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Separating Sense from Nonsense in the us debate on the Financial Meltdown David Coates

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Separating Sense from Nonsense in the US debate on the Financial Meltdown
David Coates

The US debate on the causes of the financial meltdown, and the policies appropriate for its resolution, has a different center of gravity to that prevalent in Western Europe. Free-market solutions continue to be canvassed by conservative and libertarian politicians and political commentators with an intensity that is rarely found elsewhere, reflecting the extent to which a significant minority of American voters and policy-makers remain wedded to a principled anti-statism. This article surveys those views, and the rebuttals to them now coming from more centre-left elements of the US political class. It argues for the superiority of the latter, while noting that one serious adverse consequence of this positioning of the US debate is its capacity to distract attention from important underlying structural causes of the housing crisis and associated credit crunch.

About the author
David Coates is the Worrell Professor of Anglo-American Studies at Wake Forest University in North Carolina. E mail

Any European watching the unfolding of the global financial crisis triggered by the spread of toxic US mortgage-backed securities must surely be struck by both the parochialism and the introspection of much of the American debate on the causes of our present misery. As governments across the advanced industrial world struggle to find policies appropriate to the scale of the generalized recession, it would seem to be only in America that key sections of the political class fail to engage with the global nature of the crisis or the US responsibility for it, choosing instead to debate the appropriateness or otherwise of state intervention in any form. The center of political gravity in the United States has settled so far to the right in the post-Reagan years that even the modest Keynesianism of the Obama administration is widely labeled in conservative circles here as nothing less than rampant socialism, and as such a profound threat to the American way of life. To understand the options currently available in Washington DC, a European audience would do well to understand the depth to which unalloyed free market ideas have embedded themselves in contemporary US political culture. One purpose of this paper is to enhance that understanding. Another is to report on the nature and limits of the current center-left response to this persistent and debilitating conservatism (Coates 2009).


When the Obama administration brought its stimulus bill to a vote in the US Congress in February 2009, not a single Republican in either House voted in support of the measure. A president arguing that his administration should offer direct help to struggling home owners, and extend the previous Republican administration’s bailout package to US banks, met a principled resistance from a minority party that rejected outright the Obama policy stance. The Republican counter argument contained the following key elements.

  1. The roots of the crisis lie not in the unregulated workings of the US housing market but in its politicization, primarily by Democratic politicians.

This is not Alan Greenspan’s crisis, so the argument runs, it is Barney Frank’s. It was Barney Frank – and Democrats of his ilk – who systematically encouraged the two publicly-underwritten mortgage giants (Fannie Mae and Freddie Mac) to provide credit to social groups hitherto excluded from house ownership by their lack of adequate earning power. The conservative case here is that it was Democrats, not Republicans, who saw political capital in the spread of subprime loans to marginal groups – often African-American urban voters – and so used the 1977 Community Reinvestment Act, and pressure on Fannie and Freddie, systematically to lower the bar on income requirements for house purchase. Democrats may now find political capital in bewailing the adverse impact of the credit crisis on the American poor – spreading first foreclosures and then unemployment down the American income distribution – but it was actually they who laid the foundations for the crisis they now bewail. Ann Coulter, as always, put the case in its least adorned way. “From the Community Reinvestment Act that pressured banks into affirmative-action lending, to those ‘government sponsored enterprises’ Fannie Mae and Freddie Mac – who bought up all the resulting subprime loans and repackaged them as ‘investment grade’ securities – the greasy thumb-prints of government were all over this fiasco from beginning to end.” (Coulter, 2009)

  1. Bank deregulation is not a cause of this crisis. Over-regulation and mismanagement is.

There are some conservative voices out there decrying the inadequacy of regulatory practice – building the case that the regulations were there but were inadequately enforced – but the more normal route taken by the Republican Right is simply to deny that the financial industry is, or has been, deregulated, and then to turn the criticism on its head – pointing to the way regulation distorts the market and leaves consumers vulnerable to crises generated from market distortions. “The three overriding facts” of our present circumstances, Cato’s David Henderson has written, “are (1) we have not had a period of light regulation, (2) deregulation didn’t fail, and (3) regulations make things worse”.(Henderson, 2008:8) On this argument, recent bank failures have been the product of excessive regulation rather than of deregulation – and not just the regulation of banks – there is even conservative scholarship arguing that the over-regulation of land use was an additional source of the house price inflation that eventually brought the system of subprime loans crashing to the ground.(Cox, 2008)

