The crisis: Proximal causes

The 2008 global financial crisis commenced acutely in the United States (Reference Bordo and Landon-LaneBordo and Landon-Lane, 2010; Reference BoyerBoyer, 2009; Reference DavisDavis, 2011). There is widespread consensus about its more consequential proximal causes. For example, the housing and credit bubbles that were forming in certain American cities in the preceding years were key trigger events (Reference Acharya and RichardsonAcharya and Richardson, 2009: 196; Reference CrottyCrotty, 2008). In and of themselves, economic bubbles are not inherently negative in the long-term but rather an inevitable feature of the boom-bust cycle (Reference CrottyCrotty, 2008). However, the pre-2008 bubbles arose from a confluence of atypical elements. These included an absence of appropriate oversight and prudential supervision by regulators, improvidence and lack of planning on the part of stakeholders in the financial services and real-estate sectors and, in certain cases, corrupt and duplicitous business practices by the same parties (Reference Gould and ThwaitesGould, 2014; Reference Lokrou and GouldLokrou and Gould, 2014).

As late 2008 approached, distal influences on the – soon to be – financial crisis were firmly cemented in place and provided context for the more well-known direct trigger events to play out. There was unprecedented housing debt in the US that had found its way, in the form of derivatives, on to the balance sheets of financial institutions throughout the world. A derivative was a newly developed type of contract made between a mortgage holder and a third party. It took the form of a secondary bet placed on an aspect of market performance. Derivatives may be used to create disconnect between a primary price fluctuation and the benefit a third party derives from such a change. For example, according to how a deal is structured, the holder of a derivative could make a substantial gain (or loss) from a small rise (or drop) in the price of the element against which their wager is pegged. In the case of the pre-2008 US sub-prime market, two classes of derivative, credit-default swaps (CDS), and collateralised debt obligations (CDO)^{Footnote 1} had special import (Reference BoyerBoyer, 2009). A CDS is a bet that lending institutions allowed to be made against the probability of mortgage default (Reference BoyerBoyer, 2009; Reference Gould and LokrouGould and Lokrou, 2012). The third party could make payments in exchange for speculating that bundled loans would – or would not – be able to be repaid. In accepting such a contract, the third party was acquiring an asset that often had a ledger value many times higher than the worth of the re-bundled mortgages from which it was derived. Credit rating agencies had mostly over-valued subprime-derived securities.^{Footnote 2} Hence, when under-capitalised housing investors were not able to repay debt and found themselves in negative equity positions, mortgage-backed securities (derivatives) changed from being assets that were often many times larger than the value of the original housing loan to being liabilities of equivalent magnitude. Indeed, major insurance and merchant banking institutions which had invested heavily in derivatives such as Lehman Brothers (LB) and American International Group (AIG) were rendered insolvent due to housing loan default (Reference BoyerBoyer, 2009). However, just prior to the crisis these institutions had balance sheets portraying their worth as many tens of billions of dollars.

As an immediate consequence of widespread mortgage default, the American real estate bubble burst in September 2008. In this context, a burst bubble is intended to evoke an image of the valuations of securities tied to property in the US dropping precipitously. This devaluation was unprecedented in modern times and had three immediate global recession-inducing consequences (Reference Gould and ThwaitesGould, 2014). First, there was reduced credit availability to both consumers and businesses. Second, there was a crisis of consumer confidence over bank liquidity and solvency. Third, banks stopped – or substantially reduced – lending to each other. These impacts induced losses on stock exchanges throughout the world; specifically through their influence on securities held by European investment banking firms and, more generally, through their effects on the confidence of consumers outside of North America. While such events were unfolding, real estate prices in the United States plummeted unprecedentedly such that, by October 2008, 20% of American properties were in negative-equity positions (the mortgage owing on them was in access of their market value) (Reference Haughwout and OkahHaughwout and Okah, 2009). Between June 2006 and June 2009, median US house prices fell by approximately 30% (Reference Case and QuigleyCase and Quigley, 2008). This diminished aggregate household wealth by roughly seven trillion dollars (Reference Mishel, Bivens and GouldMishel et al., 2012).^{Footnote 3} In an effort to limit damage, Western governments reacted with remedial measures. These were initially more stimulatory than austerity-related. For example, in the United States, the newly elected Obama administration employed pump-priming and prop-up strategies following the collapse of merchant bankers LB and the takeover of Merrill Lynch (ML) by the Bank of America (BofA). The US Federal Government invested 85 billion dollars to ensure that merchant bank AIG stayed viable. Overall, the Federal Reserve sponsored stimulatory initiatives to ensure that the shadow-banking sector remained solvent with high-profile payments of 653 billion dollars to key institutions on 12 November 2008 and another 904 billion on 14 January 2009 (Reference BoyerBoyer, 2009). Although it originated in the United States, the crisis rapidly became international in its scale and impacts. For example, towards the end of the year, the European Union Commission recommended a 200 billion euro stimulus package (about 1.5% of the aggregate gross domestic product (GDP) of the countries being targeted). This initiative was ratified in December.

