Liquidity As Brake on Real Growth

The excess liquidity created since the 1970s—over and above what real investment has been able to absorb—has been flowing into financial asset investment. It has become far easier to create additional liquidity than it has been to find real investment outlets for it. The amount of liquidity has been so massive, and the growth of related debt levels so rapid, that governments and their central banks have been losing control of both—excess liquidity and incessant debt creation. Not surprisingly, the shift to financial investing has followed.

After having unleashed finance capital in the 1970s and 1980s to address the crisis of the 1970s, to expand capital globally to open new markets, to establish the unstable alternative to the Bretton Woods international monetary currency and trading regime, the system has not been capable of containing, managing or regulating the excess liquidity nor the excessive debt creation that has erupted in turn.

The historic contradiction is that the liquidity explosion set in motion in the 1970s is becoming a brake on economic growth it is supposed to generate. The massive liquidity and the ever-rising debt it has created have become a destabilizing force for the system, as financial asset investing crowds out real asset investment, and in turn is generating a host of related problems like chronic low job creation, stagnant wage income growth, weak consumption trends, slowing productivity, drift toward goods deflation, rising income inequality, and constantly emerging financial asset bubbles worldwide.

Restructuring Financial and Labor Markets

The trends associated with liquidity, debt, the shift toward financial asset investment and speculation, the slowing of real asset investment, the growing spread between the two forms of investment, the consequences for income growth to pay debt, the drift toward goods deflation amidst proliferating financial asset price bubbles—all together contribute toward fragility in the system. But this fragility does not occur in a vacuum. There is an institutional framework that is both the product of these trends and simultaneously a determinative factor of the trends themselves. Minsky referenced the institutional factor as relevant to financial fragility. Keynes spoke of the professional investor as responsible in part for instability in enterprise (real asset) investment. Both left room for further development of these contributions to understanding financial instability.

Financial Market Structural Change

The financial structure of global capitalism has changed tremendously and fundamentally since the 1970s. There has been an explosion of financial institutions that have played a key role in channeling the massive liquidity and credit injected into the global economy over the past four decades into investment projects—most of which have been financial asset in nature. New financial securities and products have been created for this excess liquidity to purchase. That means new, liquid financial markets have been created in which to buy and sell these financial securities. But investment is made by investors, i.e. by agents, who are both collective and individual. Financial institutions, old and new, buy and sell the new securities in the new markets. So do super wealthy individuals, who do so directly or else place their money capital in the hands of these institutions to invest on their behalf. They constitute the new ‘finance capital elite’ in the global economy—i.e. the inheritors of Keynes’ notion of the ‘professional speculator’ and of Minsky’s notion of the institutional framework behind financial fragility.

By new financial structure we mean this network of financial institutions sometimes called shadow banks, the liquid financial asset markets in which they speculate worldwide, and the new finance capital elite composed of the management of these shadow institutions and the 200,000 or so global very high and ultra high net worth individuals who invest either through the institutions or directly themselves in the financial markets. Conservative estimates indicate this network of global shadow banks and high net worth investors today control approximately $100 trillion in investible liquid and near liquid assets.

It is this new financial structure of institutions, markets, asset products, and agent investor-elites that together constitute the definition and meaning of ‘financialization’. Other narrow definitions based on share of total profits or employment, or the ‘FIRE’ (Finance, Insurance, Real Estate) sector, or influence in government quarters, or other variables are but ‘symptoms’ of financialization further defining the term.

Shadow banking expansion is a concomitant institutional expression of the key trends and growth of systemic fragility. The shadow sector continues to grow, evolve in form, and deepen within the global capitalist economy. Commercial, regulated banks have become integrated with the shadow sector in various ways, including institutionally. That was one of the problems that led to the generalized credit and banking collapse in 2007-09. It was the investment banks (Bear Stearns, Lehman Brothers), the dealer-brokers (Merrill Lynch), insurance companies (AIG), mortgage companies (Countrywide), GE Credit, GMAC, Fannie Mae-Freddie Mac, and others—all shadow banks—that first collapsed. Because of their integration with the commercial banks, these too were dragged down. Major banks like Citigroup, Bank of America, WaMu, RBS and others in the UK, and Eurozone banks in Belgium, Ireland, Iceland and elsewhere went ‘bankrupt’ or were put on life support by governments even though technically insolvent (e.g. Citigroup and Bank of America).

