Trevor Evans is a professor at the Berlin School of Economics, and has also worked in Nicaragua and other countries. He has written especially on the interrelation between finance and capitalist crises. He spoke to Martin Thomas.
After the 1929 crash the United States government introduced very tight controls of the financial system. From 1933 to the early 70s the financial sector was very tightly regulated. By the 1970s the banks were looking for ways to get round the controls. There was a political shift in the late 70s, after Ford became President of the US, and from 1980 onwards there was a process of liberalisation.
The most first important change was in 1980, when the legal upper limit on interest rates was abolished. There was a series of laws, under Reagan and Clinton, up to the 1999 law which completely abolished the remainder of the regulations which had been introduced in 1933.
This process of liberalisation of the financial sector created the basis on which all sorts of innovations could develop, and resulted in a huge expansion in the size of the financial sector relative to industrial and commercial capital.
The whole pattern of capitalist accumulation has become much more centrally driven by finance than it was before 1980. The United States, since the 1980s, has been looking for new ways of promoting accumulation in the US and maintaining its international position.
The 1980s began with very high interest rates of about 20%. That resulted in a major recession which dealt a massive blow to working-class organisation in the United States and, indeed, around the world, as the high interest rates led to the Latin American debt crisis and the resubordination of Third World countries.
During the 1980s there was a huge wave of mergers and takeovers in the United States, comparable with the wave at the end of the 19th century — a massive restructuring of the US corporate sector, made possible by new forms of financial instrument, particularly junk bonds. It was followed by a process of rationalisation, with the least competitive units being closed, and constant pressure to force real wages down and re-establish a higher rate of profit for the first time since the big crises in the 1970s.
The banks then ran out of money at the end of the 1980s, and the Federal Reserve responded by lowering interest rates and pumping money into the economy to prevent the over-lent banks from running into problems. Lower interest rates led to a weaker dollar. That helped US exports, and laid the basis for a slow recovery in the early 1990s.
The so-called IT boom followed in the second half of the 90s. You had a period when high profits, rising share prices, and very strong investment in fixed capital fuelled each other. Again, the process was very, very dependent on an expansion of credit. The huge investments in IT, particularly in the new global fibre-optic networks, were financed by credit. In addition, firms were buying borrowing to buy back their own shares in order to push up share prices and make themselves less vulnerable to takeovers.
The bubble burst at the beginning of 2000, and that is where we get to the beginning of the current story. The collapse of share prices from the spring of 2000 onwards was comparable to the crash in 1929. Why didn’t we get a string of bank crashes and a depression? The Federal Reserve had learned to intervene very rapidly. It cut interest rates sharply, from 6.5% in January 2001 to a low of 1% two years later. That generated a massive expansion of credit.
Anyone following the financial sector was sure that this was breeding trouble. Most people did not at first look at the subprime mortgage sector, but rather at the new wave of leveraged buyouts, in some ways a repeat of the 1980s, now led by so-called “private equity” firms, but essentially, again, financing takeovers by issuing debt. That looked like the most vulnerable point.
There was also the extraordinary growth of derivatives, particularly credit derivatives [bits of financial paper which “derive” from other bits — representing, for example, “future” assets, or “bets” or “hedges” on whether certain financial prices will go up or down]. That was probably the biggest time-bomb of all sitting in the system.
And then there was the mortgage growth. The US system makes it relatively easy to refinance your house mortgage, so households took out new mortgages to pay off their old mortgages and draw an extra amount to finance consumption. That extra consumption from borrowing drove the expansion from 2001-2 to 2007. Business investment was very weak, because businesses had so over-invested in the late 90s.
As a result of financial liberalisation, it was possible for banks and other lenders to grant mortgages to low-income households who in the past would not have qualified. And it was attractive — they could charge much higher interest rates. They would send people out to working-class neighbourhoods to offer very attractive initial rates and convince people that they could get credit to buy a house more cheaply than they could rent. At a time when house prices were rising, and the borrowers could remortgage a couple of years later on an increased price for their house, that seemed like a good deal.
The crisis which broke in August 2007 was the end of the third of the waves of expansion, since the early 1980s, which have been closely linked to the process of financial liberalisation.
