2.1 … but it could not be exported to other countries, apart from the United Kingdom…

But this hope was naive, because ultimately, the economic structures of the United States were quite singular (Artus, 2009). Only the United Kingdom had a similar configuration. In all the other countries, notably Japan, Germany and France, the prevailing rationale that determined economic activity was one of productivism and creation of added-value in non-financial companies, much more than one of shareholder value and all-out financialization (Table 1). The weak spread of stock wealth in relation to disposable income, the modest levels of capital gains and a norm of profitability much lower than that entailed by Anglo-American shareholder value all formed obstacles to the establishment of a finance-led growth regime. Moreover, formalization reveals that if productivism is the prevailing rationale, then the introduction of shareholder value damages the macroeconomic equilibrium, both for companies and employees. It was therefore not in these countries’ interest to adopt the American model, since they had different sources of growth and international competitiveness. In a way, the harshness and persistence of the Japanese crisis following the bursting of the 1980s bubble bears witness to this major divergence between different OECD countries (Aglietta, 1992; Boyer, 2004; Yoshikawa, 2002).

The present research therefore moderates the prediction initially made by certain regulationists that financialization was the heart of the regime of accumulation that would succeed Fordism (Aglietta, 1998). Since then, the bursting of the Internet bubble and the subprime crisis have clearly brought to light the limits of finance-led accumulation, which does not appear to be endowed with the same long-term dynamic stability as the Fordist growth model (Aglietta & Réberioux, 2005; Boyer, Dehove, & Plihon, 2004; Plihon, 2001, 2002; Jorion, 2008; Conseil d’Analyse Economique, 2008).

2.2 … The very success of financialization can lead the economy into a zone of financial fragility…

The other interest in formalizing this regime of accumulation is that it allows us to identify the parameters that play a key role in the possibility of driving the economy into a zone of financial instability.

1. First, it may be that the rate of return demanded by the financial community reaches such a high level that it is impossible for any macroeconomic equilibrium to sustain it. During the Internet bubble, for instance, the norm was gradually raised from 5% up to as much as 15%. In passing, we can also understand, at a microeconomic level, why non-financial companies have been driven to use ever higher leverage (Plihon, 2002) or resort to creative accounting to invent profit levels high enough to satisfy the capital markets (Boyer, 2005). Fair value accounting further accentuates these effects by adding an accounting accelerator to the typical financial accelerator (Boyer, 2007).

2. A second source of destabilization can result from the growing importance of wealth in consumption decisions. Beyond a certain threshold for the wealth effect, the economy is on an explosive path, and any possibility of a stable regime disappears. And yet, through a constant stream of financial innovations, the access to credit has been made ever easier and may have provoked the equivalent to this phenomenon at the end of the American housing bubble. In a way, the source of the crisis lay in the popularization of the attractions of financialized growth.

3. The central bank may be too slow in adjusting the interest rate to suit the economic situation. In this case, if it maintains interest rates too low for too long, it may endogenously trigger the collapse of the previous macroeconomic equilibrium. In a sense, this is the criticism that has been levelled at Alan Greenspan since 2007, that he did not have the courage to raise interest rates, preferring to see a housing bubble succeed the stock market bubble.

4. Lastly, since the stabilization of ROE is based on greater flexibility of jobs and wages, the responsiveness of wages may reach such a level that it contributes to the destabilization of the economic equilibrium, in this case in a depressionary direction. This factor is likely to play a decisive role during the phase of correction of the excesses of financialization.

To varying degrees, these four developments have marked the American trajectory over the last two decades.

2.3 … And result in a series of ever more severe crises

Even before the systemic nature of the crisis that began in September 2008 became apparent, the American financial system had been touched by a series of crises, initially perceived as being sector-specific and limited, whereas they were in fact the first symptoms of the fact that this financialization built on a succession of financial innovations had reached its limits. With hindsight, it is possible to reinterpret the so-called crisis of the new economy as an expression of the conflict between the impatience of finance as regards expected profits and the reality of the long process of converting innovations into profitable products (Boyer, 2002a). The subprime crisis stemmed from the fact that financial intermediaries had become less and less accountable for their actions, because of the generalized separation between financing and risk, resulting in an explosion in the volume of derivatives and, within the shadow banking system, the deterioration in the quality of the corresponding assets (Bourguinat & Briys, 2008). The US public authorities, believing in the superiority of the market over any kind of public evaluation, contributed to the birth of the crisis through their inaction.

