POLITICAL ECONOMY OF THE FINANCIAL CRISIS AND REGULATION: FROM BRETTON WOODS TO BASEL II AND THE CURRENT CRISIS

Fernando Sánchez Cuadros

“Only after the speculative collapse does the truth emerge”

A Short History of Financial Euphoria

John Kenneth Galbraith

“This crisis is the fruit of dishonesty on the part of financial institutions,

and incompetence on the part of policymakers”

Joseph Stiglitz

Introduction

The current financial crisis has revealed deep inconsistencies in and the inappropriateness of financial regulation implemented in the early 1980s, during what became known as the “conservative revolution.” To the United States, the “new concept” had a very specific function: shoring up the eroding foundation on which US hegemony was built.[1] Increasing imbalances in foreign trade and public finance, inflationary pressure, oil shocks and their geopolitical ramifications, loss of competitiveness in industrial manufacturing, the nationalist challenge of the Third World, and a never-ending Cold War highlighted the inability of the United States to remain the backbone of the world order constructed at the end of World War II and created an unacceptable cost for the economic adjustment that would be necessary to reverse the trend toward a weakening of the profit rate and the erroneously labeled “deindustrialization” of the capitalist economy.

The response was to promote a restructuring of the world economy, eliminating all vestiges of a “neutral” monetary pattern based on the dynamics of the dollar and the financial system. Reagan’s goal was to reverse declining profits from the financial portion of capital and turn it into the new international mainstay of accumulation of capital. That simple fact completely conditioned thinking about the relationship between the financial system and the economic system as a whole, leading to growing autonomy of financial activity; in other words, the financial became separated from the real through a rapid process of financial internationalization promoted in the Euromarket. This process reached a turning point with the emergence of petrodollars and the indebtedness of unbalanced economics, which accompanied that phenomenon in developing countries, while developed economies were engaged in accelerated technological change and were trying to reverse the downturn in terms of trade that occurred in the second half of the 1970s and wage pressures on profits. There were additional factors in the United States because of the country’s hegemony.

Deregulation of the financial system gave economic dynamics the impetus needed to attain those goals, and the United States became the foremost promoter of liberalization and opening markets, including financial markets.

The problem of financialization

Accumulation of capital and financial hegemony

Capitalism’s last great cycle of expansion occurred after World War II, in the 1950s and 1960s, as a result of agreements among the world powers at the time, including those that had opposed each other during the war. The conviction that the distribution of markets through warfare was no longer acceptable[2] was accompanied by the design of an economic architecture that looked to free trade and cooperation to encourage expansion of investment to increase employment and income. The liberal utopia of competition and complementarity appeared to finally have found fertile ground, after its collapse in World War I and the crisis of the 1930s. That model, however, assumed the leadership of the United States, which guarded its hegemonic aspirations closely.

This expansion cycle came to an end in the second half of the 1970s, because of a steady decrease in the benefits realized by companies due to excess installed capacity, wage pressure and greater competition for markets spurred by the decrease in revenues, competition that was addressed through technological innovation. Conflicts between capitalists, between capital and labor, and between states representing national capital marked a transition between 1965 and 1973.[3] The Welfare State’s labor victories meant higher costs for companies, which encouraged investment in countries where lower wages or access to cheaper raw materials boosted competitiveness, leading to intercapitalist competition. Strong labor movements were accompanied by the rise to power of political parties of workers.[4] In the second half of the 1970s, the increase in prices of raw materials, especially petroleum, put even more pressure on profit recovery.

From the US standpoint, at the state level the conflict could be solved by devaluing the currency and abandoning the gold standard, putting an end to the Bretton Woods accords. The United States was overwhelmed by pressure on its current account and a growing current account deficit; “wracked domestically by intense social conflicts stemming from the Vietnam War and civil rights, the political price of subjugating monetary circulation to the discipline of the gold standard had a clear social component that also included the risk of alienating workers from the ideologies and practices of the dominant bloc.”[5]

Capital’s other response to declining profits was foreign investment. In the quest for lower wages, the ability to sustain workers’ pay rates weakened in advanced countries. Once the policies promoted by the Reagan and Thatcher governments undermined the work force as a class, capital was “redirected from low- and medium-income areas toward the United States.” The choice of an inflationary (as opposed to deflationary) route to address the crisis of the 1970s was more decisive and effective than international capital mobility in eroding the labor movement’s gains.[6] This was the greatest achievement of Ronald Reagan’s monetarism.