Shadow banking has also spread into non-bank multinational corporations. GE, Ford, GM, and others have themselves long operated ‘finance company’ shadow banks. And today a growing percentage of multinational companies are de facto, in house, shadow banks as well—what might be called ‘Deep Shadow’ banks. Shadow banking is spilling out into new corners of the economy all the time, pioneering new ground in online finance and what’s called ‘crowd funding’. All these institutions would not exist, however, were it not for the excess liquidity available for them, and their elite investors, to invest and for the proliferating liquid markets in which they invest. Nor would they exist without the financial innovation that has created the financial products which they buy and sell in those markets.

Considering just the history of the US economy, every serious ‘great’ recession and depression since the early 19th century has been associated with some form of shadow banking engaging in speculative financial asset investing. Excess liquidity and debt have always been a prelude to a financial banking crash that then dragged down the real economy. In the wake of each crisis, banks and shadow banks were regulated. However, after a period new forms of shadow banking arose again and the shift toward financial speculation and instability resumed.

The restructuring of the financial sector in the US and UK economies did not just happen. It was the outcome of conscious policy initiatives that began in the late 1970s and early 1980s, and continued to evolve thereafter. Changes came slower and later in Europe and Japan. And the penetration of shadow banking and financial speculation in China only dates from the end of the 2009 global crash, but has accelerated there the fastest to date. Policies included not only pushing financial deregulation but enacting special tax privileges, ease of institution start up, permitting opaque trading of securities (especially derivatives), and other measures.
Although a number of ‘official’ reports on shadow banking have appeared in recent years, most have defined it narrowly by focusing on a few selective characteristics. Some associate the institutions with certain financial markets and instruments. But none tie the institution, instruments and markets involved with the ‘agents’ element—i.e. the finance capital elite of professional investors and speculators worldwide.

Creating and expanding the ‘markets’ and financial instruments traded was even easier. With the exception of equity, commodities, and bond ‘exchanges’ most markets are virtual and electronic. And even those are increasingly redirected in part to what are called ‘dark pools’, where only the financial elite and institutions get to trade stock and other securities, in total secret, invisible to the rest of the John Doe trading public. As for financial engineering of new securities, hire a couple of ‘whiz kids’ from the Wharton School of Finance and they develop the new ‘games’. It all begins to resemble less a form of investment per se, and more a form of financial ‘consumption’ by the very high net worth financial elite.

As the financial sector restructuring continued to evolve through the 1980s and 1990s, the number and size of shadow banks, of liquid markets, and of securities increased several fold—as did their profits and the total investible assets under their control. As the structure developed so too did the scope of the financial investing. Innovations like ‘securitization’ of various financial asset classes and the rapid expansion of derivatives accelerated the investing in financial assets. The great returns fed the continuing structural change, which encouraged even greater returns. By the 2000s, financial assets were being created out of anything that might have some kind of income stream—like bonds issued based on a rock star’s concert tour or from a UK pub chain’s beer sales. And securities were merged with other securities to create a third security, which was then ‘marked up’ and resold. For example, mortgages on homes were merged into mortgage bonds, marked up and sold. The mortgage bonds were then ‘securitized’ by being merged with, say, Asset Backed Securities (ABS), marked up and resold again as a ‘collateralized debt obligation’ (CDO). CDOs were combined with other CDOs to create a synthetic CDO and resold. And credit default swaps (CDS) were then issued as insurance contracts sold on the CDOs in the event this shaky edifice of securities might somehow tumble.