4.1 The stock market crash of 19 October 1987: the ghost of 24 October 1929 soon forgotten

This episode started with the collapse of the Dow Jones on the New York Stock Exchange, equivalent in value to the crash that marked the beginning of the crisis in 1929. The analysts started asking themselves the question that Minsky had taken as the title of his famous work: “Can it happen again?” In a conception of the economy governed by the notions of equilibrium and the temporal invariance of the basic economic mechanisms, a depression equivalent to that of the 1930s was expected. In the end, this prediction proved to be completely erroneous, for two main reasons (Table 2).

The origin of the two crises was completely different. In the former case, stock market speculation simply amplified a disequilibrium in the regime of accumulation, which explains the scale of the economic and social costs in the United States in the 1930s. In the crisis of 1987, there was sustained growth, although the underlying international context was troubled by exchange rate uncertainty. The disequilibrium was essentially confined within the financial sphere.

1. The US central bank had learnt from the errors of its predecessors in the 1930s: instead of allowing a chain of bankruptcies to develop on the capital market, Alan Greenspan provided the threatened operators with abundant liquidities. Ex post, we therefore observe the continuation of growth and slight inflation, rather than depression and deflation.

So stock market crises keep developing, but they are never the same. In this case, it was the financial innovations of the early 1980s that were at the origin of the crisis. At that time, a new method of stock portfolio management was developed, associating every transaction with an option hedging against potential losses from unexpected changes in the market. But for other financial players, this simply served as a support for speculation on such a scale that the innovation supposed to stabilize the financial system ended up leading it into crisis (Biondi, 2011; Pradier, 2011; Stout, 2011). At the same time, all the players on the market invested in software allowing them directly to place the orders entailed by this optimization programme. A marked fall in stock prices then triggers a depressionary spiral: everybody wants to sell and almost nobody wants to buy. We can draw three lessons from this already distant episode.

1. In this case, it was the general adoption of the strategy of market risk coverage that triggered the occurrence of the risk against which the agents were trying to protect themselves, at a microeconomic level: in a way it was the convergence of perfectly rational microeconomic strategies that blocked the market. This feature can also be found in most of the other crises, including the subprime crisis (see Figure 10, below).

2. The central role of the Fed was confirmed by this episode: faced with a liquidity crisis, whatever the responsibilities of the other players and whatever the risks of moral hazard, the central bank acts as the lender of last resort, restoring the continuity of the system of payments. This characteristic is present in most of the crises examined in the present article.

3. Upon demand by the political authorities – but not by the professionals, who argued that the mechanisms of the market should be allowed to operate freely! – circuit breakers were introduced to halt trading in the event of exceptional price movements. Thus, the financial markets record the sedimentation of rules instituted to prevent the repetition of past crises. When the political authorities go back on some of these rules, such as the separation between commercial banks and investment banks, a return to old forms of crisis becomes possible, as some of the developments in the subprime crisis have shown.

The first of these lessons, but not the other two, was demonstrated in the following US crisis.

4.2 A first crisis, quickly overcome, that warned of the dangers of derivatives: the collapse of LTCM

Market finance theories have developed greatly since the beginning of liberalization. Statistical and mathematical techniques have become more sophisticated and the theorists have proposed new methods of evaluating risk and consequently of pricing derivatives. The contributions of Black and Scholes (1973) and Merton (1973) opened up a wide domain of possibility for the invention of new derivatives. Far from observing the regularities resulting from the functioning of the market, these theorists invented a new method of evaluation and presented it to the financial community, which adopted it so wholeheartedly that it was now the regularities postulated by the theoretical model that appeared in the market prices. This performativity of financial theory was a novelty, compared with standard micro- and macroeconomic theories (MacKenzie & Millo, 2003).

It was tempting to believe that this remarkable mastery of risk evaluation had eliminated any danger of major financial crisis. The collapse of long-term capital management (LTCM) is interesting precisely because it shows that financial crises are not necessarily the result of ill-informed agents acting irrationally or the herding behaviour of the crowd (Kindleberger, 1978, 1994; Shefrin, 2000), but may derive from the implementation of a new approach to the optimization of returns on capital, so vigorous that it destabilizes the macroeconomic regularities, all the more so when something occurs that is considered to be a once-in-a-century event (Taleb Nassim, 2007; Cont, 2009) at least in the light of retrospective analyses (Figure 4).

