The Regulatory Roots of Neoliberal Finance

In terms of understanding both the trajectory and the contradictions of capitalism in the second half of the twentieth century, it is very significant that a new era of financial competition, growth and innovation was not spawned during the reactionary 1980s under the neoliberal imprint of Reaganism and Thatcherism, but during the heyday of Keynesianism in the radical 1960s, under the imprint of John F. Kennedy’s Camelot and Lyndon B. Johnson’s ‘Great Society’. It is often forgotten that, matching the rise of the radical new left in sociology and history departments of US universities in the 1960s, was a new generation of MBAs, ‘bright and ambitious students . . . paying more attention to business strategy, product development, marketing, and costs, the stuff of business-school curricula’ (Sylla Reference Sylla2002: 62). The members of the 1960s generation who were recruited into the expanding financial sector were also oriented to ‘changing the system’ – albeit in a very different way from their more radical counterparts – and, as it turned out, they were rather more successful at it. Some of them also went into the regulatory agencies, adding to the agencies’ prestige and confidence. But the agencies were no longer as unchallengeable as before, insofar as economists, lawyers and accountants now commonly intervened in regulatory debates.

Market liberalization was, as Moran’s study of ‘the financial services revolution’ clearly showed, accompanied by ‘the growing codification, institutionalization and juridification of the system of regulation, in the effort to either prevent scandals and crisis or to manage the consequences when they have happened’ (Moran Reference Moran1990: 46). As Moran argued, moreover, it was not so much neoliberal ideology that broke the old system of financial regulations, as it was the increasingly dysfunctional effects of the New Deal’s corporatist financial controls, precisely because of the growth in the complexity and scale of the financial sector that had already taken place. The new breed of regulators themselves did not necessarily call for greater public control since ‘the essential feature of the American regulatory system . . . its fusion of the public and private spheres’ (Moran Reference Moran1990: 39) ensured that the regulatory agencies became subject to contradictory pressures as US financial institutions outgrew the New Deal incubator through the post-war decades, and by the 1960s they were following US multinational corporations and new Eurodollar markets abroad.

Although the Securities and Exchange Commission (SEC) itself proved largely immobile until the ‘big bang’ it detonated in the mid-1970s that wiped away many of the New Deal restrictions on investment banks, other regulatory agencies in the 1960s were among ‘the most enthusiastic destroyers of the regulatory structure’ (Moran Reference Moran1990: 46). Thus, while the US Treasury’s Office of the Comptroller of the Currency (OCC) underwent considerable expansion, gave a good deal more autonomy to its regional bank examiners and established its own Research Division staffed by professional economists, under Kennedy’s appointee James J. Saxon, it became at the same time one of ‘the main sources of regulatory innovations designed to circumvent restrictions of competition’ (White Reference White1992: 9). As early as 1962 an important Office of the Comptroller of the Currency report contended that maintaining interest rate ceilings on bank deposits contradicted the ‘free market’ in government bonds that had been permitted since 1951 under the Treasury–Federal Reserve Accord (White Reference White1992: 9). For its part, the Justice Department by 1968 had also ‘put the full weight of its institutional prestige, and of anti-trust ideology behind the public critique of the anti-competitive character’ of the New Deal regulatory system, and secured very broad support for this ‘from Chicago-style efficient market theorists to leading Keynesians like Samuelson’ (Moran Reference Moran1990: 43). This broad reaffirmation of faith in the virtues of competition in the financial sector, even among those who supported the growth of the state and its regulatory agencies, was also an important foretaste of the subsequent neoliberal turn of the American state.

At first, the signs seemed to indicate that the state would retreat further from regulation of the financial sector, but the reality soon proved more complicated. The 1971 Report of the Hunt Commission, appointed by President Richard Nixon to study how to ‘improve the functioning of the private financial system’, had already been oriented to moving ‘as far as possible towards freedom of financial markets and equip all institutions with the power necessary to compete in such markets’ (Hunt Commission 1971: 9). In August 1973 Nixon, arguing that the public was better served by the free play of competitive forces than by the imposition of regulations, proposed to Congress the gradual elimination of interest rate ceilings. This was in fact delayed until 1980, but with the famous ‘big bang’ it delivered to Wall Street in 1975, the Securities and Exchange Commission dramatically shifted away from its long-maintained support for the cartel-like structures of brokers, investment banks and corporate managers that had dominated the capital markets since the 1930s. Congressional investigations attracting considerable media attention had provided the pension and mutual funds and insurance companies, supported by retail-oriented investment banks such as Merrill Lynch, with a forum to make their case for the abolition of fixed rates on brokerage commissions on Wall Street. What was notable about the amendments to the Securities Acts that ushered in this foundational instance of ‘deregulation’, however, was that this did not amount to reducing the power of the state. On the one hand the Securities and Exchange Commission removed barriers to price competition and market entry, but on the other hand the Securities and Exchange Commission acquired more powers, not only to intervene in the structures of self-regulation – so as to enforce competitive market structures, promote market transparency and target insider practices – but also to set a limit to the debt-to-capital ratios of investment banks. There were, moreover, ample profitable options open to investment bankers in the commercial paper and mutual fund money markets when they lost their fixed margins on brokerage services.

Indeed, the sheer density of both public and semi-public regulation in US domestic financial markets meant that institutional reform in this sector became a key dimension of capitalist strategies for innovation and the construction of competitive advantage. This could especially be seen when, immediately after the collapse of the Bretton Woods system of fixed exchange rates, the Chicago Mercantile Exchange (the world’s central futures market in livestock long after the slaughterhouses were gone from Chicago) gave birth to the financial derivatives revolution by inventing a futures market in currencies. According to the head of the Chicago Mercantile Exchange, Leo Melamed, who initiated the process in 1971 with the help of Milton Friedman, this could not have been done without ‘the cadre of traders who left the known risks of the cattle, hog and pork belly pits for the unknown dangers of foreign exchange’ – although it also took plenty of ‘planning, calculation, tenacity and arm-twisting’ on his part (Melamed Reference Melamed1992: 43). The Chicago Board of Trade, which was also still the world’s centre of futures trading in wheat, corn and soya even though grain was no longer stored in Chicago, soon followed by launching a futures market in US Treasury securities. The key role state regulation played in the process was indicated by the creation in 1974 of the Commodity Futures Trading Commission (CFTC) to regulate derivatives in a way that facilitated their development. Melamed recognized that the Commodity Futures Trading Commission would be ‘beneficial to the growth of our markets. Our plans relating to new financial instrument futures were ambitious and could be greatly assisted by a federal stamp of approval’ (Melamed Reference Melamed1992: 108).

