My apologies for not posting in a while, it’s been a busy month and a half. Although I will continue to be very busy until early May, I thought I would at least post some of the material I’ve been working over the past several weeks. The following is an essay I wrote for my International Political Economy class regarding the ideological roots of the financial crisis. I write it from a structuralist and constructivist perspective. Although it does not necessarily reflect my actual views/opinions on the origins & genesis of the financial crisis, it does bring up some key points that I think are worth mentioning.
NEOLIBERALISM AND THE GLOBAL FINANCIAL CRISIS
This paper explores the complex subject of what the main contributors to the recent global financial crisis were, specifically by asking what governmental policies and ideas either contributed to or failed to mitigate the crisis. Upon careful analysis, several conclusions were reached. First, an ideology of neoliberalism was instilled in states by non-state actors in reaction to the economic developments of the post-war period. These states moved not only to adopt neoliberal policies themselves but also to impose such ideas and policies on other states via international institutions and organizations. Ultimately, it is argued that the adoption of neoliberal economic policies stemming from the development and transmission of neoliberal ideas via state and non-state actors allowed for pre-crisis economic imbalances to form.
Beginning in the summer of 2007, signs of distress in global financial markets began making first appearances. By the end of the next year, the world found itself engulfed in the worst financial crisis and resultant recession since the Great Depression. The inability of policymakers and analysts to forecast the coming of this calamity and to identify its many contributors beforehand is alarming, and by itself provides ample justification for an in-depth analysis of what ultimately went wrong. Specifically, it is asked in this paper what the underlying structural causes of the financial crisis were, and how government policies and prevailing ideologies either helped contribute to or failed to mitigate such causes. Finding the answers to these questions will be crucial in helping governments to rethink dominant economic ideologies and to craft better policies that can help to prevent financial crises in the future. Additionally, this research topic is pertinent to the study of the International Political Economy (IPE). The policies enacted by governments are all related to how scarce resources are allocated in the global economy. It is this interaction between the political and economic that solidifies this issue as being relevant to IPE (Balaam & Dillman, 2014).
Pre-crisis Economic Imbalances: A Historical Overview
There were a wide variety of underlying economic contributors to the global financial crisis that had been incubating well in advance of the crisis’ systemic phase that began in mid-2007. These took the form of a variety of irregularities in sectors ranging from trade to investment to disparities in income and wealth. The key theme that runs across all causal factors, however, is the notion of imbalance.
The economic imbalances that predate the crisis are perhaps most clearly identified when first looking at international trade. Starting in the 1980s, the United States and other developed nations started to log enormous annual trade deficits, reflected in an abrupt negative swing in their current account balances. This essentially means that the value of goods and services being imported started to vastly exceed the value of exports. After a mild retreat in the early 90s, the annual U.S. trade deficit ballooned, widening by approximately $740 billion from 1996 to 2006 (Wolf, 2008). In order to finance current account deficits, a country must either borrow funds from abroad or sell assets to foreigners to maintain a net balance of payments. The United States and other debtor nations did both, and foreigners (especially countries with large trade surpluses and huge capital reserves) flooded them with excess capital, helping to drive down interest rates and feed pre-crisis housing bubbles (Balaam & Dillman, 2014). By 2007, multiple counties had become dangerously dependent upon speculative capital for economic growth (Sherman, 2011). The presence of these debt-driven global trade imbalances was a key contributor to the crisis.
Trade did not just fuel massive current-account imbalances, however. It also played a role in another major contributor to the financial crisis: growing income inequality within developed countries. According to the Organization for Economic Development and Cooperation (OECD), the average Gini coefficient among OECD member nations increased from .28 in the mid-1980s to .31 in the late 2000s, indicating a more unequal domestic distribution of income (Growing Income Inequality in OECD Countries: What Drives it and How Can Policy Tackle It?, 2011). Regardless of the causes of inequality, a growing consensus exists among economists that there is a positive correlation between income inequality, household debt, and bank failures (Noah, 2012). Specifically, it is thought that a general stagnation in incomes for those in the lower and middle income brackets will cause them to borrow and take on debt to maintain or advance their living standards, a situation that is economically unsustainable in the long-run (Correa & Seccarecccia, 2009).
All of this combined to create a third major imbalance, elevated levels of consumer and commercial debt. A surplus of credit and the resulting low interest rates in combination with a higher consumer need to borrow caused consumer debt levels to skyrocket. Additionally, financial institutions took advantage of low interest rates to build up leverage, or the measurement of debt taken on to make investments (Hubbard, O’Brien, & Rafferty, 2014).