The huge losses incurred by one sole financial institution, originally of modest size, raised two problems for the public authorities responsible for financial stability.

Figure 4

The collapse of Long-Term Capital Management: an ad hoc solution brokered by the Fed with no review of public control.

The sophisticated derivatives that are supposed to cover the risk of certain agents actually expose other agents to risks that are all the greater as they become the accredited or even exclusive suppliers of this type of product. This conclusion, drawn from observation of the LTCM crisis, is also confirmed by diverse models that take into account the specificities of the current organization of the financial market. These models show that creation of a futures market and a derivative can push the economy into a zone of financial fragility, under conditions very similar to the characteristics of existing markets (Artus, 1990; Brock, Hommes, & Wagener, 2006; Li & Rosser, 2001). This contradicts the (false) conclusion one might draw from the last chapter of Gérard Debreu’s Theory of Value (1959): if all the futures markets are open, then an equilibrium can exist under the usual conditions. As we move closer to this ideal, we should therefore observe greater financial stabilization. This conjecture is essential, since it underpins the strategies of creation and multiplication of derivatives, but it is refuted by recent financial literature.

1. The sudden appearance of losses running into billions of dollars is the direct consequence of the use of extremely high leverage, with factors of 30–50. Under these conditions, it only takes a price fall of 3.3% or even 2% for the losses to exceed the value of the equity capital. This was the whole problem with hedge funds or even the management of an experienced firm like Lehman Brothers: it only possessed 1 billion dollars in equity to cover more than 30 billion in assets.

One might have thought that the various regulatory authorities might be worried by these risks and seek to impose some kind of limit on the more dynamic managers of Wall Street. But self-organization by the market players was the solution favoured by Alan Greenspan, who encouraged other, healthier investment banks to take over LTCM. This elegant and economical solution – from the viewpoint of public finances – therefore helped to conceal the dangers of derivatives and of hedge fund strategies.

4.3 The Enron episode: a second opportunity wasted

Setting aside the precise characteristics of the derivative involved, the same sequence of events can be observed, mutatis mutandis, for the energy derivatives proposed by Enron. This was the era of the new economy and hopes of a dematerialization of economic activity: why sink investments into facilities for producing and transporting energy when there are substantial profits to be made by organizing the futures market of the corresponding contracts, with a modest capital outlay with the added advantage of allocative flexibility. Just like LTCM, Enron was so successful that it became the flagship company to which many others aspired, so exceptional were the returns it posted.

In 2000, however, we learned that these results were largely achieved through accounting practices which, although legal, were extremely dubious. They consisted in discounting to present value all the returns associated with existing contracts, while at the same time concealing the corresponding costs in satellite accounts that were not consolidated with those of the parent company (Baker & Hayes, 2004; Benston, 2006; Healy & Palepu, 2003; Mistral, de Boissieu, & Lorenzi, 2003). Essentially, the problem raised therefore concerned the information available to the financial market: whence the call for greater transparency and for the accountability, including penal, of CEOs and financial directors, which gave rise to the Sarbanes-Oxley Act (Figure 5).

Figure 5

The fall of Enron: tougher accountability rules for senior executives, but with no reform of accounting practices or supervision of new derivatives.

However, several problems remained.

1. First, the Enron executives had used their contacts in the political world to dissuade the financial supervisory authorities from imposing any control or regulation whatsoever over derivatives, under the two pretexts of a complexity they alone could master and the principle of freedom of enterprise. We were to observe a similar phenomenon for subprimes in the second half of the 2000s.

2. Second, and above all, accounting practices oriented exclusively towards the financial community and implementing the principle of fair value represented a serious threat to financial stability. They introduced strong procyclicity into the results posted, which were, moreover, virtual (Boyer, 2007). As much as investors were satisfied during periods of speculative boom, so they suffered a risk of sudden bankruptcy during periods of adjustment. We need look no further for the reason behind the collapse of Lehman Brothers, or the takeover of Merrill Lynch by Bank of America. As the products became ever more sophisticated and the volumes traded continued to increase, the sums committed grew so large, during the second half of the 2000s, that they threatened the financial stability of the whole American system.