All along the way, debt was increasingly leveraged in the purchases of the various tiers of products. Financial returns rose so long as asset prices did, and more debt and leverage occurred. Escalating debt meant rising financial fragility. But the fragility from debt was offset, shielded and obscured by rising income streams from the price appreciation—so long as prices continued to rise. Once the price of financial assets began to slow, the income stream vanished. But the debt remained. And as asset prices turned down, the offset to fragility from rising price and profit income evaporated. Now financial fragility was driven not only by high debt levels but by the second variable, income, rapidly falling as asset prices collapsed. All that was 2007-09.

Today the financial structure continues to evolve. New online forms of shadow banks are rapidly evolving. New derivatives are being created. Asset management products are the hot item in China, for example. And the financial elite continue to move their money around the numerous global liquid financial markets. Out of Euros, pesos, and Canadian and Australian dollars into US dollars. Out of commodity futures into US and Euro junk bond debt. Out of China stocks into high end US and UK real estate property. Out of emerging market stocks into Exchange Traded Funds (ETFs). Out of betting on Chinese stock price rises into betting on a Chinese stock price collapse.

What the preceding describes is how financial fragility, to use Minsky’s term, has continued to rise since 2009. The private business debt levels have escalated, as perhaps five trillions of dollars in junk bonds and corporate investment grade debt, leveraged loans, and other securities have been issued since 2009. That debt will remain unless defaulted or written off. But the income or cash flow (to use Minsky again) can easily evaporate should asset prices fall—i.e. should a major China-precipitated global stock market correction occur, or bond prices rise too rapidly once the US and UK start raising interest rates, or oil prices fall below $40 a barrel and commodity prices continue to tumble further. Then both debt and income decline begin to reinforce each other. Then fragility accelerates, perhaps to a point that may ‘trigger’ a financial instability event of global proportions.

Minsky, Keynes and others focused on the financial side of fragility, i.e. on bank and non-bank business fragility driven by the debt-income relationship just noted. Minsky mentions household fragility, but sees it occurring as a consequence of spillover effect from deteriorating financial fragility. But this is incorrect. Spillover may occur. But there is a separate dynamic of structural change—in labor markets and impacting wage incomes—that has been developing in parallel to financial structure change. Labor market change also began in the late 1970s and has continued to develop ever since.

Labor Market Structural Change

Similar to financial sector structural change, labor market change has not occurred by accident or by some natural process. It too has been the consequence of conscious policy decisions made by politicians, government, and industry business leaders since the late 1970s. And since 2000 those changes have been further intensified.

The rise of wage incomes has slowed significantly throughout the advanced economies due to the general shift from hiring full time, permanent workers to hiring part time and temporary workers—the latter at lower rates of pay and weekly total earnings due to shorter hours. Everywhere in the advanced economies this has been a major trend. It is a practice that dates from the 1980s but has accelerated after 2000. Additional wage compression has occurred as these workers are denied normal retirement eligibility or have their retirement benefits reduced and, in the US, are forced to pay more for less healthcare benefit coverage. Workers either must pay out of pocket for the loss, or do without retirement income, thus lowering their real wage income further.

The more frequent and deeper recession cycles and the slower job recoveries that have typically followed have also reduced wage incomes. Secularly for decades now, tax incentives for moving companies and jobs offshore have gutted formerly higher paying jobs and thereby also reduced incomes in the United States.

Minimum wage and overtime pay laws have atrophied over the period with the same effect. Forms of wage theft by service sector employers have also increased. More young workers are desperately undertaking ‘wage-less’ internships with employers in the false hope of someday being hired to a real job. Meanwhile, employers turn over and ‘churn’ them in order to continue to get others to work without having to pay them. The so-called ‘sharing’ economy (Uber, Lift and other transport companies) is destroying jobs and income for taxi drivers and public transport workers, and this trend threatens to break out into other industries enticing more employees to work part time for less and with no benefits. The net income declines, as those who gain income realize less additional income than is lost by others losing their jobs.

