As of spring 2008, we're probably just a third of the way through the unfolding debacle in the housing, credit, and financial markets. In political and regulatory terms, the ultimate problems and remedies have only begun to define themselves.
We're not just looking at an ordinary recession. Since the 1970s, the United States has redefined itself from a manufacturing nation to a financial economy built on debt, leverage, and a considerable ratio of speculation. Both political parties have been complicit in this, and the downturn now beginning will be unusual and potentially tragic.
The case being made in some reform-minded and progressive circles -- that we are on the cusp of a grand political, ideological, and pro-regulatory opening such as that of 1933 -- has some logic but also merits a considerable amount of economic and historical caution. The plausible analogies deserve a quick run-through. To begin with, there is the prospect that, over the next few years, the largest credit bubble since the Roaring Twenties is going to unwind with at least some of the angst and pain of the Depression years. In 2007, total credit-market debt in the U.S. reached almost 340 percent of gross domestic product, far above the previous high-water mark of 287 percent a few years after 1929. Second, it is also becoming likely that the 2006?2010 decline in U.S. home prices will be the largest in three-quarters of a century.
However, there are also good economic reasons why the analogy should not be overindulged; today's U.S. political economy is quite different from that of 70 years ago in several ways. First, whereas the 1929 crash came in the wake of three to four years of strongly deflationary trends in the global commodity markets, today's international economy is caught up in what appear to be major inflationary pressures in global agricultural and energy prices. In its panic over deflation, today's Federal Reserve may be more likely to err in the direction of feeding inflation.
The second relevant caution is that finance is a far more dominant element in the current-day U.S. economy than anyone could have imagined in the era of Herbert Hoover. Even amid 1929 ballyhoo and tickertape, finance was overshadowed by manufacturing. In the 1990s, by contrast, financial services sprinted ahead of manufacturing as a share of U.S. GDP. By 2006, financial services counted for over 20 percent of the economy, and manufacturing just 12 percent. As of 2008, portions of this swollen sector -- mortgage finance, reckless securitization products like Collateralized Debt Obligations (CDOs), and elements of the credit markets -- now threaten to implode. Still, even if the de-leveraging of the U.S. economy over the next few years is as painful as it was during the 1930s, that does not necessarily re-recommend the New Deal regulatory model. It will probably recommend some model that the 2008 political debate has not even touched upon.
The third relevant caveat is that the United States is now far more exposed to negative international actions and perceptions than it was in the 1920s and 1930s. Back then, the United States enjoyed three beneficial attributes: It was the world's leading energy producer, the world's leading manufacturer, and the world's leading creditor nation. So favored, the U.S. economy was able to survive the years of Herbert Hoover's inactive stewardship. Over the last decade, however, under the derelict management of George W. Bush, the United States has cemented its embarrassing status as the world's leading debtor nation, the No. 1 importer of foreign manufactured goods, and the No. 1 importer of foreign oil. As a result, the shrunken dollar has lost over 40 percent of its value against the euro since 2002. That shrinkage could even intensify if foreigners believe that the U.S. government, in particular the Federal Reserve Board, is committed to supplying liquidity to rescue reckless financial institutions at risk of inflation and at the expense of dollar holders.
The careful reader may now be saying: Ah, so in some ways, the next couple of years could be more trying than 1929?1932. Yes, at least insofar as this time we have a half-century of undisputed global economic hegemony to lose. However, the 1930s analogy may be a political illusion. New Deal-style interventionism, which succeeded in the largely domestic financial context of the 1930s, is probably not suited to the realigning global economic milieu of 2009-2112. Realistically, it will be a year or two before we have a good idea of what might be better suited. Still, the next administration will have to have a proactive international strategy with respect to oil and currency matters, two particular failures of the Bush regime.
My concern is that the U.S. economy truly faces its most serious difficulty since World War II or the Depression, and the established wisdom of Democratic and Republican gurus alike has little handle on the dilemma's causation or probable time frame. The last two presidential elections where major economic weakness was front and center -- 1980 and 1932 -- had ingredients and predicaments that dated back several years or more, and both out-parties had their election arguments reasonably at hand. Even so, the consequent economic reform and policy debate stretched out for two to three additional years. As of April 2008, we are further behind this new cycle's analysis-and-debate curve.