3. Third, the last paradox is that while securitization was supposed to spread the risk, which it did to some extent, it also led to the specialization of certain investment banks or insurance companies in certain segments of the market. The resulting concentration of risk therefore increased the probability and violence of financial crises when private firms are obliged to reveal to the market the extent of their losses, information that is kept private as long as possible. Whence the consternation of the public authorities, obliged to commission other private firms to verify the financial situation of companies they were thinking of taking over, as was the case for Bear Stearns.

4.4 The ambiguity of shared responsibilities in financial supervision: Northern Rock

This brings us to another central point, well-illustrated by the bank run that occurred in England in 2008. Because of the division of labour between the different financial supervisory bodies, and their sedimentation over time, the public authorities were initially confounded by the abruptness of the Northern Rock crisis (Figure 6).

The origins of this crisis lay in an innovation that initially met with great success: this bank, specialized in mortgages, decided to use massive bond issues as a means to grow its activity and win market share. After few years, Northern Rock became the leading company in the sector – as long as the British housing bubble continued to grow. The different supervisory authorities (the Bank of England, the Financial Services Authority, the Treasury and the City) remained silent, despite the fact that this strategy generated new risks for the bank and by extension for the British financial system. When the downturn in the housing market arrived, it triggered a spiral of asset depreciation, because of both bad debts and the bank’s falling share price. Customers, alarmed by a statement from an external authority, rushed to withdraw their deposits from the bank.

To begin with, the Bank of England, governed by an economist well aware of the problems of moral hazard that the rescue of Northern Rock would raise, refused all aid. There was also ambiguity over the sharing of responsibilities between the different regulatory and supervisory authorities. In keeping with a British tradition, the government hoped that the City would manage to find a solution without any need for state intervention. But the panic started to grip the whole of the British banking system, and in the end the government was obliged to nationalize the bank. This was certainly not a measure that New Labour had included in their manifesto! Whence the pertinence of Ben Bernanke’s comment: “There are no ideologues in a financial crisis.”

Figure 6

The financial innovation that caused the first bank run since 1856 in the United Kingdom.

This new episode confirms the lessons to be drawn from previous crises and provides some new elements for consideration.

1. First, given the plasticity of finance, an innovation implemented by a second-tier bank is capable of generating a movement of sufficient power to endanger the bank itself and even the whole financial system. It is then easy to understand the importance of having regulations and supervisory authorities covering the whole of the financial system.

2. Second, when a crisis does arise, there may be ambiguity as to the supervisory authority concerned, because modern innovations connect up all sorts of different financial instruments (including loans, derivatives, bonds, swaps, insurance and options). This ambiguity can be prejudicial to an orderly resolution to the crisis. The different authorities may have different ideas about how to address financial crises. Some prefer to avoid the next crisis at the risk of exacerbating the present one by refusing the public bail-out of inept or reckless speculators. Others consider that in a market economy, nothing can be more important than monetary and financial stability, even if that means paying out money to save the firms that started the crisis.

3. Lastly, the speed of the downturn, the growing interconnectivity between different markets and the facility with which a vicious circle of generalized asset depreciation can be triggered generally tip the balance in favour of public rescue, whatever the political programmes of the governments concerned, the warnings of economists or the protests of opposition parties. The American trajectory since 2007 provides a good illustration of the improvisation that seems to govern the management of systemic financial crises.

5.1 The US mortgage derivatives crisis: silence from the regulatory authorities followed by massive intervention

This episode leads us to another factor in the genesis of bubbles associated with financial innovations, namely the role of the central bank in fixing low interest rates. This was the case in the United States after the bursting of the Internet bubble, which prompted a programme of stimulus involving tax reductions and the maintenance of low interest rates to relieve financial institutions and indebted households. The Republican administration also announced a programme of access to home ownership for minorities and disadvantaged groups in the US population. Mortgage establishments leapt at the new opportunities for profit that this opened up: they offered loans without bothering to make any request for collateral or for information about income, in the hope that the continuing surge in real estate prices would be the best guarantee. There was also particularly active lobbying, which succeeded in ensuring that the corresponding financial products and their securitization were not covered by any regulations whatsoever. Thus, all the ingredients were brought together for the typical development of a high-risk financial innovation (Figure 7).

Figure 7

A theoretically dangerous innovation, but in line with the policy of promoting home ownership.

