged fiscal crimes of countries now in crisis was an effort at self-exculpation: as the eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis.’43 This lending was so reckless, as another commentator noted, that what was at stake ‘was not just the solvency of the Greek government but the stability of the German financial system’.44 Moreover, had the irresponsibility of the banks been recognized, then the complicity of the French and German states would also have had to be acknowledged. As journalist Martin Sandbu writes, from the French perspective on relations between the government and the banks: [I]t is anathema not just to restructure sovereign debt, but to let banks fend for themselves instead of bailing them out at taxpayer expense. In France, credit allocation – even though at the hands of nominally private banks – has always been an affair of the state. This attitude, which it shares with Germany, has resulted in French and German banks being the most 102

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highly leveraged in the world, safe in the hitherto unchallenged belief that the state will always stand behind them.45

In short, moral hazard or perverse incentives to engage in reckless lending – owing to the explicit or implicit backing of the state – are central to the reason why banks were left out of the narrative of blame. Not only would the stability of the European financial system be threatened, but the credibility of those states safeguarding that stability would be eroded. Creditors, European authorities and the business press used the ensuing panic to focus the blame solely on unchecked government borrowing and the Greek government’s fudging of its balance sheet, completely suppressing the role played by irresponsible foreign creditors. Equally significant, the same forces used Greece’s crisis to create the impression that sovereign debt crises caused by profligate spending had also overtaken Ireland, Spain and Portugal – although these countries had public debt-to-GDP ratios that were rather low. In the cases of Spain and Ireland, the ratio was actually lower than Germany’s.46 The process of heaping blame on Greece acquired ethnocentric overtones. For instance, the German newspaper Bild urged that ‘proud, cheating, profligate Greeks’ who exploited responsible German taxpayers should be expelled from the eurozone.47 The stereotype became about lazy southern Europeans versus hardworking abstemious northern Europeans. The impact on European solidarity so painstakingly built up in the post-war years was not inconsequential. But it was not only Germany that had a stake in perpetuating the image that the Greek government was responsible for the crisis engulfing Greece and its creditors. American conservatives, who were then fighting the Obama administration’s spending plans, saw it to their advantage to portray Greece’s present as America’s future should the government’s budget deficit continue to rise. 103

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Saving the banks, crucifying Greece From the point of view of the European authorities and the German government, Greece could not be allowed to declare bankruptcy since that would also announce the insolvency of the French and German banks to whom Greece owed hundreds of billions of euros. As former Greek Finance Minister Yanis Varoufakis put it: ‘Between them the leaders of France and Germany had a stake of one trillion euros in not allowing the Greek government to tell the truth: that is, to confess to its bankruptcy.’48 Moreover, Greece could not be allowed to leave the eurozone, since that might lead to the collapse of the eurozone and unpredictable political consequences. The way out of this dilemma was to bail out the banks by giving the Greek government multibillion euro loans that it would use to pay off the foreign creditors of the government and the Greek banks, and which would be repaid from cuts in the social expenditure of the government. As Karl Otto Pöhl, a former head of Germany’s Bundesbank, admitted, the draconian exercise in Greece was about ‘protecting German banks, but especially the French banks, from debt write-offs’.49 Varoufakis sardonically called the process a game of ‘extend and pretend’ – that is, extend Greece a loan to bail out the banks and pretend it continues to be solvent and will be able to pay off the loan.50 The first loan, put together by eurozone members, the ECB and the IMF, was for €110 billion, the bulk of which went to pay off foreign banks, and most of the rest to restructure Greece’s private banks. The quid pro quo was a savage austerity programme that would radically cut back government social expenditure, including wage and pension cuts. As a result, GDP fell by a cumulative 20 per cent until 2012 and was projected to fall another 5 per cent until 2014. Unemployment rose to 28 per cent, with youth unemployment above 60 per cent.51 These results were foreseen, but they were justified by the theory of internal devaluation, the basic idea of which was that, as 104

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Varoufakis put it, government expenditure cuts would bear down on prices and wages, leading to Greek oil, shipping fees and hotel services becoming much cheaper for German, Chinese and French customers, restoring Greece’s competitiveness in its exports and services and attracting foreign investment inflows that, in time, would trigger growth and raise incomes. The problem in this scenario was that it ignored real-world processes: [N]o sane investor is attracted to a country whose government, banks, companies, and households are all insolvent at once. As prices, wages, and incomes decline, the debt that underlies their insolvency will not fall, it will rise. Cutting one’s income and adding new debt can only hasten the process. This is of course what happened to Greece from 2010 onwards … In 2010, for every 100 euros of income a Greek made, the state owed 146 euros to foreign banks. A year later, every 100 euros of income earned in 2010 had shrunk to 91 euros before shrinking again to 79 euros by 2012. Meanwhile, as the official loans from European taxpayers came in before being funneled to France and Germany’s banks, the equivalent government debt rose from 146 euros in 2010 to 156 euros in 2011.52

A second bailout package was given in February 2012; its terms for Greece were even more cuts. This time, however, there was a haircut, or a cut in expected returns, for the banks, something the Germans agreed to only grudgingly since it would have been impossible to get a second massive bailout through the Bundestag without it. Investors holding 60 per cent of Greek debt saw the face value of their bonds, which came to roughly €200 billion, cut by half; the length of the loans stretched out over decades; and interest payments reduced. The rapid collapse of Greece triggered by the austerity programme had forced through the painful realization 105

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that, without some cuts in the massive repayments it owed to the banks, Greece would be further away from recovery than ever. As one analyst put it: The more the government cut, the worse the economy suffered; the International Monetary Fund was later forced to conclude that the damage to economic activity from deficit cuts had been badly underestimated. With no recovery for sovereign debt, and with the downturn eroding private borrowers’ ability to service their loans, Greek banks sat on growing unrealized losses. They were unable to channel credit to those private sector companies that might have expanded, so a credit crunch compounded the fiscal austerity to depress the economy further.53

Thus, more than €100 billion of Greek debt was ‘vaporized’.54 The haircut was, however, designed to ‘mainly hit Greek pension funds, Greek semi-public institutions, and Greek savers who had bought government bonds, while the loans provided by the IMF and the European institutions in 2010 would of course remain inviolable’.55 The taboo against ‘sovereign debt restructuring’ – a euphemism for bankruptcy proceedings for an indebted state – had been broken, but no sooner was this done than the ‘eurozone’s policy-making class quickly reinstated it, by insisting that Greece was a unique case and smothering any other eurozone sovereign’s debt’.56 Since there was no way an economy geared to austerity could miraculously go back to a growth path that would provide the money Greece needed to pay back its debts, it was not long before the country required a third loan from the ECB and the IMF, this time to pay back not only private lenders but the ECB and the IMF themselves.

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The price of membership in the euro club Negotiations for this third loan proved to be the most contentious. Greek Prime Minister Alexis Tsipras broke them off because he thought the conditions imposed by Germany condemned his country to permanent austerity. The Greeks voted to reject the new deal, but Tsipras went back to the negotiating table because accepting the deal was the only way in which Greece could remain in the eurozone. Why Tsipras walked away initially is understandable, if one considers in detail how the eurozone authorities wanted to break down the loan and the conditions that would accompany it. Of the €86 billion provided by the loan, plus an expected €8 billion from the sale of Greek assets and the government’s income:

• €54 billion would be spent on debt payments by the government; • €15 billion would be devoted to debt payments that Greece defaulted on in the summer of 2015, primarily to the IMF, and to increasing the Greek government’s currency reserves; and

• €25 billion would be used for ‘recapitalization’ of local banks.

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The conditions included further cuts in pensions and raising the retirement age from 65 to 67, further cuts in social welfare spending, a review of labour legislation with a view to loosening it, and the sell-off of Greek assets worth €50 billion, including the privatization of the ports of Piraeus and Thessaloniki. The last condition was the most controversial. According to one account: The demand to sell off certain industries and assets by a given date [leaves] the Greek government with little room to bargain, as potential buyers know it is being forced to sell, a true fire sale. Nowhere in the Eurozone demands do they consider whether [the] industries targeted are best run in the public or private sector, nor do they take account of the 107

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fall in Greek government income from no longer owning profitable enterprises.58

The prospect of the country being locked into debt slavery, austerity and stagnation for 15 years at the very least was evident in figures collated by the Jubilee Debt Campaign: With the new loans Greek government debt is now projected by the IMF to be 196% of GDP by the end of 2015, €330 billion. By 2020, the IMF predicts debt will still be 183% of GDP (an increase in absolute terms to €367 billion), based on the recession continuing in 2016, then growth of 2.5%–3% from 2017 to 2020. The European Commission predicts that debt will be 175% of GDP by 2020 and 122% by 2030 again based on relatively high economic growth from 2017 on.59

The IMF, it has been noted by many, has proven to be more accommodating to the Greek government’s pleas for a less harsh adjustment programme, perhaps mindful of the disastrous impact of its policies during the Asian financial crisis. The ECB and the German government, however, were determined to squeeze the Greeks, motivated mainly by a stern desire to make Greece serve as an example of irresponsible borrowers while hypocritically ignoring irresponsible lenders. As one high-ranking German official told former Greek Finance Minister Varoufakis: ‘A debt is a debt is a debt.’60 Eurocross Financial liberalization promoted by neoliberal thinking was one of the major drivers of the European financial crisis. The two other key drivers were the euro and Germany’s low-wage, exportoriented political economy. 108

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The euro once represented Europe’s gleaming future. Now it stands for what went wrong with the European project. In the standard history of the creation of the euro, the common currency of 17 countries in Europe, the noble goal of deepening European integration is often stressed as the motive. Realpolitik, however, accompanied this process, and it was realpolitik that trumped that noble goal of European solidarity in the end. In former Greek Finance Minister Varoufakis’s wide-ranging account of the European financial crisis, the euro stemmed from the project of French leaders to harness German economic power to European integration under French political and administrative leadership. The euro project began as a ‘French plan to usurp an institution cherished by the German people – the Bundesbank – subsume it into a French-dominated central bank and extend into Germany and the rest of Europe policies close to Paris’s heart’.61 Germany – or, specifically, the German Bundesbank or Central Bank – was a reluctant bride, but when the folly of merging currencies without a political union exploded in crisis, Germany, on whose economic might and financial stability the euro rested, became the stern taskmaster whose idea of disciplining errant members of the eurozone was to subject them to permanent austerity. Putting the cart before the horse In Varoufakis’s account, money and the cost of money – that is, the interest rate – are not neutral; they are intensely politicized. And the essential problem of the creation of the euro was the decision of Paris and Berlin to create a common currency before achieving a political union, which would have been accompanied by institutions that would perform the tasks of taxation, spending, investment and recycling financial resources. The ECB, whose principal tasks were to douse inflation and manage the issuance of the common currency, was simply one piece in a much bigger 109

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economic structure that was absent. The original Franco-German project rested on a key assumption, and it was a dubious one: that a common currency would pave the way for a political union because the problems created by the use of the currency would force different governments to push forward to a higher stage of institutional unification. While this might not have been exposed as essentially wishful thinking when there was growth and financial stability, it could not be but a tragic illusion that would be ripped apart when the pressure building down below came to the surface. Varoufakis poses the question: How could so many top journalists, academics, functionaries and politicians believe that they could sustainably bind together the French franc and the Deutsche Mark, let alone the Italian lira, the Spanish peseta and the Greek drachma, without a political mechanism for recycling German and Dutch surpluses and managing private and public sector deficits? Did they not see that German surpluses, left to Frankfurt and Parisian bankers to scatter throughout Europe’s periphery, would flood the deficit regions, causing massive bubbles? How did they expect the eurozone, bereft of any mechanism for coping, to handle the preordained bursting of these bubbles?62

The Bundestag ‘guarantee’ Aside from the absence of the key institutions necessary for the euro’s proper functioning, the system had two other fatal flaws. One was that a common currency encouraged bankers to view credit extended to households and enterprises in weaker economies as carrying the same risk, or close to the same risk, as credit extended to those in stronger economies. With the euro, Spanish, Greek and Italian banks now found it easier and cheaper to get loans from German or French banks, because the latter fell under the illusion 110

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that the loans would be guaranteed by Germany’s Bundesbank. In other words, risk was artificially eliminated by the euro, whereas in reality many of the private and public debtors in the eurozone’s 16 other member countries did not have the same capacity to pay as German debtors. This resulted in a virtual orgy of lending by French and German banks that were flush with cash, with preferred customers being households and enterprises in southern Europe, which had not been trawled by the banks in pre-euro days as intensively as those in northern Europe, owing to their lower levels of private indebtedness. In 2009, the exposure of German banks to the so-called PIIGS (Portugal, Italy, Ireland, Greece and Spain) was a mind-blowing €704 billion. This was more than the total capital base of Germany, leading Varoufakis to claim that, if ‘Greece went under, and contagion brought down some of the other peripheral banks, Germany’s banking system would be toast’.63 Trapped The second major glitch associated with the adoption of the euro was a country’s loss of any room for manoeuvre if it fell into a severe debt crisis. Having an independent currency, say the peso, would allow one to devalue it relative to the euro, and bring about a more favourable balance of trade that would yield a rise in income that could pay off the debt. This is, of course, in theory – as Mark Blyth has pointed out: ‘The problem with keeping up with the Germans is that German industrial exports have the lowest price elasticities in the world, meaning Germany makes really great stuff that everyone wants and will pay more for in comparison to all the alternatives.’64 But assuming that devaluation would have some impact, having a common currency precluded such a solution. Indeed, this was not an option for a very practical reason: even if one decided to withdraw from the euro and create one’s own 111

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currency, the process would take a minimum of 12 months. And hinting that one would take this option would trigger a ruinous panic. In Varoufakis’s words: [People] will rush to liquidate whatever wealth they have, convert it to euros, take their euros out of the banking system and either stash them under the bed or carry them across the border to Germany or Switzerland for safekeeping. Before you can say ‘panic’, banks fail, the country is drained of all value, and the economy collapses.65

The euro then was a Hotel California. You could check in, but you could never leave.66 In the end, monetary union, which had been intended to result in a political union based on intra-European solidarity, ended up promoting discord, the subjugation of one group of countries by another, and a deeper democratic deficit as the unelected technocrats of the ECB, working with a powerful German government, made life and death decisions for millions of people. With unending austerity and no counterbalance to the power of Germany, the project of monetary union as it stands would best be disbanded, says Joseph Stiglitz: Many within Europe will be saddened by the death of the euro. This is not the end of the world: currencies come and go. The euro is just a 17-year-old experiment, poorly designed and engineered not to work. There is so much more to the European project, the vision of an integrated Europe, than a monetary arrangement. The currency was supposed to promote solidarity, to further integration and prosperity. It has done none of this: as constructed, it has become an impediment to the achievement of these goals.67 112

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Germany beggars its neighbours As in the case of the US, financial factors interacted with structural factors to create the crisis. In the US, the current account deficit created by massive imports of cheap manufactured goods from Asia, and in particular from China, led to the creation of reverse financial flows that played a central role in fostering consumer indebtedness. In Europe, labour market reforms in Germany, and the trade and financial circuits, created the conditions for the creation of deep indebtedness for Germany’s neighbours. Structurally, the central problem that emerges here is Germany. Once seen as the sick man of Europe, Germany underwent painful neoliberal reforms in the late 1990s and the first years of the twenty-first century under the leadership of Chancellor Gerhard Schröder. Agenda 2010, which was put together by Peter Hartz, a former personnel director of Volkswagen, was essentially an employers’ programme of economic restructuring to regain profitability that was implemented by a social democratic government. The Hartz reforms were, as economist George Zestos points out, neoliberalism at its most punitive: The Hartz reforms created incentives for workers to search for work and find employment because it was no longer in the workers’ interest to remain unemployed, since liberal long unemployment benefits were drastically cut. The German agenda restructured the Federal Employment Agency and modernized the welfare system. Wages and other benefits, such as pensions and healthcare for workers, were substantially reduced as new types of employment were introduced. Wages under these new types of employment were set outside the contracts that customarily were agreed and signed through negotiations between trade unions and employers’ associations.68 113

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‘Precarious employment’ favoured by the reform package proliferated in the form of fixed-term contracts, agency work and temporary work, since high unemployment ‘tilted the bargaining power of labour away from trade unions towards companies, which imposed their conditions under the threat that they would invest abroad and close factories in Germany’.69 By making German labour cheaper, the Hartz reforms made German products much more competitive than the products of its neighbouring countries in the EU, thus allowing German products to increase their market share in these economies. The lower disposable income of German workers also made them less likely to consume higher-priced foreign goods. Heiner Flassbeck and Costas Lapavitsas provide a good description of what happened next. With German unit labour costs undercutting those in the other countries by a rising margin, German exports flourished while imports slowed down. Countries in southern Europe, but also France and Italy, began to register widening trade and current account deficits, and suffered huge losses of their international market shares. Germany, on the other hand, was able to preserve its share despite mounting global competition from China and other emerging markets. In a nutshell, Germany has operated a policy of ‘beggar thy neighbour’ but only after ‘beggaring its own people’ by essentially freezing wages. This is the secret of the German success over the last fifteen years.70

The effect of the Hartz reforms on Germany’s relations with its trading partners was evident in the statistics. Whereas real GDP growth in the 1960s, 1970s and 1980s was mainly driven by domestic demand, the share of exports in GDP went from 24 per cent in 1995 to 51 per cent in 2013, and the share of imports from 23 per cent to 44 per cent. As analysts Daniel Detzer and Eckhard Hein 114

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point out: ‘Growth was thus increasingly driven by net exports, and the relevance of domestic demand declined dramatically. This was equally true for private consumption and investment.’71 Threatened by mounting deficits, Germany’s weaker partners in the eurozone, however, were caught in a trap owing to their being part of the Economic and Monetary Union. As noted earlier, had they had their own currencies, a solution to their increasing trade deficits vis-à-vis Germany would have been to devalue their individual currencies, thus making German goods more expensive locally and their goods more competitive in the German market. Unable to do so, these countries borrowed heavily from international financial markets, including German banks, to cover their rising deficits, as well as to provide social security support to workers being displaced by German exports. In this sense, the massive rise in the lending of German banks to southern European countries was related to the rise in Germany’s trade surpluses to these countries. ‘Internal devaluation’, or cuts in wages and social security benefits, was, of course, the other option, and this was undertaken in most cases after the outbreak of the financial crisis, as the price for getting financial assistance to prevent economic collapse. Internal devaluation should have had a positive effect, since it should have made cheaper exports from the deficit countries more attractive in the surplus country, resulting in more foreign exchange to pay off loans and triggering more intensive economic activity. But, as noted earlier in the case of Greece, it has had little effect in getting distressed economies to grow and in bringing down unemployment. While the trade balance was achieved in some instances, as in Greece, this was mainly because of a reduction in imports, not a rise in exports.72 The weak performance of exports could not make up for the negative effects of austerity in the non-traded sector. As Joseph Stiglitz notes: 115

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Internal devaluation increases economic fragility by bringing more households and firms to the brink of bankruptcy. Inevitably, they cut back spending on everything. The cutbacks in imports were one reason that [the] trade balance was improved; the cutback in domestically produced goods is one reason that GDP declined so much.73

In sum, the mix of financial liberalization, the euro and Germany’s structural adjustment proved to be a highly toxic one. Germany’s ‘beggar thy neighbour’ political economy made it an export-led powerhouse that converted its neighbours into deficit countries. To cover their current account deficits, Germany’s neighbours needed financial resources. Financial liberalization transformed the cross-border flow of northern European bank assets into a deluge, a process that was facilitated by the adoption of a common currency, which gave the banks the illusion that lending to governments, enterprises and households in southern Europe was practically riskless, since they assumed that the Federal Republic’s Bundesbank would stand behind the multibillion dollar debt of recipient countries. When the thunderbolt from Wall Street illuminated financial realities in 2008 and showed that all of the bankers’ key assumptions were groundless, the process of European economic integration went sharply into reverse, ending up in today’s dismal picture of a continent in permanent crisis. Social democracy in crisis An account of the economic crisis in Europe from a progressive perspective would not be complete without touching on the role of social democracy in both the crisis and the developments leading up to it. Why? Because social democratic parties were not only the main party on the left, but in key countries – notably Britain, 116

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France and Germany – they were in power at various times during this period, and were central to forming and executing policies. New Labour’s Faustian bargain In an effort to move beyond its traditional working-class base, the UK’s New Labour under Tony Blair and Gordon Brown struck up an alliance with finance capital: that is, the City. The deal was to make London a prosperous global centre for finance, recycle some of the profits for New Labour’s social programmes for its traditional working-class base, and woo the middle classes with the low mortgages that the financial inflow made possible. Gordon Brown, first as chancellor then as prime minister, became the ideologue of ‘light-touch’ regulation of finance, and for this and his ambition to make London outstrip New York as a financial centre, he was ‘lionized’ by bankers.74 The centre of New Labour’s paradigm, or its bet, was that financial services ‘would power a new service-based economy’ that would compensate for the decline in the manufacturing sector, which had been the base of its traditional working-class clientele. The new white-collar class associated with the rising dominance of financial services would be enrolled in the voting lists of ‘forward-looking’ New Labour, while monetary contributions would come from the City’s financial elite. A good account of Labour’s comprehensive transformation from a working-class-based party is provided by the Centre for Research on Socio-Cultural Change of the University of Manchester: The New Labour project was based on enthusiastic acceptance of Conservative doctrine about economic transformation and private sector enterprise that follows from flexibilized labour markets and lower income and corporation taxes. Politically, New Labour distanced their party from the trade unions and thereby made Labour financially dependent on, and 117

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sympathetic to, City donors and other high-wealth individuals. A new style of politics had also emerged whereby business supports not the centre right, but whatever side is winning, in the hope of sympathy after the election … [I]n 1999, at the height of New Labour triumphalism, for example, 60 per cent of Labour’s income came from individual donors (20 per cent from donors over £5,000). The trade unions, which once generated 90 per cent of the Party’s income, by then provided only 30 per cent.75

The curious partnership of austerity and French socialism As for the French socialists, the turning point appears to have been the economic crisis of the early 1980s, which was provoked by Federal Reserve chief Paul Volcker’s steep interest-rate policy. With the budget deficit growing, capital fleeing and the franc being repeatedly devalued, François Mitterrand pulled back from his ambitious programme of nationalization and aggressive government spending and loosened capital controls to avoid further currency devaluations. As commentator Paul Cohen notes, ‘the most striking shift of the post-Mitterrand era was the French left’s rallying to the privatization creed’.76 In spite of a joint socialist–communist campaign promise to halt privatizations, the socialist–communist–green coalition led by Lionel Jospin that reigned from 1997 to 2002 privatized the bank Crédit Lyonnais and other corporations, as well as selling minority stakes in Aérospatiale, Air France and France Télécom.77 In place of nationalization and a more socialized economy, the priority of Mitterrand and his successors on the left became the creation of the Economic and Monetary Union. The curious logic in prioritizing the establishment of a monetary union, from the socialists’ point of view, was that austerity or neoliberalism could be defeated only on the European level, and this could be done only if 118

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the French could prove to their German partners – Europe’s moneybags – that they could impose a successful austerity programme on themselves. It seems to have escaped the French socialists that the Maastricht Treaty of 1992 – the agreement that led to the euro’s creation and that they were instrumental in bringing about – was an extremely neoliberal free-market document that would have made it very difficult for a future socialist government in France to move towards greater state control. As Varoufakis saw it: President Mitterrand’s government abandoned anti-austerity policies on the dubious grounds that austerity could only be defeated Europe-wide once the French economy was subjected to doses of austerity sufficiently large to placate the money markets and convince Germany’s elites to bow to the superior wisdom of French economic policymaking. French ‘socialist’ austerity would, according to this ill-fated plan, lull the Bundesbank into a sense of security [that would allow] French bureaucrats to erect a European Central Bank in France’s image. From there the single European currency would spread Mitterrand and Delors’ expansionary growth-oriented antiausterity policies – the same ones they had just abandoned at home – throughout the union.78

‘Or so the fairy tale went’ is Varoufakis’s sardonic comment, since how the Germans could be fooled and how the strict Maastricht criteria could be evaded on a European level remained a mystery – except, of course, to the French socialist elite. When the financial crisis broke in 2008, and country after country was driven to take loans from the Troika on condition that they would impose crushing austerity, progressives in the deficit countries had little faith in the French socialist technocrats and other social democrats in Brussels and Frankfurt, due to the 119

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contradiction between their seeming sympathy for anti-austerity but actual support for austerity. As an Irish economist acidly put it: Contrary to common perceptions, balancing budgets has not been a tactic of Europe’s economic liberals, but of the EU’s social democrats. They have sought social solidarity in a social contract based on high employment, strong social services and egalitarian wages – all wrapped in a protective shell of prudent finances. The Irish and European approaches today emphasize only the shell, including precious little of the social protection. The rediscovery of an older social democratic project involving prudence, protection and economically productive activity – an approach too long marginalized within EU policy debates – is long overdue.79

The SPD prepares Angela’s lunch To many observers, Germany is one of the main reasons for the eurozone’s problems, and they specifically point to the Hartz reforms, which were put in place in the early 2000s by the SPD-led (Social Democratic Party of Germany) government of Chancellor Gerhard Schröder. As noted earlier, the reforms, packaged as Agenda 2010, were a Thatcherite package that relied on cutting medical benefits, slashing pension and unemployment benefits, raising the age of retirement from 65 to 67, outsourcing health insurance and abolishing craft or guild membership requirements. Political essayist Perry Anderson described this package as ‘a more comprehensive bout of neoliberal legislation than [Britain’s] New Labour, a much invoked model, was ever to do’.80 A conservative government could not have carried out these policies without evoking massive resistance. Only a labour government could discipline labour. But the price paid by the social democrats was high. Some 100,000 members, including 120

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former Finance Minister Oskar Lafontaine, split from the party, with many joining the former Communist Party of East Germany (renamed the Party of Democratic Socialism, or PDS) to form the Die Linke party, or ‘The Left’. Trade union members also withdrew their allegiance to the party en masse, and the loss of their support was a key factor in the party’s rout in the 2009 elections, when it suffered the heaviest losses in its history and saw its seats in the Bundestag reduced to 23 per cent. Achim Post, head of the SPD’s International Politics Department, saw the Hartz reforms ‘as a case of the party doing something that was for good for society but not in the party’s best interests’.81 However, there is strong feeling in the party that the SPD ended up doing the dirty work for German capitalism, only to be sidelined and to see Angela Merkel reap the political rewards. Contrary to Post, however, progressives, including many among the social democrats, disagreed that the reforms were for the ‘good of society’. They said that what orthodox economists saw as a ‘new resiliency’ in the German economy had to be balanced against the emergence of new social inequalities. Inequality and poverty increased more rapidly in Germany in 2000–05 than in any other OECD country. While unemployment stands at a relatively low 3.4 per cent, a large number of those employed do not earn enough to meet their basic needs and have to resort to state subsidies. Moreover, the impact of the reforms was devastating to Germany’s neighbours. As noted earlier, by significantly reducing the cost of German labour, the reforms beggared many other countries in the eurozone, forcing them to borrow to cover the resulting deficits. Not only did Germany’s firms benefit from their exports, but German banks profited from the loans they made to other countries to cover their deficits. The end result was these countries’ virtual bankruptcy and their having to be bailed out under very austere conditions. 121

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Germany’s reduction of its neighbours into virtual vassals has troubled many party members, not least former German Chancellor Helmut Schmidt. At the party congress in 2012, Schmidt, now the party’s ‘grand old man’, summed up the troubled relationship of Germany, which straddles the geographical centre of Europe, with the rest of the continent thus: ‘When the centre is weak, the periphery moves into the centre. When the periphery is weak, the centre expands to the periphery.’ The key to a stable Europe is a balanced relationship and that balance has been disrupted by recent developments, he implied. The centre has become too strong, and nations now fear their economic governance being dictated by Germany and its preferences for fiscal and monetary tightness, strictures against debt, and obsession with inflation. Moreover, the fear of economic supervision by Germany is coupled with the fear that the austerity measures the Merkel government is promoting might provoke recession or depression – and he reminded his audience that it was deflation and depression, not inflation, that ended the Weimar Republic, the first attempt at democracy in Germany, and brought Hitler to power. Schmidt went on to assert that Germany’s neighbours’ fears had a basis in the past wrongs Germany had inflicted on its neighbours. Their fears were justified. More importantly, Germans had to relearn that their political and economic success in the last 60 years would not have been possible without the ‘support and solidarity of others’, and that it was now Germany’s turn to ‘show solidarity with our neighbours’. Otherwise, Germany might ‘risk isolation in Europe’.82 Many in the party have pushed to get the SPD to take a stronger stand against the permanent austerity to which Merkel is foisting on deficit countries, so as not to offend the Bundestag. So far, however, the SPD has gone along with this approach. With the party suffering another major defeat in the 2013 elections, it joined Merkel’s Christian Democratic Union in a ‘Grand Alliance’. Merkel 122

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agreed, but the price was high: she placed SPD leaders in key sensitive positions, where they had to take a lot of the flak for imposing austerity. These included the Foreign Affairs and Economic Affairs and Energy Ministries. When Greek Prime Minister Tsipras temporarily pulled out of the talks for a third bailout in 2015 and sought his country’s vote on what was on offer, SPD party leader Sigmar Gabriel, who served as economic affairs and energy minister in the coalition government, lashed out at Tsipras, saying that the Greek leader had ‘torn down the last bridges’, leaving ‘hardly any chance … for a compromise’ between the eurozone leaders and Athens.83 This led to the perception that he was trying to ‘out-Merkel Merkel’. Debacle of a proud tradition British Prime Minister Margaret Thatcher is the figure most identified with the advent of neoliberal policies in Europe. After her, however, it has been figures from Europe’s key social democratic parties that have played the main roles in promoting neoliberalism: Tony Blair and Gordon Brown in the financialization of the British economy, François Mitterrand in pushing the Maastricht Treaty, the free-market-oriented agreement that led to the establishment of the euro, and Gerhard Schröder in imposing the Hartz reforms that led to Germany pushing its neighbours into crisis, and eventually financial vassalage. Blair and Brown, Mitterrand and Schröder made their compromise with neoliberalism with the best of intentions, which was to achieve economic growth so that some of it could be siphoned off to serve as social expenditure for the working class. That proved to be a tragic illusion. True, there appeared to be a few good years in the 1990s. But, ultimately, the Faustian bargain led in each case to a severe crisis that outweighed whatever economic benefits they had managed to bring about. Thus, one of the main casualties of the financial crisis in Europe has been social democracy. The collapse of financialization 123

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in Britain led to Labour’s irreversible crisis even before the Brexit debacle. One might say that the eurozone mess that has dragged so many countries deeper into permanent stagnation, while subjugating them to Berlin, has led to the increasing irrelevance of social democratic parties as vehicles for people’s aspirations for economic emancipation. The unravelling of its historic compromise with neoliberalism and finance capital, to pirate the words of the Italian communist leader Enrico Berlinguer in a different context, has left social democracy with little moral capital, triggering, along with the migration issue, a great number of its working-class constituent to move to parties of the extreme right. Varoufakis expresses social democracy’s crisis most eloquently, and it is worth quoting him in full: With paper profits mounting, European social democrats and American democrats were lured into a Faustian bargain with the bankers of Wall Street, the City of London, Frankfurt and Paris, who were only too pleased to let reformist politicians take a small cut of the loot as long as the politicians consented to the complete deregulation of financial market[s] … Bankers were unshackled and centre-left politicians no longer had to wrestle the captains of industry to fund their social programmes. Financiers had only to feign displeasure at handing over some crumbs from their substantial table for the politicians to acquiesce in the logic and the ethics of financialization, suspend their critical attitude to capitalism and believe deeply that the financial sector knows best how to regulate itself … And so, when in 2008 the vast pyramids of financial capital came crashing down, Europe’s social democrats did not have the mental tools or the moral values with which to combat the bankers or to subject the collapsing system to critical scrutiny … Lacking the ethical, intellectual 124

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and financial weapons that they and their predecessors had willingly retired or refused to create some years before … Europe’s social democrats were ready to fall. Ready to retreat. To bow their heads to the bankers’ demands for bailouts to be purchased with self-defeating austerity for the weakest. To shut their eyes to the transfer of the costs of the crisis from those responsible for it to the majority of citizens, Germans and Greeks alike, the very people that social democrats were supposed to represent.84

Varoufakis sadly concludes: ‘European social democracy went to ground, leaving the way open to racist ultra-rightist thugs all too happy to act as the protectors of the weak – as long as the latter had the right blood, skin colour and prejudices.’85 Except for the part about the thugs – at least not yet – the parallel with the US situation and the triumph of Donald Trump is all too obvious.

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European social ’ democracy s Faustian bargain with big finance Interview with Walden Bello,

Transnational Institute, 24 May 2017

Europe’s social democrats played a central role in unleashing the financial sector that created the European economic crisis that continues till today. You’ve looked closely into how the financial crisis that erupted in 2008 played out in different parts of the world. What did the financial crisis in Europe have in common with the US crisis? One common factor in the US and Europe was unregulated, undisciplined finance capital. First, European banks, including German banks, bought huge amounts of toxic subprime securities, and as a result they saw their balance sheets gravely impaired, and, in the case of many, they had to be bailed out by their governments. Second, European banks engaged in the same uncontrolled lending to real-estate ventures, thus creating a huge property bubble in places such as the UK, Ireland and Spain. Another common factor was that European countries had also adopted ‘light-touch’ regulation, under the influence of Wall Street and neoliberal theories like the so-called ‘efficient market hypothesis’, which asserted that financial markets left to themselves would lead to the most efficient allocation of capital. Even the German authorities 126

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were under the spell of such doctrines, so they were caught by surprise by the massive exposure of their banks to toxic subprime securities and to poor credit risks such as Greece. And what was unique about or particular to the European crisis that distinguishes it from the US crisis? The main thing that distinguished the crisis in Europe from the US crisis was the complication introduced by 19 states having a common currency without a fiscal or political union. On the one hand, the euro gave lenders the illusion that the credit risk of the weaker economies was practically the same as that of the stronger economies, encouraging them to lend to the former without due diligence. On the other hand, being in the eurozone severely limited a country’s options to recover since it eliminated devaluation as a means by which an economy could move from a trade deficit to a trade surplus. The euro became a gilded cage in which the weaker economies have been condemned to longterm stagnation. What was Germany’s role in the financial crisis? How did German policies shape what happened in, for example, Greece? Germany had a central role to play in the generation of the crisis. First of all, the neoliberal reforms called the Hartz reforms, which were implemented by the social democratic government in the early 2000s, made German labour relatively cheap compared with its neighbours. This turned many other European nations into deficit countries in their trade relationship with Germany. To cover their deficits, as well as to support social security measures for those displaced by German exports, the governments of these countries, including Greece, borrowed heavily from German banks. Second, unrestrained by supposedly sober German government institutions such as the Bundesbank, German banks did not perform due diligence on borrowers such as Greece and lent massive amounts, 127

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recklessly. German exposure in Greece came to some €25 billion, leading Barry Eichengreen, a prominent finance expert, to comment that what was at stake ‘was not just the solvency of the Greek government but the stability of the German financial system’. Third, while refusing to acknowledge the responsibility of its banks and heaping the blame wholly on Greece and other borrowing countries, Germany has stubbornly dictated the austerity policies that Greece and other countries have been forced to adopt. These policies are designed to recover the bulk of the loans made by Germany’s banks. Even the IMF acknowledges that these austerity policies simply doom Greece and other southern European countries to long-term stagnation, but Germany insists on its pound of flesh, and this can only end up promoting the spread of anti-EU right-wing populist movements. So what about the standard accounts that say the Greek crisis was triggered by the revelation in 2009 that the government had been cooking the books? Well, you have to consider that, in 2007, two years before the statistics scandal, the tango of frenzied lending by German and French banks and addictive borrowing by the Greek government and private banks had already pushed Greece’s debt to €290 billion, which was 107 per cent of GDP. Yet Greece was still seen as a good credit risk. What made the situation in 2009 different was the spread of the global financial crisis from Wall Street to Europe, with banks collapsing or being bailed out by governments. The fallout from Wall Street made the creditor countries worry that private borrowers in the debtor countries would not be able to pay back their loans. So they pressed countries such as Greece, whose government was already highly indebted, to also take responsibility for or nationalize the private sector’s debt. This conversion of private debt into a state liability transformed the financial crisis in Europe into a sovereign debt crisis. The Greek statistical 128

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cover-up mainly functioned as an excuse for the creditor governments to crack down on the debtor states. You quote Joseph Stiglitz as saying that the euro is just a 17-yearold experiment, poorly designed and engineered not to work. Does that mean you think the euro will not survive? As I said earlier, the problem with the eurozone is that it is a monetary union that does not have the necessary requisites of a fiscal union or a political union that would set up the rules and mechanisms to allow the central authorities to move capital from surplus to deficit regions. Right now there are only two ways to resolve the trade imbalances within the eurozone. One is internal devaluation – that is, the adoption of harsh austerity policies that would cheapen labour and make a deficit country’s exports competitive. This carries the risk of subjecting a country to long-term stagnation owing to a sharp reduction of effective demand. The other way is to simply get up and go, leave the eurozone, and adopt a new currency, the value of which would be low compared with the euro, thus making one’s exports ‘competitive’. Not surprisingly, this would also carry the risk of squeezing effective demand in the debtor economy. However, the second option would allow one much more room for manoeuvre than if one were trapped in a loveless, depressed marriage like the eurozone. So in my sense, the countries in the eurozone face the choice of either moving towards full fiscal and political union, which would make financial transfers largely a matter of funds being automatically activated to flow from surplus to deficit areas in a fully unified economy, as in the United States. Or they end the monetary union. My sense is that there is no middle way. What would you say the role of social democracy was in the crisis? Social democracy is deeply implicated in the crisis. While Margaret Thatcher became the face of neoliberalism, social democrats had a 129

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central role in pushing neoliberal measures throughout Europe. New Labour promoted financial liberalization and light-touch regulation in the UK, with Gordon Brown, first as chancellor, then as prime minister, becoming, as one writer puts it, ‘lionized’ by the City as a result. François Mitterrand and the French socialists were the principal champions of the euro, in what former Greek Foreign Minister Yanis Varoufakis describes as a French project to harness German economic power to European integration under French political and administrative leadership. And, in Germany, it was under the Social Democratic Party (SPD) government of Gerhard Schröder that the labour market ‘reforms’ were implemented that reduced labour wages and consolidated Germany’s position as a surplus country and its neighbours as deficit countries, forcing them to rely on German banks to cover their trade deficits. The Christian Democratic party could not have done what the social democrats did, but Angela Merkel and the conservatives ended up eating the SPD’s lunch. Could the financial crisis in Europe have been averted? If so, how? Yes, it could have been averted if there had been very stringent regulations governing finance put in place by governments that did not see finance capital as a partner but as a force to be disciplined. Finance has to be put in its proper place as a mechanism to get capital from those who have it to those who can apply it to productive use. More and more, it seems like only a nationalized banking system can properly fulfil this function. Having said this, I share the apprehension of the American economist Hyman Minsky that, so long as capitalism reigns, finance capital will find ways to adjust to government regulations to again engage in reckless lending.

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Are we out of danger now, or is there a chance that this could happen again? No, we are not out of danger because financial-sector reform, which was pushed in the immediate aftermath of the financial crisis, has been ineffective or not implemented due to the successful lobbying efforts of financial corporations. Finance capital remains undisciplined. In the meantime, owing to austerity policies, much of Europe’s real economy is in the grip of permanent stagnation. This creates the temptation for unregulated finance capital to engage again in speculative ventures, where one squeezes value from already created value through the creation of bubbles that are destined to collapse, again bringing chaos in their wake.

