Crisis Theory Needs a Demand Story

In an essay dated June 2005 (and republished in 2009 as Chapter 2 of The Great Recession) Michael Roberts has a perceptive account of what he calls ‘the property time bomb’.  He notes that never before had real house prices risen so fast for so long in so many countries, and quotes an Economist article of June 2005 which called it, ‘the biggest bubble in history’.

The total value of residential property in the OECD had more than doubled from $30bn to $70bn in the previous five years.  House values had never been higher in America, Britain, Australia, New Zealand, France, Spain, Holland, and Ireland. This was a bigger bubble bigger than the stock market boom of the 1990s that collapsed in 2000, or the great boom of the 1920s which ended in the Great Depression of 1929-33.  In The Great Recession [TGR]  Michael writes that:

World capitalist growth now depends on US household spending and US spending depends on housing prices in the US rising forever.  This is a pyramid scheme that will topple over eventually… the US housing bubble is set to burst …the US economy will drop like a stone, as many Americans face bankruptcy when they cannot make their mortgage payments, while others will have to pull in their spending horns … this year the UK and Australian housing markets have slumped.  With that economic growth has slowed to under 2 per cent a year. Spending in the shops has stopped growing altogether (TGR p.10).

Here Michael’s line of causation directly accords with the analysis which Atif Mian and Amir Sufi were to elaborate in their 2014 book, House of Debt which has attracted much attention.  In Michael’s 2005 discussion, a fall in profits is mentioned only in passing, and as a  consequence of a fall in consumer demand, not as a cause of the crisis – ‘if the housing market collapses that will make a huge hit on the profits of big business’ (p.12).

In Feb 2006 Michael published another accurate and well-documented analysis of the growing crisis caused by falling house prices in the UK, Australia and the US.

The downturn in the US housing market has now started … housing affordability, particularly in the coastal cities is stretched to the limits. America’s households are leveraged up to their eyeballs and now rely on rising housing prices to supplement their incomes … so even just a slowdown in house price rises would hit consumption (TGR p.17).

What has already happened in the UK and Australia, he suggests, shows what lies in store for the US.

The collapse of a house price boom in the UK (and in Australia) last year is the future for US homeowners.  The price fall deducted something like 2-3 per cent from real spending growth in these economies.… UK retail sales are now growing at their weakest rate for 20 years and recorded the worst figures for January sales since 1945 … and unemployment is steadily rising. (TGR p.17).

This fall in demand – and the reasons for it – is a major dimension of the 2007 -09 crisis in the US and in the way in which the crisis unfolded in other countries, notably Ireland and Spain.  It is essential that the house price / housing debt / demand story be incorporated into any fully developed Marxist account of the crisis.

Yet in recent years Michael’s thinking about the 2007-09 crisis has taken a radically different direction.  His new book The Long Depression is to be welcomed as currently the most thorough exploration of the crisis from a falling profits standpoint.  It contains a wealth of indispensable empirical material, the analysis covers the major sectors of the global economy, and it is a lively read. Here I focus only on Michael’s account of the US phase of the crisis.

In arguing for the tendency of the rate of profit to fall as the crucial underlying cause of the 2007-09, Michael has given far too little weight to other causal forces which were in play.  The house price/consumer demand dimension of the crisis is mentioned only occasionally and briefly. In his main discussion of the 2007-09 US crisis (Chapter 5), housing as such is not discussed.  There is only a passing mention that:

investment in real-estate took an almighty plunge after the credit-fuelled boom up to 2007, but investment in productive assets also tumbled.  The mass of profits dropped like a stone, especially for the financial sector (TLD p. 67).

Factually this is not correct.  The general category of real-estate includes the vast sector of commercial property and this did not collapse in 2007.  The initial crash was in residential house prices and it started at the beginning of 2007, well before the banking crisis became serious. Certainly investment in the house construction sector fell, but overall investment levels in the non-financial sector did not fall until 2009. (See my earlier post  for a summary of the evidence).  The effect of a fall in investment by firms in the residential housing sector was more than counterbalanced by an increase in investment in other sectors. The Economic Report of the President for 2008 says that:

In contrast to residential investment, real business investment in non-residential structures grew at a strong 16 per cent annual rate over the four quarters of 2007… investment in equipment and software grew 3.7 per cent, a bit faster than the 2006  pace. (ERP 2008 p.32).