State agencies such as the Commodity Futures Trading Commission were keen to promote the spreading and hedging of risk, including by the many non-financial corporations that invested in derivatives to protect themselves from volatile commodity prices, floating exchange rates and fluctuating interest rates. This determined the explicit ‘why not?’ approach that the Commodity Futures Trading Commission adopted in allowing space for self-regulation and innovation in derivatives markets – an approach sealed in 1978 by the Treasury’s conclusion that the exchange of derivatives on the US debt that the New York Federal Reserve brought to the bond markets would, by allowing for some hedging of risk, help stabilize and increase the holdings of US Treasury bonds (Seeger Reference Seeger1985: 12–14). It was on this foundation that the internationalization of the derivatives markets took off in the next decade. It was institutionalized with the opening of the London International Financial Futures Exchange in 1982, on the occasion of which Melamed (Reference Melamed1992: 70) noted: ‘It was necessary first to convince the world financial community that financial futures were a necessary adjunct to the management of risk. It took years of late nights and early mornings, an incalculable amount of traveling, unceasing gospel spreading, arm twisting and ear bending.’ It was on this, more than on risk-modelling equations provided by Nobel prize-winning economists, that the derivatives revolution was built.

The derivatives revolution was crucial to the stabilization of currency markets in the wake of the end of fixed exchange rates; it was also intimately linked to the internationalization of the US bond market, which was occurring at the same time as the development of the separate Eurodollar bond market. In 1970 foreign private investors already held almost 10 per cent of US Treasury securities. The aggregate value of these holdings was 50 per cent higher than that of all Eurobonds, and indeed was aided by the enhanced institutional capacity for the global distribution of Treasury securities, which was facilitated by US investment banks operating in the Eurobond market. By 1980 foreigners held over 21 per cent of US Treasuries and over the previous decade their aggregate value had increased seven-fold (Aquanno Reference Aquanno2009: 124–5). The financial uncertainty that followed the collapse of the fixed exchange rate system, amidst the volatility of commodity prices and rising short-term interest rates amidst inflation, actually enhanced the attractiveness of Treasury bills to international investors, who recognized the depth and liquidity of the US bond market despite all the hand-wringing about declining US power and economic strength. This was accompanied, moreover, by the immediate growth (by some 230 per cent) of New York’s ‘Yankee’ bond market (where foreign governments and corporations issued securities in US dollars) after the removal of capital controls in 1974. The Yankee bond market did not in the long run retard the growth of the Eurobond market: the two financial centres in New York and London, with US banks the central agents in both of them, continued to grow through the 1970s.

The Federal Reserve’s change of procedure in 1979, to using fluctuating interest rates to implement its monetary policy, meant that bond prices (which move inversely with interest rates) fluctuated more than ever. The Wall Street investment banks then responded to the increased volatility in interest rates that accompanied Paul Volcker’s monetary policy by shifting further to trading in bonds, commercial paper and other securities. This was also crucial to turning investment banking into a much more speculative business. ‘Had Volcker never pushed through his radical change the world would be many bond traders and one memoir the poorer’, Michael Lewis noted in his famous 1989 Wall Street memoir on ‘the golden age of the bond man’, Liar’s Poker. ‘A Salomon salesman who had in the past moved five million dollars’ worth of merchandise through the traders’ books each week was now moving three hundred million dollars through each day’ (Lewis Reference Lewis1989: 35–6). The main purveyors of the new financial instruments, not only on Wall Street but globally, were the new firms of the 1960s such as Salomon Brothers and Goldman Sachs, which displaced old established ones such as Dillon Read and Kuhn Loeb. They were the principal conduits for the massive inflow of capital from abroad, assisted by the removal in 1984 of tax penalties on the foreign purchase of corporate bonds (the final remnant of the capital controls introduced in the 1960s to protect the dollar).

At the same time the US investment banks greatly expanded their operations in the City of London as well as spreading out into the European continent, and beyond. In addition to underwriting the bonds that covered the growing indebtedness of US federal, state and municipal governments, and facilitating the privatization of state assets at home and abroad, the banks were also at the centre of the burgeoning commercial paper, corporate bond and stock markets of the 1980s. With the top five firms dominating in each of these markets, the return on equity for the large investment banks exploded to 48 per cent between 1980 and 1984, before stabilizing over the following two decades at just below 20 per cent (Augar Reference Augar2005: 56). It was the new bankers of the 1960s generation, such as Goldman Sachs’ Robert Rubin, who now hired the economists, mathematicians and engineers (the ‘quants’) who modelled risk with sophisticated computer programs, and thus, as Charles Ellis (Reference Ellis2008: 403) says in his history of Goldman Sachs, ‘deliberately and conscientiously transformed the bond business from the old business of making judgments and taking risks on interest rates and bond maturities . . . to a business that concentrated on managing spreads and arbitrages in deliberately crafted portfolios across markets and between different types of securities all over the world’.

The action was not confined to Wall Street’s investment banks. The large US multinational commercial banks were also now fully engaged in what Gillian Tett (Reference Tett2009: 17) has described as the ‘years of bold innovation that made high risk trading and aggressive deal making the gold standard of the Street [where] “a kill or be killed” ethic prevailed’. She notes that, shortly after Salomon Brothers engineered the first major derivative bond swap between IBM and the World Bank in the early 1980s, JP Morgan used its City of London operations to circumvent the Glass–Steagall Act and allow its clients to take advantage of the explosion of derivatives markets. By the early 1990s, after also pioneering the development of credit default swaps, half of JP Morgan’s trading revenues came from derivatives contracts. But JP Morgan was only one of eight US banks that by then together accounted for over 50 per cent of interest rate and currency swaps worldwide, as well as 90 per cent of US bank derivatives activity. There was a similar concentration of derivatives activity in the US investment banking sector (US General Accounting Office 1994: 36–7). This concentration was closely related to the highly complex information and risk-management systems that were required to allow the risk on bonds with different interest rate and currency structures to be traded without any bonds actually changing hands.