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4 Asia and finance capital From the Japanese bubble to ’ China s financial time bomb

Introduction Ten years after the 2007–08 global financial crisis, the US is stuck in an uncertain recovery and Europe is mired in stagnation. The BRICS, the so-called ‘emerging markets’ grouping composed of Brazil, Russia, India, China and South Africa, have failed to step up to the plate to replace Europe and the US as the engines of the global economy. It is now becoming clear that the world is in the grip of long-term stagnation, with occasional and short-lived sparks of growth of some parts of the global economy. It seems only yesterday that East Asia had the reputation of being the home of ‘miracle economies’. That era is long gone. Asia was the site of two major financial crises in 30 years: the collapse of what was called the Japanese ‘bubble economy’ in the late 1980s and early 1990s; and the Asian financial crisis of 1997–98. In retrospect, these two debacles were key moments in the volatile rollercoaster known as ‘financialization’, or global capitalism’s increasing recourse to speculative rather than productive investment to stave off a crisis of profitability brought about by a global crisis of overproduction. The collapse of the bubble economy in the late 1980s, from which Japan has not recovered, came out of the blue. It was unexpected in a world that was still not used to economic troubles brought on by financial crises. However, when another real-estateled bubble inflated in Asia in the mid-1990s, with features very similar to the Japanese bubble, alarm bells should have sounded. To 135

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most investors and government authorities, however, the massive inflation of assets was simply another aspect of the ‘Asian miracle’. And when the US economy boomed in the early 2000s, on the strength of credit-financed consumer spending and skyrocketing real-estate values, the parallels to the run-up to the Asian financial crisis should have led the authorities to take strong action. But again, the danger signs were ignored because it was felt that ‘this time would be different’. Today, with the world still mired in the stagnation brought about by the global financial crisis, yet another bubble is inflating, this time in China. There are divergent assessments on whether or not China will, in fact, plunge into crisis. But the consensus is that if it does, the global economy into which China has become integrated as the world’s ‘manufacturing centre’ will not escape the waves triggered by the financial earthquake. Faced with this prospect, will the world respond differently than it did to the three previous crises? Japan: from the bubble to Abenomics Japan poses one of the biggest puzzles in modern economic history. As one leading expert on Japanese economics puts it: Japan astounded the world with its economic performance not once, but twice. Japan performed its economic ‘miracle’ from the 1950s through the 1980s, and then it produced an equally stunning descent into crisis in the 1990s. In the former period Japan had the strongest economic performance in the industrialized world; in the latter it had the worst. Japan’s transition from hyper-success to hyper-failure presents a compelling puzzle for analysts: What went wrong?1

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The puzzle remains. Over a quarter of a century after it began, Japan’s long stagnation continues, with a negative impact not only on the Japanese people’s quality of life, but also on their morale. A few months that I spent in Kyoto in 2017 left two distinct impressions related to Japan’s long stagnation. One was the large number of older people making up the population; people over 65 now comprise over 26 per cent. The second was what can only be described as a state of national depression over the economy, with a large part of the population having lost hope in the future and feeling rudderless. The state of the economy is worsening Japan’s demographic crisis. A recent national survey found that, as a result of financial insecurity, 69 per cent of males and 59 per cent of females aged 18–22 years had no sexual partner; 30 per cent said that they had no ‘hope’ for such a relationship; and 42 per cent of both sexes said that they were virgins. The survey, taken in 2015, also showed that the number of children desired by respondents was smaller than in 2010.2 Depression is rife among all age groups, with more and more youth falling prey to it. Among young people, this condition is known as hikikomori; it is partly caused, psychologists say, by the prolonged economic stagnation. As one report put it: Most psychologists believe that one of the root causes of hikikomori is the Japanese idea of ‘sekentei’, which is basically your reputation in the community and the pressure one feels to impress others. This is an immensely important social construct in Japanese society … After World War II, the post-war generation worked feverishly hard to rebuild Japan, which had been nearly flattened by the worst war in the history of mankind. Through their efforts they turned Japan into an economic powerhouse. You might say they were too successful. The Japanese economy’s stagnation in 137

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the 1980s meant no future generation could ever hope to aspire to the achievements of their parents or grandparents. Yet, there was still the expectation on them from their parents and grandparents to ‘build a better future’ … Most young Japanese people deal with this pressure with varying levels of acceptance, but there is a large minority that cannot. And when they fail, they feel like total failures and begin to pull away. Yet, by pulling away from society, that feeling of losing sekentei becomes stronger and the urge to pull away more increases. Thus begins a vicious repeating cycle.3

Poverty in Japan is largely invisible, leading some visitors from crisis-ridden Europe to joke: ‘If this is stagnation, I’ll have it anytime.’ Yet poverty is present and growing. The proportion of households living in poverty increased from 13.2 per cent in 1988 to 16.1 per cent in 2012.4 Japan was once seen as one of the world’s most equal societies, but its enduring economic stagnation has left this reputation in tatters. According to the OECD, current levels of inequality in Japan are approaching those of the US: Japan’s top quintile (the richest 20 per cent of the population) earns about six times more than the lowest quintile, while in the US the richest quintile earns 7.8 times more than the lowest quintile.5 Overproduction and stagnation Many economists have sought to unravel the puzzle of Japan’s long stagnation, but no consensus has been reached. This chapter does not try to solve the puzzle either, but instead has a modest aim: to understand how finance contributed to the crisis that overtook the Japanese economy, and that continues to keep it in thrall. Perhaps the best place to start is in the late 1970s, when the long period of post-World War Two expansion came to an end and a crisis of overproduction and profitability overtook the global economy. 138

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The trend towards global stagnation in the last quarter of the twentieth century is clearly illustrated in the figures gathered by the economic historian Angus Maddison, regarded as a reliable source on global economic trends. The annual rate of growth in global GDP fell from 4.9 per cent in what is now seen as the post-World War Two ‘golden age’ (1950–73) to 3 per cent in 1973–89 – a drop of 39 per cent.6 Confirming this trend, United Nations figures show that global GDP grew at an annual rate of 5.4 per cent in the 1960s, 4.1 per cent in the 1970s, 3 per cent in the 1980s, and 2.3 per cent in the 1990s.7 The fundamental cause of the long downturn was a crisis of profitability. This stemmed from the reduced growth in demand and rising excess industrial capacity, which in turned triggered intense competition among the centre or developed economies. In the immediate post-war period, the US helped revive the economies of Europe and Japan by providing massive aid as well as serving as a market for their goods. By the late 1970s, however, the centre economies became less complementary and more competitive. ‘In global capitalist production,’ notes Japan specialist Bai Gao, ‘the success of Japan and Germany in exporting their products to international markets not only went hand in hand with the failing competitiveness of the United States in 1971–1989 but also contributed to overproduction and to the decline of profitability of global capitalism as a whole.’8 In short, the United States, Europe and Japan built up huge industrial capacity at a time when many parts of the world were too poor or too unequal to absorb the industrialized world’s output. The excess capacity – the difference between actual and potential output – of the 1980s was exacerbated by the massive expansion of industrial and manufacturing plants in the newly industrializing countries (NICs) of East Asia, particularly in South Korea and Taiwan. As historian Robert Brenner notes, by 1990: 139

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the share of world exports of goods held at this point by all of non-OPEC, non-Japanese Asia had risen to 13.1 per cent, higher than that of the US (11.7 per cent), Germany (12.7 per cent), or Japan (8.5 per cent). In the immediately preceding years, the four Asian NICs had not only stepped up their export of heavy industrial capital-intensive outputs, but had also begun to venture into technology-intensive lines.9

The seeds of the Japanese financial crisis During Japan’s economic ascent, its government was acclaimed for what was regarded as its deft management of economic development. This involved not only the Ministry of Trade and Industry’s strategy of ‘picking winners’, or selecting and promoting promising industries, and ‘administrative guidance’ of the private sector, but also the Ministry of Finance’s coordination of the country’s banks to support this developmental thrust. What was not appreciated at the time, however, was that the Ministry of Finance’s financial strategy would bear the seeds of an overproduction crisis. Essentially, the strategy was to encourage a high savings rate in order to fuel a high investment rate. The Ministry of Finance realized, Asia expert Steven Vogel writes, that: Japan needed high levels of savings and investment to propel growth but that the private sector would be likely to underinvest unless the government shared some of the risk. The government deployed a wide array of tools to promote savings … Savers subsidized investment by depositing money into savings accounts that earned lower-than-market rates of interest, thus raising the demand for credit and giving the government the leverage to allocate credit to priority sectors. The banks were willing to go along because they could lend to firms at below-market rates and still 140

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maintain reasonable spreads (margins between deposit rates and lending rates).10

The strategy worked for as long as local and global demand was dynamic and rising. But the rise in local demand was eventually constrained by people’s high level of savings, even as intensified international competition slowed the rate of growth of Japanese exports. This levelling off of demand ran counter to corporate planning, which focused on adding capacity in the first half of the 1980s, expecting that exports would continue to rapidly increase under the cheap or undervalued yen regime.11 Overproduction and overcapacity were the results, with the consequent downward spiral in profitability leading to an oversupply of capital meant for productive investment. ‘Japan,’ one report underlined, ‘has a staggering overcapacity in a vast array of industries dotting the landscape, with more bank branches, gas stations, construction companies, and automakers than the nation and its global customers can support profitably.’12 Not surprisingly, corporate bankruptcies increased, doubling from 5,292 in 1990 to 10,728 in 1992 and the amount of liabilities quadrupling. These levels stayed roughly the same until the end of the decade.13 Those that skirted bankruptcy began to reduce their investment, with private-sector investment declining at an annual rate of 5.3 per cent in real terms from 1991 to 1994.14 With demand for loans from the big industrial firms falling, banks (to maintain their profit levels) increased their lending to real-estate and other enterprises engaged in speculative activity. The big corporations themselves, which were able to fund themselves using retained earnings, the stock market or international financial sources, threw their excess cash into domestic speculative activity – an activity that came to be known as zaitech – where industrial corporations generated profits from investing in stocks and bonds. The development of zaitech, notes Gao: 141

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indicates that, sustained by the liberalization of finance, Japanese corporations began to shift away from their real business to financial speculation. Ironically, when the world praised Japanese corporations for their long-term thinking in business strategy in the 1980s, Japanese corporations had begun to turn to short-term profits at a rapid rate.15

The flow of cash into real estate fuelled a massive speculative bubble that reached unimaginable levels. In 1989, all of Japan’s land was valued at approximately four times the value of all property in the United States despite the fact that Japan’s land area was only 4 per cent that of the US. The Imperial Palace East Gardens alone, as noted earlier, were valued as much as all the property in the state of California, or all of Canada.16 Clearly, by the mid-1980s, the property market was overheating and it was only a matter of time before the bubble was pierced. The Ministry of Finance and the Bank of Japan were reluctant to act, and when they did so, the consensus goes, it was too late. Inflating the bubble The reluctance to act stemmed from the fact that not only were the Ministry of Finance and the Bank of Japan aware of the creation of a bubble in stock and real-estate prices, but they also encouraged it with their policy of ‘window guidance’ – a practice of signalling to private banks how much credit to create and provide to nonfinancial firms. As economist Richard Werner writes: The problem was not that bank lending was out of control. To the contrary, it was controlled almost perfectly by the Bank of Japan’s window guidance. Instead, the problem was the policy taken by the Bank of Japan in setting those loan growth quotas. Since the Bank of Japan chose far larger quotas 142

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than banks thought necessary, compliance with window guidance meant that banks were forced to peddle their loans to real estate speculators. The Bank of Japan appeared to have been aware that its credit controls were sharply raising the allocation of new money to the real estate sector, thus pushing up real estate prices.17

As one Bank of Japan official admitted: ‘All the banks tried to use their loan growth quota to the maximum and did all they could do to give out loans. But the loans did not go to normal corporations, such as steel [or] automobile construction, but instead to non-bank financial institutions [which engaged in real-estate speculation]. This became the bubble.’18 The reasons why the Ministry of Finance and Bank of Japan loosened credit rather than tightening it (even as the property bubble reached unprecedented heights) stemmed from a variety of motives, among them fear of triggering a recession, maintaining the profitability of the banks, and deep concern about the unpredictable consequences of bursting such a massive bubble. Feeble response to the recession When the bubble did burst and the economy lurched into recession, the response was clumsy and inadequate. Collapse in demand, from both corporations and consumers, required government action. Massive and decisive countercyclical policies were the need of the hour. However, monetary policy, in the form of interest rate cuts, was weak in response to the magnitude of the crisis, consisting of a small reduction in rates spread over four years. Besides, as economist Richard Woo has noted, in a ‘balance-sheet recession’, or one stemming from the bursting of a bubble, monetary policy has limited effectiveness since corporations and consumers would rather pay off their debts than acquire new debt.19 143

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The potentially more effective response – fiscal policy taking the form of government efforts to raise effective demand through job creation and other means to place money in the hands of consumers – was likewise weak and indecisive. Despite a deepening recession, the government: undertook only half-hearted stop–start fiscal stimulus in the mid-1990s … Later, based on the incorrect presumption that the Japanese economy was soon reverting to its previous trend, the Japanese government raised the consumption tax in April 1997 from 3 per cent to 5 per cent. Then everything went wrong for the Japanese economy for the rest of the 1990s. The Asian currency crisis started during the summer of 1997. In the fall of the same year, the domestic banking crisis hit the Japanese economy, revealing the seriousness of the non-performing loan problem. In 1998 and 1999, Japan experienced its worst recession since the first oil crisis in the early 1970s. To combat this sharp economic downturn, the government implemented a series of large fiscal stimulus packages. However, all were smaller than advertised, were less than fully implemented, and allowed cuts in public investment.20

Moreover, it was not coordinated with monetary policy. ‘No effort was made to coordinate monetary fiscal policies during the lost decades,’ says one study, which went further to claim that, ‘indeed, at times the Ministry of Finance and Bank of Japan appeared to be pursuing completely different objectives. The result was that monetary and fiscal policies often worked at cross-purposes, with expansionary monetary policy offset by tight fiscal policy and vice versa. The unfortunate result was intermittent and inadequate fiscal stimulus.’21

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Zombie banks One of the biggest problems was the government’s refusal to address non-performing loans (NPLs) – loans carried by the banks that totalled around 15 per cent of GDP and that were acting as a brake on the banks’ viability as mechanisms for economic resuscitation. The government also prevented banks declaring themselves bankrupt. Indeed, the Ministry of Finance tried to solve the problem of economic stagnation by providing cheap money to the banks so as to get them to produce large current earnings that would allow them to write off NPLs and begin normal lending again.22 With investment demand low, however, this merely worsened the problem. Economist Kobayashi Keiichiro puts forward an explanation for the authorities’ reluctance to deal with the issue of NPLs on the books of what were called ‘zombie banks’ in the popular parlance: The peculiar structure of banking regulation and supervision centered on a closed financial community that included [the] Ministry of Finance’s Banking Bureau and large private banks. The coziness of the relations in this community reinforced the thinking behind the now-famous ‘convoy’ system of Japan’s banking, in which all the main banks were helped by the government to move forward together; none was allowed to lag behind (or go bankrupt), and external actors had hardly any say. The system helped prevent the tardiness of dealing with NPLs from exposure to outside criticism, a situation that persisted due to an unspoken set of agreements between the Ministry of Finance’s Banking Bureau and the financial world.23

This web of ties let the issue drag on, making sustained recovery more and more distant as time went on. The more appropriate response, according to Vogel, would have been the following:

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Given the scale of the crisis, the financial authorities should have adopted the approach that had succeeded elsewhere, one that cuts against the very grain of Ministry of Finance tradition. This would have meant publicly disclosing the scale of the problem, using public funds to recapitalize the banks, creating a new debt-collection agency to buy up the bad loans from the banks and sell them off in the market, and pressing the banks to write off or sell off their loans in an efficient manner.24

Macroeconomic policy versus structural reform To Keynesian economists such as Paul Krugman and Joseph Stiglitz, the key problem was lack of aggregate demand, and the way around this was through innovative monetary and fiscal policy. This included ‘inflation targeting’ or deliberately stoking inflation through various radical monetary and fiscal policies in order to ward off the greater danger of deflation and get the economy moving again. Government printing of money was proposed by Stiglitz to raise effective demand – an idea that was later associated with US Federal Reserve Chairman Ben Bernanke and caricatured as dropping money from helicopters to people who would then spend it, thus igniting economic activity. With monetary and fiscal policies either poorly implemented, poorly timed, or at cross-purposes, by 2000 depression took hold of the national psyche, and deflation (or a downward spiralling of prices) meant that deepening recession took hold of the economy. A good description of Japan’s condition over the past 17 years is provided by one analyst: Once deflation took hold, it worked its way through the economy in textbook fashion. Businesses began to hold off on investment and households stepped back from buying big-ticket items, delaying purchases on expectations that prices 146

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would decline. Financial strategies adjusted to the deflationary environment … And firms grew reluctant to hire workers on the lifetime contracts … increasingly opting for ‘non-regular workers’ with lower basic wages, less job security, fewer benefits, less training, and lower productivity.25

Failure to persuade consumers to spend led to the rise of the so-called structural reform school, members of which saw the solution as being the dismantling of the key institutions that had been associated with Japanese capitalism in the period when it was catching up with Western economies. These institutions included the keiretsu system, the conglomerate-like collection of enterprises grouped around one bank; administrative guidance by the Ministry of Trade and Industry and window guidance by the Ministry of Finance; and lifetime employment for corporations’ core workforces. Deregulation, privatization and liberalization of trade became the watchwords of the structural reform school, and they received a powerful boost from the support of the United States, which wanted, for its own purposes, to open up the Japanese economy to US imports and the Japanese financial system to US banks. The position of the structural reform (or ‘supply-side’ school) was fortified by widespread disenchantment with the institutions of the famous Japanese developmental state, which was dedicated to catching up with the West, and with the power of bureaucrats whose reputation was tied to the successful past performance of these institutions. This did not necessarily mean, however, that the public had ceased to value the relative equality and strong social solidarity that had been associated with these institutions – conditions that were threatened by the neoliberal structural reforms. In the mid-1990s, Prime Minister Ryutaro Hashimoto’s ‘Big Bang’ reform programme promoted deregulation and liberalization of the financial sector. The policy was implemented unevenly, 147

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probably because the economic managers feared that deregulation would worsen the crisis since it would weaken the government’s role at precisely the time when more effective government intervention was needed. A second wave of reforms came with the ensuing administration of Prime Minister Junichiro Koizumi, the crowning achievement of which was the privatization of a keystone institution: the Japan Postal Bank. However, demand- and supply-side solutions were not policy options chosen on technocratic grounds alone. Political coalitions were constructed around each approach. Certain sectors, such as big corporations and consumers, benefited more from supply-side reforms while others, such as labour, small businesses and farmers, were or would be hurt. Other sectors were indecisive in their response. As a result, these coalitions proved to be unstable, and so the policy oscillated between the two poles, with neither being given a chance to be implemented substantially before coalition politics or electoral developments forced a move back to the other pole. As political economist Keiichi Tsunekawa writes: It is inaccurate to argue that the long-term economic stagnation of Japan has been caused by the inadequacy of neoliberal reforms such as trade liberalization and deregulation. The neoliberal encroachment on the developmental, clientelist, and welfare-statist policies has indeed been serious over the last three decades, still the Japanese economy continues to stagnate. The real cause of Japan’s trouble is the lack of any consistent policy orientation. Both voters’ preference and government policies have switched too easily between neoliberal reforms and expansionary demand-side measures, thereby obstructing any quick and decisive government response to the post-bubble, NPL problem aggravated by the AFC [Asian financial crisis]. The resultant uncertainty for future market conditions has 148

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deterred both investment and consumption, thus prolonging the recession.26

Although Tsunekawa does not mention it, perhaps another major factor was the continuing widespread support of many sectors for the values of relative equality and job security, which meant that there was a reluctance – even on the part of the beneficiaries of structural reforms such as big corporations and consumers – to thoroughly dismantle the institutions that had promoted these values.27 It was only in around 2005 – 15 years after the banking crisis began – that a pragmatic mix of measures, including infusing public funds into the troubled banks (something that the authorities had not wanted to do earlier for fear of public censure), helped the Japanese banking system get a grip on the NPL issue. But, by then, the melange of weak expansionary and fiscal policies that at times were working at cross-purposes, and the zigzag between demandand supply-side approaches, had left the country in policy drift, seemingly unable to get out of stagnation. Japan’s financial system was not shattered, but it was severely weakened. It is said that this situation had one merit: it made the banks and authorities timid about experimenting with the financial innovations coming out of Wall Street in the early 2000s, thus preventing the system from being brought down by the toxic assets that ravaged the US, British and European financial systems. But that, apparently, is no longer the case. Japanese banks are now trading in derivatives and other financially engineered products – something that formerly cautious banking experts now support in the name of financial upgrading.28 Moreover, banks have plunged into fintech, or the innovative consolidation via the internet of financial services for corporate and individual consumers that were formerly handled by diverse financial intermediaries. As one noted economist asserted, the fintech craze may lead Japanese banking into 149

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uncharted, dangerous waters.29 One suspects that the world may not have heard the last about the troubles of Japan’s financial system. Enter ‘Abenomics’ When the current government of Shinzō Abe came to power in 2012, it unveiled what was applauded as a bold solution to the state of stagnation that combined demand- and supply-side measures. ‘Abenomics’, as it has come to be known, had three ‘arrows’. The first was aggressive monetary expansion, essentially providing interestfree money to banks, corporations and consumers – in short, aggressive ‘quantitative easing’, as this process became known. The second arrow was massive fiscal stimulus, with the government spending large amounts on infrastructure and social welfare. The third arrow was more long term, consisting of supply-side neoliberal reforms, one element of which was Japan’s joining of the Trans-Pacific Partnership (TPP), which would provide external pressure on the country to liberalize its trade, financial and corporate structures. After almost seven years, however, Abenomics has not produced impressive results. A balanced assessment is provided by the IMF, one of the backers of the approach. Ironically, given its past reputation as a doctrinaire inflation fighter, the Fund approvingly reports that the monetary ‘Big Bang’ programme ‘raised actual and expected inflation far more effectively than many imagined possible. This has lowered real interest rates and raised asset prices, contributing to stronger consumption, credit demand, and, more recently, investment.’ But although there are other tentative, positive indicators, the IMF concludes that ‘Japan is not fully back’. It could be that, while it may look good on paper, short-term demand management amidst long-term structural reform may in fact be contradictory, since the former promotes greater consumer purchasing power while the latter consists of neoliberal measures that would negatively affect this. Moreover, now that President 150

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Donald Trump has scrapped the TPP, a key element of Abenomics is gone. Things remain fragile, with the IMF warning that a relapse into deflation remains a possibility.30 Some prominent Japanese economists are bolder in their assessment of Abenomics. Naoyoki Yoshino, dean of the Asian Development Bank Institute, says that Japan’s age structure, where over 25 per cent of people are now over 65, renders the usual monetary and fiscal stimulus ineffective, since retired people have a greater propensity to save rather than spend the added liquidity compared with working-age people.31 Eisuke Sakakibara, the influential former vice minister of the Ministry of Finance, says that Abe’s focus on growth is misplaced, since Japan is now a mature economy, for which a 1 per cent GDP growth rate should be considered normal.32 Another celebrated economist, Noriko Hama of Doshisha University, agrees with Sakakibara that low growth is normal for Japan’s status as a mature economy, adding that Abenomics, which she calls ‘nonsense economics’, is not driven by sound principles but by Abe’s politics, which seek to regain Japan’s imperial might.33 So what can we say of the state of the Japanese economy at this point?

• First, the roots of its malaise are intrinsically connected to the overproduction that has overtaken global capital.

• Second, the turn to speculative finance, which created the

bubble that eventually felled the economy, was driven by the crisis of profitability brought about by overproduction and excess capacity.

• Third,

macroeconomic, demand-side management has not

worked, a major reason being that it was implemented so ineptly by bureaucrats.

• Fourth, supply-side (neoliberal) reforms have been made – more

in some areas than in others – but neoliberal transformation 151

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has been incomplete, perhaps largely because of the strong value placed on equality and the resistance to neoliberal measures that would significantly increase inequality. • Fifth, all institutions that were central to the developmental state in the period of catch-up have been discredited because they have failed to lift Japan out of almost 30 years of stagnation. This includes the bureaucracy, banks and corporations. With the discrediting of the bureaucracy, politicians now have a stronger hand in deciding economic issues and promoting economic solutions. • Sixth, Abenomics has had mixed results, with only the ‘arrow’ of monetary expansion seeming to work. Economists have thus come up with new explanations for the failure of the economy to respond to the orthodox policies to revive it. These range from Japan’s ageing population radically reducing the effectiveness of macroeconomic solutions to the claim that Japan does not have a problem of stagnation but is undergoing a normal transition to maturity, and that this is reflected in a low growth rate. The Asian financial crisis Japan played a key role in the generation of the Asian financial crisis. First of all, the excess capacity that characterized Japan’s industry was transferred to East and Southeast Asia via a wave of Japanese direct investment – the result of a revaluation of the yen relative to the dollar that made it more expensive to manufacture in Japan. At least $15 billion of Japanese direct investment flowed into Southeast Asia between 1985 and 1990, with Indonesia receiving $3.1 billion, Thailand $3.7 billion and Malaysia $2.2 billion.34 The inflow of Japanese capital allowed what had become known as the Asian NICs to escape the credit squeeze of the early 1980s (which 152

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was triggered by the debt crisis in developing countries); surmount the global recession of the mid-1980s; and move on to a path of high-speed growth. At the heart of the currency revaluation (called the endaka) was the ratio of foreign direct investment inflows to gross capital formation, which leapt spectacularly in the late 1980s and 1990s in Indonesia, Malaysia and Thailand. However, it was not just the scale of Japanese investment over this five-year period that had an impact – it was also the strategy that accompanied it. The Japanese government and the keiretsu planned and cooperated closely in the transfer of corporate industrial facilities to Southeast Asia. One key dimension of this process was the relocation not only of big corporations such as Toyota and Matsushita, but also of the small and medium-sized enterprises that supplied them with services and components. Another feature of the process was the functional integration of complementary manufacturing operations that were spread across the region in different countries. The aim was to create an Asia Pacific platform for re-export to Japan and to third-country markets. This was industrial policy and planning on a grand scale, managed jointly by the Japanese government and corporations and driven by the need to adjust to the revaluation of the yen agreed upon in the 1985 Plaza Accord, which made production in Japan no longer competitive. As one Japanese diplomat candidly said: ‘Japan is creating an exclusive Japanese market in which Asia Pacific nations are incorporated into the so-called keiretsu system.’35 Japan exports the ‘bubble economy’ The process was largely beneficial as long as Japanese foreign direct investment was coming in, but when the growth in Japanese export markets began to slow owing to the global crisis of overproduction, the chain of events that would eventually lead to the Asian financial 153

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crisis began. These countries had built up investment-hungry export machines that needed to be fed with more investment. Japan expert Charles Hughes sums up the arguments of those who blamed Japanese policies for their role in triggering the crisis: Japan was seen to have fostered a vulnerable model of growth in the region due to the influx of Japanese portfolio and production DFI [direct foreign investment], which, although it enabled the states of the region to acquire some of the capital and technology necessary to overcome bottlenecks in production and raise their international competitiveness, also encouraged an unhealthy reliance on inward investment to finance current account deficits without resorting to government borrowing. Japan, it is argued, shifted its investment bubble to East Asia, with the states of the region becoming over-dependent on the supply of Japanese capital and vulnerable to any drop in its supply, and the massive flows of Japanese investment working to compound the potential speculative bubbles in the region by creating the impression of economic dynamism which attracted volatile ‘hot money’ portfolio investments from other developed states taking advantage of the dollar-pegged currencies of East Asia and concomitant lack of exchange risk. In a sense, then, Japanese DFI provided [the] ‘first hit’ which was to turn the East Asian states into … unstable investment ‘junkies’.36

The process described by Hughes is oversimplified but it is essentially accurate. Japanese investment was the key trigger of Southeast Asia’s rapid growth, which, when it declined due to global overcapacity, forced those countries to rely on bank and speculative capital from Japan and the West that was knocking on their doors to take advantage of the ‘Asian Miracle’. Just as earlier it had been the 154

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source of the bulk of foreign direct investment in East Asia, Japan was also the source of much of the speculative capital that flowed in. As analyst Kirsten Nordhaug notes: ‘Japan’s loose post-bubble monetary policies also created surplus liquidity which “leaked out” to East Asia. Japanese banks lent large amounts of money to the region at a low interest rate, both to Japanese subsidiaries and to locally owned firms.’37 Southeast Asia: speculative capital supplants foreign direct investment38 In Southeast Asia, the surge in portfolio investment and short-term private bank credit in the early 1990s followed an earlier rise in foreign direct investment that started in the mid-1980s. As noted earlier, between 1985 and 1990, some $15 billion of Japanese direct investment flowed into the region in one of the largest, swiftest movements of capital to the developing world in recent history. This direct investment was accompanied by billions of dollars more in bilateral aid and bank loans from Tokyo. Moreover, it provoked an ancillary flow of billions of dollars in direct investment from the newly industrialized economies of Taiwan, Hong Kong and South Korea. It was this prosperity that attracted portfolio investors and banks, and, with the collapse of Mexico during that country’s financial crisis in 1995, fund managers, who channelled the biggest chunk of their investments and loans for developing-world markets to the East Asian region. The interests of speculators seeking better climes than the relatively low-yield capital markets of the North and the risky markets of Latin America coincided with the search by Asian technocrats for alternative sources of foreign capital as infusions of the yen levelled off in the early 1990s. On the advice of fund managers and the IMF, Thailand followed Mexico’s example and formulated a three-pronged strategy. It 155

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liberalized the capital account and the financial sector as a whole; maintained high domestic interest rates relative to those in Northern money centres to lure portfolio investment and bank capital; and fixed the local currency at a stable rate relative to the dollar to insure foreign investors against currency risk. Portfolio investments rose in both equities and bonds, and so did credit from international banks to Thai financial institutions and enterprises. The latter engaged in what they perceived as the very profitable carry trade: that is, they took advantage of the large differential between the relatively low rates at which they borrowed from Northern money-centre banks in Tokyo and New York and the high rates at which they could re-lend the funds to local borrowers. In the short term, the formula was wildly successful in attracting foreign capital. Net portfolio investment came to around $24 billion in the three years before the crises erupted in 1997, while at least another $50 billion entered in the form of loans to Thai banks and enterprises. These results encouraged finance ministries and central banks in Kuala Lumpur, Jakarta and Manila to copy the Thai formula, with equally spectacular results. According to Washington’s Institute of International Finance, net private capital flows to Malaysia, Indonesia, the Philippines, Thailand and Korea shot up from $37.9 billion in 1994, to $79.2 billion in 1995, and to $97.1 billion in 1996.39 Japan was a central source of funds. In 1996, Japanese banks had $265 billion in outstanding loans to East Asian countries, with $83.9 billion in the three countries that eventually became epicentres of the Asian financial crisis – Thailand, Indonesia and South Korea.40 While most foreign portfolio investments came from the US and Europe, a large proportion of the funding of these portfolio investments was actually sourced in Japan. As Nordhaug notes: Investors borrowed at low interest rates in Japan, changed yen into dollars and re-invested those dollars throughout the world. 156

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A large amount of the funds went to the East Asian highgrowth area. Most East Asian countries (with exceptions such as China and Taiwan) undertook significant capital account liberalization to attract these funds from the early 1990s.41

In retrospect, the experiences of Thailand and its neighbours demonstrated the fatal flaws of a development model based on huge, rapid infusions of foreign capital. First, just as in Mexico, there was a basic contradiction between encouraging foreign capital inflows and keeping an exchange rate that would make the country’s exports competitive in world markets. The former demanded a currency pegged to the dollar at a stable rate, in order to draw in foreign investors. But with the dollar appreciating in 1995 and 1996, so did the pegged Southeast Asian currencies. Consequently, international prices of Southeast Asian exports rose. Second, the bulk of the incoming funds consisted of speculative capital seeking high, quick returns. With little regulation of its movements, foreign capital did not gravitate to the domestic manufacturing sector or to agriculture, which were considered low-yield sectors that would provide a decent rate of return only after a long gestation period. The high-yield sectors with a quick turnaround time to which foreign investment and foreign credit inevitably gravitated were the stock market, consumer finance, and, in particular, real-estate development. In Bangkok, at the height of the boom in the early 1990s, land values were higher than in urban California. People who had witnessed the growth of the Japanese real-estate bubble in the late 1980s could not but speculate that another bubble had grown and was waiting to burst. Not surprisingly, a glut in real estate developed rapidly. Bangkok led the way with $20 billion worth of new commercial and residential space unsold by 1996. Foreign banks had competed to push loans onto Thai banks, finance companies and enterprises in the boom 157

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years of the early 1990s; by the middle of the decade, lenders woke up to the realization that their borrowers were loaded with NPLs. Alarm bells began to sound. The flat export growth rates for 1996 (an astonishing zero growth in both Malaysia and Thailand) and burgeoning current account deficits were worrisome. Since a foreign-exchange surplus earned through the consistently rising exports of goods and services was the ultimate guarantee that the foreign debt contracted by the private sector would be repaid, the slowing of exports was a blow to investor confidence. What the investors failed to realize was that the very policy of maintaining a strong currency, which was calculated to draw them in, was also the cause of the export collapse. Many also overlooked the fact that the upgrading of the quality of exports, which could have counteracted the rise in export prices, had been undermined by the easy flow of foreign money into the speculative sectors of the economy. Manufacturers had channelled their investments into these sectors in order to harvest quick profits, instead of pouring them into the long, slow process of research and development and of improving the skills of the workforce.42 By 1997, it was time to get out. Because of the liberalization of the capital account, there were no mechanisms to slow down the exit of funds. With hundreds of billions of Thai baht chasing a limited number of dollars, the outflow of capital threatened to be highly destabilizing. Many big institutional players and banks began to leave, but what converted a nervous departure into a catastrophic stampede was the speculative activity of hedge funds and other arbitrageurs. Gambling on the authorities’ eventual devaluation of the overvalued baht, they accelerated the process by unloading huge quantities of the Thai currency in search of dollars. In the Thai debacle, hedge funds played a particularly key role. Hedge funds are essentially investment partnerships that are limited to the very wealthy, are often based offshore, and are little 158

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regulated. Specializing in combining short and long (or selling or buying) positions in different currencies, bonds and stocks in order to net a profit from the combined transactions, the funds had been attacking the baht occasionally since 1995, led by the best known hedge fund operator, George Soros. But the most spectacular assault occurred on 10 May 1997, when, in just one day, hedge funds are said to have ‘bet US$10 billion against the baht in a global attack’.43 At the end of July, according to an IMF report, approximately $7 billion of the Bank of Thailand’s $28 billion forward book (the value of contracts for currency exchange for the future, based on less attractive rates for the local currency than the current rate) was ‘thought by market participants to represent transactions taken directly with hedge funds. Hedge funds may have also sold the baht forward [that is, at less attractive terms for the local currency than the current rate] through offshore counterparties, onshore foreign banks, and onshore domestic banks, which then off-loaded their positions to the central bank’.44 Under such massive attacks, the Bank of Thailand lost practically all of its $38.7 billion of foreign-exchange reserves between the end of 1996 and mid-1997. On 2 July, the decade-long peg of 25 baht to the dollar was abandoned, and the Thai currency lost over 50 per cent of its value in a few months. Jakarta and Kuala Lumpur experienced the same conjunction of massive capital flow, property glut, and a rise in the current account deficit. The nervousness had existed there, too, but the baht collapse was what triggered severe anxiety among foreign investors. Political economist Jeffrey Winters describes the deadly dynamics: Suddenly, you receive disturbing news that Thailand is in serious trouble, and you must decide immediately what to do with your Malaysian investments. It is in this moment that the escape psychology and syndrome begins. First, you 159

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immediately wonder if the disturbing new information leaking out about Thailand applies to Malaysia as well. You think it does not, but you are not sure. Second, you must instantly begin to think strategically about how other EMFMs [emerging market financial managers] and independent investors are going to react, and of course they are thinking simultaneously about how you are going to react. And third, you are fully aware, as are all the other managers, that the first ones who sell as a market turns negative will be hurt the least, and the ones in the middle and the end will lose most value in their portfolio – and are likely to be fired from their position as an EMFM as well. In a situation of low systematic transparency, the sensible reaction will be to sell and escape. Notice that even if you use good connections in the Malaysian government and business community to receive highly reliable information that the country is healthy and is not suffering from the same problems as Thailand, you will still sell and escape. Why? Because you cannot ignore the likely behaviour of all the other investors. And since they do not have access to the reliable information you have, there is a high probability that their uncertainty will lead them to choose the escape. If you hesitate while they rush to sell their shares, the market will drop rapidly, and the value of your portfolio will start to evaporate before your eyes.45

Winters comes to a radically different conclusion from Adam Smith, who believed that the invisible hand of the market should bring about the greatest good for the greatest number. Winters writes: The chain reaction was set in motion by currency traders and managers of large pools of portfolio capital who will operate under intense competitive pressures that cause them to behave 160

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in such a manner that is objectively irrational and destructive for the whole system, especially for the countries involved, but subjectively both rational and necessary for any hope of individual survival.46

Speculative capital fells a tiger economy Unlike in Southeast Asia, South Korea’s development had not been based principally on foreign investment. Instead, it rested on capital amassed through a monopoly of the domestic market by local capital and on an aggressive mercantilist policy promoted by the state. A close working relationship between the private sector and the state fostered high-speed industrialization. By ‘picking winners’, providing them with subsidized credit through a governmentdirected banking system and protecting them from competition from transnationals in the domestic market, the state nurtured chaebol, or industrial conglomerates, which it later encouraged to enter the international market. In the 1980s, the state–chaebol combination appeared to be unstoppable in international markets, as the deep pockets of the commercial banks were extremely responsive to government wishes and provided the wherewithal for Hyundai, Samsung, LG Electronics and other conglomerates to carve out market shares in Europe, Asia and North America. It did not take very long, however, for the tide to turn against the Koreans. Several factors contributed to this, including overinvestment resulting in overcapacity, which led to declining profitability. Easy credit through government-controlled banks had been a central reason behind the ‘Korean Miracle’, but, by the early 1990s, the credit demands of the chaebol to support investment and expansion had become voracious. At the same time, foreign banks and foreign funds were eager to lend to Korea and pressed Washington, the World Bank, and the IMF in turn to pressure the 161

