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Elements of Novelty, Known


Mechanisms, and the
Fundamental Causes of the
Recent Crisis
a
Alberto Russo
a
Department of Economics and Social Sciences,
Università Politecnica delle Marche (Italy)
Published online: 07 Dec 2014.

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To cite this article: Alberto Russo (2014) Elements of Novelty, Known Mechanisms,
and the Fundamental Causes of the Recent Crisis, Journal of Economic Issues, 48:3,
743-764

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JOURNAL OF ECONOMIC ISSUES
Vol. XLVIII No. 3 September 2014
DOI 10.2753/JEI0021-3624480308

Elements of Novelty, Known Mechanisms, and the Fundamental


Causes of the Recent Crisis

Alberto Russo

Abstract: This article briefly describes the evolution of the recent economic crisis
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based on different theories toward my own interpretation of it. The deregulation


wave of the last decades has created new profit opportunities in various contexts —
from labor flexibility to privatization and from financialization to globalization — so
promoting a renewed process of capitalist accumulation after the stagflation of the
1970s. This has taken place at the cost of a wide-ranging increase in inequality and
instability, thus bringing a cascade of crises, including the latest one of 2008.

Keywords: capitalist accumulation, deregulation, globalization, financial


instability, financialization, inequality

JEL Classification Codes: E66, P17, G01

An economic transaction is a solved political problem …


Economics has gained the title Queen of Social Sciences by
choosing solved political problems as its domain.
— Abba Lerner (1972, 259)

The separation of economics from politics and political


motivation is a sterile thing. It is also a cover for the reality of
economic power and motivation. And it is a prime source of
misjudgment and error in economic policy.
— John K. Galbraith (1987, 299)

Financial innovations and the originate-and-distribute scheme of risk management


have been among the key elements of novelty introduced in recent decades. Another
relevant innovation has been the removal of financial segmentation. These
“innovations” (in many cases, legislative changes toward deregulation) allowed the
implementation of increasingly risky financial transactions, and a consequent increase
of financial profits. At the same time, the complexity of financial products made the
risk-yield nexus more opaque, and the spread of risk across operators increased

Alberto Russo is an assistant professor of economics in the Department of Economics and Social Sciences at Università
Politecnica delle Marche (Italy).

743

©2014, Journal of Economic Issues / Association for Evolutionary Economics


744 Alberto Russo

financial fragility and systemic risk. This destabilized the financial system and
eventually led to its collapse. Moreover, in recent years, monetary policy lowered
interest rates, thus leading to excessive risk-taking and indebtedness. It is worth noting
that excessive risk-taking may be due to high — rather than low — interest rates, as
suggested by the “adverse selection” model of credit markets (Stiglitz and Weiss 1981).
Risk-taking and, in particular, household debt-to-income ratios increased throughout
the 1980s, 1990s, and 2000s, at very different interest rate levels. So, the level of
interest rates per se does not seem to provide a sufficient explanation of excessive risk-
taking and rising debt-to-income ratios. Alternative explanations, in a context of
growing inequality, are based on the “relative income hypothesis of
consumption” (Duesenberry 1949; Frank 2007; Levine et al. 2010; Setterfield 2013).
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Therefore, other factors may play a major role such as, for instance, “financial
deregulation.” Thus, the savings-and-loans crisis in the late 1980s in the US was a
consequence of financial deregulation during a period characterized by high interest
rates. At the same time, the low level of real interest rates during the 1960s and 1970s
did not lead to excessive risk-taking and over-indebtedness in a context of much more
tightly regulated financial markets. However, starting from the collapse of the U.S.
subprime mortgage market in 2008, the “financial crisis” spread throughout the
world, generating a global recession.
Although financial innovations were at the root of it, the recent financial
collapse — and the real aspect tied to the “Great Recession” — has much in common
with previous crises. A known mechanism at the base of financial crises is the Minskian
pro-cyclicality of credit and debt-to-income ratios. According to a Kindleberger-Minsky
perspective, the trigger of the crisis may be an event such as “financial liberalization.”
In general, money and finance play a fundamental role in generating unstable
economic dynamics in an uncertain environment. In a Keynesian perspective,
regulation is needed in order to manage the macroeconomy and to avoid a crisis (or,
at least, to hasten the exit from it). But the crisis can be also considered an inevitable
event of the “cyclical development,” according to alternative theoretical approaches.
For example, in Schumpeterian “creative destruction” or in a Marxian perspective, the
destruction of capital resulting from the “contradictions” of capitalist development
creates the conditions to restore the accumulation process. Therefore, the recent
episode may be interpreted not just as a “financial crisis,” but as an event due to “real
causes” such as the lack of aggregate demand, the fall of profit rates, excessive
exploitation and over-accumulation of capital, and so on. But different mechanisms
and their interaction lead to alternative explanations.
According to my view, the fundamental causes of the recent crisis are tied to the
deregulation cycle inaugurated in the 1980s, largely in the US and UK. The political
decisions implemented in the last decades have created new profit opportunities in
various contexts, thereby boosting a renewed process of capitalist accumulation after
the crisis of the 1970s. This process has taken place at the cost of a wide-ranging
increase of inequality and instability, thus generating a cascade of crises (both at the
national and international level), including the most recent one. In a sense, the
“financial crisis” is the most visible manifestation of a deeper problem due to “real
Fundamental Causes of the Recent Crisis 745

causes.” As will be shown below, advanced countries experienced a decline of profit


rates from the 1950s to the late 1970s, then partially recovered based on market
deregulation, global relocation of production, and financial liberalization. In a
nutshell, the post-WWII “material expansion” (which was characterized by relatively
high growth rates of the real GDP in advanced economies) reached a limit. The
deregulation wave that followed, based on a new political course, allowed a partial
recovery of profit rates by compressing wages (because of labor market flexibility,
outsourcing, imports from developing countries, and so on) and counteracting the
resulting lack of aggregate demand (related to growing inequality) through “financial
expansion.” This, in turn, allowed households to keep up with consumption habits
(consumer credit, subprime mortgages, and etc.), and rentiers to find profitable
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opportunities in the financial markets.