The housing credits were mainly then sold on, by grouping large numbers of mortgages as bonds that could be traded. Those bonds were in turn transformed into other bonds which could get more attractive ratings. It appeared that the big banks were selling the bonds on, but what became clear last summer was that many of them were also holding some of the new bonds themselves, not on their own books, but in off-balance-sheet vehicles to get round all the international rules on capital requirements [i.e. rules which say that banks must have a certain stash of cash, of their own, to underpin their operations].
Once everybody realised that this was going on, the banks took fright at lending to each other. In the second week of August, the inter-bank money market dried up. Banks were no longer willing to trust each other, because nobody knew who had huge liabilities which they had kept secret.
The expansion since 2001-2 has seen all sorts of financial instruments expanding on a huge scale. When the crisis broke, for example, many banks were left holding loans for leveraged buyouts which they had planned to sell on.
Interest rates being low since 2001-2 meant that financial institutions could borrow cheaply, but on the other hand the financial return on their lending was quite low. That was why they were so interested in forms of lending which involved leverage, where the borrower uses a relatively small amount of his own capital and borrows the rest in order to buy up a firm. You had private equity firms which would borrow ten times as much as they would put up themselves for a purchase. The hedge funds [whose business is, essentially, betting in the financial markets with borrowed money] would borrow up to thirty times their own capital.
When the central bank sets a low interest rate, the financial sector goes searching for leverage. That means that if things go well, they get high returns; the moment things go wrong, the leverage goes into reverse, and they make huge losses.
a way out?
The Fed has now pushed its interest rate very low. That will relieve the pressure on some of the financial institutions under stress.
But the traditional channels by which central bank monetary policy operate are running into problems. In the advanced capitalist countries, the main way that monetary policy operates is that the central bank buys bonds and thus provides central bank money to the inter-bank money market. Usually the central bank has a target for the interest rate in the inter-bank money market, and then banks in turn charge an interest rate which is a mark-up on that inter-bank rate for their outside lending.
Since last August the inter-bank money market interest rate has been very substantially above the central bank interest rate. When the central bank pumps money in, it can keep the overnight interest rate at about the level it was, but one-month borrowing and three-month borrowing rates are significantly — in terms of the money markets: 0.5% or 0.75% — above the target of the central bank. The traditional transmission mechanism of central bank monetary policy is not working because the banks don't trust each other.
Clearly the Fed is helping financial institutions which are faced with liquidity problems [i.e. which have sufficient assets, but not sufficient ready cash].
Commercial banks have direct resort to the money markets, or they can borrow [from the central bank] on the lender-of-last-resort facility. But Bear Stearns was an investment bank [i.e. dealing only in the financial-investment markets, not in deposits from or loans to the general public or for commercial purposes]. It did not have access to the lender-of-last-resort facility. So the Fed had to engineer the takeover of Bear Stearns by J P Morgan Chase, which is a universal bank, i.e. commercial bank and investment bank.
Lowering the official interest rate has guarded against further financial institutions going bankrupt. But in truth they are continually displacing the problem.
When the first post-1980 expansion ran into trouble at the end of the 1980s, and the Fed responded by pushing money in, it prevented a deep recession in 1991, and laid the basis for the next expansion — and the bubble at the end. By pushing money into the system in 2001, the Fed prevented another deep recession, at the cost of yet a further build-up of credit bubbles.
They can't keep on doing that forever. The scale of the collapse being staved off becomes bigger each time. Whether they will stave off collapse this time, I don't know. Some commentators are suggesting that the worst of the financial crisis may be over, and it's possible. But these complex bonds are distributed around a huge number of people, and financial crisis could flare up again.
In any case, pushing the extra money in means that the financial institutions are now more indebted. There is more overhang. If the Fed establishes the basis for a new expansion next year, it is going to start with even higher levels of debt, of higher financial liabilities, than the last one.
Question to Bryan Evans: In past writings, you have emphasised that Marxist theories of capitalist crises do not see them as just financial. A crisis happens through the interaction of financial disturbances and basic movements in profits. But recently profit rates have been high. The rate of profit in Britain in 2007 quarter three was the highest since the statistical series started in 1965. Does that dispel the risk of the financial crisis having a big impact in trade and production?
Profit rates have been recovering in the advanced capitalist countries since the early 1980s. There have been intermittent downturns, but broadly speaking profitability was re-established in the major transformation of the 1980s.
