The Legacy of the Crash Read online

  Finance

  There are striking similarities between New York and London as financial centers, and very strong linkages between the two. US-owned and headquartered financial institutions have a real presence in the City of London; British banks are minor but real players in New York. In both economies, the financial sector is a key contributor to GDP, a key conduit of foreign (and bountiful) investment flows, and a key contributor to the trade balance. Both financial centers experienced systematic deregulation in the years after 1980. Both came to be dominated by a handful of major institutions (commercial banks, investment banks, hedge funds and insurance companies) committed to organizational growth and enhanced profits. These were institutions that were increasingly involved in (and actively hungry for) the buying and selling of mortgage-backed securities, and ever more linked together in a shadow banking network of new financial instruments operating below the regulatory radar. In both financial centers, cultures developed of banking superiority, high and expanded bonus payments, and increasingly breathless speculation. At the start of the crisis, each financial center contained rogue institutions that had allowed themselves to become excessively leveraged. At the start of the crisis too, each financial center contained institutions that were considered both too big to fail and yet too insolvent to continue without government assistance. At the end of the crisis – and in large measure because of that assistance – each financial center, to differing degrees, contained institutions that were even bigger (and so even less able safely to be allowed to fail), that were once more extremely profitable, were paying out generous bonuses to senior staff and were resisting calls for tighter financial regulation.

  Though the relationship between New York and London as financial centers is a close one, it is in no sense an equal one. Nor are the regulatory structures and philosophies operative in each exactly the same. In a very real sense the US exported the financial crisis of 2008, and the UK imported it. It is true that many UK financial institutions were enthusiastic importers of US-generated financial instruments; but it remains the case that the instruments they imported were US-made. It was subprime mortgage securitization from the US housing market, not from the UK housing market, that infected the global (including the London) financial networks with toxic assets in the years up to 2008. It was US-based credit-rating agencies that gave those assets Triple-A ratings they did not warrant. It was major US financial institutions that drove the subprime frenzy; and it was US-based companies (especially Lehman Brothers and AIG) who were key players in the escalation of leverage rates to unsustainable heights in London no less than in New York. UK banks were not innocent in the process. Most followed suit. Some, like Northern Rock, followed suit with internally generated enthusiasm. The Northern Rock business model was voluntarily adopted though still Lehman-backed. But the space within which to develop and generalize that business model, and in which to enshrine a culture of speculation and high-risk profit taking, was far greater in the US than in the UK. It was far greater partly because, in the US, the regulatory structure was so complex relative to the single UK oversight exercised by the FSA. It was also far greater because – though light regulation was the norm in both cities – the people heading the US regulatory agencies were so committed to regulating with only the lightest of touches. In the US, as the FSA was being empowered in London, Congress was dismantling Glass-Steagall and even the Clinton administration was declining to regulate the new financial products then emerging.

  Crisis and responses

  In both the US and UK, the period of rising house prices and thriving financial institutions came to a definite end during a shared September 2008 shock. At this time, house prices fell, inter-bank lending rates rose, repossessions and defaults on loans increased, and a credit-crunch ensued as lending slowed. These conditions led to a serious destabilization of the banking system, and triggered a common set of policy responses that were simultaneously institutional, fiscal and monetary. On the institutional front, policy-makers in both countries exhibited a shared willingness to save the banking system from collapse by guaranteeing bank deposits, buying toxic assets, recapitalizing banks and subjecting them to stress tests. On the fiscal front, policy-makers in both countries proposed big initial spending programs – quickly in the UK, slightly later in the US. On the monetary front, both central banks cut interest rates and utilized internal and globally coordinated quantitative easing. In addition to these common political responses, which were initially geared toward the national and global stabilization of the banking system, the countries experienced a common popular response. Both saw growing antagonism to bankers, increased calls for tighter regulation, and an at least temporary acceptance of the key role of public policy in lifting the economies out of recession. These popular responses propelled further reforms, as policymakers worked to create new regulatory structures, to rekindle economic growth and job creation, and to deal with soaring levels of public debt.