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Koreans to open up their financial sector. Korea then entered the OECD, which required it to liberalize its capital account, financial sector and foreign investment regime.47 Although Korea formally adopted a gradualist strategy – embodied in the so-called Reform of the Foreign Exchange System – the inflow of foreign funds was, in fact, anything but gradual. In 1993, the Kim Young Sam government relaxed its controls over cross-border capital flows, allowing both conglomerates and newly created banks greater liberty to borrow abroad. As Ravi Arvind Palat of Binghamton University has pointed out, the 1993 financial liberalization signified the weakening of the state as a buffer between the local economy and the international economy on the one hand, and, on the other, the rise of an uncontrolled private sector as the principal mediator between the two arenas.48 The results were disastrous. Korean banks plunged gleefully into the interbank market, ‘taking advantage of lower interest rates overseas and passing the funds on to their domestic customers … [T]his was hardly prudent banking practice since it meant that Korea Inc. was borrowing short-term money abroad – money that had to be repaid in hard currency – and lending it long-term to the expansion-crazed chaebol.’49 But, as always, it took two to tango, and ‘foreign banks rushed into this promising new market, led by the Europeans and the Japanese’.50 South Korea’s foreign debt promptly trebled, from $44 billion in 1993 to $120 billion in September 1997, and went on to reach $153 billion in February 1998.51 Most aggressive among the borrowers of short-term foreign funds were the 30 new merchant banks, which accounted for $20 billion of the $153 billion debt.52 The high-profile collapse of some severely indebted chaebol early in 1997 and the financial panic in Southeast Asia in the summer of 1997 combined to make the Korean economy a sitting duck. Exhibiting much the same herd mentality demonstrated by 162

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fund managers during the Southeast Asian crisis a few months earlier, the banks began pulling out, paying little attention to the fact that Korea had a more advanced, solid industrial economy than Thailand or Indonesia, or that it was a member of the OECD. As one IMF staffer recalled: I was being called by a lot of banks in October and November, and it was amazing how little they knew about Korea. They’d ask, ‘Has Korea ever defaulted?’ Well, the answer is no. They’d ask, ‘How recent is Korea’s miracle? Isn’t it all driven by foreign capital flows?’ Well, it’s not. I remember one indignant guy in New York saying, ‘We’re a responsible bank; we cannot roll over our claims in a nontransparent country.’ And I thought, ‘Well, you certainly seem to have been able to lend to them!’ In a panic situation, once something becomes an issue, no bank wants to be left out on a limb.53

When fund managers began to dump the local currency, the won, in early November 1997, the Korean government tried to defend the exchange rate by using its reserves. It promptly lost about $10 billion, or over one-third of its foreign currency reserves. The won was devalued on 17 November, resulting in a 24 per cent loss in value against the dollar by early December 1997, or a 24 per cent hike in the cost of servicing dollar-denominated loans by local borrowers. With Korean banks and firms facing bankruptcy, the IMF negotiated a record $57 billion rescue to enable Korean borrowers to repay their international creditors. This funding did not, however, halt the flight from the won by foreign banks – nor did an additional $10 billion provided by the US and other governments over Christmas week. Only the looming threat of a bankruptcy that would disrupt the global financial system compelled Washington to pressure 163

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bankers to roll over their loans to Korea, which caused the haemorrhaging of money to stop.54 On 29 January 1998, a consortium of 13 international banks agreed not to take any more money out of the country and to restructure $24 billion of the short-term debt scheduled to be paid in 1998: they would swap these shortterm loans for new debt that would not be payable for one to three years.55 In his account of those tense days, Washington Post reporter Paul Blustein remarked: ‘In a sense, the international banks got away with murder. They had foolishly injected billions of dollars of short-term loans into a country with a shaky financial system, yet they were suffering no losses.’56 Indeed, as the key architect of the bailout, then Secretary of the Treasury Robert Rubin admitted, not only that the banks emerged unscathed – they ‘were paid back in full and ended up receiving a higher rate of interest in the interim’.57 After the fall In both Mexico and East Asia, creditors and speculative investors got off pretty lightly thanks to rescue packages put together by the IMF. Yet the price was high for the people in these countries. In exchange for rescue funds, governments were forced to adopt IMF policies that emphasized stabilization, which included cutting government expenditures and raising interest rates. Instead of playing a countercyclical role to offset the collapsing private sector, government policy speeded up the contraction of the economy. In 1998, the economies affected by the crisis plunged into recession or registered zero growth. Joseph Stiglitz, former Chief Economist of the World Bank, noted: ‘[A]usterity, the Fund’s leader said, would restore confidence in the Thai economy … [E]ven as evidence of policy failure mounted, the Fund barely blinked, delivering the same medicine to each ailing nation that showed up on its doorstep.’58 But as over 1 million people in Thailand and 22 million in Indonesia sank beneath the poverty line in just a few weeks, 164

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not even the IMF could deny the devastating results of its policy. Indeed, the IMF (in a mid-1999 paper) issued what amounted to an admission of guilt, stating that, in the East Asian countries it advised during the crisis, ‘the thrust of fiscal policy … turned out to be substantially different … because the original assumptions for economic growth, capital flows, and exchange rates … were proved drastically wrong’.59 But the price paid by the affected countries was not just their people’s suffering. They were forced to yield large tracts of their sovereign authority over their own economies. As the late Asia expert Chalmers Johnson argued, a good case can be made that Washington’s opportunistic behaviour during the Asian financial crisis reflected the fact that ‘having defeated the fascists and the communists, the United States now sought to defeat its last remaining rivals for global dominance: the nations of East Asia that had used the conditions of the Cold War to enrich themselves’.60 The IMF’s confession vindicated Malaysia’s policy during the crisis. Prime Minister Mahathir bin Mohamad, as is well known, blamed foreign speculators for the crisis, singling out George Soros, and took precisely those steps that the IMF and Western experts had warned against: imposing capital controls and currency controls, including fixing the exchange rate. Mahathir also refused the assistance of the IMF, convinced that the infamous conditionalities of the Fund would provoke a recession and erode national economic sovereignty. As its neighbours saw their currencies abused by speculators and their economies plunging into recession, Malaysia saw its economy recover earlier and more vigorously. Capital controls had a stronger association with a smaller drop in GDP growth, industrial output and real wages than IMF programmes in the other crisis-hit countries, noted Thomas Pepinsky.61 He also observed that, ‘by facilitating macroeconomic expansion and eliminating stock and currency speculation, capital controls appear to 165

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have given Malaysian policymakers the breathing room to engineer economic recovery’.62 The situation could not have been more different in neighbouring Thailand. There, local authorities agreed to remove all limitations on foreign ownership of Thai financial firms, accelerate the privatization of state enterprises, and revise bankruptcy laws along lines demanded by foreign creditors. As then US Trade Representative Charlene Barshefsky told Congress, the Thai government’s ‘commitments to restructure public enterprises and accelerate privatization of certain key sectors – including energy, transportation, utilities, and communications – which will enhance market-driven competition and deregulation – [are expected] to create new business opportunities for US firms’.63 Likewise, in Indonesia, Barshefsky emphasized that: the IMF’s conditions for granting a massive stabilization package addressed practices that have long been the subject of this [Clinton] Administration’s bilateral trade policy … Most notable in this respect is the commitment by Indonesia to eliminate the tax, tariff, and credit privileges provided to the national car project. Additionally, the IMF program seeks broad reform of Indonesian trade and investment policy, like the aircraft project, monopolies and domestic trade restrictive practices, that stifle competition by limiting access for foreign goods and services.64

The national car project and the plan to set up a passenger jet aircraft industry had elicited the strong disapproval of Detroit and Boeing respectively. In the case of Korea, the US Treasury and the IMF did not conceal their close working relationship, and the Fund clearly played a subordinate role. Not surprisingly, the concessions made 166

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by the Koreans – including raising the limit on foreign ownership of corporate stocks to 55 per cent, permitting the establishment of foreign financial institutions, fully liberalizing the financial and capital market, abolishing a restrictive classification system for automobile imports, and agreeing to end government-directed lending for industrial policy goals – coincided closely with Washington’s push to liberalize Korea before the crisis. As Barshefsky candidly told members of Congress: Policy-driven, rather than market-driven, economic activity meant that US industry encountered many specific structural barriers to trade, investment, and competition in Korea. For example, Korea maintained restrictions on foreign ownership and operations, and had a list of market access impediments … The Korea stabilization package, negotiated with the IMF in December 1997, should help open and expand competition in Korea by creating a more market-driven economy … [I] f it continues on the path to reform there will be important benefits not only for Korea but also the United States.65

Summing up Washington’s strategic goal, Jeff Garten, Undersecretary of Commerce during President Bill Clinton’s first term, said: ‘Most of these countries are going through a dark and deep tunnel … But on the other end there is going to be a significantly different Asia in which American firms have achieved a much deeper market penetration, much greater access.’66 Liberalizing Asia: the record The IMF and Western political and economic interests took advantage of the crisis to impose what they described as ‘international best practices’ in the governance of banks and corporations in crisis-hit countries. The aim was to break up what were branded 167

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as ‘crony capitalist coalitions’ and open up the economy to greater foreign investor presence. At first glance, this push appears to have achieved notable success, but, as Andrew Walter points out, what government and business interests evolved was a strategy of ‘mock compliance’. Mock compliance was formal compliance with the demands of external forces through the passing of new laws reforming the banking system and establishing the independence of regulators, coupled with informal resistance to, or non-compliance with, these formal strictures by entrenched private-sector interests. Explaining why Indonesia registered full compliance with only two out of the 25 Basel Core Principles forged by the neoliberal global banking establishment, Walter writes: It is clear that ratification failure has not been the main obstacle to substantive compliance in Indonesia. Although there were delays in legislation and implementation … most of the formal regulatory framework was in place by the end of 1999. Given this, private sector opposition to compliance shifted to less visible forms. It is difficult to judge the relative importance of regulatory forbearance, administrative failure, and private sector compliance avoidance in substantive compliance failures, because all three are often interrelated in the Indonesian case.67

In Thailand, the post-crisis hegemony of neoliberalism was even more short-lived. In 2001, the pro-IMF governing coalition was ousted with the election of a parliamentary contingent dominated by the Thai Rak Thai Party (TRT) led by Thaksin Shinawatra. Thaksin promptly paid off Thailand’s debt to the Fund and declared Thailand’s ‘independence’ from the institution. After three stagnant years under governments faithfully complying with the IMF’s neoliberal prescriptions, Thaksin implemented 168

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countercyclical, demand-stimulating neo-Keynesian policies to get the economy back on track. The Thai government provided lowinterest loans, instituted government-financed universal healthcare, and gave each village 1 million baht ($40,000) to spend on a special project. Despite dire predictions from neoliberal economists, these measures contributed to propelling the economy onto a moderate growth path.68 As for financial and corporate reforms that had been initiated in the aftermath of the crisis, these fell by the wayside, with the government spending little energy in supporting them. Indeed, upon taking power, says Allen Hicken: Thaksin immediately put the brakes on privatization and liberalization. When the privatization effort was finally revived in 2003, shares were generally offered only to domestic stockholders, and where foreign investors were involved, their shares did not carry voting rights. In the area of telecommunications, the setting up of an independent regulatory agency, mandated by law, slowed to a crawl. At the same time, the government worked to keep the sector closed to foreign participation – all to the benefit of Thaksin’s companies.69

Ironically, it was Thaksin’s reversal of this telecommunications policy to allow the Singapore government-owned Temasek substantial shares in the Thaksin family-owned Shin Corporation (a sale that benefited the Thaksin family to the tune of $2 billion in tax-free profits) that was the undoing of the government, leading to a military coup in September 2006. Governments throughout Southeast Asia, for the most part, saw IMF reforms as a means by which Western interests were prying open their economies under the guise of ending ‘crony capitalism’. While they felt compelled to make some concessions because 169

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they had accepted IMF rescue funds, they wanted to yield as little ground as possible, substituting mock compliance for substantive compliance. What they focused on instead were measures to protect their economies from the Western financial speculators that had targeted their currencies and had brought on the crisis. Never again would they allow this to happen. It is therefore not surprising that all countries geared up their export sectors to earn dollars that could then be stowed away as foreign reserves that could be deployed for future battles against speculators. Reserve accumulation was a form of ‘self-insurance’ against future crises by countries that had been taught the bitter lesson of relying on the IMF when facing capital account and current account crises. From less than $1 trillion before the Asian financial crisis, East Asian countries had accumulated over $4 trillion by 2008.70 Countries in the region also sought to create regional arrangements that would substitute for reliance on the IMF. In September 1997, at the height of the crisis, Eisuke Sakakibara, then vice minister of Japan’s Ministry of Finance, proposed the creation of an Asian Monetary Fund (AMF), the bulk of whose funding would come from Japan. This was vetoed by the US and China – the former because it feared the emergence of a rival to the IMF, which it dominated, and the latter because it might lead to the creation of a ‘yen bloc’ that would enhance Tokyo’s geopolitical and geoeconomic position. Indeed, the AMF initiative did seem to be one that sought to advance Tokyo’s desire to accelerate the region’s recovery as well as to speed up its integration under Japanese auspices in order to pull Japan out of its stagnation. More successful was the strategy of forging a network of bilateral agreements that would promote the sharing of reserves among countries if any of them came under attack by currency speculators. This was the ASEAN Plus Three network, better known as the Chiang Mai Initiative. Although the bilateral swap amounts agreed 170

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were not that substantial, the Chiang Mai Initiative was nevertheless of great significance for the different regional actors, according to Asia specialist Jennifer Amyx: For a few actors in the region, such as Indonesia and the Philippines, this project represents, foremost, a borrowing facility, allowing these countries to potentially draw on more foreign exchange reserves than each alone possesses. For the ‘plus three’, which have abundant foreign exchange reserves, it, foremost, provides an opportunity to build political capital with Southeast Asia, as well as some leverage for pressuring international financial institutions such as the IMF to address more seriously their underrepresentation of Asia. For other ASEAN economies, such as Singapore, Thailand, and Malaysia, this project is most useful for the opportunities that its accompanying policy dialogue process provides to exert peer pressure on China. It also offers insights into developments in China at a time when changes in the Chinese financial system and foreign exchange regime could have huge effects on the operations of its neighbours.71

Among all the East Asian economies, Korea was probably the most transformed by the neoliberal push by external powers. While the chaebol and the banks did put up strong resistance and were able to slow down some reforms, for the most part the neoliberal push was successful. Perhaps the most salient indicators are in the financial system. About a decade after the crisis, foreign investors now have majority stakes in six out of seven nationwide commercial banks, gaining control of three. Some 33 per cent to 50 per cent of bank assets in the country are accounted for by the foreign-controlled banks. Liberalization of the capital market has led to the share of equity-market capitalization by foreigners reaching 43.3 per cent.72 171

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Foreign institutional investors have also built up considerable stakes in the bulk of listed Korean blue-chip companies, although they do not yet control them.73 Perhaps the most reliable assessment of the state of liberalization of the Korean economy is provided by Jungryn Mo, who argues that foreign capital has flowed in even as ‘Korean banks and companies have failed to reach transparency and accountability standards comparable to those of their competitors in advanced economies’ and ‘the movement of the financial system toward a market-based system has been progressing … at an uneven pace’.74 Indeed, one can even say that, in some instances, the government has been more lenient with foreign-owned institutions than with domestic ones. In one notorious instance, this almost led to another financial disaster: while the government pressured domestic banks to offset their debts with foreign currency-denominated assets so as to square their foreign-exchange positions, it did not require foreign banks to do the same. As a consequence, the shortterm debts of foreign banks piled up very rapidly, exceeding those of domestic banks by 2006. When the 2008 financial crisis hit, the Korean won depreciated by almost 30 per cent, leading to a situation where the ratio of international reserves to short-term debt fell rapidly from 200 per cent in 2006 to 126.4 per cent in the third quarter of 2008. What saved Korea from plunging into its second financial crisis in ten years was a $30 billion currency swap approved by the US Federal Reserve Board in October 2008.75 The roots of the near disaster, according to Yasunobu Okabe, lay in the postAsian financial crisis policy of the Korean government, which was ‘highly permissive to the entry of foreign capital’, leading to ‘highly optimistic’ government expectations that ‘were disappointed by the large capital flight by foreign banks’.76 Why was post-Asian financial crisis liberalization so successful in Korea but so limited in its impact elsewhere in East Asia? Part 172

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of the answer lies in the strong support from the population that the crisis-era reform government of Kim Dae-jung enjoyed owing to the widespread perception that reckless borrowing from international lenders by the chaebol or conglomerates created the crisis. But another part of the answer lies in geopolitics. The Korean economy could not be allowed to go under by the US, which saw Korea as its front-line military protectorate. Thus, the US government was directly involved in the rescue programme, not leaving this one to the IMF to manage alone. As noted earlier, it was pressure from the US Treasury Department that got international banks to roll over their loans to Korea at a crucial juncture in the crisis. The quid pro quo was firm government action to carry out the neoliberal reorganization of labour, the disciplining of the chaebol, and the opening up of the financial sector to US and other foreign firms. Despite labour protests and resistance from the chaebol and the banks, the Kim Dae-jung government and its successors fulfilled their part of the deal. At the end of one decade of reform, the vaunted Korean developmental state had been replaced by a neoliberal state. No longer was Korea the most difficult place in which to do business, as US firms were wont to complain before the Asian financial crisis. ‘Asia’s revenge’ The US gaining the upper hand in its effort to open up Korea and Asia was not the end of the story. As noted earlier, to protect themselves from further attacks from Western speculators, the economies of the region engaged in an export drive that netted them billions of dollars – a great part of which was cornered by the region’s central banks. As noted earlier, East Asian reserves – excluding Japan’s – went from less than $100 billion in 2000 to more than $4 trillion in 2007. The central banks did not, however, keep all of these reserves in a state of hibernation – after all, banks must use money to make money. A large part was recycled back 173

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to developed economies through the purchase of assets such US Treasury bills. Much of this was then re-lent to private financial institutions that used it to create credit that financed US consumer spending, particularly in housing. While Asian money did not create the global financial crisis, it was, unwittingly, a contributing factor. While the US and European financial systems were savaged by the crisis, Asia’s financial institutions escaped, virtually unscathed. Such was ‘Asia’s revenge’. China: the third phase of

the global financial crisis? Despite its integration into the global capitalist economy, China was spared by the Asian financial crisis of 1997–98 and avoided being drawn into the global financial crisis of 2008. But ever since the Shanghai stock market cratered in the summer of 2015, the big question being asked by some is: is it China’s turn next? China escaped the 1997–98 Asian financial crisis because it had not liberalized its financial sector. Despite advice from Western economists to accelerate the sector’s opening up, China had prevented its currency, the renminbi or yuan, from being convertible, maintained strong controls on capital flows, had a rudimentary stock market, and had very little foreign debt. It had just begun the process of setting up diverse state banks, and their role amounted to little more than providing funds to state-owned enterprises, with little concern about the profitability of these loans. While laws for direct investment were liberalized to encourage foreign firms to relocate to China to take advantage of cheap labour, the opening up of the financial sector lagged behind, ‘mired in the ways of the old planned economy and awash in bad debts’.77 The banking system, writes James Stent, ‘still operated as a fiscal agent of government, as a bursar for the disbursement of government funds’.78 174

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Conflicting lessons from the Asian financial crisis While it was not caught up in the crisis, China performed a significant service to the regional economy by not devaluing its currency, keeping it at 8.28 yuan to the dollar. Engaging in competitive devaluation with the stricken economies would have worsened the regional situation and prolonged the recession and stagnation that hit its neighbours. With its huge trade surplus, China could afford to essentially do nothing and wait out the crisis. But the Chinese absorbed the hard lesson taught to its neighbours about the volatility of international capital. As China specialist Barry Naughton writes: China learned the same broad lessons about more prudent international policy that the most directly affected crisis countries learned: keep the currency low enough to maintain consistent export surpluses, build up foreign exchange reserves, avoid reliance of short-term bank loans, and above all, never allow yourself to become dependent on the IMF for macroeconomic insurance.79

But, paradoxically, the Asian financial crisis also provided the trigger for China’s financial sector to become liberalized, modernized, and truly capitalist. As Edward Steinfeld writes, while the key lesson that many developing countries took from the crisis was the danger posed by global finance, China’s reforming leaders, including Prime Minister Zhu Rongji, saw the crisis as providing the justification for accelerating the process of transforming the country’s banking system into a fully capitalist one. The reason for this, says Steinfeld, was the realization that there were deep similarities between China and its collapsing neighbours: they had ‘economies dominated by politically connected industrial behemoths, bank-dominated and heavily state-influenced financial systems devoted to funding such behemoths, and high levels of household savings providing much 175

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of the liquidity’.80 Suddenly, terms such as moral hazard, nonperforming assets, and unfunded liabilities appeared ‘to apply just as equally, in the minds of the Chinese, to China itself. In essence, it was not capitalism that suddenly fell into doubt, something the Chinese could have treated as a foreign problem, but rather, the East Asian developmental model, something that the Chinese unmistakably identified their own country as being part of.’81 In short, the Chinese absorbed what they thought to be the principal lessons of two conflicting paradigms: uncontrolled speculation by foreign capital may have triggered the crisis, but a deeper cause was ‘crony capitalism’. Reformers liberalize finance Over the next few years – from the late 1990s into the early 2000s – bringing the financial sector up to date became one of the reformers’ priorities. The aim was, as Zhou Xiaochuan, governor of the People’s Bank, put it, the creation of ‘comprehensive, enterprise-like, commercial banks without direct administrative controls’.82 This involved cleaning up the massive amount of non-performing loans that had resulted from the nearly unconditional lending to state enterprises in the previous period. Making the balance sheets of the state banks healthy was essential to Zhu Rongji’s goal of having the banks listed on the Hong Kong stock exchange, where underwriting handled by the major Western investment banks would force the state banks to bring their corporate governance and accounting systems up to global standards, ‘passing muster with international auditors and the scrutiny of foreign securities exchange examiners’.83 Also central to this process of modernization was the professionalization of bank staff via the recruitment of Chinese citizens trained in financial management in Western universities. Western banking, however, took a big hit when the global financial crisis erupted in 2007–08. By that time, China’s financial 176

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upgrading was in motion, but it had been carried out with caution. Although flotations on the Hong Kong stock market resulted in some foreign banks gaining minority ownership in the China Construction Bank, Bank of China and Industrial and Commercial Bank, Chinese banks had very little exposure to toxic securities such as the subprime securities hawked by Wall Street that had led to the impairment of bank balance sheets in the US and Europe. The crisis, however, had the effect of slowing down, if not stopping, further measures that reformers, Western advisers and Western banks had pushed – in particular, privatization of the state banks, interest-rate liberalization and widening access to credit for private enterprises. Liberalizers versus the export lobby It is important to underline that the crisis brought to the fore conflicts that had been developing among leaders of the Communist Party and the Chinese state. There were broadly two wings that increasingly were at loggerheads. One was the liberalizers, committed to transforming the economy into a fully fledged capitalist economy marked by a stronger role for market forces, which they believed would promote a more efficient allocation of resources. The other was the set of interests that had developed and coalesced around the export-oriented strategy that had made China the ‘world’s manufacturer’. Over time, the export lobby had become a powerful force, and its main argument in debates at leadership level was that China’s very success as an export superpower meant that economic policy should not harm the interests and policies that had been responsible for this. The lobby included government planning bodies such as the National Development Reform Commission and the Ministry of Finance, both of which had generated the strategy of export-led industrialization; export-oriented state and private enterprises; local government and Communist Party bodies 177

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in the coastal provinces; and state-owned construction firms whose infrastructure projects underpinned the export-led strategy. This is not to say that the liberalizers and the export-led lobby did not share some interests and points of view. Both favoured China’s cheap labour policy. Both supported the break-up of the Mao era institutions of job security, including the withdrawal of state subsidies for loss-making state enterprises that had not adapted to the export-led strategy. Financial policy was, however, another matter. Here the battle lines were drawn. Reformers wanted a more rapid reform of the financial system, pushing for liberalizing the low interest rates on deposits that had subsidized the export lobby as well as ending the virtual monopoly on bank loans enjoyed by the latter. Not only would the allocation of resources be more efficient, they argued, but millions of long-exploited savers would benefit, as would private businesses that had no access to credit from the state banks. The export lobby, however, was able to slow down reforms, and they were helped in no small measure by the conflict between the liberalizers at the People’s Bank of China and anti-reformists ensconced in the big state banks. As Eswar Prasad points out: ‘The big banks, in tandem with the large state-owned enterprises and provincial governments that they bankroll, have been fierce and powerful opponents of reforms. The system, as it is structured, works well for these groups, which hardly makes them eager for greater liberalization.’84 The leadership of President Hu Jintao and Premier Wen Jiabao that took over in 2002 tended to accommodate the export lobby, but, at the same time, it was worried that China’s economy had become too dependent on exports. It was also sensitive to criticisms that the export lobby was cornering most of the nation’s real and financial resources, leading to greater inequality in the country and serving as kindling for social protest, to which the Communist Party was extremely sensitive. 178

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The export lobby hijacks the stimulus When the Chinese growth rate began to dip as a consequence of the global financial crisis, the Hu–Wen leadership rolled out a $585 billion stimulus programme, which, in relation to the size of the economy, was bigger than the concurrent $787 billion stimulus that the Obama administration injected into the US economy. Its aim was not only to serve as a countercyclical instrument to reverse economic contraction. It was also meant to trigger a macroeconomic reorientation of the Chinese economy from export-led to domestic-led growth by increasing the purchasing power of consumers. Western analysts including Barry Naughton have credited the stimulus programme with saving China from spinning into recession while at the same time faulting it for essentially putting an end to the big push towards economic liberalization that was championed by Zhu Rongji at the turn of the twenty-first century. Their argument is that the stimulus involved a lapse into the ‘old socialist ways’, where funds were indiscriminately funnelled by the banks to the big state enterprises and local governments in order to have an immediate impact, resulting in inefficient, wasteful spending. This revived the spectre of non-performing loans for the big Chinese state banks that the reforms of Zhu Rongji had banished, and brought back the worst features of state management. These analysts are correct that the focus on rolling out the stimulus froze liberalization initiatives. But what transpired was not a retreat to socialism in the sense of prioritizing the interests of those groups that had been left behind by China’s export-led growth. Alongside workers and peasants, these disadvantaged sectors included the small and medium-sized entrepreneurs serving local markets and the general population in their roles as savers and consumers – in short, as economist Hongying Wang put it, all those who have ‘suffered from the financial and public finance systems that have deprived them of their fair share of the national wealth’.85 179

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Since they controlled the channels through which trillions of renminbi could be quickly deployed – the big state banks, local governments, and big state and private enterprises – the export lobby didn’t just neutralize the plan to make domestic consumption the cutting edge of the economy. It was also able to hijack the massive stimulus programme that had been intended to place money and resources in the hands of consumers. According to statistics Wang cites from Caijing Magazine, some 70 per cent of the stimulus funds went to infrastructure, while only 8 per cent went to social welfare expenditure such as affordable housing, healthcare and education.86 Financial repression and the real-estate bubble Major reforms fell by the wayside, including two that would have had a significant impact on income distribution and would have altered the composition of winners and losers: an end to the policy of ‘financial repression’, or keeping the interest rate on savings low in order to subsidize the export lobby; and providing greater access to bank loans to private and state enterprises that had been deprived of them thanks to the monopoly on credit enjoyed by the privileged export lobby. Indeed, the persistence of the old policies created new sources of instability for the financial system. China has had a high level of national savings, with the national savings rate accounting for 53 per cent of GDP in 2007–08, up from 38.1 per cent in 1998–2002. Household savings accounted for 22.9 per cent of GDP in 2007–08, up from 18.5 per cent in 1998–2002. What the policy of financial repression meant was that increasing numbers of Chinese, particularly among the newly emerging middle class, became dissatisfied with the meagre benefits they derived from depositing their money in bank accounts with low state-determined interest rates. Investing in real estate became an attractive alternative. According to economist Nicholas Lardy, data indicate that the pronounced growth in real-estate investment did 180

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not stem from a rising rate of home ownership or from accelerated urbanization, but from real estate becoming a preferred type of asset. The key reason for this was a dramatic decline in real returns on bank deposits, with the average return on one-year deposits becoming negative after 2003. In contrast, returns on newly built residential property rose in real terms from 2.3 per cent in 1998– 2003 to 4.6 per cent per annum in 2004–10.87 Thus, with little money to be earned from bank deposits, a great number of the Chinese public gravitated towards the real-estate and property markets. This move was encouraged by the authorities, who were worried about the public’s discontent with the lack of profitable outlets for their savings. This encouragement included easing lending requirements at state banks to allow people to invest not only their savings but also borrowed cash. Speculation in property was the investment of choice for many years, with over 18 per cent of all households in Beijing, for instance, owning two or more properties.88 But as in the US during the subprime property bubble, the market attracted too many investors, leading to a speculative frenzy that saw real-estate trends see-saw crazily as fears spread that the bubble was about to burst. Still, prices in major cities continued to rise, hitting a peak in early 2017, when worried authorities began to take measures to prick the bubble: for example, the Beijing Municipal Commission of Housing and Urban–Rural Development raised minimum down-payments from 50 per cent to 60 per cent.89 Indeed, about 60 Chinese cities have enacted more than 150 restrictive policies on home purchases and prices since March 2017. These measures targeted lower-tier cities that had become popular destinations for speculators who were no longer eligible to buy homes in overinvested tier 1 and tier 2 cities and were eyeing new areas.90 Authorities faced a dilemma. On the one hand, workers complained that the bubble had placed owning and renting 181

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apartments beyond their reach, thus fuelling social instability. On the other hand, the economy had become hooked to the property boom: a sharp drop in prices could pull down the rest of the economy, and, with China’s increasingly central role in the global economy as a source of growing demand, take the rest of the global economy along with it as well. According to an authoritative source, since it accounts for 20 per cent of national demand: The real estate sector is at the heart of the problem because of its wide-ranging and complex interconnections with other sectors. Any slowdown in the real estate sector would adversely affect construction-related industries along its entire supply chain, including steel, cement, and other construction materials. The quality of the loans extended to those related industries will also be affected, leading to higher NPLs. Shocks to the real estate sector could have an even wider impact on banks’ asset quality. Chinese households have more than 40 per cent of their total wealth in the form of housing. Lower property prices impose a negative wealth effect on households and will reduce consumption demand. This will feed back into lower corporate sales and profits, and ultimately, slower GDP growth. Weaker corporate profits and negative household wealth effects will reduce debt-servicing capacity.91

Currently, Chinese authorities are careful to deny that the dynamics of the real-estate sector mean that a bubble similar to the one that developed in the US in the 2000s and Japan in the 1980s has come into being. But one of Japan’s foremost authorities on the Chinese economy says that real-estate prices have run out of control. If you take three indicators and compare them to the US and Japanese indicators during their bubble periods, you have to 182

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conclude China is in a bubble. These indicators are housing prices in relation to the average consumer’s income, the rate of growth of the economy in relation to the growth rate of loans to real estate, and the rate of real estate loans in relation to the growth rate of total loans. The ratios are as high as those of the US and Japan. The biggest threat to China is asset price inflation.92

From the real-estate bubble to the stock-market bubble Uncertainties in real-estate investment, which the government has tried hard to control for over a decade in an attempt to prevent the emergence of a bubble like the subprime one seen in the US, has pushed many middle-class investors seeking higher returns to the country’s fledgling stock market. The result has been a see-saw between real estate and stocks as the preferred investment asset, reflecting shifts in investor sentiment. The stock market has been the more volatile of the two. A good account of this volatility is provided by Nicholas Lardy: A massive run-up in prices pushed the Shanghai Stock Market A-share market index to a peak of 6,251.5 in October 2007. Subsequently, even before the onset of the global financial and economic crisis, the market [was] sold off, with the index falling by more than half by mid-year 2008. The market then plunged further, with the index hitting a low of about 1,800 at the time of the Lehman collapse in the fall of 2008. Despite China’s relatively strong economic growth during the global economic crisis and a particularly rapid recovery in corporate profits in 2010, by end-June 2011 the A-market share index stood at only 2,800, less than half its peak level in October 2007. Most Chinese households, having been burned by the stock market, have limited their equity investments.93

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But apparently Chinese households have short memories. Frenzy again gripped the stock market in 2014. With China’s stock-market value going above $10 trillion and the Shanghai index rocketing upward by 150 per cent between mid-2014 and mid-2015, the market seemed both a safe and highly rewarding bet. Hundreds of thousands of small investors rushed into the casino, many betting with money borrowed from Chinese state banks. When the Shanghai index reached its highest point in mid-June, a Bloomberg analyst observed that the previous year’s gain alone was ‘more than the $5 trillion size of Japan’s entire stock market. No other stock market has grown as much in dollar terms over a 12-month period.’94 A steep, 40 per cent plunge in the Shanghai index followed. Hundreds of thousands of Chinese investors posted huge losses and are now in debt. Many lost all their savings – a significant personal tragedy in a country with a poorly developed social security system. As early as 2001, Wu Jinglian, known as the country’s leading academic reform economist, had characterized the corruption-ridden Shanghai stock exchange as a ‘casino’, where investors would inevitably lose money over the long run.95 Subsequent events proved him right: Shanghai was every bit as much a casino as Macau. The rise of shadow banking The low bank deposit interest rates that favoured the export lobby were one source of financial instability. The virtual monopoly of access to credit by export-oriented industries, state-owned enterprises and the favoured coastal regions produced a second threat: the emergence of a shadow banking sector. A shadow banking sector is perhaps best defined as a network of financial intermediaries whose activities and products are outside the normal, government-regulated banking system. Shadow banking has come 184

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to refer to a variety of financial instruments, ranging from relatively common financial products such as money market mutual funds, asset-backed securities and real-estate investment trusts to more complex products such as hedge funds, structured finance vehicles and leveraged derivative products associated with financial engineering, which are usually funded by investment banks and large institutional investors.96 Many of the transactions involving the products of shadow banking are not reflected on the regular balance sheets of financial institutions, so that these project an inaccurate picture of their condition. When liquidity crises take place, however, the fiction of the investment vehicles’ independence is ripped apart by market actors who factor these off-balance-sheet transactions into their assessment of the financial health of the mother institution. The shadow banking system’s emergence in China came about ‘to circumvent tight bank lending quotas and interest rate regulations to meet a real sector (especially SMEs [small and medium-sized enterprises]) need for access to credit, and a concurrent demand for higher yielding saving/investment products by China’s household and corporate savers’.97 Since the formal banking system was skewed towards short-term lending, the emergence of the shadow banking system responded to enterprises’ need for longer-term credit, especially for projects that took a long time to mature. Unable to change the formal banking practices owing to the resistance of the export lobby, reformers at China’s Central Bank did not discourage this ‘financial innovation and development’.98 By the end of 2013, according to one of the more authoritative studies, the scale of shadow banking risk assets totalled 32.2 trillion renminbi, or 53 per cent of GDP.99 The global average, in contrast, was 120 per cent of GDP, leading to the assessment of some experts that the Chinese shadow banking system was still some distance from a Lehman scenario. 185

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There were, however, some characteristics of the Chinese situation that caused concern. First, many shadow banking creditors had raised their capital by borrowing from the formal banking sector. Should a shadow banking crisis ensue, it was estimated that up to 50 per cent of the NPLs of the shadow banking sector could be ‘transferred’ to the formal banking sector, thus bringing it down too.100 As one worried assessment put it: In the shadow banking system, where regulatory oversight is less intensive, there is insufficient official data on the status of NPLs, provisioning, and CAR [capital adequacy ratio], but they are likely to be worse off than those of the banks. Shadow banks borrow mostly from the banking system, with a relatively small amount of self-financing. If shadow banks went into financial difficulties, their NPLs could spread to the banking system, impairing its asset quality. This means that the NPLs of the whole banking system could be higher than the 1 per cent disclosed in the banks’ books, but a more realistic estimate would have to examine the potential credit losses in the shadow banking sector.101

Second was the link between the shadow banking sector and the real-estate sector. Over 30 per cent of the total new issuance of combined unit trust products in 2010 and 2011, and 10 per cent of existing trust products at the end of 2013, were accounted for by the real-estate sector. Moreover, a large proportion of the loans extended to borrowers had property as collateral.102 Thus, a sharp drop in property valuations would immediately have a negative impact on the shadow banking sector in the form of a proliferation of NPLs. Is China, in fact, still distant from a Lehman-style crisis? Interestingly, the authoritative study by Sheng and Soon provides worrisome statistics but concludes that ‘China’s shadow banking 186

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problem is still manageable, but time is of the essence and a comprehensive policy package is urgently needed to preempt any escalation of shadow banking NPLs, which could have contagion effects’.103 As a number of authorities have pointed out, it is the negative synergy between real-estate inflation, shadow banking loans to real estate, and formal banks’ loans to shadow banks that poses the greatest danger to the Chinese economy. In terms of its global impact, some claim that a shadow banking crisis in China ‘has no direct systemic implications, since China is a net lender to the world and very few foreigners hold Chinese shadow banking assets’.104 Still, they admit, it could have negative contagion effects on foreign holdings of China’s bonds and securities, forcing their sell-off, with the added destabilizing effects on China’s financial system.105 Not mentioned is the fact that a financial crisis would inevitably have an impact on the real economy, forcing lower growth, if not a global recession of the order of the one that began in 2008–09. With China’s centrality in global trade, this decline would have a massive impact on an already stagnant global economy. Conclusion China’s cautious financial liberalization shielded it from the Asian financial crisis. The minimal exposure of its banks to toxic assets, such as subprime-mortgage-based securities, saved its financial system from the crisis that savaged the US and European financial systems. The $585 billion stimulus that the Chinese leadership set in motion in response to the global recession that came on the heels of the financial crisis prevented the country’s growth rate from declining significantly. However, its strategic aim of redistributing income and transforming the growth strategy from an export-led to a domestic demand-led process failed, as the 187

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powerful export lobby hijacked the bulk of the stimulus funds. This coalition was also able to prevent liberalization of the interest rate on savings deposits and an end to its monopoly on credit from the big state banks. This contributed to people putting their savings into real estate and the stock market, creating speculative bubbles in both. It also created a shadow banking sector whose assets grew rapidly in relation to GDP. Today, the negative synergy between real-estate loans, the expansion of the shadow banking system, and the dependence of the shadow banking system on loans from state banks is creating or has already created a speculative bubble that threatens not only the Chinese economy but the global economy as well. The Chinese bubble could be the third phase of the global financial crisis.