The derivatives activities of these banks were crucial to the making of global capitalism because they could, as Bryan and Rafferty (Reference Bryan and Rafferty2006: 49) put it, ‘blend together (or make transmutable) different forms of capital, [and] create a market of conversion between fixed and floating rate loans, and between different currencies’. While this certainly involved extensive leveraging and speculation, it met the hedging needs not only of financial institutions (which exchanged 40 per cent of all swaps among themselves), but also of the many corporations seeking protection from the rapidly evolving vulnerabilities associated with global trade and investment. Moreover, there was a pronounced shift from the earlier standardized commodity and currency derivatives on organized exchanges, such as the Chicago Mercantile Exchange, to over-the-counter (OTC) bilateral contracts that banks fashioned themselves. Following the recession of the early 1980s, these custom-made derivative products supplemented Wall Street’s fresh knack for tapping pension funds and rendering them into the loans that leveraged the corporate takeovers, mergers and restructurings that Ronald Reagan’s tax allowances encouraged. The practice developed in the 1970s by the Bank of America, among others, of ‘slicing and dicing’ mortgage loans and selling them to institutional investors was applied to corporate bonds and loans in the 1980s, and to credit default swaps in the 1990s.

What had initially led Wall Street’s investment banks to sell mortgage-backed instruments that ‘looked and tasted’ like safe bonds was the desire to gain access to the large investor base represented by institutional investors such as pension funds and insurance companies: ‘If there was a master plan, it was to meet the needs of our institutional investor clients’, noted Laurence Fink (Reference Fink1976: 121–2), Wall Street's leading player in this arena. The 1970s had seen the introduction and tightening of minimum funding requirements for pension funds, while new tax breaks for individual contributions to retirement savings plans had launched a massive explosion of mutual funds. Both developments sharply increased the demand for new hedging instruments, such as mortgage-backed and other derivative securities, to protect the pension and mutual funds’ investments in bonds, equities and real estate. By the beginning of the 1990s, four out of every five pension funds were using derivative products. There was no little irony in the extent to which the growth of pension funds, one of the main products of US workers’ ability to secure retirement benefits under the class compromise in the post-war era, had become one of the central pillars of the neoliberal financial order that accompanied the defeat of American trade unionism in the 1980s.

The Federal Reserve’s Learning Curve

It was highly significant that in the new age of finance the Federal Reserve came into much greater prominence. As a Federal Reserve paper later exulted: ‘In the early 60s, the Federal Reserve was little known outside of the financial services industry and university economics departments. Twenty years later Fed Chairman Paul Volcker was one of the most recognized names in American public life’ (Goodfriend Reference Goodfriend1997: 1). In fact, not only investors on Wall Street but businessmen everywhere increasingly seemed more attuned to the decisions of the Federal Reserve than Soviet managers were to Gosplan’s. Just as the Federal Reserve discovered, in its monetarist moment, that the range and diversity of liquid financial instruments now available made the money supply almost impossible to define and control, it also discovered that this very range and diversity left financial markets extremely sensitive to the Federal Reserve’s interventions in setting the interest rate for federal funds. Since this was the foundation of the calculation of risk on all other financial instruments, the Federal Reserve ‘increasingly became the fulcrum on which the US economy turned’ – though this political role was often obscured, since Federal Reserve officials would ‘present their activities as the product of “market forces” while at the same time continuing to regulate the economy’ (Krippner Reference Krippner2007: 488).

Aside from its monetary policy role, the Federal Reserve was on what it described as ‘a learning curve’ about how innovations in financial instruments and the blurring of lines between banks and non-banks would affect its supervisory and regulatory functions. The largest US commercial bank holding companies, long engaged in investment banking activities abroad, had by the early 1980s begun moving into a range of brokerage, insurance, financial counselling, tax planning and other such services at home (with ad hoc Federal Reserve approvals consistently upheld by Supreme Court rulings; Meltzer Reference Meltzer2009: 1). Thus although the New Deal’s Glass–Steagall Act was not formally repealed until the end of the 1990s, by the mid-1980s the transformations in banking and finance had gone so far that regulators were keenly aware that every regulation along the old New Deal lines ‘offered an opportunity to profit from circumvention’ (Meltzer Reference Meltzer2009: 1205). Yet at the same time, as the Federal Reserve Bank of New York’s 1986 Report (1986: 4) put it, there remained ‘public interest considerations associated with the banking and financial system that call for a higher degree of official supervision and regulation than is needed in other kinds of business enterprise’. It can thus be seen how misleading is the widespread notion that the transformation of US finance was primarily due to deregulation. Even though the volume of deregulation rhetoric was certainly pitched even higher during Reagan’s presidency than its already considerable level under Jimmy Carter, the US financial markets remained ‘amongst the most heavily regulated sectors of the American economy’ (Vogel Reference Vogel1996: 3). The supervisory burdens of the regulatory agencies actually increased through the course of the 1980s. The number of its bank examiners, having declined in the first half of the decade from some 2,300 to 1,800, had by the end of the 1980s returned to its 1979 peak, while the Office of the Comptroller of the Currency’s expenditures grew 25 per cent faster than the banking system’s assets (White Reference White1992: 61–2).

Given the transformations in finance that had taken place, and that the regulatory agencies had encouraged, these regulatory and supervisory functions could not ward off the long series of financial crises that became characteristic of the new age of finance. This meant that the Federal Reserve’s function as lender of last resort was increasingly called upon to bail out failing banks which stood as strategic nodes in the international circuits of capital. Troubled small banks which could not be safely merged with larger ones were closed by the Federal Reserve and the Treasury, and their depositors paid off by the Federal Deposit Insurance Corporation (FDIC), while the large banks were bailed out, thanks to their importance not only for the US economy but also for the international clearing-house system, whose hundreds of billions of dollars of daily interbank payments greased the wheels of global capitalism. The pattern of letting banks that were too small to matter go under, while acting as lender of last resort to save the ones that were ‘too big to fail’ was set in 1982 when Volcker bluntly told the Federal Open Market Committee (FOMC): ‘if it gets bad enough, we can’t stay on the side or we’ll have a major liquidity crisis. It’s a matter of judgement as to when and how strongly to react. We are not here to see the economy destroyed in the interest of not bailing somebody out’ (Meltzer Reference Meltzer2009: 1105).

