Financial Crisis Management and the Pursuit of Power

American Pre-eminence and the Credit Crunch

Mine Aysen Doyran

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781351936460
• Edition: 1
• Topic: Business
• Subtopic: Financial Risk Management
• Index: Business

How does America manage crisis on behalf of international finance in the absence of a global state? Doyran explores the relationship between state power and global finance and in particular examines the various attempts by the US state at financial crisis management. The case studies highlight the dramatic consequences of the rise of financial capitalism in the US economy, and also explore regulatory sources of market failures, systemic risk and moral hazard. This book focuses on this primary issue facing scholars of American power in various social science disciplines, including political science, finance and international relations, professional financial analysts and Government officials. This book is for the critical reader who is interested in financial policy and wants to learn more about the causes and consequences of the rise of financial markets.

Chapter 1

Introduction

Since the demise of the Bretton Woods system, major financial crises have taken place in the US and globally. Financial markets departed from established norms following the collapse of the Breton Woods system in 1973, especially in 1998-2009. Particularly vulnerable were stock markets and currencies identified with the super-profitable but risky emerging markets. Although systemic crises beset financial markets throughout the 1970s and 1980s, recent occurrences were triggered domestically and then spread globally. The crisis that began in the US housing market in August 2007 brought to light a number of deficiencies in the national financial architecture, especially in the oversight of systematically important institutions, the management of systemic risks and vulnerabilities, and the resolution of financial institutions. A global credit crunch was in the making that could seriously damage the US economy and drag the rest of the world down with it. As hundreds of billions in mortgage-related investments went bad, some of the largest investment banks collapsed or were taken over by other banks.

The global nature of the crisis has made it clear that financial liberalization, while offering many benefits such as efficiency and innovations exposed the limits to deregulated markets with major economic consequences globally. Given that the US is a major financial center and provider of dollars used as currency reserves, it remains possible that a major crisis in the metropolitan centers will ripple through the rest of the global financial system and push economies worldwide towards depression. The global nature of the crisis has also raised worries about the “demise of the Anglo-American model of capitalism” that would “usher in a new era for the expanded role of the government and strengthened financial supervision on a global scale” (Lim 2008). Policy makers now have to confront a number of problems such as escalating costs to taxpayers, rising unemployment, prolonged recession, and the resolution frameworks for systematically failing financial institutions. These problems will continue to leave a troubling legacy until deep reforms safeguard the maintenance of an increasingly volatile finance.

In light of growing concerns over the ability of the US to handle an impending crisis at home, are we still in the epoch described by Henry Luce as “the American Century”? Is the current global financial crisis likely to introduce a new era of expanded role for the government and major institutional and regulatory reform in the global economy and in the USA? Does the post-Bretton Woods system contain structural flaws that make it more prone to crisis and thus less resistant to hegemonic intervention? Or will it reinvigorate US global power? Should the US financial system be re-regulated and include more controls, and if so, by whom? What are the possibilities that financial reform legislation representing anything but palliative measures will be enacted? What are the strengths and weaknesses of revived Keynesian economic solutions?

As a consequence of such theoretical and by implication normative questions, this book explores the dynamics between state power and crisis management by examining US policy responses to three financial crises with the US at the core. Within the purview of this examination are various attempts by the US state at crisis management within the historical period encompassing: the emerging market debt crises of 1998-2000, including Russian-LTCM, the dot.com bubble of 2000-Enron, and finally the US subprime financial crisis of 2007-2010 (Table 1.1). The case studies serve to highlight the larger consequences of the rise of securitized finance and reveal issues with wider implications for financial regulation in the post-Bretton Woods era. Asset price bubbles and credit booms triggered the crisis in each case by producing speculative “manias”, “crashes” and “panics” with a major decline in economic activity and—finally—prolonged recession. These crises are of central importance because they are not only financial in nature but also deeply political, with real economic and social consequences. While they are rooted in factors common to previous episodes, they also highlight both new elements and the potential dangers from an ill prepared liberalization of capital. From this perspective, they are examples not only of inadequate financial supervision, but also market failures involving “increased interconnectedness among financial markets, nationally and internationally, with the US at the core” (Claessens, Dell’Ariccia, Igan and Laeven 2010: 7). Worries over US exposure to recurrent crises led to inter-governmental forums like the G-20 seeking to contain future such instability and collectively “manage common systemic problems” (Beeson and Bell 2005: 3-4).

