Systemic Dilemmas of the West as Seen from the Financial Crisis

Zhan Yongxin

Systemic Dilemmas of the West as Seen from the Financial Crisis

Zhan Yongxin

With some exceptions, the world is presently in a state of peace, but destabilizing factors are on the rise and turbulence has intensified in some regions. Western countries have one after another suffered from episodes of financial turmoil, economic recession, and mounting debt crises. These developments are not only regarded as the roots causes of the increasingly chaotic international situation; they also raise doubts about the capitalist system itself and prompted people across the world to have more in-depth discussion of the prospects of economic development.

I. A Crisis of Faith in the System

It has been more than four years since the U.S. subprime mortgage crisis triggered the international financial crisis, creating the worst economic conditions in the West since World War II. However, western economies have still not seen any strong or sustained recovery, and they find themselves in persistent fiscal and financial difficulties. As a result, the global economy has been sluggish and plagued with difficulties. Directly tied into these developments, quite a number of countries have witnessed intensified social conflicts and continued upheavals.

“The year of 2011 was seriously overloaded.”

—Russian Power

Since the start of 2012, the review of and outlook for the international economic situation has been anxious and confused around the world. Russia’s weekly magazine Kommersant-vlast (“Power”) described the year of 2011 as “seriously overloaded.”British newspaper The Guardian said that the current global upheaval is likely to be the beginning of a turbulent era. An American Defense News Weekly editorial called on all countries to deal with a “tougher” situation. In January, reports released by the United Nations, the World Bank and the International Monetary Fund all lowered expectations for global economic growth and stated that financial fragility has increased, economic growth prospects have diminished, and downside risks have escalated.

Continued economic sluggishness, financial turmoil, accumulated debt, rising unemployment, and social anxiety in the Western world have sparked extensive, heated discussions in the international community. The discussions are not simply on how to get over the economic, fiscal and financial difficulties in the short-term, but more so on the root causes of the current crisis and how the capitalist system will continue to develop in the future.

Two years ago, a number of prominent figures in the U.S. and EU economic and financial community stated that the economic turmoil at the time differed from the previous operations of economic cycles. They put forth a concept called the“new normal” which described the post-financial crisis era. According to these figures, in the post-financial crisis era, due to deleveraging, reduced liabilities, and strengthened financial regulation, the rate of return on financial assets will decline, the risk premium will maintain a high level, the volatility of macroeconomic variables will increase, and lower economic growth will comprise a “new normal” for debt-ridden Western countries. The subsequent development of the situation, especially the deepening European debt crisis and the rise of the“Occupy Movement” in the U.S. and beyond, has made people further realize that it is not enough to simply seek answers from the preexisting economic status quo. Whether Western countries like it or not, they have to admit that the crisis has extended from economic to political and social areas, forcing Western countries to face a major systemic dilemma.

The crisis has extended from economic to political and social areas, forcing Western countries to face a major systemic dilemma.

The World Economic Forum in Davos was convened this year under the title “The Great Transformation: Shaping New Models.” The Forum organized a debate focused on the question of whe-ther 20th century capitalism was failing 21st century society. Forum President Klaus Schwab publicly asserted that “capitalism, in its current form, no longer fits the world around us.” With the advent of the New Year, the Financial Times ran a series of articles entitled Capitalism in Crisis. The underlying message was that the international community questions the capitalist system and is urgently attempting to explore a way out.

Some scholars have tried to look for reasons at the level of policy formation. London School of Economics political science professor Martin Jacques and French economist Gérard Duménil claim that the current crisis is rooted in the rise of neo-liberalism of the Thatcher and Reagan era in the late 1970s. German historian Hans Ulrich Weller and Stanford University senior fellow Francis Fukuyama argue that the crisis represents a lack of financial sector regulation. Some others try to find answers in the field of sociology. International Labor Organization Director-General Juan Somavia points out that extreme inequality has exacerbated the crisis of capitalism. Former U.S. Labor Secretary Robert Reich simply blames the crisis on the greedy nature of mankind, adding that everyone is an accomplice.