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From Japanese bubble to Chinese time bomb Interview with Walden Bello,

Transnational Institute, 16 October 2017

Asia’s financial crisis came a decade before the global crisis, but it has had a lasting influence and left a legacy that could sow the seeds for the next global crisis. How did the Asian financial crisis in 1997–98 differ from the one that broke in the US and Europe in 2008? The Asian financial crisis in 1997–98 was similar to the 2008 global financial crisis in that it was also the product of speculative bubbles in real estate and the stock market created by the search for high profits by finance capital. The difference was the role of currency speculators and hedge fund operators in hastening the bursting of the bubble and the collapse of the real economy; these actors played a negligible role in the 2008 crisis. These speculators, led by George Soros’s Quantum Fund, targeted the overvalued currencies of the Asian economies, particularly the Thai baht, betting on the probability that they would be devalued relative to the dollar owing to investor fears that the bubbles would burst, thus accelerating the devaluation of the currencies and making tremendous profits once the Asian currencies were devalued. Had the speculators not been active, the bubbles would still have burst and the real economy would still have entered into severe crisis, but the ‘landing’ would probably have been less rough. 189

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Where the uniqueness of the 2008–09 crisis lay was in the fatal marriage of a real-estate bubble with financial engineering. Tremendous amounts of cash flowed into real estate and were ploughed into loans, a great many of them of dubious quality because the debtors’ capacity to repay the loans was questionable – thus the term subprime loans. Financial engineering allowed mortgage originators to slice, dice and package these loans into securities that were then sold to banks and other financial institutions, which then resold them to other banks and financial institutions. When the mortgage holders could no longer service their mortgages, the quality of the loans was drastically impaired. But billions of dollars of these now toxic securities were circulating in the global financial system, upending the balance sheets of the US and foreign banks and institutions that held them and driving many, including Lehman Brothers, to bankruptcy, and others, like Citi and the German regional banks, to require a massive government rescue. What were the underlying causes of the 1997 Asian financial crisis? The underlying causes were the ‘push’ of finance capital to have a piece of the so-called Asian economic miracle and the ‘pull’ of the Asian corporate elites and governments to bring in capital to feed their investment-hungry export-oriented economies. By liberalizing their capital accounts and investment regimes, the latter triggered an inflow of foreign capital, but this went mainly to real estate and the stock market, creating speculative bubbles in these sectors. When the bubbles burst, with the help of currency speculators and hedge funds, they brought down the real economy, forcing the stricken Asian governments to resort to borrowing from the IMF and the US to pay off their debt obligations as well as those of their private sectors. In the long view, however, the Asian financial crisis was one key moment of the crisis of overproduction that has plagued the global economy since the 1970s, as investment in productive activity became 190

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less and less profitable, resulting in more and more capital being channelled to speculative activity, or making money out of money. You talk about the Japanese bubble. What was it? And how did the Japanese government’s policy response impact on both Japanese and Southeast Asian economies? The Japanese bubble economy stemmed from tremendous overinvestment in the productive sector, which reduced profitability and encouraged the banks to lend to enterprises engaged in speculative activity such as real estate. The magnitude of the bubble that resulted is indicated by the fact that, in the late 1980s, the Imperial Palace East Gardens in Tokyo had the same value as all the property in the state of California. When the bubble burst owing to a collapse in demand, many borrowers were left high and dry, leading to a vast accumulation of NPLs at the banks. Instead of pushing the banks to clean up their balance sheets, the Ministry of Finance allowed the banks to keep the loans on their books, severely affecting their continued profitability and earning the most impaired the description of ‘zombie banks’. At the same time, to lift the economy from the resulting recession, the government adopted fiscal and monetary policies that were either too timid or worked at cross-purposes, as well as neoliberal economic reform efforts that were marked by indecisiveness. The latest attempt to end over 25 years of stagnation is the so-called ‘Abenomics’, which, after nearly seven years, has failed to bring about the desired results. What was the impact of the IMF’s structural adjustment policies imposed on Asian countries that were bailed out? The IMF’s structural adjustment policies that were imposed on the crisis economies in return for rescue programme loans had very negative effects. First of all, the funds the IMF gave were used mainly to repay foreign lenders and investors, with the government merely acting as an intermediary; little was channelled to reviving the domestic 191

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economy. Second, the policies the Fund demanded – severe cutbacks in government spending, wage cuts and a weak currency – worsened the recession into which the crisis economies were plunged. The private sector was collapsing. What should have occurred was countercyclical government intervention: that is, government spending to counter the private-sector collapse. Instead, there were pro-cyclical policies such as government spending cuts, which worsened the recession. Third, the recession created immense human suffering, with some 22 million Indonesians being plunged below the poverty line, as were over 1 million Thais. How did China escape the 1997–98 Asian financial crisis? And what impact did it have on Chinese economic policy in subsequent decades? China escaped the 1997–98 Asian financial crisis owing to its barriers to the entry of speculative capital. Despite advice from Western economists to accelerate the opening up of its financial sector, China had prevented its currency from being convertible, maintained strong controls on capital flows, and had very little foreign debt. China also did the region a favour by not engaging in competitive devaluation with the stricken economies, which would have prevented them from increasing their exports to gain foreign exchange to pay off their debts and buy much-needed imports to resume economic activity. Paradoxically, however, the crisis accelerated the liberalization of the Chinese financial sector domestically, since the reformers led by Prime Minister Zhu Rongji thought that one of the key lessons of the crisis was to avoid the privileged relationships between conglomerates and the banks that funded them which led to corrupt lending practices that made the economy vulnerable to crisis. In other words, the Chinese absorbed what they thought to be the principal lessons of two conflicting paradigms: uncontrolled speculation by foreign capital may have triggered the crisis, but a deeper cause was ‘crony capitalism’. 192

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How has Asia been affected by the recent 2008 financial crisis? How did it emerge less scathed than the EU and US? The Asian economies were affected negatively mainly by the downturn in demand for their exports to Europe and the US, as the financial crisis forced these advanced capitalist economies into recession. However, there was very little exposure among Asian banks to toxic securities like those based on subprime loans, which key US and European banks carried in their balance sheets and that nearly ruined them. The Asian financial crisis ten years earlier had taught the Asian governments and banks to be very cautious in adopting the products of financial engineering in Wall Street that claimed to eliminate risk. What reforms have been adopted in Asia, particularly China, to prevent or deal with future financial crises? There were two key measures that the Asian governments took to prevent future crises. First, they forged a network of bilateral agreements that would promote the sharing of reserves among countries if any of them came under attack from currency speculators. Second, and more importantly, they engaged in intensive export drives to gain massive amounts of foreign exchange, a significant part of which was channelled into their foreign-exchange reserves. Reserve accumulation was a response to one of the bitter lessons the Asian governments learned from the Asian financial crisis: you don’t go to the IMF for help because the cure would be worse than the disease. From less than $1 trillion before the Asian financial crisis, East Asian countries had accumulated over $4 trillion by 2008. A large part of these reserves were loaned to the US government through the purchase of US Treasury bills as well as to US banks to fund consumption and speculation, and this helped inflate the US bubble that burst in 2008. What is the likelihood of a financial crisis in Asia in the near future? China is a prime candidate to be the site of the next financial crisis. 193

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Speculation in real estate and the stock market has been a favoured activity among people who feel that they are getting very little interest from their savings in the banks owing to the policy of limiting interest to depositors in order to subsidize the influential export-oriented manufacturing lobby. The Shanghai stock market lost 40 per cent of its value in 2015, bankrupting many investors. That event led many to shift to real-estate speculation, with the property sector now overheating in key Chinese cities, such as Beijing. This has also translated into a social problem since housing for workers is becoming less and less affordable. Although many local governments are said to be taking measures to dampen housing prices, the speculative fever continues and prices continue to rise. Speculation in real estate and the stock market is one threat. Another big threat is posed by the rise of shadow banking, which has grown to meet a demand for credit that cannot be met by the formal banking institutions, which are tied to privileged borrowers in the export sector. By the end of 2013, the assets of the shadow banking sector came to 51 per cent of GDP. A large part of shadow banking loans was invested in the property sector, so that the bursting of the property bubble could bring down the shadow banking sector. And if the shadow banking sector were to collapse, this would likely bring down the formal banking system as well, since many of the creditors in the shadow banking sector have built up their financial resources by borrowing from the formal banking sector. Given the centrality of China in the global economy, a financial crisis there will have an impact on the global economy, although there are differing opinions on how big that impact will be. There is no doubt, however, that since China has become a major source of global demand, the recession that would follow in the footsteps of a financial crisis would drag down many economies that supply raw materials and other inputs to the Chinese industrial machine.

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5 Reforming the global financial architecture Opportunities lost, 2008–18

Ten years after the onset of the global financial crisis in 2008, a massive, worldwide sell-off of stocks during a few days of wild trading in February 2018 resulted in an estimated paper loss of around $4 trillion. While the general public may not have understood why stocks were plunging when the US economy was reported to be in good shape, veteran Wall Street watchers were not surprised. For fund managers, some argued, economic growth meant that the Federal Reserve would now raise the federal funds rate that had been kept low for over ten years in an effort to resuscitate the economy. This would mean higher interest rates for borrowers, ending the period of easy money that had mainly been loaned not for productive investment, but for speculative activity. In other words, the events of February 2018 were essentially Wall Street telling the Federal Reserve: ‘Don’t raise interest rates – we want to keep using the cheap money you create to make more money.’ What seemed irrational to the country was very rational for Wall Street – and this episode reinforced the widespread feeling that Wall Street had become an even more uncontrolled threat to the interests of the majority of citizens. What was clear was that, ten years after the start of the financial crisis, speculators were as unrestrained as ever. An opportunity to bring finance capital under control so as to prevent the recurrence of increasingly destructive crises had been lost. A detailed examination of the efforts to regulate the financial products that played a big role in the crisis, reform the practices and institutions 197

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that brought it about, and radically improve the regulatory system that had failed to prevent it would underline one thing: little has changed since the crisis. Shadow banking The global financial crisis was caused by a toxic mix of speculative fever, a lax regulatory environment, and ideology. The neoliberal thrust in legislation that manifested itself in the repeal of the venerable Glass–Steagall Act was mirrored by the emergence of much more ‘light-touch’ regulation of the regulated banking sector, and no regulation at all of the exploding shadow market, where a frenzied atmosphere surrounded ‘over-the-counter’ trades of trillions of dollars of derivatives (a traded product whose value is derived from an underlying asset) with acronyms including MBSs, CDOs, CDSs and CDOs-cubed.1 These were euphemistically described as ‘exotic’. Perhaps the best description of the prevailing view of regulation before the 2008 crisis was provided by Ben Bernanke, the chief of the US Federal Reserve Board: The invisible hand approach to regulation aims to align the incentives of market participants with the objectives of the regulator, thereby harnessing the same powerful forces that allow markets to work so efficiently. In the financial arena … this approach often takes the form of creating incentives for market participants to monitor and control the risk-taking behaviour of financial firms – that is, to exert market discipline – thereby reducing the need for direct oversight by the government.2

With such a view prevailing among legislators and regulators, it is not surprising that regulatory restrictions requiring the reporting of over-the-counter CDSs and other swap transactions were actually 198

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abolished by the US’s Commodity Futures Modernization Act of 2000. The result was that the market in such instruments exploded, and ‘because it was an unregulated market, the volumes were not apparent to outside observers’. CDSs, one of the key derivatives that brought down the house in 2008, were ‘in fact credit insurance contracts; yet because they were called swaps and not treated as insurance, they escaped the regulatory requirements of insurance’.3 The question this chapter asks is whether the new legislation has in fact been able to create an effective regulatory net for the previously unregulated shadow market. The Dodd–Frank Act – the principal US government effort to regulate shadow banking – hardly does this. Market participants On the issue of who is permitted to trade in complex, financially engineered products such as MBSs and CDOs (products that were at the centre of the crisis), the Dodd–Frank Act requires hedge funds and private equity funds with more than $150 million in assets under management (AUM) to register as investment advisers and to disclose systemically relevant information to the Securities and Exchange Commission (SEC).4 But while making such information available is important, the Dodd–Frank Act fails to go further. When it comes to market participants, its rule making is half-hearted, being limited, to all intents and purposes, to stipulating that private equity funds and hedge funds may trade in CDOs, CDSs and CDOs-cubed (described below) with no SEC approval required, so long as they were sold to ‘professional investors’. As one critic has noted, the Dodd–Frank Act does not curtail ‘the continued ability of unsupervised or less supervised “shadow banking” actors such as hedge funds, private equity funds, structured investment vehicles (SIVs), money market funds, broker-dealers, exchange-traded funds (ETFs), finance companies, or even non-financial companies to mimic banking activities’.5 199

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Yet, the Dodd–Frank Act at least recognizes the problem posed by the shadow banking system. By contrast, the Financial Services Authority in London, as well as the Australian Securities and Investments Commission, have concluded that ‘the private fund industry poses no systemic risk to the financial system’.6 Mortgage-backed securities Focusing on the regulation of the creation, issuing and trading of financially engineered products themselves, one cannot avoid the conclusion that it is business as usual. As everyone knows, it was the so-called subprime assets or MBSs that triggered the global financial crisis – the most notorious of which were the subprime securities. Securitization was one of the key innovations of finance capital in the decades leading up to the global financial crisis. Practically non-existent before the 1970s, the idea behind securitization, according to Kathleen Engel and Patricia McCoy, ‘is ingenious: bundle a lender’s loans, transfer them to a legally remote trust, repackage the monthly loan payments into bonds rated by rating agencies, back the bonds using the underlying mortgages as collateral, and sell the bonds to investors’.7 While securitization occurred in many other markets, such as the credit card market, it was in the housing market that it was widely and most craftily deployed by lenders. Securitization enabled mortgage originators (the original lender) to sell MBSs to investors, thus getting rid of the risk associated with the underlying mortgage. Having got rid of the risk, the mortgage originators were encouraged to engage in reckless or risky lending to people who could not afford to service the loan – the so-called subprime mortgage holders – since the risk was now passed on to the investors. The regulatory legislation that followed the crisis could have been expected to enact strict controls on the issuing of MBSs and 200

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similar debt instruments. The Dodd–Frank solution, however, was far from strict. It was to ‘prophylactically prevent risky consumer bank lending’ by having the security issuer or mortgage originator retain some ‘skin in the game’, meaning that they would have to own at least 5 per cent of the MBSs. It was expected that this would deter them from packaging problematic mortgages that could spell losses should the underlying mortgages turn sour.8 There have been several criticisms of this provision. For some, the 5 per cent requirement is too low to have a deterrent effect on risky lending – there is a world of difference between the deterrent effect of 5 per cent and, say, 25 per cent. Secondly, ‘skin in the game’, as The Economist points out, ‘is unlikely to make the system much safer’. The fundamental problem that bedeviled the mortgage market before the crisis was the belief that risks were low, not that they were being dumped on other people. If banks misjudge the dangers, then a retention requirement does not help: institutions simply take on more risk, especially since the hit to capital of a 5 per cent exposure is pretty limited. Indeed, it may even exacerbate the problem if investors in securitized loans treat banks’ retained exposures as shorthand for good underwriting, just as they did those infamous AAA credit ratings on structured products.9

Derivatives and other complex financial products There are two contrasting views on derivatives. One is that of Alan Greenspan, the former head of the Federal Reserve Board, who saw them as ‘an increasingly important vehicle for unbundling risks’, which enhances ‘the ability to differentiate risk and allocate it to those investors most able and willing to take it … a process that has undoubtedly improved national productivity growth and standards’.10 201

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The other, better-known opinion is that of the famous investor Warren Buffett, who said that derivatives are: time bombs, both for the parties that deal in them and the economic system … [T]hese instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while latent, are potentially lethal.11

As everyone knows, Greenspan was flat-out wrong and Buffett was prescient. Securitization allowed the creation of the MBS – a relatively simple derivative whose value was derived from the capacity of homeowners to service their mortgage. Financial engineering by so-called ‘quants’ with maths backgrounds made possible the creation of even more complex products, or contracts whose values were several steps removed from those of the original assets and could only be determined through complex mathematical formulae. The most notorious of these products were the CDOs and CDSs. The value of both of these was ultimately based on the value of the underlying mortgages, a fact that was, for the most part, not transparent to investors. While the prices of CDOs and CDSs were ultimately determined by price movements of mortgages or other underlying assets, this was disguised by the fact that, in the short or medium term, the market for them appeared to behave autonomously from the market for the underlying asset. As one study pointed out: [T]he use of CDSs allowed the mortgage-backed securities market to expand even when mortgage originations slowed 202

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down. This is because there is no limit to the number of CDSs that can be written on an underlying portfolio of assets, so that in theory the market is limitless. The sector therefore claims the exorbitant privilege of being able to create assets out of thin air and also to circulate them within the trade, selling them to other institutions who are doing exactly the same thing.12

But the movement of the asset in one direction and the derivative in the opposite direction could only continue for so long, and when reality crashed through the complex maths, the result was disaster, as occurred in 2008 with the MBSs. Truly exotic, and meriting Buffett’s worry about the mysterious nature of derivatives, were the so-called ‘CDOs-cubed’, which one investors’ manual described in all seriousness as: identical to regular CDOs except for the assets securing the obligation. Unlike a CDO, which is backed by a pool of bonds, loans, and other credit instruments, CDO-cubeds are backed by CDO-squared tranches. CDO-cubeds allow the banks to resell the credit risk that they have taken once again by repackaging their CDO-squareds … CDO-squareds and CDO-cubeds can be repackaged countless times to create derivatives that are quite different from the original underlying debt security.

The manual added, apparently without intended irony: ‘These are also referred to as CDO^n to show the unknown depth of some of these securities.’13 The illusion of autonomy held only for as long as the underlying assets backing these exotic derivatives were not viewed as impaired. Once widespread defaults on subprime mortgages and other assets began, CDOs – and the CDSs that were essentially insurance contracts based on them – also quickly lost their value, placing the 203

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CDS sellers that had guaranteed the securities in a quandary. The most notorious case was that of the giant insurance firm American International Group (AIG), which was felled by its exposure in CDSs, or insurance contracts it wrote for investors seeking security for their investments. When the financial crisis broke out, the AIG Financial Products Division had insured $294 billion in corporate debt, $141 billion in European residential mortgages, and $78 billion in CDOs – a significant portion of which were written on subprime mortgages as underlying assets.14 When the subprime securities became toxic and the insured parties made their claims for payment, AIG could cough up only $2.1 billion in capital to pay them off, forcing Washington to rescue the corporation out of fear that its fall would bring down the whole global financial system, since so many of the counterparties were international financial institutions.15 One would therefore have expected the regulators to crack down on derivatives post-crisis. Amazingly, Dodd–Frank places few limitations on the creation of derivatives. Banks will be able to continue to create toxic derivatives such as CDOs-cubed or ‘synthetic CDSs’ that ‘continue to defy analysis by ratings agencies as well as by investors, with no required approval by the Securities and Exchange Commission or the new Consumer Financial Protection Bureau within the Federal Reserve as long as the products are sold only to professional investors’.16 In contrast, the Financial Services Authority in the UK is tasked with checking ‘whether new investment products serve a purpose, whether they are cost-efficient, and whether they are intelligibly described to the average investor’.17 Similarly, in France, the government’s securities market supervisor, the AMF (Autorité des Marchés Financiers), forbids the marketing of ‘complex financial products’ to investors.18 In any event, gutted by Wall Street lobbyists, the Dodd–Frank Act hardly meets the challenge of regulating a shadow banking industry that the Financial Stability Board (FSB) estimates to be 204

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worth $60 trillion to $70 trillion and other sources place at over $100 trillion – a sum almost equal to the total assets of the world’s 1,000 largest banks.19 Leverage and fractional reserve banking ‘Leverage’ in finance means being highly indebted but in a positive way – that is, funding investments with debt while maintaining a relatively small equity base, with the returns from profitable investments increasing the value of shareholders’ equity. Leverage lies at the heart of banking. It is what makes banking profitable. The ‘model’ behind gaining leverage in financial markets is essentially the same as that in retail banking: the bank makes available to its clients at high rates of interest the money it draws from depositors, or short-term liabilities, for which it pays much lower rates of interest. This is the so-called maturity transformation that Mervyn King, the former governor of the Bank of England, calls ‘the alchemy of finance’. The distinguishing feature of a bank is that its assets are mostly long-term, illiquid and risky, whereas its liabilities are short-term, liquid, and perceived as safe. Returns on risky long-term assets are normally much higher than the returns which the bank has to offer on its short-term liabilities. So banking is highly profitable … The transformation of shortterm liabilities into long-term assets – borrowing short to lend long – is known as maturity transformation. And the creation of deposits, which are regarded by depositors as safe, into loans which, by their nature, are inherently risky, constitutes risk transformation. Banks combine maturity and risk transformation … The transmutation of bank deposits – money – with a safe value into illiquid risky investments is the 205

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alchemy of money and banking. Despite innumerable banking crises, belief in the alchemy persists.20

What made the ‘alchemy’ explosive was another banking practice: ‘fractional reserve banking’, whereby banks maintain just a fraction of the value of their assets in the form of equity to back up the long-term loans they make, which are so much greater in value. As long as there was confidence in a bank, the explosive nature of the formula of lending long while borrowing short and maintaining limited amounts of equity or money remained latent. Trading in wholesale financial markets may have surpassed in volume, scale and apparent sophistication the amounts and techniques involved in relatively simple retail or commercial banking, but it rested on essentially the same alchemy. Trading in financial markets was carried out largely with borrowed money, leading Satyajit Das to say that ‘debt is the oxygen of financialization’.21 Borrowed money was used to purchase MBSs or derivatives, which rose in value in a bull market, then were sold, netting huge profits for the banks. These profitable trades raised the value of the banks’ equity, leading to higher shareholder profits and leading banks, in turn, to borrow even more at even better terms in order to buy more securities to make even higher profits. Since profits were not used to enhance equity but distributed to shareholders as dividends, the ratio of debt to equity rose geometrically. In the UK, for instance, in 2007, the major banks’ leverage ratios (total assets divided by equity capital) in just one year ranged from 20:1 to an astonishing 60:1, while the median ratio had risen during the preceding decade from 25:1 to 35:1.22 In the US, leverage ratios for some financial institutions went above 100:1.23 As an example of the so-called wonders of leveraging, Das says that, in 2007, hedge funds active in financial markets were making available around $300 billion – a sum that could be leveraged five or 206

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six times by borrowing from banks and prime brokers against the collateral of securities purchased by the funds. This meant a total buying power of $1.5 trillion to $1.6 trillion, with which funds could purchase new, riskier securities that were then used as collateral to borrow four to six times the $1.5–$1.6 trillion: that is, $6 trillion to $9 trillion. In other words, the original $300 billion could be leveraged, via debt, 20 to 30 times.24 The image is of an inverted pyramid, with a thin equity base supporting an ever growing mass of debt. Even as banks got deeper and deeper in debt, and traded riskier and riskier securities, profitable trades saw the value of equity or the rate of return to equity rise. So long as there was a bullish market, what many have denounced as simply an elaborate Ponzi scheme25 could continue. At a time of low interest rates and plentiful capital, ‘every profitable investment made by a bank with a leverage ratio of twenty times equity capital, generates simply twenty times as much revenues, profits, and fees, as was the case in the overnight interbank market before the crisis’.26 For as long as what Keynes called ‘animal spirits’ did not flag, and for as long as there was confidence, the debt-to-equity indicators were not a cause for alarm. Yet the signs of overheating were everywhere. One of them was that, amidst more intense competition, lower interest rate margins – the difference between borrowing and lending rates – were leading to lower profits per dollar, even as shareholders demanded higher returns to equity and managers wanted higher salaries and more stock options. The solution was even greater lending and borrowing to buy and sell riskier and riskier securities in order to increase the asset base to support higher returns to equity. In the case of US banks, net interest margins fell from around 4.0 per cent in the 1990s to below 3.5 per cent by 2006. This meant that their net revenues had fallen to less than $35 million for every $1 billion they lent out, rather than being at 207

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$40–45 million, a drop of some 20 per cent. This encouraged banks to step up their lending operations in order to boost profits with a higher volume of assets. By increasing the latter, the total volume of profit they received was higher, even if the profit they got on each billion dollars in assets was lower. The result was much higher bank leverage.27

But once confidence was jolted – as it was with the widespread defaults on mortgages backing the MBSs – the picture could change very, very quickly, posing the problem of loss of liquidity for the overextended, over-indebted banks once their creditors began to call in their loans, owing to the very small amount of equity they maintained relative to their assets. ‘Although excessive leverage had enabled the maximization of profits during the bubble,’ Paul Langley writes, ‘it also magnified losses and made the prospect of insolvency much more likely once the bubble burst.’28 This was essentially the crisis that engulfed Lehman Brothers, AIG, Citigroup and other giant financial institutions – one they could not have survived had the government not come in to save them (with the exception of Lehman Brothers) with hundreds of billions of dollars of liquidity injections to assure lenders and investors that the institutions continued to be solvent. As noted above, leverage in wholesale, interbank markets was essentially similar to the dynamics of retail banking. The bulk of depositors’ money entrusted to the bank was lent to borrowers, with the bank keeping as equity or capital a sum that was equivalent to only a fraction of what was loaned, thus the term ‘fractional reserve banking’. But there was one vital difference. Ever since the banking crisis that accompanied the Great Depression, individual depositors’ money has been insured by the government’s Federal Deposit Insurance Corporation (FDIC) in the US, with similar schemes existing in other developed countries. This is not 208

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the case with loans made to banks in the financial markets, where no government guarantee has been legislated. In high finance, securities served as the collateral or guarantee of payment to the banks’ creditors. But if the credibility or value of these securities was damaged, as it was during the financial crisis, then the only outcomes were either bankruptcy or a government bailout, since the very limited equity possessed by the banks simply could not meet the demands of their creditors if they called in their loans. AIG, for instance, had just a few billion dollars to support the $441 billion in swap or insurance obligations it had incurred, and if it ‘reneged on its swaps, institutions that had bought default protection on the bonds they held would be forced to take write-downs, eroding their capital and forcing them to raise more equity just when stock markets were in disarray’.29 Much to the consternation of both progressives and free marketeers, the US government ended up bailing out AIG to the tune of $182 billion. Thus, in the aftermath of the Wall Street collapse, one of the big demands of reformers was a decrease in the gearing ratio, or the ratio of corporate debt to equity, in order to prevent reckless lending on borrowed money and thus avoid the expensive bailouts funded by taxpayers’ money.30 ‘Regulating banks to have more equity and less debt addresses banks’ solvency most directly,’ say two of the most influential backers of the ‘more equity’ school, because, ‘when equity represents less than 5 per cent of the total value of the assets, as is often the case for banks, a small drop in the value of the assets endangers the bank’s solvency’.31 If solvency risk is reduced, the likelihood of liquidity problems and runs is also reduced because depositors and other creditors are less nervous about their money. Moreover, beyond the banks’ own ability to absorb losses without becoming distressed, the fraction of assets that a bank may have to suffer 209

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after losses in order to recover its equity ratio is smaller if it has more equity. Therefore the contagion caused through asset sales and interconnectedness is weaker when banks have more equity. Increasing banks’ ability to absorb losses through equity thus attacks fragility most effectively and in multiple ways.32

Lower debt-to-equity ratio and the Chicago Plan While a lower ratio of debt to equity is now seen as one of the key measures to prevent another financial crisis, few have embraced the solution that Irving Fisher and other economists proposed during the Great Depression: the ‘Chicago Plan’ of 100 per cent reserve banking. This plan proposed that – in contrast to fractional reserve banking – banks would loan only an amount equivalent to the value of their equity, thus providing a 100 per cent guarantee to depositors that their money was safe should the banks’ loans sour. While assuring their solvency, however, this plan would also have eliminated the ability of banks to turn a profit, since they would have had no other function but to ‘hold money deposits for customers and make payments between accounts’, and ‘their ability to create credit and money by simultaneously crediting and debiting a borrower’s loan and deposit account would be eliminated’.33 In short, money creation through fractional reserve banking and similar arrangements is the source of bankers’ profits. The Chicago Plan was radical, so it was not surprising that it did not fly during the Great Depression, nor did it fly after the Great Recession, although it had some adherents.34 However, even the much lower expectations of reformers were dashed by the reforms that eventually emerged. In the US, the Federal Reserve mandated a 5 per cent ratio of equity to total assets. Other countries have higher ratios, but none of the developed countries approach the level of 20 to 30 per cent favoured by some reformers.35 210

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The proposal from the Basel Committee, the unofficial international regulatory body on banking capital and other key requirements, initially favoured a 7 per cent requirement composed of a 4.5 per cent equity requirement and a ‘capital conservation buffer of 2.5 per cent of risk-weighted assets’.36 However, it then moved to proposing a 3 per cent minimum level of equity, provoking two experts to say: ‘If this number looks outrageously low, it is because the number is outrageously low.’37 Moreover, the Basel proposal was not set to become law as a result of a treaty but was essentially a recommendation from an informal institution of central bankers whose main concern is to stabilize a global financial system dominated by big private banks. As Anat Admati and Martin Hellwig, who advocate much higher equity ratios, point out, the power of the private sector is ‘particularly striking’ in banking and finance:38 Although they can put in place any laws and regulations that they see fit, politicians are not in the driver’s seat in their relations with banks. Bankers know more about banking than politicians. Moreover, politicians want the bankers’ cooperation to make the investments the politicians favor – or campaign contributions. When bankers warn that capital requirements will hurt bank lending and reduce economic growth, they are rarely challenged by politicians, not only because politicians do not see through the banks’ claims but also because they do not want to upset their symbiosis with bankers.39

The Volcker Rule and ring-fencing The US Glass–Steagall Act is credited as one of the factors behind the period of relative financial stability from the mid-1930s to the early 1980s. It set up a firewall between investment banking and retail and commercial banking. This wall prevented banks from 211

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using government-insured depositors’ funds for risky investments. Under the Glass–Steagall Act, the story goes, retail banking became a predictable activity of taking deposits and making housing, car and other consumer loans. Investment banking, on the other hand, was where the action was, where innovation resulted in financial instruments that enabled the banks to make huge profits, facilitating deals among financial market players. The advent of securitization in the 1990s, which packaged mortgage loans into products that could be traded in the market in an atmosphere where housing prices kept rising higher and higher, was a signal event that pushed commercial banks, such as Citibank, to demand a piece of the action previously monopolized by the investment banks. This culminated in the repeal of the Glass–Steagall Act and its replacement by the Gramm– Leach–Bliley Act of 1999. The resulting merger of conservative retail banking and risk-taking investment banking in the same banking institution led to the dominance of the latter. The repeal led to mergers that permitted ‘the balance sheets of the retail and commercial parts of the business to be utilized to support the more risky activities of the investment banks’.40 The consequence was the implicit extension of the FDIC insurance of retail depositors to the activities of the investment arm of the bank, creating the potential for great instability. One of the key benefits of the separation was to protect the payments system and deposit-taking activities, and hence the real economy, from banking crises. In doing so, separation limited the moral hazard problem which arose from the explicit guarantee of deposit-taking institutions and the implicit guarantee of financial bailouts for financial organizations whose failure would pose a major risk to the broader economy. Removal of the separation meant that the 212

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guarantees were extended more widely, to include the more risky financial activities conducted by investment banks.41

This implicit guarantee was one of the main precipitating factors of the global financial crisis. As Joseph Stiglitz put it: The most important consequence of the repeal of Glass– Steagall was indirect – it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money – people who can take bigger risks in order to get bigger returns.

When repeal of the Glass–Steagall Act brought investment and commercial banks together, ‘the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risk-taking.’42 The marriage was not dissimilar to that of a gambler to a pennypincher, and it predictably led to a crisis in the late 2000s. Enter Paul Volcker, the man who headed the Federal Reserve before Alan Greenspan, and whose reputation grew as the latter’s diminished over the last decade. The original aim of the Volcker Rule was to eventually bring back the division between commercial banks and investment banks enshrined in the Glass–Steagall Act. The Volcker Rule, as it eventually appeared in the Dodd–Frank Act, bans proprietary trading by banks but allows them to engage in market-making activities. This means that banks are prohibited from making use of their own accounts for short-term proprietary trading of securities, derivatives and commodity futures, as well 213

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as options on any of these instruments. It also prevents banks, or insured depository institutions, from acquiring or retaining ownership interests in hedge funds or private equity funds, subject to certain exemptions. In other words, the aim is to discourage banks from taking too much risk by barring them from using their own funds, which are provided by depositors, to make these types of investments to increase profits. The Volcker Rule relies on the premise that ‘these speculative trading activities do not benefit banks’ customers’.43 However, the rule allows banks to continue: market making, underwriting, hedging, trading government securities, engaging in insurance company activities, offering hedge funds and private equity funds, and acting as agents, brokers or custodians. Banks may continue to offer these services to their customers to generate profits. However, banks cannot engage in these activities if doing so would create a material conflict of interest, expose the institution to high-risk assets or trading strategies, or generate instability within the bank or within the overall US financial system.44

In the UK, a similar recommendation was made by the Independent Commission on Banking (or the Vickers Commission, named after its head, Sir John Vickers, the former chief economist of the Bank of England). This was ‘ring-fencing’, or the establishment of an independent legal entity within a banking group to provide retail banking services that would be banned from wholesale market practices. The aim was to ‘limit the government guarantee to the parts of the financial system that provide essential banking services and support the payments system. Keeping investment banking services outside the ring fence lessens the incentive to take on high leverage and excessive risk because the implicit guarantee 214

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(which subsidizes too-big-to-fail institutions) is no longer available.’45 That, at least, is the hope. The Volcker Rule is one of the most controversial parts of the Dodd–Frank legislation into which it was incorporated. Predictably, the banks lobbied against it, citing high compliance costs that would make US banks uncompetitive. Critics of the banks, on the other hand, said that it would not be effective in thwarting speculative activities by the banks and that the banks would find a way to water it down. Indeed, as the Dodd–Frank legislation wended its way through Congress, intense lobbying was able to dilute the Volcker Rule. First of all, the lobby was able to derail Volcker’s original intent to ban banks from owning any private equity fund or hedge fund. The final version of the law allows a bank to maintain an in-house private equity fund or hedge fund as long as the bank’s share of the latter’s stock does not go above 3 per cent.46 Equally importantly, the lobby was able to narrow down the meaning of ‘proprietary trading’ (which was banned) to ‘taking a position as principal in any security, derivative, option, or contract for sale of a commodity for future delivery’ – that is, ‘for the purpose of selling that position in the near term or otherwise with the intent to resell to profit from short-term price movements’.47 This heavy lobbying resulted in interpretations that made the distinction between ‘proprietary trading’ (banned) and ‘market-making activity’ (permitted) extremely ambiguous and difficult to monitor, as shown in the following statement by a Wall Street consulting firm: The trading desk that establishes and manages the financial exposure routinely stands ready to purchase and sell one or more types of financial instruments related to its financial exposure and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions for those types 215

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of financial instruments for its own account in commercially reasonable amounts and throughout market cycles on a basis appropriate for the liquidity, maturity, and depth of the market for the relevant types of financial instruments. The amount, types, and risks of the financial instruments in the trading desk’s market maker inventory are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties, based upon the particular financial instruments and demonstrable analysis of historical customer demand, current inventory and market and other factors, including block trades …’48

This has resulted in a situation in which enforcement is reduced to reading the intention of a trade, since the process would give no indication of whether a trade in which the bank were the principal was meant to achieve a profit from short-term price movements or if the bank were simply engaged in the routine activity of maintaining stock values or hedging against loss. As the Financial Times put it: It is no mark against a law that it requires judgments about intent. The distinction between manslaughter and murder works well enough. Some intentions are trickier to read than others, though. Those that divide proprietary trading and market-making are often all but impossible to track. This had made the Volcker rule – which forbids banks from proprietary trading while allowing them to make markets – a cumbersome regulation of questionable effectiveness.49

From the perspective of protecting depositors, the Volcker Rule is an ineffective halfway measure. It is a compromise that is not a substitute for the reinstatement of the Glass–Steagall Act’s strict 216

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separation of ownership of commercial banks from investment banks. Short of restoring the firewall, strong capital requirements would be more effective in making banks stay away from risky trading. The big issue that confronts pro-consumer advocates at this point, however, is that, under the Trump administration, regulators sympathetic to the banks are looking to interpret and water down the implementing rules and regulations of the Volcker Rule.50 Some say that a degree of haziness in legal texts is always inevitable, and that a large part of effectiveness depends on the regulator. In this regard, both Volcker and the two authors of the Dodd–Frank Act have alleged regulatory capture, or, at the very least, the failure of the regulators to strictly implement the Volcker Rule owing to pressure from those being regulated. The too—big—to—fail conundrum The problem of moral hazard – that is, an incentive to take risks with the expectation that one would be bailed out by public money – is at the heart of the so-called too-big-to-fail (TBTF) issue that has bedevilled reformers. Interestingly, the solution presented itself at the very outset of the financial crisis. Nationalization of the big insolvent financial institutions such as Citigroup and AIG could have been undertaken, as proposed by economists including Joseph Stiglitz and Paul Krugman. After nationalization, the failed behemoths could have either remained nationalized or been split up into smaller units that would not threaten system failure should they go under. Instead, the Treasury Department compounded the problem by pushing the merger of investment banks with commercial banks to prevent the troubled institutions from going under by extending the protective cover of the capital base of the bigger or more secure partner. These shotgun marriages – or, in some cases, deathbed 217

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nuptials – were made between Merrill Lynch and Bank of America; Wachovia Bank and Wells Fargo; and JPMorgan, Bear Stearns and Washington Mutual. Massive capital injections coming from the $787 billion Troubled Assets Recovery Program (TARP) were then poured mainly into nine big banks: JPMorgan Chase, Citigroup, Wells Fargo, Bank of America, Merrill Lynch, Goldman Sachs, Morgan Stanley, Bank of New York Mellon, and State Street Bank. The message was that these banks were too-big-to-fail. As a result of government action, the banks got even bigger after the peak of the financial crisis. As of 2017, JPMorgan had amassed $2.56 trillion in assets, or nearly twice as much as at the end of 2006 when the subprime mortgage bubble was beginning to burst. Bank of America’s assets have soared by 56 per cent since the end of 2006, to $2.28 trillion. Wells Fargo’s assets total $1.93 trillion, an increase of nearly 300 per cent since the end of 2006.51 Since the crisis, the six largest US banks now control nearly 70 per cent of all the assets in the US financial system, having increased around 40 per cent against overall asset growth of only 8 per cent.52 The TBTF message to the international banking community was repeated by the FSB in November 2011, when it listed 29 banks whose failure would have negative systemic consequences globally. These included eight banks in the US, four in the UK, four in France, three in Japan, two in Germany, two in Switzerland, and one each in Belgium, China, Italy, the Netherlands, Spain and Sweden.53 Rather than pushing the named banks to exercise caution and prudence, the FSB announcement likely reinforced their conviction that they were TBTF. Instead of tackling the TBTF problem head-on, the Dodd– Frank legislation exacerbated it by declaring that every banking organization larger than $50 billion was ‘systemically important’. As one critic noted:

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This is pure fiction, but it signals that these banks – simply because of their size – are more likely than others to be rescued if they are in danger of failing. The same will apply to non-banks like insurance companies (AIG, Prudential), finance companies (GE Capital), hedge funds, and moneymarket funds if they are designated as ‘systemically important institutions’ by the Financial Stability Oversight Council (as the three mentioned companies have been).54

The subsidy to such institutions, according to the same critics, was ‘real and measurable’, allowing the TBTF-designated banks to reap the benefit of the government’s implicit backing. ‘That benefit is not just some vague, “I’ll-be-here-for-you-tomorrow” feel-good thing. No, it’s a hard-edged financial leg up that separates winners from losers, acquirers from acquirees, and in the end will determine whether our financial system consists of many large and small firms or only a few behemoths.’55 Executive pay Among the most controversial issues related to the financial crisis was that of the financial packages of bank executives. At the beginning of the crisis, bank executives were among the most highly remunerated, their privileged place in the compensation hierarchy being connected to the cultural transformation of banking from a conservative to a high-risk enterprise, as mentioned by Stiglitz. As three students of the ‘culture of risk’ put it: The new breed of financiers and financial advisors [is] not concerned to show themselves as trustworthy and prudent, careful stewards of our wealth. On the contrary, they’re guides who know the secret roads and paths to wealth, who will lead 219

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us along the way to riches. They can manage the risks, show us how to outsource them, and take advantage of opportunities to cash in. They are gamblers, not stewards, they are speculators, not conservators, daring, not prudent, smart rather than wise. And this leads to, or helps support, a completely different set of outcomes. First, it supports the tendency to adopt the maximization of shareholder value as the criterion for good performance, leading to short-termism, with the target of maximum present value. And, second, managing risk and maximizing shareholder value deserves high pay, very high pay. So this approach tends to justify enormous salaries and earnings, especially in the form of stock options.56