Shortly after Alan Greenspan replaced Volcker at the helm of the Federal Reserve in 1987, the stock market crash of that year immediately confronted him with the inherent volatility of the new age of finance. As an important study by the US General Accounting Office (1997: 61–2) put it a decade later, the speed and extent of the collapse could only be understood in terms of the way ‘the increased linkages between the equities markets and the futures markets could change the character of a financial crisis . . . The primary concern of federal officials was that the system for allocating credit would be halted, and the financial system would stop functioning.’ But what was no less remarkable than the suddenness and scale of the crash was the immediate, decisive and coordinated state response to it, as the same 1997 report itself noted: ‘The readiness of federal officials to manage the market crash largely depended upon the availability of information that federal agencies had routinely collected, the existing communication networks among the agencies, and the ability of the agencies to influence the behavior of market participants and their creditors.’ As a Wall Street Journal report put it: ‘The banks were told to keep an eye on the big picture – the global financial system on which all their business ultimately depends. A senior New York banker says the Fed’s message was, “We're here. Whatever you need, we’ll give you” ’ (Stewart and Hertzberg Reference Stewart and Hertzberg1987).

The turnaround was stunning. The Dow Jones Index immediately resumed its unprecedented climb and by 1999 the price of corporate equities had increased 12-fold over their level in 1980. But this did not mean that it was unconcerned by the increased likelihood of further financial crises. On the contrary, as the New York Federal Reserve’s annual reports in the years after the 1987 crash make very clear, it saw what was happening in financial markets as a double-edged sword, expanding the range and cheapening the costs of financial transactions while at the same time producing such a massive increase in market volatility as to make financial crises more likely. The Federal Reserve’s concerns were registered internationally in the increasing importance it attached by the late 1980s to the Bank for International Settlement (BIS) ongoing negotiations at Basel on international capital adequacy standards for banks; while on the domestic side by 1991 it had already expressed some anxiety that expanding securities-based mortgage markets would allow even local banks and mortgage brokers to pass risk on to others and thus relax prudential standards in their loan operations. Examiners were placed in all the major banking institutions, and the Federal Reserve broadened its daily monitoring efforts to include investment banks and other securities dealers, as well as preparing measures to extend its emergency lending powers to them.

The deepening coordination with other regulatory agencies that this required had in fact been institutionalized immediately after the 1987 crash with the creation, in March 1988, of the President’s Working Group on Financial Markets. Regularly bringing together the most senior officials from the Treasury, the Federal Reserve, the Securities Exchange Commission and the Commodities Futures Trading Commission, it was seen among insiders on Wall Street as acting as a mere cover for what was dubbed the ‘plunge protection team’. What was clearly involved here was the state walking the tightrope of allowing volatile financial markets to flourish, while managing and containing the inevitable financial crises that volatile financial markets spawned. This certainly became the abiding view at the US Treasury. As explained in the most important report on what it was up to in the 1990s (prophetically called American Finance for the 21st Century), the Treasury believed that giving regulatory priority to ‘failure prevention’ could only mean ‘tying the hands’ of financial institutions, which would ‘inevitably put a damper on innovation, at considerable cost to the economy as a whole and potentially to America’s world leadership in financial services’. What was needed instead was supervision of a kind that supported the financial sector’s ‘mercurial growth’ – and precisely because it was recognized that this would inevitably give rise to financial crises, the main goal of financial policy should be ‘failure containment’ (Litan Reference Litan1998: 5).

In sharp contrast with the repeated interventions by the Clinton administration in many of the 72 financial crises in low- and medium-income countries in the 1990s (Reinhart and Rogoff Reference Reinhart and Rogoff2008: Table A.3), the Bush administration that succeeded it certainly appeared more interested in military interventions than economic ones. This was despite the millennium opening with a stock market crash (the bursting of the ‘dot.com’ bubble), with the scandal-ridden downfall of Enron (Fortune magazine’s choice as ‘America’s Most Innovative Company’ for six years running) and with major financial crises in Turkey and Argentina that very much resembled those of the 1990s. Bush’s first secretary of the Treasury, Paul O’Neill, was publicly critical of his predecessors’ repeated efforts to contain economic crises around the world, going so far as to deride Robert Rubin for playing at being ‘chief of the fire department’. Rubin’s response (2003: 297) was that, once faced with ‘the messy reality of global financial crises’ the new administration would soon take up its imperial economic responsibilities: ‘They say they won’t intervene. But they will.’

Before the crisis hit in 2007, the financial sector’s share of corporate profits reached 33 per cent (more than double its share in 1980), with an increasing proportion of bank earnings generated by derivatives and securities trading on their own account, as opposed to traditional underwriting practices. By 2007, five US investment banks accounted for 35 per cent of world revenue generated by underwriting bond issues, organizing initial public offerings (IPOs), equity trading, syndicated loans and over-the-counter derivatives. More than half the world’s total of pension, insurance and mutual funds were under the management of US financial firms, as were two-thirds of hedge funds and private equity funds. The extent to which the activity of US finance was intimately linked to the integration of global production could be seen from its central role in cross-border mergers and acquisitions (which accounted for three-quarters of foreign direct investment). The financial practices that made such growth possible involved massively raising debt-to-capital ratios, which was facilitated by incentives in compensation schemes for financial market actors that drove ‘transactions that produced immediate income but exposed the financial system to massive risks’ (Mishkin Reference Mishkin2011: 55).

