The financialization of America

The best book I’ve read on the current financial crisis was published right before the crisis occurred.  Bad Money: Reckless Finance, Failed Politics and the Global Crisis of American Capitalism, by Kevin P. Phillips, was written in 2007 and published in early 2008, and it all-but-predicted what was to happen next.

bad_moneyPhillips asserted what I’ve been saying for 20 or so years, but with greater insight and better research – that the United States cannot go on forever consuming more than we produce, borrowing more than we save and importing more than we export, and that a day of reckoning will come.

Simon Johnson and James Kwak in 13 Bankers proposed reforms to safeguard our financial system from recurrent crises. Phillips went further. He said we Americans will lose our material standard of living and our position in the world unless we find a way to recreate an economy based on production of goods and services rather than banking and finance.

Phillips worked in the Nixon White House as a political strategist. His first book was The Emerging Republican Majority in 1969, and he has written extensively since then about history, politics and economic trends.  The theme of his recent books is the shift from an economy based on production to one based on finance and debt, and why such an economy is not sustainable.

During the first half of the 20th century, the United States had the most productive industrial economy in the world and, at the end of World War Two, the world’s only important industrial economy to emerge undamaged by the war. This enabled us Americans to enjoy the world’s highest material standard of living. We came to think of this as permanent and automatic, but it isn’t.

Starting in the 1970s, the United States faced the challenge of other industrial nations – first Japan and Germany, then the east Asian “tigers” and now China and India – who were capable of matching us in productivity. The U.S. response was to hold down the wages of American workers, shift production overseas and facilitate the increase of borrowing and debt.

Wages of American workers have been stagnant for the past 30 or so years. Average Americans have resisted the lowering of their material standard of living by working longer hours and more days of the year, by sending more family members into the work force (increasing labor force participation rates) and by taking on more debt.  This process may have reached its limit.

Debt and credit are now the driving force in the U.S. economy, Phillips reported, and the financial sector of the economy is increasingly disconnected from the goods-producing sector. The U.S. government, under both Democratic and Republican administrations, has been content to stand aside and let manufacturing industry decline.  But the government has again and again come to the rescue of the financial sector, in the savings and loan crisis, the Mexican debt crisis, the Long-Term Capital Management rescue and many others. The Bush-Obama bailout of the big Wall Street banks was the latest and biggest of a long series. We’ll see if the recent government rescue of General Motors and Chrysler will change this pattern.

Phillips’ Bad Money shows credit market debt, which was relatively small in relation to national output in the 1960s and 1970s, because shooting up in the 1980s. It reached 269 percent of gross domestic product in 2000 and 335 percent in 2006.  That is to say, it would have taken everything every American earned and produced for three years to pay off the nation’s individual, business and governmental debts.

In 1984, total U.S. financial and nonfinancial debt was $7.5 trillion; in 1994, $17.2 trillion; in 2006, $44.7 trillion – nearly a sixfold increase in 30 years.  The federal government’s share of this debt was 11 percent, while debt by U.S. financial institutions was 32 percent of the total, household debt was 29 percent and debt by nonfinancial business was 20 percent.

After 2000, the housing boom was the engine of financial growth. According to Phillips, the housing price boom was in part orchestrated by Alan Greenspan, chairman of the Federal Reserve Board, in order to stimulate economic growth in the aftermath of the bursting of “dot-com” stock price bubble in 2000-2001.

Lowering interest rates made it possible for families to buy more expensive houses with the same monthly payments. This encouraged a rise in house prices. As house prices rose, lenders decided it was safe to lower the required down payments. This encouraged a still further rise in house prices, which generated a “wealth effect.” People were more willing to spend because they were richer on paper, and because they could take out ever-increasing amounts of home equity loans.

This process ended with the so-called “liar’s loans” and “ninja (no income, no job or assets) loans.” Why would bankers lend to people they knew would never pay back?  They were able to pass on the risk in the form of mortgage-backed securities to unsuspecting buyers.

It would not be possible for the United States to have an economy based on debt if foreign countries were not willing to prop up our economy. They sell their oil and their manufactured goods to us, then lend to us so we can afford to keep buying.

Phillips wrote that the Japanese, the South Koreans, the Taiwanese, the Saudi Arabians and the oil-producing Gulf states have a tacit understanding that they will invest their dollars in the United States in return for U.S. military protection. Historically the Organization of Petroleum-Exporting Countries (OPEC) has priced oil in dollars, which strengthens the dollar and softens the impact of oil price increases compared to countries with weaker currencies. The Chinese also prop up the dollar, perhaps to ensure a market for their goods, perhaps to be in a position to pull the plug on the U.S. economy if necessary in a future crisis. This will not go on forever.

Foreign investment in the United States would be a good thing if the money were being used to finance start-up companies, to increase the productivity of our existing industry or to repair our deteriorating infrastructure. Unfortunately our borrowing is being used to finance consumption and current expenses, and this cannot go on forever.

There is a lot in the book I haven’t touched on, including historical perspectives of other nations which rose on the strength of manufacturing and commerce and declined as they chose to rely on banking and finance.

When I first read this book two years ago, I hoped that Barack Obama would be elected President and that he would help change the country’s direction. So far this has proved a vain hope. President Obama’s goal seems to be to put things back the way they were before. This would mean the start of a new financial bubble and a repeat of what has gone before.

Click on this for an article by Kevin Phillips in Harper’s on how the government manipulates economic statistics such as the Consumer Price Index to make trends seem less bad than they are.

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