Meanwhile, new economies emerged as the center of a “material
expansion” (characterized by relatively high growth rates of real GDP) that allowed
rich countries to import low-value-added commodities at low prices. Moreover,
advanced countries provided some of the capitals that financed the global relocation
of production. Multinational firms played a central role in this process (e.g.,
Walmart). International financial liberalization permitted the growing of current
account deficits (such as the US’s) based on a capital flow from net exporters (such as
China). However, the emergence of global imbalances and the dependency of national
economies on external financing (capital can exit a country as fast as it entered it, thus
resulting in a balance-of-payment crisis) made the international financial system more
unstable and prone to crises. Accordingly, I think that the current crisis is linked to
the underlying movements of capitalist accumulation (from the financialization of
advanced economies to the gradual shift of the world economy’s center to China and
other emerging countries), as well as to its functioning as a monetary production
economy and its political dimension.

The Recent Evolution of the Crisis: A Sketch

According to many authors, the collapse of the U.S. subprime mortgages market has
been the “epicenter” of the most recent global financial crisis. When the Fed
increased the policy rate, after a period of “low” interest rates, a rise of the subprime
mortgage delinquency rate followed, while the growth of real estate prices ceased. In
the summer of 2007, some of the primary financial institutions in the US and in
Europe declared huge losses due to the bad performance of the housing market, and
the lack of confidence diffused worldwide. Until the middle of 2008, however, the
instability had been limited to monetary and financial markets, without strongly
affecting the real side of the economy. Moreover, monetary policy interventions
implemented by central banks (quantitative easing, interest rate declines, bailouts in
collaboration with the governments, etc.) partially mitigated the financial turmoil,
counteracting the effects of a “liquidity crisis.” As a consequence, some economists
maintained that the effects of the crisis would remain confined to the financial
sphere.
746 Alberto Russo

The Lehman Brothers’ default in September 2008 resulted in a serious


deterioration of the crisis, while confidence among operators fell sharply. From this
episode on, the “real economy” began to go down. In a context of high uncertainty,
the lack of confidence caused a vicious circle of reduced propensity to lend money
and deleveraging at different levels: from interbank markets to lending to firms and
households. Hence, a “credit crunch” reduced investments, production, and
subsequently employment in various sectors and countries around the world. All in
all, after September 2008, the financial meltdown transformed into a “global
economic recession.” Beyond the details that distinguish the varied positions of
economists, a consensus has emerged on the understanding of recent events as a vast
financial crisis with heavy real effects. But this is not my interpretation (or that of a
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consistent number of economists proposing alternative analyses).


Central banks and governments have countered the worsening of the crisis by
putting significant liquidity into their economies. As a consequence, the balance
sheets of central banks have expanded, and the deficits and public debts of many
countries have risen remarkably (resulting in a large socialization of private losses).
The political choice of implementing austerity (that is, cutting public expenditures and
raising taxes), particularly in the periphery of the Euro area, is based on the
assumption that the level of public debt is “excessive.” For instance, Carmen Reinhart
and Kenneth Rogoff (2010) suggested that higher levels of public debt on GDP harm
economic growth. In particular, for a ratio higher than 90 percent, economic growth
turns to be negative. Consequently, the solution for more growth should be reducing
the incidence of public debt on GDP. But this result is based on coding errors and a
questionable manipulation of data. When properly calculated, the average real GDP
growth rate for countries carrying a public debt on GDP ratio higher than 90 percent
is actually 2.2 percent and not –0.1 percent. In general, there is a wide range of GDP
growth performances at every level of public debt for different countries (Herndon,
Ash and Pollin 2013). This is in accordance with the “functional finance” view of
Abba Lerner (1943) that the public debt on the GDP ratio is not an especially relevant
number from a macroeconomic perspective.1
In the Euro area, public debt is a problem because member states are no longer
sovereign in the sense that they no longer control their currency. Indeed, countries
that are monetary sovereigns, such as the US, the UK, and Japan, have default-proof
public debt, because their debt is payable in a currency that (the central banks of)
those countries may create without limit. In fact, the problem of excessive foreign
deficits seems to have an even greater importance, as in the Euro area, given that this
depends on trade imbalances due to marked differences in competitiveness. Indeed,
after the introduction of the euro, the divergence in the performances of member
countries resulted in growing surpluses in core countries and large deficits in

1
“The unfounded assumption that current interest on the debt must be collected in taxes springs
from the idea that the debt must be kept in a ‘reasonable’ or ‘manageable’ ratio to income (whatever that
may be). If this restriction is accepted, borrowing to pay the interest is eliminated as soon as the limit of
‘reasonableness’ is reached, and if we further rule out, as an indecent thought, the possibility to printing
the money, there remains only the possibility of raising interest payments by taxes” (Lerner 1943, 48).
Fundamental Causes of the Recent Crisis 747

peripheral ones. For instance, Germany’s inflation rate is usually lower than that of
peripheral countries. With a fixed exchange rate among member states, price
movements led to a variation of the real exchange rate that reflects the higher
competitiveness of Germany compared to the periphery of the Euro area.2
The current fiscal policy tightening (and that announced for the near future),
especially in the Euro area, makes a deepening of the crisis more likely (even though
peripheral countries are reducing their current account deficits or are even in surplus,
especially because of less imports). In the meantime, monetary policy is expansive and
unconventional measures have been implemented as a quantitative easing (QE)
strategy, while the policy rate is at zero lower bound. After the collapse caused by the
“financial crisis,” there has been an increase of equity prices,3 while economic growth
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is feeble and unemployment remains high — especially in the Euro area, where
countries are committed to reducing public indebtedness and moving toward
balanced government budget. All in all, it does not seem that policy interventions are
solving the main problems of the latest crisis.
However, while “advanced economies” faced a vast financial and economic crisis
(followed by an alarming rise of unemployment as well as public deficit and debt),
after a minor deceleration, “emerging economies” have continued to grow at high
rates in an international context characterized by global imbalances. Evidently, the
current tendency of many advanced economies towards a recessionary phase can have
negative impact on the growth performance of exporters like China and other
emerging countries. A deceleration of these countries may, in turn, have serious
implications for advanced economies, hence generating a vicious circle of a long crisis.
At the same time, the recession and austerity policies intended to curb it have resulted
in an adjustment of current accounts (mainly due to reduced imports) in the
Eurozone’s periphery. Given that the core (e.g., Germany) continues to run a current
account surplus, the Euro area as a whole is becoming a net exporter. This evolution
in the Euro area may have negative repercussions for global demand, as noted by the
U.S. Treasury (2013). However, as indicated below, the significant gap between the
growth rates of Western and Eastern economies has deep roots, and suggests that the
crisis is related to the changing geography of the global capital-accumulation process.
In addition to “globalization” (considered not as a new phenomenon, but rather with
respect to the specific characteristics of the recent historical phase), I will stress the