In 2010, the G20 (Group of 20) summit held in Toronto marked the beginning of the new global financial policy orientation of governments struggling to manage the aftermath of the crisis (Reference LoDuca and StraccaLoDuca and Stracca, 2014). The plan devised in Toronto was to reduce public debt within G20 nations by 50% by 2013 (Reference LeQueux and PeetzLeQueux and Peetz, 2013). It seemed that, at least in one sense, the bailouts had created another set of problems. Specifically, large unanticipated government outlays were now threatening the solvency and credit ratings of sovereign countries and the most palpable remedy was to be stringency, mostly manifested in the form of cuts to government services.

Neoliberalism: A break with New-Dealism

Almost four decades prior to the 2008 global financial crisis, at about the time of the Nixon Administration, the post-war economic long-boom was abating. The New-Dealist prescription seemed to be struggling to continue to deliver rising and broadly shared prosperity. From 1973 to 1975, in the worst economic slump since the great depression, industrial output fell by 10% and the US GDP dropped by 1% (Reference IssawiIssawi, 1979; Reference KolmKolm, 1977: 815). Also during this period, the world’s 25 richest countries saw their economic growth rate fall from 5% to 0% (Reference IssawiIssawi, 1979; Reference KolmKolm, 1977: 815). To add to the malaise, inflation was rising sharply during the era. However, perhaps to the casual observer, it was the 1973 Organisation of the Petroleum Exporting Countries (OPEC) crisis that seemed to herald the beginning of a new epoch. The OPEC crisis saw Middle-Eastern oil-producing nations acting in concert to quadruple the price they were charging for their product to client countries. Although much contemporaneous literature portrayed the conniving Arab Gulf State countries as setting the wheels in motion for the epoch’s incrementally increasing gloomy economic outcomes (eg Reference IssawiIssawi, 1979), in fact from as early as the 1960s more systemic elements were undermining prosperity. Return on capital deployed in Western industries was falling from around this time (Reference MoodyMoody, 2007). Specifically, from approximately the early 1960s, international competition was encroaching on domestic market share. In economic terms, Western industries were transitioning from comparatively inefficient Fordist-era structures of monopolistic competition in which cost-plus forms the basis of pricing towards configurations of perfect competition where output settles at a point where marginal cost equals marginal revenue for any particular firm. For practical purposes, super-normal investment return was regressing towards an international mean. In lay terms, Western capital was having to work harder from the 1970s. The rise of Japan in the 1950s and the Asia Tiger economies in the 1960s was reducing the rate at which surpluses could grow in the US and the productive inefficiencies associated with New-Dealism that had been subsidising the lifestyles of ordinary people were now looking like an unaffordable luxury.

At about the time of the OPEC crisis and the ensuing precipitous decline in wages that occurred as increasingly managerialist-orientated employers insisted on progressively growing profits at any cost (Reference MoodyMoody, 2007) a marginal strain of thought was becoming mainstream. Worsening economic circumstances made a fresh approach seem indispensable. Austrian-school theorists such as Friedrich Hayek and later his devotees, the anti-Keynesian/Monetarist Milton Friedman and James Buchanan, who championed public choice theory, were standing-by with a new proposal. Their prescription would, according to some, herald return to the common sense of the enlightenment as exemplified in the ideas of 18th- and 19th-century thinkers such as Jean Baptiste Say, John Locke, David Hume and Alexander de Toqueville (Reference CombeCombe, 1996). However, others interpret neoliberalism as something other than merely old wine in a new bottle and view as spin doctoring its purported lofty intellectual pedigree (Reference CombeCombe, 1996). When originally articulated in the 1970s, the new blueprint embodied two key, and related, tenets. First, government and governance are malignant influences or at least overly intrusive. Second, laissez-faire capitalism remedies economic and – more particularly – social problems. Commencing with Augusto Pinochet’s ‘Chicago-boys’ period of military dictatorship – but quickly extended to the United States and Great Britain in particular – it was soon to be the dawn of the era of the ubiquitous application of the market solution as a universal panacea.

