Post-Keynesian Observations

Understanding the Macroeconomy

12. The Subprime Crisis: Historical Factors

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[NOTE: Be sure you have read part 11 before this one! This is part of a series of posts that explain the operation of the macroeconomy and the current crisis and they build on one another.]

I’m writing while watching the Superbowl, so I hope this comes out clearly!

I covered the cyclical stuff in post 11. There, I said that investment, consumer durables, debt, and animal spirits contribute to the business cycle. I also said that these are common and so in that sense, this recession is not unique. However, one of my friends (Opsman) read the post and pointed out that there was something different: unlike any of the other recessions shown, all four came into play at the same time. Good call! I hadn’t thought about that, but it makes sense.

But wait, there’s more!

I list below three other factors that made this one particularly bad:

Financialization: I’m going to start with a factor that is probably not very well known, but which has been vital and a long time in development. Financialization refers to the trend wherein our economy has become increasingly oriented toward managing financial wealth as opposed to the production of commodities. This started in the 1980s, with encouragement from both the economics discipline and the government. The former gave their academic blessing by telling everyone that markets were rational and efficient and latter responded with deregulation of the financial industry and an increasingly hands-off approach to economic policy. It both contributed to and was in turn encouraged by the massive run up of the stock market in the 1990s (see the 4th diagram in post 11). The consequence of financialization has been an increased role played by animal spirits and a shift in industry from thinking long term to thinking short term. Both of these reduce growth and make our economy more fragile. Let me explain in a bit more detail.

If you read parts 5 and 6 of this series, then I suspect that you can probably work out most of this for yourself. If the stock market, dominated as it is by psychological factors, becomes a larger part of the overall economy, so animal spirits and other irrational factors become drivers in the macroeconomy. Financialization means that people come to look on stock prices as the ultimate indicator of firms’ and the economy’s health. But, as you know from part 6, that simply isn’t true. This has become a terribly important factor in our economy and has forced firms to pay more attention to transitory factors that can drive stock prices rather than to the true determinants of their long-term growth and profits. If I may quote myself from part 6 (particularly given what I just got done watching–great Superbowl!):

“ It’s like a football team that thinks in terms of plays rather than drives. What if the coach was forced to think that his team had to try to score a touchdown on every single offensive play, rather than being free to try to string together a series of plays (i.e., a drive) to accomplish that purpose? He might get lucky now and then, but I guarantee that the latter would actually score more points.”

We are now spending more effort trying to drive up stock prices than laying the foundation for increased productivity and growth. If stock prices truly reflected firm efficiency, it would be no problem. They don’t and yet we are tying an increasing amount of our economic future to how they move.

Subprime crisis and the housing market: Financialization meant (and continues to mean) that there were billions of dollars roaming around, looking for financial investments that would earn a high return. When the stock market collapsed before and after the 2001 recession, that money had to look elsewhere. One of the places it went was real estate and the housing market (it also went into commodities and oil, driving up gas prices, but that’s another story). As a consequence, those values were bid way up. As you can imagine, positive-feedback is common in such situations:

People buy in anticipation of appreciation => actual appreciation => additional purchases

So that fed on itself, with animal spirits providing the core driver. Meanwhile, banks were running out of customers for loans as investment and, to a lesser extent, consumer durables were getting saturated. In the rising real estate market, mortgages looked like a great idea. Of course, it was all speculative and there was no real foundation for it. Mix in some questionable business practices as mortgage writers really didn’t do too much work in figuring out if the borrowers were credit worthy (as they were going to package and sell off the mortgages at first opportunity), plus some outright fraud, and you have a collapse waiting to happen. Even worse, folks who had nothing to do with the mortgage industry were buying up the mortgage-backed securities so that the impact, when it came, was spread across the economy.

(As an aside, I’ve read a few places where they place the lion’s share of the blame for the subprime crisis on Freddie Mac and Fannie Mae because the latter were ordered to make more loans to lower-income families. I’m sure that events there did not help, but it was the private sector that was in the forefront in offering risky mortgages and then quickly passing them on to others. It was like a game of musical chairs–so long as you weren’t last, you won.)

Income Distribution: Income inequality has been growing in the US for almost 40 years, with the effect that the core demand for goods and services is being eaten away. Capitalism needs demand, and the fact that the rich spend a smaller percentage of their income than do the poor is reducing demand. The reason is very simple: the poor have to spend a higher percentage to feed, clothe, and shelter themselves. Thus, the same amount of income spread over more people leads to greater consumer spending. But we’ve been going the opposite way for decades, to such an extent that even Alan Greenspan, former chair of the Fed, has commented on it. This is not a fairness issue, it’s a question of the health of our system. Capitalism grows from the bottom up, not via “trickle down.” It is illustrative that during periods when income distributions have become more even, so our growth has been higher. Rising income inequality is yet one more reason for our current debacle.

(I wonder, too, how much immigration has been a problem here since it has meant adding even more poor folks than we already had. The fact is that at any given moment, we have a finite number of jobs. If we add more people, that means higher unemployment, whether it’s the immigrants themselves or those they replaced. I would favor a guest worker policy wherein we can welcome these folks when our unemployment is low, but let charity begin at home when unemployment is high.)

I think that pretty much covers all the major factors that led to this recession/crisis. Next, I will talk about whether or not the proposed policies will get us back on track.


Written by rommeldak

February 2, 2009 at 11:48 am

Posted in Uncategorized

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