2
Moreover, core countries (with current account surpluses) financed peripheral countries (with
current account deficits) through capital movements, as trade imbalances developed. When uncertainty
increased as a consequence of the “financial crisis,” and confidence fell down, there was a “flight-to-quality”
episode, with financial capital leaving the periphery to go back to the core, thus resulting in an increase of
the periphery vs. core spread on government bonds. The announcement by Mario Draghi that the
European Central Bank would do “whatever it takes” to save the euro (in particular, the Outright Monetary
Transactions program) resulted in a remarkable decrease of spreads, so stressing the relevance of monetary
policy in managing the crisis and public debt dynamics (although the ECB cannot directly buy government
securities on primary markets, and can operate only on secondary markets).
3
Although stock markets are performing well, and equity prices have grown in recent years, the
impact of ultra-low interest rates and unconventional monetary policy on asset prices (and the housing
market) is still inconclusive (Dobbs et al. 2013).
748 Alberto Russo

role of “financialization” in creating the conditions for the latest crisis during the
neoliberal era.4

Elements of Novelty

Many problems resulted from the diffusion of financial innovations, from subprime
mortgages to the various structured products, and financial derivatives. On the basis
of the originate-to-distribute scheme (instead of the traditional originate-to-hold one),
financial risk has spread among different operators and countries through a complex
network of connections. The removal of the segmentation of credit and financial
markets (that was introduced in many countries after the vast destruction of the Great
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Depression) has amplified this tendency. Moreover, a “shadow banking system” has
been created to collect risks off-balance sheet to avoid the constraints of the remaining
regulation. In general, financial institutions have increased the complexity of financial
products (which has made more opaque the risk-yield relationship) and financial
interconnections, with a subsequent increase of systemic risk.5
Many authors have highlighted the role of “bad regulation” of financial markets
in provoking the crisis. According to this interpretation, regulation has not been able
to assure orderly market conditions, allowing (or even supporting) excessive
speculation.6 In the US, for instance, the Gramm-Leach-Biley Act — also known as the
Financial Services Modernization Act of 1999 — removed the separation of
investment banking and insurance from commercial banks, based on the supposition
that the “segmentation” of financial markets introduced by the Glass-Steagall Act of
1933 was obsolescent. In fact, it is likely that this deregulation act paved the way to
the growing dominance of “too big to fail” banks or SIFI (strategically important
financial institutions).7 Moreover, during the Clinton Administration (with the
Commodity Futures Modernization Act of 2000), it was also decided to keep
derivatives out of the regulatory control of the Commodities Future Trading
Commission, thus allowing credit default swaps (CDSs) to be completely deregulated.8

4
According to Gerald Epstein (2005, 3), financialization can be defined as “the increasing role of
financial motives, financial markets, financial actors and financial institutions in the operation of domestic
and international economies.”
5
Excessive risk may be interpreted as a negative externality — due to a social return of financial
activities smaller than the private one, which has caused a failure of financial markets. Hence, one solution
for this problem could be a tax on financial activities in order to internalize the negative external effect.
6
According to André Orléan (2009), the financial meltdown was not due to the fact that the rules
have been circumvented, but to the fact that they were followed.
7
For a description of the political process that led to the enactment of the Financial Services
Modernization Act, and paved the way to the emergence of largely unregulated diversified financial
institutions, see Sandra Suárez and Robin Kolodny (2011). According to L. Randall Wray (2011), under
“money manager capitalist,” the economic system is characterized by highly leveraged financial institutions
seeking maximum returns in an environment that systematically underprices risk. With little regulation or
supervision of financial institutions — contrary to orthodox economic theory — markets generate perverse
incentives for excess risk.
8
According to Christopher Brown and Cheng Hao (2012), the CDS is implicated in the financial
crisis because, by enabling agents to safely increase leverage, it causes a system-wide buildup of financial
Fundamental Causes of the Recent Crisis 749

Now regulators are trying to modify the institutional context by revising old rules or
introducing new ones. The general approach has been to fight market complexity with
regulation complexity. For example, as noted by Andrew Haldane (2012), Basel I
agreement was only thirty pages long, while Basel II was 347 pages, and Basel III was
616 pages. But, in such a complex environment as the financial system, the
introduction of complex rules can be ineffective. “Because complexity generates
uncertainty, not risk, it requires a regulatory response grounded in simplicity, not
complexity” (Haldane 2012, 24).
Monetary policy has been indicated as a contributory cause to the crisis
(“Greenspan put”). “Low” interest rates have supported excessive risk-taking and
speculation through growing indebtedness, leading the system to financial
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unsustainability. When the Fed raised the policy rate, the financial system collapsed,
starting with the U.S. subprime mortgage market. Now the “monetary policy easing”
is supporting financial systems, although this effort is failing to revamp the real
economy. Indeed, unemployment rates remain high in advanced countries9 — despite
the high flexibility of labor markets — and a prolonged recession phase seems likely.
All in all, the elements of novelty were introduced in the wake of the
deregulation wave promoted by neoliberal policies (which I will further analyze when
discussing the fundamental causes of the crisis).10 These innovations triggered the
mechanisms underlying the working of the economic and financial system. However,
different mechanisms are tied to alternative theories, and then to different
understandings of the crisis.