According to the neoliberal worldview, there are four related domains where notions of commercialisation, corporatisation, and privatisation were underutilised as public policy solutions during the New-Deal era. First, private sector entities should be more freely able to compete to provide services that have hitherto been, as a matter of orthodoxy, the preserve of the public sector (Reference CombeCombe, 1996). There is a somewhat concealed agenda here; if someone wants something, indeed needs it, they should pay for it. The fact that they may not be able to is an ephemeral impediment and represents a moral failure in that the needy person has not managed their life responsibly (Reference CombeCombe, 1996). Second, with a little ingenuity, social problems such as violent crime, teen pregnancies, suicide, divorce and the like can be viewed through the prism of supply and demand and thus reconceptualised as solvable using the market solution (Reference CombeCombe, 1996). Relatedly, policy makers should be imaginative in their quest to create sunrise industries. They should proactively conceive of new functions and speculate about how privately managed entities could carry them out for profit. For example, as Reference Connell, Braedley and LuxtonConnell (2010) points out, it is only in the last 35 years that in the Western World, there has arisen the notion of supply and demand for drinking water, body parts and outer space (Reference Connell, Braedley and LuxtonConnell, 2010). Third, Joseph Schumpeter’s conception of industry creative destruction has no consequential shortcomings. Indeed, it is even beneficial for those who lose their job when an economic sector becomes redundant. The rationale here is that laid-off employees face new opportunities, for example, perhaps the chance to obtain a more interesting job in an emerging industry. Fourth, labour markets should be deregulated. Underlying this prescription is the axiom that there is less difference between labour markets and other kinds of markets than was thought to be the case. This aspect of the neoliberal agenda mostly boils down to an assault on the legitimacy of, and institutions supporting, organised labour. Neoliberal ideologues consider that unions create competitive distortions through pushing wages beyond their market value and hindering labour flexibility.

Neoliberalism inevitably comes with the promise of reduced taxes. In the Western world, this became especially salient in 1978 when California passed Proposition 13, a referendum to cap property tax. According to Reference ChapmanChapman (1998), this legislation heralded the emergence of a new policy direction for the West. However, in reflecting on changing taxation regimes over the last 40 years, Reference CampbellCampbell (2012) argues that, although in the US and other OECD countries, conservative and liberal administrations committed to the neoliberal agenda have often vied to outdo each other in the tax-cutting stakes, government receipts have mostly remained about the same as a proportion of GDP. Rather, in most Western countries – often under the guise of user-pay – there has been a shift to regressive tax regimes. Such systems, by definition, discriminate against low-income earners (Reference CampbellCampbell, 2012).

The promise of better capital allocation and ensuing efficiency dividends that accompany neoliberal theory have not well translated into benefits for ordinary people, particularly those living in the West. Indeed, even before factoring – in the impacts of the 2008 crisis, neoliberalism was failing the majority of those in OECD countries. However, prior to the crisis, proponents of rational expectations and efficient markets theory were still in their intellectual ascendancy. They could point to some upside of broad commitment to the market solution as a generic magic bullet. The problem was that such benefits were not especially relevant to the lower and middle classes. For example, in the early 2000s, the free-marketeers typically interpreted the ‘great moderation’ of the business cycle as evidence of a policy triumph (Reference Coibion and GorodnichenkoCoibion and Gorodnichenko, 2011). The post-industrial attenuated boom-bust oscillation seemed to be driven by certain of neoliberalism’s fringe elements. These included increased central bank independence, application of the ‘Taylor Rule’^{Footnote 4} in monetary policy and greater within-sector adaptability including ‘just-in-time’ inventory management but, more particularly, flexible labour use strategies supported by legislative programmes that had whittled away employee rights and protections. However, the lingering question was what was being traded-off for the smoothed-out boom-bust cycle?