The issue of executive compensation came to a head when, at the height of the financial crisis, AIG gave 418 members of the AIG Financial Products Division $165 million in bonuses; these were the people who were primarily responsible for bringing down the firm and triggering a taxpayer bailout to the tune of $182 billion. Exclaiming ‘How do they justify this outrage to the taxpayers who are keeping the company afloat?’, President Obama told his Treasury Secretary, Tim Geithner, to block the payment. However, the AIG board’s decision on the bonuses took place in March 2008, ‘long before the government intervention and was thus fully legal and untouchable’.57 (Nevertheless, public shaming and threats of government investigation led to half the bonuses being returned.58) Reformers failed, however, to capitalize on the public’s anger to put effective checks on executive pay. Perhaps the most restrictive measure that was taken was the capping of executive compensation at $500,000 in those financial institutions receiving TARP bailout funds until these institutions had fully repaid the government – which explained why, when the immediate crisis had passed, the bailed-out institutions were in a rush to repay the government. Dodd–Frank 220

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was disappointing when it came to executive compensation, merely including measures ‘to encourage management to shift from shortterm profits to long-term growth, rather than strict guidelines’.59 The law does require that all directors on compensation committees of publicly traded companies must be independent from the executives whose compensation they are supervising, but this is not likely to happen, according to seasoned Wall Street watchers. The strengthened independence of compensation committees is unlikely to impact the size of Wall Street bonuses and the fact that Wall Street executives operate like a guild system of insiders who have acquired the power to pay themselves (and each other) with no effective input from shareholders. The Dodd–Frank Act also requires the disclosure of executive compensation as compared with the company’s stock performance over a five-year period. This might alert shareholders to the issue of a discrepancy between executive compensation and stock performance, but may not be sufficient to prevent the issue altogether. Unless bonuses are reduced or at least assessed on the basis of long-term profits rather than short-term (yearly) results, incentives for risktaking and stock volatility will still exist.60

That Wall Street needs something stronger than the Dodd–Frank Act is shown in the fact that, even as the US economy was still fragile, 2010, 2011 and 2012 were record years when it came to Wall Street bonuses.61 Credit ratings agencies It took the global financial crisis to reveal to the world how powerful the so-called Big Three credit ratings agencies (CRAs) – Fitch, 221

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Standard & Poor’s, and Moody’s – had become. Before the crisis, the primary standard setter for the prudential regulation of international banks, the Basel Committee on Banking Supervision, relied on the CRAs in its standardized approach for determining the capital requirements of banks.62 Indeed, not only banks but governments saw their economic fates being determined by the CRAs, with one analyst writing: ‘The Big 3 are able to make governments kneel: recall this sentence from a French Prime Minister following France’s AAA downgrade: “We will do everything to get [the triple A] back.”’63 Given their critical role in determining whether banks are solvent, whether countries are creditworthy, or if financially engineered products such as MBSs are worth investing in, the non-existent national and international regulation for these private institutions was astounding. The 2008 financial crisis led to a slew of criticisms against the CRAs, including charges of being an oligopoly, being nontransparent in their methodologies, and having conflicts of interest owing to their being paid by banks to rate the products they were selling to investors. The most serious criticism was that the CRAs had themselves helped precipitate the financial crisis by giving positive ratings to what were actually junk instruments, notably the subprime mortgage-based securities. This was rooted, critics say, in the CRAs’ failure to discern or refusal to recognize a conflict of interest between their roles as advisers to investors and as advisers, or even as co-participants, in the creation of the products they were selling to investors. As Ahmed Naciri puts it: Contrary to what logically should have happened, to see the agencies reluctant to mingle with these structured finance transactions, they were actually becoming actively implicated in their design and they were not only requiring compensation for rating structured securities transactions, but were also 222

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requiring to be paid for being consulted on how to structure their tranches to achieve issuers’ desired if abnormally high ratings. They were, for instance, consulted extensively by issuers of these securities on matters like what kinds of mortgages would earn what levels of earnings.64

Not surprisingly, from 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple A, compared with only six private-sector companies that carried the much-coveted rating. And when the reality about the rotten basis of subprime securities became evident: [The] Big 3 were perceived to be hesitating in downgrading companies with whom they were in the consulting business. For example, issuers’ ratings were kept at investment grade only a few days before these issuers went bankrupt, despite awareness of their problem a while before; this [being] the case with Enron, Freddie Mac, and many others.65

With their role in generating the financial crisis becoming increasing undeniable, the CRAs apparently felt that an aggressive offence was the best defence, and they downgraded the US government debt from AAA and threatened to do the same to 15 other European countries. This was a miscalculation since it brought the collective wrath of the most powerful governments down on them, with the US leading the way in filing a $5 billion civil suit against Standard & Poor’s for allegedly misleading investors in the run-up to the crisis, opening the door to other suits from investors who lost money investing in triple A-ranked financial products before the crisis. There is now a rough consensus among governments and international institutions that CRAs should be subject to regulation. Yet so far there has been little in the way of actual regulation. 223

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Internationally, this does not seem to have advanced far beyond the establishment of a framework of cooperation between the FSB, the International Organization of Securities Commissions and the Basel Committee on Banking Supervision to monitor and render more transparent the activities of the CRAs. In the case of the US and the EU, broad rule-making authority was vested in certain agencies by legislation or delegation by central authorities. CRA resistance and bureaucratic inertia have made the elaboration of rules and penalties a very slow process. And not to be underestimated is a key difference (one that the ratings agencies can exploit) in the US’s and EU’s approaches to CRA monitoring that impedes international cooperation: should the market or the state be the main source of CRA supervision? Although the EU and US approaches to CRAs monitoring share certain common principles like better governance, greater transparency, and strict requirements concerning conflicts of interest, their philosophies are not the same. US authorities, for instance, believe that, by eliminating a regulatory requirement for ratings and transparency, they can reestablish a competitive, reputation-driven market for ratings. By contrast, because EU authorities are more preoccupied by ratings shopping, it doesn’t suggest any market-driven regulation and aims to promote CRAs’ accountability through supervision.66

International financial governance The lack of an effective international system of financial governance – one that would address bank capitalization requirements, regulate cross-border capital flows, formulate transnational policies on bank rescues (that is, address the TBTF problem and related moral hazard issues), coordinate transnational macroeconomic 224

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policies and promote a stable international currency regime – was felt acutely after both the Asian financial crisis and the global financial crisis. The outbreak of the latest crisis saw central banks scramble to get ahead of the situation. This was a Keynesian moment when practically all significant central banks adopted loose monetary policies and many governments assumed activist fiscal strategies to reverse the negative effects of the financial crisis on the real economy globally. The height of this revival of interventionist Keynesianism was the Pittsburgh G20 summit of 2009, where key developed and developing countries committed themselves to create ‘a global architecture to meet the needs of the 21st century’. Tasks laid out for the existing monitoring agency (renamed the Financial Stability Board, or Derivatives Service Bureau (DSB)) included:

• To make sure our regulatory system for banks and other financial firms reins in the excesses that led to the crisis. Where reckless behaviour and a lack of responsibility led to crisis, we will not allow a return to banking as usual.

• … [T]o act together to raise capital standards, to implement strong international compensation standards aimed at ending practices that lead to excessive risk-taking, to improve the over-the-counter derivatives market and to create more powerful tools to hold large global firms to account for the risks they take. Standards for large global financial firms should be commensurate with the cost of their failure. For all these reforms, we have set for ourselves strict and precise timetables.

• [T]o work for a more legitimate and effective IMF. The Fund must play a critical role in promoting global financial stability and rebalancing growth. We welcome the reform of the IMF’s lending facilities, including the creation of the 225

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innovative Flexible Credit Line. The IMF should continue to strengthen its capacity to help its members cope with financial volatility, reducing the economic disruption from sudden swings in capital flows and the perceived need for excessive reserve accumulation. As recovery takes hold, we will work together to strengthen the Fund’s ability to provide even-handed, candid and independent surveillance of the risks facing the global economy and the international financial system.67

Central bank coordination Nearly a decade after the Pittsburgh summit, the G20’s moves to achieve greater coordination of financial policies or translate them into law have had disappointing results. While the Federal Reserve made economic recovery its priority through expansive monetary policy, the ECB pushed austerity policies on the heavily indebted countries that prioritized debt repayment to German and French banks over economic recovery. The result was a long-drawn-out, very public conflict between the Obama administration and the Federal Reserve versus the ECB, the European Commission (EC) and Germany. Institutional gaps Central bank cooperation left much to be desired when it came to capital requirements. One of the lessons of the financial crisis was that banks would be less prone to take high-risk investments if they had more equity relative to loans in their total assets. Basel III, which was drafted by the Basel Committee on Banking Supervision, raised the total common equity requirement to 4.5 per cent. As pointed out earlier, while this was higher than the Basel II requirement of 2 per cent, it was far below what many experts would have considered the minimum requirement for effective 226

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deterrence of risky behaviour, which some said would range from 20 per cent to 25 per cent of assets. But even had the equity requirement been higher, Basel III was advisory, not mandatory, since the Basel Committee has no legal personality of its own. As Dirk Schoenmaker points out: The Basel Committee does not possess any formal supervisory authority, and its standards do not have legal force … Because of its lack of legal status, the Basel Committee shies away from sanctions, in [cases where] a country does not implement and enforce the agreed standards, and crisis resolution, which involves finance ministries and politicians. The committee regards these domains as the prerogatives of sovereign states.68

With respect to effectiveness as a regulatory body, the FSB tasked by the G20 to oversee the global financial system fares only slightly better. It may have a legal personality but it has no real power since the G20 ‘considers a treaty-based international organization not to be an appropriate legal form at this point’.69 Lacking the authority conferred by a formal, international agreement (as in the case of the IMF and the WTO), the FSB is limited to promoting, rather than leading and commanding, international cooperation.70 The IMF’s credibility on the line The IMF – the only existing multilateral institution with a bearing on global financial governance – came out of the Asian financial crisis with its reputation badly damaged by what it acknowledged were the wrong inflation-targeting policies it had prescribed to the financially stricken Asian countries, policies that had pushed them into a deeper crisis. A period of reform appeared to be inaugurated with the arrival of Dominique Strauss-Kahn as managing director in 2007, when a more Keynesian approached was promised. 227

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A notorious sex scandal, however, forced Strauss-Kahn to leave office in 2011, resulting in Christine Lagarde taking his place. The IMF was then brought in to resolve Europe’s sovereign debt crisis. Its participation, however, was conducted within the parameters set by the ECB and the EC, which pushed austerity policies on Greece and other indebted European countries. While the IMF tended to be less sanguine about the positive effects of austerity touted by the ECB, EC and Germany, it nevertheless went along with the prescription, resulting in it abandoning the Keynesian opening that had been promised by Strauss-Kahn. Austerity and the IMF again became inexorably linked. As for the much-promised reform of voting shares to give more weight to developing countries promised by the Pittsburgh summit, this was a case of a lot of huffing and puffing to give birth to a mouse. As noted by Mark Weisbrot and Jake Johnston: OECD countries retain an overwhelming majority of the voting share within the IMF, even after recent reforms. Further, outside of Brazil, Russia, India, and China, the rest of the developing world actually see their voting share decrease by three percentage points … More importantly, the current voting share also retains the United States’ veto over some important decisions, including changes to the IMF’s charter, which require an 85 per cent majority.71

The dollar’s continuing dominance International monetary reform was another long-awaited change, as governments grew to resent more and more the elite privileges that the dollar’s role as a reserve currency gave to the United States. The US could afford to ignore the destabilization triggered by its massive trade deficit since it simply printed dollars to finance that deficit rather than cover it with foreign exchange earned by its 228

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exports. Moreover, the dollar became a source of global instability, threatening countries with unrestrained financial outflows should investors lose confidence in their economies and fly to safety by holding dollars. In the case of Argentina, for instance, rising US interest rates in early 2018 drew capital from the country, leading the peso to plummet against the dollar by 17 per cent, creating havoc in Argentina’s external accounts.72 With so much of their wealth tied up in dollars, countries were at the mercy of the dollar’s rise and fall. For instance, in order to keep the value of its currency steady, China found that it ‘had to recycle its huge trade surpluses, and the biggest, most liquid option for investing them is US government debt’.73 China, with its vast holdings of securities denominated in dollars, was a particularly resentful hostage to the dollar’s gyrations. Not surprisingly, it called for a new global reserve currency that would be a basket of differentially weighted currencies. The Chinese push was reminiscent of Keynes’ original idea of having a supranational currency called the bancor. Keynes’ idea was shot down by the US at the Bretton Woods Conference of 1944, and the Chinese proposal has also been resisted by the US and other Western governments, preventing any movement towards global monetary reform. Central banks: powerful hostages Over the last ten years, central banks have become the de facto key instrument for both recovery and regulation, on both the national and the global level. Their new prominence is based on two developments: on the national level, the neoliberal resistance to Keynesian stimulus programmes to promote recovery; and on the international level, the absence of moves towards more effective regulation via international agreements implemented by institutions vested with the requisite authority and legitimacy. The Federal Reserve and its counterparts sought to achieve their objec229

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tive of stabilizing economies and kick-starting growth through their control over money. Conjuring or fabricating money through so-called ‘quantitative easing’ (QE) and introducing it into the global financial system to promote the illusion of stability is what the Federal Reserve and its allied central banks’ policies amounted to, say critics of the now tremendous power of these institutions. The flood of cheap money from the Federal Reserve, the ECB and the Bank of Japan came to $13.5 trillion, or 17 per cent of globally adjusted GDP. This resulted in pushing the global level of debt to $325 trillion, more than three times global GDP.74 The dynamics and contradictions of this system are laid out with admirable clarity by Nomi Prins: To garner support for their multi-trillion-dollar QE strategies, the G3 central bank leaders [US, EU and Japan] peddled the notion that they were helping the general economy. That couldn’t have been further from the truth. There was no direct channel, no law, no requirement to divert the Fed’s cheap money into helping real people. This was because borrowing and subsequent investing in the real economy required funds from private banks, and not from central banks directly. And private banks were under no obligation to do anything with this cheap money they did not want to.75

Central bank authorities realized early on that simply adjusting benchmark interest rates in their countries was insufficient to stabilize the global economy, so they resorted to the unconventional method of QE or ‘buying’ government debt by fabricating money that was then ploughed into their banking systems. Specifically, the largest private banks, including JPMorgan Chase, Deutsche Bank, and HSBC that inhaled this cheap 230

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money were not required to increase their lending to the Main Street economy as a condition of the availability of that money. Instead the banks hoarded the cash. US banks colluded with the Federal Reserve to get that cash by stashing their bonds as ‘excess reserves’ (more reserves for emergencies than regulations required) on the Fed’s books. And, because of the Emergency Economic Stabilization Act of 2008, they received 0.25 per cent interest per year from the Federal Reserve on those reserves, too. Wall Street used its easy access to cheap money to increase speculation in derivatives and complex securities. They used it to buy back their own shares, thus effectively manipulating their own stock – in broad daylight and with explicit approval from the Fed. In turn, these banks dialed back their lending to small and midsized businesses, which hampered their growth potential.76

While it does seem likely that much of the cheap money channelled to the banks was used for speculative purposes or to buy back the banks’ own shares, the bigger block to absorbing it in a stagnant economy was, as Richard Koo points out, that corporations and consumers who had become deeply indebted were seeking to pay off their debt or ‘deleverage’.77 In any event, the danger of having a system that relies so much on conjured capital, Prins points out, is that when the central bankers stop producing it, the system ‘could go into shock; markets plunge, credit seize, and a new crisis emerges. That’s why central banks are walking the tightrope between altering their policies and doing nothing to alter them, thereby continuing them by default, with no exit plan.’78 In short, as pointed out at the beginning of this chapter, central banks, while gaining power over the global economy to an unprecedented degree, have also become hostage to finance 231

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capital’s desire for the speculative fever to continue. Former Citigroup CEO Chuck Prince distilled Wall Street’s speculative game in his notorious statement: ‘As long as the music is playing, you’ve got to get up and dance.’ Easy money through low interest rates and QE by the Federal Reserve was the music that global finance did not want to end. The central banks did not always agree on all key points. The Federal Reserve, for instance, was critical of the ECB’s imposition of harsh austerity policies on the southern European countries, but they all eventually came to one position: that money creation, whether it was called QE or something else, was the principal instrument to reflate the global economy. By mid-2017, as pointed out above, the amount of securities purchased from banks with money fabricated by the G3 central banks came to over $13.5 trillion, or an astounding 17 per cent of global GDP. Despite this, growth was ‘frustratingly slow’, to use the words of Ben Bernanke, the former Federal Reserve chief. What this meant was that channelling cheap money through the banks to promote more vigorous global growth as a substitute for fiscal stimulus programmes was not working. In fact, it was threatening a repeat of the 2008 financial crisis since it had simply provided the banks with more fuel for speculation. The dilemma of the central banks is well summed up in a passage from Prins that is worth quoting in full: Selling the trillions of dollars in securities the banks have hoarded could very well cripple the system – again … Existing on a diet of artificial money and demand is anything but normal for an economic or financial system, even if it boosts markets to historic highs. If you take air out of a tire, it collapses; it you take too much QE out of the system too quickly, the system collapses. If the flow, or even possibility of conjured money was to stop, markets relying on it would tank.’79 232

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Aside from drawing criticism for their propensity to create and inflate a dangerous speculative bubble via cheap money in the interest of short-term stability, the vastly enlarged powers of the Federal Reserve and other central banks, which they have gained by stepping into the breach created by a lack of legislation and regulation on the part of the appropriate authorities, have created consternation for another reason: the threat they pose to democracy. As Paul Tucker, former deputy governor of the Bank of England, warns, the central banks ‘have been, in a popular but deeply troubling phrase, the only game in town’, deriving authority from their monetary innovations that avoided a repeat of the Great Depression while non-central bank regulators failed to act.80 The result has been the creation of another structural source of unelected power, alongside the courts and the military, which, though not (yet) a fourth branch of government, is an ‘overmighty citizen’ that poses a danger to democratic values and processes. The emerging conflict between a powerful but unaccountable technocracy and democratic institutions was captured in the response of a European Parliament committee to a review by the Basel Committee on Banking Supervision of the EU’s implementation of ‘Capital Accord’, which the association of central bank governors had agreed upon: A large majority of Members of the European Parliament cannot accept that the Basel Committee puts into question the tools to finance the economy … Even if we are aware of the necessity of international cooperation, the European law is made by the European Parliament and the Council of Ministers. The opinion of a body that is working without legitimacy and without transparency cannot modify the decisions taken democratically by the European institutions.81

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The European conundrum The challenge of reforming the financial system is particularly complicated in Europe owing to the eurozone, in which 19 of the 28 EU member countries have linked themselves with a common currency (the euro). The illusion that monetary union could be stable without a fiscal or political union was banished by the recent financial crisis; this was partly the result of uncontrolled bank lending to eurozone states that did not share a common fiscal system that was able to deal with the balance-of-payment crisis that such excessive lending inevitably brought about. What followed was the worst of all possible worlds: an ad hoc arrangement built on the raw financial power of Germany and other northern European countries to bail out the German and French banks and other institutions that had invested so short-sightedly in southern European banks and governments, and the foisting of austerity programmes on people to make them pay for the costs of the bailout.82 In October 2015, the so-called Five Presidents’ Report, entitled Completing Europe’s Economic and Monetary Union, affirmed that, despite the continuing economic and political crisis into which the financial collapse of 2008 had plunged Europe, the continent was on course to achieve ‘genuine economic union’, a ‘financial union’, a ‘fiscal union’ and a ‘political union’. Work has begun on the European Banking Union, with broad agreement on a single resolution mechanism (European Stability Mechanism or ESM) which would apply to all key European financial institutions, but with less harmony on rules for capitalization.83 Not surprisingly, much resistance has come from the private banks. The negotiations towards fiscal union, however, are what will prove to be the test if the EU and eurozone are to evolve into a more integrated economic and political entity. One obstacle is the legacy of bitterness left by austerity policies in southern Europe, which is 234

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matched by deep suspicion in Germany and other northern European countries that they will end up permanently subsidizing their poorer, fiscally strapped southern neighbours. But perhaps even more of an obstacle is the strong anti-Brussels feeling now sweeping the continent, the most significant manifestation of which was the Brexit vote in the UK in 2016. Given this backdrop, the following proposed strategy (from the EC) towards a fiscal union has struck many as unrealizable. [I]n case of a very severe crisis, national budgets can become overwhelmed, as was the case in some countries in recent years. In such situations, national fiscal stabilisers might not be enough to absorb the shock and provide the optimal level of economic stabilisation, which in turn can harm the whole euro area. For this reason, it would be important to create in the longer term a euro area-wide fiscal stabilisation function. Such a step should be the culmination of a process that requires, as a precondition, a significant degree of economic convergence, financial integration and further coordination and pooling of decision making on national budgets, with commensurate strengthening of democratic accountability. This is important to avoid moral hazard and ensure joint fiscal discipline In the meantime, we need to reinforce trust in the common EU fiscal governance framework.84

The failure of reform On the heels of the Great Depression came the massive regulatory wave of the 1930s and 1940s that brought a new era, one in which capital was forced to compromise with society by big government via laws and regulations that limited its power, redistributed its profits, and reduced the inequalities it had spawned. The great 235

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difference between the aftermath of the Great Depression and the Great Recession is precisely the very few effective reforms to tame finance capital that have emerged from the latter. This chapter has reviewed in detail how and why the effective regulation of financial products such as derivatives and mortgage-based securities, practices including leveraging and excessive bankers’ compensation, and institutions such as CRAs and the IMF has been frustrated. In discussing the failure of the Obama administration to reform finance in Chapter 2, we called attention to the continuing strength of finance capital – strength that is rooted not only in its ability to mobilize to lobby state authorities, but also in the ‘productive power’ of capital: that is (as described by Cornelia Woll), the joint production of world views, meanings and interpretations that emerge from shared perspectives among technocrats and capitalists.85 The principal element of this shared perspective that resulted from the neoliberal revolution of the 1980s and 1990s was that state regulatory action was a hindrance to the working of the ‘magic’ of the market to produce the best of all possible outcomes in terms of the efficient allocation of resources to bring about growth and prosperity. The Great Recession dented this shared ideology, but not fatally. In Washington, neoliberals within the Obama administration were able to water down both executive action and legislation designed to discipline the banks. In Europe, neoliberals in the state were even more powerful than in Washington, taking the lead in saving their financial capitalist classes by imposing harsh austerity policies on the hapless citizens of the indebted southern and eastern European countries, and on Ireland. The Keynesian spring of 2009 withered on the vine. Thwarted by neoliberal reaction on the fiscal and legislative fronts, Keynesians had only one vital avenue of action to prevent the economy from unravelling, and that was through monetary policy. Expansive monetary policy propped up the developed countries’ economies, 236

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but it also provided the grease for renewed financial speculation, which has become as frenzied now as in the run-up to the 2008 implosion. Central banks have become the most powerful of financial institutions, but they have also become hostages to speculators, who have shown their power to thwart or subvert monetary policy by unloading financial instruments when they perceive that the banks might raise interest rates, thus destabilizing the economy. With reforms stalled on both fiscal and legislative fronts because of neoliberal opposition, macroeconomic stability has become dependent on monetary policies that feed the bubble, building up the pressure for a future explosion. In Europe, the euro crisis has underlined the illusion of monetary union with fiscal union. While negotiations have led to agreement on some aspects of a banking union, steps towards fiscal union and full economic integration have to contend with a legacy of bitterness left by the eurozone policies in the current crisis, deep suspicion by Germany and northern European countries that they will end up permanently subsidizing their cash-strapped southern neighbours, and rising anti-Brussels nationalist feelings throughout the continent.

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6 How to rebottle the genie

Textbooks tell us that finance is the system that connects those with surplus funds to those who need funds (but don’t have them) to invest in the production process. In this scenario, finance is a productive and constructive force. But in the view of those who would reform the finance system, the essential problem is that finance has become an end in itself – its connection to production severed, leaving the financial economy not only separated from the real economy but also subverting it. Financial reform, say those who want it, could make the financial economy once again the ‘servant’ of the real economy, of production, and of society. In the words of one of the most passionate liberal reformers: The financial catastrophe that occurred in 2007–2008 must not cause us to make mistakes: finance is not the enemy, for the simple reason that, in and of itself, it has no quality of being good or bad. It is only a blind mechanical force that, poorly used or unsupervised, could take a turn for the worse (as we saw with the subprime crisis) or, used well and properly maintained, can offer us something better: prosperity shared by all without harm to our planet (as seen with the development of green bonds). Let us not forget that old saying, ‘Money is a poor master, but a good servant.’ That same tool, used well or poorly, according to the will of actors, can lead to the creation or destruction of value.1

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However, more progressive reformers do not labour under this illusion. They believe that finance is not a force derailed from its ‘true functions’ – but rather one that, under capitalism, displays a constant tendency to lose its connection to production and to become an end in itself. As Marx put it so well: ‘[To the possessor of money capital] the process of production appears merely as an unavoidable intermediate link, as a necessary evil for the sake of money-making. All nations with a capitalist mode of production are therefore seized periodically by a feverish attempt to make money without the intervention of the process of production.’2 Thus, while progressives may support financial reforms that limit the tendency of finance to derail the real economy, that drive, in their view, is fuelled by the dynamics of the system of production itself, by its tendency towards overproduction and stagnation, leading money capitalists to prefer to make money out of money. Liberal reformers and progressives are united, however, around two things: first, that there is an urgent need to rebottle the genie that was released during the liberalization of finance that began during the Reagan–Thatcher years; and second, that ten years after the 2008 crisis, there have been very few, if any, effective reforms put in place to stop such a crisis happening again. On the contrary, there has been aggressive counter-reform, a key manifestation of which was the US Congress successfully passing legislation in early 2018 to dilute the already weak Dodd–Frank Act of 2010.3 This chapter describes proposals for reform in ten key areas, which are accompanied by two caveats:

• They do not comprise a revolutionary programme, for two main reasons: first, they cover only the financial system and

contain no recommendations for reforming the productive system, trade or other sectors of the global capitalist system; second, they are meant to be pursued within the current 242

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dominant system of production and their achievement will not necessarily mean a break with it. Nevertheless, a successful drive to make these reforms real will add to pressures for a comprehensive transformation of the system from a capitalist to a post-capitalist one.

• No matter how attractive and rational reform proposals are, they will not materialize unless reformers are able to construct

a winning alliance of governments, civil society organizations, citizen movements and other actors both within and across national borders. What follows does not provide advice on how to construct such coalitions. What we are confident in, though, is that the proposed programme offers the substantive basis on which such coalitions can be built. Targeting hedge funds and closing tax havens Two entities emerged with greater power following the global financial crisis. One was the central bank (a topic taken up later in this chapter) and the other was private institutional investors. Though weak, the regulatory initiatives that followed the crisis covered the big banks, including investment banks such as Goldman Sachs and Merrill Lynch that converted themselves into fully fledged banks subject to government regulation. Private institutional investors such as private equity funds, hedge funds, sovereign wealth funds and pension funds continued, however, to be virtually unregulated. Collectively, these funds now control some $100 trillion, concentrated in some 20 asset management companies. These companies include BlackRock, with close to $5 trillion in assets, and Vanguard and Amundi, each with more than $1 trillion in assets.4 The implications of a financial world now dominated by these unregulated giants are well laid out by one who has dealt with them first hand: 243

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At the risk of exaggerating, I suggest that humanity may end up depending on a close circle of chief investors and chief economists to allocate savings. These investors will say that their management is highly decentralized and fragmented and therefore has little chance of going in the same direction, but who will guarantee for us that all these people are not going to think in the same way at the same time, leading to a widespread financial panic – with the catastrophic consequences that we have all seen?5

These funds have grown partly because they function as tax shelters for the global elite, and many of them are headquartered in tax havens such as the Cayman Islands and Liechtenstein. The fact that they are tax shelters, as the Panama Papers have shown, is the reason why these entities are so powerful. They have mastered the tax codes of key countries, mined them for possible loopholes, and, like the pirates of old, sail out of their sheltered coves to exploit these vulnerabilities. To take one example, one hedge fund named Renaissance Technologies was able to avoid paying $6.8 billion in taxes over 13 years, using a manoeuvre that is illegal but commonly used: the use of derivatives to claim short-term capital gains as long-term gains not subject to taxes levied on the former.6 The United States’ Internal Revenue Service (IRS) does not need new legal authority to stop the practice, but it is unwilling to take on the hedge funds. As one tax expert sees it: ‘The problem is the IRS is hopelessly outgunned, especially when it comes to complex areas of the law where aggressive entities can marshal armies of lawyers.’ Obviously, then, a key step in taming the hedge funds is to make sure tax agencies are well staffed and that ambiguous provisions in the corporate tax code that can be used for tax avoidance are either legislatively fixed or clarified in the accompanying implementing 244

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rules and regulations (which is usually where lobbyists manage to dilute or thwart the will of the legislative power). There are other measures. Owing to the secrecy they provide their clients, the hedge fund industry, claims one report, ‘seems to operate primarily through offshore jurisdictions’.7 Their preference for tax havens such as Liechtenstein, Panama or the Cayman Islands – and the impact of these on onshore economies – is captured in one report: [A] spokesperson for the UK Financial Services Authority was quoted as saying, ‘nobody ever registers hedge funds in the UK. If somebody did, we’d be scratching our heads over how to deal with it. We’d have to devise something.’ The issue has become all too obvious to both politicians and the public: what is structured offshore has a significant impact onshore … Hedge funds undoubtedly shorted shares in US, UK, French, and other banks and helped bring at least one, HBOS, to a position of needing state aid and forcing it into a merger. The sector has assumed no accountability and is tainted by the combination of very high earnings subject to very little tax.8

Closing down tax havens (or at least forcing them to lift the veil of secrecy they place on ‘resident’ hedge funds and the clients of these funds) is thus an important tool in reducing the power of these entities. Critical in these battles are transparency agreements such as the Automatic Exchange of Information among countries, which requires tax havens to disclose their corporate and financial clients – an arrangement that will cover some 100 countries by 2018.9 A potentially tougher measure is the Foreign Account Tax Compliance Act of the United States (FATCA), which requires financial institutions outside the US to determine whether they have any customers who are US citizens and report 245

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information on all of those customers’ accounts to the IRS, with any institution refusing to comply assessed an automatic withholding tax on its US-sourced income.10 Similar legislation can be adopted by other governments. Such measures need not always be agreements between national governments, or even bilateral or multilateral in character. For instance, during the 2001 Argentine financial crisis, the city of Buenos Aires adopted a policy that all companies ‘situated in [a] low [or] no-tax jurisdiction must either prove that they have genuine economic activity there (similar to that which they wish to undertake in Buenos Aires), or they have to transform into a national Argentinean company’.11 These measures should be seen as part of a multipronged attack on bank secrecy conventions and laws that have long protected both the mafia and the super-rich. Needless to say, tough penalties in the form of huge fines or jail terms for executives of funds that allow themselves to be used illegally as tax shelters would be critical to the effectiveness of anti-tax evasion agreements. Another important legal measure would be to update and upgrade anti-trust or anti-monopoly laws to apply specifically to hedge funds, private equity funds and institutional investors. Bertrand Badré’s fear of collusion is not an idle one. While it is intended as a caricature, there is much truth in Bloomberg analyst Matt Levine’s articulation of many people’s fears about the power of the private equity and hedge funds: There is something a bit weird about so many public companies, which are theoretically locked in the bitter struggle of capitalist competition against each other, all being owned by the same half-dozen mutual fund complexes. It is not entirely crazy to look at those complexes and see the old-timey ‘trusts’, dressed up in modern financial theory. If BlackRock and 246

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Vanguard and Fidelity own shares in every big company in an industry, why should they want those companies to compete hard against each other? And if the shareholders don’t want it, why should the managers compete? If you worry that US companies are increasingly being managed on the behalf of a unitary shareholder class, at the expense of workers and consumers, well, you are not alone.12

Institutional investor control of an industry might not yet be a major problem, but if there’s anything that the recent crisis has taught us, it is that it is better to be proactive than sorry. Proactive measures can include rules against buying shares in competing corporations or in the holding companies of competing oligopolies. A final measure to counteract the threat posed by hedge funds is an old prescription – one that has never been enacted but is widely endorsed – which is to tax all movements of capital across borders, be they undertaken between independent companies or subsidiaries of the same entity. The purpose of this measure, also known as the Tobin tax, is not simply to slow down the movement of capital and bring about a measure of global financial stability. It is to significantly lower the returns on hedge fund investments, making fund contributors less attracted by sales pitches that promise them large, untaxed dividends. Financial institutions will scream freedom of movement and globalists will inevitably say this measure is an attempt to return to a pre-globalized world that no longer exists. It should be remembered, however, that during the so-called Trente Glorieuses, when the post-war international economy was at its height, cross-border movements of speculative capital were severely restricted, and this was a key reason for dynamism of the productive economy that characterized most of that period.

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Banning mortgage—backed securities and derivatives

As noted earlier, MBSs were securities based on mortgages that were pooled together and converted into instruments that could be traded in the market. It was the huge demand for MBSs and the desire of mortgage originators to offload risk to buyers that served as the fatal formula for the issuance of subprime mortgage securities that flooded the global financial system with securities that became toxic after the mortgage holders could no longer service them, nearly bringing down the system. Should MBSs be retained but more rigorously controlled? In their heyday, MBSs were promoted as spreading and diluting risk, thus preventing or limiting bankruptcies resulting from mortgages gone sour. What happened is that risk was indeed spread through the system, but since there were hundreds of billions of subprime MBSs issued, risk was not diluted but became stronger and, like a virus that multiplies past a critical point, nearly killed the system. There is also the argument that MBSs allow mortgage originators to sell off mortgages and obtain capital to release for other ventures. This argument must be set against the consequences of the dangerous incentive to lower lending criteria in order to hook in subprime borrowers if one does not have to take responsibility for the consequences of non-repayment. What may be good for each mortgage originator individually is bad for the whole system collectively, a phenomenon similar to Keynes’ paradox of thrift: that is, each individual saver may be serving his or her own interest but is contributing to pitching an economy into deeper recession. The potential costs of allowing MBSs to continue to be traded are so much greater than the potential benefits, so it makes good sense to disallow them. As for derivatives, there is no quarrel with simple derivatives such as forward contracts in commodity markets; these fix financial 248

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obligations, with a premium assumed by the buyer, to insure against losses brought about by market movements during the time the contract is in force. Forward contracts or hedging in commodity markets is a form of insurance against transparent movements in the real economy. But while agricultural and other commodity futures may have been the historical predecessor of financial derivatives, the former now make up less than 1 per cent of the total market.13 Today, the derivatives markets, as Ole Bjerg points out, ‘are … dominated by trading in derivatives where the underlier is some form of financial indicator with a highly abstract relation to the actual productive economy’.14 The utility of these more complex derivatives is hard to fathom. Take the case of collateralized debt obligations (CDOs). MBSs were securitized mortgages, and CDOs were securitized MBSs. The process involved taking the lower-rated tranches of MBSs, pooling those tranches, and dividing the pool into a new set of tranches for sale to investors. Perhaps the best description of how the end product became detached from its underlying asset is laid out by Kathleen Engel and Patricia McCoy: The complexity ran riot with the resuscitation of CDO tranches. CDOs were pooled and tranched into CDOs squared and CDOs squared were resecuritized into CDOs cubed. The astonishing thing about CDOs (whether they were plain, squared, or cubed) was that the underlying bonds could be junk, yet the top tranche of any CDO could carry an AAA rating. Essentially, CDOs purported to make steak out of chicken. Arrangers pooled tranches of mortgage-backed securities with low or no ratings (the chicken) and sliced those pools into tranches, with the top tranche earning an AAA rating.15

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The fact that buyers did not really understand what they were buying is a good reason for banning finance-based derivatives. The case for banning them increases when the movements of hundreds of billions of these ill-understood instruments can potentially trigger a massive economic catastrophe, like the credit default swaps (CDSs) sold by AIG in 2008. Unleashed on the market, CDSs turned out to be Frankenstein’s monster, over which all actors lost control. A final reason for outlawing finance-based derivatives has to do with the fact that they do not fulfil any useful economic or social function: what purpose do such complex instruments as CDOs and CDSs really serve for buyers and sellers who rarely understand their dynamics? The answer is simple: speculation. Buying CDSs on US debt, for instance, does not require owning US Treasury bonds. It does not mean that the buyer expects the US to default anytime soon. One buys CDSs to speculate on price movements of the underlying asset. If the protection is higher a week after it was bought, the buyer can resell it and make a tidy profit.16 If one wants to gamble, one can go to a regular casino, instead of betting on derivatives with a massive potential to harm society. In sum, in contrast to simple, commodity-based derivatives, financial derivatives should be banned for the following reasons:

• Their dynamics cannot be understood by regular investors or

even by professional ones, as Warren Buffett famously admitted. This being the case, many of those who engage in them incur great personal risk because of their ignorance.

• The movements of these instruments, which are ill-understood even by government regulators, pose a serious potential threat

to the real economy, since they can materialize into crises in interaction with other factors.

