Robert Brenner on the crisis in the US economy
from the London Review of Books Vol. 25 No. 3 dated 6 February 2003 Robert Brenner
At 6 a.m. on 12 June 2002, four FBI agents barged into the SoHo loft of Samuel Waksal, the former CEO of the biotech company ImClone Systems Inc, and led him away in handcuffs: he was charged with insider trading. His father and daughter had dumped nearly 175,000 ImClone shares only days before the Food and Drug Administration announced that it had rejected Erbitux, the compay’s cancer drug, leading to a steep price fall. (Waksal himself had netted $57 million on an ImClone share deal the previous September, and had made an additional $72 million in 2001 from his stock options.) On 25 July, John Rigas, the former head of Adelphia Communications, was arrested, along with his two sons, on corporate crime charges. They were accused of using the company ‘as the Rigas family’s personal piggy-bank’, spending hundreds of millions of the corporation’s dollars on private jets, personal loans, luxury condominiums in Colorado, Mexico and New York City – and on the construction of a $12.8 million golf course. On 12 September, Dennis Kozlowski, the former chief of Tyco International – and described by Business Week as ‘perhaps the most aggressive dealmaker in corporate America’ – was put under arrest, charged with fraudulently obtaining over $400 million by selling Tyco shares while concealing information from investors. Kozlowski had used the funds to buy a mansion in Florida, lavish properties in Boca Raton, Nantucket and New Hampshire, a $7 million apartment for his first wife, diamonds from Harry Winston and Tiffany’s, and a fleet of fast cars and Harley Davidsons.
By August, the Wall Street Journal’s list of more than two dozen major corporations subject to official investigation included such household names as AOL Time Warner, Bristol Meyers, Dynegy, Enron, Global Crossing, Kmart, Lucent Technologies, Merck, Qwest, Reliant Services, Rite Aid, Universal, Vivendi, WorldCom and Xerox. The two largest US banks, Citigroup and J.P. Morgan Chase, are also being investigated, as is Merrill Lynch. Meanwhile, the ‘barons of bankruptcy’, as the Financial Times describes them – corporate insiders from the biggest 25 companies to go bust last year – reaped $3.3 billion from stock sales and compensation in the three years before their companies went under.
When corporate scandals first hit the headlines early in 2002, the US Treasury Secretary Paul O’Neill attributed them to the immorality of a ‘small number’ of miscreants. Apparently he’d been misinformed. The rapacious practices of these executives and firms – whether or not technically illegal – are typical of, and endemic to, corporate America. The recent scandals bear witness, however, not just to the level of individual corruption characteristic of US crony capitalism but to systemic problems in the real economy. It is because the epidemic of fraud makes manifest the ill-health of the corporations themselves that it has taken such a heavy toll on investor confidence and the stock market.
The corporate account rigging now coming to light is the direct result of the economic boom of the late 1990s, driven by an almost unprecedented increase in equity prices. Its raison d’?e has been entirely straightforward: to cover up the reality of an increasingly desperate corporate-profits picture. Between 1997 and 2000, just as the fabled economic expansion was reaching its apex, the rate of profit in the non-financial corporate sector was falling by a dramatic 20 per cent, initially as a consequence of overcapacity in international manufacturing. Under normal circumstances, this would have caused capital accumulation and economic growth to slow. As it was, however, stock prices soared, in information technology especially, even as corporate returns fell. Companies could thus access funds with unprecedented ease, either by issuing shares at highly inflated prices or by borrowing money from banks against the collateral of those overpriced equities. On the basis of this financial windfall, US corporations, especially in the IT industries, vastly stepped up their capital accumulation. The investment boom continued, with increasing growth of output and productivity. Even the staid academic economists of the Council of Economic Advisers, not to mention the chair of the Federal Reserve, celebrated a new synergy of technological change and freed-up financial markets that was ushering in an unprecedented era of progress.
The catch, of course, was that fast-rising profits are normally required to justify and support fast-rising stock prices, as well as rapid investment. Instead, as investment accelerated in the face of declining returns, overcapacity worsened, and the fall in profitability extended from manufacturing to major high-tech industries – above all, telecommunications. Faced with this patent failure of ‘fundamentals’, corporate executives were under mounting pressure to keep stock prices high by any means necessary, in order to maintain access to cheap finance and the investment funds required to compete; the fact that they had come to depend heavily on stock options for their own compensation naturally quickened the temptation. One after another great corporation falsified its accounts to exaggerate short-term earnings.
