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UK: How the Market Made Us Stupid

by Will HuttonThe Observer (London)
March 18th, 2001

Four trillion dollars is a lot of money. It is the entire annual output of Britain and France put together. It is also the amount American investors in high-tech shares have lost over the past 12 months -- and that's before their losses in the rest of the stock market. The entire rickety American economic success story has rested on a crazy stock market boom so that even taxi drivers were trading in stocks and running up unparalleled levels of debt because they felt so wealthy. Now they are left, like the rest of America, with the debts and worthless stocks.

And the crisis in the American financial system is matched by one in Japan. Japan's massive financial bubble burst 10 years ago and it has yet to clear up the financial detritus. The banking system is racked by up to $350 billion of bad debts, but the banks' capacity to ride the financial hit is undermined by the downward plunge of the Japanese stock market because their own capital is invested in the shares of other banks -- a double whammy which already means many are technically bankrupt. And if we take seriously the hint from Japanese finance minister Kiichi Miyazawa that Japan might be the first major state since the war to unilaterally write down the value of its national debt, its financial system has to be regarded as on the brink. For the world to have one calamity would be bad enough; to have two simultaneously is more than careless.

It is eerily reminiscent not of the kind of recessions of the post-war period -- which have been painful enough -- but of the recessions up until 1930, as Larry Summers, the outgoing US Treasury Secretary, has said. Japan and the US have in their different ways made the cardinal error; they allowed their stock markets to become too intertwined with their overall financial system, reinventing the impulses that made nineteenth and early twentieth century recessions so vicious. What made those recessions last twice as long as post-war recessions was that they were accompanied and reinforced by bank and stock market collapses.

In Britain there is no longer any folk memory of what it means for a bank to go bankrupt, but as recently as the 1880s major banks could go bust, sending local economies into tailspin; firms lost their credit lines and workers and consumers their savings. In the US the experience was no less raw. The New York stock market began to have national importance as early as the mid-nineteenth century, and its ups and downs rippled out across the national economy. Banks were no more stable than the strength of the city or town in which they traded, and if one went down others followed like nine-pins. As the pace of industrialisation and urbanisation quickened in Europe and the US, workers could be suddenly thrown out of work by equally sudden contractions of credit lines and investment funds. The 1930s slump was the last of the great stock market and bank-induced economic collapses.

The great success story of the 50 years that followed, led by liberal and social democratic politicians, was to tame these wild forces. A mixture of regulation, credit control and state intervention in the banking system stabilised the financial system while welfare states helped underwrite the risk to ordinary workers and give them buying power that contributed to stabilising demand.

But as the consequences of the irrationalities of stock market gyrations and wild bank-lending -- the consequence of applying free market economic principles to finance -- were forgotten, so the reasons for the regulations were forgotten too. Know-nothing politicians of the Right, their intellectual acolytes and financier paymasters lobbied increasingly for 'deregulation' and 'liberalisation'. Bit by bit the controls came off. In the US, Rooseveltian financial reforms of the New Deal were scrapped over the 1980s and 1990s as hindering the competitiveness of US banking. American finance now has all the 'freedoms' it had in the nineteenth century, taking us back to the same wild capitalism.

My hunch is that the world is about to learn an awesome lesson; the conservative theorists were wrong and the liberal Keynesians right. The information technology revolution may have constructed a new economy, but it is one that has ancient parallels. IT could never have got off the ground so quickly without stock market finance, but it had the impact of making an already febrile and irrational investment community even more stupid, speculative and herd-like than usual as it chased what it imagined were new pots of IT gold.

Moreover, IT has been one of the reasons it has been so hard to regulate finance, with the borders between banks and the stock market becoming so much more porous; banks may be bigger but their disastrous nineteenth century-type exposures to stock market losses have been reinvented. To be effective regulation had to become smarter, faster and more international, but in the current environment building the essentially left-of-centre coalitions that might effect such regulation has been difficult.

So we are where we are. In the US, rather like the 1920s, the stock market boom spawned a massive misallocation of savings as Americans abandoned caution and played the markets. They have been duped into running up a scale of personal debt rarely witnessed. Worse, the prospect of easy profit has created a new populism in which stock ownership and speculation are portrayed as democratically enfranchising -- while progressive politics, with its instinct to contain and regulate finance, is cast as against the best interests of the people.

Unravelling stock market bubbles is always painful when the linkages have been allowed to infect the entire financial system; the ordinary credit lines that lubricate the wider economy become polluted by what has happened in the stock market. In this respect Japan presents a warning. The losses go so deep that policy interventions such as lowering interest rates and reducing taxes are much less effective than they were in the immediate post-war period. The US has a market structure that means it will get the adjustment over more quickly and radically than Japan -- but that means any recession will be compensatingly more intense.

Europe will not escape the fall-out -- but it is in a much stronger position precisely because its stock markets (except in Britain) have a much less central role in its financial system. And despite some wobble under fire from ignorant American critics and their British poodles, Europe has maintained a regulatory structure that retains that insulation. As that realisation grows, the European Union will be seen as a safe haven. And Britain will be glad to be a member of a club in which economic activity is not seen as the by-product of a casino.

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