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The following article appeared in Left Business Observer #63, May 1994. It was written by Doug Henwood, editor and publisher. It retains its copyright and may not be reprinted or redistributed in any form - print, electronic, facsimile, anything - without the permission of LBO.

After non-collapse

This is the edited transcript of a talk given by LBO editor Doug Henwood at a panel sponsored by Monthly Review during the Socialist Scholars Conference in New York City, April 2, 1994. The screed referred to in the opening paragraph was published as `Financial Collapse" in issue #37.

Four years ago, I sat on one of these panels and pondered the session's title, "Collapse of the Financial System?" There was, thankfully, a question mark at the end of the title, not an exclamation point. Before taking on today's topic, "The Long Decline," it might be nice to revisit some of that old territory.

We didn't know it then, of course, but April 1990 was three months before the 1990-91 recession officially began. At that point the economy had pretty much stalled out. Growth in GDP, the great totem of mainstream economic thinking, had really peaked about the time of the 1987 stock market crash, and had been trending irregularly downward until it was going virtually nowhere when George Bush took office in 1989. So in the spring of 1990 we were in the grip of a great stagnation, but no formal downturn.

Many analysts, radical and otherwise, were a little scared of what might happen next. Was the U.S. economy like the cartoon Roadrunner, beating his feet over a chasm after having overrun the cliff, but not yet falling? Would the great debt buildup of the 1980s -- which really started in the 1970s -- have its revenge in a great deflation of the 1990s? Put another way, how would the U.S. economy respond without the stimulus of increasing leverage? As the decade turned, debt growth had slowed to a relative crawl, and that was a good bit of the reason why the economy had turned stagnant if not fully sour.

The economist Hyman Minsky, one of the great post-Keynesian students of finance, has a good model for talking about debt. He divides financial structures -- of firms, households, or countries -- into three classes: hedge, speculative, and Ponzi. A hedged financial structure is one that can comfortably meet it interest payments and eventually pay off principal out of current income. A speculative unit can meet its interest obligations, but finds it impossible to pay off the principal when it comes due -- it needs to roll it over, that is, pay off the old debt with the proceeds of a new one. And finally, a Ponzi unit is one that can't meet any of its obligations, interest or principal, without selling off other assets or having some blessing fall from the sky. The name comes from the famous financial con game run by Charles Ponzi, which promised huge returns to investors -- but could pay off the first round of plungers only with money taken in from a second round, the second from the third, and so on. Sooner or later you run out of new suckers, and the whole thing crashes down.

In the 1950s, U.S.households and corporations had hedged financial structures. Debts were low, and so were interest rates, and there were few strains in the system. As the decades passed, however, the economy, and many units too, crossed the line from hedge to speculative -- most corporations and individuals could handle the interest payments, but paying off principal was something to be postponed to the afterlife. Then, sometime in the 1980s, it began looking like the U.S. had crossed the other line, from speculative into the exotic realm of Ponzi. Corporate takeovers were frequently done with the open admission that the debt could never be comfortably serviced, and that only with asset sales or divine intervention could bankruptcy be avoided. Households, too, engaged in similar practices, as balloon mortgages were arranged -- that final balloon payment could only be made by taking out another mortgage as the first one matured.


Now these phenomena are often explained, if you can call it that, as if America woke up in an expansive mood one day in the summer of 1982 and decided to go on a binge. It's tempting to refute this analysis by pointing to Hillary Rodham Clinton's futures trading records from 1979. But of course, we can't accept such simple-minded explanations, either of the mass psychological or ad feminem sort. You could write a book on the subject of why the Roaring Eighties happened -- in fact, I'm doing that in my own book on Wall Street -- but three key points can be made here as a first draft of an explanation. Upper class households borrowed to consume irresponsibly, but most working- and middle-class households borrowed mainly because wages were not keeping pace with the cost of living. And an important reason that the corporate buyout and takeover movement got going in the first place -- and it really started in the late 1970s -- was that years of inflation and depressed profits had pushed stock prices below the value of their underlying corporate assets. In other words, you could borrow money, buy up a company's stock, and liquidate it, and come out ahead. Or, if you were more ambitious, you could try to work the assets harder, by milking capital and squeezing labor, in hopes of boosting the profit rate. At first this made economic sense, even if the real world effects like plant closures and mass firings were nasty, but as the decade went on, transactions kept taking place at higher prices and under more unrealistic expectations. And then there's the point of who financed all this supposedly irresponsible debt. After all, for every borrower there has to be a lender. And here we see a massive pool of financial assets held largely by rich individuals and institutions like banks and pension funds, that were desperate for an outlet. What better place to "invest" the money than high-rate mortgages, credit card loans, and leveraged buyouts.