Each period of expansion has to find some way of realising the surplus value [i.e. of selling the commodities which exploited labour has produced]. The vulnerability of the most recent expansion, 2002-7, was that it was exceptionally dependent on consumer spending.
Profit rates in the US were also up to their best values since the 1960s. But, particularly in the US, it now looks as if we are faced with a recession not just from the financial crisis, but from that very rapid growth of consumer spending coming to an end. That recession is going to feed back, in the course of this year, into a financial system which already has its own big internal difficulties.
US profit rates peaked in 2006. There is already a slight downturn. As consumer spending falls — investment spending was already weak, and strongly driven by investment in housing — we will probably see the coming-together of problems arising from the financial sector and of others which come from business profits falling because of slacker consumer spending.
Question: Martin Wolf, in the Financial Times of 1 May, writes that: “The ratio of household liabilities to disposable income [in the UK] jumped from 105 per cent at the end of 1996 to 164 per cent at the end of 2006... Such a rise cannot be repeated". There has to be a correction; and in the US, too, though the figure there is slightly lower, 138 per cent. Do you agree?
On this occasion, I would agree with Martin Wolf! We never know beforehand how far the elastic can be stretched. Marx wrote that the credit system is notoriously elastic. But the expansion of household debt cannot go on indefinitely. It means the level of debt service is constantly rising; a higher share of households' disposable income goes out in interest and capital repayments.
Question: What do you expect to happen to inflation? The Fed's policy seems to be based on thinking that somewhat higher inflation is not a big problem, and may even help ease the credit crisis.
The Federal Reserve in the US has a different attitude on this from the European Central Bank.
The Fed does not have an explicit inflation target. Once inflation gets to about 4%, they start reacting, but anything under 4% does not worry them. The European Central Bank has an extraordinary fetish that any inflation above 2% is unacceptable — it's a continuation of the policy of the [German] Bundesbank — and hence, since the introduction of the euro in 1999, it has been following a monetary policy that is unnecessarily restrictive.
In 2002 and 2003 the concern was about the US or Europe falling intoexperiencing deflation and the sort of problems that Japan had faced in the 1990s. Now it is different, with higher inflation, driven principally by primary commodity prices, energy and foodstuffs.
A recession in the US and Europe will ease those primary commodity prices, since primary commodity prices have followed the business cycle in the developed capitalist countries quite closely. But there are long-term structural issues here: there are limits to the quantity of oil available, and there is pressure on land for growing food. The era of very low inflation we have had over the past 10 or 15 years, driven above all by falling prices of manufactured exports from Asia, seems to be over.
Prices have begun to rise fairly fast in China now. The inflation is concentrated in food prices, but that feeds through to wages. In the export manufacturing areas along the southern coast, wages are rising.
The other dimension to understanding commodity prices is the policy of the IMF and the World Bank since the early 1980s. Primary commodity prices were relatively high in the 1970s. In the early 1980s the IMF and the World Bank turned to so-called structural adjustment programmes, forcing developing countries to open up their economies and re-specialise on the basis of comparative advantage [producing whatever export commodities they can produce most cheaply]. The supply of primary commodities increased quite strongly from the late 1980s. But that phase is also over.
The US had a major change of policy, starting in the early 70s under Nixon. Until then it had been concerned with building up a strong capitalist bloc in the world [in competition with the bloc led by the USSR], and it had been willing to countenance countries like Germany and Japan having undervalued exchange rates to promote their exports.
In the early 70s that changed. And since the 1980s we have seen the US pursuing a series of short-term moves — not a long-term strategy, because it doesn't have one — to maintain its position in the world. Part of that is the role of the dollar in the world economy, which enables the US to run its repeated current-account deficits.
This has involved the US continually having to reassert the power it has in financial markets, in economics, and of course militarily. It is going to be increasingly difficult for it to do that.
It is still the biggest and strongest economy in the world. It has a representation in most key sectors of production. It has a huge trade deficit, its exports are rising, but it has a huge trade deficit which it must finance, in effect, by borrowing from the rest of the world.
But, as with households in Britain, the US cannot indefinitely continue to accumulate international indebtedness. I did say that ten years ago, too, and here we are today, but it really cannot go on forever.
One of the things we are seeing now is an adjustment of the relative strength of the dollar in the world economy. The US will be looking for ways to reassert itself, and that makes it quite dangerous. We hope that the rulers of the US have learned from the fiasco in Iraq, but we can’t be sure.