It was in late 2008 and early 2009 that ‘investment spending (other than structures) plummeted’ (ERP 2010 p.126).  But by the fourth quarter of 2008 well over than a million jobs had been lost as a consequence of the fall in household demand which happened as a reaction to the collapse of house prices from the beginning of 2007 onward. (See Table 5 in my recent post.)

Michael does discuss debt, but now sees it as a secondary question – a trigger of crises, rather than a cause.  In his book, Chapter 6 is called Debt Matters and it contains much material of great interest.  But the analysis is focused almost exclusively on corporate debt.  There is a section on housing but it is very brief.

By mid-2006 the residential boom in the United States had reached mega proportions.  Household debt expanded rapidly during the so-called neoliberal era As a result of falling interest rates that reduced the cost of borrowing and created the ensuing property boom in many advanced capitalist economies in the past fifteen years.  The creditors were the banks and other money lenders. The assets (home values) eventually collapsed, placing a severe burden of deleveraging on the financial sector (TLD p.99).

The discussion that follows concentrates only on debt in the corporate sector.  Astonishingly there is no mention of the collapse in consumer demand as millions of households across America had began to deleveraging following the drop in house prices at the start of 2007.  No note is taken here of the mass of evidence, painstakingly presented in Mian and Sufi’s House of Debt book, that before the banking crisis went critical (when  Lehman folded in September 2008) jobs and businesses in large parts of the US had already been severely hit as a result of the contraction in consumer demand from the start of 2007 as household borrowing began to fall, and income was switched to debt repayment. See my recent post.

Michael had already dismissed the analysis in the House of Debt when it was published in 2014. Rightly he criticises its authors for lack of discussion of profit. But he then argues:

Sure consumption falls in recessions, but investment falls even more. The Great Recession and the subsequent weak recovery is not the result of consumption contracting. But investment virtually stopped (see my post ) And behind investment (whether in productive or unproductive sectors) lies profitability.

Certainly there is much to criticise in Mian and Sufi’s book, not least their failure to discuss profitability. The surplus money capital which poured into the financial systems of the US and other countries – and which fuelled the expansion of mortgage lending and housing prices was not just based, as they suggest, on East Asian trade surpluses.  As I have shown, there were two other major sources: (1) accumulations of money wealth in the hands of the rich as inequality increased, and (2) the swelling cash reserves of the corporate sector, as profits recovered faster than investment after the 2000 downturn.  Mian and Sufi also play down the impact of the banking crisis on the continuing rise in unemployment at the end of 2008 and in 2009.

But it is not convincing to say simply that a Marxist analysis must entirely reject their convincing analysis that the 2007 crash in house prices and fall in consumer demand directly led to large increases in unemployment before the banking crisis went critical. Marxism needs a demand story.

There are sections of Michael’s book which show a commendable alertness to the complex forces which determine a major crisis.  The analysis of five inter-twinned cycles in the history of capitalist development is a promising line of theoretical and empirical advance which needs to be followed. Three of the cycles are clearly evident in the 2007-09 crisis. A construction cycle (housing) was interconnected with credit processes (mortgage financing) and with the profitability for the banks of mortgage-based securities.

But Michael’s way of tracing the linkages between these dimensions of crisis runs into difficulties He creates difficulties for his account by misreading some basic elements in Marx’s value theory.

In my view, and I think in Marx’s, circulation and distribution are at a lower plane of causal abstraction, or if you like, closer to the proximate than the ultimate or underlying causes. A collapse in the stock market or in real-estate prices will not lead to a collapse in production unless there are already serious difficulties in the latter. There have been many stock market collapses without a slump in production (1987) but not vice versa.