So the U.S. financial structure entered the Ponzi phase for very good fundamental reasons: pinched household finances, poor corporate profitability, and an excess of capital in money form seeking lucrative outlet. The contradictions of this were obvious: by definition, Ponzi schemes are not sustainable. If debts can only be serviced through massive new borrowing and asset sales, when the supply of fresh credit and the demand for aging assets shrink, then the structure must collapse. And that's exactly what was happening as we convened here four years ago. The junk bond market fell apart, first through defaults, then through the prosecutorial efforts of Rudy Giuliani, who put junk's maestro, Mike Milken, in jail. The S&L industry, another source of sluttish credit, was also falling apart -- actually it had been falling apart for some time, but it wasn't until after George Bush's inauguration that this was publicly admitted. Bankruptcy filings by corporations and individuals were soaring -- actually they had been high during the 1980s, but they reached all-time record levels in 1990 and 1991. Whether voluntarily or involuntarily, the pace of new lending slowed dramatically, to the point that even solid borrowers who wanted the temporary use of other people's money for rational purposes couldn't find a loan at any price. The economy was robbed of its lifeblood, unsound credits -- and some sound ones even. Why not?

And so it looked in the spring of 1990 that the financial structure faced its greatest risks in 60 years. But the recession of 1990-91 turned out mild by conventional measures, and brief, too. That's the official recession. The extended period of slow growth, which ran from early 1989 to late 1992 or early 1993, actually was the equivalent of a deep recession drawn out over 3 or 4 years. But even after allowing for that redefinition, things didn't collapse.

Why not?

Permit me to recycle my observations of four years ago. I've made a few bad predictions over the years; please indulge me the rare luxury of vindication. As I said, no First World government would allow a financial crisis to turn into a generalized debt deflation and real- world collapse. The Third World has experienced one of those over the last decade or so, but not the First. This was allowed to happen because the First World authorities not only don't care about the hunger pangs of the Southern billions, but also because it was a marvelous club with which to beat recalcitrant governments, forcing them to drop nationalist-protectionist economic strategies and to open up to Northern multinationals. But in the First World, too many fortunes would be ruined and the risk of political unrest too high to allow a deflation to take its course. So as I said then, it was likely that U.S. government would engineer a bailout of some sort, either like the S&L bailout or of a less visible sort, like deep reductions in interest rates.

That's what happened. The S&L bailout is now almost over; it's amazing that the expenditure of 250 billion in public dollars proceeded without serious investigation of the affair, but that's the stunted nature of political life in this country for you. And the Federal Reserve forced down interest rates relentlessly and kept them there from 1989 through February of this year.

Those lower interest rates worked exactly as they were supposed to. For corporations and households with debts at adjustable rates -- those periodically changed in line with prevailing market rates of interest -- found their required interest payments shrinking, often quite dramatically. Creditworthy firms and households were also able to refinance their debts -- pay off the old ones with the proceeds of new ones, except at lower rates of interest -- and ease their burden. This freed up enormous amounts of money. At the end of 1989, according to estimates by Federal Reserve staff economists, households devoted over 18% of their after-tax income to debt service, that is, interest and principal payments; at the end of 1993, that figure had fallen below 16%. In 1990, firms were devoting nearly 40% of their profits before interest payments and taxes to interest; that figure is now below 30%. Also, lower interest rates allowed the banking system to rebuild itself. Rates paid for loans didn't fall anywhere near as much as rates paid on deposits, and long-term interest rates didn't fall anywhere near as much as short-term ones. Both developments allowed banks to rake in billions effortlessly. The first part of the mechanism is simple enough: if one year you pay your depositors 8% and your borrowers have to pay 12%, a spread of four points, and the next year you pay your depositors 3% and your borrowers pay 10%, a spread of seven points, you're a much happier banker. The second part is similar: if you take in money at 3% and invest these deposits in government bonds paying 8%, you can make 5% on your money without exercising a single brain cell. And finally, lower rates launched a tremendous rally in the stock market, which allowed corporations to sell new stock to pay off old loans. A study by the Federal Reserve Bank of New York showed that most of the money raised in the early 1990s on the stock market was devoted to the retirement of debt rather than new investments -- contrary to mainstream economic theory, by the way, which views the stock market mainly as synonymous with real investment.

Had interest rates followed the course they did in the 1974-75 or 1980-82 recessions -- rises followed by relatively modest declines, rather than the steep decline we saw in the recent cycle -- it's highly likely that a true financial crisis would have broken out. Instead, it was relatively contained, and now seems behind us.

What now?

Are we really out of the woods, or just in a clearing? Let me offer several thoughts along those lines.

First, while lower interest rates have brought about a great deal of relief, the actual stock of debt itself is hardly down at all, if any. Interest costs may be down, but principal has grown. The best way to measure this is by comparing the level of debts outstanding with the incomes that support them (see charts, this page). For nonfinancial corporations, total indebtedness is almost eight times pretax profits -- an improvement from the over 10 times level of 1990, but still above any level seen before 1982, and two to three times levels of the 1950s and 1960s. For households, the figures are even worse: at the end of 1993, total debts stood at 90% of total after-tax income, the highest level since the Fed started collecting such data in 1945. Credit card and mortgage debt is rising again, after several years of flatness -- a trend that has helped boost the real economy, for now. So that means that we haven't really crossed the line back from Ponzi to speculative, much less hedge, in Minsky's language; we're just at a more prudent level of Ponzi right now.