One aspect of the regulatory structure often singled out for particular condemnation by such critics is the low interest rate policy pursued by the Federal Reserve after 9/11. For libertarians of the Austrian school, this dysfunctional monetary policy was a classic example of what is always wrong with market regulation: of “how government tinkering with the supply of money and credit starts the economy on an unsustainable boom that has to end in a bust.” Put a central bank into play, and you necessarily distort the market-clearing capacity of unregulated interest rates. You necessarily create a financial system that “artificially encourages indebtedness, excessive leverage and reckless money management in general.” Add to that the monopoly privileges given to Fannie and Freddie, and you have a clear explanation of how and why “the new money and credit overwhelmingly found its way into the housing market.” (Woods, 2009: 26, 47)

  1. Government spending will not solve the crisis. It will extend and deepen it

At its core, the Republican argument rests on a straightforward denial of the economic literacy of John Maynard Keynes. It is not possible, they say, to spend your way out of recession. Governments do not create money, they appropriate it. Spending by governments has to be financed. It can only be financed by borrowing or taxation – both of which crowd out privately-generated investment and demand. Printing money only produces inflation. Borrowing money slows down investment. Taxation reduces levels of personal consumption. “Government spending cannot cause prosperity; it can only reallocate resources from one person or activity to another. Prosperity – economic expansion – can be achieved only by increasing total production, not simply moving it around.” (Book, 2009) Governments do not solve economic crises. They did not in the 1930s and they will not again.(Murphy, 2009) Governments simply make recessions worse.

So instead of hailing the current bailouts and stimulus packages as routes to renewed prosperity, their critics treat them as further evidence of a government-led rake’s progress. What the US faces is not a return to sustained economic growth. What it faces is a hugely inflated public spending deficit. That deficit will have to be financed. The burden of its financing will fall on future generations – “fiscal child abuse” is what Chris Edwards called it (Edwards, 2008) – and the scale of that burden threatens America as a nation with the possibility of total insolvency. Even if that insolvency does not occur, the tax burden created by debt repayment will throttle the very economic growth that the debt’s acquisition was meant to prevent. That at least is the argument.

  1. Solving the crisis definitely requires tax cuts, and possibly the closing of the Fed

Some of those pointing the finger of responsibility at the Fed are publicly pondering whether it should actually be closed (Buchanan 2009); and are doing so from within a Republican Party whose leadership is wholly committed to resolving the financial crisis by rolling back the state. In their view, public money should not be spent bailing out the feckless. Bailing out those who make economic mistakes penalizes those who don’t. It penalizes the very people whose entrepreneurship deserves our full attention and reward. Sometimes this argument is used in conservative circles to make the case against bank bailouts, and against federal aid to high-spending state governors; but more normally it is used to make the case against sending tax-dollars to car companies that cannot compete and to house buyers who cannot pay. It takes two to tango, so the argument goes. Yes, some of the mortgage-selling practices were predatory. But so too were the appetites of house buyers who signed mortgage deals which their incomes could never have hoped to support. Bailing out feckless consumers effectively taxes those many more responsible home buyers who restricted their sights to houses they knew were within their purchasing capacity. It should not be done.

What should be done instead, to put the recession behind us, is the implementation of a new round of tax cuts. Those tax cuts must be permanent; because only permanent tax cuts can hope to change the long-term behavior of American investors and consumers. They must be substantial, on both corporations and households, because only substantial tax cuts can give spenders the confidence to reignite the demand side of the US economy; and they must be matched by equivalent reductions in government spending, to avoid the deficit-creating habits of the Bush administration from whose fiscal irresponsibility many core Republicans now wish to distance themselves. The Government should not vainly attempt to spend its way out of this recession. It should get out of the way, and let the private sector do the spending for it.