The US has been enjoying a standard of living above its capacity to produce for 25 years. The overwhelming bulk of that increased consumption has gone to the top 20%, and a big part of it to the top one per cent. But those people are never satisfied. They want more and more. They want to ensure they have continued access to energy and they can continue to run the current account deficits.
I think it's going to be difficult. Over the last two or three years, China has shifted from a dollar standard [for its currency] to a basket of currencies. Russia has done the same. One or two of the smaller countries in the Middle East are shifting towards a basket of currencies, although Saudi Arabia still links its currency to the dollar.
The willingness of countries to use the dollar as reserve currency is beginning to shift, too. Many countries face a difficult dilemma at present. Countries like China have large reserves already held in dollars, and anything they do which weakens the dollar is going to hurt them. But — so far as we can tell: they don’t publish figures — new current account surpluses are not being invested solely in dollars, but more widely dispersed.
Clearly, New York is the financial centre of the world. In a sense, when we talk about international capital markets, we are really talking about the international extensions of the US capital market. There aren’t markets hanging above the Pacific or the Atlantic.
But the importance of that is declining. The euro area capital market is now in some respects comparable in size to the US capital market. It is much more fragmented; but it is slowly becoming more integrated. There is now more investment in euro instruments than there was before, although it is still much smaller than the trade in dollar instruments.
The overwhelming majority of capital flows in the world are between Europe and the United States. The Asian countries and China are investing their surpluses in dollars. That’s predominantly a one-way flow, whereas the capital markets between Europe and the US are deep, deep, deep [i.e., because of their large flows in many directions, they can generally accommodate large transactions without jerky movements in prices]. As the euro capital markets develop, that gives firms more opportunities for diversifying their holdings.
Of course, there is a risk that the current crisis could spiral into a catastrophic decline of the dollar. The IMF’s World Economic Outlook of 18 months ago was focused on scenarios for the collapse of the dollar, and all the factors the IMF identified in that report as creating a danger of what they called a disorderly devaluation of the dollar are still present.
The last time that happened was in the first week of October 1979, when Paul Volcker [then chair of the Fed} famously had to leave the IMF meeting in Belgrade, fly back to New York, and raise interest rates very dramatically, leading to a three-year recession in the whole world.
If it happened, it would probably happen very quickly. It only needs one thing, possibly even a rumour, to set off a chain of selling, and the markets can move very quickly. The US central bank would have to react instantly, and it would do so in conjunction with the other central banks. Much as they are deeply disturbed by the way the US manages its monetary policy, in a situation like that the other central banks would have no choice but to instantly collaborate with the US.
The emergency action would mean raising interest rates in the US. But in the present situation that is complicated, because it would exacerbate the credit crisis.
The growth in the last five years or so of the BRICs [Brazil, Russia, India, China, etc.] has been quite closely linked to the expansion in the US. China, although its domestic market is growing, is dependent on exports of manufactured goods. Although Brazil has a very impressive industrial sector, it has been above all exports of primary commodities — partly to the US, but also to China — which have driven recent growth.
The BRICs will continue to grow. But the rate at which they have been growing in the last five years has been linked to the consumer spending boom in the US, so they will all be to some extent affected by a downturn in the US.
The situation in China is extraordinary. There is a completely depoliticised government which is concerned at all costs to keep consumption rising for those sectors of the population that have been incorporated into the new economy — the urban population and in particular the new middle class. At the same time the government is trying to do something about the terrible situation in the countryside and about the disastrous environmental situation.
There are huge imbalances. The government is trying to deal with the rising wages in the coastal regions by encouraging new investment inland and in particular to the west, where wages are much lower. But the central states does not have much control over investment. China still does not have properly functioning market-based mechanisms, but the planning mechanisms, in so for as they now exist at all, are at a regional level, and each province wants to have its own car factory and its own steel factory. There has been huge over-investment in fixed capital.
Share prices in China have been rising to absolutely absurd levels, too. There will be a political problem when the middle class who have put their money into shares suddenly discover that it’s gone. If the government continues shifting towards a market-based financial system, there will be a financial crisis at some time, and that will hit living standards and pose a big threat to the legitimacy of the regime.
• Trevor Evans is a professor at the Berlin School of Economics, and has also worked in Nicaragua and other countries. He has written especially on the interrelation between finance and capitalist crises.