When it became apparent, in March 2007, that default rates were rising and house prices were falling, there was a sharp downturn in the market, and the previous classification of tranches of credit proved to be hopelessly over-optimistic. The subprime market disappeared, and as it had figured prominently on the books of many banks, this triggered a liquidity crisis to which the Fed responded by providing easier access to liquidities, but initially only to a modest degree. Given the huge scale of the assets involved, of the order of 3,000 billion dollars, it soon became apparent that defaults were still rising and that the banks were incapable of evaluating a growing number of assets. This was because the subprime market was now closed, and the ad hoc models drawn up by each bank, assuming constant access to liquidity and a low risk correlation, no longer provided any relevant information. We can qualify this as a systemic crisis, because the very principle of asset valuation was at the root of the discord, so that interbank lending, in particular, completely dried up (Biondi & Fantacci, 2012).

A new stage in the crisis was then reached in 2008, when the Fed guaranteed unlimited access to liquidity, encouraged mergers between financial establishments and accepted recapitalization by sovereign funds, which, not long before, had been denounced for their lack of transparency and the threat they posed to the stability of the world financial system! The most remarkable phenomenon was probably the way US policy-makers appeared to be groping in the dark. The Treasury Secretary minimized the scale of the crisis, the Fed granted facilities of access to credit and both of them called for Wall Street to act responsibly, without taking full measure of the origins and depth of the crisis. In fact, the whole system of valuation of assets and liabilities had frozen up. Under such conditions, monetary policy is a very crude and indirect tool for resolving this crisis of a largely new nature.

5.2 A crisis all the more serious because of the accumulation of financial fragilities underlying the crises since 1987

Thus the American subprime crisis combined all the features already diagnosed in the previous crises: increasing numbers of ad hoc innovations largely incomprehensible to third parties, confidence in models estimated over relatively short periods of time, certainty of permanent access to liquidity, the race for leverage to obtain ever higher returns on equity in response to the pressures of shareholder value, remuneration structures of financial intermediaries encouraging risk-taking by transferring it onto third parties, lobbying of the political authorities to prevent any intrusion by supervisory bodies into particularly profitable markets. One can understand why this crisis should be of such an unprecedented scale, because it accumulates all the problems and imbalances that have been denied or kicked down the road throughout the 2000s.

When the bubble burst and the extent and depth of the consequences for the whole of the financial system became apparent, both the market players and the experts were taken by surprise. But this is in itself astonishing because, as we have just seen, there have been plenty of warnings since the end of the 1980s, because the various crises have brought to light the different shortcomings of the financial organization of the United States. Excessive confidence in theoretical models was seen in the stock market crash of 1987 and even more so in the collapse of LTCM. The danger of giving free rein to a company to create and then manage a mass market for a potentially unstable financial product sustained by creative accounting was demonstrated by the Enron scandal. Collusion between financial operators and the political authorities to exempt the financial innovations of investment banks from any public control could be observed in energy derivatives and, of course, American mortgage derivatives. The helplessness of the political authorities, related to the fragmentation of public control, when a local bankruptcy threatens to lead to systemic collapse was apparent in the bankruptcy and nationalization of Northern Rock and the difficulty the US authorities have had in adapting their strategies to the depth of the subprime crisis since September 2008 (Figure 8). And yet one of the lessons to be drawn from the history of financial crises is that they are all the more serious and persistent when the public authorities are slow to take stock of the situation. That is one of the reasons why the current period, although different, follows in the line of the 1929 crisis (Lenglet, 2007).

Figure 8

The subprime crisis combines most of the features of the crises that have succeeded each other since 1987.

5.3 The antinomic nature of the division of labour in finance: a systemic crisis linked to the end of direct liability of financial operators

Following a dialectic process, the combination of these mechanisms produces an original form of crisis, certain aspects of which are unprecedented. The above description does not fully explain the heart of the subprime crisis. The roots of the crisis also lie in the belief, shared by financial operators and many experts, that thanks to its new techniques of risk transfer, modern finance had achieved the equivalent of the division of labour in the traditional productive sector. Securitization was believed to mark a new stage in the management of risk, by transferring it to those most capable of evaluating and assuming it (Brender & Pisani, 2001). It was therefore held to represent a major contribution to the efficiency of capital allocation and consequently to the growth and welfare of modern societies. The separation between funding and risk (i.e. the originate and distribute model) was even presented at the time as a decisive move in reducing the scale and frequency of crises.