Arguments of this kind do two things to the political debate about the housing crisis, the financial meltdown and the appropriateness of stimulus packages to resolve both. They oblige their more progressive (“liberal” in an American sense) critics to chase some particularly irrelevant hares, and they pull all of us away from a serious examination of the underlying structural causes of the present crisis, causes to which the Republican Right appears to be entirely blind. First, the hares….

  1. Political finger-pointing, if appropriate at all, has to be directed towards the right people and the right places

The timing of the stages of the crisis does not fit the vulgar ‘Barney Frank did it’ thesis. Political oversight in the years preceding the collapse of the housing bubble was predominantly in the hands of Republican lawmakers, not Democratic ones. Republicans controlled the House from 1994 to 2006, the Senate from 2002 to 2006, and the White House throughout the entire housing bubble crisis. It is more accurate to say that Barney Frank and the Democrats inherited a crisis in whose development they had consistently played just one major role. Theirs had been, and remains, a strong voice arguing for the rights of the lower middle class to own their own homes. But spreading home ownership down the income ladder was not a policy goal that Barney Frank invented or that the Democratic Party monopolized. It was a policy goal that the Clinton and the Bush administrations shared. It was a bi-partisan policy pursued through the terms of reference that successive administrations gave to Fannie Mae and Freddie Mac; terms of reference that both implemented until 2001 with notable caution. We do well to remember that, Ann Coulter notwithstanding, 75 percent of higher-priced loans made during the peak years of the subprime boom were made by independent mortgage firms and bank affiliates not covered by the Community Reinvestment Act (Barr and Sperling, 2008). We also do well to remember that as late as 2001, subprime and home equity line loans made up only 15% of all new residential mortgages. By 2006 they made up 48%.

If political oversight went wrong, it went wrong in a serious way only after 2001. It was the second Bush administration that created the lethal cocktail: a commitment to social housing mixed with a partisan enthusiasm for financial deregulation. Both elements of the cocktail had been there in the Clinton years, but in less acute form. It was the Bush appointed head of Fannie Mae who made the fatal decision to aggressively expand the number of subprime loans that Fannie Mae underwrote, primarily through the bargain he made with Countrywide Financial. Daniel Mudd made that decision despite internal warnings from his own chief credit officer (in March 2005) that the combination of these risks might be difficult for subprime borrowers to understand, and that rating agencies might not be properly assessing the risks in these securities. He made it in such a way that “between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers, more than three times as much as in all its earlier years combined.” (Duhrigg, 2008) Fannie Mae did so because its new management team was by then operating in an all-pervasive governing culture that actively prized deregulation. Leaders of the four federal agencies overseeing the banking industry even gathered for photo-shoot in 2003, posing behind a stack of paper wrapped in red tape, and holding in their hands garden shears and – in one case – a chain saw. Literally, a chain saw! (Krugman, 2007)

  1. There is a problem in the existing US regulatory structure – a problem not of excess but of weakness

The financing of housing markets is always difficult. To buy a house, people need to borrow long-term. The institutions lending them the money have to borrow short. Institutions that borrow short and lend long are inevitably unstable, able to survive only so long as long-term rates are higher than short-term ones, and rates in general remain stable over time. Historically, both the US and UK addressed the precariousness of such institutions in two ways. They insisted that only specialist financial institutions service the housing market, and that they provide mortgages only on rigorous terms. They also set up strong barriers between those institutions and the rest of the banking system. In the New Deal the US went one stage further, and created a public institution, the FNMA (Fannie Mae) to underwrite those mortgages. The problems we now face derive from the deconstruction of that historical settlement: the increasing tolerance, across wider and wider sections of the house financing system (including Fannie Mae) of lower and lower accounting standards; and the removal of the firewalls that had hitherto isolated the mortgage market from the rest of the credit-providing system.

