Profitability and the Great Recession

Ascension Mejorado, Manuel Roman

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781134638567
• Edition: 1
• Topic: Commerce
• Subtopic: Commerce Général

From the mid-1980s, investors in the US increasingly directed capital towards the financial sector at the expense of non-financial sectors, lured by the perception of higher profits. This flow of capital inflated asset prices, creating the stock market and housing bubbles which burst when the imbalance between stagnant incomes and rising debts triggered the banking meltdown. Profitability and the Great Recession analyses these trends in profitability and capital accumulation, which the authors identify as the root cause of the financial crisis, in the context of the US and other major OECD countries.

Drawing on insights from Adam Smith, David Ricardo, John Stuart Mill and Karl Marx, the authors interpret the relationship between capital accumulation and profitability trends through the conceptual lens of classical political economy. The book provides extensive empirical evidence of declining rates of US non-financial corporate accumulations from the mid-1960s and profitability trends in that sector falling from post-war highs. In contrast to this, it is shown that there was a vigorous rise of profitability in the financial sector from a 1982 trough to the early part of the twenty-first century, which led to the bloating of that sector. The authors conclude that the long-term falling accumulation trend in the non-financial corporate sector, highlighted by the bankruptcy of major automobile corporations, stands out as the underlying force that transformed the financial crisis into a fully-fledged Great Recession.

This book will be of interest to students and researchers in the areas of economics, political economy, business and finance.

1 Introduction

The path to the Great Recession

We present in this book an analysis of systemic trends in the US and other major OECD countries leading to the Great Recession, based on insights drawn from the conceptual framework of such classical economists as Adam Smith, David Ricardo, John Stuart Mill, and Karl Marx. We also provide extensive empirical evidence in support of the significance we attach to the structural determination of these trends. Thus, in line with the fundamental assumption of classical political economy, our approach highlights the link between profitability and capital accumulation trends. We argue that declining trends of US nonfinancial corporate capital accumulation from the mid-1960s to the present were caused by profit rates falling in that sector from their postwar highs to a 1982 trough, and, following a rebound extending to 1987, remaining lower and never recovering the high levels achieved in the postwar period. By contrast, the significant recovery of profitability in the financial sector from its 1982 trough outpaced the partial improvement of nonfinancial corporate profitability. We assume that businesses facing uncertain prospects regarding their new investments rely heavily on past profitability trends as a guide to the future. We argue that the bifurcation of financial from nonfinancial capital accumulation paths after the mid-1980s mirrored the growing gap between profitability paths in those two sectors. Rising profitability in financial sectors attracted growing capital flows into financial markets, including mortgage-backed securities. In the event, the formation of stock market and housing bubbles goaded the build-up of global investors' euphoria. Driven by competitive pressures and blinded by overconfidence in their chosen strategy, banks pushed the frontiers of profitable investments to perilous grounds that eventually triggered the system's crisis. In our view, however, weak accumulation trends in the nonfinancial corporate sector, the result of the inadequate restoration of profitability outside finance, transformed the financial crisis into a full-fledged Great Recession.

As the Great Recession gathered momentum, the illusions of sustained prosperity brought on by successive bubbles in the US economy since the early 1980s gave way to dark forebodings. Conventional economic theory failed to predict the slump, gauge its depth or offer a credible way out of it. Excluding the first half of the 1990s, financial euphoria did not trigger sustained accumulation upturns in nonfinancial industries: the investment boom of the early 1990s ended with a crash in 2001. Years after the onset of economic crisis, business confidence in the prospects for a speedy return to former levels of business activity remained low. The destructive force of the debacle has persisted long after its official ending. Despite the surge in corporate profits, investment spending since 2008 remained subdued. In a recent report on the state of household incomes and net worth published by the Federal Reserve, a bleak picture of the losses incurred since 2007 stands out. Median household income in the US fell 7.7 percent from its 2007 level and 6.3 percent since 2000. In the crisis aftermath, between 2007 and 2010, average family wealth declined by almost 40 percent. Household wealth in 2010 was 27.1 percent lower than the level attained in 2001 (Bricker et al., 2012).

The business outlook conveyed by leading analysts in the financial media remained mired in uncertainty despite the strong performance of major Wall Street banks. Stunned by the scope of the crisis, and smarting from the failure of conventional economists to warn of the impending crash, daring financial commentators turned to sources generally treated with derision. Anxieties generated by the unending malaise surprisingly drew the attention of Wall Street gurus to Marx's views, although as Bronfenbrenner (1989, p. 22) cleverly noted, such interest usually reflects the needs of a “rich man's Karl Marx.” In this context, going to Marx for counsel bore witness to the unease caused by the severity of the slump. The practice goes back over a decade before the financial crash in Wall Street challenged the belief in rational markets. Ten years earlier John Cassidy (1997) announced “The Return of Karl Marx” to skeptical New Yorker readers. That essay highlighted the views of an anonymous Englishman whose background, described as part of the “upper echelons” of the British civil service and the higher circles of a major Wall Street investment bank, presumably added weight to his opinions. “The longer I spend on Wall Street the more convinced I am that Karl Marx was right,” he said (Cassidy, 1997).