The chain of events set off in March 2007 clearly refuted this optimism, but the analysts developed rather superficial interpretations of the failure of securitization: it was all due to the absence of transparency, to the lack of education of poor Americans who accepted housing mortgages they could not afford, or the corruption and collusion of certain financial operators with the political authorities. The reason for the failure is in fact much more fundamental and it hoists the theorists of liberalism with their own petard. Does the Chicago School not stress the need for a clear definition of property rights and hence of contracts? Have the theorists of information asymmetry not developed numerous models to demonstrate that the principal must obtain the maximum information and draw up suitable contracts to prevent opportunistic behaviour, responsible for inefficiency or even market failure?

The creation of the subprime market diametrically opposes the recommendations of these schools of thought. The invention of securitization opens the possibility of transferring the risk of default onto the buyer of a financial security constructed from a set of loans, supposed to be homogeneous according to the valuation of credit rating agencies. The financial intermediary in turn sells some or all of the corresponding products to banks and insurance companies, who do not judge it necessary to conduct their own appraisal of the value and default risk of these securities. Even less when an insurance company, AIG for example, offers them a Credit Default Swap (CDS). In the midst of this euphoria, with few mortgage defaults, the corresponding contracts proved to be particularly profitable. And so began a cycle of generalized irresponsibility among the actors of the financial system (Figure 9).

Figure 9

The dissolution of loan liability at the origin of the subprime crisis.

In contrast to the pursuit of transparency, the players gradually lost awareness of the factors on which the profitability of their investments depended, all the more so with the proliferation of derivatives of derivatives, of which it is not even certain that their creators were capable of explaining the conditions of viability, especially at the macroeconomic level where solvency and liquidity both play an important role. Liquidity was assumed to be ever-present, whatever the economic situation, given the depth of the corresponding capital markets, and this was to have devastating consequences when interbank credit and the trade in derivatives seized up. Simultaneously, countless derivative instruments were created based on the same underlying debt. Thus, in December 2007, CDS represented 62,000 billion dollars, while the maximum value of the underlying debt was no more than 5000 billion dollars. Far from indicating a division of labour in the assumption of risk, this proliferation revealed the scale of a purely speculative phenomenon (Crotty & Epstein, 2008). Ultimately, this process of creative financial innovation accentuated the procyclicity of risk-taking: during the boom, everybody wanted these products; when the crisis emerged, nobody wanted them.

Figure 10

The boom in derivatives, particularly mortgage-related.

Source: Securities Industry and Financial Association.

Even more fundamentally, the explosion in derivatives was associated with a reduction in their quality, since the transfer of risk makes the issuer more and more insensitive to the correct valuation of the risk. All the more so since the credit rating agencies, baffled by the complexity of derivatives, nevertheless continued to rate them favourably, without applying the same techniques as those used for top-tier financial assets. The explosion in the volume of derivatives of all natures, not only those linked to mortgages (Figure 10) went hand in hand with a continuous deterioration in the valuation of risk (Figure 11).

To sum up, finance itself organized the antinomy of the division of risks which precipitated the almost complete collapse of the American financial system. A New York Times cartoonist had the following take on it.

Figure 11

The dispersion of risk leads to deterioration in the quality of mortgage credit.

Note: *2007 vintage includes deals completed through September.

Source: Standard and Poor’s.

Figure 9 illustrates not only the process leading up to it but also the unfolding of the crisis. When house prices started to fall, the losses affected not only American households evicted from their homes and mortgage companies, but almost every operator in the domains of finance and insurance. Compared with the Savings and Loan crisis of the mid-1980s, in which the overproduction of housing was accompanied by a symmetrical increase in bad debts, it was now the whole pyramid of financial instruments that came crashing down, in a deflationary spiral of financial assets (Fisher, 1933). The most striking phenomenon was the way derivative spreads rocketed (Figure 12a). Indirectly, many financial establishments were either permanent or temporary holders of these products, of which the expected loss of value was so large that it threatened to bankrupt even the high-grade financial institutions. Interbank credit became more and more problematic, because each bank doubted the solvency and liquidity of the others (Figure 12b).