The primary challenge addressed by this book is one that scholars of American power in various disciplines, including public policy, political science, economics and international relations, contend with as well. Given the practical, theoretical and by implication normative questions raised above, this book attempts to contribute to an ongoing discussion about the nature and management of international financial system, especially attempts to understand the establishment of Bretton Woods institutions and US dominance after World War II (Helleiner 1994, Walter 1991, Keohane 1980, Krasner 1977, Block 1977, Kindleberger 1973). In understanding the current instability, for example, the burgeoning literature on American power often made analogies with the Bretton Woods era (1944-73)—a period in which the US was the dominant financial power. In this analogy, political scientists and economists took the system of Bretton Woods as their point of departure and then located the US in it as the key player. For example, the conventional realist narrative postulated US dominance as the central reality of postwar international politics and Bretton Woods as a golden age of financial stability. The Bretton Woods regime coincided with the high point of the global power of the American state and international financial capital. It established a fixed exchange rate system based on the gold-dollar exchange standard. The US stipulated that any dollars held by foreign central banks were convertible into gold at $35 per ounce (Coffey 1974: 10). In the 1970s, the Bretton Woods system collapsed due to increased global competition, rampant inflation, and the US decision to de-link the dollar from gold. These developments signaled the relative demise of US hegemony and emergence of rival powers like Japan and Germany. In contrast to Bretton Woods, the post-Bretton Woods period is one dominated by a free floating exchange rate system and private capital flows. This has allowed powerful states to manipulate currencies in order to strengthen their own economies at the expense of their rivals (Soederberg 2002: 179).

Table 1.1 Major Episodes of US and International Financial Instability

Date and Period	Type and Institution	Systemic Causes	Role of the State	Crisis Management Arrangements
1998	US hedge fund collapse: LTCM	• Russian, Asian, Latin American sovereign debt defaults. • Collapse of securities market liquidity. • Sudden flight to safer country bonds, such as US Treasury bonds.	Liberal laissez-faire: • Classical liberalism; neo-liberal reforms; minimal government role in financial crisis management; deregulation.	• Domestic: Minimal US government intervention. Multilateral Formal but loose coordination through G-7/G-20, FSF and Basle Committee.
2000-2002	High tech bubble; Enron bankruptcy	• Increased speculation in high-tech stocks and derivatives trading.	Liberal laissez-faire: • Classical liberalism; neo-liberal reforms; minimal government role in crisis management.	• Domestic: Minimal US government intervention. • Multilateral: Formal but loose coordination through the G-7/G-20 and Basle Committee.
2007-2010	US mortgage securities market collapse; systematically failing financial institutions (Bear Sterns, Lehman Brothers; AIG)	• Defaults on subprime and variable interest rate mortgages. • Excessive household and corporate debt. • Contraction and liquidity problems in mortgage securitization.	Liberal interventionist: • Keynesian demand management; low interest rates and higher government spending, fiscal stimulus; large-scale bailouts.	• Domestic: Active intervention by the US government; expansionary fiscal and monetary policies. • Multilateral: Formal but mostly cursory and incomplete within existing international financial regimes through G-20, IMF and Basle Committee.

