Monday, December 5, 2011

Demand-Side Policies, Debt, and the Financialization of the American Economy

The 2008 government bailout of many of the nation’s financial institutions was troubling because the combination of private profits and socialized risks contributed to the institutionalization of moral hazard. Beyond that, though, this brings the government into active participation in the financialization of the American economy, To understand what I mean by this, consider that the United States has been one of the world’s debtor nations at two times in its history. The first time was the end of the nineteenth century and the beginning of the twentieth.  The debt at this time mainly consisted of foreign investment, shown in Figure 1.  The funds from abroad went mainly into railroads and in the nation’s emerging manufacturing industries. This was not consumer debt, but borrowing on the part of businesses for a production-oriented, supply-side economy.  Although this borrowing carried its share of risks, because it constituted business investments in building up the capacity for production,  by the middle of the twentieth century, it paid off not simply in an economic surplus but in jobs.
Figure 1. Estimates of Long-Term Foreign Investments in the United States, 1875, 1883, 1899, 1908, & 1914 (in millions of 1914 US dollars).
(Source: Chart created from data in Mira Wilkin 1989. The History of Foreign Investment in the United States to 1914. Cambridge, MA: Harvard University Press)
Our debt today is radically different. It is the debt of a consumer-oriented, demand-side economy.   From the early 1960s onward, the federal government began pursuing policies aimed at pushing the economy forward by bolstering consumer demand.  In theory, this was supposed to also encourage production as businesses sought to meet that demand.  Despite the "stagflation" of  the 1970s that was at least partly due to heavy government spending that simultaneously depressed productivity (the stagnation) and stimulated consumption (the inflation), the American economy did continue to grow in the late twentieth century. The big problem was that spending, both by government and private individuals, became the most important part of economic growth.  One consequence of this development was that domestic consumption outpaced domestic production, so that by the beginning of the 1980s, imports began to exceed exports and the gap between the two expanded sharply in the succeeding years, as shown in Figure 2.
Figure 2. U.S. Imports and Exports (in Billions of 2008 dollars), 1960-2007

(Source: U.S. Department of Commerce, Bureau of Economic Analysis, 2009. U.S. International Transactions Accounts Data. Available online at
Another kind of deficit accompanied the trade imbalance. As expectations for standards of living passed the productive capacity of Americans, consumer demand consisted increasingly of debt.  This debt became the major target of investment by foreign as well as by American business concerns. The US was no longer a center of production, but it remained a center of investment.  Nations with new economic growth, in recent years most notably China, were looking for places to invest their increasing surpluses. Domestic and foreign  investments were going increasingly into loans for Americans,  with an expanding part of the world economy becoming present-day money invested in expectations of future payments on debt.  This created ideal conditions for a bubble.
Although the federal government encouraged this financialization of the economy in a number of ways, the most notable was through the demand-side policy of encouraging the extension of home ownership.  By the early 1990s, government was encouraging the idea that everyone should become a home owner, at times presenting homeownership as virtually a right.  This served the interests of the real estate industry and it was also, at least for a time, in the interest of the banks that loaned money to prospective homeowners.  Through sophisticated instruments such as Collateralized Debt Obligations (CDOs), financial institutions both attempted to spread out the growing risk of the housing bubble and to make new investment opportunities in American debt for investors around the world.
The FIRE (Finance, Investment, and Real Estate) sector of the American economy, concerned with management of speculation in debt, grew steadily, as shown in Figure 3.  As this figure shows, the percentage of the national income controlled by this sector grew faster than the total number of jobs in it, a fact that makes sense when we consider that even if booming FIRE activities require more employees, it takes relatively few individuals to manage large amounts in investments. If I were to calculate the percentage of national wealth, rather than income, the disproportion would be even greater.
Figure 3. FIRE sector as percentages of all jobs in the labor force and incomes of those in the FIRE sector as percentages of total incomes in the labor force, 1960-2009
(Source: Chart Created from 1% U.S. Census PUMS files obtained from Steven Ruggles, Matthew Sobek, Trent Alexander, Catherine A. Fitch, Ronald Goeken, Patricia Kelly Hall, Miriam King, and Chad Ronnander. 2008. Integrated Public Use Microdata Series: Version 4.0 [Machine-readable database]. Minneapolis, MN: Minnesota Population Center [producer and distributor])

One thing this means, I think, is that those who blame "greedy" Wall Streeters for our current economic troubles may be missing the point. Presumably, people on Wall Street and elsewhere are no worse and no better than human beings at any other point in history.  All of us tend to pursue our self-interests.  The underlying problem is a demand economy based on politically encouraged debt and consumption.

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