Finally, a key imbalance to consider is a lack of transparency and elevated concentrations of risk due to unconstrained financial innovation. Major financial institutions would snap up mortgages made by mortgage lenders and repackage them into securities to be sold to investors. The problem was that many investors did not know what the actual level of risk was of the mortgages that backed the securities they held. Additionally, because lenders could sell mortgages to other actors quickly (and thereby issue more loans), they had little incentive to ensure that the loans they made were to creditworthy borrowers. Thus, financial innovation greatly decreased transparency and increased risk in the financial system (Jarvis, 2011).
All of these imbalances finally began to unravel with the bursting of various housing bubbles in the summer of 2006. Rising interest rates dampened incentives for consumers to borrow and for investors to invest in risky equities, such as mortgage-backed securities. Mortgage defaults began to rise, putting further downward pressure on housing prices. As mortgage payments evaporated, investors became even more reluctant to purchase mortgage-backed securities, causing their holders to suffer enormous losses as their value dropped. Additionally, the resultant decline in financial institutions’ net worth made other institutions reluctant to lend to them. It was this vicious cycle that nearly caused the collapse of the entire global financial system. Although this outcome was ultimately avoided, the financial crisis still ended up morphing into the infamous “Great Recession” (Hubbard, O’Brien, & Rafferty, 2014).
The Impact of Neoliberalism: No Regulation, No Mitigation
When analyzing the history immediately preceding the financial crisis, it is not difficult to see a prominent ideological shift towards neoliberalism, or market-like rule, taking hold among various state and non-state actors. Following the Great Depression, many countries entered an unofficial Keynesian “postwar compromise”, in which states became more economically interventionist to tame market forces via fiscal policies, monetary policies, and regulation (Duménil & Lévy, 2013). This consensus lasted until the 1970s, when a combination of inflation, low corporate profits, low investment, and a perception that workers had too much bargaining power caused a rejection of governmental interventionism and a political and cultural shift towards neoliberalism (Friedman, 2009). This shift towards and development of neoliberalism was aided in no small part corporate lobbying interests on behalf of the capitalist classes who were seeking greater profits and freedom from government meddling (Birch & Mykhnenko, 2010). Other lobbying activities involved businesses creating political action committees and founding think tanks, all of which helped to embed neoliberal thinking amongst policymakers (Gallagher, 2011). By the 1980s neoliberal ideology, which suggested that markets are always efficient and that government intervention should be minimized, had become very popular among the policy elite of America and, by virtue of its hegemonic clout, other states and intergovernmental institutions as well (Birch & Mykhnenko, 2010). As will be demonstrated, it was ultimately the adoption of these neoliberal economic policies worldwide that permitted global pre-crisis economic imbalances to advance to unsustainable levels.
The acceleration of trade liberalization around the world was one notable facet of this emerging neoliberal ideology. Beginning with the Uruguay round of trade negotiations, a more uninhibited version of trade in which protectionism was curtailed and remaining trade barriers were abolished became established institutional thinking (Balaam & Dillman, 2014). The underlying rationale for free trade goes back to David Ricardo’s infamous law of comparative advantage, in which it was theorized that living standards rise when countries specialize in producing goods and services they are most efficient at producing (Krauss, 1997). Trade barriers infringe upon this process by attempting to protect certain industries and workers, which leads to lower competitiveness and economic inefficiencies, theoretically harming living standards.
Ultimately, this neoliberal ideology was transformed into trade liberalization via two major routes, international trade agreements and IMF/World Bank loans. Trade liberalization was actively advocated for via various American administrations, first through the General Agreement on Trade and Tariffs (GATT), then the World Trade Organization (WTO) (Balaam & Dillman, 2014). Meanwhile, IMF and World Bank loans to developing countries became conditional upon the latter implementing various economic reforms, including trade liberalization. Indeed, as recently as 2006, an estimated 26 out of 40 developing countries still had privatization and liberalization conditions attached to their IMF loans (Kovach & Fourmy, 2006). In this way, trade liberalization became international economic policy.
Unfortunately, the liberalization of trade would allow for the buildup of several of the pre-crisis imbalances mentioned earlier. In developed nations, the post-liberalization increase in competition with developing countries meant that the former experienced an erosion of low and middle-skill jobs, as developing nations had comparative advantages in such tasks (Dowd, 2009). This contributed to rising economic inequality in developed countries and the resultant rise in unsustainable consumer debt. Additionally, suppressed domestic wages in developed countries and the increased ability to import cheap goods due to free trade also lead to massive global trade imbalances in which some countries developed trade surpluses and other developed trade deficits. Countries with trade surpluses invested their excess capital reserves into countries with trade deficits, and the latter then used these funds to finance their deficits. Had trade liberalization not occurred, it is plausible that these unsustainable imbalances could have been mitigated (Correa & Seccarecccia, 2009).