The 2007–8 Crisis

The American crisis that started in 2007 was not caused by either over-accumulation or trade imbalances but rather by the volatility of capitalist finance. It was triggered in the seemingly mundane sector of mortgage credit, where finance mediated working-class access to housing and then quickly spread into the more rarefied world of interbank lending and corporate commercial paper markets. It was because US finance had become so integral to the functioning of twenty-first-century global capitalism that the ultimate impact of this crisis throughout the international economy was so profound. As the Federal Reserve began to raise interest rates in mid-2004 (to over 5 per cent by mid-2006), partly in an effort to deflate the housing bubble gradually, it faced what Greenspan called a ‘conundrum’. Housing prices peaked in 2005, accompanied by a dramatic rise in the number of mortgage defaults, yet since foreign capital was attracted all the more by these higher rates there was no drying-up of mortgage credit, and house-building starts only peaked at the beginning of 2006. But the end was nigh: between the last quarter of 2005 and mid-2007 residential investment fell by 22 per cent, along with a sharp reduction in the number of sub-prime borrowers. As the rise in the default rate of non-prime borrowers started to exceed projections, the issuance of asset-backed securities slumped by almost 30 per cent. Securitization everywhere quickly lost much of its lustre, as banks ended up holding assets that they were unable to value, and rating agencies now fuelled the problem by downgrading the risky securities they had previously treated as virtually equivalent to US Treasury bonds. It was now clear that once a debt had been sold on, sliced up and mixed with a variety of other debts, there was little hope of establishing in any meaningful way the value of the resulting asset. Paul O’Neill later graphically captured the predicament facing investors: ‘If you had ten bottles of water and one bottle had poison in it, and you didn’t know which one, you probably wouldn’t drink any one’ (Solomon Reference Solomon2008).

By March 2007 the newly appointed chairman of the Federal Reserve, Ben Bernanke, warned that Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) could be a source of ‘systemic risk’. Yet, as late as July 2007, Tim Geithner at the New York Federal Reserve and Hank Paulson at the Treasury were still playing their appointed roles of trying to calm markets with reassuring speeches about the housing slump being ‘at or near bottom’, and financial markets outside the US being ‘now deeper and more liquid than they used to be’ (Morgenson Reference Morgenson2011). But by this time an unravelling of financial positions and credit chains was already producing a liquidity crunch in the US commercial paper and money markets that had become so pivotal in global finance. By August the Treasury had switched to full crisis management mode, with Paulson ‘in hourly contact with the Fed, other officials in the administration, finance ministries and regulators overseas and people on Wall Street’ (Bajaj Reference Bajaj2007). Meanwhile, the Federal Reserve was in contact with the European Central Bank, the Bank of Japan and the Bank of England about the role they would all play as lenders of last resort. Bernanke, drawing on his academic work at Princeton University in the 1980s on how the Great Depression could have been prevented, warned Paulson that massive US government loans to banks might be necessary, and Bernanke had agreed. ‘ “I knew he was right theoretically,” Bernanke said. “But I also had, and we both did, some hope that, with all the liquidity out there from investors, that after a certain decline that we would reach a bottom” ’ (Baker Reference Baker2008: 33). Yet, what the crisis of 2007–8 proved was that without the state the private market has no secure bottom.

The really crucial point of contagion was the short-term wholesale lending market between large international financial institutions. This interbank market had become increasingly central to the operation of the global payments system, and with seven out of every ten transactions taking place in US dollars, it was the most important focus of the Federal Reserve’s monetary policy; a select few Wall Street banks, operating as ‘market makers’, were especially central in reallocating the liquidity provided by the Federal Reserve. As a result, the Federal Reserve acted quickly to ensure that banks all over the world had access to an adequate amount of dollar holdings to meet their obligations. By mid-August, lining up at the New York Federal Reserve’s discount window for hundreds of millions were not only US banks such as JP Morgan Chase, Bank of America and Wachovia, but also Germany’s Commerzbank, and even the Bank of China Ltd. For all the talk over the previous decade about the need for financial transparency, these loans were concealed for fear that they would further undermine market confidence and stir up domestic populist resentments (they would only be revealed by a court order in April 2011, almost four years later). To get around this political problem, the Federal Reserve established new swap lines of credit to funnel dollars to foreign central banks so they could allocate dollars directly to their banks. Unlike earlier swap arrangements between central banks, set up to compensate for balance of payments deficits, these arrangements were explicitly aimed at providing international liquidity, with the additional effect of getting foreign central banks to act as conduits for the application of the Federal Reserve’s looser monetary policy to their own domestic economies. The US Federal Reserve was indeed acting as the world central bank in the context of the crisis, trying to ensure thereby that interbank rates would decrease and normal mechanisms for access to dollar funding would be restored.

For its part, the US Treasury organized in late 2007, first, a consortium of international banks and investment funds, and then an overlapping consortium that included mortgage companies and financial securitizers, to take concrete measures to calm the markets. By early 2008 the Federal Reserve not only directed, oversaw and guaranteed to the tune of $30 billion, JP Morgan’s takeover of Bear Stearns but also placed examiners inside each of Wall Street’s investment banks. In a radically new departure, the Federal Reserve dramatically expanded the programmes through which it provided liquidity to banks, including taking mortgage-backed securities onto its own books. By taking responsibility for illiquid securities that otherwise could not be sold, or even find a value, the Federal Reserve was thereby acting not only as lender of last resort but also as ‘market maker of last resort’ (Buiter Reference Buiter2008). While all this state intervention resembled similar activism that had succeeded relatively well in terms of containing crises in the past, it could not prevent this crisis from assuming still greater proportions. In early September 2008, after a summer of considerable turbulence, uncertainty and anxious anticipation, during which major investors began selling their holdings of government-sponsored enterprise (GSE) securities and seeking refuge in Treasury bonds, the American government took direct control of Fannie Mae and Freddie Mac. Given the importance of these two giant government-sponsored enterprises, not only for households’ spending power but also for interbank rates and foreign economic relations, the top priority was to preserve their operations and prevent any market rumours of default. The takeover of government-sponsored enterprises prevented a full-scale meltdown and had the crucial effect of converting their debt into Treasury debt, but it added little additional liquidity in the markets for mortgage-backed securities and could not prevent the demise of two major investment banks. One catastrophe was averted when, through the Treasury’s orchestration, Merrill Lynch was sold to the Bank of America (which would itself receive $45 billion in federal aid in the coming months). But another catastrophe – at Lehman Brothers, whose banking business had begun with commodities-trading and brokerage operations in the 1850s – was not.