But the economy could defy gravity for only so long. From the middle of 2000, the reality of the profits crisis became apparent as a never-ending parade of corporations, including almost all the stars of the boom, were obliged to report increasingly dismal earnings. Share prices began a steep descent, and investors gradually awoke to the reality that they had been had. By this time the stock market was no longer stimulating the economy: on the contrary, as their equity prices collapsed, corporations were obliged to cut back on both borrowing and issuing shares, making capital accumulation more difficult. The huge mass of superfluous plant and equipment that was the legacy of the bubble-based misinvestment boom was now apparent to everyone. Corporations were left with little reason to accumulate new means of production, or labour, but with every reason to initiate price wars. The economy plunged into recession.
To restore order, the Federal Reserve brought down interest rates in record-breaking fashion, but there was no response from corporations already overloaded with means of production. Investment continued to decline, forcing up unemployment, reducing demand and placing further downward pressure on prices and profits. An orgy of household borrowing, largely against the collateral represented by private homes, enabled the ‘almighty consumer’ temporarily to save the day. But this binge came at the cost of a new bubble in the housing market, and is likely to have only a brief half-life. Justified by 9/11 and a faltering economy – not to mention the failure of the Fed’s monetary policy – the Bush Administration has invoked the need for both stimulus and security in order to rationalise a return to Reagan’s old formula of imperial adventure, tax cuts for the rich and increases in military spending. But the proposed elimination of the tax on dividends isn’t aimed at raising demand any more than the war on Iraq, and its associated expenditure on armaments, is supposed to increase Americans’ safety. The increased deficit that will result is intended, moreover, ?a Reagan, to force cuts in non-military expenditure, especially social services for the poor, and this will act as some counterbalance to whatever stimulus it imparts. Only barely invigorated by government policy, the economy totters towards the precipice.
According to the official story – told not only in Alan Greenspan’s testimonies to Congress but in the Council of Economic Advisers’ Economic Report of the President 2001, the last under the Clinton Administration – the stock market hothoused a technological revolution in the 1990s which allowed the US economy, in contrast to its laggard rivals in Japan and Western Europe, to escape from two decades of stagnation. In this view, a ‘new economy’ focused on information technology had emerged which, by significantly increasing the possibility of productivity growth, opened up the potential for far higher profits. The stock market rose to extraordinary heights in anticipation of these profits.
Financiers, the story goes, naturally responded to these firms’ elevated share prices by lending them money, or buying their shares. Rising investment enabled the accelerated introduction of new economy technology and thus productivity growth, which made for even higher potential profits, higher share prices, better funding, accelerated investment and so forth – what Greenspan called a ‘virtuous cycle’, which issued, between 1995 and 2000, in what the Council of Economic Advisers hailed as an ‘extraordinary economic performance’. Since the stock market provides investors with unmatched information as to the most promising firms and industries, or so the theory goes, these would be expected to expand most rapidly and drive the boom most efficiently. In particular, by offering astronomical returns on the initial public offerings of the best new high-tech start-ups, the stock market allowed venture capitalists to achieve otherwise inconceivable rates of profit, and thereby to underwrite the fastest possible technological change.
The reality of the expansion of the 1990s bears little resemblance to the official version. The claim that this was an ‘extraordinary’ boom is belied by the Government’s own figures. In terms of the standard measures – growth of output, capital stock, labour productivity and wages, as well as the level of unemployment – performance in the supposedly sensational five-year period between 1995 and 2000 barely matched the levels achieved in the 25-year period between 1948 and 1973. The growth of labour productivity, the most important indicator of economic dynamism, was a full 20 per cent lower. Taking into account the whole business cycle of the decade from 1990 to 2000 and not just the five good years at the end, the average annual rate of growth of GDP per person was a meagre 1.6 per cent, compared to 2.2 per cent for the hundred-year period 1889-1989. Even by 2000, real hourly wages for production and non-supervisory workers were still palpably below, and the poverty rate above, their 1973 bests.