Without trying to frame a specific list of reforms, which I do not have, the new outline of economic- and financial-sector failures is somewhat easier to identify. Between the 1980s and the present, the United States moved in three unfortunate directions: first, the adoption of public and private debt as both an economic nostrum and culture; second, the pursuit of a neo-mercantilist policy (bailouts and other policy biases) that all but anointed finance (rather than high-value-added manufacturing) as the Washington-favored U.S. sector; and third, abetting an economic realignment through which manufacturing fell from some 25 percent of GDP in the 1970s to 12 percent in 2006, while financial services jumped from 12 percent in the 1970s to between 20 percent and 21 percent during the 2003-2006 period.
Was this three-fold change in direction ever debated in the public square or in the halls of Congress? Of course not. Most conservatives and many liberals in Washington were busy chanting a simplistic mantra -- government can't be allowed to pick winners -- while the Treasury Department's and Federal Reserve Board's favoritism toward and bailouts of finance amounted to essentially that.
Over the last quarter-century, under Republican and Democratic administrations alike, the two major tools of this transformation were debt and the socialization of risk (but not of profit). The second, of course, abetted the first. When reckless expansion of consumer, corporate, or financial debt would go sour, the government served up a bailout to help the financial sector come back, fatter and cockier than ever. To suggest "bubble and bail" as a description of U.S. economic policy over the past quarter-century is inelegant but by no means inaccurate. Obviously, this is not the way to manage a nation passing the peak of its global power and very much at risk from a reckless financial endgame.
Indeed, the historical precedents are chastening. Both of the last two leading world economic powers -- the Dutch from the 17th century into the early 18th and the British from the early 19th century to World War I -- did more or less the same thing. After they built their global economic clout they shaded away from making and trading things into a prideful emphasis on financial services and debt, and both ultimately took on international and military commitments they couldn't afford. The lesson is that global economic success breeds hubris and that hauteur breeds over-financialization.
As of spring 2008, these fat golden pheasants have come home to roost. The interaction of reckless finance and failed politics may well be bringing about the great global crisis of American capitalism. Back in the Spring of 2007, preening Wall Street strategists were heard to boast that financial output -- principally corporate bonds and structured financial products -- could in itself provide a lucrative enough export to offset most of the $800 billion yearly U.S. current account deficit. The latter principally reflected how the United States was obliged to import one-third of the manufactured goods it needed and almost two-thirds of the oil. By early 2008, however, this pretense of an eager world awaiting U.S. financial exports had collapsed alongside the credibility of CDOs and mortgage-backed securities. In 2006, foreign net acquisitions of long-term U.S. stocks and bonds came to $722 billion, but that dropped to $596 billion in 2007, because of plummeting overseas demand after the August credit-market panic. (Asian government funds that seem to be bailing out U.S. banks and investment firms are now insisting on actual ownership percentages, not just the speculative investment products that have put the U.S. financial sector into such disrepute.)
No sane parliament or Congress would ever vote to put the fate of a leading economic power at the top of its global trajectory in the hands of a sector given to manias, bubbles, panics, crashes, incessant speculation, rich-poor polarization, and roller-coaster movements in interest rates and credits. But that may well be what happened over the last quarter-century -- creating, however inadvertently, a debt bubble that dwarfs that of the 1920s.
What do we do now? What cannot work, alas, is any attempt to jump into a political time machine and reverse the political and economic decision to cast America's destiny with the ambitions of mega-finance. Better if we could reverse it -- better if debt had remained under control instead of making itself into a grand and lucrative industry. Better if housing in the United States had never been hot-wired to global credit markets. Better if financial services had been kept in the range of only 14 percent to 15 percent of GDP, while a vital manufacturing sector more akin to those in Germany, Japan, and Switzerland had been made into the 21st-century U.S. economic centerpiece.
That is no longer an option. And however satisfying the attempt might be, there is no way to whip an abusive financial sector back into shape in the 1933-1936 manner. By 1936, the financial sector was deflated and beaten, a small, shrunken lump on the Depression-era economy. As of early 2008, by contrast, the finance, insurance, and real estate sector, although somewhat trimmed, is still the largest sector in the private economy, and the financial markets remain the command center for much of the rest. Money still owns -- or at least rents -- U.S. politics. And more specifically, the financial sector -- including mortgage finance and the credit-card issuers -- is at the center of an unprecedented web of public and private debt that has been spun through and around the so-called real economy. Finance has become the real "real economy."
