Before the crash – The Great Moderation
Without going into detail it is worth situating the period that preceded the crisis in the context of what had come before, this will help reveal some of the deeper roots of the crises. In particular it is worth noting the period now known as the Great Moderation, which consisted of a period of unusual stability and powerful economic growth in the two to decades before the crash of 2007, which was the period when the root causes of the crash were assembled.
Starting with the Great Depression, the first truly global crises of entire global capitalist system, one can very schematically divide the recent history of the global economy into the following stages.
The Great Depression. A prolonged period of falling output, declining living standards, high unemployed, deflation, falling world trade. During this period many countries tried to maintain a gold standard fixed exchange rate for their currencies which forced many governments to adopt utterly inappropriate and damaging austerity measures and to reduce spending in order to comply with the requirements of the currency system (does that sound familiar?). The leadership of the major capitalist countries were paralysed by the crises. The prevailing theoretical, intellectual and policy consensus precluded any effective action and led to a deep misunderstanding of what was happening. No effective international cooperation framework existed through which a coordinated response could be delivered. Many countries tried to cope by erecting trade barriers to protect their national economies from foreign competition and this just further depressed global trade.
World War 2. The war saw a massive increase on the state management of capitalist economies and a huge increase in social programs designed to ensure the well being of the mass of the people who were now essential to modern total war. The Great Depression conditions, including unemployment, disappeared as massive government spending flooded the system with demand. The outcome of the war left all the great capitalist powers, except for the USA, hugely in debt. The economy of the USA was in a very healthy condition but many feared the depression would return. International trade had suffered prolonged and massive disruption. Germany and Japan had suffered massive physical devastation. A large block of countries in Eastern Europe (joined shortly after by North Korea and China) had joined the communist block and as a result capitalism had ceased to function in those countries.
Bretton Woods and US Post-War Hegemony. The USA, which was still run by the New Dealers, now took on for the first time an explicit peacetime leadership role of the global capitalist system. At the Bretton Woods 1944 conference a new international monetary system was created based on fixed exchange rates against the dollar, and a dollar based on a fixed exchange rate against gold. A series of new international bodies were created, the UN, the World Bank, the International Monetary fund. Government’s across the developed west adopted a Keynesian policy framework and began to routinely adjust aggregate demand in their domestic economies through fiscal and financial mechanisms to smooth out the ups and downs of the economic cycle and to ensure full employment and growth. Intellectually Keynesian economic theory dominated economic discourse and economic policy making from 1945 to around 1975.
After WW2 the USA had become a massive exporter of capital, sometimes through large direct aid programs (such as the Marshall Plan), sometimes through direct investment in the economies of other countries (particularly the ‘cold war front line’ countries of West Germany and Japan) and sometimes through military spending and military activity (the spending associated with the Korean War and Vietnam War laid the basis for the industrialisation and economic development of south east Asia for example). These capital flows were possible because the USA economy was easily the strongest in the world and for nearly two decades after WW2 the USA generated consistent and large surpluses on it’s current account. So the USA sold more than it bought, earned more than it spent, and the surplus this generated was recycled out of the USA and into the rest of the world as large capital flows out of the USA into other countries.
During the period from 1945 up until the 1970s this new system shaped by US economic dominance seemed to be very successful. Unemployment remained low. The defeated German and Japanese economies were rebuilt and began to grow rapidly. Steady growth became the norm. Living standards and the volume of world trade grew. The economy still went through cycles of growth and reduced growth but these cycles were far less severe than what had gone before. Every so often a country got into trouble and had to devalue it’s currency. But generally things seemed to be going quite well.
That all changed in the 1970s
The crisis of the 1970s: Stagflation and the collapse of the Bretton Woods system. By the late 1960s, after apparently delivering full employment and impressive growth for nearly two decades, the dominant Keynesian policy framework consensus, and the domination of Keynesian economic theory, began to disintegrate as the global economy and national economies began to behave in unexpected and problematic ways. Growth slowed, recessions became more frequent, unemployment began to creep up and inflation began to rise. All those problems suddenly intensified after the shock of the large increase in oil prices following the 1973 war in the middle east. Many western economies began to veer violently off course and inflation became dangerously high, reaching an alarming 26% in the UK in 1974. The familiar Keynesian policy instruments when deployed did not produce the expected results.
Most disorientating for policy makers and economists was the appearance of high rates of inflation combined with falling output and rising unemployment, a combination (known as ‘Stagflation’) that was considered essentially not possible in classical Keynesian economic theory. The Bretton Woods currency and exchange system based on convertibility into gold collapsed at the end of 1971 when the USA abolished the fixed rate of convertibility of dollars into gold and a long era of floating exchange rates began.
Largely unnoticed at the time a momentous reversal of global capital flows began during this period of crises in the 1970s, and these flows have continued to this day playing a large part in bringing about the financial crash.
The pattern of the USA running a persistent surplus on it’s current account and exporting capital completely reversed in the 1970s and the USA began to run semi permanent current account deficits, deficits which continue to this day. As result the export of capital from the USA ceased because the USA was now spending more than it earned and hence had no surplus to distribute but rather but rather a deficit that needed financing. The result was that capital began to flow into the USA from the rest of the world primarily at the time from Japan and Germany which were regularly running trade surpluses.