The critique and defense of capitalism always take place on multiple levels. The current systemic dilemmas of Western countries can neither be attributed solely to the policies implemented by individuals nor be blamed entirely on abstract human nature. The system itself should be reviewed for underlying causes, and the consequences of capital operation should be attributed to the capital itself.

II. Reasons for the Systemic Dilemmas

1. Rampant state capitalism

The nature of capital lies in its pursuit and continuous expansion of profit. Due to basic contradictions inherent in the capitalist mode of production, it is difficult to maintain equilibrium between the production and realization of surplus value, and insufficient demand of society is normal, thus causing the periodic outbreak of the economic crisis and the intensification of contradictions between different strata of society. In order to mitigate these contradictions, Western governments have historically strengthened direct intervention in economic operations and wealth distribution. In the 1950s and 1960s, this intervention took the form of Keynesian economics and an expansion of the welfare system, helping establish a system of state capitalism. Although state capitalism helped Western countries create an unprecedented “golden period”(1950-1973) of economic growth, it has become a major reason for the stagnation and inflation that followed.

To get rid of the stagflation of the 1970s, the Thatcher administration in England and the Reagan administration in the U.S. took the lead in pursuing neo-liberalism. They tried to compress inflation using monetary tools. In short, they sought to stimulate the economy through fiscal policy and tax cuts on the one hand, and promote privatization, deregulation, free trade and free capital flows on the other hand.

The prevalence of neo-liberalism was not intended to reduce the intervention and involvement of Western governments in their economies, instead it made the running of the economy dependent on government action to an unprecedented degree. This dependence has been obvious in attempts to tackle the financial crisis in Western countries in recent years. Facing the crisis, previously confident financial groups now appear helpless, refusing to reach into their own pockets and becoming completely reliant on government relief. Western governments, under the pretext that these institutions are “too big to fail,”have mobilized national resources to rescue them, leading to much larger government deficits and national debt rising to astronomical level.

Since the fiscal year of 2009, the U.S. federal budget deficit has surpassed one trillion U.S. dollars for three consecutive years, with 2012 expected to be no exception. According to IMF statistics, the total debt of the US, EU, UK, and Japan reached $84 trillion in 2010, about 2.4 times their combined GDPs. The total sovereign debt of the Group of Seven countries due in 2012 stood at approximately $7.3 trillion, with $2.8 trillion and $3 trillion of debt due in the US and Japan respectively. The amount of money the US federal government owes to its creditors, combined with commitments to government retirement and other programs, now tops $15.23 trillion, as sum as large as the entire U.S. economy. According to estimate from the U.S. Congressional Budget Office, the U.S. debt to GDP ratio in 2012 will be close to twice the average over the past 40 years.

Today, the Western economies have become debt-dependent in the real sense and cannot function properly without support of the government’s fiscal and monetary policy. Even more noteworthy is the fact that, after three years of relief from the government, the bankruptcy risks of private enterprises have been converted to those of the “publicly owned” state.

2. Financial capitalism gone haywire

Financial capital came into existence with the mutual penetration and infusion of monopolistic industrial and banking monopoly capital, and its initial function was to serve the industrial economy. However, under the drive to attain capital profits, the operation of financial capital has become increasingly independent and begun to dominate other forms of capital, and the features of financial capitalism in Western countries have become increasingly prominent.

In the past 20 years, two factors have played particularly important roles in promoting the rapid development of financial capitalism.