An idealized view of Bretton Woods can be found in the literature of a number of prominent international relations scholars, including Robert Keohane who argued that “between 1971 and 1976, the United States secured a flexible exchange rate regime that was closer to its own preferences than those of its partners, but given its own penchant for monetary autonomy, it could not construct a strong, stable, new regime” (Keohane 1980: 152). That US hegemony that emerged in the aftermath of World War II distinguished it from earlier powers. Its hegemony was “reciprocal and agreed upon rather than imposed” (Ikenberry 1992) and economic liberalism was sacrificed in the interest of broader systemic stability (Helleiner 1994) and Cold War coexistence with the Soviet Union (Ikenberry 1989; 1998/99, Lundestad 1986). While liberals like Keohane focused on the problem of restoring international “regimes” and cooperation after Bretton Woods as a way of constraining US power, the realist Gilpin predicted that “protectionism and economic nationalism are once again threatening the liberal economic order with the relative decline of American power” (Gilpin 1987: 88).

Despite an open international economy, financial instability and systemic crises prevail contrary to the neo-liberal expectations of fully integrated and efficient markets. On the other hand, the realist expectation of a return to a rivalry-driven multi-polar world with protectionism has not materialized. Despite having little connection to mortgage-backed securities, no part of the world was able to escape the consequences of the current crisis. Since securities backed by subprime mortgage loans were purchased around the world, the ripple effects were not just limited to the US, but also exposed major deficiencies in financial systems worldwide. The subprime mortgage crisis that began in 2007 eventually entered a second phase in which other industrial powers, particularly Great Britain, were largely affected. For example, in September 2007 subprime losses led to a big run on Northern Rock, a British bank, prompting the Bank of England to place it under government ownership. Especially hard hit were less developed countries in desperate need of external financing. While the rest of the world, particularly Europe (Iceland, Portugal, Spain, Italy, Greece and Eastern Europe) and Latin America have slowed down, “emerging market economies, in particular, have not de-coupled from the US economy” (CRS Report for Congress 2008: 3). Due to the reluctance of banks to roll over loans, investors withdrew capital from less developed countries, causing their exports to dwindle and currencies to plummet thus pushing them further into recession. In 2009, the World Bank estimated that economic growth would fall 5 percent in Latin America, 3 percent in East Asia, 2 percent in South Asia and 2.5 percent in Sub-Saharan Africa (Weissman 2009b).

The main theories associated with global financial order, however, do not adequately address the politics of financial system governance in an increasingly crisis-prone yet open finance. While there are numerous case studies about US hegemonic decline and the emergence of rival powers such as China and India, there is little analysis of US domestic responses to financial crises originating in the core but with global implications. If the US has not yet de-coupled from global economy, even as a hegemon in crisis, a new international financial architecture only becomes possible under conditions of post-crisis regulatory reform. Thus, in an effort to address the politics of financial regulation in an increasingly open but unstable economy, this book studies the US strategy for managing crisis that emerged within a particular set of historical circumstances during post-Bretton Woods. Proceeding from a case-by-case basis grounded in recent history, we examine the relationship between state power—the promotion of the financial and monetary goals of the nation-state domestically and internationally—and the provision of financial stability through the exercise of crisis management. As explained in Chapter 2, we distinguish ourselves from purely state-centric or technical accounts of crisis management. Our analysis sees financial crisis as crucial to mutually reinforcing but often contradictory interactions between the state, financial markets and private sector actors. To provide such a framework through a case study analysis of government responses, our objective is to highlight the pivotal role of the US as a destabilizing force for both the US and the international financial system—a contention based on a projection of diminishing US influence and hegemony in relative terms.

Argument

Conventional international relations theory—hegemonic stability, liberal regime, Marxist—and the economic theory of crisis management both reflect the shortcomings of financial governance literature. For the most part, the conventional narrative adopts an essentialist view of the American state; it postulates US power as the central reality of postwar politics and Bretton Woods as a golden age of stability. Within this narrative, the first two models—hegemonic stability and liberal institutionalism—both conceptualized hegemony in the classical realist tradition. Prominent realist scholars such as Stephen Krasner and Robert Gilpin applied the term “hegemon” to explain postwar international order based on the presence or absence of a unitary powerful state. Besides the realists, Keynesian economists posited a liberal international order dependent on a dominant founding power that enforces international regime norms in accordance with the provision of collective goods, such as open markets, free trade, foreign direct investment, lender of last resort, and a universally accepted medium of exchange—the dollar.