Fannie Mae was privatized in 1968, and an equivalent private institution, the FHLMC (Freddie Mac), was created alongside it in 1970 to extend the underwriting to a wider set of house mortgages. Fanny Mae and Freddie Mac functioned thereafter as private mortgage underwriters with implicit Treasury guarantees of their viability. This was never an ideal arrangement, effectively enabling both GSEs to privatize their profits while socializing their losses. As their conservative critics rightly say, the status of Fannie and Freddie as government-sponsored enterprises did give them significant market advantage over other institutions in the business of financing housing while leaving them free to lobby extensively against any tighter regulation of their lending practices. That lobbying was extensive, and deliberately bi-partisan: and did slow down reforms of the GSE’s lending practices that are only now belatedly under way.
The special status of Fannie Mae and Freddie Mac was not, however, either the only or the main weak link in what has now turned out to be a fundamentally dysfunctional US house-financing system. The main weakness lies in the steady erosion of the firewalls that divided housing finance from the rest of the credit-creating system. Those walls were removed in two ways – one formal, one not. . The formal way was the passing of a string of legislative acts that cumulatively facilitated the lowering of underwriting standards and ultimately ended the 1933 Glass-Steagall separation of commercial and investment banks. The informal way, far more potent in the end, was to failure to stop the spread of mortgage-backed securities out of the housing market into the rest of the financial system. Financial institutions traditionally unconnected to the housing market began then to participate in it on an unprecedented scale. They participated by financing aggressive campaigns to capture market share by mortgage companies willing to lower their accounting standards; and they participated by buying up in large quantities mortgages bundled up in packages that left their purchasers, and the credit rating agencies on which those purchasers relied, literally unable to assess accurately unable the viability of the mortgages so packaged.

  1. The main drivers of this crisis were private sector actors, not public sector ones

No matter what their critics now claim, Fannie Mae and Freddie Mac came into the subprime loan market only late in the day, and came to be dominant players there only briefly and only after the private banks and associated hedge funds that initially dominated this market ran into serious liquidity difficulties. The initial drivers of the flow of subprime loans in the US housing market were not public or semi-public institutions. They were private ones. “The subprime loan boom was led by investment banks and mortgage brokers, not by government sponsored enterprises.” (Barr and Sperling, 2008). Subprime loans were the brain-child of private mortgage companies keen to capture a larger and larger share of a financial market that, to them in the midst of the house price explosion, looked like a sure fire route to greater and greater profits. Countrywide Financial was the key private bank playing that role in the US. Northern Rock was its equivalent in the UK. Both had strong links to major triple-A rated financial institutions: Countrywide to Fannie Mae, Northern Rock to Lehman Brothers. The resulting housing boom was dominated by big financial institutions: “during the peak of the housing boom in 2005, the nation’s 30 largest institutions accounted for half the loans originated…Countrywide topped the list, originating more than one million loans worth almost a quarter-trillion dollars that year.” (Zandi, 2008: 95, 100) It was Wall Street, with its apparently insatiable demand for mortgage-based securities, which drove the changes in the mortgage business. “Lenders now made their money solely on volume: the more loans they originated, the greater the profit.” (Fraser, 2008: 31) What then developed with dizzying speed and complexity was a shadow banking system, one in which originating banks passed on mortgages to a mixed bag of investment banks, hedge funds, money-market funds and insurance companies, who in their turn protected themselves against risk by deploying increasingly obscure and complex derivatives such as collateralized debt obligations and credit default swaps.