Known Mechanisms

A mechanism that usually generates a financial crisis is the pro-cyclicality of credit


(Minsky 1982), where the leverage increases in expansionary phases (operators become
less risk-averse in “good times”) and decreases in recessions (agents become more risk-
averse in “bad times”). Consequently, a lower risk perception in expansions leads to
more indebtedness, thus increasing the “financial fragility” of the system.
Consequently, the economy endogenously evolves towards a critical stage of financial
instability, and a crisis follows.11

fragility. Indeed, the proliferation of CDSs may lead to an improvement of credit availability, but the
“reliance on debt to sustain consumption causes the deterioration of household financial conditions,
driving the system inexorably toward a Minsky moment” (Brown and Hao 2012, 310).
9
In the US, the unemployment rate has decreased remarkably, from 10 percent in 2009–2010 to
around 7.0 percent in 2013. But, in the same period, the labor force participation rate decreased from 66
to less than 63 percent.
10
The idea of deregulation cycles and the analysis of its consequences are not novel per se. For
seminal works on the economics of regulation, deregulation cycles, and related price movements, see
George Stigler (1963, 1971). My aim is to incorporate the evolution of such cycles into the recent
macroeconomic context.
11
As noted above, in the Kindleberger-Minsky perspective, an event that can trigger a crisis by hitting
a financially fragile system is “financial liberalization.”
750 Alberto Russo

Some authors have proposed a mathematical representation of such a


mechanism. For instance, the “financial accelerator” (Bernanke et al. 1998) is a shock-
amplifying process based on the anti-cyclicality of the risk (external-finance) premium.
In this perspective, financial factors have an important impact on business cycles, and
a “financial crisis” may have significant effects on real variables (production,
employment, etc.). In general, the contributions of new Keynesianism may explain the
real effect of financial problems, when financial markets are characterized by
asymmetric information (Greenwald and Stiglitz 1993).12
One of the major flaws of mainstream economic theory (in particular, I refer to
macroeconomics based on neoclassical microfoundations) derives from the idea of
reducing the complexity of aggregate phenomena to the behavior of a single
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representative agent (capable of optimizing its objective function, under some


constraints, across an infinite time horizon). Instead, according to Marcello de Cecco
(1990), the peculiarity of macroeconomics as the study of the system as a whole clearly
emerges from John Maynard Keynes’ theory. In this regard, Keynes argued “that
important mistakes have been made through extending to the system as a whole
conclusions which have been correctly arrived at in respect of a part of it taken in
isolation” (Keynes, 1936, xxxii). Some recent contributions in the field of agent-based
computational economics move in this direction and study macroeconomic
phenomena as emergent properties of a complex system. For instance, going beyond the
representative-agent hypothesis, Domenico Delli Gatti et al. (2010) proposed an
analysis of financially driven fluctuations in a “heterogeneous interacting agents”
framework. In this context, even a small shock can lead to large fluctuations as, for
instance, the contagion of financial distress may cause bankruptcy avalanches. In fact,
the failure of borrowers to fulfil debt commitments worsens lenders’ financial
conditions, as a result of which some agents may go bankrupt and a “snowball effect”
can develop with significant consequences for the overall economy. This mechanism
can be described as a “network-based financial accelerator,” according to which the
depth of a crisis depends both on the financial fragility of the system and the
complexity of financial interconnections. Consequently, one should consider systemic
risk, which is due to the evolution of complex financial networks, among the factors
that affect monetary policy decisions (see, for instance, Trichet 2009).
In the historical perspective proposed by Charles Kindleberger and Robert
Balibar (2005), the mechanism of Hyman Minsky is useful in describing the typical
evolution of financial crises. Indeed, the authors’ thesis is that the cycle of panic
results from the pro-cyclical changes of credit. The increase of leverage and debt-to-
income ratios conducts the economy toward a critical state of financial fragility.
“Minsky argued that the events that lead to a crisis start with a ‘displacement,’ some
12
Given the policy rate set by the central bank, the variations of the risk premium affect the level of
interest rates. However, the level of interest rates does not seem to be a sufficient factor to explain excessive
risk-taking and the increase of debt-to-income ratios. Moreover, the relationship between the policy rate and
long-term interest rates (which would have a relevant impact on the aggregate demand) is not so clear
(Stiglitz and Greenwald 2003). Finally, in a post-Keynesian perspective, the interest rate has no relevant
impact on aggregate demand and growth, and it can be considered as an exogenous distribution variable
(Lavoie 1995).
Fundamental Causes of the Recent Crisis 751

exogenous, outside shock to the macroeconomic system” (Kindleberger and Balibar


2005, 25). In some cases, the trigger of a crisis is “financial liberalization,” such as in
the 1980s in Japan and the Nordic countries (Kindleberger and Balibar 2005). One
could add the wave of financial deregulation of the last decades as tied to the latest
crisis.13 Moreover, agents’ financial memory is short and, as time elapses, the memory
of past crises vanishes, and the system may again become crisis-prone. Then, when a
new episode happens, it is widely believed that “this time [it] is different” (Reinhart
and Rogoff 2009). However, in the post-Keynesian analysis of Minsky, the financial
sector is a central channel of instability. A way to reduce instability is by downsizing
finance with respect to the whole economic system. Such an intervention should
reverse the tendency towards “the production of financial profits by means of
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financial profits” as an activity increasingly disconnected from the “real economy.”


But, according to my vision, this is not sufficient to overcome the crisis because this
does not resolve all the problems arising from “fundamental causes,” as shall be seen
below. However, Minsky’s theory of financial instability certainly plays an important
role in explaining the crisis when considered as a mechanism coupled with the other
aspects of capitalist accumulation (Palley 2010).
According to a Keynesian perspective, money and finance play a fundamental
role in generating instability and crises. With “high uncertainty,” economic decisions
(in particular, entrepreneurial investment choices) are taken on the basis of
unpredictable (incalculable) risk. As a consequence, imitation may emerge as a rational
strategy, especially in financial markets, leading to conventional behavior (Keynes
1937). In a period of turmoil, agents’ confidence falls and the “preference for
liquidity” goes up. Given that in a monetary production economy capitalists aim at
accumulating wealth, when they believe that the safest way to store up and increase
wealth is to take no further positions in producible capital goods but to hold money
and near monies instead — that is, things that can be produced with a minimal use of
real resources — an unemployment crisis develops (Graziani 2003). Then, restoring
the confidence in the economic and financial system is fundamental, but this requires
comprehending the causes at the root of the crisis, and a political change in the
course of economic growth through macroeconomic regulation.
In a Marxian perspective, the expansion of the financial sector, the increasing
role of credit to sustain consumption, labor market flexibility, outsourcing and
offshoring, and privatizations, among others, are all factors that allowed a recovery of
the capitalist accumulation process — by counteracting the post-WWII decline of the
profit rate, which culminated in the stagflation of the 1970s. As stressed by Gerard
Duménil and Dominique Lévy (2002), the profit rate of major capitalist countries
declined to a considerable extent following WWII — particularly from the 1960s
onward14 — and this decline was a crucial factor of the structural crisis of the 1970s.

