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Financialization
and the crisis
Marc Lavoie
University 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”.
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. »
Brazilian Keynesian Association, Porto Alegre, September 2009
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 cashflow) 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.
The net financial accumulation of Canadian
households was negative 2000-7!
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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
debt / PDI
200
180
160
140
120
100
80
60
40
20
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Canada
Source:
United States
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