Inter-capitalist competition and capital-labor relations alone were not responsible for economic events of the 1970s and the financialization of capitalism. The Vietnam War was a key factor because of its impact on budgeting and the balance of payments. This reflects one factor underlying the US economy’s loss of industrial power: the fight against communism meant that besides serving as lender of last resort, liquidity source, capital exporter and importer of surplus from other countries, the United States became the West’s military umbrella. The Vietnam War occurred in this context, bloating defense spending. For the United States, containing communism also meant confronting nationalist movements in the Third World, and many military fronts were opened. According to Arrighi, it was the cost of the Cold War that finally led to the devaluation of the dollar, the end of parity and the resulting collapse of Bretton Woods. And while devaluation of the dollar transferred part of the cost of the adjustment to other advanced economies, especially the United States’ closest competitors, the main goal of getting out of the agreements was “to free the US government’s fight for domination of the Third World from monetary restrictions, [giving it] unprecedented freedom to siphon off resources from the rest of the world by simply issuing its own currency.”[7] This is the essence of financialization. The United States saw Bretton Woods as a mechanism for turning its economic, trade, financial and technological supremacy into hegemony based on industrial superiority. The end of the Bretton Woods accords was necessary to reposition that hegemony in its financial system.

During the 1960s, while the system of fixed parity and capital flows regulated by monetary policy was collapsing, much of the surplus generated by petroleum exporting countries was concentrated in the international banking system, which enabled it to serve as intermediary for the “petrodollars.” Inflationary pressures from excess liquidity accumulated during the rapid expansion of investment and world trade after World War II, exacerbated by the oil shock and a recessive trend stemming from overaccumulation of capital during the “golden quarter-century of capitalism,” slowed demand for credit from large conglomerates traditionally served by the international banking system, which had to look to new markets. This enabled governments of developing countries, especially those with serious trade and budget imbalances, to get unconditional, broadly discretional loans from multilateral financial bodies.

This was the context for the first structural change in international financing, the privatization of financing, when the private international banking system became the main intermediary for surplus oil money. Attempts to channel at least some of the “petrodollars” through a fund managed by the United Nations to finance development were unsuccessful, leaving the task – and the revenues that could be generated with this liquidity – entirely in the hands of the international banking system. If the Bretton Woods accords had remained in effect and financial intermediation had not been under the control of the private banking system and subject to its profitability criteria, initiatives to generate increased development funds probably would have had a greater chance of implementation. But other urgent factors influenced the redesign of the financial architecture at that moment.

With the 1944 agreement, the United States won the “right” to go into debt in its own currency with no adjustments to its economy, in exchange for supporting, with its dollars, the liquidity that the international economic system would need to keep trade and investment from stagnating, operating as lender of last resort and guaranteeing that dollars could be freely converted to gold. It replaced the European Union as lender of last resort, ignored free convertibility, and thereby put an end to the system of fixed parity. And while it offered liquidity through its current account deficit, it was also the source of the greatest demand.

Capitalism and the competition it spurred between the major powers, once they returned to the economic scene as competitors and rivals, combined with the US strategy of basing its power on military might and the dominance of the dollar, began to erode the foundations of industrial supremacy and weaken hegemony. Toward the end of the 1970s, various international crises accentuated that decline, but did not weaken the United States’ hegemonic greed. This was the era of the conservative revolution led by Ronald Regan and the underlying change in monetary policy. The decline over the next 20 years (1973-1993) was accompanied by efforts to modify North-South relations. The massive Third World debt would play a key role in this process, channeling overabundant liquidity and opening market floodgates to flows of goods, services and capital, expanding the market for a supply that was steadily increasing because of constant technological innovation.

Although the cutback in financing for developing countries through sovereign loans was due to the growing risk of accumulating short-term debt with high interest rates and a marked deterioration of the debtors’ exchange rates, this process coincided with the shift to a restrictive monetary policy in the United States, the need to finance increased military spending, and the combined effect of the drop in petroleum prices and the rapid accumulation of surplus in Japan’s current account, along with its preference for the bond market over bank savings, all of which helped reroute sources of liquidity from the Middle East to Asia and transfer the leading role of commercial banking in capital markets. The United States had no problem in fighting for the resources used to manage an increasingly revolving external debt at the worst moment for debtor countries. At this point, the second structural change in international financing, the securitization of financing, occurred.