13
For a recent and extensive analysis of the Kindleberger-Minsky perspective on financial crises,
which discusses three different patterns of speculative bubbles, see Barkley Rosser, Jr., Marina Rosser, and
Mauro Gallegati (2012).
14
“In most countries and sectors since the 1960s, there appears to have been such a decline, most
pronounced in the manufacturing sectors” (Chan-Lee and Sutch 1985, 7).
752 Alberto Russo

The tendency of the profit rate to decline was only interrupted in the early 1980s,
when an upward trend emerged resulting in a partial recovery.15 According to Duncan
Foley (2012), this crisis was due to “the tendency for the rate of profit to fall,”16 while
the recent one (as well as the Great Depression) is rather the consequence of a rising
rate of exploitation (counteracting the long-run tendency of the profit rate to fall), and
of the increasing difficulty faced by societies in managing a large and growing surplus
value, with great demands on the financial system to recycle it. According to
Deepankar Basu and Ramaa Vasudevan (2011), who proposed a decomposition
analysis of the U.S. profit rate, the recent crisis had not been preceded by a prolonged
period of declining profitability, but rather by a period of rising profitability due to a
favorable trend in both profit share and technology.17 As a matter of fact, after a
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period, during which the profit rate recovers, the countervailing tendencies eventually
lead to instability. Indeed, at some point, the contradiction between the individual
goal of maximizing profits (“micro”) and the collective one (“macro”), consisting of
the valorization of capital, will give rise to an inevitable crisis. In recent years, this has
been due to extreme inequality, financial instability, and global imbalances. The
financial collapse is the most apparent manifestation of a more general crisis, due to
fundamental causes, whose realization has been postponed and amplified by financial
factors.

Fundamental Causes

In recent decades, a progressive decline of the labor share has occurred in advanced
economies (about 10 percent in Europe and Japan, and 3-4 percent in Anglo-Saxon
countries since 1980), especially in unskilled sectors (IMF 2007, chapter five). Among
the possible causes are the following: skill-biased technological change; labor market
reforms (aimed at increasing “flexibility,” especially in some European countries);
national and global relocation of production through outsourcing and offshoring;
migrations, import of commodities from low-cost countries (tied to a strong rise of the
global labor supply); and others.18 In fact, the decrease of the labor share (combined

15
As for the decline of the profit rate in the US, its value in 1982 fell by more than 50 percent
compared to the decade 1956–1965. The decline involved all sectors, with the exceptions of a quite specific
set of industries denoted as “highly capital intensive industries,” such as railroads. As for its recovery since
1982, the profit rate recovered less than half the total decline by 2000 (Duménil and Lèvy 2002).
16
On the decline of U.S. profits and the successive recovery in the 1980s, both at the aggregate and
sector levels, see also Fred Moseley (1991), Merih Uctum and Sandra Viana (1999), and Alan Freeman
(2009).
17
The critical factor emerging from their analysis is that the run-up of the crisis was characterized by
a sharp decline of capital productivity due to increasing capital intensity from 2000 onward, while labor
productivity continued to rise.
18
“Changes in labor market policies have had a positive effect on the labor share in Anglo-Saxon
countries, but a much more modest effect on average in Europe, particularly in large European economies
where labor policies are estimated to have actually contributed to a decline in the labor share” (IMF 2007,
177). In particular, “labor globalization has negatively affected the share of income accruing to labor in
advanced economies (the labor share). … Rapid technological change — especially in information and
communication sectors — has had a bigger impact, particularly on the labor share in unskilled sectors” (IMF
2007, 180).
Fundamental Causes of the Recent Crisis 753

with a decrease of public expenditure and downsizing of the welfare state) may reduce
effective demand in a context of growing inequality. Actually, consumer credit and
other forms of indebtedness prevented this from happening for a while, but at the
cost of an increasing financial instability and the concomitant big crisis. By contrast,
in a period of labor flexibility and decentralization — characterized by a declining
bargaining power of unions — the profit share increased. According to Foley (2012),
the expansion of financial markets allowed a vast recycling of the surplus value which
followed the “excessive exploitation” of the neoliberal decades.
Contrary to the Keynesian principle that public intervention is needed to
regulate a highly uncertain economic environment with inadequate self-adjusting
properties, the political choices at the basis of deregulation during the last decades have
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promoted a general tendency towards liberalization and privatization. The aim is to


reduce the “intrusiveness” of the public sector in private affairs, resulting in new
profit opportunities for private capitals in various contexts (from infrastructures to
public services, education, and so on).19 Starting from the US and UK, the political
process of deregulation has gradually eliminated the rules which had been created
after the Great Depression (in other European countries the process has been slower,
following European directives). Deregulation boosted financial profits, but also
generated some crises in “core-country” of the world economy (e.g., Wall Street in
1987, savings and loans in the 1980s and 1990s, the New Economy bubble, and the
subprime mortgages crisis in 2008). At the same time, the deregulation of the
international financial system opened new investment channels (“globalization of
finance”) at the cost of rising global instability (especially due to short-run speculative
operations), from which various crises have followed. Moreover, the flow of capital as
foreign direct investments (FDIs) supported a global industrial reorganization
(“globalization of production”) based on the mounting importance of Eastern
economies in “traditional” sectors (due to low-cost production).20 In the meantime, a
decline of manufacturing and a rise of services and finance occurred in Western
economies.21