The first factor is the increased support of state authorities in the West. The enormous wealth generated by the financial capital undoubtedly generates enormous political influence. Just look at the experience of the Clinton Administration Treasury Secretary Robert Rubin, the Bush Administration Treasury Secretary Hank Paulson, European Central Bank president Mario Draghi, etc., and it is not difficult to understand why Western governments’ decision-making is almost always highly consistent with the interests of the financial elite. To allow financial capital to develop and maximize the benefits calls for a relaxation of financial supervision. Former Federal Reserve Chairman Alan Greenspan may have been relatively cautious in his use of interest rate instruments, but he never begrudged his trust in financial markets. Until the eve of the financial crisis, Greenspan still declared in his memoirs, “Why do we wish to inhibit the pollinating bees of Wall Street?” As he urged and pushed, the United States passed the Financial Services Modernization Act in 1999, repealing the Glass-Steagall Act adopted during the Great Depression which strictly distinguished commercial banks from investment banks. While deregulating financial capital, the U.S. administration also refused to limit financial derivative products. With a series of deregulations, banking services that originally provided credit and loans for the real economy became mixed up with speculative investment banks, leading to a tendency towards gambling in Western economies. The volume of deregulated financial markets has been almost ten times that of the regulated financial markets. A great amount of financial activities such as credit default swaps and creditor-protection securities have proceeded outside the realm of regulation. The financial derivatives market has developed at an unmatched speed, and the value of related products grew from $866 billion in 1987 to $454 trillion in 2007. When financial capital rapidly expands independent of the real economy, virtualization and economic bubbles are difficult to avoid.

In order to achieve an expansion of financial capital around the world, Western countries also spared no effort in removing various restrictions on financial capital in the multilateral areas. In 1997, the IMF decided to promote the “full liberalization of capital movement,” slashing the control of various countries over their capital accounts. That same year, the WTO reached an agreement on the free flow of global financial services, aiming to allow any financial service provider to freely enter its member states and enjoy treatment like that experienced by national services. In 1998, the OECD reached a Multilateral Agreement on Investment, allowing a country’s industrial companies to have complete freedom to intervene in other country’s domestic economies, acquiring local companies and controlling local markets. Pushed by Western countries, the globalization of financial capital has become a core factor in the latest round of economic globalization. The volume of cross-border financial capital flows increased from just more than one trillion U.S. dollars in 1990 to $8.2 trillion in 2006, with its ratio to total cross-border capital flows rising from 80% to 85%.

The second factor was the combination of the financial industry with the real estate industry. The rapid expansion of the U.S. real estate industry took full form as the country entered the 21st century. From 2002 to 2006, the U.S. economy grew at an average annual nominal rate of 5.4%, while the real estate industry increased annually by 15%, almost three times the growth rate of the larger U.S. economy. Over the same period, U.S. home prices rose 90%, equivalent to an annual average rate of 11%. At its peak in 2006, the housing market was overvalued by as much as 50%. More and more Americans could have access to low-cost mortgages in the form of subprime loans, creating a key factor that stimulated the growth of the real estate market. Subprime mortgages had been used by the financial sector as a tool to assist the real estate industry in alleviating the insufficient demand, and the practice was recognized as being high return and high risk. The payment protection for the subprime mortgage is not based on the borrower’s repayment ability, but on the assumption that real estate prices will continue to rise. To reduce risks, sub-prime mortgages were further financialized, creating more derivative products. Housing real estate and other real estate could be monopolized and form a great proportion of the total wealth, therefore the financialization of the real estate industry substantially promoted the explosive growth of the financial sector and further aggravated the country’s economic bubble. In the first five or six years of this century, the volume of “home creditor mortgage securities” and “creditor protection securities”issued in the form of “home risk mortgage loans” (i.e. “subprime mortgage”) increased tenfold from $100 billion to $1 trillion. The market for “credit default swaps” almost reached $50 trillion, which was five times the U.S. gross domestic product.

The expansion of financial capital is not sustainable without a grounding of the real economy, and the reality is that such contradictions will eventually burst the bubble of virtual wealth. It would be no surprise to see the financial sector suffer a heavy blow when the housing price trends were reversed, and as a result low-income groups where coldly evicted from their new homes.

3. The eroded social foundations due to social inequality

All Western countries like to brag about how the capitalist system can achieve optimal resource allocation and distribution, but facts do not always support their arguments. The economic and social realities of recent years have kept the people in Western countries again and again asking why the 99% majority always suffers while the 1% minority enjoys an opulent lifestyle, even during a financial crisis.

