An overview of the Great Recession

Nowhere to Hide: The Great Financial Crisis and Challenges for Asia
by Michael Lim Mah-Hui and Lim Chin (Institute of Southeast Asian Studies, Singapore, 2010)

Review by T Rajamoorthy

THE number of books on the US financial crisis which erupted in 2007 and plunged the world into an economic recession just keeps growing.

This book is a welcome addition to this growing literature. It is written in a breezy and readable style  and attempts to explain to the layman, in a brief compass, the causes of this crisis. It also has the added merit of highlighting the many issues and debates which the crisis has raised.

The authors devote the first four chapters to a discussion of the causes of the crisis. They contend that the crisis should be analysed at three inter-related levels: the level of theory and ideology; the level of financial industry practices and malpractices; and finally at the level of the structural imbalances in the international economy. In this review, I propose to consider each of these in turn.

In analysing the impact of ideology, the authors charge 'neoclassical economists, monetarists and rational expectations theorists' with responsibility for the crisis as it is they who have dominated and guided business, finance and economic thinking during the last few decades. But, for all the promise of a broad analysis of the common underlying assumptions of all these different strands of free-market economic thought to explain the crisis, the authors choose to focus almost exclusively on the New Classicals (i.e., 'rational expectations theorists'). This is further narrowed down to one component in the intellectual armoury of the New Classicals: the 'efficient market hypothesis' (EMH).

'Modern financial theory,' explain the authors, 'is based on the belief in the efficient market hypothesis (EMH). The price of an asset, or its fair market value, is a result of an estimation of the present value of its future income stream based on a constant stream of information. Every decision to buy or sell reflects a judgement on the future income stream and the discount rate; these information change every moment and are captured in the myriad of data provided by all types of data sources. As data change, market prices likewise change.'

The authors go on to point out that since EMH proponents hold that market prices are an accurate reflection of the true value of financial assets, markets should be given a free rein to determine prices. There is therefore no case for a role or interference by governments or other external authorities.

After subjecting the EMH to strong criticism and showing up its inadequacies, the authors claim that it was the inordinate influence of this pernicious theory on policy makers that was to blame for much of the crisis. 'Foremost of these,' they go on to charge, 'are central bankers like Alan Greenspan.'

Unfortunately for the authors, this charge against former US Federal Reserve chief Greenspan is somewhat misplaced. Greenspan may have been guilty of many crimes, but certainly not of having allowed himself to be seduced by the EMH. Perhaps it was the shock of the 1987 New York Stock Exchange crash which disabused him of any illusions he may have had about this hypothesis; as he explains in his The Age of Turbulence:

'... the theory of efficient markets cannot explain stock-market crashes. How does one make sense of the unprecedented drop (involving the loss of more than a fifth of the total value of the Dow Jones Industrial Average) on October 19, 1987? As a newly anointed Fed chairman, I was watching the markets very closely. What new piece of information surfaced between the market's close at the end of the previous trading day and its close on October 19? I am aware of none. As prices careened downward all that day, human nature, in the form of unreasoning fear, took hold, and investors sought relief from pain by unloading their positions regardless of whether it made financial sense. No financial information was driving those prices. The fear of continued loss of wealth had simply become unbearable. And while the economy and corporate profits subsequently advanced, it took nearly two years for the Dow to recover fully.' (p. 465)

The limitations of trying to explain the crucial decisions of policy makers by the influence of the EMH are also evident with respect to the moves to liberalise and deregulate the US financial markets. There is no denying that the New Classicals with their EMH did provide ideological justification for these moves. However, it is important to note that one of the key figures in the Clinton administration who played a leading role in effecting these changes had already gone on record as a critic of the EMH. Lawrence Summers helped craft the 1999 Gramm-Leach-Bliley Act which repealed the 1933 Glass-Steagall Act (the legislation which had prohibited commercial banks from offering investment and insurance services). He also played a key role in defeating all attempts to regulate over-the-counter derivatives. Yet in a well-known 1986 article questioning the claims of the EMH, Summers, who was to serve Clinton as Treasury Secretary, had criticised its proponents for 'insisting on the basis of very weak evidence that market valuations are always rational'.