Even though the USA sold less than it bought, it’s currency, after a period of instability and devaluation in the 1970s, did not continue to lose value. This was because of a seemingly unlimited willingness of various institutions and countries to buy and hold large quantities of dollars (the birth of this period was marked by the emergence of the Eurodollar market in London which became the main conduit for the movement and recycling of these expatriated dollars).
The political response to the crises of stagflation, and the crises of Keynesian economic theory, was led by the right primarily by Reagan and Thatcher, and consisted of a rejection of the Keynesian consensus. The new thinking and the new policy frameworks it created, often rather erroneously labelled ‘monetarism’, meant that the state would stop trying to manage aggregate demand, would allow the markets to operate as freely as possible, would allow unemployment to rise more or less to whatever level the markets dictated, would mostly allow large failing firms to go bust, and would focus the efforts of government policy on managing the money supply, ensuring monetary stability focussed on the control inflation.
The Great Moderation: 1980s to 2007
The Great Moderation refers to a reduction in the volatility of business cycle fluctuations starting in the mid-1980s, believed to have been caused by institutional and structural changes in developed nations resulting from the 1970s period of instability. Sometime during the mid-1980s major economic variables such as real gross domestic product growth, industrial production, monthly payroll employment and the unemployment rate began to decline in volatility. Although the period was punctuated by financial crises such as Black Monday in 1987, the Asian currency crises of 1998 (a topic that will be covered in another article) and the dot com crash of 2000 none of these crises became generalised systemic crises in the financial system and none caused global impacts.
The period of the Great Moderation, a period when the business cycle seemed to become much more gentle, and when there was more or less steady growth year after year was characterised by the following characteristics.
A globalisation of trade and commerce and a global expansion of the capitalist system.
The longest period of interrupted growth since WW2.
Very big improvements in the material well being and welfare of most of the human race.
The spread of democratic government to many more countries and regions
Accelerating economic growth in many developing countries including very rapid growth in China.
Continuing, and eventually deepening, imbalances in global trade
The development of huge capital flows which ‘balanced’ the trade imbalances
The dependence of these capital flows upon ‘artificial’ currency arrangements
The building on top of these capital flows of a vast, insanely complex and as it turned out deeply fragile global financial apparatus, which between 2007 and 2008 imploded.
During the period of the Great Moderation global markets were connected into system of greatly enhanced global trading connections. Trade barriers fell. Previously primarily non-capitalist economies collapsed into, or slowly transformed into, fully capitalist economies. As a result the global financial systems became connected together and grew hugely in both size and complexity (some of the consequences of this will be explored below).
Arguably the most important change was the embrace of ‘reform and opening up’ by China after 1978, under the leadership of Deng Xiaoping, which meant that by the early 21st century China had become the second largest capitalist economy in the world. The election of Margaret Thatcher as British prime minister in 1979 and of Ronald Reagan American president in 1980 began a revolution in the high-income countries, including privatisation of what previously had been publicly owned companies and liberalisation of financial systems. The European Union’s Single European Act was agreed in 1986 and started a move towards a single market free of trade restrictions or barriers, and the Maastricht Treaty ratified in1993 put the EU on the path towards the abolition of exchange controls and the currency union, which was launched in 1999. In 1989 the Soviet empire in Central and Eastern Europe collapsed. In 1991 the Soviet Union abandoned communism and disintegrated. In the same year India began a process of extensive external and domestic liberalisation, dismantling it’s previous system of protectionist trade barriers and tariffs. The Uruguay Round of multilateral trade negotiations was completed in 1994 which led to the removal of a large number of trade barriers and protectionist measures across the global. The World Trade Organisation replaced the General Agreement on Tariffs and Trade in January 1993. Subsequently, China joined the WTO in 2001. During the Great Moderation global capitalism greatly extended it’s reach, scope and scale.
At the same time some crucial technological development made it possible to massively increased international trade. Containerisation, a system of intermodal freight transport developed after WW2, spread around the globe. Containers have standardised dimensions and can be loaded and unloaded, stacked, transported efficiently over long distances, and transferred from one mode of transport to another—container ships, rail transport flatcars, and semi-trailer trucks—without being opened. The handling system is completely mechanised so that all handling is done with cranes and special forklift trucks. All containers are numbered and tracked using computerised systems. The global adoption of the standardised container system greatly reduced the costs of shipping goods over long distances and was a key factor in huge growth in international trade during the Great Moderation. In 1996 the world’s largest container ship could carry 6,000 containers. In 2014 the largest container ship could carry 19,224 containers.
The period of the Great Moderation also saw dramatic improvements in information and communication technologies (ICT), these included the spread and improvement of the humble telephones system, the spread of fax machines for document exchange over distance, the spread of cheap and powerful PCs, the development of the internet, the web and email, and the current phase which is the spread of handheld networked computers (otherwise known as smart phones) to billions of even the most poor people across the planet. The specific role of ICT in the financial crises will be explored in another article but the development of rapidly improved communications and data handling system (combined with containerisation), combined with the liberalisation of trade agreements, greatly facilitated a very large growth in international trade. Supply chains that were spread in complex nets around the global could be managed with relative ease, micro trading at distance could become feasible, small businesses could address global markets, ‘just in time’ production management system could be developed and used in relation to international markets and trading.
During the Great Moderation capitalism became a truly globally integrated economic system, the pace of growth picked up significantly and the global economy grew substantially. This seeming triumph of modern capitalism obscured the development of what were to prove to be destabilising imbalances and weaknesses in the pattern of global trade and within the global financial system, however the achievements of the Great Moderation were real and positive.