Stubbornly high unemployment rates reveal the seriousness of poverty and inequality. The U.S. unemployment rate exceeded 10 percent in October 2009 after hovering around 9-10%. It is still at a high of more than 8%, though the unemployment rate would be as high as 15% if “part-time” employment (i.e. underemployed) were taken into account. Compared with the pre-crisis situation, the U.S. experienced a net loss of over five million jobs. Eurostat data released on January 31 showed that the unemployment rate was as high as 10.4% in 17 Eurozone countries in December last year, and in Spain the unemployment rate was 22.9% with youth unemployment exceeding 50%. In the UK, the number of youths not in education, employment or training (NEET) recently hit a new high. According to the British Department of Education statistics, as of last November, the number of 16-24 year old NEET youths reached 1.163 million, an increase of 137,000 compared with the previous period of measurement. A related survey also found that in addition to an increase in the number of NEET youths, the status of NEET for a youth has been protracted, and the children of poor families are more easily reduced to NEET status.

What is even more disturbing to Western society is the widening gap between the rich and the poor, and the decline of the middle class, which was once considered the heart of Western capitalism. Morgan Stanley Asia Chairman Stephen Roach admitted that the gap between rich and poor reached its widest margin in history. Even Francis Fukuyama, who put forth the “end of history” thesis 20 years ago, has revised his claim and recognized that “liberal democracy” combined with market economy is not always so wonderful. He recently pointed out that the actual living standards of middle-income Americans have seen no increases since the 1970s. Americans can afford to buy cheap mobile phones and clothes, but they increasingly are unable to afford the cost of housing, medical insurance, and pension insurance. The gap between the rich and poor has rapidly expanded in the United States over the past 30 years. In 1974, the wealthiest 1% of American families accounted for 9% of GDP; in 2007, this percentage expanded to 23.5%.

The OECD 2011 report also noted that in the 22 member states surveyed, the income gap has widened by 10% since the mid-1980s, and the situation has been even worse in 17 of these member states. United States Institute for Policy Studies reported that the average CEO of a large U.S. company made $10.8 million in 2010, an increase of 28% over the previous year. Meanwhile the average U.S. worker earned $33,121 last year, an increase of only 3%. The CEO’s income was 325 times higher than the average worker’s income. According to official U.S. statistics, in the decade after 1999 the median income of the bottom 10% of American households decreased by 12% while that of the top 10% of households fell by only 1.5%. Overall, median household income adjusted for inflation declined by 7% compared with 1999.

“Liberal democracy combined with market economics is not always so wonderful.”

—Francis Fukuyama

Unemployment and poverty are both consequences of an economic and financial crisis, but they are also the cause of the next crisis. When a great amount of tangible and intangible wealth is created quickly, the existence of unemployment and poverty will ag-gravate the contradictions and inconsistencies between the production and realization of surplus value.

In addition, social inequality is found not only in the differences in people’s living standards but more importantly in the positions of individuals in the system of social production and the degree of their influence on decision-making.

4. Impact of economic globalization

During the Cold War, the confrontation between the two blocs put the world market in a fragmented state. In the colonial system, the exchange between colonies and sovereign states was not a reciprocal trading relationship. By the 1980s, the world’s national liberation movement basically completed its mission, and developing countries had achieved national independence and had become at least nominally become equal members of the world market. China took the initiative to reform and open up to the outside world, moving towards a market economy in a country with one fifth of the world population; the collapse of the Soviet Union and Eastern European bloc removed the last political barriers that had divided the world market. An unprecedented global market was born, laying the foundation for a new round of economic globalization.

This new global market has created conditions for the rapid expansion of capital, brought huge profits to the owners of capital, and also provided development opportunities wherever capital goes. What has followed is a hollowing out and virtualization of western economies amid the rapid rise of emerging countries, leading to major changes in the international economic landscape. Asia’s share in global economic output rose from 15% in 1990 to more than 28% today. In 2010, Asian exports accounted for 31.6% of the global total, and regional trade accounted for 52.6% of the total foreign trade of Asian countries. The real GDP of emerging economies accounted for 49% of the world in 2010, and it is expected to exceed this level in 2011, while total consumption has surpassed the United States. In 2007-2011, national income grew by less than 0.6% in the U.S., contracted by 0.3% in EU, and fell 5.2% in Japan. In China, it grew by more than 42% during the same period.