What all this serves to underscore is that not all worshippers in the temple of the free market are necessarily devotees of the EMH. Many who subscribe to the neoclassical doctrine of self-correcting markets may well reject the claims of the EMH.

For the authors, the EMH is instrumental in explaining not only policy makers' behaviour but also market behaviour during the crisis. Thus they are at pains to show how faith in the EMH induced financial traders and bankers to act recklessly by taking unjustified risks. Such attempts to explain market recklessness by the impact of the EMH are, to say the least, somewhat risky. Are we to conclude that had market players been exposed to a more benign financial theory, it would have made much of a difference?

This impression that the authors place a high premium on the proper 'education' of financial traders to prevent market excesses is reinforced by their lament that in the last few decades the Economic Value Added (EVA) school of thought has occupied a dominant place in the curriculum of banking and financial institutes. The principal author relates how, when he attended a three-day seminar on EVA  organised by the New York Institute of Finance while working in the banking industry, he was shocked to be told by his instructor that of all the objectives of  a business, there is only one that matters, 'that is how to maximise shareholder value'. Why he should have been shocked is something of a mystery, but it is a reflection of how seriously and sincerely the authors hold the view that if only bankers and financiers had been taught that there was more to life than making profits, some of the worst excesses could possibly have been avoided!

The rise of the financial sector

Turning now to the authors' exposition of the financial industry's practices and malpractices, which constitutes the second level of their analysis of the crisis, in the first (Chapter 2) of the two chapters devoted to this purpose, they do a good job in succinctly explaining how financial innovation coupled with the liberalisation and deregulation of the financial industry set the US economy on a combustible course.

The following chapter, which seeks to explain how the US financial sector trumped the industrial sector, is somewhat confused, however. It begins by asking the question, 'What enabled the financial industry to become so powerful?' The answer offered by the authors appears to be that the industry grew exponentially and became the most influential lobbyist in Congress and the White House. This enabled it to shape the whole regulatory process to serve its interests ('regulatory capture'). But all this begs the question: what enabled it to grow so phenomenally that it outstripped the industrial sector and thus become so powerful? The answer is not regulatory capture, as this was only possible after it had already become powerful.

There is no easy answer to this question, but the fact that finance really began to emerge as a force and began to outstrip manufacturing only after the 1974-75 downturn of the US and world economy indicates that the answer has to be sought in the turbulent aftermath of this economic dip. One critical factor was surely the monetarist response of the Fed under Paul Volcker from 1976 onwards. The huge interest rates to curb the soaring inflation and subsequent phenomenal rise in the value of the dollar decimated US industry while providing fertile ground for the massive expansion of the financial sector. While this is not the whole story and it is too much to expect a book of this size to exhaustively deal with this complex issue, the point is that the authors do not even address the question they pose.

In the third level of their analysis of the crisis, the authors focus on structural imbalances in the international economy, specifically the imbalances between the US real economy and financial sector, the country's  wealth and income imbalance, and the US current account imbalance with the rest of the world, notably with China. Although market and regulatory failures were the immediate causes of the crisis, the authors contend that its seeds are to be found in the above structural imbalances created decades ago.

For the authors, of these three, it is the income imbalance, largely the outgrowth of the so-called 'Reagan revolution', that was central in creating the conditions for the crisis. 'Extreme inequality, on the one hand, results in underconsumption for the vast majority of people at the bottom, and on the other hand, excess savings for a tiny minority at the top.' The vast majority, with inadequate income and low purchasing power, has a high marginal propensity to consume which can only be met by the assumption of an unsustainable level of debt. The tiny minority with excess savings has a high appetite for investments which corporations seek to whet by the production and sale of exotic financial instruments. 

The result is the growth of a debt economy and this is reflected not only in the US domestic debt but also in its current account deficit, i.e., the third imbalance above. This deficit is ultimately sustained by huge capital inflows from China and other East Asian  countries, the US' key trading partners. It is these countries, with their huge trade surpluses, which are financing the growing US debt.

However, the phenomenal growth of household and corporate debt was sooner or later bound to spawn asset and debt bubbles which are unsustainable. When they burst (as they did in 2007), a financial crisis was the inevitable consequence.