To grasp what drove the economy in the 1990s demands a longer historical perspective. The economic expansion during that decade took place against the background of the ‘long downturn’, the era of slowed growth in the world economy that followed the long postwar boom. Between 1973 and 1995 the growth of output, investment, productivity and wages was one third to two thirds lower than during the previous quarter century, while unemployment levels were several times higher (except in the US). What was mainly responsible for the extended slowdown was overcapacity and overproduction in the international manufacturing sector, which led, by way of incessant downward pressure on prices, to reduced profitability – and the failure of successive attempts made by corporations and governments successfully to respond to this. The problem originated in the later 1960s as a consequence of the intensification of international competition, which itself resulted from the stepped-up entry into the world market of lower-cost producers based in Japan, as well as Western Europe. During the 1970s, overcapacity and overproduction worsened as leading firms in advanced capitalist countries found that it made more sense to respond to their problems with competitiveness and profitability by stepping up investment in their own oversubscribed lines than by reallocating capital into new ones, thus reproducing the initial problem. Meanwhile, firms based in the developing economies, especially in East Asia, found they could enter certain lines at a profit despite overcapacity. Only ever greater doses of Keynesian deficit spending prevented the onset of deep crisis, but at the cost of runaway inflation.
In the early 1980s, led by Thatcher and Reagan, the US and the other advanced capitalist states introduced high interest rates and deep austerity in order to encourage the shedding of the high-cost, low-profit means of production that were holding down profitability, as well as to raise unemployment in order to reduce wage growth. But the immediate result was the outbreak of debt crisis in the Third World, accompanied by the threat of depression in the US. Keynesianism had to be reintroduced to keep the international economy turning over. The advanced capitalist states were clearly unwilling to sustain a severe depression of the sort that, in the past, served to eliminate superfluous means of production and labour and to provide the foundation for an upturn. But the price of economic stability was a rise in interest rates to record-breaking levels, which, in combination with still reduced profit rates, reined in capital accumulation and economic growth, which remained heavily dependent on government deficits until the end of the decade.
Appearances to the contrary, the long downturn was not transcended even during the 1990s. Between 1990 and 1995, the advanced capitalist economies suffered their worst half-decade of the postwar epoch. For the decade as a whole, their performance taken together was, despite the US boom, hardly better than that of the 1980s; which itself was down from the 1970s; which, in turn, had been much worse than the 1960s and 1950s.
It was against the background of a slow-growing global economy that the US launched its economic revival. Between 1985 and 1995, the US manufacturing sector used an impressive recovery of international competitiveness to achieve an increase in profitability that was responsible for bringing the profit rate in the private economy as a whole above its 1973 level for the first time since the end of the 1960s. By 1994, this rise in profitability had set the stage for the investment boom that would be the main source of economic dynamism in the later 1990s; US economic expansion had begun in earnest.
The means by which the manufacturing sector achieved its recovery of profitability were typically destructive. The Plaza Accord, imposed by the US Government on its leading partners and rivals in 1985, led to a 40-60 per cent fall in the dollar against the yen and the deutschmark over the following ten years, dramatically lowering the cost of US goods compared to those of its main competitors. Employers held real wage growth close to zero for the whole decade. The Reagan Administration slashed corporation taxes. While investment continued to stagnate until 1993, companies shed masses of high-cost, low-profit means of production and labour in order to raise productivity.
But the fact that the US’s recovery of profitability was the result mainly of corporate downsizing and the gouging of workers, citizens and overseas rivals proved highly problematic for the two next largest economies, the Japanese and the German. For most of the period there was little growth in US aggregate demand. Demand for plant and equipment and for consumption goods both stagnated. Government demand fell, too, as from 1993, the Clinton Administration – going back on America’s historical willingness to sustain deficits to stimulate the global economy – turned to balancing the budget. Meanwhile, US manufacturers’ reductions in relative costs through wage restraint, productivity increase and dollar devaluation allowed them to appropriate world market share from their competitors in Japan and Germany.