Unions have been increasingly decimated or destroyed since the 1980s, thus eliminating union wage differentials that provided more income for unionized workers. The institutional vehicle for unions achieving wage differentials—i.e. collective bargaining—has been chipped away for decades. The main tactical weapon, the right to strike freely, has been circumscribed and all but effectively prohibited. Laws and agency rules have wrapped a legal web around union organizations and their activities, funneling unions and their members into an ever narrowing field of permissible activity.

The reduction of what were once ‘export-import’ wage differentials has been added to the elimination of union wage differentials with the same effect. Free trade has replaced the export-import wage differentials in advanced economies, with new jobs with lower wages. Meanwhile, no firm evidence is provided that shows net wage incomes from free trade has risen to equal or offset the net wage income loss in advanced economies.

All these developments reflect major changes in labor markets, especially in the advanced economies. Many of the above labor market changes originate in the production process, introduced by employers as cost saving initiatives to offset declining productivity and profits. But governments have been totally complicit in the process, passing legislation and rules that encourage employers to introduce the labor market changes. Governments then subsidize those changes with tax incentives, and eliminate previous legal limits and restraints on the practices that previously existed.

Occurring first most intensively in the ‘core’ of the advanced economies, US, North America, and the UK, similar changes in labor market conditions that reduce wage incomes have since been introduced or proposed in Europe and Japan under the cover of what’s called ‘structural reforms’ or, more explicitly, labor market reforms. These structural reforms are designed to compress wage incomes in order to make exports more competitive to steal growth from competitors. Japan and Europe are today particularly engaged in introducing and expanding labor market reforms—aka wage and benefit compression—to boost exports and domestic production at the expense of other competitors. Labor market change along the lines introduced by the core advanced economies, in effect now for decades and intensifying, are therefore also spreading geographically. They are becoming one of the several defining characteristics of 21st century global capitalist economy.

Labor market structural changes thus have the consequence of reducing real wage incomes for the majority of households and consumers. Stagnant or declining real wages means a rise in consumption fragility, all things equal. But wage stagnation also results in a rise in consumer household debt, as households attempt to maintain living standards under pressure from stagnating and falling wage incomes by taking on more consumer debt. Fragility grows more or less simultaneously from two directions—from slowing consumer incomes and rising consumer debt. The result is reflected in the growing share of debt financed consumption, compared to consumption growth reflecting income gains, in total household consumption.

The growing share of debt-induced consumption by households in recent years not only raises consumption fragility. Household debt also has the effect of dampening government fiscal multipliers, making traditional fiscal policies less effective. It is one reason why economic recovery since 2009 has been so anemic. In that sense, residual household debt after 2009 is similar to business and bank debt, which dampens the effect of money multipliers on non-bank borrowing, and in turn lowers actual and potential real investment.

Structural Change and Fragility

Both financial restructuring and labor market restructuring have steadily raised fragility over time. Both lead to excessive debt. Financial restructuring has enabled and assisted the shift to financial asset investing, facilitating the leveraging of increasing amounts of debt. Independently, labor market restructuring has resulted in stagnating and declining wage incomes, requiring households to turn to more debt in order to maintain living standards and consumption. While both financial restructuring and labor market restructuring have their own independent dynamic contributing toward fragility, the fragility they create in their respective sectors—financial and households—also feedback on each other and thus intensify the fragility of each.

A final observation is that financial sector debt has played a larger role in generating financial fragility than household debt has toward consumption fragility. For example, in the US data shows that escalation of total debt—business, banking, consumer and government—has been mostly business debt and most of business debt has been financial institutional debt. Data by the Bank of International Settlements corroborates this trend worldwide. It is private sector debt that has accelerated fastest since 2009 and that has been mostly corporate debt, not consumer debt. Since 2000, and 2009 in particular, government policies have restored income to business and financial sectors. So declining income has not been a major contributing factor to financial fragility.