Historically, the US assumed the same kind of hegemonic role after World War II that Great Britain did in the 19th century by providing public goods perceived as beneficial for the international community. The hegemonic power acted as an international lender of last resort—a crisis manager—in order to prevent systemic crises from turning into worldwide depressions. The public goods supply problem was resolved when the hegemon provided liquidity (monetary credit) to less powerful countries during a major financial crisis. Charles Kindleberger, a Keynesian economist best known for his influential analysis of the Great Depression, noted: “For the world economy to be stabilized there has to be a stabilizer, one stabilizer” (Kindleberger 1973: 305, 1981: 247).

Liberal institutionalists, on the other hand, saw the hegemonic power as the ultimate guarantor of international cooperation and a “benevolent” state that could foster collective action internationally (Keohane 1984). Liberals emphasized the ways in which an “embedded” international order forces the hegemon to exchange some “legitimacy” for benefits it cannot obtain by force or military threat. The international compliance with hegemony is rooted in universal norms of financial governance (capital adequacy standards, for example) and inner sense of obligation to international rules rather than in fear of retaliation by the dominant power. By contrast, Marxists tended to see hegemony as an exploitative and imperialistic feature of the world capitalist system that works to the advantage of the most powerful states. For them, the metropolitan bourgeoisie exploits its own workers and those in the periphery through control of financial power, international investments and the ideological superstructure (Wallerstein 1980, 1974). Marxists saw the Asian financial crisis as an opportunity for the US to reap seigniorage gains from developing nations based on its global reach and financial power. These crises in turn allowed the US to exercise its structural power over other states, especially those in the South, by manipulating and expanding international monetary arrangements. Bubbles are thus an inevitable result of over-investment in the financial sector when traditional manufacturing cannot produce satisfactory profits. The more sophisticated and extensive credit markets become, the greater the likelihood that dislocations can take place leading ultimately to a slump and long-term stagnation (Kliman 2003: 119-36). Financial crisis, in Marxist analysis, is essentially a crisis of US capitalism through the increasing globalization of finance capital.

Those who adopted Marxist perspectives tried to avoid the state-centric pitfalls but still fell short of capturing the dynamics of class formation, institutional linkages between regulators and private sector actors and the politics of finance within the nation-state. The realist unit of analysis (that conceptualizes power as contained within a single state) is replaced by a closed elite structure that represents the capitalist class. Classical realists, for example, would agree with Marxist Wallerstein who claimed that the US “is no longer so strong that it can be called hegemonic and therefore it can no longer call the tune politically” (Wallerstein 1982: 40).

Despite distinct emphases and units of analysis, conventional paradigms described financial stability in terms of a single state’s preponderance of power or structural dynamics in global capitalism. Accordingly, all three predicted that a decline in hegemonic power would precipitate the breakdown of the liberal international order. The breakdown of this order was precipitated by US refusal to back the dollar by gold in 1971, which was a prelude to the de-linking of the dollar from gold. This was followed by greater “incoherence in US policy and greater instability in the international economic regime” (Krasner 1977: 635-6). For example, declinists saw events such as the financial crises of the 1970s and the Asian financial meltdown as a symptom of the final collapse of US capitalism and the resurgence of speculative finance as the cause of what came to be known as neo-liberalism. Consequently, all the countries, even the most powerful ones, are forced to adopt the same policies by world market forces and to pursue similar, i...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• 1 Introduction
• 2 State Power and Crisis Management: A Political-Economic Approach
• 3 Domestic and International Origins of the Bubble Economy: Institutions, Ideology, Regulations
• 4 Russia-LTCM and Enron Defaults: A New Type of Financial Instability 1998-2002
• 5 Domestic Politics of Financial Regulation in the Post-Enron Period
• 6 US Financial Crisis of 2007-2010: The Collapse of the Shadow Banking System
• 7 Post-Crisis Financial Regulatory Reform
• 8 International Regulatory Responses
• 9 Conclusion: Hegemonic Instability
• Bibliography
• Index