Most of the discussion of the causes of the current global economic crisis has focused on the failure of regulators to prevent banks, hedge funds and other such entities from exceeding prudential lending limits. The crisis hit when the debt mountain became so big that lenders refused to go on rolling over loans. To prevent repeat crises the solution is to beef up financial regulation and limit the growth of credit.
True enough as far as it goes, but it begs the question of why regulation failed on such a spectacular scale. The short answer is that regulation failed because of structural changes which made it likely that any system of regulation would fail. Until action is taken to moderate these structural changes repeat crises are only too likely.
The first such change is the explosive growth of the financial sector in many economies, relative to the 'real economy'. A whole new economic paradigm emerged, in which wealth creation came to be based on the creation and manipulation of credit and debt, seemingly without limit. The simplest indicator is the stock of global financial assets (equities, public and private bonds, and bank assets) relative to world GDP, which soared from 1.2 times in 1980 to 4.4 times in 2007. In the US, the share of domestic corporate profits accruing to the financial sector jumped from 20-30% in the 1990s to more than 40% in the current decade. Also in the current decade, average compensation in finance averaged between 30 and 50% more than in comparable professions (like medicine and law, holding constant the length of education and the risk of being fired). In 1980, by contrast, the 'wage premium' in finance was about zero.
This 'financialization' of the economy reached a peak in the US and Britain. As the financial sector grew larger and more profitable, financial executives came to exercise a near veto on relevant public policy. Arguing that financial markets are as efficient and self-regulating as markets for other goods and services, they pressed the regulators to act more as cheerleaders than as discipliners. The Securities and Exchange Commission, one of the main US regulators, cut its enforcement staff by 11% in 2005-2007, and imposed 50% lower financial penalties.
The second structural change is related to income distribution. As both cause and effect of financialization, income became much more unequally distributed, especially in the US and Britain. Most of the increase in household income since 1990 accrued to a tiny proportion of households at the top, in "winner-take-all" fashion. In the US during the 7 year economic upswing of the Clinton administration, the top 1% of households captured 45% of the total growth in pre-tax income; and during the 4 year upswing of the Bush administration the top 1% captured no less than 73% of the total growth. By 2007 the top 1% received 23% of US disposable income, up from 9% in 1980. (By 1929 the top 1% had also received 23%, and the percentage had then fallen continuously to reach about 10% by 1970.)
The growing concentration of income at the top after 1980 was one of the main contributors to the fast growth of US financial markets; and financial markets in turn channelled income to the top of the distribution. US politics came to be shaped by those representing the interests of the financial sector and households at the top of the distribution. Naturally, they championed the "light-touch regulation" which enabled their rising prosperity and power.
Meanwhile, the average income of the bottom 90% of the US population actually fell between 1973 and 2006, having in earlier decades since the Second World War grown twice as fast as that of the top 1%.
You would think that in a democracy such a sharp polarization of incomes would generate countervailing pressures. Why not in this case? This is the third part of the answer as to why regulation failed. As income polarization increased, households in the bottom 90% began to supplement their stagnant real incomes by borrowing. US household debt relative to personal disposable income more than doubled between 1980 and 2006, from 65% to 136% (and 170% in the UK). This huge increase in borrowing – in the form of mortgages, credit card loans, auto loans and the like – helped to fuel the growth of the financial sector. The central bank assisted the process by encouraging so much lending for house purchase as to generate fast rising house prices after 2002, from which households in the bottom 90% were able to boost their consumption and pay for private education and health care by taking out home equity loans.
Households' debt-fuelled consumption helped to mitigate tensions which would otherwise have erupted in the face of income polarization, and kept American and British democracy ticking over smoothly – and regulation weak -- even as the top few percentiles of the population lifted free from the rest.
Capitalism tends to alternate between periods of liberalism, in which market activity is subject to little regulation, and periods when states and societies try to regulate markets, especially financial and labour markets. From the Second World War until about 1980 'interventionism' prevailed, accompanied by good economic performance in most of the western world. Since around 1980 the world has shifted towards liberalism, accompanied by worse average economic performance in the western world but excellent performance for the financial sector and for the top of the income distribution. The open question is whether the current global crisis will be severe enough to force a shift back towards a more social democratic form of capitalism, or whether we will go forward with a little tweaking of the current rules and face more serious crises in the next decade.
Robert Wade is Professor of political economy, London School of Economics, winner of Leontief Prize in Economics 2008