However, this has not been similarly true for households and consumption fragility, where governments have not restored incomes to the majority of households. Consequently, declining income has been a contributing factor, along with rising debt, to households. Non-government policy forces also contribute to this decline. Financial asset prices recover and accelerate after a financial crash much faster than labor prices (i.e. wages). Financial institutions recover more quickly than households after a crash and recession. Unlike the business and financial sector, households cannot raise their prices—i.e. wage—incomes. Continued labor market restructuring holds down wages even in the recovery from recession phase, whereas continued financial market restructuring serves to raise financial asset prices and therefore incomes during the recovery phase. That is a fundamental difference between financial restructuring and labor market restructuring.

A consequence is that households remain more consumption fragile in recovery due to the dual effect of stagnating wage incomes and rising household debt than financial institutions, banks, shadow banks, etc., that experience debt escalation in recovery but also income (cash flow) recovery as well that serves to postpone financial fragility. That is, until financial asset prices (and incomes) collapse in another crisis. Then financial fragility accelerates for financial institutions as well. It is only then—in the immediate crash and contraction phase—that the two forms of fragility—financial and consumption—begin to feed off of each other and each causes the fragility of the other to worsen in tandem.

Fiscal-Monetary Policy: From Stabilizing to Destabilizing

Both fiscal and monetary policy must be considered among the nine key trends that are associated with rising systemic fragility and therefore instability.

Mainstream economic theory views fiscal and monetary policies as serving to restore stability in the system once a financial crisis and/or recession occurs. Fiscal policy—i.e. government spending and tax measures—are viewed as providing a necessary stimulus when either a financial crash or real contraction occurs. Taxes are cut. Spending is increased. GDP recovers. For monetary policy, the central bank increases the money supply through what are called ‘open market operations’, or by reducing reserves private banks must keep on hand and not lend, or lowering the central bank’s interest rate at which private banks may borrow from it. Mainstream theory explains this leads to lower interest rates that stimulates borrowing from banks. This all seems logical, but it’s not how the system works—not since 2009 or even 2000 in the advanced economies especially. The question at this point is how and why do traditional forms of fiscal and monetary policies today, especially in the advanced economies, contribute to systemic fragility.

The tendency of monetary policy to lead to more fragility not less, is the most obvious. Take central banks’ pumping excess liquidity into the global economy ever since the end of Bretton Woods in 1973, followed by the elimination of controls on global capital flows in the 1980s, and the technology revolution in the 1990s that accelerated money flows electronically by many fold. The massive liquidity injections have contributed significantly to debt, financial asset speculation, and other structural factors that have resulted in escalating fragility. Central bank supervision of the private banking (and shadow banking) sector has proved a colossal failure. That too has allowed, even encouraged, the almost unaltered rise of financial asset investing and speculation. Bank policy of more than seven years of near zero, and real zero or lower, interest rates has contributed mightily to household consumption fragility as tens of millions of households dependent on fixed interest income have witness their income streams from interest virtually disappear. Zero interest rates policy amounts indirectly to a transfer of income from retirees and others on fixed incomes to banks, shadow banks, and speculators.

Monetary policies, both traditional (open market operations, etc.) and emergency (special auctions, quantitative easing, QE, and zero-bound rates) have bailed out the private banks since 2009, at least in the US and the UK, but have done little or nothing for stimulating the real economy. Estimates are that it now takes four dollars of central bank money injection to get one dollar of real GDP growth, compared to two dollars for every dollar in previous decades. That’s a ‘multiplier effect’ of only 0.25. That’s true not only in the advanced economies, like the US, but apparently, by latest estimates, in China as well. Central bank policies of massive liquidity injection as the primary policy response to a crisis may bail out the banking system, but only temporarily. That same liquidity that bails out the banks in the short run, also adds to the excess liquidity that simply leads in the long run to more debt and more financial speculation that ends up creating another crisis again. So monetary policy has been, and remains, only a temporary palliative to the fundamental causes of the crisis and, in fact, actually exacerbates those same causes over the longer term. Such monetary policy is like giving a terminal cancer patient a massive dose of chemotherapy, which only buys time for the patient, makes him sicker, destroys his immune system, and weakens him for when the patient’s condition worsens once again.