The editorial director of the Harvard Business Review, Justin Fox, in a recent commentary on the apparent disconnect between the widely publicized rise in US corporate profits and low rates of growth in output and employment, rued the lack of “good explanations of secular shifts in profits” (Fox, 2010) and also turned to Marx wondering if “is it finally time to read Das Kapital.” Fox emphasized that, contrary to widely held perceptions, “Pre-tax domestic nonfinancial corporate profits…are nowhere near record levels as a share of national income,” down by more than half the percentage reached in the late 1940s, well below the ratios reached in the decades before 1980. Fox suggested that despite subpar nonfinancial corporate yields, the great ascent in “financial industry profits and ‘rest of the world’ profits” documented by the Bureau of Economic Analysis raised overall corporate profits. Recovery remained lackluster because “for much of the business community, profits are not that high by historical standards.”

Raising the dreaded question, Nouriel Roubini (2011) wondered whether capitalism was “doomed” and settled on the possibility that “Karl Marx … was partly right in arguing that globalization, financial intermediation run amok and redistribution of income and wealth from labor to capital could lead [c]apitalism to self-destruct.” For his part, George Magnus (2011), senior economic adviser at UBS investment bank, suggested that lacking clear solutions to the persistent malaise in global markets, “Policy makers struggling to understand the barrage of financial panics, protests and other ills afflicting the world would do well to study the works of a long-dead economist: Karl Marx.”

Most other influential commentators skipped Marx altogether, bringing up instead the unstoppable force of technological change. Thus, while acknowledging the gravity of “current woes” in the Financial Times series on “Capitalism in Crisis”, Lawrence Summers called for “smart reinvention” of the economy in view of the fact that “few would confidently bet that the US or Europe will see a return to full employment, as previously defined, within the next five years. The economies of both are likely to be demand constrained for a long time.” His diagnosis extended to China as well, finding the root cause of the depression “deep within the evolution of technology.” (Summers, 2012).

Now well before Summers’ technocratic view of historical evolution gained popularity, Ricardo and Marx singled out technological progress as a crucial force shaping profitability and capital accumulation trends. It is widely acknowledged that new technology in the 1930s led to the displacement of farm workers and more recently manufacturing labor. Such structural changes did not simply issue from advances in the technical conditions of production but rather from their impact on profitability and capital accumulation trends.

Profitability: the missing link in Stiglitz's view of structural change

Joseph Stiglitz's account of structural change in the US economy since the 1930s to the present provides a powerful historical framework in which to set our empirical findings. Evaluating developments from the heights of society's welfare, however, Stiglitz's story of structural change overlooks the decisive role played by business profitability in shaping the nature of growth and depression. In our view, glossing over the power of profit to direct capital flows in a capitalist economy weakens Stiglitz's ability to sort out the direction of structural change. We, on the contrary, identify profitability as the driving force behind the historical growth and stagnation of agriculture, manufacturing and (financial) services. In our view of structural change, periods of depression represent critical stages in the evolution of capital and profits. Irving Fisher's insight from 1932 – that “A depression is a condition in which business becomes unprofitable. It might well be called the Private Business Disease. Its worst consequences are business failures and wide-spread unemployment” (Fisher, 2011, p. 19) – captures our views of the significance of profits and the impact of their decline upon capital accumulation.

Stiglitz (2011) believes that in order to assess the nature of the financial crisis triggering the Great Recession “we have to understand the economy's problems before the crisis hit.” In his view “the economy was very sick before the crisis… America and the world were victims of their own success,” meaning that labor productivity in manufacturing had surpassed the growth in aggregate demand, “which meant that manufacturing employment decreased. Labor had to shift to services.”

His argument provides a convenient setting to frame our own interpretation of the forces behind the financial excesses triggering the Great Recession: “the problem today is the so-called real economy. A crisis of the real economy lies behind the Long Slump just as it lay behind the Great Depression” (Stiglitz, 2012). In our view, the underlying cause of the current crisis was a declining rate of capital formation in the nonfinancial corporate sector compensated by the runaway growth of financial activities. Indeed, the long-term capital accumulation trend outside the financial sector fell after the mid-1960s, and, despite a cyclical but incomplete recovery of profitability in the 1980s, its level remained historically low.

Stiglitz has consistently refused to identify the financial sphere as causing the crisis, referring to the ensuing credit freeze as a mere pathology of the banking sector. He has repeatedly stressed that, while “the financial sector's inexcusable recklessness, given free rein in mindless deregulation, was the obvious precipitating factor of the crisis” (Stiglitz, 2011), the underlying cause should be found in the real economy. Stiglitz's view of the structural changes in the real economy behind the financial crisis provides an account of the accumulation crisis that transcends Minsky's narrow focus on the development of financial fragility due to overconfidence. In that light, Stiglitz's account will serve as a contrasting reference in our heterodox version of the crisis theory.