But the stock market deals with fictitious capital, in which contractual claims on the flow of surplus-value are traded.  It is external to the circuit of productive capital. As Marx says at the start of Capital Vol. 3, ‘the capitalist production process, taken as a whole, is a unity of the production and circulation processes (p.117).  Capital in the money form is both the starting point and the necessary terminus of the social reproduction sequence. Only to the extent that demand is available at each stage in the circulation process can value and surplus-value be realised in the money form.

Levels of abstraction are not the same as a hierarchy of causal processes.  Michael is right to say that a large-scale collapse of demand needs explanation and that Keynesian accounts are inadequate.

To say the cause of the Great Recession was due to a lack of demand is bit like saying that that the cause of the streets being wet today is because it is raining today. That tells us nothing about why it is raining today and/or what causes rain to happen. Describing the Great Recession as a lack of demand is just that, a description, not an explanation.

The critique of Keynesian demand management in this article is well argued and deserves careful study. But in his insistence that demand is simply and directly determined by the level of productive investment, Michael seriously weakens the explanatory power of Marxist political economy. In his review of the Mian and Sufi  book he writes:

It’s investment that is the swing factor in recessions and recoveries, not consumption. Or to be more exact, it is profits that call the tune, because investment demand drops off when profits do. As profitability falls over time, eventually the mass of profit will fall and this will force weaker businesses to cut back on investment or even close down. Then there is a cascade of falling ‘effective demand’ as companies go bust or lay off labour.

Here some of the tendencies identified in Marxist analysis are treated as direct causal determinations operating automatically.  Both factually and theoretically the explanation of the 2007-09 crisis which results is seriously flawed, given that overall investment levels in the US non-financial sector did not fall until 2009.

House Prices and Consumer Demand in the 2007-9 US Crisis

In Marxist debate about the causes of the 2007-9 crisis in the US it is often assumed that we must choose between seeing it as either simply a financial crisis, or as one whose basic cause was a failure of profitability in the productive sector. Many believe that the fundamental primacy of production in Marxist theory must mean that a crisis of such enormous proportions can only have been the result of the tendency of the rate of profit to fall.

In fact the crisis had two quite different, though connected, dimensions and neither was based on a fall in the average profitability of non-financial companies. Both then and since, it was the near collapse of the US banking system which has attracted most attention. But the troubles in Wall Street did not become serious until March 2008, when Bear Stearns, one of largest investment banks in the US had to be saved from bankruptcy by the Federal Reserve.  Banking troubles had limited effect on the wider economy until September 2008 when Lehman Brothers folded, and a systemic collapse suddenly became a possibility.

A broader economic crisis had begun early in 2007, and at its centre was a rapidly spreading contraction in consumer demand. House prices in the US had been rising with increasing speed since about 1995.  On the strength of the increase in the value of their homes, households had built up high levels of mortgage and other forms of debt. At the end of 2006, the bubble reached its limits.  House prices began to fall, first in California, Arizona and Florida, but soon across the entire country. Faced with an erosion in the value of their homes, millions of households reacted by cutting back on borrowing, and starting  to pay off debt.  Consumer demand was compressed, the rate of increase in GDP began to fall, and by the start of 2008 unemployment was starting to rise rapidly.  The first phase of the crisis in the US actually began in 2007, and in the housing sector.

Housing was also to play a key role in the financial crisis which followed in 2008.  The banks had lent over $1 trillion in mortgages to subprime borrowers, many of whom were unable to sustain the level of payments required   In addition, the banks had created a vast number of securities, which were based on bundles of these mortgage contracts. These had been widely sold, in enormous quantities, to banks in the US and Europe, or retained on the books of the banks which had originated them.  The spreading tide of defaults on mortgage payments made many of these securities worthless, and trashed the balance-sheets of the major banks which had purchased them.

Across the political spectrum it has been widely assumed by commentators and researchers that the key mechanism which undermined production and jobs was the freeze-up of the banking system. A focus on the mesmerising drama of the possible collapse of the financial system has led to a general acceptance of the banking channel explanation for the huge rise in unemployment in the crisis.  The conventional narrative runs as follows. Hit by severe losses, and threatened with collapse, in the 2008-9 period the banks drastically reduced their lending.  Unable to borrow working capital from the banks, industrial and commercial companies were forced to cut investment.  There was a multiplier effect as falling investment led to loss of jobs, and the contraction of growth and demand.