This is no vague abstraction. The growth of public and private (consumer, corporate, and financial) debt shown in the table at right is closely related to the rise of what the press has belatedly started to call the debt industry. Indeed, most financial-services conglomerates can list debt and credit instruments (cards, securities, and fees) as their principal products and services. For what is sometimes lumped together as Wall Street, the rise in total U.S. financial and non-financial debt from $2.4 trillion in 1974 to a staggering $44.7 trillion in 2006 was a vocational Comstock Lode.
It has been a commonplace in political Washington that "bad" debt is principally the public kind associated with federal budget deficits, and the rest of it doesn't matter that much. But however convenient this differentiation may be for members of Congress who receive 40 percent or 50 percent of their campaign funds from the financial-services industry, it is also deceptive. As the table shows, between 1974 and 2006, the biggest growth was not in public or non-financial business debt but in financial and consumer (principally mortgage and credit card) debt. In short, the decisive increase was in the facilitation of the debt and housing bubbles and the ballooning of the financial-services sector. Take particular note of the $10 trillion growth of financial debt between 1994 and 2006. This was a fair part of what skyrocketed financial assets, fueled the hedge funds, leveraged the financial sector into the economic catbird's seat, and transformed debt into a systemic booby trap.
The Federal Reserve Board's rapid money supply expansion aided and abetted the expansion of private debt, while the government's periodic bailouts -- of the Mexican peso in 1994 and Long-Term Capital management in 1998 -- minimized Wall Street's casualties. Together, these policies gave dangerous encouragement to the reckless elements of the financial sector. During the 1997-2001 period, this private debt boom nurtured the high-tech bubble along with such malefactors as Enron, WorldCom, and Global Crossing; then, between 2002 and 2006, it fed the malfeasance of mortgage lenders and Wall Street packagers of such exotic instruments as CDOs and deceptive mortgage-backed securities.
Both Democratic and Republican presidents pursued these policies. The Reagan administration and the first Bush administration indulged in deficit-ridden public finance and reckless lending practices in commercial banks and savings and loan institutions alike; the bailouts were notorious. The Clinton administration brought down the federal budget deficit but bailed out Wall Street repeatedly and abetted the private-debt orgy that nurtured the tech bubble. The second Bush administration, together with the Greenspan Fed, encouraged the blowing up of a giant mortgage and housing bubble to replace the stock-market bubble that imploded in 2000-2001. The Republicans may be more to blame over five presidential terms than the Democrats were during just two, but both parties seem to have pursued a common underlying financial mercantilism of bubble and bail.
Perhaps that is why, when the Federal Reserve Board threw any trace of classical free-market economics out the window to rescue Bear Stearns, to cut interest rates by three-quarters of a percent, and to open up its vaults to investment firms wallowing in the consequences of their own strategic misjudgment, the three major presidential hopefuls, Democrats Barack Obama and Hillary Clinton and Republican John McCain, were uncritical and broadly supportive. The socialization of credit risk is now bipartisan public policy. The intimate collaboration of the federal government and the financial sector is now bipartisan public policy. A desperate attempt to patch leaks in the overgrown debt bubble is now bipartisan public policy. If anybody seems inclined to break with the bipartisan past, however, it is Obama.
The United States is not a second Japan, but the extent to which the U.S. government has also been drawn into financial mercantilism, subsidies and assets management not unlike that of the Japanese in the early 1990s, deserves serious attention. Certainly the senior officials of the U.S. Treasury and the Federal Reserve Board are not going to be wearing the Adam Smith ties so naively sported by Reaganite economists in the early 1980s.
The diminished international reputation of both the United States and its battered currency remains a huge problem. The dollar -- the principal hostage to foreign perceptions of these massive U.S. shortcomings and dependencies in goods and energy -- has paid a steep price and may have further slippage ahead. The oil-producing nations and top manufacturing countries that hold large reserves in their central banks and sovereign wealth funds may be convinced to drop their commitments to the dollar. Some may doubt that the U.S. can straighten out its economic affairs. Others may conclude that pegging their own currencies to a slumping dollar is causing too much inflation, as it is currently in Hong Kong or the Persian Gulf.