No matter that the Fed opened up lines of credit, this radical uncertainty could not be dispelled. It is only a consequence of the fact that most of the financial products depended on the separation between funding and assumption of risk, in such a way that the very nature of the underlying assets became problematic. The difficulty of valuation is therefore more than just a simple problem of technique; it results from the ill-defined nature of the assets piled up on the basis of overstretched credit relations. This is far-removed from traditional financial panics in which crowd behaviour precipitates the collapse of a whole system. So most of the crisis from March 2007 to September 2008 took place within the American financial system: “who owes how much to whom?” Nobody knew. The Treasury had no idea, nor did the Fed… or even Wall Street, for that matter. It is this sense that the subprime crisis was systemic. This complexity was largely deliberate and organized in order to circumvent banking regulations and hide debts off balance sheets, thereby increasing distributable profits and consequently bonuses.

Figure 12

The interbank credit freeze and accumulated mistrust of capital markets.

Source: Artus (2008a).

Ironically, we might affirm that this crisis is a triumph of the Hayekian conception of prices as a vector of information: for having constantly perverted that conception, Wall Street destroyed itself an organizational model and as a hegemonic power in defining the economic priorities of the United States. This was evidenced by the collapse of stock prices in the banking sector, because the mistrust of investors was focused decisively on the viability of the current configuration of the US system (Figure 12c). But contrary to Hayek, the financial system can only function smoothly and without crisis if it is regulated by an institutional framework outside the market. This had been the case after the Second World War until the emergence of the movement of deregulation.

7.1 Radical rethinking of the virtues of financialization

In the conventional theories, finance is assumed to help stabilize economic fluctuations, improve the efficiency of capital allocation and meet the financing needs of the real economy. The present analysis shows, on the contrary, that the real sector is the next victim of the excesses of liberalization and uncontrolled financial innovation. So it is that American public opinion, usually prompt to criticize the negative role of Washington and federal regulations, is now asking for financial organization to be taken in hand by the state. The slogan “let us get rich quickly even if we don’t know why” has been replaced by an urgent plea to “deliver us from predatory finance and protect our assets”.

Another irony of the period is that up until September 2008, the countries that had been “backward” in adopting financial modernity resisted better than Wall Street and the City. In October, however, with the continued inability of the American government to resuscitate the US financial system, the crisis started to spread, with the bankruptcy of various British, German, Belgian, French and Icelandic firms, to such an extent that the G8 leaders envisaged taking over control of finance on an international level (Table 3).

7.2 The complete inadequacy of anti-crisis tools inherited from the past

The perception of finance may have changed considerably, but politicians have failed to reassess the suitability of the tools at their disposition, be it the essential role of the central bank as lender of last resort, defeasance structures for “toxic” assets, or the role of public spending and fiscal policy in supporting economic activity (Lordon, 2008). The specificity of the subprime crisis is obvious: the financial community created a pyramid of increasingly esoteric financial instruments, far-removed from the underlying products. This ended up making it impossible to value all the corresponding assets from the moment the housing market turned down, and the conventions by which these assets were valued (mark to market, model to market) were demolished. It is then easy to understand the ineffectiveness of traditional policies aiming to avoid a repetition of 1929. It was in vain that the Fed flooded the retail banks and then the investment banks with liquidities, that the Treasury pursued a Keynesian policy of fiscal stimulus or announced the creation of a defeasance structure endowed with 700 billion dollars to relieve financial operators of subprime-related products: the financial institutions continued to doubt each others’ liquidity and solvency, because they were incapable of valuing the net worth of their balance sheets. Intervention at the root of the problem of market seizure, that is to say the appropriate valuation of each asset, is the only way to generate an endogenous recovery of confidence and thus of stock prices and credit (Table 4).

7.3 An uncertain outcome: lost decade or depression?

The slowness of the public authorities in perceiving the origin and scale of the subprime crisis had macroeconomic consequences. Initially, many observers thought that the United States was going to follow the same path as the Japanese economy of the 1990s of long stagnation accompanied by the risk of deflation. This danger cannot be excluded, but the magnitude of the financial paralysis and the speed of the adjustment of macroeconomic activity after September 2008 suggest a typical scenario of deflation/depression, although there is nothing self-evident about that diagnosis. In this respect, we cannot avoid reference to the famous article in which Irving Fisher (1933) explains how over-indebtedness can lead to deflation.