• Their

main use is for speculation, not insurance against

individually or socially useful purposes such as protection 250

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against negative price movements provided to farmers by forward contracts. Moving towards 100 per cent reserve banking Excessive leverage (a high ratio of debt to equity) in the lending operations of banks such as Lehman Brothers was one of the central causes of the 2008 financial crisis – the banks had insufficient funds to give back to investors when panic took hold. This necessitated the US government’s bailout of the big banks and the insurance behemoth AIG to prevent a similar run on them. Raising the portion of equity to total assets thus became one of the demands of reformers. Basel III responded by recommending an equity floor of 3 per cent of total assets. This did not satisfy the reformers, however, who demanded a higher ratio – some recommending 20 to 30 per cent.17 Even more radical was the so-called ‘Chicago Plan’, originally put forward by economist Irving Fisher and a group of economists at the University of Chicago including Frank Knight, Henry Simons and Paul Douglas in response to the banking crisis during the Great Depression. Later backers of the plan have spanned the spectrum of post-war economists, from Milton Friedman on the right, to James Tobin in the centre, to Hyman Minsky on the left. The Chicago Plan proposed 100 per cent reserve banking in place of fractional reserve banking: that is, the bank would hold 100 per cent liquid reserves against deposits. This meant that, with deposits 100 per cent covered by liquid assets, loans to the private sector would have to be made from equity or long-term debt incurred by the bank, not from short-term debt from its creditors and depositors. This would enable banks to meet creditors’ and depositors’ demands for their money in the event of an economic crisis.18 The merits of the Chicago Plan are well articulated by Mervyn King, former governor of the Bank of England: 251

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The great advantage of reforms such as the Chicago Plan is that bank runs and the instability they create would disappear as a source of fragility. The Chicago Plan breaks the link between the creation of money and the creation of credit. Lending to the real economy would be made by wide banks [as opposed to narrow banks] and financed by equity or long-term debt, not through the creation of money. Money would once again become a true public good with its supply determined by the government or central bank. Governments would not have to fight against the swings in money creation or destruction that automatically occur today when banks decide to expand or contract credit. It was the sharp fall in credit and money after 2008 that led to the massive expansion of money via quantitative easing. As Irving Fisher put it, ‘We could leave the banks free … to lend money as they please, provided we no longer allowed them to manufacture the money which they lend … In short, nationalize money but do not nationalize banking …’ Such reforms would indeed eliminate the alchemy in our banking system, which the official reform agenda fails to tackle.19

King hesitates, however, to fully support the idea, citing important opposition from the banks that fear losing the ‘implicit subsidy’ that the government Federal Deposit Insurance Corporation’s (FDIC’s) coverage of depositors’ accounts now provides them with, and the ‘disruptive’ effects of such a move in the form of ‘a costly reorganization of the structure and balance sheet of existing institutions’.20 These are not, however, sufficient grounds for not making the move. First of all, resistance from the banks to any attempt to limit their room for manoeuvre is a given. Second, the move to 100 per cent reserve banking could be carried out in stages: for instance, from 3 per cent equity to total assets to 30 per cent after four years, then to 60 per cent after eight years, and finally 100 per cent after ten years. 252

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A move towards 100 per cent reserve banking, as noted above, has had support across the political spectrum. Those on the right see it as a step away from uncontrolled debt creation, while some on the left see it as potentially ‘revolutionary’. Bjerg cites three reasons for the latter: First, control of the money supply would be shifted from commercial banks and credit markets to the central bank and the government, which would restore the government’s capacity to apply measures of monetary policy in order to stabilize the economy or perhaps even steer economic development towards specific societal goals such as equality and sustainability. Second, the profits from issuing new money (seigniorage) would be reclaimed by the central bank and made available to the government for public spending rather than being appropriated by for-profit private banks and distributed to shareholders, managers, speculators or other members of the current monetary aristocracy. Rather than borrowing from private banks and investors at variable interest rates, the state would be able to borrow at zero interest from its own central bank, thus reducing or even eliminating the growing volume of debt that is currently burdening many national economies. And third, the risk of bank runs and monetary collapse would be eliminated as banks would have no other liabilities than what is immediately covered by their reserves of central bank money.21

Nationalizing those TOO–BIG– TO–FAIL As noted earlier, the too-big-to-fail problem was exacerbated rather than resolved by reform efforts following the financial crisis. US government action to merge weaker with bigger banks resulted in the biggest banks in the United States becoming even bigger. The FSB 253

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identified 29 banks whose failure would have negative consequences globally, thus signalling to their managements, according to critics, that they would not be allowed to fail. The Dodd–Frank legislation also encouraged moral hazard, they say, when it designated as ‘systemically important’ all banks that had more than $50 billion in assets. Yet a relatively simple way to turn things around and discourage moral hazard would be to stipulate that because they are ‘systemically important’, banks with over $50 billion in assets should automatically be nationalized to ensure that they would not be a burden to the public should a financial crisis occur. The prospect of preventive nationalization will constitute the ultimate deterrent to the banks’ efforts to grow even bigger at a time when evidence is plentiful that bigger bank size has become dysfunctional in terms of promoting efficiency, financial stability, societal welfare, and even shareholder interest.22 Stronger deterrence can be further achieved if legislation stipulates that, once a bank reaches a certain threshold, say $25 billion, this will automatically trigger an intensive government audit of its condition and performance. The $50 billion figure is useful as it is already enshrined in the Dodd–Frank legislation – short-circuiting debates about what size merits the too-big-to-fail label. As for what happens to nationalized banks, they should be broken up into smaller entities in anti-trust fashion, although there should be no stipulation that these resulting entities should be in private ownership. They may also be state-owned entities, community-owned institutions or cooperative enterprises. In this regard, that state or nationalized banks can be profitable while prioritizing the needs of the community is shown in the case of the highly successful state-owned Bank of North Dakota in the US, which: had almost $4 billion in assets and a $2.67 billion loan portfolio at the end of last year [2010], according to its most 254

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recent quarterly financial report. It made $58.1 million in profits in 2009, setting a record for the sixth straight year. During the last decade, the bank funneled almost $300 million in profits to North Dakota’s treasury.23

Reverting back to Glass– Steagall As noted earlier, the Volcker Rule, as eventually embodied in the Dodd–Frank Act, does not provide a guarantee that federally insured deposits will not be used for speculative activity thanks to two concessions made to the banks. First, the line between proprietary trading (from which the banks are banned) and market-making activities (in which they are allowed to engage) in is an exceedingly porous one. Legally permissible moves to ensure that a bank’s investments do not deteriorate in value can easily shade off into speculative activity implicitly backed by FDIC-insured deposits. Second, a bank is allowed to maintain a hedge fund in-house provided it does not own over 3 per cent of the fund. This will, however, be an open invitation for the bank to plough a large part of its resources into it, since even just 3 per cent of a hedge fund worth hundreds of billions of dollars could run into a few billion dollars’ worth of federally insured depositors’ money. In other words, despite the Volcker Rule, the banks are still organically connected to the trading operations of the largely unregulated shadow banking system, with banks being allowed to use government-insured depositors’ funds for risky activities such as those that led to the massive bailouts in 2008. Under the Trump administration, a major effort has been under way to roll back the Dodd–Frank Act, with the already weak Volcker Rule being a special target. Not satisfied with the concessions they obtained allowing them leeway to use depositors’ money for risky trading, the banks have proposed changes that (one report notes) 255

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‘won’t go so far as to eliminate the ban on proprietary trading, but … would make it easier for banks to comply and give them more control over defining what constitutes improper trading’, meaning that the proposed changes ‘could expand the types of trading that banks are permitted to engage in’.24 Defending an already watered-down Volcker Rule is not, however, enough. A reform agenda must include a return to the strict Glass–Steagall separation between commercial and investment banking that was one of the pillars of financial stability in the mid-twentieth century. Cracking down on executive greed Bankers continue to be very unpopular, with post-crisis scandals like that of Wells Fargo (making up millions of unauthorized accounts for thousands of unsuspecting customers) doing nothing to improve the image of the greedy, devious and overpaid banking executive. In some jurisdictions, reformers have capitalized on public disenchantment with the banks to successfully push through measures to cap or limit executive pay. In the EU, the European Parliament enacted legislation curbing the bonuses of bank executives that capped cash bonuses at 30 per cent of total bonuses and required that at least 40 per cent of the total bonus be deferred for three to five years.25 While there is debate on how much bite the EU caps have, their significance must not be understated. As Bertrand Badré notes, bankers are probably the only professionals to have their compensation set by EU directive.26 Moreover, the present legislation can be a precedent for future, more stringent, bonus and salary curbs. In Switzerland, nearly 70 per cent of voters in a 2013 referendum agreed to give shareholders a veto over executive compensation and forbade large bonus payments or ‘golden handshakes’ to departing 256

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executives, giving the country ‘some of the world’s strictest controls on executive pay’.27 However, a referendum later that same year rejected a proposal to limit the pay of top executives to just 12 times the salary of the pay of the lowest-paid worker. A similar proposal was approved unanimously in Israel’s parliament, although the ratio of top to lowest pay stipulated was a much higher 44, with higher taxes imposed on anything above that ceiling.28 A proposal for a similar ratio-based pay cap was rejected at the EU, although recent amendments have limited bonuses to one year’s pay and require shareholders to vote on executive pay every three years. The Dodd–Frank Act in the US requires financial corporations to disclose their pay ratios but does not mandate specific ratios. A bill stipulating a pay ratio of 25 has been introduced in Congress but it has not yet been taken up. However, the Obama administration did set a cap on executive compensation of $500,000 for the banks that had been bailed out under the Troubled Asset Relief Program (TARP) and had not yet fully repaid the federal government. Bonus caps, ratio-based compensation and maximum pay are different ways of skinning a cat, as the Americans say. Advocates can adopt the method best suited to their electorates, a vast section of which continues to be fired by populist anger over bank executives’ greed and abuses. The appeal of certain proposals must not be underestimated. For instance, it is not at all inconceivable that a bill that limits the top pay of bank executives to $500,000 would make headway in the US legislative process, especially if the TARP precedent were cited and were shown to have had no negative impact on the performance of the TARP-supported banks. Moreover, the national terrain need not be the only place where such proposals can be introduced and implemented. Taking a leaf from the Buenos Aires’ municipal resolution on hedge funds cited earlier, the $500,000 compensation cap could be the subject of a vote in 257

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New York City, where Wall Street is located, and it probably would have a good chance of passing if floated in a referendum. The banking industry, of course, will scream that pay caps will drive the best talent away from the top banks. Even if that claim were true – and it is probably not – it might, in fact, be a good thing for the best talent to be driven out of a non-productive and destabilizing industry and encouraged to go into more productive or useful occupations. Squeezing out the credit ratings agencies The role of CRAs in helping precipitate the 2008 financial crisis is well known. They are currently on the defensive owing to the damage to their reputations, yet, as perhaps the most respected academic expert on CRAs claims, they ‘continue to generate little informational value, and yet be rewarded handsomely for their ratings. They continue to operate as an oligopoly with special regulatory treatment.’29 CRAs represent a case of regulatory capture. A clear example of this was when the Dodd–Frank Act removed CRA exemption from liability for misstatements in a registration or investment prospectus under section 11 of the US Securities Act of 1933 – a move that would have opened the gates to suits against the CRAs for fraud, deception, malice, incompetence, or all of the above. The CRAs responded by refusing to rate a number of new complex instruments. Then the SEC refused to implement the Dodd–Frank Act’s elimination of CRA exemption from liability on the grounds that ‘certain parts of the asset-backed securities markets would not properly function if the SEC implemented the Dodd–Frank mandate’.30 Whatever the reason, the SEC refused to implement the law. Given such regulatory capture, a first step in a strategy to bring CRAs under control would be a congressional review of the SEC’s 258

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implementation of the Dodd–Frank provisions relating to CRAs, with the intent of preventing the SEC from flouting the law. This must be accompanied by legislation to ban the CRAs from rating all derivatives and other complex securities, and exposés of the questionable ratings methodologies of the top CRAs to encourage investors to reduce their reliance on such ratings. A fourth prong would be to apply anti-trust law to break open the cartel of Standard & Poor’s, Moody’s and Fitch. Needless to say, this campaign will have to be carried out largely in the US since the CRA giants are US-based and US-regulated entities. ’ ‘ Agenda for a new Bretton Woods This is probably the most difficult area for reform since the canopy of global and regional institutions that have passed for a system of global governance are in a state of great disarray – a situation that is perhaps at its most serious since World War Two, owing to the erosion of the US-dominated liberal order and the crisis of globalization. What many had hoped would serve as the lynchpin of the global financial system – the IMF – has failed to fill the role of banker of last resort and instead become an enforcer of depressive structural adjustment in Europe, along with Germany, the European Commission and the ECB. Moreover, efforts to reform its system of representation over the last 30 years have yielded few positive results, with the Western powers determined to preserve their hegemonic position. The same failure to accommodate the big emerging economies as well as the less-developed countries has hobbled the ambition of its sister institution, the World Bank, to become the undisputed centre of development finance. The G20, FSB and Basel Committee on Banking Supervision31 have failed to follow through on their promise of becoming Keynesian institutions promoting global financial stabilization that 259

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they displayed in the immediate aftermath of the financial crisis in 2008–09. Moreover, they are lacking in the formal legal personality that is necessary to give their actions the stamp of full legitimacy, authority and credibility. In the meantime, alternative multilateral centres have emerged that are essentially challenging the existing system, such as the Asian Infrastructure Investment Bank (AIIB), controlled by China, and the New Development Bank and the Contingent Reserve Arrangement of the so-called BRICS. As Eswar Prasad notes: The AIIB stands as a perfect example of China’s impatience with marginal changes in the rules of global governance. It is now grabbing the reins and seeking to rewrite the rules but in a way that ostensibly improves on the existing order, which China and other emerging markets see as having been defined by and mainly serving the interests of the major advanced economies. And there is not a dearth of interest in the AIIB, showing that there is little hesitation among both emerging and advanced economies in joining a Chinese-led institution.32

Rather than piecemeal reform, what is perhaps needed now at the global level is a new Bretton Woods Conference that would match – if not surpass – in ambition the historic meeting of July 1944 that set up the World Bank and the IMF. This would be a groundbreaking effort to create more representative institutions to govern the global financial system, reform the international monetary system, and organize financing for economic development, social development and environmental restoration. With trends away from globalization accelerating, the world would probably be better served by a decentralized system of institutions instead of the centralized IMF–World Bank–WTO consortium of global governance that has prevailed during 260

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globalization’s rise, that has been structurally prone to capture by the world’s most powerful nations, and that has served mainly the interests of the global elite. Aside from decentralization, among the principles that should guide the new system would be upholding developmental space for national economies, especially in the global South, the reduction of inequality both within countries and among countries, and achieving a balance between economic development and environmental protection. In the area of global finance and the monetary system, four key reforms are needed: 1. An effective, global system of capital controls and currency taxes to counter the power of private equity funds and hedge funds to shift capital from one jurisdiction to another to take advantage of differences in investment opportunities or currency exchange values. 2. More stringent taxes on the rich at the national level while preventing them from fleeing to tax havens through coordinated regional or global efforts to shut down the latter. 3. Setting up institutions to provide financing for development, climate, and public health that will be funded by state funds derived from taxing national and global elites instead of drawing them from private–public partnerships with institutional investors that can easily be subverted by the latter. (Together, these three reforms are urgent to curb the power of institutional investors, who are now the most powerful players in the global economy.) 4. Urgently setting up, by international agreement, a fiat currency to serve as an international means of exchange to end the dollar’s monopoly as a reserve currency – a condition that allows not 261

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only unfair seigniorial advantages to the United States but is increasingly destabilizing to national economies. The same objective of diluting the strength of the dollar could be achieved by international or regional agreements to substantially increase the use of other strong currencies such as the euro, yen, Swiss franc and renminbi in international or regional settlements.33 Making central banks accountable Central banks, it is said, became ‘the only game in town’ after the outbreak of the 2008 financial crisis.34 Not unexpectedly, this prominence drew serious criticisms from various quarters. These have to be addressed by any reform programme. One charge is that central bank efforts to provide liquidity to the financial system by channelling it through the big private banks led to them sitting on the money, using it for speculation, or employing it to buy back their own stocks. For instance, liquidity provided by the Federal Reserve was instrumental in JPMorgan Chase’s plan to buy back $19.4 billion of its own shares, its most ambitious programme since the 2008 crisis, and in Citigroup’s effort to buy back $15.6 billion of its stocks.35 This criticism is valid. There is no reason why the money created by the central bank should be channelled through the private banks – except as a result of ideological bias. Handing money directly to the people to create demand and ignite the economy was caricatured by Wall Street as Ben Bernanke dropping dollar bills from helicopters because they were worried that such a move would underline how superfluous they (the banks) were. But there are other, more constructive and socially useful ways to get money into people’s hands in a downturn – for instance, by directing money to public works programmes to repair infrastructure, or by investing in the research and development of technologies for the generation 262

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and distribution of renewable energy. There is no limit to the possibilities of socially useful investment that would trigger demand and generate employment for which central bank-created liquidity could be used. When fiscal measures are stalled by right-wing opposition, channelling central bank-created liquidity to such demand- and employment-generating projects would do much more to help an economy in recession than giving money to banks to sit on, speculate with, or use to buy back their stocks. Another serious criticism of central banks is that, with their larger role, society is putting its future more and more in the hands of ‘unelected power’, thus subverting democratic accountability. This is much like the charge of democratic deficit levelled at the EU technocracy. It is also related to the concern that the ideal of ‘central bank independence’ effectively means central bank nonaccountability to society. The idea of central bank independence has recently taken a drubbing. For some, it simply isn’t true in practice, and the most egregious example they cite is the way in which the ECB became an abject servant of the German Bundesbank and the German government’s push to impose harsh austerity policies on Greece. For some, it is a bad idea. In this view, it is essential that in democratic systems there is no non-accountable institution and that the lines of accountability are spelled out clearly. In representative democracies, the accountability of executive agencies is to both the chief of state and to the legislative power. Even if, as in the case of the Federal Reserve and the ECB, the legislative power does not fund the central bank, for reasons of democratic accountability it is imperative that the latter must be accountable to the former: for example, Congress in the US and the European Parliament in the EU. Had EU authorities been clear about the subordination of the ECB to a mature European legislative body, there is a good chance that the devastating austerity policies that were imposed on Greece, 263

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Portugal, Spain and Ireland could have been avoided. Instead, what we saw was the worst of all possible worlds: a nominally independent central bank implementing the policies of the powerful Bundesbank and German government. As Yanis Varoufakis so aptly put it: ‘[W]hile Gordon Brown could rely on the Bank of England to pump out the cash to save the City of London, eurozone governments had a central bank whose charter did not allow it to do the same. Instead, the burden of saving the inane bankers fell on the weakest citizens.’36 Central bank independence might have seemed of not much consequence in the early twentieth century, but things are different now. The Federal Reserve is now one of the most powerful institutions in Washington, unconstrained by checks and balances, as the former chief economist of the US Department of Labor wrote: It would be wrong to infer that the Fed is suited to its heroic role. Our constitution, our history and even our common sense tell us that Congress and the president should sort out the federal budget. They are elected and answerable to the public, and the Fed is not … The Fed and its chairman are unaccountable. Most government agencies complain that another branch or office of government stops them from doing what they would really like to do … Call it gridlock, call it checks and balances, call it what you like – our federal government is well-designed to block extraordinary gyrations and dramatic changes in policy … Not so the Fed. With little more than a wink and a nod, the Fed and its chairman can purchase practically all the paper it wants, currently $85 billion a month, in Treasury and mortgage-backed securities. No small feat … Who within government could block the Fed from making these purchases or pursuing almost any other action? No one, it turns out. The Fed is an agency that has largely 264

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escaped oversight … It operates without check, without balance. It appears to work when the other branches of government fail, but it offends our sense of constitutional democracy.37

While it might be an exaggeration to say that the chair of the Federal Reserve is the most powerful official in Washington, it is arguable that he or she is the second most powerful. True, the president nominates the Federal Reserve chair, but once nominated and confirmed by the Senate, there is no check to his or her power. For such power to be legitimate in a democracy, its possessor must be elected. It is, in short, high time for the position of the central bank chair to be a nationally elected one. The euro: a choice between full union and exit There are no easy solutions for the eurozone. As it stands now, the currency area has evolved into a two-class union, where Germany and the northern European states dictate the terms of economic survival to southern and eastern Europe. The only way forward is to move towards full fiscal and political union, with sensitivity to the different levels of development and priorities among the different countries. Maintaining the budget deficit at no more than 3 per cent of total GDP – a rule that Germany itself breached in the past – is unrealistic, and a fiscal union will mean that, as in the US, surplus regions will have to transfer funds to deficit regions, at least for a time, until a combination of planning and the market reduces or eliminates differences in development. If the eurozone’s dominant nations cannot accept these and other conditions necessitated by uneven development within the union, then it is better for the less-developed countries to leave in order to gain the macroeconomic wiggle room they currently lack under the euro regime, such as the power to devalue a currency in 265

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order to ease a trade deficit. As Joseph Stiglitz writes, it is important for affected countries to avoid romanticizing the euro project: ‘The euro is just a 17-year-old experiment, poorly designed and engineered not to work. There is so much more to the European project, the vision of an integrated Europe, than a monetary arrangement.’38 Conclusion This chapter has proposed solutions to address the key problems created by global finance, starting with what has emerged as the main threat after the 2008 financial crisis: institutional investors and the tax havens from which they sail out to exploit the vulnerable points of the system. The measures proposed constitute a ‘minimum programme’: that is, a set of moves that strengthen the world’s defences against another financial crash while not eliminating the possibility of such an event. Capitalism as a system is structurally prone to generate financial crisis, and the programme outlined here assumes a global economic system that continues to function under the rules of capitalism. However, pushing these reforms will be a giant step in a longer process of transformative change. That change cannot, however, take place without addressing in a fundamental way all other key dimensions of capitalism, especially its engine: the insatiable desire for greater and greater profits.

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7 Conclusion Why financial reform is not enough

In 2018, as the world marked ten years since the 2008 financial crisis, two contradictory scenarios were unfolding: one was a massive, worldwide sell-out of stocks during a few days’ wild trading in February 2018, which resulted in a steep plunge in stock prices and an estimated paper loss of $4 billion. The other was the façade of normality conveyed by the media about the US economic recovery finally taking hold. Markets stabilized following the plunge, but there was little optimism that this stability would last. Over the next few months, the question for many market players and non-players alike was not if another crash would take place, but when. For there was no fooling the world that something significant had changed since the last crash. Indeed, for many of those following Wall Street, the elements for a crash were out there, circling to create a perfect, financial storm. Towards the perfect storm What were these elements? First, there was Wall Street’s resistance to reform. The Dodd– Frank Act had not only proved to be of dubious effectiveness, but the US Congress had begun the process of gutting it by loosening the enforcement of its key provisions for banks with under $250 billion in assets. This took place even as the industry enjoyed record profits, ripping apart the banks’ claims that the legislation was killing their profitability.1 269

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Second, the too-big-to-fail problem had become worse. The big banks that had been rescued by the US government in 2008 because they were seen as too-big-to-fail had become even more too-big-tofail, with the ‘big six’ US banks – JPMorgan Chase, Citigroup, Wells Fargo, Bank of America, Goldman Sachs and Morgan Stanley – collectively having 43 per cent more deposits, 84 per cent more assets, and triple the amount of cash they held before the 2008 crisis. Essentially, they had doubled the risk that felled the banking system in 2008.2 Third, the products that had triggered the 2008 crisis were still being traded. This included around $6.7 trillion in MBSs sloshing around, the value of which was maintained only because the Federal Reserve had bought $1.7 trillion of them.3 US banks collectively held $157 trillion in derivatives, about twice global GDP. This was 12 per cent more than they possessed at the beginning of the 2008 crisis. Citigroup alone accounted for $44 trillion, or 50 per cent more that its pre-crisis holdings, prompting a sarcastic comment from one analyst that the bank seemed ‘to have forgotten the time when they were a buck a share’, alluding to the low point in the bank’s derivatives’ value in 2009.4 Fourth, the new stars in the financial firmament – the institutional investors’ consortium made up of hedge funds, private equity funds, sovereign wealth funds, pension funds and other investor entities – continued to roam the global network unchecked, operating from virtual bases called tax havens, looking for arbitrage opportunities in currencies or securities, or sizing up the profitability of corporations for possible stock purchases. Ownership of the estimated $100 trillion in the hands of these floating tax shelters for the super-rich was concentrated in 20 funds. Fifth, these actors were racking up profits in a sea of liquidity provided by central banks, whose releasing of cheap money resulted in the issuance of trillions of dollars of debt, pushing the level of debt globally to $325 trillion, more than three times the 270

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size of global GDP.5 There was a consensus of economists along the political spectrum that this debt build-up could not go on indefinitely without inviting catastrophe. The limits of fabricated demand The role of central bank-induced liquidity in eventually deepening instead of mitigating the crisis is worth discussing. Even as they profited from injections of cheap money into the big banks, the denizens of Wall Street knew that central bankfomented demand was artificial. As many of them saw it, the central bank-backed creation of debt was a case of ‘fabricated demand’ that might keep investors happy and the economy above water for a time, but would have to end at some point, with unpleasant consequences for the economy and for investors. A succinct analysis of the unsustainability of central bank-fabricated demand was provided by one investment adviser: With the goal of increasing asset prices and inducing the wealth effect to spur economic activity, the central banks bought assets aggressively for years, and it worked to at least calm the nerves of investors. Institutional investors even piggy-backed on this effort … Anyone who appreciates the simple notion that price is a function of supply and demand recognizes that the substantial capital inflows from the combined central banks spurred asset prices higher for years, and most investors did not want to fight it, with justification.6

A turning point, however, was imminent, he continued: [G]iven the changes that are happening to liquidity, many of those same investors are not appreciating the risks quite yet. 271

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If high levels of fabricated demand served to increase asset prices, the opposite is likely when those asset purchase programs reverse as they are now … Now that fabricated demand is over, natural demand levels will prevail again, but natural demand is also far lower than where current demand still is perceived to be. [We] are in the third major down period in US history, and now central bank stimulus efforts have turned on their head. That creates a double drain on demand … The stock market, bond market, and real estate markets are set up for a crash based on simple liquidity observations. Price is based on supply and demand, and demand is cratering.7

Why would the debt creation of central banks not sustain demand? One answer is provided by observers such as Nomi Prins: it was not reaching firms and consumers and was being used by the banks for speculation or buying up their stocks. While it does seem likely that a large part of the money might have been employed in this fashion, what also appears to be the case is that, despite recordlow interest rates, people were not borrowing because they were paying back debt after binging on it, and companies were reluctant to borrow to increase production because there was little added demand in the real economy.8 The fundamental problem:

inequality and falling demand Ultimately, it was the dynamics of the real economy that appeared to be the real determinant of developments in the financial economy. This was not a novel insight. From the perspective of Marxist economists, the gyrations of the financial economy were a result of the deep-seated contradictions of the real economy, in particular the tendency towards overproduction, or supply outstripping demand. 272

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One cannot understand the 2008 crisis and its aftermath without taking into account the crisis of overproduction that had put an end to the long boom known as the Trente Glorieuses, or Thirty Glorious Years, from the late 1940s to the late 1970s. The escape route from the ‘stagflation’ crisis (a combination of stagnation and inflation) that gripped the industrial world was a combination of neoliberal restructuring, globalization of production, and financialization – each of which is explored here. Neoliberal restructuring essentially involved a redistribution of wealth towards the rich ‘investor class’, which in theory would create incentives for them to invest in production. Meanwhile, production was globalized (through the transfer of productive facilities to take advantage of the cheap labour in developing countries) in the hope that this would make production more profitable. But these two neoliberal measures were wracked by a contradiction. By cutting into or restraining the income of workers and the middle class in favour of the so-called investor class, they ended up restraining the demand for products. This left the system resorting to financialization as the main way to escape the conundrum of overproduction. Financialization involved channelling surplus capital to speculation as the key source of profits, along with the creation of vast debt to increase aggregate demand – and thus profitability – in the real economy to compensate for stagnant or declining wages. Financialization depended on the creation of speculative bubbles to drive investment, the results being the dot.com bubble in the late 1990s followed by the subprime mortgage bubble in the mid-2000s. Not surprisingly, overinvestment in these areas followed, and this resulted in the deflation of these bubbles followed by recession and stagnation. With little natural demand in the economy, fabricated demand through the injection of trillions of dollars in cheap money into the banks became the instrument to trigger demand and thus bring the economy back to life. That solution seems to 273

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have run its course and we are back to the underlying problem that now seems so intractable: inadequate demand. The role of depressed wages and sharply rising inequality in reducing the dynamism of the real economy has been even more sharply emphasized recently by progressive researchers. To Josh Bivens of the Economic Policy Institute (EPI), ‘The failure of wages of the vast majority of Americans to benefit from economy-wide growth in productivity (or income generated in an average hour of work) has been the root cause of the stratospheric rise in inequality and the concentration of economic growth at the very top of the income distribution.’9 Not only did this produce a social crisis, but, even before the Great Recession that followed the 2008 crisis, growth had already been constrained ‘more by slow growth in aggregate demand than by slow growth in the economy’s productive capacity’.10 Not surprisingly, the crisis of demand degraded productive capacity, resulting in a negative feedback termed ‘hysteresis’ by economists: Crucially, there is ample evidence that the degraded growth in potential output is itself another casualty of too-slack demand. It is now well-known that changes in productive capacity (i.e., the supply side of the economy) are likely affected by changes in the demand-side of the economy. The most obvious example concerns capital investment. When demand is weak, customers disappear and workers’ wages don’t grow as fast, or grow at all, as rising unemployment crushes workers’ bargaining power. A shortage of customers and weak wage growth blunts the incentive of firms to invest in plants or equipment to expand capacity or save on labor costs. This in turn slows the growth of the economy’s capital stock, a key input in its productive capacity. Short recessions will leave only a small scar on an economy’s productive capacity, but there is now ample evidence 274

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that longer and steeper recessions can do serious damage to even the economy’s potential, let alone actual, growth. We have clearly seen this dynamic over the past decade.11

’ ‘ Orthodox economists and secular stagnation An interesting development is that a number of influential orthodox economists have now swung around to the progressive position of attributing what they have called ‘secular stagnation’ to a crisis of profitability in the real economy. For instance, David Lipton, the First Deputy Managing Director at the IMF, revealed in an important 2016 lecture at the Peterson Institute that one school at the Fund, to which he apparently belongs, feels that ‘low growth is a symptom of an increasing scarcity of profitable investments that began well before the 2008 crisis. Real interest rates have been falling for 15 years and, looking at very low interest rates on long-term bonds, markets appear to expect a long-lasting secular stagnation.’12 Perhaps the establishment economist most associated with the theory of secular stagnation is Larry Summers, former Secretary of the Treasury under Bill Clinton and one of Barack Obama’s key economic advisers. To Summers, the central problem of the economy is the weak demand in the real economy over the last two decades, and extraordinary measures have not been able to surmount it. As he expressed it in one interview: One of the arguments that I’ve made is that we had the mother of all housing bubbles, we had a vast erosion of credit standards, we had really easy money, we had the Bush tax cuts plus the Iraq war, and all that got us in the pre-crisis period was adequate growth. Doesn’t that show that there’s some kind of secular stagnation that you needed all that extraordinary stuff to get to adequate plus growth?13 275

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Like the EPI’s Bivens, Summers says that the result is hysteresis, or an amplifying of negative feedback, since ‘lack of demand creates its own lack of supply down the road in terms of productivity growth’.14 To Summers and other secular stagnation theorists, the loss of dynamism is something that affects not only the industrial world, where maturity is accompanied by lower growth rates, but the developing world as well. For Lipton, the convergence with the advanced economies that had been touted as one of the benefits of globalization by its neoliberal proponents was slowing down in the case of developing economies. But perhaps more alarming, he noted: IMF projections suggest that many major emerging economies are not headed for convergence at all. For many countries, even abstracting from currency movements, per capita income is either flat or falling as a share of US per capita income … Productivity gains and capital deepening look set to fall short, contributing to political strains as expectations of better jobs and higher living standards are not realized. Sadly, this now appears to be true of Brazil, Russia, Mexico, South Africa, and others.15

The limits of financial reform If weak demand in the real economy brought about by inequality is the problem, then it is obvious that quantitative easing and negative interest rates can bring only very limited and temporary relief to an economy in crisis, and creating debt may in fact deepen the crisis in the medium term. Moreover, a programme of reform in the financial sector would likewise be insufficient to bring longer-term stability to the financial sector. Indeed, without addressing the crisis of demand in the real economy, a reformed financial sector would find it difficult to resist for long the intense pressures for capital to seek profitability in finance rather than in a stagnant productive sector. 276

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In sum, a programme of financial reform would have to be integrated into a more comprehensive programme of reform of the real economy. This enterprise would have to seriously address the lack of demand rooted in increasing inequality. It would have to bravely acknowledge its roots in the unequal power relations between capital and labour, how this unequal power translates into increasing inequality, and how inequality translates into anaemic demand that acts as a brake on the expansion of production. Reformed capitalism or post-capitalism? For some, the most urgent need is how to reform capitalism. For others, capitalism’s constant search for profitability is a fundamental source of instability that will ultimately undermine all efforts at reforming it – as happened to post-war Keynesianism in the late 1970s. What is needed, they say, is a post-capitalist programme. Such a post-capitalist strategy is made all the more urgent by the limits to economic expansion and growth imposed in particular by the environment and the climate – limits that can be breached only at the risk of inviting a global catastrophe which many, including the author, claim is already in the process of unfolding. One thing is certain. A renewed commitment to globalization – which is what liberal reformers such as Lipton of the IMF call for – will simply be laughed off the table, as he himself seemed to admit in his Peterson Institute lecture.16 It is increasingly clear that the way forward will be largely determined by the outcome of a political struggle between two post-globalization camps. The first espouses a defensive programme that involves state management of the economy but leaving the capitalist mode of production largely intact (along with its class inequalities), although with discriminatory privileges for whole communities based on ethnicity, blood and race, and with borders sealed to migrants. The second espouses 277

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stronger state and civil society management of the economy, one that moves it beyond capitalism, with a strong dose of radical income and wealth redistribution, while welcoming migrants and protecting democratic processes. One would not be too far off in characterizing this as a confrontation between fascism and social democracy. This struggle, however, is another story, one that is beyond the scope of this book. But the one conclusion we can come to is that, unless a determined effort is now made to bring capitalism under control, ‘the future belongs to me’, as that young member of the Nazi party sings in that chilling scene from the movie Cabaret.

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Notes Chapter 1 1 See, among others, ‘How China’s Going to Try to Control its Massive Housing Bubble’, Bloomberg, 28 November 2017, https://www.bloomberg. com/news/articles/2017-11-27/china-s-war-on-bubbles-means-homessales-set-to-fall-in-2018, accessed 30 July 2018. See also K. Bradsher, ‘China’s Housing Market is Like a Casino. Can a Property Tax Tame It?’, New York Times, 22 January 2018, https://www.nytimes.com/2018/01/22/ business/china-housing-property-tax.html, accessed 30 July 2018. 2 A. Sheng and N. C. Soon (2016) Shadow Banking in China. Chichester: John Wiley, p. 151. 3 W. Jinglian, quoted in A. Kuhn, ‘Chinese Markets “Worse than a Casino”,’ Los Angeles Times, 29 March 2001, http://articles.latimes.com/2001/ mar/29/business/fi-44137, accessed 30 July 2018. 4 ‘China’s Stock Market Value Exceeds 10 Trillion for the First Time’, Bloomberg, 15 June 2015, https://www.bloomberg.com/news/ articles/2015-06-14/china-s-stock-market-value-exceeds-10-trillion-forfirst-time, accessed 25 June 2017. 5 ‘Shanghai’s Stock Index Ends 2018 as the World’s Biggest Loser as Trade War, Slowing Chinese Economy Weighs on Confidence’, South China Morning Post, 31 December 2018, https://www.scmp.com/ business/markets/article/2179765/hong-kong-shares-steady-earlytrading-after-wall-streets-wild?fbclid=IwAR0y7B6E-F4d6D7nv0P_ HWAoxGp8xHue7NTR5bZ_BZK3zq9IdvqgZWtL2Xc, accessed 14 January 2019. 6 S. Leng, ‘Firms Sucked into Black Hole of Shadowy Debt’, South China Morning Post, 18 July 2018. 7 Sheng and Soon, Shadow Banking in China, p. xxiv. 8 Ibid., p. xxix. 9 ‘Finance Has Always Been More Profitable’, Noahpinion, 28 February 2013, http://noahpinionblog.blogspot.jp/2013/02/finance-has-alwaysbeen-more-profitable.html, accessed 1 January 2013. 10 K. Marx (1971) Capital, Vol. III. Moscow: Progress Publishers, p. 58. 11 M. Amato and L. Fantacci (2012) The End of Finance. Cambridge: Polity Press, p. 42. 279

PAPER DRAGONS 12 H. Minsky (1982) Can It Happen Again? Armonk NY: M. E. Sharpe, p. 284. 13 Berkshire Hathaway 2002 annual report, http://www.berkshirehathaway. com/2002ar/2002ar.pdf, accessed 4 March 2018. 14 A. Mian and A. Sufi (2015) House of Debt. Chicago IL: University of Chicago Press, p. 2.