19
Two famous statements at the basis of the neoliberal ideology underlying the post-1970s political
process of deregulation are the following: “In this present crisis, government is not the solution to our
problems; government is the problem” (President Ronald Reagan 1981). “They’re casting their problem on
society. And, you know, there is no such thing as society. There are individual men and women, and there
are families” (Prime Minister Margaret Thatcher 1987).
20
“Real wages (corrected for purchasing power) have been converging rapidly and are relatively high
in Asian countries that started developing earlier (Hong Kong SAR, Korea, Singapore, and Taiwan
Province of China). Wages in other Asian countries, including China, have been converging at a slower
pace, though this has accelerated in recent years” (IMF 2007, 169).
21
As Bruce Greenwald and Judd Kahn (2009) note, the manufacturing share of GDP in the US
(more than 30 percent in 1950) has changed from 27 percent in 1970 to 18 percent in 1990, and to 16
percent in 2000, following an evidently declining trend. Meanwhile, the share of services (9.0 percent in
1950, 13 percent in 1970, 19 percent in 1990, and 22 percent in 2000) as well as of finance, insurance, and
real estate (9.0 percent in 1950, 11 percent in 1970, 17 percent in 1990, and 20 percent in 2000) increased,
mainly due to productivity growth. In this perspective, automation, and not globalization, is the major
factor responsible for job losses in both manufacturing and lower-level services. According to Greenwald
and Kahn (2009), a similar transition from agriculture to manufacturing was at the basis of the Great
754 Alberto Russo

Focusing on the U.S. macroeconomic trends since the 1960s, Till van Treeck
(2009) shows that some of the main changes occurred after the 1970s. Relative to the
two sub-periods — to and since the early 1980s, I summarize these findings as follows:
First, income inequality was relatively low and roughly stable, then it drastically
increased to levels comparable to the 1920s. Second, the personal net-worth-to-income
ratio was relatively stable or slightly decreasing, and then strongly increased. Third,
the personal savings rate was relatively high and slightly increasing, and then
drastically declined, reaching negative values for the first time since the early 1930s.
Fourth, the personal debt-to-income ratio was relatively low and roughly stable, and
then drastically increased. Fifth, non-financial corporations retained a large and
roughly stable fraction of their net profits, and then they heavily increased the
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dividend-payout ratio. Sixth, the growth rate of net capital stock displayed cyclical
movements around a relatively high trend, and then showed an overall declining
trend with the exception of the “new economy” boom of the 1990s. Seventh, the
contribution of net new equity issues to the financing of fixed capital investment by
non-financial corporations was small but positive, and then became negative and very
large in absolute value. Eight, firms’ debt-to-capital ratio was relatively low, and then
increased.
The post-1970s deregulation wave increased inequality and indebtedness, both
for households and firms, promoting a broader role for finance in the working of the
economy.22 For instance, in the US, the financial corporations’ pre-tax profit rose
from an average of 13.9 percent of all corporate profits in the 1960s to 25.3 percent
in the 1990s, and 36.8 percent in the period 2000–2006.23 In general, from the 1970s
to the 1990s, there was an increase of the share of national income received by
financial institutions and financial wealth holders in the majority of OECD countries
(Epstein and Jayadev, 2005).24
Furthermore, “individual workers and households have been led into the
financial system with regard to both borrowing and holding financial assets. The
retreat of public provision in housing, health, education, pensions, and so on, has
facilitated the financialization of individual income, as have stagnant real wages. The
result has been the extraction of financial profits through direct transfers of personal
revenue, a process called financial expropriation” (Lapavitsas 2010, 25). Based on
systematic misinformation due to the increasing complexity of financial products and
the opacity of the yield-risk relationship in a context of strong uncertainty, the growth

Depression of the 1930s due to a productivity increase in the primary sector, and the subsequent sectoral
dislocation then was solved by public expenses and WWII (see also Delli Gatti et al. 2012).
22
“The tight regulations forced the financial sector to concentrate on promoting capital
accumulation in the nonfinancial sector. Starting in the 1970s activity in financial markets and the profits
of financial institutions began to rise relative to non-financial activity and profits” (Kotz 2008, 4).
23
Data from U.S. Bureau of Economic Analysis presented in David Kotz (2008).
24
The entire working of financial markets changed in recent decades. “[T]he financial sector
gradually shifted from loan-based financing of the nonfinancial sector to more market-based and more
speculative activities” (Kotz 2008, 16). Specifically, “banks have turned toward mediating transactions in
open markets, thus earning fees, commissions and trading profits. They have also turned toward individuals
in terms of lending and handling financial assets” (Lapavitsas 2010, 24-25).
Fundamental Causes of the Recent Crisis 755

of profits has been boosted by a process of financial expropriation directly out of


personal income.
The financialization of nonfinancial corporations during the 1980s and 1990s
in the U.S. economy is now a well-documented phenomenon. “This is apparent in the
sharp rise of their financial income and in the increased holding of financial assets
from the 1980s onward” (Duménil and Lévy 2004, 100). As highlighted by Ozgur
Orhangazi (2007), before financialization clearly materialized in the 1980s and 1990s,
James Tobin (1965) maintained that real and financial investments could be
substitutes because, when financial assets offer higher returns than real activities,
more resources will be directed to finance, resulting in a crowd-out of real
investments.25 According to William Lazonick and Mary O’Sullivan (2000), the
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financialization of nonfinancial corporations is characterized by a shift from a “retain


and reinvest” strategy to a “downsize and distribute” strategy. That is, management
strategies have changed focusing more on the maximization of shareholder value and
less on long-term growth. In fact, the profit share increase of recent decades has been
accompanied by the stagnation of real investment and a sharp increase in interest
payments, dividend payments, and stock buybacks (also mergers and acquisitions may
be considered).
Engelbert Stockhammer (2004) confirms that over the past decades the financial
investment of nonfinancial corporations has been rising, while the accumulation of
capital goods has been declining. According to the author, the “shareholder
revolution” and the development of a market for corporate control have shifted
power to shareholders, thus changing management priorities with a reduction of
growth rates. An analysis of the time series of aggregate investment for the US, UK,
France, and Germany shows that financialization has been responsible for a slowdown
of accumulation (particularly for the first three countries). Gerard Duménil and
Dominique Lévy (2005) reach similar results, according to which the growth rate of
real capital accumulation depends on that of retained profits — that is, profit after
interest and dividend payments — which have diminished in recent decades.
According to William Milberg and Deborah Winkler (2010), who conducted an
empirical study on U.S. manufacturing and services industries over the period 1998–
2006, offshoring is associated with a higher share of corporate profit in total value
added.26 Offshoring significantly increased profit shares in various U.S. sectors, but