When the Federal Reserve once again convened Wall Street chief executives, now in the depths of the greatest crisis they had ever seen, and urged them to arrange a private sector bailout of Lehman Brothers, the fear of ending up with each other’s bad debts ruled out the kind of collective action they had agreed to a decade earlier with Long-Term Capital Management (LTCM). As Lehman went bankrupt, and investors immediately questioned the government’s commitment and organizational capacity to support the private institutional pillars of the financial system, the Federal Reserve’s Bernanke came to the conclusion that 12 of the 13 most important institutions in the US ‘were at risk of failure within a period of a week or two’ (Financial Crisis Inquiry Commission 2011: 354). What had to be faced most immediately was the imminent collapse of AIG, the world’s largest insurance company, which had been writing so much credit default swap protection for the investment banks. The Federal Reserve had already gone well beyond the normal boundaries of its regulatory remit by extending help to investment banks, but it now ventured into even newer territory as it took responsibility for the survival of an insurance company whose commitments constituted a key pillar of the markets for securitized products and complex derivatives.

The Federal Reserve now fast-tracked applications by both Goldman Sachs and Morgan Stanley to be regulated as bank holding companies, thereby giving them permanent access to the Federal Reserve’s discount window. The further expansion of the Federal Reserve’s swap lines to other central banks provided foreign banks with more than $560 billion by the end of 2008. The justification later offered for the Federal Reserve acting as the world’s central bank was that ‘foreign banks support the trade of other countries with the United States, facilitate international purchases of U.S. financial assets and foreign direct investment in the country and deepen global financial markets for dollar assets’ (Goldberg and Skeie Reference Goldberg and Skeie2011: 53). Yet, with the end to the crisis still nowhere in sight, the Federal Reserve and the Treasury now faced the prospect of becoming involved in an endless series of interventions that would have entangled them in patchworks of ad hoc financial arrangements. In this situation, the government proposed a sweeping plan to try to flush sufficient toxic debt out of the system to restore its liquidity. In early October 2008, after weeks of resistance, a reluctant Congress was finally induced to pass the Economic Stabilization Act, which included a $700 billion Troubled Assets Relief Program (TARP). A particularly memorable instance of how US elites have to accommodate to – and at the same time overcome – a populist political culture was Henry Paulson’s declaration before the House Financial Services Committee, as he tried to get his Troubled Assets Relief Program through Congress, that ‘the American people are angry about executive compensation and rightfully so’. (This was rather rich, given that when he had headed up Goldman Sachs, he had been Wall Street’s highest paid CEO.) When he appeared before the Congressional hearings to defend his Troubled Assets Relief Program to save the financial system, Paulson acknowledged that Wall Street’s exorbitant compensation schemes are ‘a serious problem’, but he immediately added, ‘we must find a way to address this in legislation without undermining the effectiveness of the program’ (Stout Reference Stout2008, emphasis added). What was clearly implicit in this statement was that the cooperation from bankers, which was the sine qua non for the programme to work, would not be forthcoming if they were asked to bear what they considered to be too heavy a financial burden.

The Treasury was given full discretion over the allocation of the Troubled Assets Relief Program funds, and it exploited this latitude when Paulson soon announced that most of the funds would be used to purchase equity stakes in financial institutions. In buying bank shares, they were following the lead of the UK’s Labour government, whose prime minister, Gordon Brown, was widely credited with having saved the financial system by initiating the provision of massive public capital to the banks in the autumn of 2008; it was quickly also made clear that the nationalized banks would still ‘operate on a commercial basis at arm’s length’ from any government direction or control (Hampton and Kingman Reference Hampton and Kingman2008). With the US taking the same route, so that the federal government soon owned a third of Citigroup’s shares, both the US and the UK were effectively socializing the losses of the private banks. But socializing their losses did not entail socializing control. The fact that the Treasury did not ask for much in return for covering the bank’s losses threw into sharp relief the accumulating political contradictions that came with this crisis. With one firm after another apparently buckling under the weight of their bad investments, the socialization of the banks’ losses was increasingly seen to be both ineffective and unfair – a factor that had already played its part in the outcome of the November 2008 presidential election.

The Old/New Practice of Failure Containment

US President Barack Obama’s election paved the way for the American Recovery and Reinvestment Act, passed in February 2009, but expectations that radical Keynesian economists would now be running the Treasury proved wide of the mark. Paulson’s conversations with Obama at the height of the financial crisis before the 2008 election had convinced him that Obama ‘genuinely seemed to want to do the right thing. He wanted to avoid doing anything publicly – or privately – that would damage our efforts to stabilize the markets and the economy’ (Paulson Reference Paulson2010: 13–14). Obama’s appointment of Timothy Geithner as his secretary of the Treasury was in fact predicated on this; as head of the New York Federal Reserve Bank, Geithner was particularly seen as ‘on side’ with Wall Street. It was Paul Volker, ironically, despite his central role in overcoming Keynesian-era inflation three decades earlier, who was now seen as Obama’s most economically progressive adviser.

Geithner’s ‘Financial Stability Plan’, introduced in March 2009, followed the lines of what had gone before. The Treasury would purchase more bank stock, while emphasizing that the long-term objective was to keep the banks in private hands. The new asset management funds the Treasury would set up to unblock financial markets (along the lines of the Resolution Trust Corporation during the Savings and Loan crisis) were accurately described by the Financial Times’ Martin Wolf (Reference Wolf2009): ‘Under the scheme, the government provides virtually all the finance and bears almost all the risk, but it uses the private sector to price the assets. In return, private investors obtain rewards – perhaps generous rewards – based on their performance via equity participation, alongside the Treasury. I think of this as the “vulture fund relief scheme”.’ Amidst public outrage over the millions the banks were still paying to the executives who had created the mess, President Obama justified his Treasury secretary’s plan with words very similar to Paulson’s six months earlier: ‘You’ve got a pretty egregious situation here that people are understandably upset about . . . So let’s see if there are ways of doing this . . . that are constitutional, that uphold our basic principles of fairness, but don’t hamper us from getting the banking system back on track’ (Ward Reference Ward2009, emphasis added). Obama’s ‘but’ spoke volumes since it showed that it was the incentives that capitalists insisted on as necessary to save the economy that trumped basic principles of justice. Paying bankers so astronomically more than workers could, in the context of the crisis, hardly be justified in terms of their contribution to market efficiency. It could only be explained in terms of ‘failure containment’. All this meant that the system of class power and inequality that generated the crisis was being reproduced.