In a wide-ranging survey of the impacts of the West’s post-Keynesian public policy emphasis, Reference Weisbrot and RayWeisbrot and Ray (2011) focused on economic indicators as well as social/psychological measures within low- and middle-income countries to compare the period 1960–1980 with 1980–2005. Neoliberal champions had argued that these nations would be first in-line to receive the advantages of the new approach (Reference PutnamPutnam, 2001). However, Reference Weisbrot and RayWeisbrot and Ray (2011) concluded that, far from them being the beneficiaries of neoliberalism, they had in fact declined, particularly on key financial indices. Within the United States – a country that was always going to be at risk of setback when measured in narrow economic terms – it is conspicuous that even social justice indicators have it in 2015 at number 25 out of 31 OECD countries, just above Turkey, Greece and Chile (Reference Kauder and PotrafkeKauder and Potrafke, 2015). When further unpackaged, this result glosses over the fact that the new social and economic order has been especially difficult for some sectors of the population. For example, researchers such as Reference Case, Coates and PloughCase and Coates (2017), and Reference Case and DeatonCase and Deaton (2017) have been tracking the aggregate fate of middle-aged white Americans (particularly white American males) without college degrees since 1999. They note that the mean mortality-rate for this cohort was declining steadily throughout the 20th century, but in the 21st century began to rise precipitously. According to the authors, the trend reversal is largely attributable to psychological factors including depression and anxiety leading to suicide and drug overdose. In developing this thesis, they propose that lost status arising principally from job insecurity and career disruption in the age of neoliberalism are consequential antecedents of such disquieting contemporary phenomena. Research of this kind is eye opening. It reveals a weakness in neoliberal theory that proponents of the approach find difficult to bat away. This matter is dealt with in depth by Reference Wilkinson and PickettWilkinson and Pickett’s (2010) book, The Spirit-Level: Why Inequality Matters. These authors provide data indicating that an across the board rise in levels of prosperity will have adverse aggregate psychological impacts if it creates a concomitant growth in income inequality. However, insofar as neoliberalism is concerned, the problem is somewhat different from what happens when the wealth-gap widens. In fact, at odds with what neoliberal theorists originally assured would happen, the new approach has not even provided overall rising prosperity, even differentially rising prosperity. On the contrary. For example, in 2000, once again before the 2008 crisis, Reference CrottyCrotty (2000) declared neoliberalism to have failed to live up to expectations. He summarised his dismal perspective on the matter, thus …

Some remnants of New-Dealism nested in the neoliberal agenda

It will be argued here that poor regulatory oversight and public policy failure – mostly on the part of well-intentioned Democratic-Party administrations – created, in combination with an overall agenda of neoliberalism, consequential antecedents of the 2008 crisis. As noted, scholars have made much of the role-played by sub-prime and adjustable-rate mortgages in the pre-crisis years (e.g. Reference BoyerBoyer, 2009; Reference TarrTarr, 2010). When analysed retrospectively, the issuance of loans to those with poor credit histories appears as an unambiguous influence on rising real-estate prices and a subsequent over-supply of properties (eg Reference CrottyCrotty, 2008). However, prior to the crisis, such salience was less obvious. Indeed, in the 1990s and early 2000s, for example, there was widespread and genuine failure to appreciate the roles played by investment banks and hedge funds, the so-called shadow banking industry, in providing credit to the American economy. The contextual elements creating irresponsible financing arrangements were mostly well intentioned but did not suit their broader neoliberal circumstances. Here, four of these will be presented and interpreted as dysfunctional legacy elements of the New-Deal era. The goal is to prosecute the case that public policy failure – in the form of an overall agenda of neoliberalism combined with a half-hearted commitment to certain more Keynesian-style elements – created the most important pre-conditions for the eventual implosion.^{Footnote 5} These four key legacy elements – argued here to be consequential – are as follows: the Community Reinvestment Act (CRA) (1977) and its subsequent application and amendments; the Federal Department of Housing and Urban Development’s (HUD) pressuring of government chartered corporations to purchase (or securitise) subprime loans in 1992; the US Federal Reserve’s orientation towards prudential supervision and monetary policy in the years between 2001 and 2006; and, the 1999 overturn of the Glass-Steagall Act from 1933 (Reference WilmarthWilmarth, 2002). As noted, repeal of Glass-Steagall was not so much a New-Dealist legacy element as it was a catalyst for other dysfunctional factors to combine synergistically.