That the assault on the living standards of working people and the redistribution of wealth to the rich and the super-rich under the Reagan revolution is not only morally indefensible but has definitely  contributed to the continuing economic malaise of the US, is not a matter of dispute. But what of the authors' claim that the resulting inequality was one of the structural causes of the financial crisis?

'Underconsumption'

At the outset, it is important to clarify the role 'underconsumption' plays in their analysis of the crisis. When the authors use the term 'underconsumption' to characterise the condition of the low-income majority in the US, they are not contending (as did JA Hobson, the first of the leading underconsumptionists to use the term) that this deficiency of purchasing power engendered a deficiency of consumption and this, coupled with its corollary of excess saving, directly caused economic stagnation and crisis.

What the authors appear to be saying is that the skewed distribution of income resulted in purchasing power not going into the hands of those with a higher propensity to spend. The consequence is that the impoverished majority was driven or lured into debt, including mortgage equity debts, while the tiny minority with huge savings but no productive investment outlets was left with no option but to channel their funds into exotic financial instruments. In this way, the groundwork was laid for the growth of bubbles and crises.

There have been a number of more detailed studies which have advanced variants of this underconsumption analysis to explain the crisis and there is no denying that the argument is persuasive. While this book sets out only the bare bones of such an analysis, there is certainly much food for thought here. 

Unfortunately, the underconsumptionist argument here becomes somewhat muddled with the authors' suggestion that the problem of household debt lies as much in the uncontrolled consumerist tendencies of the US populace as in their inadequate incomes. The authors allude to this by drawing attention to the fact that 'despite stagnating household incomes, household consumption increased from about 60% of GDP in the 1960s to over 70% in 2007'. They point out that it is Asia and the oil-producing countries, with their huge current account surpluses, which are supporting 'the consumption habits of the US households and government'. To reinforce this point, they make the observation that 'ironically, the poorer nations are financing the spending habits of US households'.

The point is that the charge of consumerism may vitiate the claim that it was the income imbalance that provided the structural basis for the crisis. If indeed the real problem is one of consumerism, it could be argued that the issue of income and wealth inequality may not be of much consequence. Having a more balanced income structure may not make much of a difference since a populace afflicted by consumerism would still get itself in debt.

On the whole issue of underconsumption as an explanation, it is worth noting that some critics have pointed out that the origins of the current crisis have to be traced back to the 1974 economic downturn after the postwar boom. The US never fully recovered from this critical downturn and thereafter it lurched from one crisis to another. They argue that the whole turn to finance to restore profitability has to be seen as a response to this downturn. The fact that the 1974-75 economic crisis erupted when gross social inequalities had not yet emerged in the US is surely suggestive that other critical causes may be at work.

In the remaining two chapters of the book, the authors return to these themes and suggest reforms. Chapter 5, which deals with the response of Asia to the crisis, takes up some of the key challenges facing the region. The most important of these is the limitations of the export-oriented model which hitherto has served as the engine of growth for most of these countries. In calling for a rebalancing towards domestic investment and consumption, the authors also stress the need for greater regional cooperation and integration.

The chapter also deals with the problem of capital flows into the region but the discussion of solutions to this phenomenon is somewhat marred by the ambivalent approach of the authors to capital controls. Instead of stressing the cardinal importance of such controls and the fact that so much of the problems that developing economies have faced in recent years (particularly during the 1997 Asian crisis) has arisen from their abandonment, the authors resort to a textbookish discussion of the 'pros and cons of free capital flows'. Hopefully the recent resurgence of such destabilising flows into the region, which has compelled countries such as South Korea and Indonesia to impose such controls, has persuaded the authors to rethink their equivocation on this issue.   

The final two chapters also touch on the dominance exercised by the US through the continued use of the dollar as the international reserve currency and the prospects of its replacement with the Chinese yuan. The authors are of the opinion that there is no immediate likelihood of a single alternative currency emerging to replace the dollar. 'More likely is the emergence of several co-anchor currencies that will dilute the hegemony of the US dollar as a trading and reserve currency.' 

All in all, this book, despite its shortcomings, is a good starting point for a debate and discussion of the many controversies and issues which the financial crisis has thrown up.

T Rajamoorthy, a senior member of the Malaysian Bar, is Editor of Third World Resurgence.

*Third World Resurgence No. 244, December 2010, pp 41-43