The process of economic globalization has brought huge profits to Western countries, but at the same time they also face a double impact: their weakened competitiveness and other countries’ enhanced competitiveness.

5. Cyclical factors that deepen the crisis

There is a general consensus that cyclical fluctuations take place in Western economies. But for nearly 20 years before the outbreak of the current international financial crisis, Western economies witnessed prolonged prosperity, shortened recessions, and decreased volatility. Some in Western countries even believed that the economic cycle would end and a lasting prosperity would be maintained. The fiscal and financial crises and the continued sluggishness of the real economy in the past two years have made these predictions vaporize into thin air.

In fact, economic cycles remained in the West before the outbreak of the crisis but were later deformed. A variety of factors contributed to this phenomenon. First, Western governments engaged in strong intervention through monetary and fiscal policies. Especially in the United States since late 1980s, the Federal Reserve has kept low interest rates as a basic policy to deal with cyclical fluctuations. Loose credit has been used to support aggregate demand, leading to a reduced duration of crises, as well as less obvious boundaries between the depression and the recovery due to an accelerated rise of the economy. Second, economic globalization has on the one hand provided Western countries with new markets for their products, while on the other hand it has made it possible for inexpensive goods from developing countries to pour into Western countries, keeping prices down in local markets and thus allowing greater space for Western governments to make economic adjustments. Third, just as industry and industrialization eased the seasonal fluctuations of agricultural production, the information technology industry and informationization ironed out the cyclical fluctuations of the traditional industrial economy. Since the 1990s, the rapid development of the information technology industry has led to further deformation of the economic cycles in Western countries. As Greenspan said, “information technology has doubtless enhanced the stability of business operations.” In the United States, information technology and other high-tech industries have replaced the traditional cyclical industries as the main driving force promoting economic growth. For example, in the mid-1990s when American auto and other traditional industries fell into recessions, the sudden emergence of the IT industry promoted sustained economic growth. Since then, the emergence of the Internet economy, most saliently with the growth of e-commerce, has helped delay the arrival of economic recession, so that the economy continues to rise.

However, the factors listed above have changed in a significant ways, and government intervention is no longer able to be sustained in Western countries. Economic globalization has not only made the world flat but also turned it into a more crowded place, and many say that scientific and technological innovation is reaching a peak. Some scholars even believe that Western economies, now at a low ebb, are facing the Kondratieff cycle (50-year cycles of technical innovation), the Kuznets cycle (20-year cycles of real estate), the Juglar cycle (10-year cycles of capital investment) and the Kitchin cycle (three-year cycles of inventory), and remain in low ebb.

It is therefore safe to say that policy and technology may ease but cannot eliminate the contradictions in the Western economies, and that as long as the basic contradictions involving the capitalist mode of production persist, the cyclical fluctuations of Western economies will not disappear. When long-term factors such as technological innovation and capital investment and short-term factors such as inventory exactly overlap at troughs, it will undoubtedly become a more lengthy economic recovery.

At the outset of the current financial, fiscal, and economic crisis, some people in the West intended to fault China and other emerging countries, claiming that “unfair competition”coming from these countries caused an imbalance in the world economy. However, the above analysis has revealed that the Western crisis stems from the nature of capital. It also shows that the defects in the capitalist system have caused economic and social imbalances. Of the many factors discussed, overflowing state capitalism and out-of-control financial capitalism are the primary reasons for the crisis, while the gap between rich and poor and cyclical fluctuations have exacerbated the crisis. The hollowing out and virtualization of Western economies is dictated by the nature of capitalism in seeking profits, not caused by emerging countries.