25
Using data from a sample of nonfinancial corporations from 1973 to 2003, Orhangazi (2007)
finds a negative relationship between real and financial investment. From this firm-level investigation, it
emerges that two aspects of financialization may have negative consequences on real investment, especially
in the case of large firms. First, high financial profit opportunities result in higher financial investment,
leading to a decline of real capital accumulation. Second, increased financial payments leave firms with
fewer funds to invest and shorten the planning horizon of firms’ management.
26
Offshoring has been a winning strategy for U.S. corporations facing price competition in product
markets. To maintain profits, firms have extended their global production chains, thus bringing costs under
control. But “the potential dynamic gains of offshoring associated with reinvestment of the higher profits it
brings have not fully realized. To the extent that corporations have become financialized — mainly through
an increase in dividend payments and share repurchases, but also with increased merger and acquisition
activity and large executive compensation packages involving stock options — this has diminished the
capture of dynamic gains of offshoring” (Milberg and Winkler 2010, 277).
756 Alberto Russo

there has been a shift in the use of these profits. Firms reduced their spending on
plant and equipment and expanded their spending aimed at immediately increasing
shareholder value.27
All in all, a picture emerges, according to which, financialization has been a
fundamental factor in the recovery of profits from the 1980s onward in leading
capitalist economies, as well as a phenomenon involved in a slowdown of real capital
accumulation. Indeed, “the evidence suggests that a growing share of the financial
system actually slows overall economic growth” (Cecchetti 2012). Not surprisingly, the
average growth rate of advanced countries during the neoliberal decades was lower
than in the post-WWII “regulated capitalism.”28 Meanwhile, real capital accumulation
based on the expansion of production and trade has been faster in Asian countries,
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starting from Japan and following with the “Asian tigers,” China, and India (Table 1).
However, in recent decades the expansion of credit has prolonged the
development of some countries, although it has especially boosted financial profits.
But the ascent of finance in a period of difficulty for the real economy may signal an
uncertain future for economic development. According to Marcello de Cecco (2007),
one of the finding of Keynesian analysis is that an “excess of finance” may lead to the
collapse of a capitalist economy, and that financialization has emerged as a
characteristic of economic systems more likely in periods of decline than of ascent in
the economic history of various countries.
Following the French economic historian Fernand Braudel (1984), the
expansion of finance may be seen as a “sign of autumn” of a country which has
reached a maturity stage in its process of economic development. According to
Giovanni Arrighi (1994), a financial expansion occurs when the material expansion of
productive forces reaches its limits. In this sense, “financial capitalism” is not a
specific phase of capitalist development, nor is it its final stage. Rather, financial
capitalism is a recurrent phenomenon involved in the critical phases of reorganization
and enlargement of world capitalism, during which the center of the accumulation
process tends to move to another location.
Arrighi (1994) identified four overlapping systemic cycles of accumulation (as
sequences of two phases — first a material expansion and then a financial expansion),
each lasting a “long century”: the Genoese-Iberian cycle (fifteenth-early seventeenth
centuries), based on the alliance between the territorial power of Spain and the capital

27
Moreover, as Duménil and Lévy (2004) point out, the profit rate on U.S. direct investment abroad
(that is treated as a financial asset in flow of funds accounts) has been significantly higher than the global
profit rate of the nonfinancial corporations (the average values over the period 1958–2000 are 14.5 and 8.0
percent, respectively).
28
“Comparative study of advanced countries has demonstrated the presence of financialization in
general but has also revealed variation arising from institutional, historical and political factors” (Lapavitsas
and Powell 2913). It is worth noting that, as the tendency toward financialization developed, economic
growth was relatively stronger in those countries where financialization was relatively pronounced (such as
in the US and UK) than in less financialized countries (like Germany and Japan). In a globalized world
characterized by growing inequality, the stagnation of aggregate demand has led to two growth models, a
debt-led model and an export-led model, with the possibility to run large current account deficit allowed by
international financial deregulation (Stockhammer 2013).
Fundamental Causes of the Recent Crisis 757

power of Genoese capitalists; the Dutch cycle (late sixteenth-late eighteenth centuries),
based on the expansion of the United Provinces and the commercial and financial
power of Amsterdam; the British cycle (mid eighteenth-early twentieth centuries),
based on the material expansion following the Industrial Revolution and the growing
importance of London as an international financial center; and the U.S. cycle (from
the late nineteenth century to the latest financial expansion).29 Then, the autumn of
the leading capitalist organization is also the springtime of another location: The crisis
of the 1970s — the “spy-crisis” of U.S. hegemony — signaled the transition from the
material to the financial expansion in the leading capitalist economy. The recent
period of turmoil could be considered the “terminal crisis” of U.S. hegemony, while a
new center of capital accumulation is developing in East Asia — particularly in China
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(Arrighi 2007).30

Table 1. The Post-WWII Growth Performance of Major Economic Areas

Countries 1950–1959 1960–1969 1970–1979 1980–1989 1990–1999 2000–2006


United States
United States 1.74 3.40 2.50 2.41 1.95 1.30
Europe
France 3.46 4.71 2.83 1.72 1.19 0.97
Germany 8.49 3.55 2.91 1.73 1.54 0.79
Italy 6.14 6.17 3.09 2.14 1.13 0.78
UK 1.87 2.20 2.23 2.69 1.88 1.87
Japan
Japan 8.50 12.26 3.55 3.36 0.75 1.19
NIC
Hong Kong 3.64 7.06 7.20 6.23 2.18 3.77
South Korea 4.55 6.63 9.81 9.51 5.34 3.96
Singapore –0.15 7.16 8.84 4.88 4.69 2.31
Taiwan 4.51 7.25 9.70 8.13 6.18 2.53
BRIC
Brazil 3.29 2.25 6.00 0.05 0.93 0.78
Russia 2.91 3.24 1.61 1.06 –4.05 7.59
India 1.58 1.21 0.31 3.53 4.10 5.33
China 5.32 0.77 3.35 7.29 6.90 10.97
World
World economy 2.67 3.08 2.06 1.37 1.33 2.81

Source: Author’s elaborations of Angus Maddison’s (2006) data.


Notes: Per capita growth rates are in PPP according to the value of “Geary-Khamis” 1990 international dollar. In
regard to Russia, I refer to the territories of the former USSR.For each column, the three highest rates are in bold.

