The Not So Great Transformation

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The Not So Great Transformation

Curtis R. Brooks

A Senior Thesis submitted in partial fulfillment of the requirements for the degree of

Bachelor of Arts in International Political Economy

University of Puget Sound

9 May 2011


The Financial Crisis of 2008 can be attributed to a change in ideology from Keynesian to free market that reflected a transformation of U.S. political and economic thought. The central question this paper will pursue is why did a shift in macro political economic thought, from the Great Depression to the deregulation period of the 1980’s occur and how it contributed to the Financial Crisis of 2008. The trend in ideology shifted from the dominant belief that intervention in the market was needed for economic stability in the 1930’s, to the belief that the markets would self-regulate and that state intervention was not needed in the 1980’s. I have found that a shift towards regulation and the trend towards economic liberalism pushed by a combination of corporate and state interest’s best illustrates Karl Polanyi’s transformation. The latest shift in market’s power over society was accommodated by a creed, that mixed political, economic and corporate interests justified the subjugation of society for the betterment of the market as the “right thing to do”. But it also allowed room for very risky practices by both the government and corporations, to take root and that grew into an open and free market. Apart from creating more wealth , the idea of curtailing the market’s ability, for political and economic stability, was looked down upon.

To understand the context of this shift I analyze two time periods; the Great Depression (1929-1939) and the deregulation period (1970-2000). By comparing and contrasting the predominant economic ideas and concepts of each time period and how they influenced actions of the day, one can see how a trend of deregulation and hypercapitialism contributed to the financial crisis. As a result, the financial crisis cannot just be attributed to the actions of banks but also the government. Reform can only come from a change in the predominant political economic ideology, apart from laissez-faire and deregulation to a more regulation controlled and sustained form of capitalism. It cannot come from just balancing budgets or systematic adjustments.


A vast amount of recent literature attempts to point out the causes of the Financial Crisis of the 2008. In some cases authors point out several causes that together contribute to the financial crisis but few attempt to look at the financial crisis from a wider view. Balaam and Dillman point to five factors seen throughout the literature that contributed to the crisis in some way or another.1 They are: weak regulation by the government, a lack of global governance, a global glut of finance, individual behavior (greed) and ideology. These five factors cumulated into a “perfect storm” that saw housing prices plummet and bank failures related to bad or toxic mortgaged based investments. The crisis spread to Europe and many other parts of the world and resulted in high unemployment, increase in debt and cuts in social programs because of the drop in government income.

My thesis will not focus on the crisis itself so much as explain why it occurred from a broadening context of historical changes in ideas of political, economic, and social institutions. In effect, my argument is that of the five factors offered to explain the current financial crisis more so than arguing else, ideas reflect a change in the U.S. and European political economy such that state- market relations dramatically shifted between the 1930’s and 1980’s resulting in not only the current financial crisis, but others as well.

The changes in political economic ideology began in the 1930’s and culminated with the Financial Crisis of 2008. Since the 1960’s, policy makers and corporations have reflect an increase in power of corporations and financial institutions generated an executive creed that promoted certain rules, incentives as well as unique culture. This creed was self-fulfilling and endorsed many irresponsible and irrational behaviors when it came to finance but also, trade and many other policies. This happened over the course of decades as the free market was promoted and state regulation of the economy was torn down. This allowed for the creation of unsustainable financial practices and ‘Too Big To Fail’ banking institutions. This pendulum shift from the teaching of Keynes to that of Milton Friedman and other supporters of free market ideas set in place the “seeds of destruction” of the current financial system and probably capitalism as we know it.

This paper first looks at the five most prominent causes of the current financial crisis and argues that ideology played the most prominent role in bringing about the financial crisis. This is followed by a historical overview examining this shift in political economic ideology through the key thinkers of the Great Depression and deregulation period against this ideological backdrop. I explain why this shift took place and how the U.S. economy changed, bringing about a shift in private power and entrenchment of the pervasive economic liberal creed. Finally this paper ends with concluding remarks and suggestions about how this problem might be fixed. For one of the unique problems of this financial crisis, was that the threat of failure came from within the system itself.

Part I: Five Causes of the Financial Crisis

There are countless causes for the current financial crisis; most have been proposed by academia, media, officials and experts. According to Balaam and Dillman (2011) they are; the U.S. balance of payments problem, the U.S. regulatory regime, a myopic ideology that promoted globalization and the “magic of the market”, individual’s behavior and finally weak global governance.2 Combined, these causes result in a perfect storm for which no single country, government or company alone was responsible. For the financial crisis required emergency international action by each industrialized country to address these problems.