The outcome was that during the early 1990s German and Japanese manufacturing profitability fell sharply just as the US was assembling the basis for its boom. This hydraulic pattern – by which the recovery of one manufacturing economy would find its counterpart in the crisis of another as the exchange rate shifted – reflected the system’s slowed growth, and would be repeated time and again. From 1991 both the Japanese and German economies experienced their worst recessions of the postwar epoch. By 1995, there had still been no palpable recovery in the advanced capitalist economies as a whole. The long downturn was alive and well.
In the spring of 1995 the yen rose to 79 to the dollar; as recently as 1985 it had stood at 240. The Japanese manufacturing economy, obliged to absorb this enormous increase in the relative cost of its goods on the world market, seemed on the verge of freezing up. Having just weathered the international disruption caused by a major financial crisis in Mexico that had reverberated throughout Latin America, the US Government could not allow the Japanese economy to fail. Japan’s economy was second only to that of the US, and a crisis there would pose a threat to international stability. The country was also the US’s leading creditor, and a Japanese crisis would probably have led to a fire sale of US bonds, forcing up interest rates and cutting short the American recovery in the run-up to the 1996 elections. With the so-called ‘reverse Plaza Accord’ of summer 1995, the US Government therefore agreed with its Japanese and German counterparts to drive up the dollar.
This agreement constituted a turning point in the evolution of the world economy. It reversed the dominant economic trends of the previous decade and, in a crucial sense, prepared the way for every major development of the next five years: the decline of US profitability, the historic equity price increase, the stock market-led economic boom – and the crash and recession that have followed.
The first, and most consequential, effect of the dollar revaluation was to put an abrupt end to the decade-long recovery of US profitability. Between 1997 and 2000 the corporate manufacturing profit rate dropped by more than 15 per cent, so that the US economy lost what had up to this point been a major source of its momentum. This sudden increase in pressure on the rate of profit posed a threat not just to the US but to the entire world economy. To counter the long downturn, and the reductions in profitability that lay behind it, governments and corporations across the globe had been taking ever more stringent measures to reduce costs. But the unavoidable by-product of their offensive had been the shrinking growth of aggregate demand across the system, which now threatened to short-circuit international economic recovery. Wage and social spending increases had been cut back increasingly sharply over the 1970s and 1980s. In the run-up to monetary union, European governments had imposed even tougher austerity measures, and the Clinton Administration had followed suit.
In the context of increasingly sluggish domestic markets, the rest of the world was obliged to look to the US market to provide the export demand to keep their economies going. But with American wage growth flat and government demand rapidly shrinking after 1993 as the Federal deficit fell, dependence on the US market translated into ever greater dependence on the growth of US investment – which, it was hoped, would result in greater imports both of new plant and equipment and, by way of higher employment and rising wages, of consumer goods. With the new downward stress on the manufacturing profit rate deriving from the rise of the dollar, however, the capacity of the US to serve as the ‘market of last resort’ appeared under threat.
And yet, from 1996, US economic expansion took on a new dynamism, and carried the rest of the world along. What increasingly drove it was a stock market that soared to unmatched heights, despite the weakening of corporate profitability from 1997. Between the early 1980s and 1995, the rise of equity prices had been no greater than the rise of profits. Henceforth, a growing chasm would open up between the two. As the Wilshire 5000 Index soared 65 per cent between 1997 and 2000, corporate profits (after tax and net of interest) fell by 23 per cent.
What laid the basis for the stock market’s dizzying ascent was a major, long-term easing of credit. This resulted, initially, from the same co-ordinated move in 1995 by the G3 powers to drive up the dollar that had brought about growing downward pressure on the US manufacturing profit rate. To push down their own currencies relative to the dollar, the Japanese – and other East Asian governments – bought US assets, especially Treasury instruments, in massive quantities. The resulting flood of money on US markets brought about a sharp reduction in long-term interest rates. Meanwhile, seeking to secure stability in the wake of the Mexican financial crisis, the Federal Reserve lowered short-term interest rates. Investors took advantage of the declining cost of borrowing to pour money into the stock market, driving up equity values. And with the dollar going up, stock prices automatically rose in value in international terms, which attracted more investment that, in turn, drove the stock market even higher.