In the 1980s, the financial dry spell played a decisive role in the adjustment process and, subsequently, in the nature of the reform implemented in the 1990s. This process occurred within the framework of what became known as globalization, referring to an accelerated worldwide flow of production, trade and finance. For developing countries, the reform meant increased integration into the world economy through:

  • The opening of their markets via trade liberalization, which usually failed to consider the need to adapt the productive apparatus to make it competitive, and which assumed that mere exposure to competition would be sufficient to make production competitive. This process ignored the impact of cost differentials, technological know-how, and access to distribution and supply channels, in which conglomerates clearly had a competitive advantage, and eliminated the need for an industrial policy. Production costs have been high, and while exports increased in many cases, there has not been sufficient diversification in types of goods and markets. Economies like those of Brazil and Southeast Asia, which took greater advantage of the trade opening, tended to have a more complex, more industrialized productive apparatus.
  • The second means of integration, financial liberalization and deregulation, was even more harmful, because it conditioned financial intermediation on the urgent need to attract capital to complement scant internal savings. This was aggravated by the production sector’s tendency of import and the rigidity of its export structure; in most cases, financial integration has not increased the capacity to retain surplus or stimulate internal savings. Instead, it has perpetuated the financial dependence that tends to accompany technological dependence, which cannot be eliminated by opening up trade. In the 1990s, the “return” to capital markets was strongly determined by low US interest rates and the permissiveness granted to financial capital with liberalization. As a result, short-term capital predominated.
Financial crisis and architecture of the international financial system

The architecture of the international financial system (IFS) consists of a series of institutions that regulate and supervise international financial activity, the norms, regulations and agreements that serve as the basis for this oversight, and public and private agencies that participate in international financial transactions.

In recent years, IFS regulators have been convinced that to function properly, domestic financial systems must not only become part of the IFS, liberalizing and opening their markets, but must also establish prudent regulation, balancing the national risks of financial activities with careful, responsible performance by financial intermediaries.

This conviction has become stronger, and emphasis has shifted from opening and liberalization to orderly liberalizationof the movement of capital. This shift essentially acknowledges that the rapid opening of capital markets has weakened, rather than strengthened, national capital markets, increasing contagion and the vulnerability of financial systems. This increased financial fragility is occurring in a milieu in which the speed of capital flows has accelerated markedly because of communications technologies and computer systems, which reduce the time and cost of capital movement and make it possible to profit from short-term market advantages created by price differentials in financial assets, interest rates and exchange rates.

Internationally, especially since the late 1990s, various measures have been taken to strengthen the IFS. The International Monetary Fund (IMF), World Bank (WB), Bank for International Settlements (BIS), financial supervisory bodies coordinated by the Basel Committee, and the Group of 30 — an international committee of well-known figures in the financial world, academia and international bureaucracy, which acts as consultant or adviser to multilateral bodies and the Group of Seven (G7) for multilateral decisions about the international economic system — have taken on the task of studying, designing and promoting measures to strengthen the IFS architecture.

Many of these efforts have focused on improving regulation and supervision of the financial system. This approach emphasizes provisions aimed at the orderly liberalization of capital flows, reinforcing market supervision, improving international oversight of national economic policies by promoting good practices and transparency in monetary policy, providing more rapid and higher-quality information, expanding collaboration and consultation at the regional level, and including the private sector in the prevention and solution of financial crises.

The sequence, depth and scope of the crises that began in 1994 revealed the link between financial fragility and the deep, accelerated liberalization of capital markets, which allowed capital to move from one market to another with no regard for the impact of sudden, massive inflows and outflows on domestic markets. Debate over the new international financial architecture has therefore emphasized the need to better foresee crises and mitigate their impacts, creating an environment that would leverage the positive effects of capital flows while controlling negative impacts.

Private capital is extremely mobile, partly because of technological facilities, but also because of the accelerated deregulation and opening up of financial systems in industrialized countries in the 1970s and 1980s, and in developing countries since the 1980s. These changes are closely related to the development of the IFS since the 1970s. The current financial crisis demonstrates that regulations have been less effective in governing financial entities’ accounting (there has been a proliferation of off-the-books operations), leveraging with little capital, the uncontrolled profusion of hedge funds and structured products, and the creation of a murky financial system in which many financial institutions could take on banking functions, and in which conditions for requesting and granting loans were relaxed.[8] This dynamic and the corresponding regulatory weakness resulted from financial dominance that not only went unquestioned, but was also encouraged by both regulatory bodies and monetary policies.