This aggressively expanding mortgage industry, and its associated shadow banking system, proved extremely resistant to regulation. When Countrywide Financial, for example, was pressured to change its lending practices by the Office of the Comptroller of the Currency, it abruptly changed its regulator, opting instead for the far less strident Office of Thrift Supervision. Nor was Countrywide Financial alone in doing this. Between 1995 and 2005 the “top 25 US originators of subprime mortgages…spent almost $370 million in Washington…on lobbying and campaign donations as they tried to ward off tighter regulation of their industry.” (Luce, 2009) And well might they resist, because unregulated predatory lending was very profitable before 2008, and made a lot of money for a lot of people. Adjustable rate mortgages, Alt-A mortgages, low/no down-payment mortgages, interest-only mortgages and negative-amortization mortgages proliferated, because those developing them were able to take a healthy fee at each stage of the transaction, fees taken before the inevitable toll of defaulters emerged to cloud the horizon. “The risk of those mortgages spread through the financial system thanks to the [proliferation there of a new] ‘originate and distribute’ business model: make a loan, pocket the fee, bundle the mortgage with others and sell the securitized package to another institution to assume the risk”(Jost, 2008:16); and it spread way beyond US shores through the sheer size of dollar debt held internationally because of the scale and persistence of the US trade deficit. In the first decade of the new century, what Zandi called “a self-reinforcing cycle” rapidly developed: American consumers flush with easy access to cheap credit bought heavily whatever the rest of the world was happy to sell, and the dollars sent overseas quickly returned as investments in US-based financial instruments, especially mortgage-based securities, in a flow of imported capital that brought interest rates down even lower in the US, making credit here cheaper still. (Zandi, 2008:80)

  1. The Fed is indeed to blame, but less for what it did than for what it failed to do

It is hard to think that bank deregulation was not a key element in this story when the former Fed chairman is on the record, conceding a flaw – to Henry Waxman no less. The conversation between them ran as follows. (Andrews 2008)

Waxman: You had the authority to prevent irresponsible lending practices that led to the subprime loan crisis. You were advised to do so by many. Do you feel that your ideology pushed you to make decisions you wish you had not made?

Greenspan: Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.

Waxman: Were you wrong?