Incidentally, much of the improvement in the finances of Mexico and other major Latin American debtors is due to lower interest rates, not the restructuring machinations of the so-called Brady plan. Though interest rates are down, the stock of debt has risen, just like here in the USA.

That means the economy is unusually vulnerable to higher interest rates, which may be why we've seen such a rout in the financial markets ever since the Fed started pushing up rates on February 4. Debt service burdens will rise again, reversing the happy process of the last several years. And while the banking system may have healed itself, the broader financial system is more leveraged than ever. In fact, never in history has the ratio of financial to tangible assets been so high -- and it's tangible assets, things like land and machines, that produce real wealth, while financial assets are merely claims on real wealth. Another part of Minsky's analysis is that when governments and central banks bail out over-extended plungers, they "validate threatened financial structures," and only lay the groundwork for even greater adventures in leverage in the next up cycle.

We've certainly seen that. While the S&Ls and junksters have disappeared, new players moved into the vacuum -- like the vast pools of speculative capital called hedge funds, who generally borrow $10 for every real dollar they have to their name, and who speculate in every market around the world. Also, lower rates have led to despair among individual investors, who have plunged into various highly speculative markets unaware of the risks involved. Should rates rise much more, and the Wall Street rout develop into something on the order of the 1973-74 bear market, when stocks lost nearly half their value, these individuals will see a lifetime of savings dwindle if not vanish. Those who are not wiped out will likely pull in their horns and stop spending money, and the marvelous carousel of consumption will creak and sputter.

But interest rates could rise for some time without stopping the economy, and debt could rise too, giving us something like a classic boom. The real danger to an economy is not when debts are high and rising, since more fuel is being added to the fire, but when they're high and begin falling as fresh fuel stops flowing; Ponzi units are driven to the wall, since they can't get fresh loans, and speculative units join the Ponzi clan.

The problems that led to the financial shenanigans of the last decade have not healed themselves either. Profitability is up, yes, but mainly through vicious cost cutting -- outsourcing, wage cuts, layoffs, and the rest. That boosts profits, and returns to shareholders, but at the expense of hollowing out demand by depressing incomes of what used to be called the working class, before the postmodernists and market- lovers banned the phrase. Real wages continue to decline. The usual figure you hear is that they're down around 15% over the last 20 years, but the matter can be put even more pungently than that: the amount of time it takes for someone earning the average hourly wage to make the equivalent of a household's yearly expenses is up 43%; to buy the average new house, up 45%; to buy the average new car, 57%; and to pay for a year at Yale or UCLA, 75%. So the real pay cut over the last two decades is more on the order of 40% or more, rather than 15% as measured through the abstraction known as the consumer price index. The wage trend hasn't reversed; real wages are down another 1% over the past year, even though job growth and economic growth have picked up considerably from 1989-92 levels.

So it may be that the present period is just an interlude. It may be that it's most like the expansion of the early 1970s, which, like now, followed a long expansion and a brief, mild recession -- only to be followed by a financial rout and a deep recession that ran from 1973 to 1975. Maybe Whitewater will even play a role analogous to Watergate then. Or maybe, for those seeking more dramatic parallels, we're living through a rerun of the 1934-36 boomlet, which ran aground on the tighter fiscal and monetary policies of 1937 -- a budget-balancing mania that sharply cut the deficit at the same time the Federal Reserve was driving up interest rates out of fear of inflation. Either way, the message for 1995 or 1996 isn't a pretty one.

But maybe things won't work out in such a dramatic way. As I said four years ago, it's wrong to tune your rhetoric to crisis -- either the permanent crisis favored by some lefties, or the inevitability of a real bone-cruncher just around the corner, predicted as imminent by others. My New Year's Resolution for 1994 was to quote Marx more often, and in that spirit, let me offer two of the Old Man's observations here. First, Marx said in Theories of Surplus Value that permanent crises do not exist. To say that capitalism has been in crisis for the last 20 years is contrary to Marx's spirit, and mighty foolish besides. And second, Marx said in the Grundrisse that those economists who emphasize capital's ability to overcome barriers to its growth "have grasped the positive essence of capital more correctly and deeply" than those who emphasize the barriers themselves.

So we might have a replay of 1973 or 1937 -- sharp crises, indeed, but ones from which the system eventually recovered. But we may just have more of what we've seen in the last 20 years -- continued downward pressure on living standards, fiscal crises and budget cuts, greater insecurity for a greater number even in the context of a business cycle upswing. It may be that people still think of the 1950s and 1960s, which saw sustained increases in the standard of living for nearly all First Worlders, as the norm from which the last 20 years have been the exception, rather than the other way around. In a world of free trade, tight money, and fiscal orthodoxy, GDP can grow indefinitely -- generously assuming no ecological flameout -- but it can still feel pretty awful.

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