It was just this view of the results of the crisis which in 2008 was used to justify, the expenditure of large sums of public money on rescuing the banks, and restoring their capacity to keep lending to business.

The banking explanation of the crisis has been strongly challenged in a book called House of Debt (2014).[i] Its authors, Atif Mian and Amir Sufi [M&S], are established academic economists at Princeton and Chicago respectively. Despite this disadvantage, their book can be recommended: it is short, simply written, and its results are based on a great deal of elegant empirical research which is explained with clarity.

Mian and Sufi argue that the banking crisis did not become critical until Lehman collapsed in September 2008.  They also show that, as a result of vast state subsidies, the banking system had been restored to reasonable health by 2009.  The reduction in industrial investment in the later stages of the crisis happened less because banks were unwilling to lend to industry than because industry responded to a prior fall in consumer demand by cutting investment.  The productive sector of the economy (apart from the auto industry) was generally in a strong enough financial position to survive the downturn without recourse to large amounts of extra bank finance.

So if the banks were not the primary cause of the contraction in customer demand – then what was?  Mian and Sufi focus on the fact that house prices in the US had risen with exceptional speed in the 2000-06 period.  Mortgage borrowing by US households had increased at a corresponding rate, and other forms of consumer debt as well. Mian and Sufi argue that it was the sharp fall in house prices from the start of 2007 which led to a massive contraction in consumer demand as households began to cut their current spending and run down debt. Mian and Sufi are able to show the close connection between demand contraction and the subsequent loss of jobs by making a very detailed comparison of geographical areas (pp.62-4). Their conclusion was that the drop in demand as households reduced their net indebtedness (leverage) was a direct and huge cause of the rise in unemployment in the crisis.

We estimate that 4 million jobs were lost between March 2007 and March 2008 because of household levered losses, which represents 65 per cent of all jobs lost in our sample (p.66).

Mian and Sufi argue that the widespread view that the crisis was caused by the banks was ideological special pleading to justify the fact that large sums of public money were used to rescue the banks and protect their shareholders from losses. Very little state money was made available to assist households threatened by loss of their home.

Let’s look at some of the detail. House prices in the US (in real terms) had remained basically unchanged since the end of World War 2 until the dramatic rise which started in 1995.  By 2002 average prices had risen by 30 per cent, and then accelerated even faster – over the 4 years ending in 2006, prices rose by a further 32 per cent. In many regions of the US, especially along the coasts, the rate of increase was much faster

There was a corresponding boom in the house construction industry. Output of houses rose by 50 per cent to a peak of 2.1 million in 2005 as the bubble in prices built up. But in 2005 the market was clearly over-supplied, and the number of housing starts went into decline. House construction is a quite large sector of the industrial economy and, as Mian and Sufi explain:

The collapse in residential investment was already in full swing two years before Lehman imploded. Residential investment (i.e. construction and maintenance of houses) fell by 17 per cent (on annualised basis) in Q2 of 2006. From then until the Q2 of 2009 residential investment declined by at least 12 per cent in every quarter, and reaching negative 30 per cent in Q4 of 2007 and Q1 of 2008. The decline in residential investment alone knocked off 1.1 to 1.4 per cent of GDP growth in the last three quarters of 2006 (p.32).

Obviously the profits of companies in this branch of the economy must have been hit. But as I showed in my last post other sectors more than compensated and, for non-financial companies, the average national rate of profit did not fall in a sustained way until mid-2007. (See Figure 2 in my last post More important, the evidence is conclusive that total investment did not decline in the non-financial sector until towards the end of 2008.  Thus average industrial investment levels in this crisis responded to a fall in growth, and were not its cause.. As the Economic Report of the President (2009) explained:

Real consumer spending stagnated in the first half of 2008 and then fell sharply in the third quarter in what was the largest quarterly decline since 1980. This was a major deceleration after the 2.8 per cent average annual rate of increase  during the 2001-07 expansion (p.33).