In Stiglitz's view structural changes in the US real economy, both in the 1930s and 2008, produced shortfalls in aggregate demand that only burgeoning debts were able to patch up for a time until financial defaults spread the slump throughout the entire system. From a Keynesian vantage, four years after the Great Recession of 2008 started, Stiglitz blames the lack of investment activity on a global-scale evidence for the persistent weakness in effective demand that blocks policy efforts to jumpstart the economy. While arguing that the “seeming golden age of 2007 was far from paradise,” he decries the depth of the current malaise accounting for “6.6 million fewer jobs in the United States than there were four years ago.” This is the first time since the 1930s Depression in the US that the unemployment rate exceeded 8 percent for over 4 years after the onset of an economic slump (Stiglitz, 2012).

Stiglitz's analysis stresses the similarities between the structural changes that prepared the grounds for the 1930s Great Depression and the more recent trends behind the Great Recession of 2008. As Stiglitz noted, since the 1930s to the present, the employment share of workers engaged in farm labor steadily declined from a peak of 20 percent to a 2 percent nadir. Between 1929 and 1932, farm incomes fell significantly, somewhere between one-third and two-thirds. This drastic reduction in employment and incomes happened because with “accelerating productivity, output was increasing faster than demand, and prices fell sharply” (Stiglitz, 2012). Stiglitz argues that in the 1930s, sustained growth in labor productivity in farming led to the massive displacement of labor from those sectors, along with the decline in prices and incomes; decades later, sustained growth in labor productivity in manufacturing had the same effect. In both cases, income losses led to excessive borrowing and caused the financial fragility that eventually crushed the financial system. The ensuing cascade of defaults triggered the financial crisis and the attendant credit cutoff aggravated the collapse of effective demand which had given rise to the financial excesses in the first place (Stiglitz, 2011, 2012).

In the 1930s, the economic malaise in farming spilled over into lower manufacturing sales, causing additional layoffs of manufacturing workers, and in a feedback loop a further contraction of demand for farming products. Confronted with the juggernaut of falling prices and diminishing incomes, while seeking to maintain their standard of living, farmers raised their bank borrowing. Unable to properly assess the extent of declining prices, incomes and employment, farmers and banks misjudged the risks of default, hence the growth of unsustainable debts. Then “The financial sector was swept into the vortex of declining farm incomes” (Stiglitz, 2012); today the implosion of the housing bubble triggered the financial meltdown. In both cases, the banking crisis precipitated the ensuing depression and extended its destructive power, but structural changes in the real economy caused it.

Stiglitz's valuable analysis: outside the mainstream, but not far off

We share Stiglitz's concern that the convenient assumption embedded in neoclassical theory “that markets are efficient and self-adjusting” lent credibility to deregulation of financial activities and contributed to the benign neglect of default risks involved in debt management (Stiglitz, 2010). Holding such assumptions explains why Martin Feldstein prefaced his presentation of an NBER volume dedicated to explore the Risk of Economic Crisis in 1991 with the observation that “the danger of a financial and economic crisis is more prominent in the thinking of policy officials and business leaders than in the research of professional economists.”

Belief in the self-adjustment of financial markets allowed Feldstein to confidently predict that despite “the fear of an impending major economic crisis” among the uninitiated, brought on by the various financial mishaps encountered in the 1980s, “including the failure of most of the less developed debtor countries to service their debts, the deterioration of capital among money-center banks, the large numbers of bankruptcies of the thrift institutions, the wide swings of currency exchange rates, the increase of corporate debt, and the stock market crash of 1987,” preventing a new financial crisis would simply require government policies designed to keep inflation low plus the implementation of asset diversification on the part of financial institutions (Feldstein, 1991, pp. 1–18).

Stiglitz readily recognizes that structural changes leading to systemic break-downs are part of capitalist development, and he rejects Adam Smith's claim of an “invisible hand” carrying out the task of securing a macroeconomic balance (Stiglitz, 2010). In the real world, persistent waves of “irrational optimism and pessimism” buffet global markets and lead to instability and crisis. As an example, in the wake of the 1997–1998 East Asia financial crises, Stiglitz (2011) underscored the growth of bank reserves in developing countries seeking to shield their economies from IMF “mismanagement.” In the event, this “precautionary” decision to channel export surpluses into bank reserves and thus stabilize their exchange rates led to excesses in the opposite direction. In Bernanke's (2005) view these practices generated a “savings glut,” a growing gap, that is, between global savings and investment.

Stiglitz's analysis, however, sought to emphasize the other side of what Bernanke's concept implied, namely the emergence of a world-wide “investment dearth.” Indeed, Stiglitz (2010) pointed out that such declines in investment opportunities played a central role in Keynes’ theory of crises, arguing that his interpretation provided a better guide to understanding the underlying causes of the slump. Why did the housing bubble inflate so much, despite falling nonresidential capital accumulation and declining interest rates? For Stiglitz a meaningful parallel exists between the antecedents of the Great Depression a...