III. Adjustment of Western Countries

From an objective point of view, as Karl Marx said, “No social order ever perishes before all the productive forces for which there is room in it have developed.” Over the past few hundred years, while helping create a huge amount of wealth, capitalism has often improved itself in dealing with the contradiction between productive forces and production relations, as well as the conflict between different sectors of society. This historical process is yet to see an end.

From a subjective point of view, capitalism has never had a lack of defenders. Although many people in Western society are dissatisfied with the capitalist system or periodically express their discontent with it, an overthrow of the system is clearly not a popular consideration. It remains the mainstream agenda to reach a consensus on rebuilding the capitalist order. Greenspan argued that capitalism needs to be adjusted, but he expressed his deep suspicion regarding the notion that one could make an “improvement” in the capitalist model. Harvard University Professor Lawrence Summers called for rational rather than destructive intervention in economic downturns. He claimed that once macroeconomic policy adjustments are in place, many of the current concerns would vanish.

In the coming period of time, Western countries may take the following measures to respond to systemic dilemmas:

1. They will engage in a series of debates in the realm of theory. Just as Keynesian economics was used to tackle the Great Depression, neo-liberalism adopted to fight the stagflation, and welfare doctrine introduced to alleviate social contradictions, Western society urgently needs a theory to guide them out of the current crisis. Neither the political left nor right has been able to come up with a comprehensive plan, and some of the proposals for reform have focused on the reform of the financial system and the wealth and income distribution. Some Western analysts have expressed their interest in the strict control of the economy demonstrated by powerful state-owned companies and governments in emerging countries, but this mode of economic management lacks a foundation of growth in the West. At present it will be difficult for Western society to find a theory in the near future that can play a leading role.

“No social order ever perishes before all the productive forces for which there is room in it have developed.”

—Karl Marx

2. At the level of economic and social policies, the short- to midterm goal for the West is still to take emergency measures as well as actions that can close existing loopholes. In order to overcome the crisis and prevent a deeper recession, efforts will be made to provide new public loans and restore the supply of private credit as soon as possible. Efforts will also be made to increase productive investment as much as possible, while trying to boost revenues and reduce expenditures and to consolidate the fiscal system. In the meantime, the average public will have to live through a tough period with reduced economic mobility. Longer-term measures may include transferring part of the interests of the bourgeoisie through taxation reform, and formulating new market rules that include strengthened supervision of the activities of financial capital.

3. As for sovereign debt, Western countries, and the United States in particular, will not “tighten their belt” to repay debt. Instead, they will continue to support their culture of continued debt, then monetize the debt, and finally dilute the debt through currency devaluation and inflation.

4. Western countries will seek breakthroughs in science and technology by mobilizing manpower, material and financial resources, and using more new technologies in existing industries, the West will attempt to generate new demand by the addition of new supply and profits through technological monopoly. At the same time, they will also speed up labor market reforms and enterprise restructuring in order to enhance economic competitiveness.

5. The West will support their economy through hegemony. The current financial crisis has caused less damage to the United States than to Europe, despite the fact that the crisis originated in the United States, the U.S. savings rate has been lower than those of the European countries, and the ratio of US fiscal deficit to GDP and the government debt risk are no smaller than they are in Europe. The main reason for the U.S.’s relatively good position lies in American hegemony, especially the dollar’s special status. Whereas previous hegemonic states had to impose direct rule over the sources of their wealth, the economic basis of American hegemony is not limited to any fixed area, but rather is built on the existing international monetary, financial, and trading systems. Therefore, the United States will not accept any reform in the international system that would weaken U.S. dominance, its veto power in particular. In international politics, the United States will generate and sustain certain tensions so as to increase the political and security value of the U.S. dollar and bonds, in addition to their actual economic value. Unparalleled by any other country, the United States is skillful in its integrated use of American political, economic and military means to maintain its hegemony, and in this regard all countries must maintain a high degree of vigilance.

Zhan Yongxin is Director General of the Department of Hong Kong, Macao and Taiwan Affairs, Ministry of Foreign Affairs of the People’s Republic of China.