Apart from house construction, the other major sector to be hit was auto. As would be expected in a contraction of consumer debt, car purchase (so heavily dependent on instalment credit) was severely affected. ‘During the first three quarters of 2008 motor vehicle purchases fell to 12.9 million units at an annual rate, having fluctuated around 16-7 million annual pace during the expansion’. (ERP 2009 p.33).

But a fall in the investment levels of the house construction and auto industries does not show up in the aggregate national figures Marxists use in the debate about profitability.  What happened was that falling investment in these sectors was more than compensated for by a rise in other major sectors.  The Economic Report of the President (2009) notes that:

The reorientation of the US economy – which had been underway in 2006 and 2007 – away from housing investment and customer spending and towards exports and investment in business structures [factories, offices etc.] continued through the first three quarters of 2008 … In contrast to residential investment, real business investment in non-residential structures grew at a strong 12 per cent annual rate through the third quarter of 2008. The gains during 2008 made it the third consecutive year of strong growth (ERP pp.31 and.41).

The boom in mortgage finance

What underlay the boom in house prices was a huge increase in the availability of mortgage finance.  (See M&S p.85 for convincing arguments against those who believe the line of causation was the reverse).  Mortgage lending in the US rose to a peak in 2005. Behind this surge in lending lay the global surplus of money capital which I have emphasised in a previous post as due to high profits and a lag in industrial investment in many countries, plus increasing inequality in wealth ownership. Mian and Sufi themselves emphasise the third channel through which excess stocks of money capital accumulated. The exchange rate crisis which devastated a number of East Asian countries in 1997, convinced a large number of emerging economies – including crucially China – that it was vital to convert export surpluses into large reserve holdings of dollar.  ‘As foreign central banks built up their dollar war chests, money poured into the US economy … there was a breathtaking demand for new safe assets’ ( M&S p.93).

Mortgage lending and securities based on these loans were assumed to be safe investments. The effect of a surplus in what Marx called loanable capital was the huge fall in interest rates which took effect across the global economy from about 2000 onward. In the US this fall was amplified as the Fed implemented a relaxed monetary policy to pull the economy out of the dotcom recession of 2000-1.  But, as I have recounted in an earlier post when Greenspan began to increase short-term interest rates starting in April 2004, he found to his dismay that, the supply of loanable capital was too great, and there was not the usual corresponding rise in long-term rates – such as crucially the mortgage rate.

The deeper roots of the crisis lie here.  Profit rates rose in the post-1980 neo-liberal era because of the power of the counter-tendencies.  Rates of surplus-value and profitability  accelerated to levels well beyond the capacity of the system to absorb them in productive accumulation and reinvestment. The tide of interest-bearing capital meant high profits for the banking system – but as interest rates fell, huge pressures for the banks to seek yield by in increasingly risky ways – hence the surge in subprime lending.

As surplus money capital piled up in the global system, mortgage lending and house prices rose fast in the US and other major countries. The US stock market crash of 2000 took the glitter out of equities and added to the attractiveness of housing as a safe investment.  Mortgage and other forms of household debt soared as financial companies competed to find borrowers for an ample of surplus money capital.

Housing and consumer debt doubled in the six years after 2000 and the ratio of household debt to annual income rose by 50 per cent, from 1.4 to 2.1. Mian and Sufi draw a parallel with what happened in the nine years leading up to the crash of 1929 – a huge increase in mortgage and instalment debt (p.4).

But, largely unobserved at the time, a highly dangerous situation was building up.  During 2004-6 there was a rapid increase in the proportion of new mortgages which were subprime.  Subprime mortgage lending had been especially directed to black and Latino households, previously excluded by red-lining policies by the mortgage companies. By 2006 25 per cent of new mortgages originated in the US were subprime.  The reason? Same as for payday loans – lending to poor people can be highly profitable.  The securitisation of debt allowed the risk involved to be passed on to the banks and pension funds which eagerly bought up the mortgage-based securities

A useful summary of the rip-offs involved is by Randall Wray.