What seems puzzling is that the process did not stop there, once the gap between share values and profit rates had begun to open. By late 1996, Greenspan was publicly expressing concern about the ‘irrational exuberance’ of share prices. But he was clearly even more anxious, in private, about the possible stumbling of the US economy, especially as economic growth at first proved hesitant in the face of his interest-rate reductions and as turmoil shook the East Asian markets in spring 1997. In this context, as he was well aware, the ‘wealth effect’ of a rising stock market could play a stimulating and steadying role, funding investment growth and consumer demand that could compensate for declining government deficits and the negative impact of the rising dollar on profit rates. If the prices of their equities rose, corporations would be able to access otherwise unavailable funds for investment, either by issuing over-valued shares or by borrowing from the banks. By the same token, households with rising paper wealth would find less need to save.
In undertaking the US’s first essay in what might be termed stock-market Keynesianism, Greenspan, far from seeking to control the bubble, actively encouraged it. He not only welcomed the enormous increase in liquidity resulting from the influx of foreign money and his own reduction of interest rates, but also refused to raise the cost of borrowing from the beginning of 1995 until mid-1999 (aside from a lone quarter-point rise in early 1997) or to raise the required margin on share purchases to discourage speculation. He intervened vigorously by loosening credit whenever the equity markets threatened to swoon – most spectacularly in autumn 1998, at the nadir of the world financial crisis. As a result, from 1995 until 1999, the money supply (M3) increased at six times the rate it had from 1990 until 1994, opening the way for a gigantic wave of speculation.
US corporations, in particular, were quick to exploit the easy money Greenspan was pouring their way. Between 1995 and 2000, they increased their borrowing to record levels as a percentage of corporate GDP; not only to fund new plant and equipment, but equally to cover the cost of buying back their own stocks. In this way, they sidestepped the tedious process of creating shareholder value by producing goods and services at a profit, and directly drove up the price of their shares for the benefit of their stockholders and for corporate executives, who were heavily remunerated with stock options. Between 1995 and 2000 US corporations were the largest net purchasers on the stock market.
Still, the availability of easy money can provide only an incomplete explanation of the great equity price run-up. After all, the low cost of credit cannot make people borrow with the intention of speculating; yet speculation – by mutual funds, insurance companies, pension funds and other such institutions – was indispensable to the expansion of the bubble. To explain why money continued to pour into corporate equities even as corporate profits stagnated, one has to turn to the peculiar way finance works, and the tendency of its operatives towards herd behaviour. As equity prices began to rise strongly from early 1996, fund managers were under heavy pressure to buy, even if they doubted the long-term viability of their purchases. If they failed to do so, they risked falling behind their competitors and losing their jobs. On the other hand, if, in the long run, the assets they had purchased went sour, they could not be held responsible, since so many others had done the same thing.
As a result of the historically unprecedented ascent of their share prices, corporations were able to avoid facing up to the unpleasant reality of declining returns and to sustain the long expansion of the 1990s right through to the end of the decade. The magnitude of the wealth effect celebrated – and bolstered – by Greenspan and others was unprecedented. Historically, US corporations had been largely self-financing, paying for their investments largely out of retained profits. By the end of the 1990s, however, they were borrowing at record-breaking levels (compared to output) in order to fund investment, while also financing themselves by way of equity issues to a degree never remotely approached before.
Wealthy households also saw their on-paper assets rise astronomically. According to a recent Federal Reserve study, the top 20 per cent of wealth holders could account, by themselves, for the spectacular reduction of the US household savings rate from around 8 per cent in 1993 to zero in 2000. In so doing, they also accounted for the increase in the rate of consumption that took place during that period, helping corporations realise their skyrocketing investments on plant, equipment and software. In the words of one pundit, this was the first expansion in history underwritten by ‘yuppie consumption’.
Thanks to the wealth effect of the stock-market increase, especially in information technology, the expansion did achieve increasing vitality. Non-residential investment grew by 9 per cent per annum for the rest of the decade, driving the boom. This made for a rapid growth of output, decent productivity growth, falling unemployment and even, eventually, significant wage increases. Last but not least, the huge increase in US demand that resulted from the speeding up of the expansion, plus the still rising dollar, first pulled the world economy from its doldrums of the early 1990s, then rescued it from the international financial crisis of 1997-98 and ultimately incited a new international economic upturn in 1999 and 2000.