Fiscal policy fares no better so far as reducing fragility is concerned. In theory, government spending targeting consumer households should raise household income and thus reduce consumption fragility. But the composition and timing of the spending is what counts, not just the magnitude of government income support. If the spending is in the form of subsidies it only provides a temporary stimulus that disappears as soon as the subsidies run out. If spending is on long term infrastructure projects, especially if capital intensive instead of labor intensive, then such spending also has little effect for the same reason. And if the stimulus is in the form of tax cuts, in a high debt and fragile household scenario most of the tax cuts will be hoarded or used to pay down past debt—thus adding little to the economic recovery.

What Can Be Done

What is needed is government spending or programs that eliminate household debt directly, and also result in creation of (non-terminating) jobs directly by the government. Only job creation produces an income stream that doesn’t dissipate, but continues after the initial spending occurs. But recent economic history shows that, in the advanced economies at least, even poorly composed and timed fiscal policies were only dabbled with in the immediate post-2008 crisis period. Thereafter, actual policies with regard to government spending were just the opposite. What happened, and continues to happen, was not fiscal stimulus but fiscal austerity.
Fiscal austerity policies result in a significant reduction in household wage incomes and therefore a rise in consumption fragility. So where austerity policies have been most pronounced—i.e. in Europe and Japan—consumer spending has not recovered. Policy makers and press pundits then wonder, amazingly, why that is the case. However the explanation is simple and evident: as household income stagnates or declines, consumers turn toward more debt. Together the declining wage incomes—caused in part by fiscal austerity policies—and rising debt loads add doubly to consumption fragility.

Even when occurring in the form of fiscal spending designed to stimulate the economy, government spending effectiveness has declined. Government consumer spending and tax multipliers have had a declining influence. High levels of household debt have the effect of blunting and reducing government spending multipliers, as consumer households use government spending injections to pay down past debt instead of finance new current consumption. And stagnating wage incomes have the effect of blunting multipliers as well, as government spending results in more hoarding of the spending for ‘rainy days’ they expect are more likely to occur again instead of spending the added in come on new consumption.

Government spending and tax cutting that target corporations (bank and non-bank) also get ‘bottled up’ instead of resulting in more real asset investment. Much of the business tax cuts in particular are redirected to offshore investment projects, if they exist; to more profitable financial asset investing; to stock buyback and dividend payouts; to purchasing, merging and acquiring competitors; or are just hoarded on company balance sheets.

Whether targeting consumer households or business, traditional fiscal policy has a declining effect on generating incomes—and that means more fragility. But in any event, traditional fiscal policy has hardly even been used since 2000 and especially since 2009 in the US, UK and other advanced economies. What’s been employed is fiscal austerity—and that definitely has exacerbated consumption fragility, while encouraging more financial asset investing and therefore business debt and more fragility on the financial side.
Evidence is therefore abundant, and increasingly so, that monetary policy definitely causes an acceleration in financial fragility by encouraging bank and non-bank debt build up, while chronic low interest rate consequences of monetary policy reduce household income and raise debt that exacerbates consumption fragility as well. Simultaneously, fiscal austerity policies even more strongly negatively impact household income and debt, while fiscal stimulus policies targeting bank and business tax cuts encourage still more financial asset investing, stock and dividend buybacks, mergers & acquisitions, etc., all of which encourage more business debt.
Actual fiscal-monetary policy thus has become a cause of financial, consumption, and therefore systemic fragility in the system over time, rather than serving to reduce that fragility. Policy is an important contributing cause of systemic fragility.

by Dr. Jack Rasmus
Excerpt #4, Chapter 19, Systemic Fragility in the Global Economy
Clarity Press, 2016