At least three mechanisms combine to make a period of contraction lasting several years possible and likely. At a first level, the American housing market is already showing the chain of events that lead to the gradual absorption of the overproduction of housing provoked by the removal of credit constraints. In the absence of securitization, we might have witnessed a repetition of the American Savings and Loan crisis of the 1980s. But in this case the boom in derivatives transmitted the crisis to the balance sheets of the investment banks. Under a fair value accounting regime, the corresponding losses are immediately translated into a loss of capital and a drastic downturn in the expectations that govern stock prices. This system has a paradoxical, not to say pernicious effect, as observed by Vincent Bignon, Yuri Biondi and Xavier Ragot (2009, p. 5) and Biondi and Fantacci (2012, p. 576):

When the borrower’s liabilities are estimated at their fair value, the borrower can take advantage of his loss of credibility by posting the loss of market-value of his debts as a profit. Thus, accounting no longer protects investors, because it provides no information about the emerging crisis of this borrower, whose net result and profitability appear to be unaffected by the crisis. While governments are not allowed to, banks – both in Europe and the United States – are already doing this […].

Figure 17

Three “deflation–depression” feedback loops à la Irving FISHER and adjustment under credit constraints.

Even if the real estate market was structurally stable, the stock market could amplify the transition from naive optimism to black pessimism … to the point of provoking a deflation of almost all financial assets, even those that were yesterday considered to be the safest.

The probability of a depression increases still further when radical uncertainty about the value of their assets prompts financial intermediaries to drastically reduce new credit. This has immediate repercussions on the purchase of durable goods by households, all the more so since they feel poorer due to the depreciation of their stock market and real estate wealth. In the winter of 2008–2009 a new depressionary spiral started when the profits of almost all non-financial, non-real-estate agents were revised downwards, setting off a new downward spiral of stock prices (Figure 17).

It was therefore to be feared that we would experience a repetition mutatis mutandis of the Great Depression. But the Fed, under the leadership of Ben Bernanke, had learnt from the errors of the 1930s, and the urgent need for Keynesian-type plans to support economic activity was recognized by both Republican and Democrat governments. That is why the parallels with the period 1929–1932 came to an end in March 2009.

7.4 The factors blocking a return to growth

However, there was no endogenous return to growth, because a new slowdown struck the economy in 2010.

1. First, because households sought to reduce their indebtedness, which put a brake on consumption in a context of falling house prices, evictions of families who could not meet their mortgage repayments and the stabilization of unemployment at a high level.

2. Second, because the banks did not convert the liquidities they had received from the Fed at almost zero interest rate into loans to the economy because they had become highly risk-averse.

3. As for non-financial companies, their improving profits hardly led to a surge in investment, because the outlook for demand remained gloomy and they observed political deadlock on the question of fiscal policy, generating uncertainty prejudicial to economic activity.

4. The US crisis affected the world economy. It triggered a Eurozone crisis, resulting from international finance’s unfavourable assessment of the sustainability of the public finances of the weakest countries, damaged by the policies pursued to counteract the consequences of the US crisis. And the emerging countries, with China at the forefront, suffered the repercussions of the slowdown in world trade, whereas their dynamism had previously been a stabilizing factor in the subprime crisis.

5. Ultimately, the strong resurgence of liberal orthodoxy played a decisive role in blocking the reforms that are needed to restore the viability of financial systems and their contribution to a return to growth. Reference to Keynesian interventionism was therefore short-lived, and far from marking the beginning of a new era.

And yet a radical reappraisal of macroeconomic and financial theory is certainly needed.

7.5 The need for social control of finance

The above exposition suggests an alternative strategy to the one actually pursued since the 1980s. It derives from the hypothesis, largely confirmed by our historical comparative analysis, that financial crises are not always inevitable, and that methods exist to reduce their frequency and/or impact, although without eliminating them completely, for they are consubstantial with capitalism. But we can sketch the outlines of what could become a new financial system (Rochet, 2008;The Economist, 2009). The history of finance and the subprime episode show that the costs of the present strategy can be considerable for public finances and for society. One could therefore seek to design systems which, while conserving the principle of the efficiency of capital allocation, significantly reduce the frequency and impact of financial crashes. There is every indication that a cost–benefit comparison of the ex ante and ex post treatment of crises would be far from unfavourable to the former option (Table 5).

In 2008, one epoch was ending and another highly uncertain one was beginning, shaped by the complex interaction between political strategies, industrial conflicts and the reconfiguration of economic paradigms. In 2012, finance is still putting up resistance and orthodoxy is making a comeback, but the reality principle will win through in the end and justify the return to a virtuous synergy between finance and society.