The first contributing factor proposed was the global capital glut. Generally, the U.S. runs a balance of payments deficit, meaning the country imports more than it exports and invests heavily outside the U.S. This results in more money leaving U.S. markets than entering those same markets. In the last few years this figure has shot up due to overconsumption and excessive military spending.3 Normally the U.S. can sustain deficit spending. Through international trade and investment, other countries have accumulated surpluses with a large proportion being reinvested into the U.S helping to pay for US. debt, but countries, such as China, Japan, Germany and Saudi Arabia that at run balance of payment surpluses have been choosing to save their money instead. U.S. spending that may have been offset by revenue brought in by foreign direct investment, can no longer be sustain U.S. debt. 4 If those surpluses stay saved another crisis may be created based on the spending rate of the United States. The issue that may arise here is why those states did not invest in the U.S. when the market should have shifted their funds over through investment and speculating.

The second contributing factor proposed has to do with the failure of the U.S. regulatory regime in preventing the financial crisis from occurring. The agencies and the U.S. regime are charged with overseeing business transactions, to uphold the regulatory laws and to pursue any malicious activity. Since the crisis there have been two main camps about their role in the crisis: those who charge the regulatory regime for not doing enough, and those who said the regime was doing too much. Those who argue the regulatory regime was not doing enough claim that the formation of the “Too-Big-To-Fail” created too much systemic risk. Banks and business should not have been allowed to grow that big because it decreases market health and competition. Even after the government bailouts, the number of large banks had decreased making the situation worst in terms of preserving a competitive market. Another regulation that would have slowed the growth of these “Too-Big-To-Fail” institutions would have been to raise the required capital reserves each bank had to have at any certain time.5 By having to keep higher stores of capital, these institutions might not have made as many risky investments and even if their investments went south, the capital required would have helped offset the losses. More specifically a look into the role of regulating Morris points out that one of the causes of the financial crisis was the conflict of interest between the regulatory bodies and the banks themselves. The people who argue this point wanted more government intervention to help stabilize the market.6

However Taylor thinks the regulatory regime has interfered too much with the market. That the government’s involvement precipitated for the conditions, which lead to a financial crisis in the first place.7 It began when the government (F.E.D.) lowered interest rates, allowing money to be borrowed cheaply and creating a short-term boost in the economy. Easier access to money and governmental housing programs made it easier for loans to be obtained during the 2000’s. This perpetuated endless loans by U.S. and other banks that in the end failed. Some of these critics argued that these banks should be allowed to fail so that appropriate actions could be taken by the banks themselves to clean up their own mess.8The people who argue this point want less government intervention and believed that it was the government’s fault in the first place for not letting the market punish imprudent bakers.

The third contribution was a shortsighted ideology that promoted the “magic of the market” and along with it globalization. This ideology supported the free-market; that the market would be the most efficient way of doing business and by restricting protectionist measures to support producers. In Johnson and Kwak the ideology, in this case finance created a culture around elites that favored a mixed political laissez-faire and free market economic agenda.

This ideology also generated theoretical issues that in time led banks and policy makers to be too casual when addressing asset bubble symptoms. Balaam and Dillman argue that economists should have included human behavior, especially greed, along with rational choice ideas in their methodology.9 Many of the actions taken in rational consideration were not accounted for as being good for the system. Politicians and economists choosing to believe in this ideology did not consider the debt or development issues that arose from economic liberalism as ramifications of their beliefs.

The fourth issue, coincidently related, is individual behavior in the market system that contributed to the financial crisis. Illegal activities or illicit behavior are present in all political and economic systems.10 There are solutions to these very human characteristics. Lang make the point that a breakdown in corporate governance allowed for basic principals in modern risk management to be ignored. 11The high concentration of mortgage backed securities violated these principles and without management permission such a high percentage would have not been reached. During this process there was a tendency to accept unnecessary risk in the anticipation of asset growth. This was based on the assumption that assets would only grow in value in the near future. Suetin brings to light that these assets were overvalued because their value was bid up by debt created demand.12 The financial markets were devastated by unethical lending practices as argued that really could not be sustained.