Just as unemployment was well on its way to reaching over 10 per cent (from under 6 per cent as late as mid-2008), the ‘stress tests’ that the Federal Reserve conducted on the 19 largest US bank holding companies in May 2009 showed that nine of them already had adequate capital. In June 2009 the White House declared that financial regulatory reform would be a top priority alongside healthcare reform, promising greater oversight and increased transparency in financial markets, as well as a new consumer protection agency. But what was most remarkable was how little the Obama administration intended it to disrupt the regulatory status quo. There was no move to place absolute limits on the size of bank holding companies or to change the nature of the private rating system, let alone to reinstate Glass–Steagall. Yet with Goldman Sachs’ net income surging to a record $13.4 billion for the year, while unemployment remained at 10 per cent, Obama’s frustration at the political costs of this – which were hardly mitigated by Goldman’s promise to reduce its annual bonus pool from $22 billion to $16 billion, and to donate $500 million to charities – led the president to propose two new measures in January 2010. One was a ‘Financial Crisis Responsibility Fee’ to be paid by the largest banks; the other was to prohibit ‘proprietary trading’ by deposit-taking banks (that is, using their own capital to speculate as well as operate their own hedge funds), a reform prominently associated with Volcker.

Expressing his irritation over ‘the activities of lobbyists on behalf of those institutions’ against such measures, Obama proclaimed that he ‘did not run for office to be helping out a bunch of fat cat bankers’; he warned the bankers that now that the banks were ‘back on their feet we expect an extraordinary commitment from them to help rebuild our economy’ (Fifield Reference Fifield2009). This served to present the minor reforms he was advancing in a way that led to misleading headlines such as ‘Obama declares war on Wall Street’ and ‘Banks face revolutionary reform’. It also obscured the fact that the Federal Reserve and the Treasury shared a distinct lack of enthusiasm for even such a modest reform as the responsibility fee, since it could further limit lending by banks and complicate the conduct of monetary policy. They recognized too that isolating banks’ own proprietary trading would be very difficult, since this practice was so closely related to the trades in stocks, bonds and derivatives they carried out for their clients. Indeed, the integration of commercial and investment banking on a global scale now made any return to the New Deal type of regulation virtually impossible. Even Volcker spoke not in terms of reviving Glass–Steagall but only of returning to its ‘spirit’.

In fact, the new regulations introduced under the Obama administration conformed to the regulatory regime that had facilitated the immense growth of US and global financial markets since the 1970s: ‘failure containment’, more than ‘failure prevention’, was still the operative doctrine, with the goal being less to save any given financial institution than to limit the systemic financial risk that might be caused by its insolvency, and to take macro and micro prudential measures that would limit the scope of bank failure and make containment possible. The Federal Reserve and Treasury’s response in the wake of the crisis was not so much to alter the direction of financial regulation as to close off some of the more glaring loopholes and remove some of the deficiencies of the existing system. The Wall Street Reform and Consumer Protection Act, passed into law in July 2010, was largely based on drafts by Federal Reserve and Treasury staff, although its proposals were given tremendous political fillip by the way senators Chris Dodd and Barney Frank arranged a merger between Senate and House versions of the legislation. Dodd–Frank (as the Act came to be known) established a new Financial Stability Oversight Council (composed of various regulatory agencies, including the Federal Reserve and chaired and advised by the Treasury) which limited the Federal Reserve’s ability to lend directly to financial firms in trouble by preventing it from extending credit other than through programmes with ‘broad-based eligibility’.

While the Act narrowed the Federal Reserve’s emergency lending powers that had drawn so much popular ire, the practical impact of the legislation was to give the Federal Reserve a considerably expanded role in supervising and regulating not only the big banks but also the big hedge funds and insurance companies. All those with assets exceeding $50 billion, deemed ‘systemically important financial institutions’ (SIFIs), would be subjected to greater scrutiny by the Federal Reserve. The higher capital adequacy requirements were carefully constructed so as not to undercut the competitive advantages enjoyed by large financial firms. The hype about Dodd–Frank’s prohibition of proprietary trading (‘the Volcker rule’) was largely negated by the numerous exceptions it specified, and in effect left it to the Federal Reserve to impose greater capital requirements and some broadly defined limits on these activities. Dodd–Frank allowed the Federal Reserve to preserve its key interventionist tools as well as the room to develop new ones. Broadening the Federal Reserve’s regulatory remit over the financial system was, as we have seen, precisely the direction in which the American state had been heading for more than two decades.

Potentially more important in terms of a new direction was the regulation of derivative transactions. Although towards the end of the Clinton administration the Treasury and Federal Reserve had combined to prevent this, the Obama administration made it a key aspect of its legislative agenda. By May 2009 it had set out a plan to require standardized derivatives to be centrally cleared along the lines of the Chicago Mercantile Exchange, with financial safeguards and comprehensive oversight. The leading derivative dealers, despite having resisted such a move for two decades, were now prepared to support this for reasons that were ‘not entirely defensive’ since it was ‘in the long-term material interest of the derivatives industry given the economic costs experienced during the crisis’; their main concern was for ‘a form of regulation that was flexible and which delegated the details and implementation to the private sector’ (Helleiner and Pagliari Reference Helleiner and Pagliari2010: 85–6). Nor did the plan upset the largest Wall Street banks such as Goldman Sachs, JP Morgan Chase or Morgan Stanley, which were confident that they could dominate the clearing-houses (Story Reference Story2010). In the event, Dodd–Frank’s provisions on derivatives regulation largely left it to the regulators to work out the details. It did not take long before the Treasury announced that the most commonly used derivatives, foreign exchange swaps and ‘forwards’ – ‘a vital tool of business’ used to hedge against fluctuations in currency values – would be exempt from the rules because an ‘additional process’ of regulation ‘could have serious negative economic consequences’ on global trade and capital flows (US Department of the Treasury 2011).