29
According to Minqui Li, Feng Xiao, and Andong Zhu (2007), the sequence of the systemic cycles
of accumulation are related to the long-term movement of the profit rate in the capitalist economy.
30
This would not be a real news from a historical point of view, given that the intercontinental trade
during the sixteenth and seventeenth centuries was especially characterized by a huge flow of silver from the
West to the East — from the Americas to Europe, and then to China and other countries of Southeast Asia
— and a corresponding flow of commodities in the opposite direction — Asian manufactured goods to
758 Alberto Russo

In recent decades, after major market-oriented reforms, China has followed a


development process based on a mix of international openness and protection
(controlling the external value of its currency and capital movements — generally
accepting FDIs and not short-term speculative investments). In a sense, China has
benefited from the advantages of globalization “without globalizing itself too much.”
However, this is not an entirely new strategy in a historical perspective (Bairoch 1993;
Landes 1998), and it has important theoretical and political bases, such as for
example, John Stuart Mill’s “infant industry,” Friedrich List’s “national system of
political economy,” and Alexander Hamilton’s “report on manufactures.”
Endogenous growth theory has partially rediscovered these aspects, stressing the
relevance of particular industries and/or factors, such as R&D and human capital,
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and the need to specialize in the “right” sectors to improve long-run performances.
Moreover, the control on short-term speculative investments has protected China
(and some other Asian countries) from the consequences of the 1997 crisis. For
instance, Joseph Stiglitz (2002) maintains that the gradualism in the transition to a
market-oriented environment has been a winning strategy for some countries, while
one of the major causes of the Asian crisis has been deregulation that occurred too
fast.
All in all, the so-called global imbalances emerged as a consequence of the
penetration of China and other emerging economies in global markets. As a result,
capitalist accumulation has expanded eastward following the profitability of low costs
of production,31 and benefiting from capital flows leaking out from the West (FDI,
MNEs, etc.). This is a process initiated by the same political decisions that have
gradually deregulated and financialized advanced economies and the international
system.
On this basis, the recent crisis has been interpreted as a phenomenon which was
due to the underlying movements of capitalist accumulation shaped by political
choices. In coming years, a further enlargement of the capitalism’s “container” (in
Braudel’s terms) may follow, resulting in the incorporation of other less developed
economies in the global process of capitalist accumulation, including Latin America
and some African countries. In a sense, this is in line with Rosa Luxemburg’s idea
that, since its earliest days, capitalism has lived — and could only live — by expanding
into surrounding non-capitalist space (Luxemburg in Sweezy 1997).32 Indeed, the
evolution of emerging economies toward more advanced productive specializations
(with an increasing role of knowledge and scientific research, and rising cost of
production, wages included) would need a new periphery from which to import raw

Europe and European manufactured goods to the Americas. Therefore, the silver from the Americas was
used to settle the trade deficit that Europe had with the East (Cipolla 1976).
31
For a comprehensive discussion on the geographical aspects of capital accumulation and the crisis,
see David Harvey (2010).
32
Obviously, the space on earth is limited and the expansion of capital accumulation has a natural
limit. Therefore, the exhaustion of space would lead the capitalist system to a final crisis, from which there
would be no escape. See Luxemburg ([1951] 2003) on this interpretation as well as a comprehensive
discussion of the globalizing process of capitalist development and its limit.
Fundamental Causes of the Recent Crisis 759

materials, intermediate products, and generally commodities produced with lower


labor cost. This process would result in a reconfiguration of the international division
of labor, hierarchically structured around the new center of world capitalism. But a
long multi-polar phase would precede this outcome, and the transition to a new global
order would be characterized by great instability. It is worth noting that the current
tendency of many advanced economies toward recessions can have relevant negative
effects on the growth performance of exporters like China and other emerging
countries. A deceleration of these countries may, in turn, have serious implications
for advanced economies, thereby causing a vicious circle of extended crises.
The financial dominance of Western countries in the international system tends
to delay their relative economic decline. However, this financial dominance may not
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last long if the performance of their real economies continues to be weak, while the
East is growing at double-digit rates.33 For reasons explained above, and mainly
because capital accumulation has become a highly financialized process, a drastic
revision of financial rules could even worsen the outlook for advanced countries by
reducing financial profits, unless there is a radical change in the political course.

Conclusions

Since the 1980s, the deregulation cycle has led to a renewed process of capital
accumulation based on labor flexibility, production decentralization, privatization,
globalization, and financialization. After the post-WWII decline of profit rates
culminated in the stagflation of the 1970s, the countervailing tendencies triggered by
neoliberal policies resulted in a partial recovery of profitability. But due to the typical
working of capitalist development, the same elements at the basis of capital
accumulation — causing in this case growing inequality, financial instability, and
global imbalances — gave rise to massive crises, only the most recent episode of the
neoliberal era.
In my view, the expansion of credit and finance postponed the crisis, only to
amplify its effects, producing a severe financial collapse as its more apparent
manifestation. In the meantime, the geography of the global process of capital
accumulation continues to change based on the ascent of emerging economies (where,
due to global deregulation, capital from advanced countries gets high returns, in
addition to financial speculation). In other words, while Western countries suffer the
damages resulting from the excesses of the last decades’ financial belle époque, the
center of the global accumulation process tends to move eastward.
In this perspective, the crisis consists of a destruction of capital required to
restore the conditions of profitability for capitalist development. The question is

33
A relevant precedent is Britain’s progressive decline as a manufacturing producer and exporter
between the late nineteenth century and the beginning of the twentieth century, as well as “its increasing
dependence on the world market for import of foodstuffs and raw materials and its Empire as an outlet for
its exports” (De Cecco 1975, ix). Accordingly, what continued to support Britain’s central role in the
international financial system for a while concerned more political power than economic advantages.
760 Alberto Russo

whether the recent destruction has been sufficient in this sense, or the deepening of
the current instability (also due to the neoliberal recourse to austerity measures)
portends that the next crisis is not far away. Indeed, a long period of crisis may be
expected when a fundamental change of the global process of capitalist accumulation
is in progress, as was the case with the long crisis of late nineteenth century, the Great
Depression of the 1930s, and the crisis of the 1970s. Today, the goal of austerity seems
to be the entrenchment of the neoliberal course34 through an increase in
unemployment, which further weakens the working classes, cuts public spending, and
limits the welfare state. Austerity, however, has had little impact on the underlying
causes of the latest economic turmoil, ranging from the dominance of finance to huge
inequality.
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