Officials in Beijing, Singapore, Riyadh, or Brussels expecting U.S. politicians to confront this nation's fundamental problems during the 2008 election year will be waiting for Godot. Honesty about the American debt bubble or the failures of Washington or Wall Street will be intermittent, at best. If the Republicans are known as the party that kowtows to corporations, the Democrats are coming on strong with their own ties to finance. Not only do the Democrats lead in 2007-2008 contributions from the financial sector, hedge funds especially, but the political geography of their national coalition is increasingly centered in the cosmopolitan states that include the leading money centers: Boston, New York, Philadelphia, Chicago, San Francisco, and Los Angeles. It is very hard to imagine a Democratic president or Congress reversing field to support stiff reforms of the sort sure to be opposed by financial-sector leaders. McCain presumably would be even less inclined.
Let me give some hypothetical examples of the problems crying out for deep reforms. Just as the 1990s leap of financial services ahead of manufacturing in the U.S. economy resembled the triumph of manufacturing over agriculture in the late 19th century, we see today another example of the initial inability of government regulation to deal with the new economic power axis. This most obvious failure came with respect to what bond billionaire Bill Gross calls the "shadow" financial system -- the new non-bank financial enterprises from hedge funds to structured investment vehicles and issuers of asset-backed securities -- that has grown up virtually unsupervised outside the existing bank regulatory framework. New legislation is in order, but nothing far-reaching can happen before the November elections.
In 1999, even the older elements of the financial sector -- banks, insurance companies, and the like -- flexed their new muscle successfully enough to repeal the federal Glass-Steagall Act, which had long separated deposit-taking banks from investment activities. Within a few years of repeal, banks, insurance firms, mortgage lenders, and investment companies had intertwined through mergers and holding companies and launched new innovations and experiments. One conspicuous example involved banks, real estate lenders, and issuers of mortgage-backed securities teaming up to offer slick, new, exotic financing to people who were at best marginally qualified homebuyers in order to be able to resell the mortgages en masse through mortgage-backed securities and CDOs. Anyone who expects the Democrats to take the lead in re-enacting portions of Glass-Steagall in 2009 should remember that the three most conspicuous proponents of repealing Glass-Steagall in 1999 were Democrats -- Bill Clinton, former Treasury Secretary Robert Rubin, and Citigroup Chairman Sanford Weill.
As for the securitization process, regulators in Europe, Britain, and elsewhere appalled by the "opaque" products have called for international regulation that sets out enforceable descriptive criteria and perhaps even requires a necessary degree of standardization. There is a chance that other nations will insist that new standards be met. The Bush administration has shown no interest in this kind of solution, but little has been heard from Capitol Hill, either.
The next president will also need to confront the role of banks: If the important mega-banks are too big or too interconnected with the rest of the financial sector to be allowed to fail, then why are they allowed to indulge in every form of speculation and anti-social behavior, from counseling Enron on tax evasion to gouging on credit-card interest and fees? Martin Wolf, chief commentator of the Financial Times, has contended that "what we have [in banking] is a risk-loving industry guaranteed as a public utility." If banks are to be rescued because they are too big to fail, they should also become, in the manner of a public utility, too well-behaved and too responsible to fail.
Looking ahead, if the Federal Reserve Board fails in its attempt to favor, subsidize, and bail out the broad financial sector -- not just commercial banks but brokerage houses -- then the Fed itself could jump to the head of the list of institutions in need of regulatory reform. During the 1980s, conservative economist Milton Friedman called banking "a major sector of the economy in which no enterprise ever fails, no one ever goes broke. The banking industry has been a highly protected, sheltered industry. That's because the banks have been the constituency of the Federal Reserve."
If Friedman were alive today, he would have to enlarge his critique: The overall financial sector has now become the constituency of the Federal Reserve, which has guided and subsidized its slow but threatening takeover of the U.S. economy. To enlarge the Fed's role now, as Treasury Secretary Henry Paulson urges, is only to reward complicity and culpability.
Having raised these possibilities, I am not sanguine about change. The lesson of history is that previous leading world economic powers, from Rome and Imperial Spain to the Netherlands (back when New York was New Amsterdam) and early 20th-century Britain, have been unable to reform themselves in time to avoid decline. Politics has failed in the face of entrenched interests. In the process, excessive debt and dependence on finance rather than production has been front and center. New nations move to the head of the line -- and these days we can see Asia smiling.