The fact remains, however, that a stock-market rise driven by speculation, far from discerning the most promising fields for expansion – as it does in the fables of the Federal Reserve, the Council of Economic Advisers and orthodox economic theory – was systematically misdirecting investment, because it was not based on rising rates of return. The rapid growth of expenditure on plant and equipment in new-economy industries took place against a background of falling profitability in manufacturing; that decline soon extended to information technology and telecoms. Productivity growth increased, but could not lead to a raising of the rate of return because it resulted from the same overinvestment that was simultaneously creating overcapacity and overproduction. The consequent downward pressure on prices benefited consumers in the short run; but by forcing down profits, it limited investment, growth and employment in the longer term. Between 1997 and 2000, as the boom peaked, the rate of profit in the non-financial corporate sector as a whole fell by a fifth.
The ‘virtuous cycle’ touted by Greenspan was little more than hype. What drove the economy during the second half of the decade was a vicious cycle that proceeded from rising equity prices to rising investment, in the face of falling profitability, which issued in increasing overcapacity that lowered profitability still further. It was the increasing defiance of gravity by both the booming economy and the bubbling stock market that opened the way to the corporate accounting scandals, the stock-market crash and the new recession.
This economic process worked itself out most dramatically in the IT sector and, especially, in telecoms. The high-tech frenzy was prompted by Clinton’s 1996 Telecommunications Act, which deregulated the telecoms market. A phalanx of new entrants rushed in, hoping to capitalise on what they took for granted would be an unprecedented growth of demand, generated by the endless expansion of the Internet. By virtue of what they assumed would be their technological superiority, they also counted on wresting market share from such giants as AT&T, Sprint and Verizon. Their strategy was focused on the stock market and finance. By expanding through mergers and acquisitions with the greatest possible speed, they sought to win the approval of equity markets – dazzling them with size and growth, rather than profits. On this basis, they aimed to drive up share prices and thereby find the finance they required for further growth.
The emerging telecoms companies were soon laying tens of millions of miles of fibre-optic cable across the US and under the oceans, with the indispensable assistance of America’s leading financial institutions – above all, its greatest banking conglomerates. These ‘one-stop’ financial supermarkets had emerged from an ever deepening process of financial deregulation, closely overseen and patronised by the Clinton Administration and a Democratic Party leadership determined to exploit the hugely increased fund-raising opportunities they knew would materialise from their embrace of the neoliberal programme and, in particular, the agenda of the great banks. Under the watchful supervision of Robert Rubin, who, having been CEO at Goldman Sachs, was made Clinton’s Treasury Secretary in 1993, the already disintegrating barriers between investment banks, commercial banks and insurance companies – originally erected by the New Deal, in response to the 1990s-style excesses of the 1920s – were obliterated.
The climax came in April 1998 when Travelers Insurance, owners of the investment bank Salomon Smith Barney, merged with the commercial bank Citicorp to form Citigroup, in direct defiance of the still valid Glass-Steagall Act, the pivotal piece of New Deal legislation regulating finance. These giants were clearly confident that the Government would sanction the merger – and with good reason: Citicorp donated $4 million in campaign contributions during the 1996 and 1998 electoral cycles. The finance, insurance and real-estate industries spent over $200 million on lobbying during 1998 and donated another $150 million in the course of the 1998 electoral campaign. Above all, the newly merged mega-bank knew it could count on Rubin, and the Treasury Secretary didn’t let them down. He made sure that Congress permitted their merger and was promptly rewarded when, five months after resigning his post in the Clinton Administration, he was appointed chairman of the executive committee of Citigroup, now the country’s largest financial institution.
The banking monoliths that arose from the financial deregulation process were supremely well placed to garner the fees for underwriting the share issues, floating the bonds and organising the mergers and acquisitions of the newly deregulated telecoms industry. It was therefore only natural that they encouraged – and enabled – the telecoms firms’ obsession with expansion. They were pleased, too, in their role as commercial banks, to lend their clients however much money they wanted (sometimes at below market rates), so long as they could secure, in their role as investment banks, these companies’ underwriting business and the associated fees. They were all too read