The passing of the Community Reinvestment Act is the first, and most temporally distal, legacy element of consequence in the lead-up to the financial crisis of late-2008. At the behest of the newly elected Carter Administration acting under pressure from community welfare groups including the Association of Community Organisations for Reform Now (ACORN) and the Southern Poverty Law Centre (SPLC), the US Congress passed the CRA (1977). Because of the revised policy direction, henceforth, banks and financial institutions were required to offer credit without discrimination to all sectors of communities they served. The intent here was to ensure that less-wealthy people could not easily be denied a loan or redlined, to use the Act’s vernacular. The new law limited the redlining of fledgling and small businesses seeking commercial finance and, in particular, aspiring first homeowners. At that time, the conservative banking community was uneasy about loosened credit availability but was forced to acquiesce under threat that they would be denied government approval to undertake merger and acquisition activity (Reference GetterGetter, 2015; Reference Holmes and HorvitzHolmes and Horvitz, 1994; Reference KrosznerKroszner, 2008; Reference Park and GouldPark and Gould, 2017). In 1995, the Clinton Administration, through its HUD, placed additional pressure on banks to provide credit to low income earners. During this period, new lenders like Countrywide entered the financial services sector with plans to compete in ways that had been regarded as reckless throughout the 20th century. For the first time in modern banking history, the widespread practice emerged of not adequately using savings deposits to mitigate loan risks. This strategy put some – particularly the fledgling – lending institutions on the path of insufficient capitalisation. To support issuance of loans to less affluent people, the government’s new sub-prime authorisation provided for a, so-called, second-tier form of mortgage application that did not meet conventional standards of creditworthiness (Reference GetterGetter, 2015; Reference StricklandStrickland, 2004). The notion of relying on statute law to force issuance of credit was a radical departure from orthodoxy. Subprime loans often provided 100% financing and did not take account of credit scores. They were frequently made without documenting income.

In historical accounts of the global financial crisis, it is sometimes overlooked that, in 2003, the Bush Administration pushed for the most wide-ranging review of housing loan financing arrangements since the savings and loans crisis that had occurred a decade earlier. Of course, there had been some securitisation of risky mortgages in the 1990s when firms like Bear Stearns, a wholly private entity, had begun underwriting debt. However, by the time of the Bush Administration’s proposed review, irresponsible financing arrangements were omnipresent. Perhaps even more disquietingly, the major sub-prime lenders were government-chartered entities: Fanny Mae and Freddie Mac (Reference SimkovicSimkovic, 2013). The overhaul plan – which the Democrat-controlled Congress opposed and defeated – was to regulate more intensively these institutions through creation of an independent agency administered by the Justice Department (Reference StricklandStrickland, 2004). Those arguing for beefed-up external control and financing restrictions argued that if American taxpayers were to underwrite mortgages then public sector stewards should be able to assure them that their liabilities are adequately capitalised. The Democrats voted against tighter scrutiny including Securities and Exchange Commission (SEC) reporting.^{Footnote 6} Apparently, they considered that more restrictive lending practices would unduly disadvantage poor people. In something of an unholy alliance, executives at lending institutions had – by now – mostly changed their stance on the issuance of risky loans and supported the Democrats. However, it was not concern for the poor that was motivating the bankers. Rather, it was the fact that their bonuses were now typically structured so that their remuneration increased when they reeled-in borrowers. As predicted by agency theory, they became less concerned about the solvency of their employing entity but focused instead on maximising their commissions, pegged in one form or another to how much they were able to lend (Reference EssenburgEssenburg, 2014).

The second legacy influence on the 2008 financial crisis occurred in 1992 when the HUD compelled Freddie and Fannie to purchase (or securitise) sub-prime loans. There were two – somewhat contradictory – reasons why the Secretary, Democrat Andrew Cuomo, intervened in this way. First, he argued that it was prudent to diversify the risk associated with mortgage default. Second, he sought to make more credit available to the poor and disadvantaged (Reference Gould and ThwaitesGould, 2014). In keeping with these priorities, Congress passed the Federal Houses Enterprises Financial Safety and Soundness Act (FHEFSSA) which mandated that Fannie and Freddie buy (securitise) a minimum of 45% of all loans which had been issued by depository institutions to people of low and moderate incomes. In 1995, the Treasury Department established the Community Development and Financial Institutions Fund (CDFIF) that provided banks with public money to be provided as additional subprime lending. The House Financial Services Committee (HFSC), comprised of top democrats Barnie Frank, Chris Dodd, and Chuck Schumer, enthusiastically championed these loosened credit initiatives.