Greenspan: Partially.
This was less a case of deregulation than of a failure to keep regulatory capacities up to speed as securitization became so significant a feature of the interactions of major US financial institutions. The sin here was one of omission as much as of commission. It was the scale and growth of securities collateralized by mortgages that is so striking in the run-up to the financial meltdown: there were $18.5 billion of such securities circulating in 1995, but $507.9 billion a decade later. “The amounts involved were mind-boggling”, operating in what Kevin Phillips called “the financial wild west” – the suitability of the term reflecting “the relative lack of regulation and enforcement in these newly important financial precincts” in which “hedge funds fit the gunslinger image”, living “on the barely regulated edge”. Allowed to run free by a Fed chairman who “philosophically rejected interference with the magic of the marketplace” (Phillips, 2008: 102,107) these new financial institutions came to replace old-style depository institutions as the core of the financial system, holding 50.1 percent of all financial assets by 2006, with the depository institutions down to 23.8 percent – in 1976 that figure would have been 67.6 percent. And with size came the capacity to generate money: lots and lots of money, whose size, growth and dubious asset-foundation Alan Greenspan chose to ignore until it was too late
It is true that the Fed chairman did voice alarm – late in the day (2005) – about the funding and practices of Fannie Mae and Freddie Mac; and yet he remained to the end of his tenure at the Fed reluctant to tighten controls on the flow and distribution of the new financial products spreading with such speed through the US (and then global) banking system: not least the rapidly expanding number of mortgage-backed securities, and the associated credit default swaps designed to protect individual institutions against mortgage default. It was the developments of those new products that pushed the weaknesses of housing finance into the very core of first American (and then global) financial networks. Mortgage-backed securities were not new of course. They can be traced back to the 1970s. What was new was their scale, and the fragility of the subprime mortgages packaged within them. What was new was how far they spread through the entire financial world under the light touch of Greenspan’s regulatory regime and philosophy, and how poorly the credit-rating agencies responded to that spread.
Add to that two other pieces of public policy: one bipartisan, one not. The bipartisan bit was the commitment to the granting of tax relief on mortgage interest – a huge middle class tax subsidy that built into the whole US housing finance system a propensity to inflate demand. Because of it, people earning enough to get a mortgage (a growing proportion of the population as accounting standards fell) were able to get a bigger mortgage than they might otherwise have acquired, because tax relief on the interest on that mortgage effectively turned the federal government into a subordinate co-purchaser. And the decision to extend that tax relief to second mortgages meant that vast swathes of the US middle class got tax relief on their equity lines of credit too, with the federal government effectively giving them tax relief on whatever they chose to spend that line of credit on (rarely home improvements!) Then add to the mix the Fed’s interest rate policy – bringing rates lower and lower after 2001 – and you have all the ingredients for a classical overheated housing market: with prices escalating in a seemingly unending spiral that brought more and more speculative capital in to fuel the spiral still further.
5. Tax cuts were not and are not the answer
The current trashing of Keynesian economics by supply-side conservatives is the ultimate nonsense. Government spending does not crowd out private spending when private spending has stalled. What government spending does, if properly directed, is trigger again private sector employment, wages, demand and growth. Government spending in a stagnant economy has a multiplier effect. Print a dollar, give it to someone lacking a wage, they will spend it, it becomes income for the person receiving it, who then spends it on. The extra revenue generated, if large enough, sustains a flow of taxation back to the government that more than compensates for the original dollar. The trick is to properly target it – to spent it, that is, where the “bang for the buck” is greatest – spend it where it is least likely to be saved and most likely to be passed on. We have tables telling us where the bang is biggest: invariably on infrastructure investment rather than tax cuts. Following those tables will not produce “generational theft”. On the contrary, properly-targeted public spending can only leave future generations, not with debt, but with better roads, schools, housing and hospitals.
There is something deeply parochial about the current libertarian call for the closure of the Fed, as though the problem of US finance lies in the very existence of a central bank rather than in its periodically inadequate policies. The Federal Reserve System was in place in the United States before and during the Depression – and so is available for censure for failing to prevent the unemployment of the 1930s – but it was also in place through the 1950s and 1960s, when US living standards doubled and the US trade balance was heavily in surplus. Certain sections of the American political class apparently fail to realize that every successful capitalist economy possesses a central bank – the UK has had one from 1694 – and that such central banks have cohabited with both successful and unsuccessful periods of economic growth. And of course they have, for central banks are vital mechanisms of monetary control, in economies that require – as a basic function of their state – the regulation of money. Market economies rely on the exchange of commodities, and money is the key facilitator of that commodity exchange. It must not itself become a commodity: and yet it has. The problem in the United States is not that we have a Federal Reserve System. It is that that system has lately lost control of its monopoly of its money-making function. It has lost control of that function to a shadow banking system driven by short-term profit-taking, one in which money itself has become a commodity – something to be bought, sold, speculated in, and floated regardless of its asset base. Far from closing the Fed, the solution to this financial crisis requires that the Fed reassert itself, and break the independent power of a banking system that, in the deregulatory culture of the last two decades, has swung dangerously out of control.
Financial crises are like layered cakes. To grasp them in their totality you have to cut your way through every level.

  • The top level of this one is the US housing market, with its high level of tax subsidization and securitization. At the very least, public policy has to provide relief for those facing immediate foreclosure on their primary residence, with the choice being between schemes that restructure mortgage packages and those that bring public bodies in as co-buyers. This is no time for inactivity because of moral hazard. Everyone is touched by this crisis: house owners who cannot pay their mortgage; house-owners who can but who see their house values driven down by the foreclosures of others; house-owners whose job security is threatened or lost (and with it, their homes) by the impact of bad mortgages on the flow of credit in the wider financial system; and house-owners who see the quality of their local communities undermined by failing businesses and shrinking local tax revenues. When everyone is drowning, it has to be a case of “lifeboats for all”.

  • Longer term, tighter regulation is clearly required to recreate – in a new climate of complex financial products – a strong firewall dividing the housing market from the rest of the financial system. If that can be done by moving back towards Glass-Steagall, with general banking excluded from either direct or indirect linkages to housing finance, all well and good; but that is unlikely. That horse bolted long ago, and it is unlikely ever again to be re-stabled: which is why the full nationalization of Fannie and Freddie, with a public monopoly on mortgage provision for primary residences, must be in the mix for longer-term solutions. So too must be a larger program of public housing, and the incremental removal of tax relief on first and second mortgages.