Chapter 2 1 ‘Efficient Market Hypothesis’, Investopedia, 2017, http://www. investopedia.com/terms/e/efficientmarkethypothesis.asp?lgl=no-infinite, accessed 1 January 2017. 2 A. Turner (2016) Between Debt and the Devil: Money, Credit, and Fixing Global Finance. Princeton NJ: Princeton University Press, pp. 37–8. 3 S. Das (2011) Extreme Money: The Masters of the Universe and the Cult of Risk. London: Penguin, p. 482. 4 Ibid. 5 Speech by Deputy Governor Jon Nicolaisen at the Norwegian Academy of Science and Letters, 12 April 2016, http://www.norges-bank. no/en/Published/Speeches/2016/2016-04-12-DNVA, accessed 1 January 2017. 6 C. Crouch (2009) ‘Privatized Keynesianism: An Unacknowledged Policy Regime’, British Journal of Politics and International Relations 11 (3), pp. 382–99, http://onlinelibrary.wiley.com.proxy.binghamton.edu/ doi/10.1111/j.1467-856X.2009.00377.x/full, accessed 1 January 2017. See also R. Bellofiore (2014) ‘The Great Recession and the Contradictions of Contemporary Capitalism’ in R. Bellofiore and G. Vertova (eds), The Great Recession and the Contradictions of Contemporary Capitalism. Cheltenham: Edward Elgar, p. 14. 7 M. Amato and L. Fantacci (2012) The End of Finance. Cambridge: Polity Press, p. 42. 8 J. M. Keynes (1937) ‘The General Theory of Employment’, Quarterly Journal of Economics 51, pp. 212–23. 9 Ibid. 10 B. Lucarelli (2011) The Economics of Financial Turbulence. Cheltenham: Edward Elgar, p. 60. 11 J. M. Keynes (1930) A Treatise on Money. London: Macmillan, pp. 41–3. 12 Ibid. 13 J. Bibow (2009) Keynes on Monetary Policy, Finance, and Uncertainty. London: Routledge, p. 5. 14 J. M. Keynes quoted in ibid. 15 J. M. Keynes (1936) The General Theory of Employment, Interest, and Money. London: Macmillan, pp. 161–2. 280

notes 16 H. Minsky (1982) Inflation, Recession, and Economic Policy. London: Harvester Press, p. 81. 17 H. Minsky (1982) Can It Happen Again? Armonk NY: M. E. Sharpe, p. 284. 18 H. Minsky (1982) Stabilizing an Unstable Economy. New Haven CT: Yale University Press, p. 119. 19 Ibid., p. 78. 20 Lucarelli, The Economics of Financial Turbulence, p. 95. 21 Figures from US Bureau of Economic Affairs, cited by V. Popov and K. S. Jomo (2015) ‘Income Inequalities in Perspective’, Development 58 (2–3), p. 202. 22 R. Desai (2016) ‘The Value of History and the History of Value’ in T. Subasat (ed.), The Great Financial Meltdown. Cheltenham: Edward Elgar, p. 154. 23 P. Mason (2015) PostCapitalism: A Guide to Our Future. London: Penguin, p. 91. 24 Ibid., pp. 91–2. 25 R. McCormack, ‘The Plight of American Manufacturing’, The American Prospect, 21 December 2009, http://prospect.org/article/plight-americanmanufacturing, accessed 1 January 2017. 26 C. Duhigg and K. Bradsher, ‘How the US Lost Out on iPhone Work’, New York Times, 21 January 2012. 27 D. Alpert (2013) The Age of Oversupply. New York NY: Penguin, p. 11. 28 A. Farlow (2013) Crash and Beyond. Oxford: Oxford University Press, pp. 8–9. 29 D. Basu and R. Vaseduvan (2011) ‘Technology, Distribution, and the Rate of Profit in the US Economy’. Working Paper 2011‐32. Amherst MA: Department of Economics, University of Massachusetts Amherst’, p. 36, https://scholarworks.umass.edu/cgi/viewcontent. cgi?article=1139&context=econ_workingpaper, accessed 10 January 2017. 30 Popov and Jomo, ‘Income Inequalities in Perspective’, pp. 196–205. 31 ‘Could It Happen Again?’, The Economist, 20 February 1999, p. 19. 32 See the debate in D. Harvey (2016) ‘Crisis Theory and the Falling Rate of Profit’ in Subasat, The Great Financial Meltdown, pp. 37–54; M. Roberts, ‘Monocausality and Crisis Theory’ in ibid., pp. 55–72; A. Freeman, ‘Booms, Depressions, and the Rate of Profit: A Pluralist, Inductive Guide’ in ibid., pp. 73–94. 33 Basu and Vaseduvan, ‘Technology, Distribution, and the Rate of Profit’. 34 ‘Finance Has Always Been More Profitable’, Noahpinion, 28 February 2013, http://noahpinionblog.blogspot.jp/2013/02/finance-has-alwaysbeen-more-profitable.html, accessed 1 January 2013. 35 K. Marx (1971) Capital, Vol. II. Moscow: Progress Publishers, p. 58. 36 Das, Extreme Money, p. 77. 281

PAPER DRAGONS 37 Ibid. 38 Alpert, The Age of Oversupply, p. 52. 39 Crouch, ‘Privatized Keynesianism’. 40 Freddie Mac is the Federal Home Loan Mortgage Corporation (FHLMC) and Fannie Mae the Federal National Mortgage Association (FNMA). 41 R. Rajan (2010) Fault Lines. Princeton NJ: Princeton University Press, p. 39. 42 Crouch, ‘Privatized Keynesianism’. 43 Alpert, The Age of Oversupply, p. 61. 44 A. Mian and A. Sufi (2015) House of Debt. Chicago IL: University of Chicago Press, p. 8. 45 Ibid., p. 99. 46 J. Y. Lin (2013) Against the Consensus: Reflections on the Great Recession. Cambridge: Cambridge University Press, p. 2. 47 Mian and Sufi, House of Debt, pp. 96–8. 48 T. V. Somanathan and V. Anantha Nageswaran (2015) The Economics of Derivatives. Cambridge: Cambridge University Press, p. 115. 49 Keynes, The General Theory, p. 155. 50 Mian and Sufi, House of Debt, pp. 103–4. 51 Farlow, Crash and Beyond, p. 38. 52 Ibid., p. 39. 53 Somanathan and Nageswaran, The Economics of Derivatives, p. 117. 54 Das, Extreme Money, p. 73. 55 Ibid., pp. 69–74. 56 G. Zestos (2016) The Global Financial Crisis. London: Routledge, p. 101. 57 Ibid., p. 121. 58 Ibid., p. 122. 59 B. Eichengreen (2016) Hall of Mirrors. Oxford: Oxford University Press, p. 327. 60 E. Sommeiller and M. Price (2016) The Increasingly Unequal States of America. Washington DC: Economic Policy Institute, http://www.epi. org/publication/income-inequality-by-state-1917-to-2012/, accessed 1 January 2017. 61 Mian and Sufi, House of Debt, p. 2. 62 Ibid. 63 Ibid. 64 Ibid., p. 23. 65 R. Koo (2009) The Escape from Balance Sheet Recession and the QE Trap. Singapore: John Wiley, p. 26. 66 J. Cochrane (2010) ‘Fiscal Stimulus, RIP’, https://faculty.chicagobooth. edu/john.cochrane/research/papers/stimulus_rip.html, accessed 1 January 2017. 282

notes 67 P. Krugman (2012) End This Depression Now. New York NY: W. W. Norton, p. 117. 68 Mian and Sufi, House of Debt, p. 128. 69 Ibid., p. 125. 70 Koo, Escape from Balance Sheet Recession, p. 26. 71 Ibid., pp. 15–16. Or, as Keynes himself put it: ‘[A]lthough the amount of [an individual’s] own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself ’ (Keynes, The General Theory, p. 84). 72 Mian and Sufi, House of Debt, pp. 156–7. 73 Quoted in C. Woll (2014) The Power of Inaction. Ithaca NY: Cornell University Press, p. 101. 74 Simon Johnson quoted in J. Lybeck (2016) The Future of Financial Regulation. Cambridge: Cambridge University Press, p. 408. 75 S. Pizzigati and S. Anderson (2016) Executive Excess 2016: The Wall Street Bonus Loophole. Washington DC: Institute for Policy Studies, http:// www.ips-dc.org/executive-excess-2016-wall-street-ceo-bonus-loophole/, accessed 1 January 2017. 76 Ibid. 77 P. Krugman, ‘Banking on the Brink’, New York Times, 22 February 2009, http://www.nytimes.com/2009/02/23/opinion/23krugman.html, accessed 1 January 2017. 78 Ibid. 79 Eichengreen, Hall of Mirrors, p. 293. 80 Ibid., p. 296. 81 E. J. Fox, ‘Here’s the Stunning Amount of Money Top Wall Street CEOs Made in 2015’, Vanity Fair, 21 March 2016, http://www.vanityfair.com/ news/2016/03/wall-street-ceo-pay-2015, accessed 1 January 2017. 82 Mian and Sufi, House of Debt, p. 150. 83 Ibid., p. 142. 84 Ibid., p. 133. 85 Ibid., p. 131. 86 Eichengreen, Hall of Mirrors, p. 317. 87 Mian and Sufi, House of Debt, p. 131. 88 A. Admati and M. Hellwig (2013) The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about it. Princeton NJ: Princeton University Press, p. 95. 89 Ibid., p. 96. 90 Ibid. 283

PAPER DRAGONS 91 Lybeck, The Future of Financial Regulation, p. 397. 92 Admati and Hellwig, The Bankers’ New Clothes, p. 110. 93 Lybeck, The Future of Financial Regulation, pp. 406–7. 94 Ibid., p. 411. 95 P. Hurtado, ‘The London Whale’, Bloomberg Quicktake, 16 October 2013, https://www.bloomberg.com/quicktake/the-london-whale, accessed 1 January 2017. 96 Woll, The Power of Inaction, pp. 56–60. 97 Ibid., p. 7. 98 Ibid., p. 40. 99 J. Kirshner (2014) American Power after the Financial Crisis. Ithaca NY: Cornell University Press. 100 Woll, The Power of Inaction, pp. 50–6. 101 Quoted in Woll, The Power of Inaction, p. 52. 102 P. Morici, ‘The United States is Becoming Too Much Like Greece’, Fox News, 15 June 2012, http://www.foxnews.com/opinion/2012/06/15/ united-states-is-becoming-too-much-like-greece.html, accessed 1 January 2017. 103 Woll, The Power of Inaction, p. 102. 104 Eichengreen, Hall of Mirrors, pp. 298–9. 105 The points I make here are more fully developed in ‘How Obama’s Economic Legacy Lost the Elections for Hillary Clinton’, Foreign Policy in Focus, 16 November 2016, http://fpif.org/obamas-legacy-lost-electionshillary/, accessed 1 January 2017.

Chapter 3 1 H. Pym (2014) Inside the Banking Crisis: The Untold Story. London: Bloomsbury, p. 12. 2 G. Rayner, ‘Banking Bailout: The Rise and Fall of RBS’, Telegraph, 20 January 2009, http://www.telegraph.co.uk/finance/newsbysector/banks andfinance/4291807/Banking-bailout-The-rise-and-fall-of-RBS.html, accessed 25 January 2017. 3 Pym, Inside the Banking Crisis, p. 100. 4 E. Engelen, I. Erturk, J. Froud, S. Johal, A. Leaver et al. (2011) After the Great Complacence: Financial Crisis and the Politics of Reform. Oxford: Oxford University Press, p. 141. 5 Ibid., p. 145. 6 S. Das (2011) Extreme Money: The Masters of the Universe and the Cult of Risk. London: Penguin, pp. 10–11. 7 J. Lepper, M. Shabani, J. Toporowski and J. Tyson (2016) ‘Monetary Adjustment and Inflation in the UK after 1980’ in E. Hein, D. Detzer and 284

notes N. Dodig (eds), Financialisation and the Financial and Economic Crisis: Country Studies. Cheltenham: Edward Elgar, p. 76. 8 A. Turner (2016) Between Debt and the Devil: Money, Credit, and Fixing Global Finance. Princeton NJ: Princeton University Press, p. 93. 9 J. Lybeck (2016) The Future of Financial Regulation. Cambridge: Cambridge University Press, p. 149. 10 Ibid. 11 Ibid., pp. 155–6. 12 Ibid., p. 153, 158. 13 M. King (2016) The End of Alchemy: Money, Banking, and the Future of the Global Economy. London: Little, Brown, pp. 110–11. 14 Ibid., p. 118 15 M. Sandbu (2015) Europe’s Orphan: The Future of the Euro and the Politics of Debt. Princeton NJ: Princeton University Press, pp. 84–5. 16 Turner, Between Debt and the Devil, p. 79 17 Ibid., p. 216. 18 Ibid., p. 6. 19 Pym, Inside the Banking Crisis, pp. 174–6. 20 Turner, Between Debt and the Devil, pp. 187–90; King, The End of Alchemy, pp. 356–7. 21 Unidentified interviewee quoted in C. Woll (2014) The Power of Inaction. Ithaca NY: Cornell University Press, pp. 106–7. 22 Pym, Inside the Banking Crisis, p. 224. 23 ‘Poorest of the Rich: A Survey of the Republic of Ireland’, The Economist, 16 January 1988. 24 ‘Ireland Shines’, The Economist, 15 May 1997, http://www.economist.com/ node/149333, accessed 10 February 2017. 25 F. O’Toole (2009) Ship of Fools: How Stupidity and Corruption Sank the Celtic Tiger. London: Faber and Faber. 26 S. Ó Riain (2017) ‘Road to Austerity’ in W. Roche, P. O’Connell and A. Prothero (eds), Austerity and Recovery in Ireland. Oxford: Oxford University Press, p. 34. 27 O’Toole, Ship of Fools, p. 19. 28 Sandbu, Europe’s Orphan, p. 30. 29 ‘Europe Approves Irish Rescue and New Rules on Bailouts’, New York Times, 28 November 2010, http://www.nytimes.com/2010/11/29/business/ global/29euro.html, accessed 29 January 2017. 30 A good discussion of this issue is found in Woll, The Power of Inaction, p. 153; Lybeck, The Future of Financial Regulation, pp. 250–3. 31 Lybeck, The Future of Financial Regulation, p. 247. 32 Ó Riain, ‘Road to Austerity’, p. 34. 33 ‘Demonstrators in Ireland Protest Austerity Plan’, New York Times, 285

PAPER DRAGONS 27 November 2010, http://www.nytimes.com/2010/11/28/world/ europe/28dublin.html, accessed 29 January 2017. 34 W. Roche, P. O’Connell and A. Prothro, ‘Poster Child or Beautiful Freak?: Austerity and Recovery in Ireland’ in Roche et al., Austerity and Recovery in Ireland, p. 13. 35 ‘Ireland Unemployment Rate’, Index Mundi, http://www.indexmundi. com/ireland/unemployment_rate.html, accessed 19 January 2017. 36 ‘The True Cost of Austerity and Inequality: Ireland Case Study’, Oxfam, September 2013, https://www.oxfam.org/sites/www.oxfam.org/files/ cs-true-cost-austerity-inequality-ireland-120913-en.pdf, accessed 19 January 2017. 37 M. Blyth (2013) Austerity: The History of a Dangerous Idea. Oxford: Oxford University Press. 38 Roche et al., ‘Poster Child or Beautiful Freak?’, p. 20. 39 Ó Riain, ‘Road to Austerity’, p. 37. 40 Lybeck, The Future of Financial Regulation, p. 260. 41 J. Stiglitz (2016) The Euro. New York NY: W. W. Norton, p. 112. 42 Sandbu, Europe’s Orphan, p. 56. 43 M. Wolf (2014) The Shifts and the Shocks. New York NY: Penguin Press, p. 79. 44 B. Eichengreen (2016) Hall of Mirrors. Oxford: Oxford University Press, pp. 346–7. 45 Sandbu, Europe’s Orphan, p. 226. 46 Blyth, Austerity, p. 65. 47 Quoted in Eichengreen, Hall of Mirrors, p. 353. 48 Y. Varoufakis (2017) Adults in the Room: My Battle with the European and American Deep Establishment. New York NY: Farrar, Strauss, and Giroux, p. 26. 49 Ibid. 50 Ibid., p. 46. 51 Lybeck, The Future of Financial Regulation, p. 260. 52 Varoufakis, Adults in the Room, pp. 36–7. 53 Sandbu, Europe’s Orphan, pp. 140–1. 54 Eichengreen, Hall of Mirrors, p. 368. 55 Varoufakis, Adults in the Room, p. 41. 56 Sandbu, Europe’s Orphan, p. 143. 57 ‘The Never-ending Austerity Story: Why Greece’s Third “Bailout” Changes Nothing’, Jubilee Debt Campaign, 12 February 2016, http://jubileedebt. org.uk/reports-briefings/briefing/the-never-ending-austerity-story-whygreeces-third-bailout-solves-nothing, accessed 24 January 2017. 58 Ibid. 59 Ibid. 286

notes 60 Y. Varoufakis (2016) And the Weak Suffer What They Must? London: Bodley Head, p. 9. 61 Ibid., p. 140. 62 Ibid., pp. 141–2. 63 Ibid., p. 159. 64 Blyth, Austerity, p. 76. 65 Varoufakis, And the Weak Suffer What They Must?, p. 142. 66 Ibid. 67 Stiglitz, The Euro, pp. 294–5. 68 G. Zestos (2016) The Global Financial Crisis. London: Routledge, p. 138. 69 Ibid. 70 H. Flassbeck and C. Lapavitsas (2015) Against the Troika: Crisis and Austerity in the Eurozone. London: Verso, pp. 24–5. 71 D. Detzer and E. Hein (2016) ‘Financialisation and the Crises in the Exportled Mercantilist German Economy’ in E. Hein et al., Financialisation and the Financial and Economic Crisis, pp. 165–6. 72 Stiglitz, The Euro, p. 100. 73 Ibid., p. 102. 74 Engelen et al., After the Great Complacence, p. 144; Das, Extreme Money, pp. 10–11. 75 Engelen et al., After the Great Complacence, p. 145. 76 P. Cohen (1980) ‘Lessons from the Nationalization Nation: State-owned Enterprises in France’, Dissent, Winter, https://www.dissentmagazine. org/article/lessons-from-the-nationalization-nation-state-ownedenterprises-in-france, accessed 28 January 2017. 77 Ibid. 78 Varoufakis, And the Weak Suffer What They Must?, p. 116. 79 Ó Riain, ‘Road to Austerity’, p. 37. 80 P. Anderson (2009) ‘A New Germany?’, New Left Review 57 (May–June), https://newleftreview.org/II/57/perry-anderson-a-new-germany, accessed 29 January 2017. 81 Notes from meeting with Achim Post, December 2011. 82 Notes on Schmidt’s comments at the SPD congress, December 2011. 83 ‘Social Democrats Get Tough on Greece’, Handelsblatt Global, 9 July 2015, https://global.handelsblatt.com/politics/social-democrats-get-tough-ongreece-258933, accessed 29 January 2017. 84 Varoufakis, And the Weak Suffer What They Must?, pp. 211–12. 85 Ibid.

Chapter 4 1 S. Vogel (2006) Japan Remodeled. Ithaca NY: Cornell University Press. 287

PAPER DRAGONS 2 P. Brasor, ‘There’s Nothing Weird About Sexless Japan’, Japan Times, 1 October 2016, http://www.japantimes.co.jp/news/2016/10/01/national/ media-national/theres-nothing-weird-sexless-japan/#.WOvlJY7ieRu, accessed 10 April 2017. 3 ‘What is Hikikomori? Could it be One of Japan’s Most Serious Problems?’, Japan Info, 21 November 2016, http://jpninfo.com/64533, accessed 9 April 2017. 4 M. Wakatabe (2015) Japan’s Great Stagnation and Abenomics. Basingstoke: Palgrave Macmillan, pp. 8–9. 5 A. Gordon (2015) ‘ Making Sense of the Lost Decades’ in Y. Funabashi and B. Kushner (eds), Examining Japan’s Lost Decades. London: Routledge, p. 94. 6 A. Maddison cited in J. Crotty, ‘Why There Is Chronic Excess Capacity’, Challenge, November–December 2002, p. 25. The usual dating for the ‘golden age’ or ‘Thirty Glorious Years’ is 1950–80. 7 Ibid. 8 B. Gao (2001) Japan’s Economic Dilemma. Cambridge: Cambridge University Press, p. 5. 9 R. Brenner (1998) ‘The Economics of Global Turbulence’, New Left Review 229 (May–June), p. 185. 10 Vogel, Japan Remodeled, p. 32. 11 U. Hiroyasu, T. Yamada and Y. Harada (2016) ‘Regulation Approach to Japanese and Asian Capitalisms: Understanding the Varieties of Capitalism and Structural Dynamics’ in N. Yokokawa, K. Yagi, H. Uemura and R. Westra (eds), The Rejuvenation of Political Economy. London: Routledge, p. 132. 12 S. Sugawara, ‘Excess Capacity Slowing Japan’s Recovery’, Washington Post, 25 December 1998, p. B-9. 13 K. Mera (2000) ‘The Linkage of the Economy with Land Price Fluctuations: The Case of Japan in the 1990s’ in K. Mera and B. Renaud (eds), Asia’s Financial Crisis and the Role of Real Estate. Armonk NY: M. E. Sharpe, p. 87. 14 Ibid. 15 Gao, Japan’s Economic Dilemma, p. 169. 16 R. Werner (2005) New Paradigm in Macroeconomics. Basingstoke: Palgrave Macmillan, pp. 135–6. 17 Ibid., p. 292. 18 Ibid., p. 293. 19 R. Koo (2009) The Escape from Balance Sheet Recession and the QE Trap. Singapore: John Wiley, p. 26. 20 K. Kuttner, I. Tokuo and A. Posen (2015) ‘Monetary and Fiscal Policies during the Lost Decades’ in Funabashi and Kushner, Examining Japan’s Lost Decades, pp. 23–4. 288

notes 21 Ibid., p. 29. 22 Ibid., p. 89. 23 K. Keiichiro (2015) ‘The Two “Lost Decades” and Macroeconomics: Changing Economic Policies’ in Funabashi and Kushner, Examining Japan’s Lost Decades, p. 43. 24 Vogel, Japan Remodeled, p. 50. 25 J. Schiff (2015) Can Abenomics Succeed? Washington DC: International Monetary Fund, p. 1. 26 K. Tsunekawa (2015) ‘Japan: The Political Economy of the Long Stagnation’ in T. J. Pempel and K. Tsunekawa (eds), Two Crises, Different Outcomes: East Asia and Global Finance. Ithaca NY: Cornell University Press, p. 214. 27 M. Anchorduguy (2005) Reprogramming Japan: The High-tech Crisis under Communitarian Capitalism. Ithaca NY: Cornell University Press. 28 Noroyuki Yoshino, interview with author, Tokyo, 9 June 2017. 29 Noriko Hama, interview with author, Tokyo, 19 June 2017 30 Schiff, Can Abenomics Succeed?, p. 8. 31 Interview with author, Tokyo, 9 June 2017. 32 Interview with author, Tokyo, 14 June 2017. 33 Interview with author, Tokyo, 19 June 2017. 34 Figures provided by Japan’s Ministry of Finance. 35 H. Okazaki, ‘New Strategies toward Super-Asian Bloc’, This Is [Tokyo], August 1992. Reproduced in FBIS Environment Report, August 1992, p. 18. 36 C. Hughes (2011) ‘Japanese Policy and the East Asian Currency Crisis: Abject Defeat or Quiet Victory?’, Review of International Political Economy 7 (2), pp. 219–53, http://www.tandfonline.com/doi/abs/10.1080/ 096922900346956, accessed 19 August 2017. 37 K. Nordhaug, ‘Asian Monetary Fund Revival’, Focus on the Global South, undated, https://focusweb.org/publications/2000/Asian%20 Monetary%20Fund%20revival.htm, accessed 30 June 2017. 38 This subsection and the next draws substantially from my earlier work Dilemmas of Domination: The Unmaking of the American Empire (New York: Henry Holt, 2005), pp. 114–23. 39 Institute of International Finance (1998) Capital Flows and Emerging Market Economies. Washington DC: Institute of International Finance, p. 3. 40 Nordhaug, ‘Asian Monetary Fund Revival’. 41 Ibid. 42 HG Asia (1996) Communique: Thailand – Worth a Nibble Perhaps but not a Bite. Hong Kong: HG Asia. 43 T. Kantong, ‘The Currency War Is the Information War’. Talk at the seminar workshop on ‘Improving the Flow of Information in a Time of Crisis: The Challenge of the Southeast Asian Media’, Subic, Philippines, 29–31 October 1998. 289

PAPER DRAGONS 44 B. Eichengreen and D. Mathieson (1998) ‘Hedge Funds and Financial Market Dynamics’. Occasional Paper 166. Washington DC: International Monetary Fund, p. 17. 45 J. Winters, ‘The Financial Crisis in Southeast Asia’. Paper delivered at the Conference on the Asian Crisis, Murdoch University, Fremantle, Western Australia, August 1998. 46 Ibid. 47 A. A. Park (2001) ‘Korea’s Management of Capital Flows in the 1990s’ in S. Griffith-Jones, M. Montes and A. Nasution (eds), Short-term Capital Flows and Economic Crises. Oxford: Oxford University Press, pp. 80–1. 48 R. Arvind Palat (1999) ‘Miracles of the Day Before?: The Great Asian Meltdown and the Changing World Economy’, Development and Society 28 (1), pp. 25–6. 49 P. Blustein (2001) The Chastening. New York NY: Public Affairs, pp. 125–6. 50 Ibid., p. 126. 51 Arvind Palat, ‘Miracles of the Day Before?’, p. 25; I. Grabel (1999) ‘Rejecting Exceptionalism’ in J. Michie and J. Grieve Smith (eds), Global Instability: The Political Economy of World Economic Governance. London: Routledge, p. 52. 52 Grabel, ‘Rejecting Exceptionalism’, p. 52. 53 Quoted in Blustein, The Chastening, p. 127. 54 Ibid., pp. 196–205. 55 Grabel, ‘Rejecting Exceptionalism’, p. 53. 56 Blustein, The Chastening, p. 202. 57 R. Rubin and J. Weisberg (2003) In an Uncertain World. New York NY: Random House, p. 241. 58 Joseph Stiglitz, quoted in The Nation, 13 May 2000. 59 IMF (1999) ‘IMF-supported Programs in Indonesia, Korea, and Thailand’. Occasional Paper 178. Washington DC: International Monetary Fund, p. 62. 60 C. Johnson (2000) Blowback: The Costs and Consequences of American Empire. New York NY: Henry Holt, p. 206. 61 T. Pepinsky (2008) ‘Economic Recovery in Indonesia and Malaysia’ in A. MacIntyre, T. J. Pempel and J. Ravenhill (eds), Crisis as Catalyst: Asia’s Dynamic Political Economy. Ithaca NY: Cornell University Press, p. 235. 62 Ibid. 63 Testimony of Charlene Barshefsky before the Way and Means Subcommittee, US House of Representatives, 24 February 1998. 64 Ibid. 65 Ibid. 66 Quoted in ‘Worsening Financial Flu Lowers Immunity to US business’, New York Times, 1 February 1998. 290

notes 67 A. Walter (2008) Governing Finance: East Asia’s Adoption of International Standards. Ithaca NY: Cornell University Press, p. 76. 68 W. Bello (2007) ‘All Fall Down: The Asian Financial Crisis, Neoliberalism and Economic Miracles’, Asia Pacific Journal/Japan Focus 5 (8), http://apjjf. org/-Walden-Bello/2486/article.html, accessed 30 June 2017. 69 A. Hicken (2008) ‘The Politics of Economic Recovery in Thailand and the Philippines’ in MacIntyre et al., Crisis as Catalyst. 70 F. Allen and J. Yun Hong (2011) ‘Why Are There Large Foreign Exchange Reserves? The Case of South Korea’, Korea Social Science Journal 38 (2), p. 13. 71 J. Amyx (2008) ‘Regional Financial Cooperation in East Asia since the Asian Financial Crisis’ in MacIntyre et al., Crisis as Catalyst, pp. 127–8. 72 J. Mo (2008) ‘The Korean Economic System Ten Years after the Crisis’ in MacIntyre et al., Crisis as Catalyst, pp. 261–2. 73 Ibid., p. 264. 74 Ibid. 75 Y. Okabe (2015) ‘Institutional Path Dependence in Korea and Thailand’ in Pempel and Tsunekawa, Two Crises, Different Outcomes, pp. 104–5. 76 Ibid., p. 106. 77 J. Stent (2017) China’s Banking Transformation: The Untold Story. Oxford: Oxford University Press, p. 76. 78 Ibid. 79 B. Naughton (2015) ‘China and the Two Crises: From 1997 to 2009’ in Pempel and Tsunekawa, Two Crises, Different Outcomes, p. 116. 80 E. Steinfeld (2008) ‘The Capitalist Embrace: China Ten Years after the Financial Crisis’ in MacIntyre et al., Crisis as Catalyst, p. 190. 81 Ibid. 82 Quoted in L. Goostadt (2011) Reluctant Regulators. Hong Kong: Hong Kong University Press, p. 81. 83 Stent, China’s Banking Transformation, p. 85. 84 E. Prasad (2017) Gaining Currency: The Rise of the Renminbi. Oxford: Oxford University Press, p. 67. 85 H. Wang (2014) ‘Global Imbalances and the Limits of the Exchange Rate Weapon’ in E. Helleiner and J. Kirshner (eds), The Great Wall of Money. Ithaca NY: Cornell University Press, pp. 118–19. 86 Ibid. 87 N. Lardy (2012) China’s Economic Growth after the Global Economic Crisis. Washington DC: Peterson Institute of International Economics, p. 89. 88 Ibid., p. 91. 89 C. Silva, ‘China Worried about a Housing Bubble as Prices Soar’, Newsweek, 18 March 2017, http://www.newsweek.com/housing-market-2017-chinareal-estate-prices-are-570265, accessed 24 June 2017. 291

PAPER DRAGONS 90 ‘Chinese Efforts to Stem Housing Bubble Show Promise’, Bloomberg Views, 1 2 June 2017, https://www.bloomberg.com/view/articles/2017-06-12/chineseefforts-to-stem-housing-bubble-shows-promise, accessed 24 June 2017. 91 A. Sheng and N. Chow Soon (2016) Shadow Banking in China. Chichester: John Wiley, pp. 151–2. 92 Interview with Japanese economist, identity withheld on request, Tokyo, 9 June 2017. 93 Lardy, China’s Economic Growth, p. 90. 94 ‘China’s Stock Market Value Exceeds 10 Trillion for the First Time’, Bloomberg, 15 June 2015, https://www.bloomberg.com/news/articles/ 2015-06-14/china-s-stock-market-value-exceeds-10-trillion-for-firsttime, accessed 25 June 2017. 95 Lardy, China’s Economic Growth, p. 90. 96 Sheng and Soon, Shadow Banking in China, p. 18. 97 Ibid., pp. xxii–xxiii. 98 Ibid. 99 Ibid., p. xxiv. 100 Ibid., p. xxv. 101 Ibid., p. 138 102 Ibid., pp. 150–1. 103 Ibid., p. xxix. 104 Ibid., p. xxiv. 105 Ibid.

Chapter 5 1 MBSs are mortgage-backed securities; CDOs are collateralized debt obligations; CDSs are credit default swaps. Their complex characteristics are detailed in this chapter. 2 Quoted in P. Langley (2015) Liquidity Lost: The Governance of the Global Financial Crisis. Oxford: Oxford University Press, p. 131. 3 T. V. Somanathan and V. Anantha Nageswaran (2015) The Economics of Derivatives. Cambridge: Cambridge University Press, p. 110. 4 W. Kaal (2015) ‘The Systematic Risk of Private Funds after the Dodd– Frank Act’, Michigan Business & Entrepreneurial Law Review 4 (2), p. 176. 5 J. Lybeck (2016) The Future of Financial Regulation. Cambridge: Cambridge University Press, p. 411. 6 Kaal, ‘The Systematic Risk of Private Funds’, p. 173. 7 K. Engel and P. McCoy (2011) The Subprime Virus. Oxford: Oxford University Press. 8 A. Mushell, ‘Mortgage-backed Securities and Dodd–Frank: Inconsistent and Possibly Dangerous’, Markets Media, 30 September 2016, http:// 292

notes marketsmedia.com/mor tgage-backed-secur ities-dodd-frankinconsistent-possibly-dangerous-by-ari-mushell/, accessed 9 July 2018. 9 ‘Skin in the Game or Skin Deep?’, The Economist, 29 March 2011, https:// www.economist.com/blogs/freeexchange/2011/03/mortgage-backed_ securities, accessed 29 March 2018. 10 Speeches of Federal Reserve officials at Futures Industry Association, Boca Raton, Florida, 19 March 1999, http://www.federalreserve.gov/boarddocs/ speeches/1999, accessed 4 March 2018. 11 Berkshire Hathaway 2002 annual report, http://www.berkshirehathaway. com/2002ar/2002ar.pdf, accessed 4 March 2018. 12 E. Engelen, I. Erturk, J. Froud, S. Johal, A. Leaver et al. (2011) After the Great Complacence: Financial Crisis and the Politics of Reform. Oxford: Oxford University Press, p. 58. 13 ‘Collateralized Debt Obligation Cubed – CDO-Cubed’, Investopedia, https://www.investopedia.com/terms/c/cdo3.asp, accessed 4 July 2018. 14 Lybeck, The Future of Financial Regulation, p. 365. 15 Engel and McCoy, The Subprime Virus, pp. 73–4. 16 Lybeck, The Future of Financial Regulation, p. 411. 17 Ibid., p. 411, footnote. 18 Ibid., p. 411, footnote. 19 Lybeck, The Future of Financial Regulation, pp. 411–12. 20 M. King (2016) The End of Alchemy: Money, Banking, and the Future of the Global Economy. London: Little, Brown, p. 104. 21 Quoted in O. Bjerg (2014) Making Money: The Philosophy of Crisis Capitalism. London: Verso, p. 194. 22 Langley, Liquidity Lost, p. 90. 23 T. Norfield (2016) The City: London and the Power of Global Finance. London: Verso, p. 132. 24 S. Das (2011) Extreme Money: The Masters of the Universe and the Cult of Risk. London: Penguin, p. 224. 25 Ponzi schemes, named after the notorious Charles Ponzi, are investment scams that pay returns to investors from their own money, or from money paid in by new investors. Ultimately, the amount of new money coming in is far outstripped by the amount of payments coming due, leading to the collapse of the scam, and to flight on the part of the Ponzi artists. 26 Engelen et al., After the Great Complacence, p. 110. 27 Norfield, The City, p. 132. 28 Langley, Liquidity Lost. 29 Engel and McCoy, The Subprime Virus, p. 105. 30 Lybeck, The Future of Financial Regulation, p. 369. 31 A. Admati and M. Hellwig (2013) The Bankers’ New Clothes: What’s Wrong 293

PAPER DRAGONS with Banking and What to Do about it. Princeton NJ: Princeton University Press, p. 95. 32 Ibid. 33 A. Turner (2016) Between Debt and the Devil: Money, Credit, and Fixing Global Finance. Princeton NJ: Princeton University Press, p. 187. 34 Ibid., p. 188. See I. Bennes and M. Kumhof (2012) The Chicago Plan Revisited. Washington DC: International Monetary Fund; A. Jackson and B. Dyson (2013) Modernizing Money: Why Our Monetary System Is Broken and How it Can Be Fixed. London: Positive Money. 35 Admati and Hellwig, The Bankers’ New Clothes, p. 182. 36 Ibid., p. 189. 37 Ibid., p. 177. 38 Ibid., p. 202. 39 Ibid., p. 203. 40 S. Jaffer, N. Morris, E. Sawbridge and D. Vines (2014) ‘How Changes to the Financial Services Eroded Trust’ in N. Morris and D. Vines (eds), Capital Failure: Rebuilding Trust in Financial Services. Oxford: Oxford University Press, p. 41. 41 Ibid., p. 42. 42 J. Stiglitz, ‘Capitalist Fools’, Vanity Fair, 9 December 2008, https://www. vanityfair.com/news/2009/01/stiglitz200901-2, accessed 4 July 2018. 43 ‘What is the “Volcker Rule”?’, Investopedia, https://www.investopedia. com/terms/v/volcker-rule.asp, accessed 4 July 2018. 44 Ibid. 45 S. Jaffer, N. Morris and D. Vines (2014) ‘Restoring Trust’ in Morris and Vines, Capital Failure, p. 367. 46 ‘Volcker Said to Be Disappointed with Dilution of Rule’, Bloomberg, 30 June 2010, http://www.washingtonpost.com/wp-dyn/content/video/ 2010/07/01/VI2010070103212.html, accessed 4 July 2018. 47 Daniel Tarullo, member of the Board of the Federal Reserve, quoted in Langley, Liquidity Lost, p. 129. 48 K. Scott, ‘Implications of the Volcker Rule for Foreign Banking Entities’, Norton Rose Fulbright, March 2014, http://www.nortonrosefulbright. com/knowledge/publications/113806/implications-of-the-volcker-rulefor-foreign-banking-entities, accessed 4 July 2018. 49 ‘Drop the Volcker Rule and Keep What Works’, Financial Times, 12 February 2017, https://www.ft.com/content/72f3ba98-eef1-11e6-930f061b01e23655, accessed 4 July 2018. 50 B. Bain and J. Hamilton, ‘Wall Street Regulators are Set to Rewrite the Volcker Rule’, Bloomberg, 1 August 2017, https://www.bloomberg.com/ news/articles/2017-08-01/volcker-rewrite-is-said-to-start-as-trumpregulators-grab-reins, accessed 4 July 2018. 294

notes 51 M. Egan, ‘Too-big-to-fail Banks Keep Getting Bigger’, CNN Money, 21 November 2017, http://money.cnn.com/2017/11/21/investing/banks-toobig-to-fail-jpmorgan-bank-of-america/index.html, accessed 4 July 2018. 52 S. Das, ‘Banks Are Getting Bigger, Not Smaller: Clearly They Learnt Nothing from the 2008 Financial Crisis’, Independent, 12 March 2017, http://www.independent.co.uk/voices/banks-still-haven-t-learnt-theirlessons-from-the-financial-crash-a7625311.html, accessed 4 July 2018. 53 Lybeck, The Future of Financial Regulation, p. 86. 54 P. Wallison and C. Hurley, quoted in Lybeck, The Future of Financial Regulation, p. 405. 55 Ibid. 56 R. Chappe, E. Nell and W. Semmler (2015) ‘Booms, Busts, and the Culture of Risk’ in B. Jessop, B. Young and C. Scherrer (eds), Financial Cultures and Crisis Dynamics. Abingdon: Routledge, p. 133. 57 Lybeck, The Future of Financial Regulation, p. 374. 58 Ibid. 59 Chappe et al., ‘Booms, Busts, and the Culture of Risk’, p. 136. 60 Ibid., p. 137. 61 Ibid. 62 A. Naciri (2015) Credit Rating Governance: Global Credit Gatekeepers. London: Routledge, p. 139. 63 Ibid., p. xvi. 64 Ibid., p. 120. 65 Ibid., p. 123. 66 Ibid., p. 144. 67 ‘G20 Leaders Statement: The Pittsburgh Summit’, G20 Information Centre, 24–25 September 2009, http://www.g20.utoronto.ca/2009/2009 communique0925.html, accessed 1 May 2018. 68 D. Schoenmaker (2013) Governance of International Banking: The Financial Trilemma. Oxford: Oxford University Press, pp. 8–9. 69 Ibid., p. 9. 70 Ibid. 71 M. Weisbrot and J. Johnston (2016) ‘Voting Share Reform at the IMF: Will it Make a Difference’. Washington DC: Center for Economic Policy and Research, p. 3, cepr.net/images/stories/reports/IMF-votingshares-2016-04.pdf, accessed 2 May 2018. 72 G. Ip, ‘Dollar’s Dominance Creates Ripples Globally’, Wall Street Journal, 10 May 2018, p. A2. 73 J. McDonald, ‘China Calls for New Global Currency’, ABC News, undated, http://abcnews.go.com/Business/story?id=7168919&page=1, accessed 4 July 2018. 74 N. Prins (2018) Collusion: How Central Bankers Rigged the World. New York NY: Nation Books, p. 2. 295

PAPER DRAGONS 75 Ibid. 76 Ibid., p. 3. 77 See R. Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession. Singapore: John Wiley, 2009. 78 Ibid., pp. 2–3. 79 Ibid., p. 249. 80 P. Tucker (2018) Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State. Princeton NJ: Princeton University Press, p. 5. 81 Statement of the Economic Affairs Committee of the European Parliament, quoted in ibid., p. 45. 82 D. Howarth and L. Quaglia (2016) The Political Economy of the European Banking Union. Oxford: Oxford University Press, p. 21. 83 Ibid., pp. 204–5. 84 European Commission (2015) Completing Europe’s Economic and Monetary Union. Brussels: European Commission, p. 14. 85 C. Woll (2014) The Power of Inaction. Ithaca NY: Cornell University Press, pp. 50–6.

Chapter 6 1 B. Badré (2018) Can Finance Save the World? Oakland CA: Berrett-Koehler Publishers, pp. 12–13. 2 K. Marx (1971) Capital, Vol. II. Moscow: Progress Publishers, p. 58. 3 A. Rappeport and E. Flitter, ‘Congress Approves Big Dodd–Frank Rollback’, New York Times, 22 May 2018, https://www.nytimes.com/2018/05/22/ business/congress-passes-dodd-frank-rollback-for-smaller-banks.html, accessed 17 June 2018. 4 Badré, Can Finance Save the World?, p. 60. 5 Ibid. 6 H. Gleckman, ‘Have We Created a Two-tiered Tax System – One for the Powerful and One for the Rest of Us?’, Tax Vox, 22 July 2014, https://www. taxpolicycenter.org/taxvox/have-we-created-two-tiered-tax-system-onepowerful-and-one-rest-us, accessed 17 June 2018. 7 R. Palan, R. Murphy and C. Chavagneux (2010) Tax Havens: How Globalization Really Works. Ithaca NY: Cornell University Press, p. 243. 8 Ibid. 9 B. Knight (2017) ‘Row Ignites after Germany Slams “Tax Haven” Malta’, Deutsche Welle, 6 November 2017, http://www.dw.com/en/row-ignitesafter-germany-slams-tax-haven-malta/a-38802713, accessed 17 June 2018. 10 ‘Tax Havens/Bank Secrecy’, Global Financial Integrity, http://www. gfintegrity.org/issue/tax-havens-bank-secrecy/, accessed 17 June 2018. 11 Palan et al., Tax Havens, p. 233. 296

notes 12 L. Levine (2016) ‘Activism Might Have an Antitrust Problem’, Bloomberg, 5 April 2016, https://www.bloomberg.com/view/articles/2016-04-04/ shareholder-activism-might-have-antitrust-issues, accessed 17 June 2018. 13 O. Bjerg (2014) Making Money: The Philosophy of Crisis Capitalism. London: Verso, p. 202. 14 Ibid. 15 K. Engel and P. McCoy (2011) The Subprime Virus. Oxford: Oxford University Press, p. 52. 16 J. Tavakoll, ‘Washington Must Ban US Credit Derivatives as Traders Demand Gold (Part One)’, Huffington Post, 6 December 2017, https:// www.huffingtonpost.com/janet-tavakoli/washington-must-ban-uscr_b_489778.html, accessed 18 June 2018. 17 A. Admati and M. Hellwig (2013) The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about it. Princeton NJ: Princeton University Press, p. 182. 18 M. King (2016) The End of Alchemy: Money, Banking, and the Future of the Global Economy. London: Little, Brown, pp. 261–2. 19 Ibid., p. 263. 20 Ibid., p. 264. 21 Bjerg, Making Money, p. 264. 22 A good review of research on this topic is ‘Do We Need Big Banks?’, 18 March 2011, http://economistsview.typepad.com/economistsview/2011/03/dowe-need-big-banks.html, accessed 18 June 2018. 23 ‘Bank of North Dakota: America’s Only “Socialist” Bank is Thriving during Downturn’, Huffington Post, 25 May 2011. 24 Rappeport and Flitter, ‘Congress Approves Big Dodd–Frank Rollback’. 25 Oxford Analytica, ‘EU Adopts New Executive Pay Standards’, Forbes, 12 July 2010, https://www.forbes.com/2010/07/09/eu-executive-paybusiness-oxford-analytica.html#250d975f749e, accessed 19 June 2010. 26 Badré, Can Finance Save the World?, p. 121. 27 ‘Swiss Referendum Backs Executive Pay Curbs’, BBC, 3 March 2013, https://www.bbc.com/news/world-europe-21647937, accessed 19 June 2010. 28 ‘Israel Passes Law to Cap Bankers’ Salaries’, Guardian, 29 March 2016, https://www.theguardian.com/business/2016/mar/29/israel-passes-lawto-cap-bankers-salaries-pay-gap, accessed 19 June 2010. 29 F. Partnoy (2017) ‘What’s (Still) Wrong with Credit Ratings’. Legal Studies Research Paper 17-285. San Diego CA: University of San Diego School of Law, p. 1471. 30 Ibid., p. 1435. 31 The Basel Committee on Banking Supervision is a committee of banking supervisory authorities established by the central bank governors of the Group of Ten countries in 1974. 297

PAPER DRAGONS 32 E. Prasad (2017), Gaining Currency: The Rise of the Renminbi. Oxford: Oxford University Press, p. 234. 33 Prasad, Gaining Currency, p. 136. In terms of official foreign currency assets held at present, the dollar accounts for 64 per cent, the euro 21 per cent, the British pound sterling 4 per cent, the Japanese yen 3 per cent, the Australian dollar 2 per cent, the Canadian dollar 2 per cent, the Chinese renminbi 1.1 per cent, the Swiss franc 0.3 per cent, and the New Zealand dollar and Swedish krona 0.2 per cent each. 34 P. Tucker (2018) Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State. Princeton NJ: Princeton University Press, p. 5. 35 N. Prins (2018) Collusion: How Central Banks Rigged the World. New York NY: Nation Books, pp. 253–4. 36 Y. Varoufakis (2016) And the Weak Suffer What They Must? London: Bodley Head, p. 5. 37 D. Furchgott-Roth (2013) ‘Federal Reserve Chairman is Washington’s Most Powerful Official’, Washington Examiner, 18 September 2013, https://www. washingtonexaminer.com/federal-reserve-chairman-is-washingtonsmost-powerful-official, accessed 21 June 2010. 38 J. Stiglitz (2016) The Euro. New York NY: W. W. Norton, pp. 294–5.