New and risky types of mortgages that offered low teaser rates for two or three years, with very high reset rates were pushed. As originators would not hold the mortgages, there was little reason to worry about ability to pay. Indeed, since banks, thrifts, and mortgage brokers relied on fee income, rather than interest, their incentive was to increase through-put, originating as many mortgages as possible. By design, these “affordability products” were not affordable—at the time of reset, the homeowner would need to refinance, generating early payment penalties and more fees for originators, securitizers, holders of securities, and all others in the home finance food chain.

The flow of predatory profits through chain, depended to the complicity of a series of agents.  Brokers who sold the mortgages, and made the credit checks on borrowers.  Appraisers who valued the houses.  Banks who lent the money, and converted bundles of mortgages into risk classified securities.  The ratings agencies who issued the AAA grades which allowed mortgage-backed securities to be sold to pension funds and the like.  And insurance companies, who reassured investors that they were insured against the risk of default.

Chairman Greenspan gave the maestro seal of approval to these practices, urging homebuyers to take on adjustable rate debt.(p.9).[ii]

The crash in house prices

Between 2006 and 2009, house prices fell by an average of 30 per cent nationally, and by much more in the worst-hit regions.  By 2009 11 million houses – 23 per cent of houses with mortgages – had negative equity.  They were underwater: their estimated selling price was less than the size of the outstanding mortgage.  The total number of foreclosures reached 4 million.

It is right that so much of the commentary on the crisis has focused on the foreclosure of houses. People losing their home was one of cruellest ways in which the crisis damaged individual lives – and it happened to 1 in 25 America households.  Also, it was lending of billions of dollars to households unable to sustain repayment which brought the financial system to the edge of collapse.

But Mian and Sufi direct our attention to ways in which foreclosure led to another sort of social damage – the loss of jobs as consumer demand contracted on a national scale. They emphasise that the effect of foreclosures is to hit all house prices in the areas affected.  Even householders with no debt are caught up in a wider fall in house prices.

The key problem is debt. Debt amplifies the decline in asset prices due to foreclosures and by concentrating losses on the indebted, who are almost always households with the lowest net worth in the economy… This is especially dangerous because the spending of indebted households is extremely sensitive to shock to their net worth – when their net worth is decimated, they sharply pull back on spending.  The demand shock overwhelms the economy, and the result is economic catastrophe’ (M&S p.70).

The previous peak for foreclosures was in the recession of 2001 when about 1.5 per cent of all mortgages were in foreclosure.  In 2009 the total reached was 5 per cent.

The effect of the fall of house prices on demand was not just confined to the crisis as it evolved up to the Lehman moment.  It continued to operate through to the start of post-crisis stabilisation in 2009.

In Q4 of 2007 business investment was a positive source of growth in GDP, and was pretty much neutral till the middle of 2008.  In Q3 of 2008 business investment fell by enough to bring down GDP by 1 per cent, but in the same quarter the drop in consumption reduced GDP by nearly 3 per cent. (M&S p.35).

Mian and Sufi were able to access official data about consumer spending levels by zip code.  They were thus able to make fine-grained geographical analysis of the levels and timing of changes in demand.  They find that it was in the counties with the largest drop in house prices from 2006 to 2009 that consumption was cut back by the largest amounts – 20 per cent as compared with a national average of 5 per cent. (M&S p.36).

Job losses materialised because households stopped buying, not because businesses stopped investing. In fact the evidence indicates that the decline in business investment was a reaction to the massive decline in household spending (M&S p.34).

It was the post-Lehman financial crisis which threatened the international system as the interbank markets stopped functioning and trade credit froze.  But, especially in its early stages, and in its direct effect on US employment levels, the crisis was driven by the fall in household demand as housing prices tumbled.

[i] Mian, Arif and Amir Sufi 2014, House of Debt, Chicago: University of Chicago Press.

[ii] Wray, Randal 2007, Lessons from the Subprime Meltdown, Working Paper No. 522,  New York: Levy Institute.