The third legacy cause of the 2008 financial crisis concerned interest rates. Dysfunctional monetary policy in the period before the burst bubble(s) played-out over several years. As is often the case in matters of macroeconomics, its harmful impacts are best appreciated retrospectively. Specifically, in December 2000, the Federal Reserve had home loan rates pegged relatively high, at 6.5%. This created disincentive for real estate speculation. Indeed, it provided the last line of defence against profligate property buying on the part of those who may have been seduced by the subprime (so-called) opportunity. However, largely as a response to the burst dot-com bubble in March 2000, the cost of credit in the Western world was about to diminish. Specifically, in order to stimulate dampened demand, from January 2001 the Federal Reserve lowered official mortgage rates in the United States incrementally until they reached 1% in June 2003. There was a large increase in house buying and a concomitant rise in real-estate prices over this period. For example, property prices in the US increased by 70% between 2002 and 2006. In States like Florida and California, their price doubled (Austrade, 2008). However, such increases were also indexing another phenomenon; inflation, which in 2001 was 2.8% and by 2005 was 3.4% (Reference BoyerBoyer, 2009; Reference LabonteLabonte, 2018; Reference Schwartz, Booth, Alexander and BeenstockSchwartz, 2009: 45). At this point (2005), talk of an economic stimulus was a distant memory and the policy agenda du jour began to focus narrowly on reigning-in consumer spending. Specifically, in 2005, the Federal Reserve again tightened interest rates. Under the Chairmanship initially of Alan Greenspan and then Ben Bernanke, they rose steeply, from 1% in June 2004 to 5.25% in June 2006 (Reference LabonteLabonte, 2018). This 5-year u-curve effect was trapping real estate investors of dubious creditworthiness (i.e. those for whom the New Deal legacy elements were intended to aid) in circumstances where they could not make their monthly repayments. However, at least for the moment, the same people were mostly able to claim that the properties they had bought had increased in value.

The fourth legacy cause of the 2008 financial crisis to be examined was not especially intended to help poor people and, as such, is perhaps better viewed as a catalyst than a New-Deal legacy factor. The issue here concerns repeal of the Banking/Glass-Steagall Act, 1933 in 1999. Glass-Steagall had separated depository and investment banking activities or, more precisely, restricted the capacity of depository banks and their affiliates to engage in securities trading. However, as a point of economic history, it is noteworthy that the official overturning of Glass-Steagall was largely inconsequential. In fact, from the early 1960s, federal regulators began taking an increasingly broad interpretation of its cross-fertilisation restrictions. Hence, by the time the Act was formally repealed (in the Gramm-Leach-Bliley Act (GLBA), 1999) commentators such as Reference WilmarthWilmarth (2002) declared that the spirit of separation between depository and investment banking was – for all practical purposes – already a relic.

The role that abandonment of Glass-Steagall played vis-à-vis the financial crisis is subject to conjecture. At one extreme is Bill Clinton’s, likely partisan, view about strategic flexibility. The argument here is that the less constrained arrangements formally implemented under his administration helped limit damage because, during the acute phase of the downtown, it was desirable for bank holding companies to acquire under-capitalised securities firms and/or change the way such troubled entities are incorporated. At the other extreme, economists mostly interpret repeal of Glass-Steagall as indefensible regulatory failure. For example, Martin Mayer – who in his book The Bankers (Reference Mayer1975) had flagged concern about Citibank establishing a liquid secondary market in negotiable certificates of deposit and hence funding its activities through a shadow banking operation – has made this case. He later argued that repeal of Glass-Steagall counts as a clear-cut distal influence on the global financial crisis (Reference MayerMayer, 2009). He proposed that commercial and investment banking have little in common and require different knowledge bases and skill sets, repeal made it possible for banks to take risks that they did not understand and, network integration increases contagion if problems arise.