Financialization and the crisis

Marc LavoieUniversity of Ottawa

SOME BACKGROUND

A couple of years ago hardly any economist knew about these terms:• ABS, MBS, RMBS, CMBS, ABCP, CDO,

CDO2, CMO, CLO, CDS, EDS, SPE, SPV, SIV

• asset-backed securities, mortgage-backed securities, residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed commercial paper, collaterized debt obligation, collaterized debt obligation squared, collaterized mortgage obligation, collaterized loan obligation, credit default swaps, equity default swaps, special purpose entity, special purpose vehicle, structured investment vehicle

Some warning signs• 2005: High share of new mortgage loans that

were subprime;• 2006: Risky mortgage formula (interest only,

2/28, negative amortization)• Mid 2006: US Real estate prices stop rising• Early 2007: the cost of insuring BBB

mortgage-backed securities against default losses rose briskly (MBX or ABX indices take a plunge)

Falling values of MBX, the reverse of the cost of default insurance on MBS

A CHANGE OF POLICY PARADIGM

A second Keynesian pragmatic revolution • In contrast to previous financial crises, the

IMF advocates low interest rates and government stimulus packages with budget deficits;

• G20 leaders move away from unfettered markets and uncontrolled capitalism;

• Gordon Brown (UK): “The Washington consensus is out”;

• Financial Times: “The credit crunch has destroyed faith in the free market ideology”.

Brazilian Keynesian Association, Porto Alegre, September 2009

Some signs of frustration with regards to ‘edge’ orthodox theory• Willem H. Buiter 2009, LSE professor, former member of the

Monetary Policy Committee of the Bank of England:• « Most mainstream macroeconomic theoretical innovations

since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best. 

• Indeed, the typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so, may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. »

Two opposite views back in favour in the media• Neo-Austrian theory (Hayek, von Mises) at

the forefront of the second counter-revolution;• Post-Keynesian monetary theory (Galbraith,

Minsky) at the forefront of the second Keynesian revolution;

The neo-Austrian view (not mine!) of the crisis in a nutshell• The US government (Community Reinvestment Act

1977) forced banks to grant subprime loans.• The Fed set short-term rates at too low a level (from

2002 to 2004).• The Chinese rigged the exchange rate and flooded

long-term bond markets, also leading to overly low long-term rates.

• There would be no crises if government was small and interest rates were always set at their natural levels, or even better, if there was no central bank.

• The fiscal stimulus will make things worse!

The post-Keynesian view of the crisis in a nutshell• Western economies have moved towards a

financialization process over the last decades, with deregulation of the regulated financial system and growth of the unregulated financial system.

• The current regime of accumulation (based on low real wages and consumer debt) was unsustainable.

• Financial crises are an endogenous feature of unregulated capitalism.

• As a result, financial crises are ever more frequent and more severe.

FINANCIALIZATION

Finance capitalism Stock market capitalism Money manager capitalism Rentier capitalism

Financialization: definition• “Financialization means the increasing role of

financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (Epstein 2006)

Financial institutions – stylized facts• The importance of the financial, insurance and real

estate sector has doubled– GDP share – Profits relative to those of non-financial

corporations – Profits of banks as a percentage of their total

assets– Compensation of employees in the financial sector

as a percentage of total compensation

Non-Financial corporations – stylized facts

• Non-financial corporations now hold as many financial assets as they hold tangible assets.

• Hence the interest and dividend income of non-financial corporations as a percentage of their gross value added had tripled.

• Non-financial corporations, that used to issue new equity to finance their investments, now often buy back their shares instead.

• Non-financial corporations now raise a larger proportion of their funds through bond issues.

• The interest payments of non-financial corporations as a percentage of their gross value added has quadrupled.

• The dividend payout ratio (as a percentage of their cash-flow) has doubled.

Distributional issues – stylized facts• The wage share of income has gone down.• The share of income going to rentiers has risen.• Labour hourly productivity has grown much faster

than hourly earnings or even hourly total compensation of production and non-supervisory workers.

• The income share of the lowest quintile has fallen.• The income share of the highest quintile has risen.• There has been an incredible rise in the income

share of the top centile.

Flow-of-funds – stylized facts• The net accumulation of financial assets of

corporations is positive, meaning that they lend their surpluses to households, with about half of these funds coming from financial corporations.

• The net accumulation of financial assets of households is negative, meaning that they borrow from corporations to pay for their consumption, financial and real estate investments.

• This has been made possible in particular by the use of margin debt – the borrowing of money, collaterized by equity in the stock market or equity in homes.

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The net financial accumulation of Canadian households was negative 2000-7!

SOME SPECIFICICS OF FINANCIALIZATION

Securitization and credit default swaps

The advantages of securitization according to finance and M. Aglietta (1996)

• It reduces risk in the banking system• It makes the payment system immune to

insolvency• It spreads risk to those best able to handle it• It is a stabilizing factor• It diversifies the supply of assets• It reduces the cost of mortgages

The dangers of securitization and the innovations that went with it • It disconnects the risk of the defaulting

borrower from the bank granting the loan.• It creates a chain of self-serving agents

getting bonuses (short-termism again):– Mortgage broker, property appraiser, loan officer,

securitizer, bond rater, lawyer, underwriter, CDS issuer, investment manager.

• With deregulation, there are more fraud incentives (lender-induced liar loans)

Securitization according to Minsky 1987• Securitization helps financial globalization• Securitization will lead to credit-enhancing

mathematical techniques (AAA rated securities at BBB yields)

• There will be “a thin market if price and quality of the securities deteriorate”

• “Securitization implies that there is no limit in creating credits for there is no recourse to bank capital”

Credit default swaps according to Albert M. Wojnilower • The “supposed immunity to financial risk always turns

out to be illusory, and the risks and costs of shattering the illusion may be considerable” (1980, p. 309).

• “The recent entry of major insurance companies into the business of insuring banks and bond investors against loan defaults represents another effort to stretch the safety net. Now it can be presumed, the authorities will have to intervene to interdict a cascading of defaults only if to save the insurance industry” (1985, p. 356).

IS THIS A MINSKY CRISIS?

Yes and no!

Financial markets blew up on their own• This is not a true Minsky crisis.• In the Minsky crisis, the problem starts with

over-indebtedness of non-financial firms, and explodes because of rising interest rates.

• This was not really the case in 2007, and neither was it in 1929.

• Both in 1929 and 2007, problems arose from over-indebtedness of households, and, as in Japan, a meltdown of the real estate market and then the equity market.

US non-financial corporation debt to equity ratio

Source: Wachovia Bank

Household debt to disposable income ratio, US and Canada

0

20

40

60

80

100

120

140

160

180

200

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Canada United States

debt / PDI

Source:

Effect of a one-time increase in the flow of gross household loans to personal income (Godley-Lavoie 2007 model)

Time

Effect of a one-time increase in the flow of gross household loans to personal income

Time

Conclusion: 2009, the worse of two worlds• The real estate market crashed before these negative

effects could really take effect.• But now we have two negative effects operating at once

on consumption:– The long-run negative effects (servicing the debt

reduces disposable income) of a higher flow of household borrowing relative to income

– The short-run negative effects of high saving rates, directly from higher propensities to save, and indirectly from a lower propensity to take new debt