As the Federal Reserve went through yet another phase of what it saw as ‘institutional learning’, perhaps the most important innovations occurred in the conduct of monetary policy, as it moved to a very different system of monetary policy management, one based for the first time on paying interest on the reserves that banks held at the Federal Reserve. By manipulating the spread between its ‘interest on reserves’ (IOR) rate in relation to market rates, the Federal Reserve now had greater capacity to influence the aggregate quantity of reserves, and to direct liquidity to specific sections of the banking system, with the goal of reducing systemic risk in the interbank market. The centrepiece of this new system, of course, was the practice that came to be known as ‘quantitative easing’. At the same time, the continued attention that the Federal Reserve attached to monitoring Wall Street firms was seen when the Federal Reserve institutionalized the Comprehensive Capital Analysis and Review, which required the 35 biggest banks to prepare and submit annual plans ‘to ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks and that permit continued operations during times of economic and financial stress’ (US Federal Reserve 2011). Also significant was the New York Federal Reserve’s new Financial Institutions Supervisory Group, whereby some 150 of its staff (projected to increase to 300, and supported by many hundreds of others working inside the Federal Reserve) were directly placed inside big Wall Street firms to participate in crafting as well as monitoring their internal risk strategies. This was separate from the broader group of Federal Reserve field examiners, which climbed to 1,948 by 2011 (up 40 per cent from 2006) and the 500 staff from the Treasury’s Comptroller of the Currency, who also worked on location in big banks (Lucchetti Reference Lucchetti2011). This meant that Federal Reserve officials would virtually become integrated with the management structure of these firms, including their boards of directors. The further development of state capacity that all this entailed was designed to address ‘too-big-to-fail’ in a way that strengthened large diversified financial institutions and thereby reinforced the central role they played in integrated financial markets.

Through all this, it could certainly not be said that the state was literally ‘captured’, in the sense of being told what to do by the Wall Street banks, let alone by other derivatives dealers or the ratings agencies. What it revealed, rather, was the American state’s structural dependence on these dominant market actors. In fact, the Treasury and Federal Reserve were genuinely concerned with strengthening their own capacities to manage the effects of systemic financial volatility and to establish new measures to stabilize large diversified financial firms. Offering a remarkably clear example of the relative autonomy of the state, Geithner addressed the issue head-on at a meeting of bankers from 27 countries organized by the American Bankers’ Association in Atlanta in June 2011. In making the case for ‘tougher rules to limit risk and leverage in individual institutions’ as well as ‘shock absorbers that are critical to limiting catastrophic risk in modern financial systems’, Geithner articulated the state’s central challenge in making financial markets flourish in the wake of the crisis:

The challenges that the Treasury has faced in playing this coordinating role have endangered what the G20 leaders called the ‘sense of commitment and common purpose’ among their finance ministries and central banks. The ‘Commitment to an Open Global Economy’ they issued as their communiqué when the leaders of the G20 states were summoned to Washington for the first ever meeting, in the last months of the Bush administration, underscored ‘the critical importance of rejecting protectionism and not turning inward’, as had happened after the 1929 crash. A main international goal of the Treasury throughout the Obama administration involved renewing this commitment, which it largely succeeded in doing. It was not the newly developing capitalist states nearly as much as the incapacity of those in Europe to cope with the eurozone crisis effectively that has been seen as posing the greatest danger to global capitalism. Particularly frustrating was the limited extent to which the European Central Bank was prepared to act as lender of last resort. Behind this lay a frustration with the European states themselves. The Federal Reserve’s provision of liquidity to US financial institutions was undertaken with one eye to their passing that liquidity to Europe through the interbank market. The Treasury was intimately involved in policy discussions, directly as well as through the International Monetary Fund, with Geithner frequently phoning and even flying over to meet European finance ministers (this involved 168 meetings or phone calls in all between January 2010 and June 2012), ‘pressing Europe to take more decisive action’ (Barker and Speigel Reference Barker and Speigel2011).

To be sure, leading capitalists and officials in the US itself as well as elsewhere have certainly been concerned about how the conflict between Congress and the Obama administration would affect the global crisis. The CEO of Caterpillar, the world’s largest manufacturer of construction and mining equipment, called Washington’s debt ceiling saga in the summer of 2011 not only ‘ugly’ but also ‘a red herring’ which got in the way of Congress’s ratification of outstanding free trade agreements, as well as much-needed domestic infrastructure programmes (Weltzman Reference Weltzman2011). The Federal Reserve’s Ben Bernanke (Reference Bernanke2011), noting that Congress had ‘disrupted financial markets’, warned that ‘similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses’. Yet, although it was precisely on these grounds that the credit rating agency Standard & Poor’s downgraded US Treasury bonds, what was especially remarkable was that the appetite for these bonds, even at record low interest rates, far from abating, increased. Ruminations about an alternative reserve currency went nowhere, especially as the smouldering crisis in Europe’s interbank markets burst into flames, sending the widespread earlier expectations that the euro would challenge the dollar up in smoke.

When in his 2013 State of the Union Address President Obama chastised Congress for ‘conducting its business by drifting from one manufactured crisis to the next’, he was implicitly addressing how much this could get in the way of the Treasury’s role in ‘failure containment’. The spectre he was raising had already appeared during the debt ceiling saga in the summer of 2011, when even China was spurred to remind the US of its unique responsibilities for ‘the world’s economic soundness’ given its status as ‘the world’s largest economy and the issuer of the dominant international reserve currency’. It warned that ‘political brinkmanship in Washington is dangerously irresponsible . . . It risks, among other consequences, strangling the still fragile economic recovery of not only the United States but also the world as a whole’ (BBC News 2011). Such frictions with Congress are nothing new, of course. The baptism of fire Robert Rubin went through as soon as he became Treasury secretary at the beginning of 1995 was in good part related to Congress refusing – with a Democratic majority at the time – to ante up the American portion of the international bailout Rubin orchestrated to stem the Mexican peso crisis. Given his acute awareness of how deeply a Mexican default would have affected Wall Street, Rubin (Reference Rubin2003: 25) said he understood Congressional resistance as ‘meant to oppose us without actually stopping us’. This conflict reflects the internal contradiction which the American state faces between acting as both the state of the United States, and as the ‘indispensable’ state of global capitalism. But what is indeed remarkable about the deep partisan gridlock in Washington that characterized the Obama presidency is that it has not undermined the American state’s practice of its central role in global failure containment.