Chapter 7 1 A. Rappeport and E. Flitter, ‘Congress Approves First Big Dodd– Frank Rollback’, New York Times, 22 May 2018, https://www.nytimes. com/2018/05/22/business/congress-passes-dodd-frank-rollback-forsmaller-banks.html, accessed 24 June 2018. 2 N. Prins (2018) Collusion: How Central Bankers Rigged the World. New York NY: Nation Books, p. 2. 3 See W. Richter (2018) ‘The New Fed Looks Like it’s Ready to Dump Mortgage-backed Securities’, Business Insider, 19 May 2018, http:// www.businessinsider.com/the-new-fed-looks-like-its-ready-to-dumpmortgage-backed-securities-2018-5, accessed 24 June 2018. 4 Quoted in B. McLannahan (2018) ‘US Banks Derivatives Book Larger since Rescue of Bear Stearns’, Financial Times, 16 March 2018, https:// www.ft.com/content/201bce0c-289b-11e8-b27e-cc62a39d57a0, accessed 24 June 2018. 5 Prins, Collusion, p. 2. 6 T. Kee Jr. (2018) ‘Why a Global Stock Market Crash is Coming’, The Street, 21 April 2018, https://www.thestreet.com/opinion/why-a-global-stockmarket-crash-is-coming-14566852, accessed 24 June 2018. 7 Ibid. 298

notes 8 This is the central argument of Richard Koo’s theory of balance-sheet recession. See R. Koo (2009) The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession. Singapore: John Wiley. 9 J. Bivens (2017) ‘Inequality is Slowing US Economic Growth’. Washington DC: Economic Policy Institute, https://www.epi.org/publication/secularstagnation/, accessed 24 June 2018. 10 Ibid. 11 Ibid. 12 D. Lipton, ‘Can Globalization Still Deliver?’ Stavros Niarchos Foundation Lecture, Peterson Institute for International Economics, 24 May 2016, p. 6, https://piie.com/events/can-globalization-still-deliver, accessed 24 June 2018. 13 Quoted in ‘Secular Stagnation Even Truer Today’, Wall Street Journal, 25 May 2017, http://larrysummers.com/2017/06/01/secular-stagnationeven-truer-today/, accessed 24 June 2018. 14 Ibid. 15 Lipton, ‘Can Globalization Still Deliver?’, p. 6. For globalization theorists, differences not only in terms of development but in inequality were expected to shrink between countries. See G. Firebaugh (2003) The New Geography of Global Income Inequality. Cambridge MA: Harvard University Press. 16 Lipton, ‘Can Globalization Still Deliver?’, p. 1.

299

glossary

Bubble – A situation where the rise in the price of an asset such as land or a mortgage-backed security goes so far beyond its real value due to speculative investment in it that an implosion, or the rapid descent of the asset price to its real value, is imminent. Collateralized debt obligations (CDOs) – Collateralized debt obligations or synthetic securities created from the pooling of mortgage-backed securities of different ‘qualities’, but the value of which could not be dissociated from the ability of the original mortgage-holder to service the lowest quality mortgage backed security. Credit default swaps (CDSs) – Credit default swaps or contracts that holders of CDOs took out to insure themselves against losses if their CDOs turned sour in the event of a downturn in the real-estate market. They were termed ‘swaps’ to avoid the federal regulation to which other forms of insurance were subject. Speculators bought CDSs in the expectation that the growing risk of default would raise the price of the CDSs they purchased, and they could make a neat profit from the sale. Derivatives – A financial product that is not in itself an asset but whose value is based on the price movements of an underlying asset. One buys or sells derivatives depending on one’s sense of the likely direction of the underlying asset, making or losing money on this ‘bet’. 300

glossary

Dodd–Frank – Also known as the Wall Street Reform and Consumer Protection Act, this law was enacted in 2010 as the Obama administration’s response to the 2008 global financial crisis. Efficient market hypothesis (EMH) – A neoliberal theory that says that financial markets function efficiently since they reflect all information made available to market participants at any given time. Government regulation is thus unnecessary and indeed harmful because it would introduce distortions to this process. Thus all financial instruments are perfectly priced and market participants operate on the basis of this information. Financialization – A term that refers to a condition or state where the dynamics of speculative finance rather than that of production becomes the main driver of a capitalist economy, so that the prices of many goods, including food, are determined less by actual demand than by the movement of securities or derivatives that are ‘tied’ to them. Fractional reserve banking – A system of banking that allows a bank to hold only a fraction of the value of deposits made to it in reserve. One hundred per cent reserve banking means that total loans made by the bank must be backed 100 per cent by its equity, so that in case of a crisis, all depositors can be reimbursed. Glass Steagall – The Great Depression-era law in the United States that separated commercial banking from investment banking that was repealed during the Clinton administration in the United States by the Gramm-Leach-Bliley Act. Hedge funds – Funds formed by groups of investors using borrowed money that engage in potentially high yielding but risky 301

PAPER DRAGONS

investments which often operate from locations known as tax havens to escape high taxation in their home economies. Internal devaluation – Cutting back wages to reduce the price of exports. This serves as a substitute to devaluing the currency for those countries that cannot engage in the latter owing to their being members of a common currency area like the Eurozone. Leverage – Refers to the ratio of debt to equity in the portfolio of an investor or financier. Highly leveraged means one has a high ratio of debt to equity. Liquidity preference – A principle of Keynesian economics that holds that in times of uncertainty and crisis, investors or people more generally prefer to hold money in liquid form or ‘hard cash’ rather than in immobile forms. Mortgage-backed securities (MBSs) – Mortgage-backed securities, or assets based on mortgages that were made liquid by securitization and sold on the market by the bank serving as mortgage originator, then traded by other parties, but the value of which depended on the original mortgage holder’s ability to service the mortgage. Neoliberalism – The dominant economic ideology the fundamental principle of which is that markets must be free of regulation by the state to the greatest degree possible so as to bring about the most efficient allocation of resources in the economy, as reflected in the unit prices of goods. Market freedom extends to freedom from tariffs and import quotas, freedom from controls on capital flows, and freedom of market participants from high taxes.

302

glossary

Overproduction – The contradiction between the tremendous productive capacity of capitalism owing to massive investments in capital-intensive technology and the absorptive capacity of the population owing to social inequalities that restrain consumption. Also sometimes referred to as overaccumulation or overcapacity, this condition leads to a decline in the rate of profit, according to Marxist economists. Marx famously described this condition as the development of the forces of production being constrained by the social relations of production. Quantitative easing – This refers to the central bank pumping private banks with cash by buying the latter’s debts, with the goal of having the private banks issue low-interest loans to consumers so that consumer spending can revive the economy. Rational expectations hypothesis (REH) – A foundational neoliberal assumption that provides the theoretical basis for the efficient market hypothesis with its claim that market participants function on the basis of rational assessments of future economic developments. Securitization – Conversion of traditionally immobile assets like home mortgages into mobile, liquid securities that can be bought and sold in financial markets. Shadow banking – The set of institutions that perform banking and other financial sector activities such as lending, trading, and investment but are not subject to the same regulations as the formal (commercial) banking sector. Subprime mortgage-backed security – A security or financial product the value of which is tied to a mortgage held by a borrower whose ability to service the mortgage is considered low. 303

PAPER DRAGONS

Too-big-to-fail – The informal but real practice whereby the state bails out the biggest banks when they are insolvent owing to the belief that allowing them to collapse would bring down the whole economy.

304

index

Abe, Shinzo¯, 150 Abenomics, 150–2, 191 Admati, Anat, 68, 211 AIG (American International Group) appropriation of bailout money, 63 executive bonuses, 220 government rescue, 52, 57, 208, 220 insurance exposure, 52, 204, 208 shadow banking, 13 AIIB (Asian Infrastructure Investment Bank), 260 Alpert, Daniel, 42 Amato, Massimo, 10, 27 AMF (Asian Monetary Fund), 170 Amundi, 243 Anglo Irish Bank, 97, 98 animal spirits view, 29 anti-trust laws, 246–7, 259 Argentina, 229, 246 ASEAN Plus Three, 170–1, 193 Asia see East Asia; Southeast Asia Asian financial crisis (1998-2001) capital outflow, 159–61 China’s avoidance, 174–6, 192 compared with 2008 global crisis, 189–90 factor in US crisis, 44–6 foreign capital inflows, 44, 155–7

IMF rescue packages, 18, 44, 163–7, 191–2, 227 Japanese direct investment, 152–5 origins, 17–18, 95–6, 153–61, 190–91 and real-estate development, 44, 96, 157–8 role of hedge fund operators, 189 Asian Infrastructure Investment Bank (AIIB), 260 Asian Monetary Fund (AMF), 170 austerity ECB policies, 98–100, 226, 228, 263 Greece, 15–16, 104–8, 123 IMF loan conditions, 16, 18 internal devaluation, 115–16 Ireland, 16, 98–100 and long-term stagnation, 128 southern European states, 109, 119–20, 122–3, 263–4 UK, 93 Australian Securities and Investments Commission, 200 Automatic Exchange of Information, 245 Bangkok, real estate, 157 Bank of America, 14, 64, 218, 270 Bank of England, 89, 91, 264 Bank of Japan, 142–3, 230 305

PAPER DRAGONS

Bank of New York Mellon, 218 Bank of North Dakota, 254–5 banks/banking depositor insurance schemes, 208–9 East Asian reserves, 18–19, 45 equity/debt ratio, 210–211 equity/loan requirements, 226–7 fractional reserve banking, 206, 208 move to 100% reserve banking, 210, 251–3 proprietary trading vs marketmaking, 215–16, 255 Barshefsky, Charlene, 166, 167 Basel Committee on Banking Supervision, 211, 222, 224, 233, 259–60 Basel III, 68, 226–7 Bear Stearns, 50, 57, 218 Beijing, housing deposits, 181 Bernanke, Ben, 46, 59, 62, 146, 198, 232 Biden, Joe, 66 Bivens, Josh, 274, 276 Bjerg, Ole, 249, 253 BlackRock, 243 Blair, Tony, 16, 117, 123 Blyth, Mark, 100, 111 bonus payments, 63–4, 220, 256–8 Bradford & Bingley, 91 Brenner, Robert, 139–40 Brexit, 93–4, 235 BRICS, 135, 260 British Bankers’ Association, 93 Brown, Gordon, 16, 87, 91, 117, 123, 130, 264 Buenos Aires, company disclosure, 246

Buffett, Warren, 13, 202, 203 Buiter, Willem, 62 Bundesbank, 109, 116, 263 Bush administration, 56–7, 71 capital account liberalization, 43–4, 79 capital flows, Southeast Asia, 155–61 capitalism and financialization, 9–11 instability and uncertainty, 27–30, 82 and labour’s political defeat, 33–4 overproduction and decline of profitability, 138–40 post-capitalism, 82, 277–8 CDOs (collateralized debt obligations), 48–9, 51–2, 69, 199, 202–4, 249–50 CDOs-cubed, 69, 203 CDSs (credit default swaps), 13, 51–2, 199, 202–4, 250 central banks, 229–33 key for recovery and regulation, 229, 262 lack of democratic accountability, 233, 263–5 lack of policy coordination, 226 limits of fabricated demand, 270–72 liquidity for public works/ employment projects, 262–3 quantitative easing, 60, 81, 91–2, 150, 230–32 Chiang Mai Initiative, 170–71, 193 Chicago Plan, 210–211, 251–3

306

Index

Chinese economy export-led industrialization, 177–8 fiscal stimulus, 58, 179–80 growth affected by 2008 crisis, 7 household debt, 5, 184 household savings, 180 liberalization, 177–8, 179 potential impact on global economy, 182 real-estate bubble, 3–4, 182–3 risk factors for financial crash, 7, 186–7, 193–4 Chinese financial sector avoidance of Asian financial crisis, 174–6, 192 bank modernization, 176 bank vulnerability, 6, 186, 187, 194 effects of global financial crisis, 7, 177, 179 global currency reform, 229 interest rates, 180 liberalization, 175–7, 192 non-performing loans (NPL) risk, 179, 186, 187 real-estate loans, 6, 186 real-estate speculation, 3–4, 180–82, 194 reforms, 177, 178 risk factors for financial crash, 7, 186–7, 193–4 shadow banking risk assets, 6, 185–7, 194 stock market corruption, 5 stock market losses and personal debt, 5, 184 stock market volatility, 4–5, 183–4

Citi/Citigroup, 14, 64, 71, 208, 212, 218, 262, 270 City of London, 86–7, 117–18, 124 Clinton, Hillary, 76–7 Cochrane, John, 58–9 collateralized debt obligations see CDOs Commodity Futures Modernization Act (2000), 199 consumer demand crisis of demand, 274–5 declining wages, 12, 273, 274 helicopter drops, 61–2, 146 and income inequality, 273–4, 276–7 Japan, 146–7 US, 41, 42 Consumer Financial Protection Bureau (US), 69, 204 credit default swaps see CDSs credit ratings agencies, 101, 221–4, 258–9 crisis of demand, 274–5 crisis of overproduction, 11–12, 32–4, 38–9, 272–3 crisis of profitability, 33–4, 138–40 Crouch, Colin, 25, 42, 43 currency dollar domination, 228–9 reforms, 261–2 yen/dollar revaluation, 152, 153 Das, Satyajit, 206–7 debt global debt, 230, 270–71 personal debt, 5, 12, 43, 66, 184, 272 deindustrialization, 36, 77

307

PAPER DRAGONS

democratic accountability, central banks, 233, 263–5 derivatives banning recommendation, 248–51 believed to be risk free, 47 continuing threat, 81–2, 270 and debt, 13 Dodd-Frank reform limitations, 69–70 fraud, 49, 50, 63, 65 ineffective regulation, 198–9, 201–5 market participants, 199–200 role in financial crisis, 51–3 securitization, 12–13, 48–50 trading volume, 54 see also MBSs (mortgage-backed securities) Derivatives Service Bureau (DSB), 225 Desai, Radhika, 33 Dimon, Jamie, 65 Dodd, Chris, 68–9, 72 Dodd-Frank Act (2010) Congressional weakening, 269 credit ratings agencies, 258–9 derivatives trading unregulated, 69–70, 81–2 executive pay, 220–21, 257 objective, 68–9 shadow banking unregulated, 199–200, 204–5 ‘systemically important’ banks, 218–19, 254 Volcker Rule, 70, 72, 213–17, 255–6 dollar, international currency reform, 228–9

Dorgan, Byron, 41 dot.com bubble, 39, 40, 41, 273 Douglas, Paul, 251 East Asia banking reserves, 18–19 exports, 139–40 exports and foreign reserve accumulation, 18–19, 170, 173–4, 193 Japanese foreign direct investment, 152–5 negative effects of IMF conditionalities, 164–7 ECB (European Central Bank) austerity policies, 98–100, 226, 228, 263 democratic accountability, 263–5 and the euro, 109–110, 112 Greek loans, 104–8 Irish loans, 98–100 quantitative easing, 230 subservience to Germany, 263, 264 tasks, 109–110 economic growth and crisis of demand, 274–5 downturn, 139–40 effect of financial crisis, 15, 55, 59 effect of neoliberal restructuring, 37 efficient market hypothesis, 23–4, 78, 87–8, 126–7 Eichengreen, Barry, 65, 76, 128 Emergency Economic Stabilization Act (2008), 231 Engel, Kathleen, 249 European Banking Union, 234 308

Index

European Central Bank see ECB European financial crisis (2007/8) compared with 2008 US crisis, 126–7 France and Germany’s irresponsible bank loans, 86, 101–3, 104, 111, 127–8 Greece, 101–8 Ireland, 94–100 lack of financial regulation, 130 origins, 101–3, 113–16, 213 and social democracy, 129–30 summary, 15–16 UK, 85–94 European Parliament, 233 European Union executive pay, 256, 257 lack of political or fiscal union, 109–110, 127, 129, 234–5, 265–6 Eurozone challenges to reform, 234–5 constraints on less-developed member states, 16, 111–12, 265–6 creation, 109–110, 118–19 France and Germany’s irresponsible bank loans, 86, 101–3, 104, 111, 127–8 French project, 16, 118–19, 130 Germany’s economic and trade strength, 16, 114–15, 121–2 Greek loan conditions, 107 illusion of risklessness, 110–111, 116 Ireland’s membership, 96–7

lack of political or fiscal union, 109–110, 127, 129, 234–5, 265–6 and sovereign debt crisis, 16 Stiglitz’s recommendation to abandon, 112, 129 executive crime, 63 executive pay, 63–4, 65, 219–21, 256–8 fallacy-of-composition problems, 61 Fannie Mae, 42 Fantacci, Luca, 10 Federal Deposit Insurance Corporation (FDIC), 208, 252 Federal Reserve bank bailout, 65 banking stimulus programs, 59–60, 61 Consumer Financial Protection Bureau, 69, 204 economic recovery, 226 federal funds rate, 41 Korean currency swap, 172 lack of democratic accountability, 263, 264–5 Large Scale Asset Purchase (LSAP) programme, 60 quantitative easing, 60, 81, 230 SPV credit, 57 financial crises chances of a repeat, 131 China’s risk factors, 7, 186–7, 193–4 stock market crash (2018), 5, 8, 197, 229, 269 US-Asian compared, 189–90 US-European compared, 126–7

309

PAPER DRAGONS

warning signs, 135–6, 206–8, 269–71 see also Asian financial crisis; European financial crisis (2007/8); Japanese financial crisis financial crisis (2007/8) banks’ power of inaction, 71 compared with Asian crisis, 189–90 compared with European crisis, 126–7 credit ratings agencies, 101, 222–3, 258 East Asian financial reserves, 173–4 effect on China, 177–8 effect on US households, 13, 14–15, 55, 56, 66 origins, 12–14, 18–19, 46, 113 role of Asian financial crisis, 44–6 severity not anticipated, 25–6 US government rescue costs, 14, 54–5, 65, 208, 209, 220 US government rescue programs, 52, 54–5, 56–7, 64, 71–2, 204 warning signs, 206–8 financial markets, capital account liberalization, 43–4, 79 financial reform corporate debt to equity ratio, 209–211 credit ratings agencies, 223–4, 258–9 equity/loan requirements, 226–7 failures, 197–8, 235–7

G20 regulatory proposal, 57 IMF, 227–8 ineffectiveness, 131 international currency reform, 228–9 international financial governance, 224–9 minimum programme, 19–20, 243–66 missed US opportunities, 62–70 mock compliance, 168, 170 politician/banker relations, 211 proprietary trading and market-making ambiguity, 215–16, 255 resistance by banks, 70–71 Southeast Asia, 167–70 summary of initiatives, 19 Financial Services Authority (UK), 200, 204 Financial Stability Board (FSB), 204–5, 218, 224, 225, 227, 259–60 financialization continuing threat, 81–2 corporate landscape, 53–4 and debt, 12 dimensions, 9–11 financial speculation, 32, 39–46, 135, 273 Ireland, 100 key aspects, 12–14, 79 and poor regulation, 13–14 and production crisis, 11 and securitization, 12–13 and social democracy, 124–5 Fisher, Irving, 210, 251, 252 Fitch, 221–4, 259 310

Index

Foreign Account Tax Compliance Act (US), 245–6 fractional reserve banking, 206, 208 France AMF (Autorité des Marchés Financiers), 204 irresponsible bank lending, 101–3, 104, 111 motives for a monetary union, 109, 118–19 privatizations, 118 Frank, Barney, 68–9 fraud, 49, 50, 63, 65, 67 Freddie Mac, 42 FSB (Financial Stability Board), 204–5, 218, 224, 225, 227, 259–60 G20, 57, 225, 259–60 Gabriel, Sigmar, 123 Gao, Bai, 139, 141–2 GE (General Electric), 53–4 Geithner, Tim, 73, 220 Germany banking crisis, 86 central role in financial crisis, 127–8 Die Linke party, 121 economic restructuring (Hartz reforms), 16, 113–15, 120–21, 127 economic and trade competitivity, 16, 114–15, 121–2 irresponsible bank lending, 86, 101–3, 104, 111, 127–8 loans and austerity conditionality, 16, 108 social inequality, 121

SPD labour market reforms, 120–21, 130 Glass-Steagall Act (1933), 40–41, 69, 70, 79, 211–12, 255 global debt, 230, 270–71 global economy, Chinese crash risks, 7–8, 186–7, 193–4 globalization, 11–12, 37–9, 273, 276 Goldman Sachs, 13, 14, 57, 74, 218, 270 Gramm-Leach-Bliley Act (1999), 41, 212 Great Depression, 40, 210, 235–6, 251 Great Recession (2007-) effects, 14–15, 80 fiscal stimulus, 74–5 Ireland, 99 and neoliberalism, 78–9 origins, 32, 273 political consequences, 76–7, 93–4 UK, 92 unemployment, 14–15, 55, 56, 59, 80 US failure, 15 Greece accounting scandal, 101, 128 economic damage from deficit cuts, 105–6 eurozone membership, 104 irresponsible French and German bank lending, 101–3, 108, 127–8 loans and austerity conditionality, 15–16, 104–8, 123 sovereign debt crisis, 15–16, 74, 108, 128

311

PAPER DRAGONS

Standard & Poor rating, 101 unemployment, 104 Greenspan, Alan, 41–2, 50–51, 201–2, 213 Group of 20 (G20), 57, 225, 259–60 Halifax Bank of Scotland (HBOS), 91, 245 Hama, Noriko, 151 Hartz reforms (Germany), 16, 113–15, 120–21, 127 Hashimoto, Ryutaro, 147–8 Hayek, Friedrich, 24–5 HBOS (Halifax Bank of Scotland), 91, 245 hedge funds, 158–9, 199, 206–7, 243–7, 255, 261, 270 Hellwig, Martin, 68, 211 home owners financial crisis losses, 66 foreclosures, 15, 56, 77, 80 lack of government help, 61–2, 81 subprime housing loans, 12, 42–3, 47–51, 66 Hong Kong, investment in Southeast Asia, 155 household debt, 43, 67, 79 housing, price falls, 50 Hu Jintao, 178–9 Hughes, Charles, 154 Hurley, Cornelius, 69 hysteresis, 274, 276 IKB Deutsche Industriebank, 50 IMF Abenomics, 150 Asian rescue packages, 18, 44, 163–7, 191–2, 227

European austerity conditionalities, 16, 18, 104–6, 108 Greek loans, 104–6, 107, 108 lending facility reform, 225–6 limited Southeast Asian reforms, 168–72 negative effects of loan conditionalities, 164–7 reform, 227–8, 259 South Korea rescue package, 18, 44, 163–4 voting share reform, 228, 259 income inequality China, 3, 178 consequence of financial crisis, 80 Germany, 121 Ireland, 99 Japan, 138 neoliberal restructuring, 11–12, 36, 39 US, 55–6, 274 and weak demand, 273–4, 276–7 Indonesia banking reform, 168 car and aircraft industries, 166 financial crisis, 44 foreign capital flows, 156–7 investor panic, 159–61 Japanese foreign direct investment, 152 negative effects of IMF conditionalities, 164–5 inequality see income inequality information technology, 38 institutional investors, 243–7, 261, 270 Internal Revenue Service (US), 244 312

Index

international currency reform, 228–9 international financial governance, 224–9, 259–62 Ireland Celtic tiger, 94–5 euro adoption, 96–7 financial corruption, 97 financial crisis, 97–8 financialization, 100 information technology sector, 95 loans and austerity conditionality, 16, 98–100 recession, 99 sovereign debt crisis, 15–16, 99–100 unemployment, 99, 100 Israel, executive pay, 257 Japan Asian Monetary Fund (AMF), 170 bankruptcies, 141 bilateral aid and bank loans, 155 demographic crisis, 137 foreign direct investment, 152–5 hikikomori (depression), 137–8 industrial relocation to Southeast Asia, 153 poverty and inequality, 138 Japanese banks/banking derivatives and fintech, 149–50 loans to East Asia, 156–7 non-performing loans (NPLs), 144, 145, 149, 191

quantitative easing, 150, 230 reforms, 147–8, 149, 151–2 yen/dollar currency revaluation, 152, 153 zombie banks, 145–6, 191 Japanese economy Abenomics, 150–52 current position, 151–2 deflation, 146–7 economic miracle, 136 financial strategy, 58, 140–41 monetary policy, 61 prolonged stagnation, 137–8, 152 Japanese financial crisis Bank of Japan’s ‘window guidance’, 142–3 origins, 17, 140–42 stock and real estate bubble, 17, 141, 142–3, 191 weak monetary and fiscal policy responses, 143–4, 146–9 Jinglian, Wu, 5, 184 Johnston, Jake, 228 Jospin, Lionel, 118 JPMorgan, 14, 65, 70, 218, 262, 270 Keiichiro, Kobayashi, 145 Keynes, John Maynard, 49 Keynesianism and bank nationalization, 64, 72 banking reform, 62–3, 225 disappointing policy impact, 15, 26, 60–61 failures following financial crisis, 15, 62, 64 and financial crisis, 25–6, 56–7, 80, 225

313

PAPER DRAGONS

Obama’s technocratic approach, 15, 75–6 policy tools, 55–6 theory of money, 10–11, 26–9 US fiscal stimulus failure, 57–9, 81 US monetary policy, 60–61, 81 US reform failure, 70–76 King, Mervyn, 90, 91, 92, 205, 251–2 Knight, Frank, 251 Koizumi, Junichiro, 148 Koo, Richard, 58, 60–61, 231 Korea see South Korea Krugman, Paul, 25–6, 59, 64, 72, 146, 217 Labour government, 16, 117–18, 130 labour market, German (Hartz) reforms, 16, 113–15, 120–21, 127, 130 labour productivity, and information technology, 38 labour unions, 33–4, 35 Lafontaine, Oskar, 121 Lagarde, Christine, 228 Lardy, Nicholas, 180–81, 183 Large Scale Asset Purchase (LSAP) programme, 60 Lehman Brothers, 14, 50, 52, 71, 208 leverage, 13, 47, 205–210 Levine, Matt, 246–7 liberalization Chinese economy sector, 177–8, 179 Chinese financial sector, 175–7, 179 commonalities, 88

global capital flows, 43–4, 79 South Korea, 162, 171–2 UK banks/banking, 86–9 US banks/banking, 13, 40–41, 46, 78–9 Lin, Justin, 46 Lipton, David, 275, 276, 277 liquidity preference, 10, 27–8 Lucarelli, Bill, 28 Lucas, Robert, 24, 56, 58 Maastricht Treaty (1992), 119 McCoy, Patricia, 249 Maddison, Angus, 139 Madoff, Bernie, 63 Mahathir bin Mohamad, 165 Malaysia capital controls and economic recovery, 165–6 foreign capital flows, 156–7 investor panic, 159–61 Japanese foreign direct investment, 152 manufacturing industries, 12, 36–8 Marx, Karl, 10, 25, 39–40, 242 Mason, Paul, 33–4 MBSs (mortgage-backed securities) banning recommendation, 248 downgrading, 54 East Asian purchases, 45 in Europe, 126 global trade, 12–13, 45 ineffective regulation, 200–201 Lehman Brothers, 14 securitization, 12 still trading, 270 toxicity, 190 in UK, 88–9

314

Index

Merkel, Angela, 86, 121, 122–3 Merrill Lynch, 218 Mexico, 155, 157, 164 Mian, Atif, 45, 50, 61–2, 66–7 Minsky, Hyman, 11, 15, 25, 29–32, 56, 82, 130, 251 ‘Minsky moment’, 11, 31–2 Mitterrand, François, 118, 119, 123, 130 money, capital vs a store of value, 10–11, 26–8, 30 Moody’s, 221–4, 259 moral hazard, 69, 81, 103 Morgan Stanley, 13, 57, 218, 270 mortgage-backed securities see MBSs mortgages Northern Rock “Together Loan”, 89 subprime, 12, 42–3, 47–51, 66 total US debt, 43 Naciri, Ahmed, 222–3 nationalization financial institutions, 64, 72, 81, 217 Irish banks, 98 UK banks, 89, 91, 92–3 US banks, 64, 72, 81, 217, 253–5 Naughton, Barry, 175, 179 neoliberal restructuring Germany, 113–15 policy, 11–12, 35–7, 273 South Korea, 171–3 neoliberalism deficit and debt reduction, 24–5 efficient market hypothesis, 23–4, 78, 87–8, 126–7

and the financial crisis, 23–6 and Great Recession (2007-), 78–9 ideology, 23, 73 rational expectations hypothesis, 24, 78 and social democracy, 123–5, 129–30 UK austerity programme, 93 New Labour, 117–18, 130 Nordhaug, Kirsten, 155, 156–7 North Dakota, 254–5 Northern Rock, 50, 89, 91 Obama administration executive compensation, 220, 257 fiscal stimulus failure, 57–9, 81 missed banking reform opportunities, 62–3, 70–76 response to recession, 15, 226 Obama, Barack, 220 offshoring, 12, 36–8 Pandit, Vikram, 71 Paulson, Hank, 74 Philippines, 44, 156–7 Pinochet, Augusto, 34 Post, Achim, 121 post-capitalism, 82, 277–8 Prasad, Eswar, 178, 260 Prins, Nomi, 230–31, 272 private equity funds, 243–7, 261, 270 production crisis of overproduction, 11–12, 32–4, 38–9, 272–3 and financial system, 241–2 globalization, 11–12, 273 315

PAPER DRAGONS

profitability, crisis of profitability, 33–4, 138–40 proprietary trading, 215–16, 255 Pym, Hugh, 85, 93 quantitative easing (QE), 60, 81, 91–2, 150, 230–32 Rajan, Raghuram, 42–3 rational expectations hypothesis, 24, 78 Reagan, Ronald, 33, 34 real estate Asian overinvestment, 44, 96, 157–8 Chinese bubble, 3–4, 182–3 Chinese prices, 4 Chinese shadow banking, 6, 186–7 Chinese speculation, 180–82, 194 Irish speculation, 97 Japanese bubble, 17, 142–3 Japanese speculation, 141 uncontrolled lending, 126 see also MBSs (mortgagebacked securities); mortgages Renaissance Technologies, 244 Romer, Christina, 57–8, 81 Roosevelt, Franklin Delano, 75 Royal Bank of Scotland (RBS), 85–6, 91, 93 Rubin, Robert, 73–4, 164 Sakakibara, Eisuke, 151, 170 Schmidt, Helmut, 122 Schröder, Gerhard, 16, 120, 123, 130 secular stagnation, 275–6

Securities and Exchange Commission (SEC), 69, 199, 204 securitization, 12–13, 48–50, 200–201, 202, 212 shadow banking asset worth, 205 China, 6, 185–7, 194 continuation, 255 definition, 5–6, 184–5 in derivatives, 52–3, 198–205 emergence, 13 lack of US regulation, 199–200, 204–5 UK, 88 Shanghai stock market, 4–5, 174, 183–4, 194 Sheng, Andrew, 4, 6 Shiller, Robert, 26 Simons, Henry, 251 social democracy French socialists, 118–19 neoliberal measures, 123–5, 129–30 New Labour, 117–18, 130 SPD (Social Democratic Party of Germany), 120–23, 130 Soon, Ng Chow, 4, 6 Soros, George, 159, 165, 189 South Korea chaebol (conglomerates) success, 161–2 effects of 2008 financial crisis, 172 exports, 139–40 financial crisis (1997), 18, 44, 162–4 financial liberalization, 162, 171–2 foreign bank debts, 172 316

Index

foreign capital inflows, 156–7, 162 investment in Southeast Asia, 155 OECD membership, 18, 162 US government support, 166–7, 173 US/IMF rescue, 18, 163–4, 166–7, 173 Southeast Asia capital flows, 155–61 Chiang Mai Initiative (bilateral agreements), 170–71, 193 exports and foreign reserve accumulation, 18, 170, 173–4, 193 financial crisis, 17–18 financial reforms, 167–70 Japanese foreign direct investment, 152–5 sovereign debt crises accusation of profligate spending, 103 Greece, 15–16, 74 Ireland, 15–16, 99–100 SPVs (special purpose vehicles), 52, 57 stagflation, 32, 273 stagnation austerity policies, 128 escape routes, 35–40 global, 9, 138–40 Greece, 108 Ireland, 99 Japan, 137–8 secular stagnation, 275–6 Standard & Poor’s, 101, 221–4, 259 State Street Bank, 218 Steinfeld, Edward, 175

Stiglitz, Joseph, 25–6, 64, 72, 101, 112, 115–16, 129, 146, 164, 217, 266 stock market crash (2018), 5, 8, 197, 229, 269 Strauss-Kahn, Dominique, 227–8 structural reform school, 147–8 student loans, 43 Stumpf, John, 64, 65 subprime mortgages, 12, 42–3, 47–51, 66 Sufi, Amir, 45, 50, 61–2, 66–7 Summers, Larry, 73, 275 Switzerland, executive pay, 256–7 Taiwan, 139–40, 155 TARP (Troubled Asset Relief Program), 57, 71, 218, 220, 257 tax evasion, 244–6 tax havens, 244, 245, 261, 270 taxation cross-border capital movement, 247 of the rich, 261 Thailand bank and investment loans, 156 economic and financial reforms, 168–9 export slowdown, 158 financial crisis, 44 financial sector liberalization, 156, 158 foreign capital inflows, 155–7 hedge funds activity, 158–9 investor panic, 158–9 Japanese foreign direct investment, 152 317

PAPER DRAGONS

negative effects of IMF conditionalities, 164–5, 166 telecommunications, 169 Thain, John, 71 Thaksin Shinawatra, 168–9 Thatcher, Margaret, 16, 33, 34, 86, 123 Tobin, James, 251 Tobin tax, 247 Tokyo, Imperial Palace East Gardens, 142, 191 ‘too big to fail’ (TBTF), 14, 54–5, 69, 217–19, 270 trade unions, 33–4, 113–14, 118 Trans-Pacific Partnership (TPP), 150, 151 Troubled Asset Relief Program (TARP), 57, 71, 218, 257 Trump administration, 217, 255 Trump, Donald, 15, 76–7, 125 Tsipras, Alexis, 107, 123 Tsunekawa, Keiichi, 148–9 Turner, Adair, 88, 92 UBS, 50 unemployment effect on potential lifetime income, 56, 80 Greece, 104 Ireland, 99, 100 US, 14–15, 55, 56, 59, 80 United Kingdom Brexit, 93–4, 235 financial crisis, 15–16, 85–94 miners’ strike, 33 New Labour, 117–18, 130 public debt, 91 United Kingdom banks/banking borrowing short and lending long, 89–90

high leverage levels, 90, 206 liberalization, 86–9 nationalizations, 89, 91, 92–3 overborrowing and overinvestment, 90–91 quantitative easing, 91–2 rescue packages, 89, 91–2 ring-fencing, 214–15 United States air traffic controllers strike, 33 fiscal policy, 57–9, 74, 81 inequality, 274 monetary expansion vs fiscal policy, 15, 57–62 monetary policy, 59–62, 79, 81 and South Korea, 163–4, 173 strategic goals in Southeast Asia, 166–7 Treasury Department, 73–4 unemployment, 14–15, 55, 56, 59, 80 United States banks/banking cessation of interbank lending, 14, 54 commercial/investment bank mergers, 212–13, 217–18 commercial/investment bank separation, 70, 79, 256 East Asian reserves, 18–19, 45 equity/asset ratio, 67–8 excess reserves, 231 financial sector size, 9 fraud, 49, 50, 63 leverage ratios, 206–7 liberalization, 13, 40–41, 46, 78–9 missed reform opportunities in US, 62–70 nationalization, 64, 72, 81, 217, 253–5 318

Index

proprietary trading vs marketmaking activities, 215–16 soaring assets, 218 stock market crash (2018), 197 stress tests, 64–5 ‘too big to fail’ (TBTF), 14, 54–5, 69, 217–19, 270 Wall Street-Washington connection, 67, 72, 73–4 Vanguard, 243 Varoufakis, Yanis, 104, 105, 109–110, 111, 112, 119, 124–5, 130 Vickers Commission, 214 Vogel, Steven, 140–41, 145–6 Volcker, Paul, 213 Volcker Rule, 70, 72, 213–17, 255–6 von Mises, Ludwig, 24 Wachovia Bank, 218

wages declining, 12, 273, 274 see also income inequality Wallison, Peter, 69 Walter, Andrew, 168 Wang, Hongying, 179, 180 Washington Mutual, 218 Weisbrot, Mark, 228 Wells Fargo, 14, 63, 64, 65, 218, 256, 270 Wen Jiabao, 178–9 Winters, Jeffrey, 159–61 Wolf, Martin, 62, 102 Woll, Cornelia, 71, 72, 75 working class, 33–4, 39, 42, 77 World Bank, 259 Yoshino, Naoyoki, 151 Zestos, George, 113 Zhu Rongji, 175, 176, 179, 192

319

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