Another notable tenet of neoliberal policy was the widespread removal of capital controls beginning in the 1980s at the urging of the United States and the IMF. This process continued into the 2000s, as several bilateral U.S. trade treaties did not allow other countries to use them to mitigate balance of payments problems. Again, the assumption was that markets would allocate resources (in this case, capital) efficiently. Additionally, it was thought that the cost of credit could be lowered worldwide, promoting investment and consumption to propel economic growth. What policymakers did not foresee, however, was that capital would be used speculatively and investment would become increasingly risky, helping to inflate asset bubbles worldwide (Gallagher, 2011). The imposition of capital controls, such as taxes, price or quantity controls, or banning of trades in international assets, would have helped nations to deal with unstable and unsustainable asset bubbles (Neely, 1999). Instead, pressure from governments and major financial institutions ensured that the IMF continued to push strongly for the continued removal of capital controls on a global scale (Gallagher, 2011).
This removal of capital controls went hand-in-hand with another contributing trend, the deregulation of the financial services and banking industries. A prime example of this is the repeal of the Glass-Steagall Act of 1933 by the Clinton administration. This act separated commercial banking from investment banking, prohibiting institutions from having elements of both at once. Since investment banking was largely unregulated at the time, as more and more institutions became hybrids, more and more of their activities became unregulated. This meant that the use and development of risky and opaque (but high-yielding) financial instruments, such as mortgage-backed securities, became quite prevalent. Additionally, in many nations, capital requirements to cushion potential losses were lowered, with America’s Securities and Exchange Commission going so far as allow firms to determine what was appropriate for themselves (Macdonald, 2012). When combined with a lack of antitrust enforcement, these neoliberal policies of non-intervention resulted in the emergence of ‘too-big-to-fail’ financial institutions that took on excessive risk with ineffective safety nets (Stucke, 2010). Similar spurts of deregulation occurred in other countries as neoliberal doctrine spread. While this came via IMF/World Bank loan conditions for many developing countries, for developed countries the pressure came mainly from financial markets, business interests, and think tanks, both domestic and foreign in origin (Beder, 2009). Had such deregulation not occurred, unconstrained financial innovation and its resulting lack of transparency likely could have been slowed or halted.
Although it is true that not all states liberalized at the same pace or to the same extent, the transmission of neoliberalism as an ideology between multiple state and non-state actors and its resultant liberalizing effect on policy is widely accepted to have occurred globally. Nonetheless, an argument could be made that it was in fact too much governmental intervention, not too little, that helped to build pre-crisis imbalances. For example, some argue that governmental agencies such as Fannie Mae and Freddie Mac in the United States helped to inflate the American housing bubble by buying, securitizing, and backing more than $1 Trillion worth of subprime mortgages, among other interventionist policies (Forbes & Ames, 2009). However, this fails to explain why asset bubbles developed internationally and in countries without such agencies. Nor does it an accurate representation of the situation, as the majority of risky subprime mortgages were made by private institutions, including 83% of subprime mortgages issued in 2006 (Goldstein & Hall, 2008). The fact that private institutions held a majority of the riskiest assets (and primary contributors to the crisis) directly counteracts the central argument of neoliberal ideology, that private market actors will allocate resources efficiently and rationally. Clearly, this was not the case.
Overall, it is clear that the development and transmission of neoliberal policies and ideas played a key role in the genesis of the global financial crisis. In response to the perceived failures of state intervention in the economy during the 1970s, various non-state actors launched campaigns to embed an ideology of noninterventionism amongst the policy elite of different countries. Additionally, several states placed significant pressure on intergovernmental and international institutions to both adopt neoliberal ideas and promote the spread of neoliberal policies on a global scale. As a result, on the mistaken neoliberal assumption that markets are always rational and efficient, an array of economic imbalances and misallocations formed that could only be corrected by a near total collapse of the entire global financial system. Although it is now known how neoliberalism as an ideology spread and how it played a role in the crisis, further research is necessary to determine why it was so difficult for different states to reject neoliberalism even as its many shortcomings became increasingly clear. So as to ensure the maintenance of humanity’s economic well-being and security, it is vital that such questions are not left unanswered.
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