  Yet because the underlying dynamic of the crisis was so fundamentally different in the two economies, the policy response that it generated differed too: differed in width, differed in sequence and differed in trajectory. In the UK, as we have just seen, much of the financial crisis was imported into the banking system via the purchase of US financial products. The housing problems in the UK made the crisis worse, certainly, but the housing market did not create the financial crisis to the same extent that it did in the US. Policy was therefore narrower in the UK; since housing was not as central to the crisis, UK policy was less focused on the foreclosure dimension than was policy in the US. The sequence of immediate policy responses also varied in the two countries: the UK went from bank guarantees to recapitalization, to nationalization, to toxic asset isolation, to stress tests, to bank surcharges, to belated minor regulatory change. While the US also began with bank guarantees, policy there focused on absorption of toxic assets before sequentially turning to recapitalization, stress tests, bank surcharges, and eventually, extensive re-regulation. The US saved its banking system (though not its housing finance system) without nationalization; the UK did not. Finally, the trajectory of policy differed between the two. While both countries were initially committed to fiscal stimuli, the UK now definitely is not. The Obama administration’s current fiscal strategy is less clear, though it definitely remains opposed to the austerity budget strategies favored by both the Coalition government in London and its Republican opponents in Washington, DC.

  Shaping forces

  Similarities

  Both economies shared a level of exposure to the impact of the credit crisis which set them apart from other major economies. All major economies were affected – the crisis was genuinely global – but none were affected so deeply as the US and UK. All were (through their banking systems) to some degree culpable, but none were as responsible as the US (and the UK) for the origins and dissemination of the crisis. So there is something special and different about the modern US and UK economies that set them apart. Superficially, the similarity seems rooted in a shared growth model, one anchored in debt. The US, for its part, has known two sustained periods of economic growth in the post-war era. The first, from 1948 to 1973, rested on a capital-labor accord that regularly raised the wages of blue-collar unionized northern male workers. It was a growth model based on rising labor productivity and strong internal sources of consumer demand. The second, from 1992 to 2008, was similarly based on rising labor productivity, but this time growing income inequality (and weak labor unions) left internal consumer demand dependent on rising levels of personal debt (Coates, 2010a). The slightly more sustained UK growth experience from 1992 to 2008 contained a stronger internal wage dynamic, but it too ultimately depended for its capacity to raise living standards on the willingness and ability of people to deploy (via credit) wages they had not yet earned. By 2009, the volume of consumer credit outstanding in the US had reached $2.48 trillion. By June 2010, total UK personal debt stood at £1.46 trillion – the consumer credit pa
rt being £218 billion. In such a context of debt, it is hardly surprising that any substantial expansion of home ownership should require subprime lending, or that the growing wealth of the financial sector should have become such a source of popular resentment.

  The ability of people to borrow on this scale tells us that the financial institutions in each economy had grown to play a critical intermediating role between producers and consumers. The growing weight of finance relative to manufacturing was similarly marked in both economies: outsourcing and the decline of home-based manufacturing was a feature of both. But banks cannot lend what they do not first borrow: and the other common feature of the financial institutions in both economies was their enhanced capacity to do this. That capacity was itself partly the result of growing income inequality – the accumulation of surpluses by the super-rich had to be put somewhere. But mainly the capacity of Washington/New York and London to attract capital was the product of the global role played now by the US and previously by the UK as imperial powers. Foreign capital flowed into the US in vast volume in the years after 9/11. It flowed into London in smaller amounts, but still far more plentifully than into Frankfurt or Tokyo. It was when it stopped flowing – when confidence broke down in September 2008 – that the crisis began; and because it was into the US and UK that foreign investment funds had flowed so easily, the impact there was disproportionately great.

  Money flows of this volume made the creation and proliferation of ever more complex financial instruments both possible and profitable. The flows also kept interest rates disproportionately low, helping to fuel the housing boom and the purchase of houses by people further and further down the increasingly unequal income ladder. The flows were a response to a new global pattern of surplus and deficit through which the US and UK became major debtor economies. The US quite simply followed a path which the UK had trodden long before. It stopped being the manufacturing center of the global system. Instead, the US became the world’s consumer of last resort and the system’s dominant borrower. In 2006, the US’s current account deficit was $857 billion. The UK’s was $68 billion – far smaller than that of the US but still qualitatively inferior to the current account surpluses of established economies like Germany and Japan and of the new emerging giants (China in particular). Oil economies and export-led growth economies drew revenues to themselves. Those revenues flowed back as foreign investment to the US and UK. The US and UK became debt-soaked, functioning at their existing levels of output and consumption only so long as the flows continued. In September 2008, briefly, those flows stopped.

  Differences

  Despite the above similarities between the US and UK, their different experiences during and after the financial crisis were shaped by undeniable variations between the two countries. These variations come on several levels: political, economic, and global.