One suggested solution would be left to individuals in the market to consciously avoid those financial institutions that display or promote this culture. But actions that may warrant attention usually go hidden from the public’s eye. Ponzi schemes and irrational investments can last up to decades before collapsing. Other solutions presented take the form of tougher regulation and harsher criminal penalties in regards to white collar crimes.13 In the wake of the financial crisis there have been calls to beef up surveillance and security to prevent these human traits from making themselves present on the public stage.

Increased regulation on the domestic level will have little effect on an industry that is very international. Companies will just move to countries with less regulation and continue business as usual elsewhere. That is unless there is a globally coordinated effort of governance is worked out amongst the world leaders. Some critics say regulation on the international level would hamper the positive effects, like integration, globalization would have much like the argument for the role of the government.14 But coordination on the international level on regulation is only part of it. The financial crisis forced many countries to work together when addressing economic rescue packages. Global governance have come a long way since World War II and the establishment of supranational organizations but these organizations should continue to push for greater cooperation to prevent contiguous outbreaks and their global consequences.

These five contributing factors; the U.S. balance of payments problem, the U.S. regulatory regime, a myopic ideology that promoted globalization and the “magic of the market”, individual behavior, and finally weak global governance played very important roles in bringing about the Financial Crisis of 2008 yet there is one that is more important than the others. Ideology, contribution number three, is the most important because it determines the beliefs and actions one might choose to make. The other four contributions are actions based upon this ideology and can be folded into a belief system behind their role in the crisis. This political economic ideology is highlighted in and by some of the various contributors to states of the financial crisis. I maintain that it is the values associated with economic liberalism that in effect act as a string that holds the other four elements together such that all five explain the crisis.

Part II: Birth of the Liberal Creed

Karl Polanyi, a political economist of the 19th century wrote extensively on the economic revolution that began in 18th century England. In his book The Great Transformation, Polanyi describes how the modern state and market developed hand in hand to form the market economy. The market was created by man to serve his purpose. For part of it resulted from the commodification of land , labor and capital over a period of roughly two hundred years. The Speenhamland Laws were a responsive measure to these things being commodified, as there was a shift away from serfdom to individual workers moving in a market. This brought about the destruction of the basic social order that had existed earlier in history. Many other things changed especially in the early 1800’s to complete this great transformation.

In England during this time there was a shift from single tradesmen to mass production method as the industrial revolution progressed. There was also a shift away from aristocracy owning the means of production to a merchant class, which also meant a shift in political economic interests. The state regulation of the economy was recognized but it served the merchant class to limit the state power, so as to benefit from trade and individual production. Merchants wanted to protect their profits, especially on grain at first, but later an manufacturing. They wanted to use the state to increase trade, wealth and power. Later this was put into practice by the empire to force open markets.

The organizing principle that united these merchants in a time when society was creating a market economy was economic liberalism.15 Liberalism is the view that individuals could compete in a constructive manner guided by reason and not emotion to maximize their earnings.16 This was rooted on the fundamental belief that humans are naturally rational and self-interested. Economic liberalism came about as a challenge to the predominate view of the 17th and 18th century, mercantilism. Mercantilists believed that the market economy should be used to support the state’s interests.17 Early economic liberals tended to value a market free from restrictions of trade or individual pursuits contrary to political liberalism which generally values egalitarian actions and market intervention. The term economic liberalism seen in the 1980’s, can trace its roots much farther back.

Two important supporters of economic liberalism were Adam Smith and David Ricardo. Smith argued that there were invisible forces which guided the nature of the market and that these forces constituted an ‘invisible hand’, made up of rational choices which added up to benefit all.18 David Ricardo, the champion of the emerging capitalist class, argued that economic restrictions such as the Corn Laws prohibited the workings of natural market forces. For Ricardo, these market forces were the most efficient way of producing goods to be sold and traded19

By the 1800’s a staunch critic of economic liberalism and capitalism in general was Karl Marx. Marx argued that the economic processes controlled the means of life and that private property was made to function with profit as its end.20 Marx argued that private ownership over the means of production, along with the constant push for profit created massive social hardship due to the exploited labor in the mills and industrial factories. The subsistence of the worker together with the value of labor, had been calculated and human life commodified all for the pursuit of higher profits for the growing merchant class and industrialists.

Economic liberalism was driving force behind the economic change of the 19th century. The power behind liberal values of polices grew as the society and the market became more interwoven. Economic liberalism would also prove to be the driving force of change in the 20th century after the Great Depression.

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