Wednesday, September 14, 2011

The Great Crash 2008, Part Two

. Wednesday, September 14, 2011

In the last chapter of The Great Crash 1929, "Cause and Consequences", JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed from the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the second.

Galbraith's second possible reason for why the 1930s depression was so great was that the corporate structure in the US economy was poor:

The fact was that American enterprise in the twenties had opened its hospitable arms to an exceptional number of promoters, grafters, swindlers, impostors, and frauds. This, in the long history of such activities, was a kind of flood tide of corporate larceny. 
The most important corporate weakness was inherent in the vast new structure of holding companies and investment trusts. ... dividends from the operating companies paid the interest on the bonds of the upstream holding companies. The interruption of the dividends meant default on the bonds, bankruptcy, and the collapse of the structure.

There are really two things here. First, Galbraith claims that the 1920s were prone to a widespread prevalence of fraud. Second, that corporations were structured in such a way that a disruption in finance would batter the real economy because financial firms owned many of the most important firms in the real economy. Throughout the book he offers a lot of evidence that fraud and other shenanigans were prevalent in the 1920s, although he does nothing to establish the claim that the 1920s were somehow worse in this regard than decades before or since. He does more throughout the book to show how the corporate structure was organized with productive firms downstream that were owned by financial firms upstream. The two were tightly linked, so that a major perturbation to one sector could have adverse effects on the others.

Some of these charges have been levied about the corporate system in the run-up to the 2008 crash. While I think claims that the financial crisis is a result of fraud or other criminal activity are generally over-stated, and I know of no reason to believe that criminal activity in the financial sector was more prevalent during the 2000s than other periods, there certainly was some of that going on. Perhaps more plausible is the argument that compensation schemes in major financial firms were skewed towards excessive risk-taking and boosting the short-run value of firms, not long-run stability. That may be true as well, although the only piece of research I've seen that directly examines that question finds the opposite (although another study shows that executives of large banks sold their companies stock more than they bought it, perhaps indicating that they didn't have much confidence in their firms' activities).

The second part of Galbraith's claim is more interesting to me, and potentially much more important. Was there was a shift in the underlying structure of the economy that altered the pattern of corporate organization? I don't know of any research showing the specific dynamic that Galbraith describes -- dividends from downstream productive firms paying for activities of upstream financial holding companies -- but something else happened:
From this analysis came two striking figures. The first is a map [above; click for larger version] of links between companies in five key economic sectors: technology, oil, other basic materials, finance linked to real estate and other finance. As of 2003, the sectors are relatively distinct, with real estate isolated. By 2008, they’re a tightly linked jumble, with finance at the center. 
I wrote about this research last year:
To me, there are two ways of looking at this. The first is the conclusion reached by Keim, that interdependence on its own can be stabilizing, until it reaches a critical mass, at which point increased interdependence destabilizes the system. Interdependence obviously went up throughout the 2000s. But another way to look at it is to examine the pattern of interdependence, rather than the occurrence of interdependence. 
It is clear that the financial sector became much more central to the economy, so the economy as a whole became much more susceptible to trouble in the financial sector. In this way, the U.S. economy appears to display a feature of non-random, hierarchical networks, which is that they are robust to shocks in peripheral parts of the network, but fragile to shocks at the center. In other words, if a shock had hit the peripheral oil sector (as happened, in fact, in the middle part of the decade), the increased interlinkages with finance would make the economy more resilient. But once a shock hit finance, the central sector, everything else was prone to collapse as well.
In other words, the major American industries -- tech, energy, real estate, etc. -- all became very strongly linked to finance. This generated lots of profits during the 2000s, but also left the entire economy more susceptible to a shock to the financial system. So the tightly-linked corporate structure that emerged in the 2000s may indeed have had quite a lot to do with why the financial panic had such a devastating (and persistent) effect on the real economy.


LFC said...

Perhaps you've addressed this earlier, but what was it that 'caused' the shift in the structure, i.e., the tighter links of the various sectors to finance? (I would have a guess or two, but would be interested in your view, if not too big a question for a comment thread.)

Kindred Winecoff said...

My guess is that it's linked to developments in the global political economy, which have increased the rewards for high-skilled services (huge increase in global demand) while reducing the rewards for low-skilled labor (huge increase in global supply). The US, which has a comparative advantage in high-skill services, thus shifted more and more into those services. Finance chief among them. Something similar has happened in the UK, I believe.

I wrote about some of this in the context of criticizing Cowen's *Great Stagnation* hypothesis:

But I'd also add that network dynamics in the international financial system are important. I briefly discussed that here:

The Great Crash 2008, Part Two




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