  • But in the end the ability of people to buy their houses turns on the level of their earnings. Housing finance will remain problematic, for the bottom third of the US population, until general wages rise again and income inequality is significantly diminished. A stable housing market in the US, as elsewhere, requires more than an adequate supply of houses and a stable financial system to lubricate their purchase, though it clearly needs both of those. It also needs a generalized rise and distribution in the capacity of people needing houses to buy them without the risk of default. American housing will not be stable and shared until American prosperity is stable and shared. There are big things, way beyond housing, that need to be done.

This points to a core issue that is currently largely ignored in the US public debate: namely the all-pervasiveness of debt in the US economic model – not just housing debt but also general consumer debt, government debt and international debt. Of the latter three, government debt is the one most often discussed and criticized, and yet it is the least troublesome of the lot. Public sector deficits rise and fall with the scale of government spending and the size of tax revenues. Well-directed public spending has, and no doubt will again, generate the economic growth and tax flows that can take the public sector back into surplus. It is the other two debts that underpin this financial crisis, and that ought to be of greatest concern. It is the scale of US overseas indebtedness – anchored in the growing lack of domestic competitiveness of US-based manufacturing industry – that has flooded the global financial system with unwanted dollars, dollars whose reinvestment back into US financial institutions inflated the supply of credit available for house purchase and ensured that a housing collapse here would race out (tsunami-like) into the wider global economy. And it is the scale of personal indebtedness in the United States – anchored in the stagnation of real wages/hour for the bulk of American workers since the mid 1970s – that made subprime loans so attractive to so many Americans, and yet made it so difficult for them to pay off those loans when their “teaser” period was over. The immediate crisis requires an immediate response, directed at the top two layers of the cake, but to avoid its repetition over the long term public policy will also need to do something fundamental about the internal and external dependence of US living standards on a collective propensity to live beyond our means.

This long-term weakness of the US economy requires a fundamental resetting of its underlying social contract. The post-war US economy has known two broad periods of growth: that between 1948 and 1973 when strong trade unions sustained wages and internal demand, and that after 1992 when weak unions failed to prevent wage stagnation. In that second period, internal demand was maintained only by extending the working day and by maxing out credit cards. The former model is clearly the preferable one. The US needs to return, and at some speed, to a social compact in which rising productivity and rising wages go together, so that people buy commodities today out of wages they earn today, not out of wages they might earn tomorrow and which they bring forward only by borrowing at high rates of interest. The US needs to return to a world in which houses are one of the few things that Americans borrow big time to buy. It also needs to return to a world in which the bulk of the things American workers buy they also make. America needs to stop being the “global consumer of last resort.” The underlying requirement now is one of reconfiguring investment in the United States so that good jobs return to America, and of reconfiguring the tax code so that good wages return to the American working class.
The barriers to that reconfiguration lie largely in the institutions that created this crisis in the first place. For the US, like the UK, has what Martin Wolf recently called “a strategic nightmare: it has a strong comparative advantage in the world’s most irresponsible industry” – finance.(Wolf, 2009) The US economy has lost the comparative advantage it once possessed in its core manufacturing capacity, and it needs to get it back. In the middle of the bailout crisis that followed the meltdown, the CEOs of the major US car companies received legitimate criticism for flying to Washington in their own private jets: but in the midst of the uproar, commentators missed the significance of the fact that they needed to fly at all. Industrial capital in the United States is politically and geographically divided from the federal government, but finance is not. The organic link between the American state and the new financial elite is strong and as yet unchallenged The US has an industrial policy: it is simply one that does not favor industry. Britain is not alone in the need to curb finance. Until and unless the US does so too, the structural weaknesses of the US economy will guarantee regular financial crises in the years to come. The ultimate lesson of the great financial meltdown of 2008 is that the United States needs a new deal as well as a new bailout. Does anyone in Washington realize that? Somehow I doubt it.
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