  Some accidental political differences arose as the crisis unfolded, the source of these differences being the timing of the crisis in relation to the electoral cycles in the two countries. In the US, a presidential election took place just as the crisis was hitting its stride; this election placed a moderate center-left government into power in Washington, replacing a more conservative party. In the UK, in contrast, such a moderate center-left government was replaced late in the crisis by a center-right one. Thus at different stages, the trajectory of policy changed course, leading the US to go slightly ‘left’ during the crisis, and the UK slightly ‘right’. These changes indicate the popular dissatisfaction in both countries with the governments that were perceived to have steered the country into crisis in the first place. The political differences between the two countries also had deeper institutional and historical roots which affected the speed and focus of the policy measures enacted. The US and UK have completely different political systems: one is federal, the other is non-federal; one is presidential, the other is parliamentary. The non-federal, parliamentary system in the UK was bound to generate a greater coherence and speed of policy implementation than any of which the US was capable. Furthermore, the center of gravity of political debates varies either side of the Atlantic. While the legitimacy of a statist response to a crisis is a common dimension of UK conservative thought, it is not heavily present in American conservatism. The US political debate contains a libertarian strand of argument which does not appear in the UK (again, allowing state intervention to be more acceptable in the latter country), while the UK must consider the voice and policy measures of the EU as the US need not.

  Both economies are post-industrial, in the sense that service employment and output have long replaced manufacturing as the key source of GDP growth and labor utilization. UK manufacturing employment peaked at 8.6 million in 1966, and is now in the region of 4 million. The US peaked later – at 19.6 million in 1979 – but is also now down: to 11.7 million. But finance still makes a significantly smaller contribution to US GDP than to UK GDP – 8 percent in one, perhaps as high as 30 percent in the other – it is the UK and not the US that has acquired what Vince Cable called ‘the Icelandic disease’: an over-reliance on finance that makes City success so critical to overall government performance (Cable, 2009, p. 164). Certainly City concerns were evident in the UK’s maintenance of higher interest rates than those ruling in Frankfurt and New York prior to the onset of the crisis. Investment funds have to be attracted to London. There is nothing self-evident about why they should flow there, whereas New York has still the automatic cache of being the financial hub of the dominant global power (still commanding the main reserve currency) and the system’s largest economy. Yet, paradoxically, the greater contribution of UK-based financial institutions to UK economic performance does not make the London government as subservient to City interests as Washington can be to the interests of Wall Street. This is partly because UK financial institutions are long used to government-led oversight through the Bank of England. It is also partly because the structures of financial regulation are so different in the two countries: the single-focused FSA automatically generated a more coherent code of behavior than any that could possibly be expected from the myriad of regulatory agencies that exist in the US at both the federal and state levels. The greater subservience of Washington to Wall Street is also partly the product of the porous nature of the US political system. Washington is much more easily penetrated (and dominated) by well-placed lobby pressure. Finally, the revolving door that carries major financial figures into and out of the US administration has no easy parallel in a UK world of career politicians, an independent civil service, and tighter ethic rules. There is elite movement between government and finance in London, but not on the Washington scale.

  Many of the differences between the US and UK are the products of domestic political and economic variations, as we have seen. However, the policies and characteristics of both countries are also shaped by global forces reflective of their relative positions in the international community. US administrations, regardless of political color, are critically concerned with the US role as the global hegemon. US leadership on the world stage has had several effects. It brings capital flows to the US by default, and it helps maintain foreign confidence in the US dollar in the face of fiscal deficit, confidence which would be denied to the currency of a lesser power. The UK, in contrast to the US, possesses only the memory of its former global dominance. As such, its government’s focus – again regardless of political color – is invariably one of maintaining the UK’s relevance among global economic leaders. Throughout the crisis, and in the face of US and German competition, the UK government was determined to maintain London’s supremacy as a financial center, a determination which contributed to New Labour’s light-touch regulatory policies and to its emphasis prior to the crisis on strengthening the financial services sector above all others. The UK must find ways to draw speculative capital to the City of London through its financial policy, while the US simply attracts such monetary flows by virtue of its dominant global role. The positions of the two countr
ies on the world stage differ as well. While the US stands alone in its globally hegemonic role, the UK is critically concerned with its position on the edge of Europe. Despite its decision to remain out of the euro zone, the UK, as a member of the EU, is constantly obliged to filter global policy concerns through this European lens. Unlike in the US, certain policies in the UK have been influenced by European concerns: the Greek and Irish debt crises, for example, spurred calls for fiscal austerity and deficit reduction on the Continent, calls with which the UK has also latterly concurred.